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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 333-50475
KMC TELECOM HOLDINGS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 22-3545325
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
(INCORPORATION OR ORGANIZATION)
1545 ROUTE 206, SUITE 300
BEDMINSTER, NEW JERSEY 07921
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
Registrant's telephone number, including area code: (908) 470-2100
SECURITIES REGISTERED PURSUANT TO SECTION
12(b) of the Act:
None
SECURITIES REGISTERED PURSUANT TO SECTION
12(g) of the Act:
None
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. [X] Yes [ ] 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
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [X].
The aggregate market value of the voting common stock held by
non-affiliates of the registrant as of March 24, 1999 was approximately
$34,450,780, based upon an estimate of the fair value thereof by management of
the registrant. There is no established trading market for the voting common
stock of the registrant and no sales have occurred within the past sixty days.
As of March 24,1999, 852,676 shares of the registrant's Common Stock, $0.01
par value, were outstanding. There is no established trading market for the
Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE. None.
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CAUTIONARY STATEMENT REGARDING FORWARD - LOOKING STATEMENTS
STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K THAT ARE NOT PURELY
HISTORICAL ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF
THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF
1934, INCLUDING STATEMENTS REGARDING THE COMPANY'S EXPECTATIONS, HOPES,
INTENTIONS OR STRATEGIES REGARDING THE FUTURE. FORWARD-LOOKING STATEMENTS
INCLUDE: STATEMENTS REGARDING THE ANTICIPATED DEVELOPMENT AND EXPANSION OF OUR
BUSINESS, THE MARKETS IN WHICH OUR SERVICES ARE CURRENTLY OFFERED, OR WILL BE
OFFERED IN THE FUTURE, ANTICIPATED CAPITAL EXPENDITURES AND REGULATORY REFORM,
THE INTENT, BELIEF OR CURRENT EXPECTATIONS OF THE COMPANY, OUR DIRECTORS OR
OFFICERS WITH RESPECT TO OUR FUTURE FINANCIAL PERFORMANCE AND OTHER MATTERS, AND
OTHER STATEMENTS REGARDING MATTERS THAT ARE NOT HISTORICAL FACTS. ALL
FORWARD-LOOKING STATEMENTS IN THIS REPORT ARE BASED ON INFORMATION AVAILABLE TO
THE COMPANY AS OF THE DATE THIS REPORT IS FILED WITH THE SECURITIES AND EXCHANGE
COMMISSION, AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE ANY SUCH
FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM THOSE EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS
INCLUDE, BUT ARE NOT LIMITED TO, THE FACTORS SET FORTH IN "ITEM 7. MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS --
CERTAIN FACTORS WHICH MAY AFFECT THE COMPANY'S FUTURE RESULTS."
PART I
ITEM 1. BUSINESS.
BACKGROUND
The initial predecessors of KMC Telecom Holdings, Inc. were founded in 1994
and 1995, respectively, by Harold N. Kamine, the Company's Chairman of the
Board. These predecessors were merged in 1996 and renamed KMC Telecom Inc. KMC
Telecom Holdings, Inc. was formed during 1997 primarily to own, directly or
indirectly, all of the shares of its operating subsidiaries, KMC Telecom Inc.,
KMC Telecom II, Inc., KMC Telecom III, Inc., and KMC Telecom of Virginia, Inc.
The principal equity investors in the Company currently include Mr. Kamine,
Nassau Capital Partners, L.P., Newcourt Capital, Inc., CoreStates Holdings, Inc.
(an affiliate of First Union National Bank), General Electric Capital
Corporation and Lucent Technologies, Inc.
COMPANY OVERVIEW
The Company is a facilities-based competitive local exchange carrier
providing telecommunications and data services in Tier III Markets (population
from 100,000 to 750,000). The markets in which we operate are predominately
located in the Southeastern and Midwestern United States. We target business,
government and institutional end-users, as well as Internet service providers,
long distance carriers and wireless service providers. Our objective is to
provide our customers with a complete solution for their communications needs.
We currently provide on-net local dial tone, special access, private line,
Internet access, ISDN and a variety of other advanced services and features.
We currently operate in twenty-three Tier III Markets. We have constructed
robust fiber optic networks in each of our markets, typically of 25 to 35 miles
in length, which we believe allow us to insure quality services, facilitate the
delivery of value-added and enhanced services, and effectively control our
costs. We currently have Lucent Technologies Series 5ESS(R)-type switches in
commercial operation in twenty-two of our existing markets. We intend to install
a Lucent switch in our remaining existing network no later than the second
quarter of 1999. We also intend to install Lucent switches in any future
networks which we may build. Over time, we expect to transition the majority of
our customers to our own networks by means of either unbundled network elements
leased from the incumbent local exchange carrier (i.e. the established local
telephone company, such as Bell Atlantic, BellSouth, Ameritech or one of the
subsidiaries of GTE Corporation) or direct connections to our own networks.
We presently plan to construct networks in approximately ten additional
Tier III Markets. We currently anticipate that these new networks will be
completed and placed in commercial operation by the end of the second quarter of
2000.
BUSINESS STRATEGY
The principal elements of our business strategy include:
FOCUS ON TIER III MARKETS. We intend to operate in Tier III Markets. We
believe that incumbent local exchange carriers tend to focus their efforts on
larger markets and generally underserve and underinvest in Tier III Markets. We
also believe that there is generally significantly less competition from other
facilities-based competitive local exchange carriers in Tier III Markets, which
allows us to gain market share more rapidly than we could expect to in Tier I
and Tier II Markets. A facilities-based competitive local exchange carrier is
one which operates its own network, including switching equipment and
transmission lines, rather than one which resells the services of others
utilizing the network of the incumbent local exchange carrier. In addition,
network construction is less expensive in Tier III Markets than in Tier I and
Tier II Markets. Generally, labor costs and the costs of obtaining rights of way
are lower in Tier III Markets. Further, many Tier III Markets permit significant
aerial deployment of fiber optic cable which is less expensive than the buried
deployment required in many Tier I and Tier II Markets. We estimate that
approximately 70% of our fiber is deployed aerially. We target markets which we
believe offer attractive demographic, economic, competitive and demand
characteristics. We select target markets from among the approximately 250 Tier
III Markets in the United States by first identifying those markets that do not
yet have significant, established competitors to the existing incumbent local
exchange carrier, and by then reviewing the specific demographic, economic,
competitive and telecommunications demand characteristics of such markets to
determine their suitability for the types of services which we offer. We
estimate market demand on the basis of the concentration of potential business,
government and institutional end-user customers in the market and the general
economic prospects for the area.
EARLY TO MARKET ADVANTAGE. We strive to be the first facilities-based
competitive local exchange carrier in a geographic area to actively market and
provide services. We believe that by effecting early entry into Tier III Markets
with a facilities-based strategy, we will be able to limit significant
competition from other competitive local exchange carriers which may focus on
Tier III Markets where no competitive local exchange carrier has yet established
operations, although we can give no assurance in this regard.
COMPREHENSIVE FIBER NETWORKS. We build geographically extensive, full
service, facilities-based networks. We believe such networks provide greater
operating leverage, facilitate the capture of market share, and are likely to
deter other competitive local exchange carriers from attempting to penetrate our
markets due to the cost of constructing a competing network of equal capability.
Prior to both the initial construction of our network backbone and any
subsequent network expansion, we perform detailed rate of return analyses to
justify the capital expenditures involved. In each of our existing twenty-three
markets, we have completed our backbone construction connecting the market's
central business district with outlying office parks, large institutions, the
locations of long distance carriers' transmission equipment and major incumbent
local exchange carrier central offices. In addition, we intend to continue to
expand our existing networks in response to anticipated customer demand.
LOCAL PRESENCE. We intend to capture and retain customers through
effective local, personalized sales, marketing and customer service programs. To
this end, we:
o establish sales offices in each market in which we operate a network,
o strive to recruit our city directors and sales staff from the local
market,
o rely principally on a face-to-face selling approach, and
o support our sales staff with locally based customer service and
technical support personnel.
Most of our existing sales personnel are local residents who have previously
worked for the incumbent local exchange carrier or other telecommunications
companies. We believe that our "Creative Solutions with a Hometown Touch"(TM)
sales approach is very important to customers in Tier III Markets, who do not
typically receive focused local sales contact or customer support from the
incumbent local exchange carrier. We seek to build long-term relationships with
our customers by responding rapidly and creatively to their telecommunications
needs.
FOCUS ON VALUE-ADDED ENHANCED SERVICE.S We believe it is strategically
important to offer these services because:
o they are a competitive differentiator,
o they provide a substantial margin opportunity,
o the incumbent local exchange carriers' prices for these services are
relatively high and are regulated,
o incumbent local exchange carriers have underinvested in facilities and
sales force related to these services, and
o we are able to offer these services without a significant marginal
cost.
LOW COST CONSTRUCTION. It is our practice to use innovative
"switch-in-a-box" construction and deployment techniques for many of our
networks. Using these techniques, transmission, switching and power equipment
are pre-installed by Lucent Technologies, Inc. under controlled factory
conditions in portable, weatherproof, storm-proof concrete buildings delivered
to the Lucent facility by our contractor. The completed buildings are then
shipped to the appropriate city for final installation, reducing costs,
installation risks and time to market.
QUALITY OPERATIONS SUPPORT SYSTEM. We are developing a high quality
operations support system to provide us with comprehensive billing, order
processing and customer care software for all existing and contemplated services
we will market. This system is designed to provide us with a single
"flow-through" order form that will entail several components, allowing each
order to be tracked from service provisioning through to complete installation.
We believe that this system will allow us to quickly address customer concerns
and provide us with a competitive advantage in customer service and operations
efficiency.
EXPERIENCED MANAGEMENT TEAM. The Company's management team includes
individuals with over 250 years of experience, collectively, in the
telecommunications industry. It is led by Harold N. Kamine, Chairman of the
Board of Directors, and Michael A. Sternberg, the Company's President and Chief
Executive Officer. Other members of the team include Roscoe C. Young II, Chief
Operating Officer, James D. Grenfell, Executive Vice President, Chief Financial
Officer and Secretary, and James L. Barwick, Senior Vice President-Technology.
SERVICES
GENERAL. We have historically provided dedicated access service and have
also resold switched services which we purchased from incumbent local exchange
carriers. In December 1997, we began providing our own on-net switched services
to our customers. For 1997 on-net switched services accounted for 32% of our
revenue and resale services accounted for 68% of our revenue. For 1998 on-net
switched services accounted for 37% of our revenue and resale services accounted
for 63% of our revenue.
PRIVATE LINE AND SPECIAL ACCESS SERVICES. We currently provide various
types of on-net dedicated service which permit the transmission of voice and
data between two points over circuits dedicated to the requirements of a
particular customer. Private line service involves the provision of a private,
dedicated telecommunications connection among different locations of the same
customer. For these services we offer several types of dedicated circuits that
have different capacities. DS-1 and DS-3 circuits are dedicated lines that can
carry up to 24 and 672 simultaneous voice and data transmissions, respectively.
Special access service involves the leasing, to long distance carriers, of
private, dedicated telecommunications lines running along our networks. The long
distance carriers use these lines to connect different locations where they have
installed transmission equipment within the market, to connect locations where
they have installed transmission equipment to the transmission equipment
locations of other long distance carriers within the market, or to connect large
customers directly to the locations of their transmission equipment. For these
services we offer OC3, OC12 and OC48 circuits. These OC-N services provide the
fastest transmission available for carriers and large business users.
SWITCH-BASED SERVICES. We have added and continue to add capability to
provide local dial tone services and switched access origination and termination
services to our networks. Switches are currently in commercial operation in
twenty-two of our existing markets and we expect to have a switch in commercial
operation in our remaining existing network no later than the second quarter of
1999. Over time, we expect to transition the majority of our customers to our
own networks by means of either unbundled network elements leased from the
incumbent local exchange carrier or direct connections. We have entered into
interconnection agreements with incumbent local exchange carriers for all of our
existing networks.
ISDN. ISDN, or integrated services digital network, is an internationally
agreed upon standard which, through special equipment, allows two-way,
simultaneous voice and data transmission in digital formats over the same
transmission line. ISDN permits videoconferencing over a single line, for
example, and also supports a multitude of value-added networking capabilities.
This service targets sophisticated business customers whose applications require
integration of services such as Internet access, video, voice or other
communications services, including high speed data transfer. By integrating
multiple applications, customers receive increased capability and may not have
any increase in costs to achieve that capability. The principal purchasers of
this service are currently Internet service providers.
LONG DISTANCE. We offer a full range of long distance products including
inter-LATA, intra-LATA, interstate, international, calling card and 800-number
services. During the first quarter of 1999, we plan to introduce KMC-branded
operator services, directory services and prepaid phone cards. We offer these
services both on-net and off-net. We offer long distance services on a resale
basis by entering into wholesale agreements with various long distance carriers
to deliver these services. We believe that many of our customers will prefer the
option of purchasing long distance services from us as part of a one-stop
telecommunications solution.
CENTREX-TYPE SERVICES. We intend to provide Centrex-type services. By using
Centrex-type services instead of a PBX (which requires the customer to purchase
and install a switching system on its own premises), customers can substantially
reduce their capital expenditures and the fixed costs associated with
maintaining a PBX network infrastructure. We currently plan to introduce our
ClearStarsm Advantage service in all of our operational markets during the first
quarter of 1999. It has been designed to support multiple applications, ranging
from basic access services to services focused on desktop applications. The
basic access service will connect to a customer's key system or PBX and will be
equipped with up to 14 features including call forwarding, speed dialing and
call transfer capabilities. More sophisticated levels of service are designed to
replace customers' existing key systems or PBXs. At the high end of service
offerings is ClearStarsm Advantage Plus, a packaged, end-to-end offering which
combines all of the basic features with Basic Rate ISDN network access, advanced
feature functionality, voice messaging and third party-provided ISDN electronic
terminal sets.
NEW ENHANCED DATA SERVICES OFFERINGS. We introduced ISDN services in late
1998. We currently plan to expand our capabilities by introducing additional
enhanced data services in 1999. We believe that these services will enhance our
ability to provide an integrated turnkey solution to our customers' voice, data
and video transmission requirements. These enhanced services will include:
o BASIC RATE ISDN. Basic Rate ISDN, or BRI, provides customers the
potential of 144 kilobits of digital communications via a single network
facility interface. We believe it will be attractive to small and medium
size customers, since it provides dial-up access to the Internet, and other
dial-up data applications, while simultaneously providing the ability to
integrate voice traffic on a single network facility.
o PRIMARY RATE ISDN. Primary Rate ISDN, or PRI, provides customers the
equivalent of 1.544 megabits of digital communications via a channelized
T-1 type facility, with 23 bearer channels for voice and data
communications and a 24th channel providing network signaling and control
for the services. We focus our PRI sales efforts on (i) Internet service
providers who use Primary Rate ISDN as a means of supporting customer
access to their operations, and (ii) end-user customers who use Primary
Rate ISDN as a network access facility for PBXs and other premise-based
switches.
o PORT WHOLESALE. Port wholesale terminates a switched data call
directly in our central office on behalf of an Internet service provider
(for end-user Internet access) or other corporate customer (for employee
remote access). As a result, it eliminates the need for an Internet service
provider or other corporate customer, which has many customers or employees
accessing its system via modems, to maintain an equally large number of
modems to permit interface, since that function is performed directly in
our central office. Although port wholesale technology is still under
development, we believe it will prove very attractive once the technology
is generally available.
o HDSL. HDSL is a method of using unconditioned, copper wire pairs for
high bit rate data transport for use in the "last mile" connecting our
network backbone ring to the customer's premises. We plan to utilize HDSL
to provide high bandwidth data and video service to small and medium size
customers.
o FRAME RELAY/ATM. Frame relay and ATM are used by some of our data
customers as a fast data transport service for wide area networks. Today we
resell these services. In the future we intend to provide these services
over our own network and utilize a third party provider for transport
outside our network.
o CLEAR STARSM ADVANTAGE PLUS. This service provides a customer with
Centrex-type functionality from our central office switch to each of the
customer's desktops. It is a packaged, end-to-end offering which provides a
combination of Basic Rate ISDN network access, advanced Centrex feature
functionality, voice messaging, ISDN terminal sets and support for premise
wiring configuration.
We plan to remain flexible in responding to evolving customer demands for
enhanced data services.
LOCAL NETWORKS
As part of determining the economic viability of a network in a particular
market, we review the demographic, economic, competitive and telecommunications
demand characteristics of the market. We estimate market demand using data
gathered from long distance carriers, the Federal Communications Commission,
local sources, site visits and specific market studies commissioned by the
Company, on the basis of the concentration of potential business, government and
institutional end-user customers and the general economic prospects for the
area.
Once we target a market for development, we design a network to provide
access to approximately 70% of the business customers in that market, either
through direct connections to our network or through unbundled network elements
leased from the incumbent local exchange carrier. Typically, we construct a
25-35 mile "self-healing" synchronous optical network ("SONET") architecture
backbone ring to provide coverage of the major business districts, government
offices, hospitals, office parks and universities, the principal locations of
the transmission equipment of long distance carriers offering services in the
area, and the incumbent local exchange carrier's central office(s). Following
construction of our backbone network, we expect to build additional loops to
increase the size of our addressable market.
The following table presents information, as of February 28, 1999,
concerning our existing twenty-three networks:
EXISTING NETWORKS
ADDRESSABLE DS-0
COMMERCIALLY ROUTE COMMERCIAL ACCESS EQUIVALENT
LOCATION OPERATIONAL(1)(6) MILES(2)(6) BUILDINGS(3) LINES(4) DEDICATED LINES(5)
- - -------- ----------------- ----------- ------------ -------- ------------------
Huntsville, AL.................... November 1997 99 1,286 13,954 40,928
Baton Rouge, LA................... November 1997 38 1,774 3,696 5,880
Shreveport, LA.................... December 1997 26 1,126 7,261 12,760
Corpus Christi, TX................ December 1997 49 1,105 5,804 2,713
Savannah, GA...................... December 1997 43 1,069 6,176 1,112
Madison, WI....................... December 1997 41 1,322 2,719 11,009
Augusta, GA....................... March 1998 37 1,023 5,910 2,911
Melbourne, FL..................... May 1998 45 2,184 2,290 6,517
Greensboro, NC.................... September 1998 25 1,900 673 -
Winston-Salem, NC................. September 1998 24 1,208 1,344 -
Tallahassee, FL................... October 1998 29 1,032 922 97
Roanoke, VA....................... November 1998 22 981 989 6
Ann Arbor, MI..................... December 1998 23 1,355 559 28
Topeka, KS........................ December 1998 38 847 534 1,368
Fort Wayne, IN.................... December 1998 27 1,411 902 144
Eden Prairie, MN.................. December 1998 94 3,509 295 -
Daytona Beach, FL................. December 1998 31 1,114 629 23
Fort Myers, FL.................... December 1998 23 814 509 1,344
Longview, TX...................... December 1998 31 688 150 -
Sarasota, FL...................... December 1998 24 1,200 1,670 48
Pensacola, FL..................... December 1999 31 1,463 2,089 -
Fayetteville, NC.................. December 1999 23 822 26 -
Norfolk, VA....................... Second Quarter 1999 149 2,505 - -
--- ------ ------ ------
TOTAL 972 31,738 59,101 86,888
- - -----------
(1) Refers to the date on which testing is completed and the switch is first
available to carry customer traffic. Fiber optic networks typically become
commercially operational for non-switched traffic in the quarter before the
switch is available to carry customer traffic.
(2) Represents current owned operational route miles except with respect to the
Norfolk network (see, Note 6, below).
(3) Addressable by either unbundled network elements leased from the incumbent
local exchange carrier or by a direct connection to the Company's own
network. We define a commercial building as one with greater than ten
employees.
(4) Represents all active digital switched channels provided to customers
either by resale via the incumbent local exchange carrier's network, direct
connection to the Company's network, or by unbundled network elements
leased from the incumbent local exchange carrier.
(5) Represents all dedicated DS-0, DS-1 and DS-3 service provided by the
Company expressed on a DS-0 basis.
(6) The quarter presented for the Norfolk network represents the Company's
estimate of the calendar quarter in which the switch for this network will
become commercially operational, although we can give no assurance in this
regard. Route miles presented for the Norfolk network represents the number
of miles currently estimated to be owned and operational at the time the
network becomes commercially operational.
The Company's requirements for a planned network are communicated to its
engineering group which finalizes the route and completes the network's design.
Independent construction and installation contractors are selected through a
competitive bidding process. Our own personnel negotiate required contracts and
rights-of-way and supervise the construction, installation and testing of
network components prior to commencing commercial service. Cable, equipment and
supplies required for the networks are available from a variety of sources at
competitive rates. The construction period for a new network varies depending
upon such factors as the number of backbone route miles to be installed, the
relative use of aerial as opposed to buried cable deployment, the initial number
of buildings targeted for connection to the network backbone and other factors.
Based upon our experience with our operational networks, we believe that a new
fiber optic network can be made commercially operational within approximately
six months after construction commences.
In a typical Tier III Market, selected office buildings are connected by
network backbone extensions or unbundled network elements leased from the
incumbent local exchange carrier to one of a number of physical rings of fiber
optic cable, which originate and terminate at our local central office. Within
each building, customer equipment is connected to Company-provided electronic
equipment where customer transmissions are digitized, combined and converted to
an optical signal. The traffic is then transmitted through the network backbone
to the Company's local central office where it can be routed to its ultimate
destination.
We are able to expand our reach in a market by collocating equipment in an
incumbent local exchange carrier's central office and leasing unbundled network
elements from that incumbent local exchange carrier in order to reach customers
located in buildings which are not directly connected to our own backbone ring.
We attempt to place collocation equipment in a sufficient number of incumbent
local exchange carrier central offices to allow us to reach approximately 70% of
the business customers in a given market, either by means of such unbundled
network elements or direct connections to our network. The decision as to
whether to collocate in a specific central office is based upon the number of
business lines, number and type of businesses, number of households and the
location of the central office within the market.
Our networks consist of digital fiber optic communications paths which
allow for high speed, high quality transmission of voice, data and video
communications. We typically install backbone fiber optic cables containing 48
to 144 fiber strands which have significantly greater bandwidth carrying
capacity than other media. Our OC-48 SONET networks support up to 32,256
simultaneous voice conversations over a single pair of glass fibers. We expect
that continuing developments in compression technology and multiplexing
equipment will increase the capacity of each fiber, thereby providing more
bandwidth carrying capacity at relatively low incremental costs.
We currently offer end-to-end fully protected fiber services utilizing
SONET ring architecture which routes customer traffic simultaneously in both
directions around the ring to provide protection against fiber cuts. If a line
is cut, traffic can be simply reversed and sent to its destination around the
other side of the ring. Back-up electronics become operational in the event of
failure of the primary components, adding further redundancy to our systems.
We monitor our fiber optic networks and electronics seven days per week, 24
hours per day, using a combination of local and national network control
centers. Local network monitoring is accomplished by means of an automatic
notification system that monitors for any system anomaly. This system provides
instantaneous alarms to an on-call network technician whenever an anomaly is
detected. The local market technician is trained in network problem resolution
and provides on-site corrective procedures when appropriate. A national Network
Reliability Center, located in Denver, Colorado, acts as the focal point for all
of our operating networks, providing integrated and centralized network
monitoring, and correlation and problem management. The Network Reliability
Center has access to all operating networks and can work independently of the
local systems to effect repair or restoration activities. The Network
Reliability Center is currently provided by Lucent Technologies, Inc. on a
contractual basis. In the future, we may develop our own national center.
We manage our network systems both locally and centrally. Customer service
calls and maintenance are primarily handled through the local offices. In
addition, as described above, we contract to provide integrated monitoring of
our networks via Lucent's National Reliability Center. This is accomplished by
the use of a sophisticated integrated management system that is connected via
the public network to all of our locations, including our Duluth, Georgia,
operations center. With this system the National Reliability Center is capable
of accessing all available information regarding the configuration and operating
condition of any network components in use. This proactive monitoring capability
is further augmented by a 24 hour a day, seven day a week call center, also
provided by Lucent at the National Reliability Center, that receives, tracks and
manages all customer calls and issues to satisfactory conclusion. The call
center works with the Company's own customer care representatives and engineers
in the Duluth facility to ensure that timely and consistent service is provided.
SALES AND MARKETING
We target our sales and marketing activities at two separate customer
groups: retail and wholesale. Retail customers are composed of business,
government and institutional telecommunications and data services end-users.
Wholesale customers typically consist of long distance carriers, wireless
service providers and Internet service providers. We currently have
approximately 180 employees engaged in sales and marketing activities.
RETAIL CUSTOMERS. We target retail customer segments such as business,
government, healthcare and educational institutions. We target all business
customers in our markets.
WHOLESALE CUSTOMERS. We currently target the major long distance carriers
such as AT&T, MCI WorldCom and Sprint, as well as Internet service providers. We
believe that we can effectively compete to provide access to these customers
based on price, reliability, technology, route diversity, ease-of-ordering and
customer service. Historically, long distance carriers have paid significant
charges to incumbent local exchange carriers to access the incumbent local
exchange carriers' networks. We provide these services at a discount. In
addition, to the extent that incumbent local exchange carriers begin to compete
with long distance carriers in providing long distance services, the long
distance carriers have a competitive incentive to move access business away from
incumbent local exchange carriers to competitive local exchange carriers such as
the Company. Wireless service providers, who need network backbone to back haul
calls, are an active customer base, as are other competitive local exchange
carriers as wholesale users. Revenues from access services may decline in future
years due to a change in pricing proposed by the Federal Communications
Commission.
SALES PERSONNEL. We establish local sales offices in each market that we
serve. Initially, each local sales office is staffed by a City Director and two
or three salespersons with the number of sales personnel expected to increase to
between four and six as our operations in the market expand. All sales personnel
are hired locally since we believe that knowledge of, and contacts in, a local
market are key factors for competitive differentiation and commercial success in
a Tier III Market. We believe that this local focus will help to set us apart
from the incumbent local exchange carriers, our principal competitors.
CITY DIRECTORS. We seek to hire local, seasoned telecommunications
managers, with sales experience, as City Directors. City Directors assist with
the initial network buildout and oversee the daily operations of their network,
in addition to managing sales staff and market development. Daily operations
responsibilities include monitoring provisioning, customer service, pricing
decisions and the billing process. A City Director works with senior management
in the strategic planning process, including capital expenditures and budget
planning. They review the costs to bring customers on-net, perform cash flow
analysis for fiber connections of new buildings to the network, and participate
in planning fiber network extensions in their markets.
SUPPLIERS
LUCENT. We have contracted with Lucent Technologies, Inc., as our primary
supplier, to purchase switching, transport and digital cross connect products.
Lucent has also agreed to implement and test our switches and related equipment.
In addition, Lucent and the Company have entered into an agreement pursuant to
which Lucent has agreed to monitor the Company's switches on an on-going basis.
BILLING SUPPORT SYSTEMS IMPLEMENTATION. We have entered into an agreement
with Billing Concepts Systems, Inc. to provide the Company with comprehensive
billing functionality, including the ability to collect call detail records,
message rating, bill calculation, invoice generation, commission tracking,
customer care and inquiry, accounts receivable and collections management, and
quality/revenue assurance. We anticipate that the agreement with Billing
Concepts will result in our ability to produce a single bill covering all of the
products and services that we provide to a customer. We have begun
implementation of the new system and expect to have it implemented in all of our
markets by the end of 1999.
OPERATIONAL SUPPORT SYSTEMS IMPLEMENTATION. We have entered into an
agreement with Eftia OSS Solutions Inc. to develop operational support systems.
These systems will manage service order processing, circuit and asset inventory,
telephone number inventory and trouble administration. The operational support
system's capabilities will be expanded during the later phases of the project to
include workforce management, local number portability management, network
management, service bureau interfaces and web-based service inquiry. We
anticipate the system will automate operational support activities and provide a
means of managing operational performance of our business. We have begun this
multi-phased project and will be implementing portions of it over the next
twelve to eighteen months.
COMPETITION
OVERVIEW. The telecommunications industry is highly competitive. Our
principal competitors in Tier III Markets will be the incumbent local exchange
carriers. In most instances the incumbent local exchange carrier is one of the
Regional Bell Operating Companies (such as Bell Atlantic, BellSouth or
Ameritech), one of GTE Corporation's subsidiaries or one of Sprint Corporation's
subsidiaries. Incumbent local exchange carriers presently have almost 100% of
the market share in those areas the Company considers its market areas. Because
of their relatively small size, the Company does not believe that Tier III
Markets can profitably support more than two competitors to the incumbent local
exchange carrier.
Other competitors may include other competitive local exchange carriers,
microwave and satellite carriers, wireless telecommunications providers and
private networks built by large end-users. Potential competitors (using similar
or different technologies) include cable television companies, utilities and
Regional Bell Operating Companies seeking to operate outside their current local
service areas. In addition, there may be future competition from large long
distance carriers, such as AT&T and MCI WorldCom, which have begun to offer
integrated local and long distance telecommunications services. AT&T also has
announced its intention to offer local services using a new wireless technology.
Consolidation of telecommunications companies and the formation of strategic
alliances within the telecommunications industry, as well as the development of
new technologies, could give rise to significant new competitors to the Company.
Both the long distance business and the data transmission business are
extremely competitive. Prices in both businesses have declined significantly in
recent years and are expected to continue to decline. In the long distance
business, we will face competition from large carriers such as AT&T, MCI
WorldCom and Sprint. We will rely on other carriers to provide transmission and
termination for our long distance traffic and therefore will be dependent on
such carriers.
We expect to experience declining prices and increasing price competition.
INCUMBENT LOCAL EXCHANGE CARRIERS. The Company's principal competitors for
local exchange services are the Regional Bell Operating Companies, the GTE
companies or Sprint. As a recent entrant in the integrated telecommunications
services industry, we have not yet achieved a significant market share for any
of our services. In particular, the incumbent local exchange carriers have
long-standing relationships with their customers, have financial, technical and
marketing resources substantially greater than those of the Company, have the
potential to fund competitive services with revenues from a variety of
businesses and currently benefit from certain existing regulations that favor
the incumbent local exchange carriers over the Company in certain respects.
While recent regulatory initiatives, which allow competitive local exchange
carriers such as the Company to interconnect with incumbent local exchange
carrier facilities, provide increased business opportunities for the Company,
such regulatory initiatives have been accompanied by increased pricing
flexibility for, and relaxation of regulatory oversight of, the incumbent local
exchange carriers. If the incumbent local exchange carriers engage in increased
volume and discount pricing practices or charge competitive local exchange
carriers increased fees for interconnection to their networks, or if the
incumbent local exchange carriers seek to delay implementation of
interconnection to their networks, our business, financial condition and results
of operations could be adversely affected.
To the extent that we interconnect with and use incumbent local exchange
carrier networks to serve our customers, we are dependent upon the technology
and capabilities of the incumbent local exchange carriers. We will become
increasingly dependent on interconnection with incumbent local exchange carriers
as switched services become a greater percentage of our business. The
Telecommunications Act of 1996 imposes interconnection obligations on incumbent
local exchange carriers, but there can be no assurance that we will be able to
obtain the interconnection we require at rates, and on terms and conditions,
that permit us to offer switched services at rates that are both competitive and
profitable. In the event that we experience difficulties in obtaining high
quality, reliable and reasonably priced service from the incumbent local
exchange carriers, the attractiveness of the Company's services to our customers
could be impaired.
COMPETITIVE LOCAL EXCHANGE CARRIER AND OTHER COMPETITORS. We will compete
from time to time with other competitive local exchange carriers. It is likely
that in one or more of our markets we will face competition from two or more
facilities-based competitive local exchange carriers. After the investment and
expense of establishing a network and support services in a given market, the
marginal cost of carrying an additional call is negligible. Accordingly, in Tier
III Markets where there are three or more facilities-based competitive local
exchange carriers, we expect substantial price competition. We believe that
operations in such markets are likely to be unprofitable for one or more
operators.
We expect to face competition in each of our markets. However, we believe
that our commitment to build a significant network, deploy switches and
establish local sales and support facilities at the outset in each of the Tier
III Markets which we target should reduce the number of facilities-based
competitors and drive other entrants to focus on the resale of incumbent local
exchange carrier service or the Company's services, or search for other market
opportunities. We believe that each market will also see more agent and
distributor resale initiatives.
REGULATION
Our services are subject to varying degrees of federal, state and local
regulation. The Federal Communications Commission exercises jurisdiction over
all facilities of, and services offered by, telecommunications common carriers
to the extent those facilities are used to provide, originate or terminate
interstate or international communications. The state regulatory commissions
retain jurisdiction over the same facilities and services to the extent they are
used to originate or terminate intrastate communications. Local governments
sometimes impose franchise or licensing requirements on competitive local
exchange carriers.
FEDERAL REGULATION
We are regulated at the federal level as a nondominant common carrier
subject to minimal regulation under Title II of the Communications Act of 1934.
The Communications Act of 1934 was substantially amended by the
Telecommunications Act of 1996, which was signed into law by the President on
February 8, 1996. This legislation provides for comprehensive reform of the
nation's telecommunications laws and is designed to enhance competition in,
among other markets, the local telecommunications marketplace by: (i) removing
state and local entry barriers, (ii) requiring incumbent local exchange carriers
to provide interconnections to their facilities, (iii) facilitating the
end-users' choice to switch service providers from incumbent local exchange
carriers to competitive local exchange carriers such as the Company and (iv)
requiring access to rights-of-way. The legislation also is designed to enhance
the competitive position of the competitive local exchange carriers and increase
local competition by newer competitors such as long distance carriers, cable
television companies and public utility companies. Under the Telecommunications
Act, Regional Bell Operating Companies have the opportunity to provide in-region
inter-LATA long distance services if certain conditions are met and are no
longer prohibited from providing certain cable television services. In addition,
the Telecommunications Act eliminates certain restrictions on utility holding
companies, thus clearing the way for them to diversify into telecommunications
services.
The Telecommunications Act specifically requires all telecommunications
carriers (including incumbent local exchange carriers and competitive local
exchange carriers (such as the Company)): (i) not to prohibit or unduly restrict
resale of their services; (ii) to provide dialing parity and nondiscriminatory
access to telephone numbers, operator services, directory assistance and
directory listings; (iii) to afford access to poles, ducts, conduits and
rights-of-way; and (iv) to establish reciprocal compensation arrangements for
the transport and termination of telecommunications. It also requires incumbent
local exchange carriers and competitive local exchange carriers to provide
interconnection for the transmission and routing of telephone exchange service
and exchange access. It requires incumbent local exchange carriers to provide
interconnection (a) at any technically feasible point within the incumbent local
exchange carrier's network, (b) that is at least equal in quality to that
provided by the incumbent local exchange carrier to itself, its affiliates or
any other party to which the incumbent local exchange carrier provides
interconnection, and (c) at rates, terms and conditions that are just,
reasonable and nondiscriminatory. Incumbent local exchange carriers also are
required under the new law to provide nondiscriminatory access to network
elements on an unbundled basis at any technically feasible point, to offer their
local telephone services for resale at wholesale rates, and to facilitate
collocation of equipment necessary for competitors to interconnect with or
access the unbundled network elements.
The Telecommunications Act also removed on a prospective basis most
restrictions from AT&T and the Regional Bell Operating Companies resulting from
the Modified Final Judgement, which was the consent decree entered in 1982
providing for divestiture of the Regional Bell Operating Companies from AT&T in
1984. The Telecommunications Act establishes procedures under which a Regional
Bell Operating Company can enter the market for "in-region" inter-LATA (i.e.,
long distance between specified areas) services, within the area where it
provides local exchange service. The Telecommunications Act permitted the
Regional Bell Operating Companies to enter the out-of-region long distance
market immediately upon enactment, and Regional Bell Operating Companies can
provide intra-LATA long distance services. Before the Regional Bell Operating
Company can provide in-region inter-LATA services, it must obtain FCC approval
upon a showing that facilities-based competition is present in its market, that
the Regional Bell Operating Company has entered into interconnection agreements
in the states where it seeks authority, that the interconnection agreements
satisfy a 14-point "checklist" of competitive requirements, and that such entry
is in the public interest. To date, such authority has not been granted, but
requests by Regional Bell Operating Companies are the subject of pending
appeals. The provision of inter-LATA services by Regional Bell Operating
Companies is expected to reduce the market share of major long distance
carriers, and consequently, may have an adverse effect on the ability of
competitive local exchange carriers to generate access revenues from the long
distance carriers.
FCC RULES IMPLEMENTING THE LOCAL COMPETITION PROVISIONS OF THE
TELECOMMUNICATIONS ACT OF 1996. On August 8, 1996, the Federal Communications
Commission released the Interconnection Decision which established a framework
of minimum, national rules enabling state public service commissions and the FCC
to begin implementing many of the local competition provisions of the
Telecommunications Act of 1996. The Interconnection Decision promulgated rules
to implement Congress' statutory directive concerning the interconnection
obligations of all telecommunications carriers, including obligations of
competitive local exchange carrier and incumbent local exchange carrier
networks. The FCC prescribed certain minimum points of interconnection necessary
to permit competing carriers to choose the most efficient points at which to
interconnect with the incumbent local exchange carriers' networks. The FCC also
adopted a minimum list of unbundled network elements that incumbent local
exchange carriers must make available to competitors upon request and a
methodology for states to use in establishing rates for interconnection and the
purchase of unbundled network elements. The FCC also adopted a methodology for
states to use when applying the Telecommunications Act's "avoided cost standard"
for setting wholesale prices with respect to retail services.
In July and October of 1997 the U.S. Court of Appeals for the Eighth
Circuit vacated certain portions of the Interconnection Decision, ruling that
the State public service commissions, not the Federal Communications Commission,
have jurisdiction over the pricing of interconnection, unbundled network
elements and resale services. The Eighth Circuit Court also ruled that the FCC's
interpretation of Section 252(i) of the Telecommunications Act of 1996, the
so-called "pick and choose" provision, was incorrect. The Eighth Circuit Court
held that the Telecommunications Act allows competitive local exchange carriers
to adopt whole interconnection agreements negotiated by other competitors, but
not to "pick and choose" pieces of existing agreements. In January 1999, the
United States Supreme Court reversed the Eighth Circuit's decisions, upholding
the FCC's authority to establish national pricing rules for interconnection,
unbundled elements and resale services. The Supreme Court also upheld the FCC's
interpretation of the "pick and choose" provisions. However, the Supreme Court
overturned the FCC's rules regarding what network elements must be unbundled by
the Regional Bell Operating Companies, and remanded to the FCC the question of
what network elements are "necessary" to competing carriers such as the Company.
In addition, the Supreme Court's decision creates some uncertainty regarding the
legal status of complaints filed at the FCC to enforce interconnection
agreements. There can be no assurance that the Company will be able to obtain or
enforce interconnection agreements on terms acceptable to the Company.
On December 31, 1997, the U.S. District Court for the Northern District of
Texas issued the SBC Decision finding that Sections 271 to 275 of the
Telecommunications Act of 1996 are unconstitutional. These sections of the
Telecommunications Act impose restrictions on the lines of business in which the
Regional Bell Operating Companies may engage, including establishing the
conditions the Regional Bell Operating Companies must satisfy before they may
provide inter-LATA long distance telecommunications services. Under the SBC
Decision, the Regional Bell Operating Companies would be able to provide
inter-LATA long distance telecommunications services immediately without
satisfying the statutory conditions. The SBC Decision has been reversed by the
U.S. Fifth Circuit Court of Appeals. Three Regional Bell Operating Companies
sought review by the U.S. Supreme Court. Petitions for certiorari were denied on
January 19, 1999. Therefore, the Regional Bell Operating Companies must continue
to comply with the statutory provisions of the Telecommunications Act in order
to obtain authority to provide in-region inter-LATA long distance services.
OTHER REGULATION. In general, the Federal Communications Commission has a
policy of encouraging the entry of new competitors, such as the Company, in the
telecommunications industry and preventing anti-competitive practices.
Therefore, the FCC has established different levels of regulation for dominant
carriers and nondominant carriers. For domestic common carrier
telecommunications regulation, large incumbent local exchange carriers such as
the Regional Bell Operating Companies and GTE Corporation are currently
considered dominant carriers, while competitive local exchange carriers such as
the Company are considered nondominant carriers. As a nondominant carrier, the
Company is subject to relatively minimal FCC regulation.
o TARIFF. As a nondominant carrier, the Company may install and operate
facilities for the transmission of domestic interstate communications
without prior FCC authorization. Services of nondominant carriers have been
subject to relatively limited regulation by the FCC, primarily consisting
of the filing of tariffs and periodic reports concerning the carrier's
interstate circuits and deployment of network facilities. However,
nondominant carriers like the Company must offer interstate services on a
nondiscriminatory basis, at just and reasonable rates, and remain subject
to FCC complaint procedures.
In October 1996, the FCC adopted an order (the "Detariffing Order") which
eliminated the requirement that nondominant interstate carriers maintain
tariffs on file with the FCC for domestic interstate services. The order
provided that, after a nine-month transition period, relationships between
interstate carriers and their customers would be set by contract. Several
parties requested reconsideration and/or filed appeals of the Detariffing
Order. On February 13, 1997, the United States Court of Appeals for the
District of Columbia Circuit stayed implementation of the Detariffing
Order. If the Detariffing Order becomes effective, nondominant interstate
services providers will no longer be able to rely on the filing of tariffs
with the FCC as a means of providing notice to customers of prices, terms
and conditions under which they offer their interstate services. If the
Company cancels its FCC tariffs as a result of the Detariffing Order, it
will need to implement replacement contracts which could result in
substantial legal and administrative expense.
o ACCESS CHARGES. The FCC has granted incumbent local exchange carriers
significant flexibility in pricing their interstate special and switched
access services on a specific central office by central office basis. Under
this pricing scheme, incumbent local exchange carriers may establish
pricing zones based on access traffic density and charge different prices
for each zone. We anticipate that this pricing flexibility will result in
incumbent local exchange carriers lowering their prices in high traffic
density areas, the probable area of competition with the Company. We also
anticipate that the FCC will grant incumbent local exchange carriers
increasing pricing flexibility as the number of interconnections and
competitors increases. On May 16, 1997, the FCC took action in its CC
Docket No. 96-262 to reform the current interstate access charge system.
The FCC adopted an order which makes various reforms to the existing rate
structure for interstate access that are designed to move access charges,
over time, to more cost based rate levels and structures. These changes
will reduce access charges and will shift charges currently based on
minutes to flat-rate, monthly per line charges. As a result, the aggregate
amount of access charges paid by long distance carriers to access providers
in the United States may decrease.
The FCC also announced that it intends in the future to issue a Report and
Order providing detailed rules for implementing a market-based approach to
further access charge reform. That process will give incumbent local exchange
carriers progressively greater flexibility in setting rates as competition
develops, gradually replacing regulation with competition as the primary means
of setting prices. The FCC also adopted a "prescriptive safeguard" to bring
access rates to competitive levels in the absence of competition.
This series of decisions is likely to have a significant impact on the
operations, expenses, pricing and revenue of the Company. The access charge
order has been affirmed by the Eighth Circuit U.S. Court of Appeals on August
19, 1998. The FCC released a Public Notice on October 6, 1998 asking the parties
to refresh the record on access charge reform. The FCC specifically requested
comment on pricing flexibility proposals submitted by two Regional Bell
Operating Companies.
UNIVERSAL SERVICE REFORM.
On May 8, 1997, the Federal Communications Commission issued an order to
implement the provisions of the Telecommunications Act of 1996 relating to the
preservation and advancement of universal telephone service. The Universal
Service order affirmed Congress' policy principles for universal telephone
service, including quality service, affordable rates, access to advanced
services, access in rural and high-cost areas, equitable and nondiscriminatory
contributions, specific and predictable support mechanisms and access to
advanced telecommunications services for schools, health care providers and
libraries. The order added "competitive neutrality" to the FCC's universal
service principles by providing that universal service support mechanisms and
rules should not unfairly advantage or disadvantage one provider or technology
over another. All telecommunications carriers providing interstate
telecommunications services, including the Company, must contribute to the
universal service support fund. The contribution factors for first quarter 1999
contributions are 3.18% for the high cost and low income fund (to be derived
from the Company's estimated quarterly interstate and international gross
end-user telecommunications revenue) and .58% for the schools and libraries and
healthcare fund (to be derived from the Company's estimated quarterly
intrastate, interstate and international gross end-user telecommunications
revenue).
STATE REGULATION
The Company believes that most, if not all, states in which it operates or
proposes to operate will require a certification or other authorization to offer
intrastate services. Many of the states in which the Company operates or intends
to operate are in the process of addressing issues relating to the regulation of
competitive local exchange carriers. The Company will also be subject to tariff
filing requirements.
These certifications generally require a showing that the carrier has
adequate financial, managerial and technical resources to offer the proposed
services in a manner consistent with the public interest.
The Company, through its subsidiaries, KMC Telecom Inc. and KMC Telecom II,
Inc., has obtained intrastate authority for the provision of its dedicated
services and a full range of local switched services and long distance services.
In most states, the Company is required to file tariffs setting forth the terms,
conditions and prices for services that are classified as intrastate. The
Company, through its subsidiaries, KMC Telecom Inc., KMC Telecom II, Inc., and
KMC Telecom III, Inc., plans to obtain additional state authorities to
accommodate its business and network expansion.
Some states impose, in addition to tariff filing requirements, reporting,
customer service, and quality requirements, as well as unbundling and universal
service requirements. In addition, the Company will be subject to the outcome of
generic proceedings held by state utility commissions to determine state
regulatory policies with respect to incumbent local exchange carrier and
competitive local exchange carrier competition, geographic build-out, mandatory
detariffing and other issues relevant to competitive local exchange carrier
operations. Certain states have adopted specific universal service funding
obligations.
In addition to obtaining state certifications, we must negotiate terms of
interconnection with the incumbent local exchange carrier before we can begin
providing switched services. Our executed agreements are subject to the approval
of the state commissions. State commissions have approved our agreements. We
anticipate state commission approval of our other interconnection agreements.
We believe that, as the degree of intrastate competition increases, the
states will offer the incumbent local exchange carriers increasing pricing
flexibility. This flexibility may present the incumbent local exchange carriers
with an opportunity to subsidize services that compete with the Company's
services with revenues generated from non-competitive services, thereby allowing
incumbent local exchange carriers to offer competitive services at prices below
the cost of providing the service. We cannot predict the extent to which this
may occur, but it could have a material adverse effect on our business.
We actively participate in various regulatory proceedings before the
states, the outcome of which may establish policies that affect our competitive
and/or economic position in the local and other telecommunications services
markets.
We also may be subject to requirements in certain states to obtain prior
approval for, or notify the state commission of, any transfers of control, sales
of assets, corporate reorganizations, issuances of stock or debt instruments and
related transactions.
Local Government Authorizations. We are required to obtain street use and
construction permits and licenses and/or franchises to install and expand our
fiber optic networks using municipal rights of way. In some municipalities where
we have installed or anticipate constructing networks, we will be required to
pay license or franchise fees based on a percentage of gross revenues or on a
per linear foot basis, as well as post performance bonds or letters of credit.
We are actively pursuing permits, franchises and other relevant authorities for
use of rights-of-way and utility facilities in a number of cities .
FRANCHISES AND PERMITS
The construction of a network requires the Company to obtain municipal
franchises and other permits. These rights are typically the subject of
non-exclusive agreements of finite duration providing for the payment of fees or
the provision of services by the Company to the municipality without
compensation. In addition, the Company must secure rights-of-way and other
access rights which are typically provided under non-exclusive multi-year
agreements, which generally contain renewal options. Generally, these rights are
obtained from utilities, incumbent local exchange carriers, other competitive
local exchange carriers, railroads and long distance carriers. The
Telecommunications Act of 1996 requires most utilities to afford access to
rights-of-way to competitive local exchange carriers on non-discriminatory terms
and conditions and at reasonable rates. However, there can be no assurance that
delays and disputes will not occur. The Company's agreements for rights-of-way
and similar matters generally require the Company to indemnify the party
providing such rights. Such indemnities could make the Company liable for
actions (including negligence) of the other party.
CUSTOMERS
No single customer accounted for more than 10% of our consolidated revenues
in 1998. Our five largest customers accounted for 32% of our consolidated
revenues in 1997 and 11% of our consolidated revenues in 1998. We expect
customer concentration to continue to decrease as we expand into additional
markets and increase full scale marketing of an integrated service package. In
the near term, however, the loss of, or decrease of business from, one or more
of our principal customers could have a material adverse effect on our business,
financial condition and results of operations.
Although they are not our customers, we did recognize revenue of
approximately $2.9 million, or 12.9% of our 1998 revenue, from incumbent local
exchange carriers primarily related to reciprocal compensation for terminating
local calls from customers of the incumbent local exchange carriers to Internet
service providers which are our customers. Of this amount approximately 99% is
attributable to reciprocal compensation due to the Company from BellSouth. See
Item 7 "Management's Discussion and Analysis of Financial Condition and Results
of Operations - Overview - Revenue" for a discussion of a dispute which has
arisen between incumbent local exchange carriers, such as BellSouth, and
competitive local exchange carriers, such as the Company, with respect to the
obligation of incumbent local exchange carriers to make reciprocal compensation
payments to competitive local exchange carriers with respect to the termination
of local calls to Internet service providers.
EMPLOYEES
As of February 28, 1999, we had approximately 559 full time employees. None
of our employees are represented by a labor union or subject to a collective
bargaining agreement, nor have we experienced any work stoppage due to labor
disputes. We believe that our relations with our employees are good.
GEOGRAPHIC AREAS
We have no foreign operations. All of our networks are located in, and all
of our revenues are attributable to, the United States.
ITEM 2. PROPERTIES.
The Company is headquartered in Bedminster, New Jersey in approximately
10,000 square feet of office space, approximately 7,200 of which it leases from
Kamine Development Corp. (an entity controlled by Mr. Kamine, the Company's
Chairman of the Board). The lease with Kamine Development Corp., which expires
in January 2007, provides for a base annual rental of approximately $217,000
(adjusted periodically for changes in the consumer price index), plus operating
expenses.
The Company also maintains an operations center in an aggregate of
approximately 41,000 square feet of leased space in Duluth, Georgia under leases
which expire at various dates from June 2001 through February 2003. The Company
also owns or leases facilities in each of its existing markets for central
offices, sales offices and the location of its switches and related equipment.
We believe that our facilities are in good condition, are suitable for our
operations and that, if needed, suitable alternative space would be readily
available.
ITEM 3. LEGAL PROCEEDINGS.
By letter dated August 29, 1997, the Company notified I-NET, Inc. that the
Company considered I-NET to be in default under a Master Telecommunications
System Rollout Agreement dated as of October 1, 1996 as a result of I-NET's
failure to provide design plans and specifications for several systems for which
it had agreed to provide such plans and specifications, to properly supervise
construction of the systems or to provide personnel with the necessary expertise
to manage the projects. By letter dated October 27, 1997, I-NET demanded payment
of all amounts it alleged were due under that agreement and a related agreement
(aggregating $4.1 million) and stated that it would invoke the arbitration
provisions under the agreement if the parties could not agree as to the amount
due and payment terms on or before November 27, 1997. By letter dated December
1, 1997, I-NET extended its deadline for reaching agreement to December 15,
1997. Although the Company and I-NET conducted discussions, they were unable to
reach an agreement and, on February 12, 1998, the Company received a demand for
arbitration from Wang Laboratories, Inc., the successor to I-NET. The demand
seeks at least $4.1 million. The Company believes that it has meritorious
defenses to Wang's claims and has asserted counterclaims seeking in excess of
$2.5 million as a result of I-NET's defaults under the Master Telecommunications
System Rollout Agreement. The arbitration proceedings are currently underway.
The Company believes that resolution of this matter will not have a material
adverse impact on its financial condition. No assurance can be given, however,
as to the ultimate resolution of this matter.
The Company is from time to time involved in other litigation incidental to
the conduct of its business. There is no other pending legal proceeding to which
the Company is a party, however, which, in the opinion of the Company's
management, is likely to have a material adverse effect on the Company's
business, financial condition and results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth
quarter of 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
There is currently no established trading market for the Company's Common
Stock, $0.01 par value per share. As of March 24, 1999 there were six holders of
record of the Company's Common Stock.
The Company has never declared nor paid cash dividends on its Common Stock
and does not presently anticipate paying any cash dividends on its Common Stock
in the foreseeable future. The Company currently expects that earnings, if any,
will be retained for growth and development of the Company's business.
The Company, as a holding company, depends upon the receipt of dividends
and other cash payments from its operating subsidiaries in order to meet the
Company's cash requirements. Pursuant to the terms of a Loan and Security
Agreement, dated as of December 22, 1998, among our subsidiaries, KMC Telecom
Inc., KMC Telecom II, Inc., KMC Telecom Leasing I, LLC, KMC Telecom Leasing II,
LLC and KMC Telecom of Virginia, Inc. and a group of lenders led by First Union
National Bank and Newcourt Commercial Finance Corporation (the "Senior Secured
Credit Facility"), those subsidiaries are restricted in their ability to pay
dividends on their capital stock. Pursuant to the terms of a Loan and Security
Agreement, dated as of February 4, 1999, among our subsidiary, KMC Telecom III,
Inc., Lucent Technologies, Inc. and the collateral agent thereunder (the "Lucent
Facility"), KMC Telecom III, Inc. is restricted in its ability to pay dividends
on its capital stock. The indenture applicable to the Company's 12 1/2% Senior
Discount Notes due 2008, imposes certain restrictions upon the Company's ability
to pay dividends on its capital stock.
Subject to the foregoing and to any restrictions which may be contained in
future indebtedness of the Company, the payment of cash dividends on the Common
Stock will be within the sole discretion of the Company's Board of Directors,
and will depend upon the earnings, capital requirements and financial position
of the Company, applicable requirements of law, general economic conditions and
other factors considered relevant by the Company's Board of Directors.
On January 29, 1998, the Company sold 460,800 units to Morgan Stanley & Co.
Incorporated, as Placement Agent. Each unit consisted of one 12 1/2% Senior
Discount Note due 2008, with a principal amount at maturity of $1,000, and one
warrant to purchase 0.21785 shares of Common Stock of the Company. The exercise
price of the warrants is $.01 per share of Common Stock. The aggregate number of
shares of Common Stock subject to the warrants is 100,385. The aggregate
offering price of the units was $249,965,568 and the aggregate underwriting
discounts and commissions were $9,998,623. Of the aggregate net proceeds of the
offering of the units, after underwriting discounts, commissions and certain
expenses of the offering, approximately $10,446,000 was attributed to the
warrants. The sale of the units to the Placement Agent was made in reliance upon
the exemption from the registration requirements of the Securities Act of 1933,
as amended, provided by Section 4(2) of that Act, on the basis that the
transaction did not involve a public offering. The Placement Agent agreed that
any resales which it made would be made only (i) to qualified institutional
buyers as defined in Rule 144A under the Securities Act, (ii) to institutional
accredited investors as defined in Rule 501(a)(1), (2), (3) or (7) under the
Securities Act, or (iii) outside the United States to persons other than U.S.
persons in reliance upon Regulation S under the Securities Act.
In September 1998, the Company granted options to purchase an aggregate of
262,500 shares of its Common Stock to employees of the Company and employees of
certain affiliates of the Company under the 1998 Stock Purchase and Option Plan
for Key Employees of KMC Telecom Holdings, Inc. and Affiliates. The majority of
these options were issued to replace options to purchase shares of common stock
of the Company's subsidiary, KMC Telecom Inc., which had been issued in earlier
years, prior to the organization of the Company and the establishment of the
present holding company structure. No consideration was received by the Company
for the issuance of the options. The options have various exercise prices with
157,500 exercisable at an exercise price of $20 per share, 52,500 exercisable at
an exercise price of $30 per share, and 52,500 exercisable at an exercise price
of $40 per share. The issuance of the options was made in reliance upon the
exemption from the registration requirements of the Securities Act provided by
Section 4(2) of that Act, on the basis that the transaction did not involve a
public offering.
ITEM 6. SELECTED FINANCIAL DATA.
The selected financial data set forth below for the period from May 10,
1994 (date of inception) to December 31, 1994 and for the years ended December
31, 1995, 1996, 1997 and 1998 were derived from the audited financial statements
of the Company and its predecessors. The data presented below should be read in
conjunction with "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations" and the consolidated financial statements
and notes thereto included elsewhere in this Report.
MAY 10, 1994
(DATE OF
INCEPTION) TO
DECEMBER 31, YEAR ENDING DECEMBER 31
----------------------------------------------------------
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
STATEMENT OF OPERATIONS DATA:
Revenue........................................... $ - $ - $ 205 $ 3,417 $ 22,425
Operating expenses:
Network operating costs........................ - - 1,361 7,735 37,336
Selling, general and administrative............ 4 1,591 2,216 9,923 24,534
Stock option compensation expense.............. - - 240 13,870 7,080
Depreciation and amortization.................. - 6 287 2,506 9,257
--------- ---------- ---------- ---------- ----------
Total operating expenses.................... 4 1,597 4,104 34,034 78,207
--------- ---------- ---------- ---------- ----------
Loss from operations.............................. (4) (1,597) (3,899) (30,617) (55,782)
Interest income................................... - - - 513 8,818
Interest expense (a).............................. - (23) (596) (2,582) (29,789)
--------- ---------- ---------- ---------- ----------
Net loss.......................................... (4) (1,620) (4,495) (32,686) (76,753)
Dividends and accretion on redeemable preferred
stock.......................................... - - - (8,904) (18,285)
--------- ---------- ---------- ---------- ----------
Net loss applicable to common shareholders........ $ (4) $ (1,620) $ (4,495) $ (41,590) $ (95,038)
========= ========== ========== ========== ==========
Net loss per common share......................... $ (0.01) $ (2.70) $ (7.49) $ (64.93) $ (114.42)
========= ========== ========== ========== ==========
Weighted average common shares outstanding........ 600 600 600 641 831
========= ========== ========== ========== ==========
Other Data:
Capital expenditures (including acquisition)...... $ - $ 3,498 $ 9,111 $ 61,146 $ 161,803
EBITDA(b)......................................... (4) (1,591) (3,613) (28,111) (46,525)
Cash used in operating activities................. 4 (779) (2,687) (8,676) (33,573)
Cash used in investing activities................. - (1,920) (10,174) (62,992) (180,198)
Cash provided in financing activities............. 1 2,728 14,314 85,734 219,399
Ratio of earnings to fixed charges (c)............ - - - - -
AS OF DECEMBER 31,
-------------------------------------------------------------------------
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
(IN THOUSANDS)
--------------
BALANCE SHEET DATA:
Cash and cash equivalents...................... $ 6 $ 34 $ 1,487 $ 15,553 $ 21,181
Investments held for future capital expenditures - - - - 27,920
Networks and equipment, net.................... - 3,496 12,347 71,371 224,890
Total assets................................... 8 3,704 16,715 95,943 311,310
Long-term debt................................. - 2,727 12,330 61,277 309,225
Redeemable preferred stock..................... - - - 35,925 52,033
Redeemable common stock and warrants........... - - - 11,726 22,979
Total nonredeemable equity (deficiency)........ (3) (1,623) 389 (26,673) (104,353)
ACCOMPANYING NOTES ARE ON FOLLOWING PAGE.
(a) Excludes capitalized interest of (i) $37,000 for 1995, (ii) $103,000 for
1996, (iii) $854,000 for 1997 and (iv) $5.1 million for 1998. During the
construction of the Company's networks, the interest costs related to
construction expenditures are capitalized.
(b) EBITDA consists of earnings (loss) before net interest, income taxes,
depreciation and amortization. EBITDA is provided because it is a measure
commonly used in the telecommunications industry. It is presented to
enhance an understanding of the Company's operating results and is not
intended to represent cash flow or results of operations in accordance with
GAAP. EBITDA is not calculated under GAAP and is not necessarily comparable
to similarly titled measures of other companies. For a presentation of cash
flows calculated under GAAP, see the Company's historical financial
statements contained in "Item 8. Financial Statements and Supplementary
Data."
(c) The ratio of earnings to fixed charges is computed by dividing pretax
income from continuing operations before fixed charges (other than
capitalized interest) by fixed charges. Fixed charges consist of interest
charges, dividend obligations and amortization of debt expense and discount
or premium related to indebtedness, whether expensed or capitalized, and
that portion of rental expense the Company believes to be representative of
interest. For 1994, 1995, 1996, 1997 and 1998, earnings were insufficient
to cover fixed charges by $4,475, $1.8 million, $4.6 million, $33.5
million, and $81.9 million, respectively.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
This Management's Discussion and Analysis of Financial Condition and
Results of Operations reflects the historical results of the Company. Due to the
limited operating history, startup nature and rapid growth of the Company,
period-to-period comparisons of financial data are not necessarily indicative,
and you should not rely upon them as an indicator of the future performance of
the Company. The following discussion includes forward-looking statements.
OVERVIEW
GENERAL. We are a facilities-based competitive local exchange carrier
providing telecommunications and data services in Tier III Markets. The markets
in which we operate are predominately located in the Southeastern and Midwestern
United States. We target business, government and institutional end-users, as
well as Internet service providers, long distance carriers and wireless service
providers. Our objective is to provide our customers with a complete solution
for their communications needs. We currently provide on-net local dial tone,
special access, private line, Internet access, ISDN and a variety of other
advanced services and features.
We have invested significant capital and effort in developing our
telecommunications business. This capital has been invested in the development
of our networks, the hiring of an experienced management team, the development
and installation of operating systems, the introduction of services, marketing
and sales efforts, and acquisitions. We expect to make increasing capital
expenditures to build additional networks, to expand current networks to
additional customer buildings, long distance carrier points of presence and
incumbent local exchange carrier central offices, and to broaden our service
offerings, and may consummate acquisitions. Proper management of the Company's
growth will require us to maintain cost controls, continue to assess market
potential, ensure quality control in implementing our services as well as to
expand our internal management, customer care and billing and information
systems, all of which will require substantial investment.
The development, construction and expansion of our networks requires
significant capital, a large portion of which is invested before any revenue is
generated. We have incurred, and expect to continue to incur, significant and
increasing operating losses, negative EBITDA and net cash outflows for operating
and investing activities while we expand our network operations and build our
customer base. Based on our experience to date and that of our competitors, we
estimate that a new network will begin to generate positive EBITDA within 24 to
36 months after commencement of commercial operations. Construction periods and
operating results will vary from network to network. There can be no assurance
that we will be able to establish a sufficient revenue-generating customer base
or gross margins in any particular market or on a consolidated basis.
The facilities-based competitive local exchange carrier business is capital
intensive. We estimate that the total initial costs associated with the purchase
and installation of fiber optic cable and transmission and switching equipment,
including capitalized engineering costs, will average approximately $8.0 million
to $10.0 million for each standard Tier III network, depending upon the size of
the market served, the scope and complexity of the network, and the proportion
of aerial to underground fiber deployment. Our actual costs could vary
significantly from this range. The amounts and timing of these expenditures are
subject to a variety of factors that may vary significantly with the geographic
and demographic characteristics of each market. In addition to equipment and
construction expenditure requirements, upon commencement of the construction
phase of a network we begin to incur direct operating costs for such items as
salaries and rent. As network construction progresses, we incur costs associated
with construction, including preparation of rights-of-way, and increased sales,
marketing, operating and administrative expenses. We capitalize certain direct
costs related to network planning and construction costs for new networks.
The initial construction of a network takes approximately six months,
depending upon the size and complexity of the network. The time required during
the construction phase is also significantly influenced by the number of route
miles involved, the mix of aerial versus underground fiber deployment, possible
delays in preparing rights-of-way, provisioning fiber optic cable and electronic
equipment, and required construction permits and other factors, including
weather.
LOCAL SERVICES. To facilitate our entry into local services, we plan to
install switching equipment in all of our markets. Switches are in commercial
operation in twenty-two of our existing markets. We expect to have a switch in
commercial operation in our remaining existing network no later than the second
quarter of 1999. We intend to install Lucent Technologies, Inc. switches in any
future networks which we may build. Once a switch is commercially operational,
we offer local dial tone and value-added enhanced services such as ISDN,
Centrex-type, voice mail and other custom calling features, and switched data
services.
We expect operating margins to improve as switching becomes operational and
switched services are provided on-net, the network is expanded (primarily by
adding buildings to the network), and larger volumes of traffic are carried on
the Company's network. Although under the Telecommunications Act of 1996 the
incumbent local exchange carriers are required to unbundle local network
elements, thereby decreasing operating expenses by permitting us to purchase
only the origination and termination services we need, we cannot assure you that
such unbundling will be effected in a timely manner and result in prices
favorable to the Company.
REVENUE. Historically, we have derived our revenue primarily from resale of
switched services, along with special access, private line and Internet access
services provided on our facilities. Future revenues will include increasing
amounts of on-net switch-based services, long distance services and value-added
enhanced services, such as ISDN, Centrex-type services, BRI, PRI and port
wholesale. The Company maintains interconnection agreements with incumbent local
exchange carriers in each state in which it operates. Among other things, these
contracts govern the reciprocal amounts to be billed by competitive carriers for
terminating local traffic of Internet service providers in each state. The
Regional Bell Operating Companies have advised competitive local exchange
carriers, such as the Company, that they do not consider calls in the same local
calling area which are placed by their customers to competitive local exchange
carrier customers which are Internet service providers to be local calls under
the interconnection agreements. The Regional Bell Operating Companies claim that
these calls should be classified as exchange access calls, even though the
Federal Communications Commission exempted local calls for Internet service
providers from payment of access charges. The Regional Bell Operating Companies
claim that, as a result, they do not owe any compensation to competitive local
exchange carriers for transporting and terminating these calls. The Regional
Bell Operating Companies have threatened to withhold, and in many cases have
withheld, reciprocal compensation to competitive local exchange carriers for the
transport and termination of these calls. During 1998, the Company recognized
revenue from incumbent local exchange carriers of approximately $2.9 million, or
12.9% of 1998 revenue, for these services. Payments of approximately $135,000
were received from the incumbent local exchange carriers during 1998. Management
believes reciprocal compensation for Internet traffic to be an industry-wide
matter that will ultimately be resolved on a state-by-state basis. To date,
twenty-nine state commissions have ruled on the issue and found that incumbent
local exchange carriers must pay compensation to competitive carriers for local
calls to Internet service providers located on competitive carriers' networks. A
number of other state commissions currently have proceedings pending to consider
this matter. The Federal Communications Commission has concluded that calls to
Internet service providers are interstate calls and are therefore exempt from
local termination charges. However, the FCC also stated that existing
interconnection agreements providing for such termination charges must be
honored by the incumbent local exchange carriers. The Company accounts for
reciprocal compensation with the incumbent local exchange carriers, including
the activity associated with the disputed Internet service provider traffic, as
local traffic pursuant to the terms of its interconnection agreements.
Accordingly, revenue is recognized in the period that the traffic is terminated.
The circumstances surrounding the dispute are considered by management
periodically in determining whether reserves against unpaid balances are
warranted. As of December 31, 1998, no reserves have been considered necessary
by management.
OPERATING EXPENSES. Our principal operating expenses consist of network
operating costs, selling, general and administrative expenses, stock option
compensation expense, depreciation and amortization, and interest expense.
Network operating costs include charges from incumbent local exchange carriers
for resale services, termination and unbundled network element charges; charges
from long distance carriers for resale of long distance services; salaries and
benefits associated with network operations, billing and information services
and customer care personnel; franchise fees and other costs, including direct
city administration costs. Network operating costs also include a percentage of
both our intrastate and interstate revenues which we pay as universal service
fund charges. Selling, general and administrative expenses consist of sales
personnel and support costs, corporate and finance personnel and support costs,
legal and accounting expenses. Depreciation and amortization includes charges
related to plant, property and equipment and amortization of intangible assets,
including franchise acquisition costs. We expect depreciation and amortization
expense to increase as we place additional networks into service. Interest
expense includes interest charges on our 12 1/2% Senior Discount Notes and our
Senior Secured Credit Facility and, in the future, will include interest charges
on the Lucent Facility. Interest expense also includes amortization of deferred
financing costs. Interest expense will increase substantially in future periods
as a result of the issuance of the 12 1/2% Senior Discount Notes and increased
borrowings under the expanded Senior Secured Credit Facility and the Lucent
Facility, discussed below, to finance network build-out.
RESULTS OF OPERATIONS
1998 COMPARED TO 1997
REVENUE. Revenue increased from $3.4 million for 1997 to $22.4 million for
1998. This increase is primarily attributable to the fact that for 1998 we had
eight systems in commercial operation during the entire period, as well as 14
additional systems which became commercially operational at various points
during the period, as compared to 1997 when we had only one system in commercial
operation during the entire period, with 7 systems becoming commercially
operational at various points during the period. In addition, each of our
networks that was commercially operational during 1997 generated increased
revenues during 1998. Revenue for 1997 and 1998 included $2.3 million and $14.2
million (including $2.9 million of revenue from reciprocal compensation in
1998), respectively, of revenue derived from resale of switched services and an
aggregate of $1.1 million and $8.2 million, respectively, of revenue derived
from on-net special access, private line and switched services.
NETWORK OPERATING COSTS. Network operating costs increased from $7.7
million in 1997 to $37.3 million in 1998. This increase of approximately $29.6
million was due primarily to the increase in the number of systems in commercial
operation in 1998 and the related increases of $14.5 million in costs associated
with providing resale and unbundled network element services, $5.3 million in
personnel costs, $1.6 million in consulting and professional services costs,
$3.4 million in contracted network support costs, and $1.1 million in facilities
related costs, $1.0 million in travel related costs and $2.7 million in other
direct operating costs.
Costs associated with providing on-net services were greater than revenue
generated from on-net services because we were required to hire personnel and
staff local offices prior to generating revenue and obtaining sufficient revenue
volume to cover such fixed operating costs.
Costs associated with providing resale services are greater than the
revenues currently generated because of narrow discounts on ongoing resale
services provided to us by the incumbent local exchange carriers and because
initial installation charges by the incumbent local exchange carrier to us are
greater than our installation charges to our customers. Resale is primarily an
interim strategy for us to create a backlog of customers to be transitioned to
our on-net switched facilities once our own switches become commercially
operational.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased from $9.9 million in 1997 to $24.5 million in
1998. This increase of approximately $14.6 million resulted primarily from
increases of $8.5 million in personnel costs, $900,000 in professional costs
(consisting primarily of legal costs), and $1.2 million in travel related costs,
as well as increases in other marketing and general and administrative costs
aggregating approximately $4.0 million.
STOCK OPTION COMPENSATION EXPENSE. Stock option compensation expense, a
non-cash charge, decreased from $13.9 million in 1997 to $7.1 million in 1998.
This decrease reflects reduced charges in 1998 related to changes in the fair
value of the Company's Common Stock and lower amortization expense related to
the vesting terms of the options during 1998, as compared to the level of such
charges in 1997. The expense charge for 1998 includes the net effect of a credit
resulting from the termination of the KMC Telecom Inc. stock option plan, which
was substantially offset by a charge related to the adoption of the KMC Telecom
Holdings, Inc. stock option plan in September 1998.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased from $2.5 million for 1997 to $9.3 million for 1998, primarily as a
result of depreciation expense associated with the greater number of networks in
commercial operation during 1998, as well as higher amortization of intangible
assets.
INTEREST EXPENSE. Interest expense increased from $2.6 million in 1997
to $29.8 million in 1998. This increase resulted primarily from the issuance of
the 12 1/2% Senior Discount Notes during the first quarter of 1998, which
generated interest expense of $29.6 million in 1998, as well as the increased
expense attributable to the higher level of borrowings under the predecessor to
the Senior Secured Credit Facility in 1998. The Company capitalized interest of
$5.1 million related to network construction projects during 1998 and $854,000
during 1997.
NET LOSS. For the reasons stated above, net loss increased from $32.7
million for 1997 to $76.8 million for 1998.
1997 COMPARED TO 1996
REVENUE. Revenue increased from $205,000 for 1996 to $3.4 million for 1997.
Revenue increased primarily because we began aggressively marketing our services
in our first market, Huntsville, Alabama, which generated $1.6 million of
revenue for 1997. In addition, the network in Melbourne, Florida, which we
purchased during 1997, and the six other systems which became commercially
operational during 1997, generated an aggregate of $1.8 million in revenue
during 1997. Furthermore, we initiated marketing efforts in May 1997 in all of
the markets in which our networks had become commercially operational or in
which we were constructing networks. For 1997, out of total revenues of $3.4
million, we derived $2.3 million from resale of switched services and $1.1
million from special access and private line services, of which $943,000 was
generated by on-net services.
NETWORK OPERATING COSTS. Network operating costs increased from $1.4
million for 1996 to $7.7 million for 1997. The increase was due primarily to
costs of $2.4 million associated with hiring personnel and staffing local
offices, $1.8 million in selling, customer care, insurance, facilities and other
direct operating costs and $2.1 million in costs associated with providing
resale services which we initiated in May 1997.
Costs associated with providing on-net services were greater than revenue
generated from on-net services because we were required to hire personnel and
staff local offices prior to generating revenue and obtaining sufficient revenue
volume to cover such fixed operating costs.
Costs associated with providing resale services are greater than the
revenues currently generated because of narrow discounts on ongoing resale
services provided to us by the incumbent local exchange carriers and because
initial installation charges by the incumbent local exchange carrier to us are
greater than our installation charges to our customers. Resale is primarily an
interim strategy for us to create a backlog of customers to be transitioned to
our on-net switched facilities once our own switches become commercially
operational.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased from $2.2 million for 1996 to $9.9 million for
1997. The increase was due primarily to increases of $4.3 million attributable
to hiring additional personnel in all categories, particularly in senior
management and sales and marketing, $1.1 million in consulting costs (primarily
related to marketing services), and $1.2 million in legal expenditures
(primarily incurred in connection with vendor contracts and regulatory
activities). We expect that selling, general and administrative expenses will
continue to increase in absolute terms as we continue to expand our network
services and marketing activities, but that they will decline as an overall
percentage of revenue.
STOCK OPTION COMPENSATION EXPENSE. Stock option compensation expense, a
non-cash charge, increased from $240,000 in 1996 to $13.9 million in 1997. The
increase was due primarily to an increase in the fair value of KMC Telecom
Inc.'s common stock.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses
increased from $287,000 for 1996 to $2.5 million for 1997. The increase
reflected the six networks that became commercially operational and the one
network that was purchased during 1997 as well as higher amortization of
intangible assets.
INTEREST EXPENSE. Interest expense increased from $596,000 for 1996 to $2.6
million for 1997, primarily reflecting borrowings under the predecessor to the
Senior Secured Credit Facility in 1997, as well as amortization of deferred
financing costs of $561,000. We capitalized interest of $854,000 related to
network construction projects during 1997. Interest expense will continue to
increase as a result of the issuance of the 12 1/2% Senior Discount Notes and to
the extent that we increase our borrowings under the Senior Secured Credit
Facility.
NET LOSS. For the reasons stated above, net loss increased from $4.5
million for 1996 to $32.7 million for 1997.
STOCK COMPENSATION PLAN
During 1996 and 1997, KMC Telecom Inc., now one of the Company's principal
operating subsidiaries, granted options to purchase shares of KMC Telecom Common
Stock pursuant to its 1996 Stock Purchase and Option Plan for Key Employees of
KMC Telecom Inc. and Affiliates (the "KMC Telecom Stock Option Plan"). On June
26, 1998, the Board of Directors of the Company adopted, effective upon
stockholder approval, the 1998 Stock Purchase and Option Plan for Key Employees
of KMC Telecom Holdings, Inc. and Affiliates which authorizes the grant of
options to purchase Common Stock of the Company (the "KMC Holdings Stock Option
Plan"). During the third quarter of 1998, the Company replaced the options to
purchase KMC Telecom Common Stock previously granted under the KMC Telecom Stock
Option Plan, with options to purchase Common Stock of the Company granted under
the KMC Holdings Stock Option Plan and granted options to certain additional
employees of the Company. The Company, upon cancellation of the outstanding
options under the KMC Telecom Stock Option Plan, reversed all compensation
expense previously recorded with respect to such options. Additionally, to the
extent the fair value of the Common Stock of the Company exceeds the exercise
price of the options granted under the KMC Holdings Stock Option Plan, the
Company will recognize compensation expense related to such options over their
vesting period. The net effect of the cancellation of the options outstanding
under the KMC Telecom Stock Option Plan and the grant of options under the KMC
Holdings Stock Option Plan resulted in a credit to compensation expense of
approximately $600,000 in 1998.
Certain provisions in the stock option awards granted under the KMC
Holdings Stock Option Plan will necessitate that such awards be treated as
variable stock compensation awards pursuant to Accounting Principles Board
Opinion No. 25. Accordingly, compensation expense will be charged or credited
periodically through the date of exercise or cancellation of such stock options,
based on changes in the value of the Company's stock as well as the vesting
schedule of such options. These compensation charges or credits are non-cash in
nature, but could have a material effect on the Company's future reported
results of operations.
LIQUIDITY AND CAPITAL RESOURCES
We have incurred significant operating and net losses as a result of the
development and operation of our networks. We expect that such losses will
continue, as we emphasize the development, construction and expansion of our
networks and build our customer base, and that we will generate operating
losses. As a result, cash provided by operations will not be sufficient to fund
the expansion of our networks and service capabilities. We have financed our
operating losses and capital expenditures with equity invested by our founders,
preferred stock placements, credit facility borrowings and the 12 1/2% Senior
Discount Notes.
In February, 1999, we issued 25,000 shares of Series E Senior Redeemable,
Exchangeable, PIK Preferred Stock, 40,000 shares of Series F Senior Redeemable,
Exchangeable, PIK Preferred Stock and warrants to purchase 24,660 shares of our
Common Stock for aggregate gross proceeds of $65.0 million.
In February 1999, our subsidiary, KMC Telecom III, Inc., which will own the
approximately ten additional networks which we currently plan to construct by
the end of the second quarter of 2000, entered into a secured vendor financing
facility with Lucent Technologies, Inc. (the "Lucent Facility"). Under this
facility, KMC Telecom III, Inc. will be permitted to borrow, subject to certain
conditions, up to an aggregate of $600.0 million, primarily for the purchase
from Lucent of switches and other telecommunications equipment. At the present
time, only $125.0 million is available under this facility. An additional $125.0
million will become available when KMC Telecom III, Inc. receives an additional
$35.0 million of funded equity or qualified intercompany loans, as defined in
the facility. The balance of $350.0 million will become available only upon (a)
additional lenders agreeing to participate in the facility so that Lucent's own
aggregate commitment does not exceed $250.0 million and (b) the Company
satisfying certain other requirements, the most significant of which is the
Company raising, and contributing to KMC Telecom III, Inc., at least $300.0
million from the sale of high yield debt or equity.
In December 1998, we refinanced and expanded our $70.0 million senior
secured credit facility with Newcourt Commercial Finance Corporation (which was
formerly known as AT&T Commercial Finance Corporation). Under the refinanced and
expanded facility, which is with a group of lenders led by First Union National
Bank and Newcourt Finance (the "Senior Secured Credit Facility"), our
subsidiaries KMC Telecom Inc., KMC Telecom II, Inc., KMC Telecom Leasing I, LLC,
KMC Telecom Leasing II, LLC and KMC Telecom of Virginia, Inc., which own our
existing twenty-three networks, are permitted to borrow up to an aggregate of
$250.0 million, subject to certain conditions, for the purchase of fiber optic
cable, switches and other telecommunications equipment and, once certain
financial conditions are met, for working capital and other general corporate
purposes.
In January 1998, the Company sold 460,800 units, each unit consisting of
one 12 1/2% Senior Discount Note due 2008, with an aggregate principal at
maturity of $1,000, and one warrant to purchase 0.21785 shares of Common stock
at an exercise price of $.01 per share. The gross and net proceeds of the
offering were approximately $250.0 million and $236.4 million, respectively. The
12 1/2% Senior Discount Notes are unsecured, unsubordinated obligations of KMC
Telecom Holdings, Inc. and mature on February 15, 2008.
Net cash provided by financing activities from borrowings and equity
issuances was $219.4 million for 1998. The Company's net cash used in operating
and investment activities was $213.8 million for 1998.
The Company made capital expenditures of $9.1 million in 1996, $61.1
million in 1997 (including the acquisition of the Melbourne, Florida network for
a purchase price of $2.0 million) and $161.8 million in 1998. The Company
currently plans to make additional capital expenditures of approximately $200.0
million during 1999. Continued significant capital expenditures are expected to
be made thereafter. The majority of these expenditures is expected to be made
for network construction and the purchase of switches and related equipment to
facilitate the offering of the Company's services. In addition, the Company
expects to continue to incur operating losses while it expands its business and
builds its customer base. Actual capital expenditures and operating losses will
depend on numerous factors, including the nature of future expansion and
acquisition opportunities and factors beyond the Company's control, including
economic conditions, competition, regulatory developments and the availability
of capital.
At December 31, 1998 the Company had outstanding commitments aggregating
approximately $30.6 million related to the purchase of fiber optic cable and
telecommunications equipment as well as engineering services, principally under
the Company's agreements with Lucent Technologies, Inc.
At December 31, 1998, the Company had $41.4 million of indebtedness
outstanding under the Senior Secured Credit Facility, and had $208.6 million in
borrowing capacity available under the Senior Secured Credit Facility, subject
to certain conditions.
We believe that our cash, investments held for future capital expenditures
and borrowings available under the Senior Secured Credit Facility and the Lucent
Facility, together with the net proceeds from our February 1999 issuance of our
Series E and Series F Senior Redeemable, Exchangeable, PIK Preferred Stock, will
be sufficient to meet our liquidity needs through the completion of our existing
twenty-three networks and the approximately ten additional networks currently
planned for completion by the end of the second quarter of 2000, although we can
give no assurance in this regard. Thereafter, the Company will require
additional financing. However, in the event that our plans change, the
assumptions upon which our plans are based prove inaccurate, we expand or
accelerate our business plan or we determine to consummate acquisitions, the
foregoing sources of funds may prove insufficient to complete all such networks,
and we may be required to seek additional financing. Additional sources of
financing may include public or private equity or debt financings by the
Company, capitalized leases and other financing arrangements.
Pursuant to certain provisions of our Series A Cumulative Convertible
Preferred Stock and Series C Cumulative Convertible Preferred Stock, we may not
increase the authorized number of shares of our preferred stock or common stock
without the consent of the holders of two-thirds of the shares of both those
series. The Company has only three million shares of common stock authorized. We
can give no assurance that additional financing will be available to the Company
or, if available, that it can be obtained on a timely basis and on acceptable
terms or within the limitations contained in our Senior Secured Credit Facility,
the Lucent Facility, the indenture applicable to our 12 1/2% Senior Discount
Notes, the terms of our preferred stock or any future financing arrangements.
Failure to obtain such financing could result in the delay or abandonment of
some or all of our development and expansion plans and expenditures, which would
have a material adverse effect on our business, financial condition and results
of operations. Such a failure could also limit our ability to make principal and
interest payments on our outstanding indebtedness and meet our dividend and
redemption obligations with respect to our preferred stock. The Company has no
working capital or other credit facility under which it may borrow for working
capital and other general corporate purposes. We can give no assurance that such
financing will be available to the Company in the future or that, if such
financing were available, it would be available on terms and conditions
acceptable to the Company.
As of December 31, 1998, the Company and its subsidiaries had consolidated
net operating loss carryforwards for United States income tax purposes of
approximately $59.0 million which expire through 2013. Under Section 382 of the
Internal Revenue Code of 1986, as amended, if the Company undergoes an
"ownership change," its ability to use its pre-ownership change net operating
loss carryforwards (net operating loss carryforwards accrued through the date of
the ownership change) would generally be limited annually to an amount equal to
the product of (i) the long-term tax-exempt rate for ownership changes
prescribed monthly by the Treasury Department and (ii) the value of the
Company's outstanding equity immediately before the ownership change excluding
certain capital contributions. Any allowable portion of the pre-ownership change
net operating loss carryforwards that is not used in a particular taxable year
following the ownership change could be carried forward to subsequent taxable
years until the net operating loss carryforwards expire, usually 15 years after
they are generated. As a result of the cumulative effect of issuances of
preferred and common stock through September 22, 1997, KMC Telecom Inc. has
undergone an ownership change.
For financial reporting purposes, the Company has an aggregate of
approximately $109.0 million of loss carryforwards and net temporary differences
at December 31, 1998. At existing tax rates the future benefit of these items
approximates $42.0 million. A valuation allowance has been established equal to
the entire net tax benefit associated with all carryforwards and temporary
differences at December 31, 1998 as their realization is uncertain.
YEAR 2000 COMPLIANCE
Similar to all businesses, the Company may be affected by the inability of
certain computer software to distinguish between the years 1900 and 2000 due to
a commonly-used programming convention. Unless such programs are modified or
replaced prior to January 1, 2000, calculations based on date arithmetic or
logical operations performed by such programs may be incorrect.
Management's plan to address the effect of the Year 2000 issue focuses on
the following areas: applications systems (including the Company's billing
system and financial software), infrastructure (including personal computers and
servers used throughout the Company), and other third party business partners,
vendors and suppliers. Management's analysis and review of these areas is
comprised primarily of the following phases: developing an inventory of
hardware, software and embedded chips; assessing the degree to which each area
is currently compliant with Year 2000 requirements; performing renovations,
repairs and replacements as needed to attain compliance; testing to ensure
compliance; and, developing a contingency plan for each area if the Company's
initial efforts to attain compliance are either unsuccessful or untimely.
Management completed the inventory and assessment phases of the project
during the fourth quarter of 1998. The renovation, repair and replacement phase
and the testing phase have commenced; however, the Company expects to continue
these phases throughout 1999.
Further, the Company is currently in the process of implementing new
billing software systems, operational software systems and financial and
personnel software systems. Although these implementations were made necessary
by the expansion of the Company's business and were not directly related to Year
2000 issues, they have enabled the Company to utilize new software for these
purposes which the respective suppliers have certified as Year 2000 compliant.
Costs incurred to date have primarily consisted of labor from the
redeployment of existing information services and operational resources. The
Company expects to spend approximately $150,000 for these Year 2000 compliance
efforts which will be expensed as incurred. Such amount does not include the
costs of the new billing software, operational software and financial and
personnel software systems which are being implemented as a result of the
expansion of the Company's business.
If the software applications of the local exchange carriers, long distance
carriers or others on whose services the Company depends or with which the
Company's systems interact are not Year 2000 compliant, it could affect the
Company's systems which could have a material adverse effect on the Company's
business, financial condition and results of operations.
The Company has formed a contingency team to develop a work plan in the
event that certain programs and hardware are not fully compliant and operational
before January 1, 2000. The costs associated with this effort are currently
being evaluated and cannot yet be determined. In the event that certain, or all,
of the contingency plans are deployed, the Company will incur additional costs;
however, as contingency plans are not yet developed, these costs are
indeterminable at present.
Although the Company does not presently anticipate a material business
interruption as a result of the Year 2000 issue, the worst case scenario if all
of the Company's Year 2000 efforts fail would result in a daily loss of revenues
of approximately $100,000 calculated based upon 1998 revenues.
CERTAIN FACTORS WHICH MAY AFFECT THE COMPANY'S FUTURE RESULTS
LIMITED OPERATING HISTORY; NEGATIVE GROSS PROFITS, OPERATING LOSSES AND
NEGATIVE CASH FLOW
The Company was formed in September 1997 as a holding company. The
Company's subsidiaries commenced operations in 1994 and, as a result, the
Company has a limited operating history and limited revenues. We have only
recently completed the process of building many of our networks. Our prospects
must be considered in the light of the risks, expenses and difficulties
frequently encountered by companies in the early stage of development. In
connection with the construction of our networks we have incurred and expect to
continue to incur significant and increasing negative gross profits, operating
losses and negative EBITDA while we expand our business and build our customer
base. We can give no assurance that an adequate customer base with respect to
any or all of our services will be obtained or sustained.
Our negative gross profits, operating losses, negative EBITDA, cash used by
operations and capital expenditures are expected to increase as a result of the
continuation of our expansion strategy. We can give no assurance that we will
achieve or sustain profitability or generate positive EBITDA or at any time have
sufficient resources to meet our capital expenditure and working capital
requirements or make payments on our indebtedness. We must significantly
increase our revenues and cash flows to meet our debt service and preferred
stock dividend obligations.
SUBSTANTIAL INDEBTEDNESS
At December 31, 1998, we had outstanding approximately $309.2 million of
indebtedness. Our indebtedness could have important consequences including the
following:
o our ability to obtain any necessary financing in the future for
working capital, capital expenditures, debt service requirements or
other purposes will be limited,
o a substantial portion of our cash flow from operations will be
required to make debt service payments,
o our leverage could limit our flexibility in planning for, or reacting
to changes in, our business, making us more highly leveraged than some
of our competitors, which may place us at a competitive disadvantage,
and
o our vulnerability in the event of a downturn in our business will be
increased.
Failure by the Company to meet its obligations could result in a default on
our indebtedness which would permit the holders of all of our indebtedness to
accelerate the maturity thereof.
In connection with the buildup of our networks and expansion of our
services, we have been experiencing increasing negative EBITDA and our earnings
were insufficient to cover fixed charges for 1996, 1997 and 1998. We can give no
assurance that we will be able to improve our earnings before fixed charges or
EBITDA or that we will be able to meet our debt service obligations.
We cannot assure you that our cash flow from operations and capital
resources will be sufficient to repay our 12 1/2% Senior Discount Notes, Senior
Secured Credit Facility and Lucent Facility in full and a substantial portion of
our indebtedness will need to be refinanced. We can give no assurance that we
will be able to effect such refinancings.
You should be aware that our ability to repay or refinance our current debt
depends on our successful financial and operating performance and our ability to
successfully implement our business strategy. Unfortunately, we cannot assure
you that we will be successful in implementing our strategy or in realizing our
anticipated financial results. You should also be aware that our financial and
operational performance depends upon a number of factors, many of which are
beyond our control. These factors include:
o the economic and competitive conditions in the telecommunications
network industry,
o any operating difficulties, increased operating costs or pricing
pressure we may experience,
o the passage of legislation or other regulatory developments that may
adversely affect us,
o any delays in implementing any strategic projects, and
o our ability to complete our networks on time and in a cost-effective
manner.
The Senior Secured Credit Facility, the Lucent Facility and the indenture
applicable to our 12 1/2% Senior Discount Notes contain a number of significant
covenants. These covenants limit our ability to, among other things:
o borrow additional money,
o make capital expenditures and other investments,
o pay dividends,
o merge, consolidate, or dispose of our assets, and
o enter into transactions with our affiliates.
Under the Senior Secured Credit Facility and the Lucent Facility, our
subsidiaries are required to meet certain financial tests at the end of each
quarter. Failure to comply with these covenants could limit our ability to make
further borrowings, or could result in a default under the Senior Secured Credit
Facility and/or the Lucent Facility, allowing the lenders to accelerate the
maturity of the loans made thereunder. There can be no assurance that we will be
able to comply with such covenants in the future.
SIGNIFICANT CAPITAL REQUIREMENTS
Our current plans for expansion of existing networks, the development of
new networks, the further development of our products and services and the
continued funding of operating losses will require substantial additional cash
from outside sources. We anticipate that our capital expenditures for 1999 will
be approximately $200.0 million, that we will have substantial net losses to
fund in 1999 and future years and that our substantial cash requirements will
continue into the foreseeable future. We believe that our cash, investments held
for future capital expenditures, borrowings available under our Senior Secured
Credit Facility and the Lucent Facility, together with the net proceeds from our
February 1999 issuance of our Series E and Series F Senior Redeemable,
Exchangeable, PIK Preferred Stock, will provide sufficient funds for us to
expand our business as currently planned and to fund our currently anticipated
expenses through the completion of our twenty-three existing networks and the
approximately ten additional networks currently planned for completion by the
end of the second quarter of 2000. Thereafter, we will require additional
financing. However, in the event that our plans change, the assumptions upon
which our plans are based prove inaccurate, we expand or accelerate our business
plan or we determine to consummate acquisitions, the foregoing sources of funds
may prove to be insufficient to complete all such networks and we may require
additional financing. Additional sources of financing may include public or
private equity or debt financings by the Company, capitalized leases and other
financing arrangements. Pursuant to certain provisions of our Series A
Cumulative Convertible Preferred Stock and Series C Cumulative Convertible
Preferred Stock we may not increase the authorized number of shares of preferred
stock or common stock of the Company without the consent of the holders of
two-thirds of the shares of both those Series. The Company has only three
million shares of Common Stock authorized. We can give no assurance that
additional financing will be available to us or, if available, that it can be
obtained on a timely basis and on acceptable terms or within the limitations
contained in our Senior Secured Credit Facility, the Lucent Facility, the
indenture applicable to our 12 1/2% Senior Discount Notes, the terms of our
preferred stock or in any future financing arrangements. Failure to obtain such
financing could result in the delay or abandonment of some or all of our
development and expansion plans and expenditures, which would have a material
adverse effect on our business prospects.
HOLDING COMPANY'S RELIANCE ON SUBSIDIARIES' FUNDS; PRIORITY OF OTHER
CREDITORS
We are a holding company whose sole material asset is the common stock of
our subsidiaries. We have pledged all of the common stock of KMC Telecom Inc.,
KMC Telecom II, Inc. and KMC Telecom of Virginia, Inc., which own our
twenty-three existing networks, to the collateral agent under our Senior Secured
Credit Facility. In addition, all of the common stock of KMC Telecom III, Inc.,
which will own the approximately ten new networks currently planned for
completion by the end of the second quarter of 2000, has been pledged to the
collateral agent under the Lucent Facility. We also loaned or contributed a
substantial portion of the net proceeds from the offering of our 12 1/2% Senior
Discount Notes to certain of our subsidiaries. We must rely upon dividends and
other payments from our subsidiaries to generate the funds necessary to meet our
obligations. The subsidiaries are legally distinct from the Company and have no
obligation, contingent or otherwise, to make funds available for such
obligations, except to the extent that they may be obliged to repay loans made
to them by the Company. The ability of our subsidiaries to make such payments to
the Company will be subject to, among other things, the availability of funds,
the terms of each subsidiary's indebtedness and applicable state laws. In
particular, our Senior Secured Credit Facility and the Lucent Facility prohibit
our subsidiaries which are borrowers thereunder from paying dividends and
principal and interest on intercompany borrowings unless they meet certain
financial performance standards. Accordingly, we can give no assurance that we
will be able to obtain any funds from our subsidiaries. Claims of creditors of
the Company's subsidiaries, including trade creditors, will generally have
priority as to the assets of such subsidiaries over the claims of the Company
and the holders of the Company's indebtedness and capital stock. We have
unconditionally guaranteed the repayment of the Senior Secured Credit Facility
and a portion of the Lucent Facility when such repayment is due, whether at
maturity, upon acceleration, or otherwise. We have agreed to pay all amounts
outstanding under the Senior Secured Credit Facility and up to $250.0 million
under the Lucent Facility on demand, upon the occurrence and during the
continuation of any event of default thereunder.
COMPETITION
The telecommunications industry is extremely competitive, particularly with
respect to price and service. We face competition in all of our markets.
Generally, our incumbent local exchange carrier competitor is one of the
Regional Bell Operating Companies, one of GTE Corporation's subsidiaries or one
of Sprint Corporation's subsidiaries. The incumbent local exchange carriers have
long-standing relationships with their customers, have financial, technical and
marketing resources substantially greater than ours, have the potential to fund
competitive services with revenues from a variety of businesses and currently
benefit from certain existing regulations that favor the incumbent local
exchange carriers over us in certain respects.
We do not believe that Tier III markets can profitably support more than
two competitors to the incumbent local exchange carrier. Accordingly, we believe
that once we have completed the construction of our network backbone and the
installation of our switch in a given market, potential new entrants in that
market are likely to seek to deploy their capital elsewhere. We will generally
continue to build in our markets after initial backbone construction and switch
installation. We expect that this demonstration of our commitment to our markets
will further deter new entrants.
However, it is likely that in one or more of our markets we will face
competition from two or more facilities-based competitive local exchange
carriers. After the investment and expense of establishing a network and support
services in a given market, the marginal cost of carrying an additional call is
negligible. Accordingly, in Tier III Markets where there are three or more
facilities-based competitive local exchange carriers, we expect substantial
price competition. We believe that operations in such markets are likely to be
unprofitable for one or more operators.
Potential competitors in our markets include microwave and satellite
carriers, wireless telecommunications providers, cable television companies,
utilities and Regional Bell Operating Companies seeking to operate outside their
current local service areas. In particular, utilities and cable companies are
likely competitors given their existing rights of way. In addition, there may be
future competition from large long distance carriers, such as AT&T and MCI
WorldCom, which have begun to offer integrated local and long distance
telecommunications services. AT&T, TCI and Teleport also recently announced
their intention to offer local services. Consolidation of telecommunications
companies and the formation of strategic alliances within the telecommunications
industry, as well as the development of new technologies, could give rise to
significant new competitors to the Company. One of the primary purposes of the
Telecommunications Act of 1996 is to promote competition, particularly in local
markets. We believe that Tier III Markets will also see more agent and
distributor resale initiatives.
While recent regulatory initiatives, which allow competitive local exchange
carriers such as the Company to interconnect with incumbent local exchange
carrier facilities, provide increased business opportunities for us, these
regulatory initiatives have been accompanied by increased pricing flexibility
for, and relaxation of regulatory oversight of, the incumbent local exchange
carriers. If the incumbent local exchange carriers engage in increased volume
and discount pricing practices or charge competitive local exchange carriers
increased fees for interconnection to their networks, or if the incumbent local
exchange carriers delay implementation of interconnection to their networks, our
business, financial condition and results of operations could be adversely
affected. To the extent we interconnect with and use incumbent local exchange
carrier networks to service our customers, we will be dependent upon the
technology and capabilities of the incumbent local exchange carriers to provide
services and to maintain our service standards. We will become increasingly
dependent on interconnection with incumbent local exchange carriers as switched
services become a greater percentage of our business. The Telecommunications Act
of 1996 imposes interconnection obligations on incumbent local exchange
carriers, but we can give no assurance that we will be able to obtain the
interconnections we require at rates, and on terms and conditions, that permit
us to offer switched services at rates that are both competitive and profitable.
In the event that we experience difficulties in obtaining high quality, reliable
and reasonably priced service from the incumbent local exchange carriers, the
attractiveness of our services to our customers could be impaired.
Both the long distance business and data transmission business are
extremely competitive. Prices in both businesses have declined significantly in
recent years and are expected to continue to decline. In the long distance
business we will face competition from large carriers such as AT&T, MCI Worldcom
and Sprint. We will rely on other carriers to provide transmission and
termination for our long distance traffic and therefore will be dependent on
such carriers.
We expect to experience declining prices and increasing price competition.
We can give no assurance that we will be able to achieve or maintain adequate
market share or revenue, or compete effectively, in any of our markets. Any of
the foregoing factors could have a material adverse effect on our business,
financial condition and results of operations.
RISKS RELATED TO RECIPROCAL COMPENSATION
Beginning in June, 1997, every Regional Bell Operating Company advised
competitive local exchange carriers that they did not consider calls in the same
local calling area from their customers to competitive local exchange carrier
customers which are Internet service providers to be local calls under the
interconnection agreements between the Regional Bell Operating Companies and the
competitive local exchange carriers. The Regional Bell Operating Companies claim
that the calls should be classified as exchange access calls even though the
Federal Communications Commission exempted these calls from payment of access
charges so that no compensation is owed to the competitive local exchange
carriers for transporting and terminating such calls. As a result, the Regional
Bell Operating Companies threatened to withhold, and in many cases did withhold,
reciprocal compensation for the transport and termination of such calls. To
date, twenty-nine state commissions have ruled on this issue in the context of
state commission arbitration proceedings or enforcement proceedings. In every
state, to date, the state commission has determined that reciprocal compensation
is owed for such calls. Several of these cases are presently on appeal. We
cannot predict the outcome of these appeals, or of additional pending cases. If
these calls were to be determined not to be local calls and not subject to
access charges, it could have an adverse effect on our business, financial
condition and results of operations.
DEVELOPMENT AND EXPANSION RISK; NEED TO MANAGE GROWTH
We must achieve substantial growth in order to meet our payment obligations
under our indebtedness and our dividend and redemption obligations with respect
to our capital stock. Our networks have only recently become commercially
operational and we have only recently deployed switches in our networks. Our
success will depend, among other things, upon our ability to:
o assess potential markets,
o design fiber optic backbone routes that provide ready access to a
substantial customer base,
o achieve a sufficient customer base,
o secure financing,
o install facilities,
o obtain required rights-of-way, building access and governmental
permits,
o implement interconnection and collocation with facilities owned by
incumbent local exchange carriers, and
o obtain unbundled network elements from incumbent local exchange
carriers.
Our success will also depend upon subsequent developments in state and
federal regulations. In addition, we may make additional acquisitions of
existing operating systems. Any such acquisitions could divert our resources and
management time and will require integration with our management information,
payroll and other systems, existing networks and service offerings. We can give
no assurance that any networks to be developed or further developed will be
completed on schedule, at a commercially reasonable cost or within our
specifications. Our growth may place a significant strain on our financial,
management and operational resources. Our future performance will depend, in
part, upon our ability to manage our growth effectively, monitor operations,
control costs and maintain effective quality control which will require us to
continue to implement and improve our operating, financial and accounting
systems, to expand, train and manage our employee base and to effectively manage
the integration of acquired businesses. In addition, the establishment of new
operations or acquisitions will involve significant expenses in advance of
anticipated revenues and may cause fluctuations in our operating results.
IMPLEMENTATION RISKS
We are deploying high capacity digital switches in our markets. This will
enable us to offer a variety of switched access services, enhanced services and
local dial tone. We expect to incur negative gross profits and negative EBITDA
from our switched services in any given market during the 24 to 36 month period
after the switch is deployed. We expect operating margins to improve as each
network is expanded and larger volumes of traffic are carried on our network. In
each of our markets, we rely on incumbent local exchange carriers to originate
and terminate all of our switched services traffic until our own switch becomes
operational. Although under the Telecommunications Act of 1996 the incumbent
local exchange carriers will be required to unbundle local network elements and
to permit us to purchase only the origination and termination services we need,
thereby decreasing operating expenses, we can give no assurance that such
unbundling will be effected in a timely manner and result in favorable prices.
To date, we have experienced some difficulty working with incumbent local
exchange carriers to transition our resale customers to our own networks.
Certain incumbent local exchange carriers have proven unable or unwilling to
provide requisite unbundled network elements and collocation facilities on a
prompt basis. We are using Federal Communications Commission arbitration
procedures to compel these incumbent local exchange carriers to act in
conformity with the Telecommunications Act of 1996. The effect of these delays
is to temporarily reduce margins for our services (as the transition from lower
margin resale to higher margin on-net services is delayed) and to delay the
development of positive EBITDA.
We are a recent entrant into the newly created competitive local
telecommunications services industry. The local dial tone services market was
opened to competition by the Telecommunications Act of 1996, and related
regulatory rulings. There are numerous operating complexities associated with
providing these services. We will be required to develop new products, services
and systems and will need to develop new marketing initiatives to sell these
services.
Our services may not be profitable due to, among other factors, lack of
customer demand, inability to secure access to incumbent local exchange carrier
facilities at acceptable rates, competition and pricing pressure from incumbent
local exchange carriers and other competitive local exchange carriers and cost
overruns in connection with network build-outs. We expect to face significant
competitive product and pricing pressure from the incumbent local exchange
carriers in our markets. We have limited experience providing switched access
and local dial tone services and there can be no assurance that we will be able
to successfully implement our switched and enhanced services strategy.
Implementation of our switched and enhanced services is also subject to
equipment manufacturers' ability to meet our switch deployment schedule. There
can be no assurance that all of such switches will be deployed on the schedule
that we contemplate or that, if deployed, such switches will be utilized to the
degree that we contemplate. Any of the foregoing risks could have a material
adverse effect on our business, financial condition and results of operations.
Franchises obtained by the Company may require us to complete the build-out
of our network within a period specified in the franchise grant. If we are
unable to complete the build-out of a network within the specified period, or
obtain an extension of time in which to complete the build-out, our franchise
agreement may be terminable by the local authority. Any such termination of a
franchise agreement could have a material adverse effect on our business,
financial condition and results of operations.
RISKS OF ENTRY INTO LONG DISTANCE BUSINESS
In order to offer our end-user customers a complete package of
telecommunications services, we recently began to offer long distance services
on a resale basis. As a new entrant in the long distance business, we expect to
generate low gross margins and substantial start-up expenses as we roll out our
long distance service offerings. Long distance telecommunications services will
involve the origination of traffic from end-user customers, either directly
connected to our network or through facilities leased from incumbent local
exchange carriers, to our telecommunications switches. We will rely on other
carriers to provide transmission and termination services for our long distance
traffic and will therefore be dependent on such carriers. We enter into resale
agreements with long distance carriers to provide us with long distance
transmission services. Such agreements typically provide for the resale of long
distance services on a per minute basis (some with minimum volume commitments or
volume discounts). The negotiation of these agreements involves estimates of
future supply and demand for long distance telecommunications transmission
capacity as well as estimates of the calling pattern and traffic levels of our
future long distance customers. Should we fail to meet our minimum volume
commitments, if any, pursuant to these resale agreements, we may be obligated to
pay underutilization charges. Likewise, we may underestimate our need for long
distance facilities and therefore be required to obtain the necessary
transmission capacity through more expensive means. We can give no assurance
that we will acquire long distance capacity on favorable terms or that we can
accurately predict long distance prices and volumes so that we can generate
favorable gross margins from our long distance business. Our success in entering
into the long distance business will be dependent upon, among other things, our
ability to select new equipment and software and integrate these into our
networks, hire and train qualified personnel, enhance our billing, back-office
and information systems to accommodate long distance services and the acceptance
by potential customers of our long distance service offerings. If our long
distance transmission business fails to generate favorable gross margins or if
we fail in any of the foregoing respects, such failure may have a material
adverse effect on our business, financial condition and results of operations.
RISKS OF ENTRY INTO DATA TRANSMISSION BUSINESS
To complement our telecommunications services offerings, we began offering
data transmission services in certain of our markets in 1997. We now offer ISDN,
Internet access, Local Area Network-to-Local Area Network interconnect and
wide-area network services and are developing product applications for
Centrex-type, BRI, PRI, port wholesale, frame relay and ATM services to
complement our existing data services. These services are primarily targeted at
large and medium sized businesses with substantial data communications
requirements. We do not expect data transmission services to generate a material
portion of our revenues over the near term. In providing these services, we will
be dependent upon vendors for assistance in the planning and deployment of
initial data product offerings, as well as ongoing training and support. The
success of our entry into the data transmission business will be dependent upon,
among other things:
o our ability to select new equipment and software and integrate these
into our networks,
o our ability to hire and train qualified personnel,
o our ability to enhance our billing, back-office and information
systems to accommodate data transmission services, and
o the acceptance by potential customers of our service offerings.
We cannot assure you that we will be successful with respect to these matters.
If we are not successful with respect to these matters, there may be a material
adverse effect on our business, financial condition and results of operations.
GOVERNMENT REGULATION
Our networks and the provision of switched and private line services are
subject to significant regulation at the federal, state and local levels. The
telecommunications industry in general, and the competitive local exchange
carrier industry in particular, are undergoing substantial regulatory change and
uncertainty. Delays in receiving required regulatory approvals, new court
decisions or the enactment of new adverse regulations or regulatory requirements
may have a material adverse effect on our business, financial condition and
results of operations.
The Telecommunications Act of 1996 was enacted to promote competition in
the domestic telecommunications industry, including the local exchange, long
distance and cable television industries. The Telecommunications Act remains
subject to judicial review and additional Federal Communications Commission and
state public service commission rulemaking, and thus it is difficult to predict
what effect the legislation will have on the Company and our operations. There
are currently many regulatory actions underway and being contemplated by federal
and state authorities regarding interconnection pricing and other issues that
could result in significant changes to the business conditions in the
telecommunications industry. We may be required to cancel our federal interstate
tariff filings at the Federal Communications Commission and implement
replacement contractual arrangements, which could result in substantial legal
and administrative expenses. We cannot assure you that these changes will not
have a material adverse effect on our business, financial condition and results
of operations.
In addition to requirements placed on incumbent local exchange carriers,
the Telecommunications Act of 1996 subjects the Company to certain federal
regulatory requirements regarding the provision of local exchange services. All
incumbent local exchange carriers and competitive local exchange carriers must
offer reciprocal compensation for termination of traffic and provide dialing
parity. However, negotiations with incumbent local exchange carriers have
sometimes involved considerable delays and the agreements may not be on terms
and conditions that are favorable to us. In May 1997, the Federal Communications
Commission adopted a rule that will require us and other competitive local
exchange carriers to contribute to a universal service fund provided for in the
Telecommunications Act of 1996. At the same time, the Federal Communications
Commission adopted rules that will change how access charges are calculated.
These changes will reduce access charge levels closer to their cost and will
shift certain charges currently based on minutes to flat-rate, monthly per-line
charges. As a result, the aggregate access revenue paid to access providers in
the United States is expected to decrease. In addition, the Federal
Communications Commission has also adopted rules that will give incumbent local
exchange carriers pricing flexibility with respect to access charges. We cannot
assure you that the changes to current regulations or the adoption of new
regulations (pursuant to the Telecommunications Act of 1996 or otherwise) by the
Federal Communications Commission or state public service commissions will not
have a material adverse effect on our business, financial condition and results
of operations.
On December 31, 1997, the U.S. District Court for the Northern District of
Texas issued the SBC Decision finding that Sections 271 to 275 of the
Telecommunications Act of 1996 are unconstitutional. These sections of the
Telecommunications Act impose restrictions on the lines of business in which the
Regional Bell Operating Companies may engage, including establishing the
conditions the Regional Bell Operating Companies must satisfy before they may
provide inter-LATA long distance telecommunications services. The SBC Decision
has been reversed upon review by the U.S. Fifth Circuit Court of Appeals and the
U.S. Supreme Court has denied all petitions for certiorari.
State regulatory commissions exercise jurisdiction over our Company to the
extent we provide intrastate services. As such a provider, we are required to
obtain regulatory authorization and/or file tariffs or rate schedules at state
agencies in all of the states in which we operate. Local authorities regulate
our access to municipal rights-of-way. The networks are also subject to numerous
local regulations such as building codes and licensing. Such regulations vary on
a city by city and county by county basis. If authority is not obtained or if
tariffs are not filed, or are not updated, or otherwise do not fully comply with
the tariff filing rules of the Federal Communications Commission or state
regulatory agencies, third parties or regulators could challenge these actions.
Such challenges could cause an interruption or termination of our services and
could cause us to incur substantial legal and administrative expenses.
Many states also regulate transfers of control or assets, and issuances of
stock or debt instruments, by authorized carriers. Accordingly, we may be
subject to prior approval or other filing requirements for such transactions.
DEPENDENCE ON RIGHTS-OF-WAY AND OTHER THIRD PARTY AGREEMENTS
We must obtain easements, rights-of-way, entry to premises, franchises and
licenses from various private parties, actual and potential competitors and
state and local governments in order to construct and operate our networks, some
of which may be terminated upon 30 or 60 days' notice to the Company. We can
give no assurance that we will obtain rights-of-way and franchise agreements on
acceptable terms or that current or potential competitors will not obtain
similar rights-of-way and franchise agreements that will allow them to compete
against us. If any of our existing franchise or license agreements were
terminated or not renewed and we were forced to remove our fiber optic cables or
abandon our networks in place, such termination could have a material adverse
effect on our business, financial condition and results of operations.
DEPENDENCE ON BILLING, CUSTOMER SERVICES AND INFORMATION SYSTEMS
Sophisticated information and processing systems are vital to our growth
and our ability to monitor costs, bill customers, provision customer orders and
achieve operating efficiencies. Our existing billing and information systems
have been produced largely in-house with partial reliance on third-party
vendors. To date, these systems have generally met our needs due in part to our
low volume of bills and orders. As we expand the volume of our dial tone
services, the need for sophisticated billing and information systems is
increased significantly. However, because our existing provisioning system is
not electronic, it constrains our ability to grow our business at a faster rate.
We have recently embarked upon a program to implement a full suite of order
management, customer service, billing and financial applications. These
applications will include electronic order tracking software developed by Eftia
OSS Solutions Inc. and software providing comprehensive billing functionality
developed by Billing Concepts Systems, Inc. The new operational support systems
will be phased in over the next twelve to eighteen months with initial
installation expected by the end of the first quarter of 1999 and electronic
bonding expected by the end of the second quarter. The new billing system will
be phased in over the next twelve months. Our failure to (i) implement the new
operational support systems, convergent billing systems and financial
applications on a timely basis, (ii) adequately identify all of our information
and processing needs, or (iii) upgrade our systems as necessary, could have a
material adverse effect on our business, financial condition and results of
operations.
RAPID TECHNOLOGICAL CHANGE
The telecommunications industry is subject to rapid and significant changes
in technology, with the Company relying on third parties for the development of
and access to new technology. The effect of technological changes on our
business cannot be predicted. We believe our future success will depend, in
part, on our ability to anticipate or adapt to such changes and to offer, on a
timely basis, services that meet customer demands. We cannot assure you that we
will be able to anticipate or adapt to such changes and to offer, on a timely
basis, services that meet customers' demands. A failure to do so would have a
material adverse effect on our business, financial condition and results of
operations.
DEPENDENCE ON KEY PERSONNEL
We believe that the efforts of a small number of key management and
operating personnel will largely determine our success and the loss of any such
persons could adversely affect the Company. We do not maintain so-called "key
man" insurance on any of our personnel. We have employment agreements with Mr.
Kamine, the Chairman of our Board of Directors, Mr. Sternberg, our President and
Chief Executive Officer, and Mr. Young, our Chief Operating Officer, all of
which currently run through December 31, 2002. Our success will also depend in
part upon our ability to hire and retain highly skilled and qualified operating,
marketing, financial and technical personnel. The competition for qualified
personnel in the telecommunications industry is intense and, accordingly, we
cannot assure you that we will be able to hire or retain necessary personnel.
Our failure to hire or retain necessary personnel could have a material adverse
effect on our business, financial condition and results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risks relating to the Company's operations result primarily from
changes in interest rates. The substantial majority of the Company's long-term
debt bears interest at a fixed rate. However, the fair market value of the fixed
rate debt is sensitive to changes in interest rates. The Company is subject to
the risk that market interest rates will decline and the interest expense due
under the fixed rate debt will exceed the amounts due based on current market
rates. Under its current policies, the Company does not utilize any interest
rate derivative instruments to manage its exposure to interest rate changes.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following statements are filed as part of this Annual Report on Form
10-K:
FORM 10-K
PAGE NO.
--------
Report of Independent Auditors.................................................... 35
Consolidated Balance Sheets as of December 31, 1997 and 1998...................... 36
Consolidated Statements of Operations for the years ended December 31, 1996,
1997, and 1998................................................................... 37
Consolidated Statements of Redeemable and Nonredeemable Equity for the years
ended December 31, 1996, 1997 and 1998............................................ 38
Consolidated Statements of Cash Flows for the years ended December 31,
1996, 1997 and 1998.............................................................. 39
Notes to Consolidated Financial Statements........................................ 40
Independent Auditors' Report on Schedules......................................... 61
Schedule I - Condensed Financial Information of Registrant........................ 62
Schedule II - Valuation and Qualifying Accounts................................... 69
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
KMC Telecom Holdings, Inc.
We have audited the consolidated balance sheets of KMC Telecom Holdings, Inc. as
of December 31, 1998 and 1997, and the related consolidated statements of
operations, redeemable and nonredeemable equity and cash flows for each of the
three years in the period ended December 31, 1998. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these 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 audit 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, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of KMC
Telecom Holdings, Inc. as of December 31, 1998 and 1997, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted accounting
principles.
/s/ ERNST & YOUNG LLP
MetroPark, New Jersey
February 2, 1999
KMC TELECOM HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
DECEMBER 31
----------------------------
1997 1998
---- ----
ASSETS
Current assets:
Cash and cash equivalents.............................................. $ 15,553 $ 21,181
Accounts receivable, net of allowance for doubtful accounts of $34 and
$350 in 1997 and 1998, respectively................................. 1,318 7,539
Prepaid expenses and other current assets.............................. 489 1,315
--------- ----------
Total current assets...................................................... 17,360 30,035
Investments held for future capital expenditures.......................... -- 27,920
Networks and equipment, net............................................... 71,371 224,890
Intangible assets, net.................................................... 2,655 2,829
Deferred financing costs, net............................................. 4,196 20,903
Other assets.............................................................. 361 4,733
--------- ----------
$ 95,943 $ 311,310
========= ==========
LIABILITIES, REDEEMABLE AND NONREDEEMABLE EQUITY (DEFICIENCY)
Current Liabilities:
Accounts payable....................................................... $ 5,513 $ 21,052
Accrued expenses....................................................... 8,128 10,374
Due to affiliates...................................................... 47 --
--------- ----------
Total current liabilities................................................. 13,688 31,426
Notes payable............................................................. 51,277 41,414
Subordinated notes payable................................................ 10,000 --
Senior discount notes payable............................................. -- 267,811
--------- ----------
Total liabilities......................................................... 74,965 340,651
Commitments and contingencies
Redeemable equity:
Redeemable cumulative convertible preferred stock, par value $.01 per share;
599 shares authorized; shares issued and outstanding: Series A, 124
shares in 1997 and 1998 ($12,380 liquidation
preference).................................................. 18,879 30,390
Series C, 150 shares in 1997 and 175 shares in 1998 ($17,500
liquidation preference in 1998)................................. 14,667 21,643
Series D, 25 shares in 1997 and - 0 - shares in 1998.............. 2,379 --
Redeemable common stock, shares issued and outstanding,
133 in 1997 and 224 in 1998....................................... 11,187 22,305
Redeemable common stock warrants..................................... 539 674
--------- ----------
Total redeemable equity ................................................ 47,651 75,012
Nonredeemable equity (deficiency)
Common stock, par value $.01 per share; 3,000 shares authorized,
614 shares issued and outstanding................................. 6 6
Additional paid-in capital.......................................... 15,374 13,750
Unearned compensation............................................... (6,521) (5,824)
Accumulated deficit................................................. (35,532) (112,285)
--------- ----------
Total nonredeemable equity (deficiency)................................... (26,673) (104,353)
--------- ----------
$ 95,943 $ 311,310
========= ==========
See accompanying notes.
KMC TELECOM HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31
-------------------------------------------------
1996 1997 1998
---- ---- ----
Revenue................................................................ $ 205 $ 3,417 $ 22,425
Operating expenses:
Network operating costs............................................. 1,361 7,735 37,336
Selling, general and administrative................................ 2,216 9,923 24,534
Stock option compensation expense................................... 240 13,870 7,080
Depreciation and amortization....................................... 287 2,506 9,257
---------- ---------- ----------
Total operating expenses............................................... 4,104 34,034 78,207
---------- ---------- ----------
Loss from operations ................................................ (3,899) (30,617) (55,782)
Interest income......................................................... -- 513 8,818
Interest expense........................................................ (596) (2,582) (29,789)
---------- ---------- ----------
Net loss................................................................ (4,495) (32,686) (76,753)
Dividends and accretion on redeemable preferred stock................... -- (8,904) (18,285)
---------- ---------- ----------
Net loss applicable to common shareholders.............................. $ (4,495) $ (41,590) $ (95,038)
========== ========== ==========
Net loss per common share............................................... $ (7.49) $ (64.93) $ (114.42)
========== ========== ==========
Weighted average number of common shares outstanding.................... 600 641 831
========== ========== ==========
See accompanying notes.
KMC TELECOM HOLDINGS, INC.
(SEE NOTE 1)
CONSOLIDATED STATEMENTS OF REDEEMABLE AND NONREDEEMABLE EQUITY
YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
(IN THOUSANDS)
Redeemable Equity
------------------------------------------------------------------------------------------
Preferred Stock
----------------------------------------------------
Series A Series C Series D Common Stock Total
------------------------------------------------------------------------------- Redeemable
Shares Amount Shares Amount Shares Amount Shares Amount Warrants Equity
------------------------------------------------------------------------------------------
Balance, December 31, - $ - - $ - - $ - - $ - $ - $ -
1995................
Change in authorized
capital.............
Conversion of
stockholder's loan
and related imputed
interest to equity..
Issuance of common
stock...............
Issuance of stock
options to employees
Amortization of
unearned compensation...
Fair value of stock
options issued to
non-employees.......
Reclassification of
deficit accumulated
through date of
termination of
Subchapter S
election............
Net loss..............
--------------------------------------------------------------------------------------------
Balance, December 31, - - - - - - - - - -
1996................
Conversion of
convertible notes
payable to Series A
Preferred Stock..... 124 11,519 11,519
Issuance of warrants.. 2,025 2,025
Issuance of common
stock and exercise 133 10,863 (1,500) 9,363
of warrants.........
Issuance of Series C
Preferred Stock..... 150 14,199 14,199
Issuance of Series D
Preferred Stock..... 25 2,299 2,299
Accretion on
redeemable equity... 7,360 468 80 324 14 8,246
Issuance and
adjustment to fair
value of stock
options to employees
Amortization of
unearned
compensation........
Increase in fair
value of stock
options issued to
non-employees......
Net loss..............
--------------------------------------------------------------------------------------------
Balance, December 31,
1997................ 124 18,879 150 14,667 25 2,379 133 11,187 539 47,651
Conversion of Series
D Preferred Stock
to Series C
Preferred Stock..... 25 2,379 (25) (2,379) -
Issuance of common
stock............... 91 9,500 9,500
Accretion on
redeemable equity... 11,511 4,597 1,618 135 17,861
Payment of dividends
on preferred stock
of subsidiary.......
Issuance of warrants..
Cancellation of KMC
Telecom stock
options.............
Issuance and
adjustment to fair
value of stock
options to employees
Issuance and
adjustment to fair
value of stock
options to
non-employees.......
Amortization of
unearned
compensation........
Net loss..............
============================================================================================
Balance, December 31, 124 $30,390 175 $21,643 - $- 224 $22,305 $674 $75,012
1998................
============================================================================================
KMC TELECOM HOLDINGS, INC.
(SEE NOTE 1)
CONSOLIDATED STATEMENTS OF REDEEMABLE AND NONREDEEMABLE EQUITY
YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998
(IN THOUSANDS)
Nonredeemable Equity
------------------------------------------------------------------------
Total
Common Stock Additional Equity Nonredeemable
------------------ Paid-in Unearned Accumulated Equity
Shares Amount Capital Compensation Deficit (Deficiency)
------------------------------------------------------------------------
Balance, December 31, - $ - $ 2 $ - $ (1,625) $ (1,623)
1995................
Change in authorized 560 6 (6) -
capital.............
Conversion of
stockholder's loan 2,267 2,267
and related imputed
interest to equity..
Issuance of common 40 4,000 4,000
stock...............
Issuance of stock 1,283 (1,283) -
options to employees
Amortization of 44 44
unearned compensation..
Fair value of stock
options issued to 196 196
non-employees.......
Reclassification of
deficit accumulated
through date of
termination of
Subchapter S
election............ (3,274) 3,274 -
Net loss.............. (4,495) (4,495)
-------------------------------------------------------------------------
Balance, December 31, 600 6 4,468 (1,239) (2,846) 389
1996................
Conversion of
convertible notes
payable to Series A
Preferred Stock.....
Issuance of warrants..
Issuance of common
stock and exercise 14
of warrants.........
Issuance of Series C
Preferred Stock.....
Issuance of Series D
Preferred Stock.....
Accretion on
redeemable equity... (8,246) (8,246)
Issuance and
adjustment to fair
value of stock
options to employees 14,296 (14,296) -
Amortization of
unearned
compensation........ 9,014 9,014
Increase in fair
value of stock
options issued to
non-employees...... 4,856 4,856
Net loss.............. (32,686) (32,686)
-------------------------------------------------------------------------
Balance, December 31,
1997................ 614 6 15,374 (6,521) (35,532) (26,673)
Conversion of Series
D Preferred Stock
to Series C
Preferred Stock.....
Issuance of common
stock...............
Accretion on
redeemable equity... (17,861) (17,861)
Payment of dividends
on preferred stock
of subsidiary....... (592) (592)
Issuance of warrants.. 10,446 10,446
Cancellation of KMC
Telecom stock
options............. (26,191) 4,845 (21,346)
Issuance and
adjustment to fair
value of stock
options to employees 27,906 (27,906) -
Issuance and
adjustment to fair
value of stock
options to
non-employees....... 4,668 4,668
Amortization of
unearned
compensation........ 23,758 23,758
Net loss.............. (76,753) (76,753)
========================================================================
Balance, December 31, 614 $6 $ 13,750 $(5,824) $(112,285) $(104,353)
1998................
========================================================================
See accompanying notes.
KMC TELECOM HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Year ended December 31
1996 1997 1998
---- ---- ----
Operating activities
Net loss...................................................... $ (4,495) $ (32,686) $ (76,753)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization.............................. 287 2,506 9,257
Non-cash interest expense.................................. 698 610 25,356
Non-cash stock option compensation expense................. 240 13,870 7,080
Changes in assets and liabilities:
Accounts receivable...................................... (23) (1,296) (6,221)
Prepaid expenses and other current assets................ (138) (346) (826)
Accounts payable......................................... 789 2,934 7,449
Accrued expenses......................................... 417 6,062 2,953
Due to affiliates........................................ (410) (35) (47)
Other assets............................................. (52) (295) (1,821)
--------------- --------------- ---------------
Net cash used in operating activities......................... (2,687) (8,676) (33,573)
--------------- --------------- ---------------
Investing activities
Construction of networks and purchases of equipment........... (9,111) (59,146) (148,580)
Acquisitions of franchises, authorizations and related assets. (1,063) (1,846) (1,147)
Cash paid for acquisition of Melbourne Network................ - (2,000) -
Deposit on purchase of equipment.............................. - - (2,551)
Purchase of investments, net.................................. - - (27,920)
--------------- --------------- ---------------
Net cash used in investing activities......................... (10,174) (62,992) (180,198)
--------------- --------------- ---------------
Financing activities
Proceeds from stockholder loans............................... 3,542 - -
Repayment of stockholder loans................................ (4,181) - -
Proceeds from notes payable, net of issuance costs............ 10,953 59,873 938
Proceeds from issuance of common stock and warrants,
net of issuance costs....................................... 4,000 9,363 20,446
Proceeds from issuance of preferred stock, net of
issuance costs.............................................. - 16,498 -
Issuance costs of senior secured credit facility.............. - - (6,515)
Repayment of notes payable.................................... - - (20,801)
Proceeds from issuance of senior discount notes, net of
issuance costs............................................. - - 225,923
Dividends on preferred stock of subsidiary.................... - - (592)
--------------- --------------- ---------------
Net cash provided by financing activities..................... 14,314 85,734 219,399
--------------- --------------- ---------------
Net increase in cash and cash equivalents..................... 1,453 14,066 5,628
Cash and cash equivalents, beginning of year.................. 34 1,487 15,553
--------------- --------------- ---------------
Cash and cash equivalents, end of year........................ $ 1,487 $ 15,553 $ 21,181
=============== =============== ===============
Supplemental disclosure of cash flow information
Cash paid during the year for interest, net of amounts
capitalized................................................... $ 97 $ 766 $ 4,438
=============== =============== ===============
See accompanying notes.
KMC TELECOM HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION
KMC Telecom Holdings, Inc. ("KMC Holdings") is a holding company formed during
1997 primarily to own all of the shares of its operating subsidiaries, KMC
Telecom Inc. ("KMC Telecom"), KMC Telecom II, Inc. ("KMC Telecom II"), KMC
Telecom III, Inc. ("KMC Telecom III") and KMC Telecom of Virginia Inc. On
September 22, 1997, the stockholders of KMC Telecom exchanged all of their KMC
Telecom common and preferred stock for equal numbers of shares of common and
preferred stock of KMC Holdings. The merger was accounted for as an exchange of
shares between entities under common control, and no changes were made to the
historical cost basis of KMC Telecom's net assets.
KMC Holdings and its direct and indirect wholly-owned subsidiaries, KMC Telecom,
KMC Telecom II, KMC Telecom III and KMC Telecom of Virginia, Inc. are
collectively referred to herein as the Company.
The predecessors to KMC Telecom, Kamine Multimedia Corp. and KMC Southeast Corp.
(the "Predecessors") were incorporated in the state of Delaware on May 10, 1994
and April 19, 1995, respectively, and all of the outstanding common stock of
each company was owned by Harold N. Kamine ("Kamine"). Effective May 23, 1996,
Kamine Multimedia Corp. was merged into KMC Southeast Corp., and the surviving
corporation was renamed KMC Telecom Inc. The merger was accounted for as a
combination of entities under common control, and the net assets of Kamine
Multimedia Corp. were transferred at their historical cost in a manner similar
to that in pooling of interests accounting.
The Company is a facilities-based competitive local exchange carrier ("CLEC")
providing telecommunications and data services to its customers; principally
business, government and institutional end-users, as well as Internet service
providers, long distance companies and wireless service providers, primarily in
the Southeastern and Midwestern United States.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
As noted above, effective May 23, 1996, KMC Telecom was the successor resulting
from the merger of the Predecessors, and effective September 22, 1997, KMC
Telecom became a wholly-owned subsidiary of KMC Holdings. The accompanying
financial statements include the consolidated financial position and results of
operations of KMC Holdings and its subsidiaries subsequent to September 22,
1997, the results of operations of KMC Telecom from May 23, 1996, and the
combined results of operations of the Predecessors from January 1, 1996. All
significant intercompany transactions and balances have been eliminated.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with maturities of three
months or less when purchased to be cash equivalents.
INVESTMENTS HELD FOR FUTURE CAPITAL EXPENDITURES
The Company has designated certain amounts as investments held for future
capital expenditures. As of December 31, 1998, the Company's investments held
for future capital expenditures consisted of cash equivalents (bank term
deposits and commercial paper with maturities of less than 90 days) of $11.2
million and debt securities (U.S. government obligations and commercial bonds
due within 1 year) of $16.7 million. All debt securities have been designated by
the Company as held-to-maturity. Accordingly, such securities are recorded in
the accompanying December 31, 1998 financial statements at amortized cost. At
December 31, 1998, the carrying value of such held-to-maturity debt securities
approximated their fair value.
NETWORKS AND EQUIPMENT
Networks and equipment are stated at cost, net of accumulated depreciation.
Depreciation is provided over the estimated useful lives of the respective
assets using the straight-line method for financial statement reporting
purposes.
The estimated useful lives of the Company's principal classes of assets are as
follows:
Networks:
Fiber optic systems..............................................20 years
Telecommunications equipment.....................................10 years
Furniture and fixtures.............................................5 years
Leasehold improvements.............................................Life of lease
INTANGIBLE ASSETS
Costs incurred in developing new networks or expanding existing networks,
including negotiation of rights-of-way and obtaining regulatory authorizations
are capitalized and amortized over the initial term of the agreements, which
generally range from 2 to 15 years. Costs incurred to obtain city franchises are
capitalized by the Company and amortized over the initial term of the
franchises, which generally range from 2 to 15 years.
DEFERRED FINANCING COSTS
The Company capitalizes issuance costs related to its debt. Such costs are
amortized utilizing the interest method over the lives of the related debt. The
related amortization is included as a component of interest expense, and
amounted to $189,000, $561,000 and $2,279,000 for the years ended December 31,
1996, 1997 and 1998, respectively.
OTHER ASSETS
Other assets are comprised principally of non-refundable deposits for the
purchase of switching equipment, employee loans, security deposits and other
deposits.
REVENUE RECOGNITION
Revenue is recognized in the period the service is provided. Unbilled revenue
included in accounts receivable represents revenue earned for services which
will be billed in the succeeding month and totaled $1,272,000 at December 31,
1998. The Company generally invoices customers one month in advance for
recurring services resulting in deferred revenue of $1,187,000 at December 31,
1998.
NET LOSS PER COMMON SHARE
Earnings per share are calculated in accordance with FASB Statement No. 128,
Earnings per Share ("Statement 128"). All earnings per share amounts for all
periods have been presented in accordance with the provisions of Statement 128.
Diluted earnings per share have not been presented for any period, as the impact
of including outstanding options and warrants would be anti-dilutive. The
Predecessors' earnings per share have been computed as if the May 23, 1996
merger had occurred as of January 1, 1996.
INCOME TAXES
The Company uses the liability method to account for income taxes. Deferred
taxes are recorded based upon differences between the financial statement and
tax basis of assets and liabilities.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
ADVERTISING COSTS
Advertising costs are included in selling, general and administrative expenses
and charged to expense as incurred. For the years ended December 31, 1997 and
1998, such costs were $66,000 and $2,769,000, respectively.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company records impairment losses on long-lived assets used in operations or
expected to be disposed of when events and circumstances indicate that the cash
flows expected to be derived from those assets are less than the carrying
amounts of those assets. No such events and circumstances have occurred.
STOCK-BASED COMPENSATION
As permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation
("Statement 123"), the Company has elected to follow Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related
interpretations in accounting for its employee stock-based compensation. Under
APB 25, no compensation expense is recognized at the time of option grant if the
exercise price of the employee stock option is fixed and equals or exceeds the
fair market value of the underlying common stock on the date of grant, and the
number of shares to be issued pursuant to the exercise of such option are known
and fixed at the grant date. As more fully described in Note 7, the Company's
outstanding stock options are not considered fixed options under APB 25. The
Company accounts for non-employee stock-based compensation in accordance with
Statement 123.
COMPREHENSIVE INCOME
In 1998, the Company adopted FASB Statement No. 130, Reporting Comprehensive
Income, which established new rules for the reporting and display of
comprehensive income and its components in a full set of general-purpose
financial statements. This statement has no effect on the Company's financial
statement presentation because the Company presently has no items of
comprehensive income.
SEGMENT REPORTING
In 1998, the Company adopted FASB Statement No. 131, Disclosures About Segments
of an Enterprise and Related Information ("Statement 131"). Statement 131 uses a
management approach to report financial and descriptive information about an
entity's operating segments. Operating segments are revenue-producing components
of an enterprise for which separate financial information is produced internally
for the entity's management. Under this definition, the Company operated within
a single segment for all periods presented.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 1998, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position 98-5, Reporting on the Costs of Start-Up
Activities, which is effective for fiscal years beginning after December 15,
1998. This statement requires costs of start-up activities to be expensed as
incurred. The Company does not anticipate that the adoption of this statement
will have any effect on its results of operations or financial position, because
the Company currently expenses such costs.
In June 1998, the FASB issued Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities. The Company expects to adopt the new
Statement effective January 1, 2000. This statement will require the Company to
recognize all derivatives on the balance sheet at fair value. The Company does
not anticipate that the adoption of this statement will have a significant
effect on its results of operations or financial position, because the Company
presently has no derivatives.
3. NETWORKS AND EQUIPMENT
Networks and equipment are comprised of the following:
December 31
1997 1998
--------------------------------
(in thousands)
Fiber optic systems........................... $29,837 $ 99,502
Telecommunications equipment.................. 18,052 115,769
Furniture and fixtures........................ 1,518 7,340
Leasehold improvements........................ 792 1,177
Construction-in-progress...................... 23,556 11,770
--------------------------------
73,755 235,558
Less accumulated depreciation................ (2,384) (10,668)
--------------------------------
$71,371 $224,890
================================
Costs capitalized during the development of the Company's networks include
amounts incurred related to network engineering, design and construction and
capitalized interest. Capitalized interest related to the construction of the
networks during the years ended December 31, 1996, 1997 and 1998 amounted to
$103,000, $854,000 and $5,133,000, respectively.
For the years ended December 31, 1996, 1997 and 1998, depreciation expense was
$260,000, $2,122,000 and $8,284,000, respectively.
4. INTANGIBLE ASSETS
Intangible assets are comprised of the following:
December 31
1997 1998
-------------------------------
(in thousands)
Franchise costs............................... $ 1,342 $ 1,690
Authorizations and rights-of-ways............. 1,151 1,455
Building access agreements and other.......... 567 1,062
-------------------------------
3,060 4,207
Less accumulated amortization................. (405) (1,378)
-------------------------------
$ 2,655 $ 2,829
===============================
5. ACCRUED EXPENSES
Accrued expenses are comprised of the following:
December 31
1997 1998
-------------------------------
(in thousands)
Accrued compensation.......................... $ 1,179 $ 4,138
Deferred revenue.............................. 498 1,187
Other accrued expenses........................ 6,451 5,049
-------------------------------
$ 8,128 $10,374
===============================
6. LONG-TERM DEBT
SENIOR SECURED CREDIT FACILITY
On September 22, 1997, KMC Telecom and KMC Telecom II entered into an Amended
and Restated Loan and Security Agreement (the "AT&T Facility") with AT&T
Commercial Finance Corporation ("AT&T Finance") which provided for borrowings up
to an aggregate of $70 million.
On December 22, 1998, KMC Telecom, KMC Telecom II and KMC Telecom of Virginia
(the "Borrowers"), refinanced and expanded the AT&T Facility by entering into a
Loan and Security Agreement (the "Senior Secured Credit Facility") with AT&T
Finance, First Union National Bank, General Electric Capital Corporation
("GECC") and Canadian Imperial Bank of Commerce (the "Lenders"). Under the
Senior Secured Credit Facility, the Lenders agreed to lend the Borrowers up to
an aggregate of $250 million initially to be used for the construction and
expansion of fiber optic telecommunications networks in certain markets and for
payment of transaction fees and expenses and, subject to the attainment of
certain financial conditions, for working capital and general corporate
purposes.
The Senior Secured Credit Facility includes a $175 million eight year revolving
loan (the "Revolver") and a $75 million eight and one half year term loan (the
"Term Loan"). At December 31, 1998, an aggregate of $41.4 million was
outstanding under this facility.
The Senior Secured Credit Facility will mature no later than July 1, 2007. The
outstanding principal balance of the Term Loan is payable in twenty consecutive
quarterly installments of $188,000 beginning on April 1, 2002 and two final
installments of $35.6 million each on April 1, 2007 and July 1, 2007. The
aggregate commitment of the Lenders under the Revolver will be reduced on each
payment date beginning April 1, 2002. The initial quarterly commitment
reductions are 2.5%, increasing to 5% on April 1, 2003 and further increasing to
7.5% on April 1, 2006. Commencing on April 1, 2002, the aggregate Revolver
commitment will be further reduced by an amount equal to 50% of excess operating
cash flows (as defined in the facility) for the prior fiscal year until the
Borrowers achieve and maintain for at least two consecutive fiscal quarters
certain financial conditions. Additionally, in the event certain principal
amounts due under the Revolver are repaid and not reborrowed within 120 days of
such repayment, then the aggregate commitment under the Revolver will be reduced
by such amount.
Borrowings under the Senior Secured Credit Facility will bear interest payable
at the Borrowers' option, at (a) the "Applicable Base Rate Margin" (which
generally ranges from 1.75% to 3.25%) plus the greater of (i) the administrative
agent's prime rate or (ii) the overnight federal funds rate plus .5% or (b) the
"Applicable LIBOR Margin" (which generally ranges from 2.75% to 4.25%) plus
LIBOR, as defined. If the Borrowers default on any interest or principal payment
due under the Senior Secured Credit Facility, the interest rate will increase by
four percentage points. If any other event of default shall occur, the interest
rate will be increased by two percentage points. Interest on each LIBOR loan is
payable on each LIBOR interest payment date in arrears and interest on each base
rate loan is payable quarterly in arrears. Interest on borrowings outstanding at
December 31, 1998 was based on LIBOR, and the Borrowers were being charged at an
annual rate of 9.38%. The Borrowers must pay an annual commitment fee on the
unused portion of the Senior Secured Credit Facility ranging from .75% to 1.25%.
KMC Holdings has unconditionally guaranteed the repayment of the Senior Secured
Credit Facility when such repayment is due, whether at maturity, upon
acceleration, or otherwise. KMC Holdings has pledged the shares of each of the
Borrowers to the Lenders to collateralize its obligations under the guaranty. In
addition, the Borrowers have each pledged all of their assets to the Lenders.
The Senior Secured Credit Facility contains a number of affirmative and negative
covenants including, among others, covenants restricting the ability of the
Borrowers to consolidate or merge with any person, sell or lease assets not in
the ordinary course of business, sell or enter into long term leases of dark
fiber, redeem stock, pay dividends or make any other payments (including
payments of principal or interest on loans) to KMC Holdings, create
subsidiaries, transfer any permits or licenses, or incur additional indebtedness
or act as guarantor for the debt of any person, subject to certain conditions.
The Borrowers are required to comply with certain financial tests and maintain
certain financial ratios, including, among others, a ratio of total debt to
contributed capital, certain minimum revenues, maximum EBITDA losses and minimum
EBITDA, maximum capital expenditures and minimum access lines, a maximum total
leverage ratio, a minimum debt service coverage ratio, a minimum fixed charge
coverage ratio and a maximum consolidated leverage ratio. The covenants become
more restrictive upon the earlier of (i) June 30, 2001 and (ii) after the
Borrowers achieve positive EBITDA on a combined basis for two consecutive fiscal
quarters.
Failure to satisfy any of the financial covenants will constitute an event of
default under the Senior Secured Credit Facility permitting the Lenders, after
notice, to terminate the commitment and/or accelerate payment of outstanding
indebtedness. The Senior Secured Credit Facility also includes other customary
events of default, including, without limitation, a cross-default to other
material indebtedness, material undischarged judgments, bankruptcy, loss of a
material franchise or material license, breach of representations and
warranties, a material adverse change, and the occurrence of a change of
control.
SENIOR DISCOUNT NOTES
On January 29, 1998, KMC Holdings sold 460,800 units, each unit consisting of a
12 1/2% senior discount note with a principal amount at maturity of $1,000 due
2008 pursuant to the Senior Discount Note Indenture between KMC Holdings and the
Chase Manhattan Bank, as trustee (the "Senior Discount Notes"), and one warrant
to purchase .21785 shares of Common Stock of KMC Holdings at an exercise price
of $.01 per share. The gross and net proceeds of the offering were approximately
$250.0 million and $236.4 million, respectively. A substantial portion of the
net proceeds of the offering have been loaned by KMC Holdings to its
subsidiaries. On August 11, 1998, KMC Holdings consummated an offer to exchange
the notes issued on January 29, 1998 for $460.8 million aggregate principal
amount at maturity of notes that had been registered under the Securities Act of
1933 (as used below and elsewhere herein, "Senior Discount Notes" includes the
original notes and the exchange notes).
The Senior Discount Notes are unsecured, unsubordinated obligations of the
Company and mature on February 15, 2008. The Senior Discount Notes were sold at
a substantial discount from their principal amount at maturity, and there will
not be any payment of interest on the Senior Discount Notes prior to August 15,
2003. The Senior Discount Notes will fully accrete to face value on February 15,
2003. From and after February 15, 2003, the Senior Discount Notes will bear
interest, which will be payable in cash, at the rate of 12.5% per annum on
February 15 and August 15 of each year, commencing August 15, 2003. The Company
is accreting the initial carrying value of the Senior Discount Notes to their
aggregate face value over the term of the debt at its effective interest rate of
13.7%.
The Senior Discount Notes are redeemable, at the Company's option, in whole or
in part, on or after February 15, 2003 and prior to maturity, at redemption
prices equal to 106.25% of the aggregate principal amount at maturity, plus
accrued and unpaid interest, if any, to the redemption date, declining to 100%
of the aggregate principal amount at maturity, plus accrued and unpaid interest
as of February 15, 2006.
In addition, at any time prior to April 15, 2000, the Company may redeem up to
35% of the aggregate principal amount at maturity of the Senior Discount Notes
with the net proceeds from the sale of common equity at a redemption price of
112.50% of their accreted value on the redemption date.
The indebtedness evidenced by the Senior Discount Notes ranks pari passu in
right of payment with all existing and future unsubordinated, unsecured
indebtedness of KMC Holdings and senior in right of payment to all existing and
future subordinated indebtedness of KMC Holdings. However, KMC Holdings is a
holding company and the Senior Discount Notes are, therefore, effectively
subordinated to all existing and future liabilities (including trade payables)
of its subsidiaries.
Within 30 days of the occurrence of a Change of Control (as defined in the
Senior Discount Note Indenture), the Company must offer to purchase for cash all
Senior Discount Notes then outstanding at a purchase price equal to 101% of the
accreted value thereof, plus accrued interest. The Company's ability to comply
with this requirement is subject to certain restrictions contained in the Senior
Secured Credit Facility.
The Senior Discount Note Indenture contains events of default, including, but
not limited to, (i) defaults in the payment of principal, premium or interest,
(ii) defaults in compliance with covenants contained in the Senior Discount Note
Indenture, (iii) cross defaults on more than $5 million of other indebtedness,
(iv) failure to pay more than $5 million of judgments that have not been stayed
by appeal or otherwise and (v) the bankruptcy of KMC Holdings or certain of its
subsidiaries. The Senior Discount Note Indenture restricts, among other things,
the ability of KMC Holdings to incur additional indebtedness, create liens,
engage in sale-leaseback transactions, pay dividends or make distributions in
respect of capital stock, make investments or certain other restricted payments,
sell assets of KMC Holdings, redeem capital stock, issue or sell stock of
restricted subsidiaries, enter into transactions with stockholders or affiliates
or effect a consolidation or merger. The Senior Discount Note Indenture permits
KMC Holdings' subsidiaries to be deemed unrestricted subsidiaries and, thus, not
subject to the restrictions of the Senior Discount Note Indenture.
The Senior Discount Notes are "applicable high yield discount obligations"
("AHYDOs"), as defined in the Internal Revenue Code of 1986, as amended. Under
the rules applicable to AHYDOs, a portion of the original issue discount ("OID")
that accrues on the Senior Discount Notes will not be deductible by the Company
at any time. Any remaining OID on the Senior Discount Notes will not be
deductible by the Company until such OID is paid.
OTHER INDEBTEDNESS
On September 22, 1997, KMC Telecom and KMC Telecom II obtained a subordinated
term loan (the "Supplemental AT&T Facility") from AT&T Finance with an original
principal amount of $10 million. The Supplemental AT&T Facility was, by its
terms, due in full upon the closing of a debt offering with gross cash proceeds
of at least $50 million. On January 29, 1998, the entire $10 million outstanding
under this facility was repaid in full with a portion of the proceeds of the
Company's issuance of Senior Discount Notes and warrants.
During 1996, KMC Telecom issued convertible secured notes payable aggregating
$11,894,000 and $106,000 to two entities, Nassau Capital Partners L.P. and NAS
Partners I L.L.C. ("Nassau Capital" and "Nassau Partners", respectively,
collectively referred to as "Nassau") (such notes are collectively referred to
herein as the "Convertible Notes".) On January 21, 1997, the Convertible Notes,
including accrued interest through that date, aggregating approximately
$12,380,000 were converted into 123,800 shares of Series A Cumulative
Convertible Preferred Stock of KMC Telecom (such stock was subsequently
exchanged for an equal number of shares of Series A Preferred Stock of KMC
Holdings on September 22, 1997).
7. REDEEMABLE AND NONREDEEMABLE EQUITY
KMC TELECOM PREFERRED STOCK
On January 21, 1997, the Convertible Notes were converted into 123,800 shares of
Series A Cumulative Convertible Preferred Stock of KMC Telecom with an aggregate
liquidation value of $12,380,000. Effective September 22, 1997, all of the
shares of Series A Cumulative Convertible Preferred Stock of KMC Telecom were
exchanged for an equal number of shares of Series A Cumulative Convertible
Preferred Stock of KMC Holdings.
Pursuant to an agreement with Nassau, all dividends accumulated on the Series A
Cumulative Convertible Preferred Stock of KMC Telecom through September 22, 1997
($592,000) were paid upon the closing of KMC Holdings' issuance of Senior
Discount Notes and warrants on January 29, 1998.
SERIES A PREFERRED STOCK
There are 123,800 shares of Series A Cumulative Convertible Preferred Stock of
KMC Holdings ("Series A Preferred Stock") authorized and outstanding. Series A
Preferred Stock has a liquidation preference of $100 per share and an annual
dividend equal to 7.0% of the liquidation preference, payable quarterly, when
and if declared by the Board of Directors out of funds legally available
therefor. Unpaid dividends accumulate and the unpaid amount increases at the
annual rate of 7.0%, compounded quarterly. All accumulated but unpaid dividends
will be paid upon the occurrence of a Realization Event (defined as (i) an
initial public offering with gross proceeds of at least $40 million or (ii) sale
of substantially all the assets or stock of the Company or the merger or
consolidation of the Company into one or more other corporations). As of
December 31, 1998, dividends in arrears on the Series A Preferred Stock
aggregated $1,144,000. Notwithstanding the foregoing, pursuant to an agreement
among Nassau and the Company, Nassau has agreed to forego the payment of
dividends from September 22, 1997 through the date on which Nassau disposes of
its interest in the Company; provided that at the time of such disposition,
Nassau has received not less than a 10% annual compound rate of return during
the period it held the Series A Preferred Stock.
Series A Preferred Stock is convertible into Common Stock at a conversion price
equal to $20.63 per share of Common Stock, subject to adjustment upon the
occurrence of certain events. Holders of Series A Preferred Stock may convert
all or part of such shares to Common Stock. Upon conversion, subject to the
aforementioned agreement to forego the payment of dividends, the holders are
entitled to receive a cash payment of the accumulated but unpaid dividends;
provided, however, that the Company may substitute common shares having a fair
market value equal to the amount of such cash payment if the conversion occurs
before a Realization Event. Series A Preferred Stock will automatically convert
into Common Stock upon the occurrence of a Qualified Public Offering (defined as
the first sale of Common Stock pursuant to a registration statement filed under
the Securities Act of 1933 in which the Company receives gross proceeds of at
least $40 million, provided that the per share price at which such shares are
sold in such offering is at least four times the conversion price of the Series
A Preferred Stock).
The holders of Series A Preferred Stock, except as otherwise provided in the
Company's Certificate of Incorporation, are entitled to vote on all matters
voted on by holders of Common Stock. Each share of Series A Preferred Stock is
entitled to a number of votes equal to the number of shares of Common Stock into
which such share is convertible. Without the prior consent of two-thirds of the
shares of Series A Preferred Stock, among other things, the Company may not
increase the number of shares of preferred stock (of whatever series) authorized
for issuance, or declare or pay any dividends on shares of Common Stock or other
junior shares. As discussed under "Redemption Rights" below, the holders of
Series A Preferred Stock have certain redemption rights. Accordingly, such stock
has been reflected as redeemable equity in the accompanying financial
statements.
SERIES C PREFERRED STOCK
There are 350,000 shares of Series C Cumulative Convertible Preferred Stock of
KMC Holdings ("Series C Preferred Stock") authorized, of which 175,000 shares
are outstanding at December 31, 1998. 150,000 of such shares were issued in
November 1997, generating aggregate gross proceeds of $15 million and the
remaining 25,000 shares were issued in January 1998 upon the conversion of an
equal number of shares of Series D Preferred Stock. Series C Preferred Stock has
a liquidation preference of $100 per share and an annual dividend equal to 7.0%
of the liquidation preference, payable quarterly, when and if declared by the
Board of Directors out of funds legally available therefor. Unpaid dividends
accumulate and the unpaid amount increases at the annual rate of 7.0%,
compounded quarterly. All accumulated but unpaid dividends will be paid upon the
occurrence of a Realization Event. As of December 31, 1998, dividends in arrears
on the Series C Preferred Stock aggregated $1,458,000. Notwithstanding the
foregoing, pursuant to the Purchase Agreement among the Company, Nassau, GECC
and CoreStates Holdings, Inc. ("CoreStates"), each current holder of Series C
Preferred Stock has agreed to forego the payment of dividends that accumulate
during the period from issuance through the date on which such holder disposes
of its interest in the Company; provided that at the time of such disposition,
it has received not less than a 10% annual compound rate of return during such
period.
Series C Preferred Stock is convertible into Common Stock at a conversion price
equal to (i) from the date of initial issuance to the date which is 30 months
after the date of such initial issuance, $52.50 per share of Common Stock and
(ii) from and after the date which is 30 months after the date of initial
issuance, $42.18; provided that both such amounts are subject to adjustment upon
the occurrence of certain events. Holders of Series C Preferred Stock may
convert all or part of such shares to Common Stock. Upon conversion, subject to
the aforementioned agreement to forego the payment of dividends, the holders are
entitled to receive a cash payment of the accumulated but unpaid dividends;
provided, however, that the Company may substitute common shares having a fair
market value equal to the amount of such cash payment if the conversion occurs
before a Realization Event. Series C Preferred Stock will automatically convert
into Common Stock upon the occurrence of a Qualified Public Offering.
The holders of Series C Preferred Stock, except as otherwise provided in the
Company's Certificate of Incorporation, are entitled to vote on all matters
voted on by holders of Common Stock. Each share of Series C Preferred Stock is
entitled to a number of votes equal to the number of shares of Common Stock into
which such share is convertible. Without the prior consent of two-thirds of the
shares of Series C Preferred Stock, among other things, the Company may not
increase the number of shares of preferred stock (of whatever series) authorized
for issuance, or declare or pay any dividends on shares of Common Stock or other
junior shares. As discussed under "Redemption Rights" below, the holders of
Series C Preferred Stock have certain redemption rights. Accordingly, such stock
has been reflected as redeemable equity in the accompanying financial
statements.
The Series C Preferred Stock is subject to redemption at the option of the
Company, in whole but not in part, in connection with an "Acquisition Event." An
Acquisition Event is defined to mean any merger or consolidation of the Company
with any other company, person or entity, whether or not the Company is the
surviving entity, as a result of which the holders of the Company's Common Stock
(determined on a fully diluted basis) will hold less than a majority of the
outstanding shares of Common Stock or other equity interest of the Company,
person or entity resulting from such transaction, or any parent of such entity.
SERIES D PREFERRED STOCK
There are 25,000 shares of Series D Cumulative Convertible Preferred Stock of
KMC Holdings ("Series D Preferred Stock") authorized, none of which are
outstanding at December 31, 1998. There were 25,000 of such shares issued to
Nassau in November 1997, generating aggregate gross proceeds of $2.5 million. In
January 1998, Nassau exercised its conversion rights and converted all of its
shares of Series D Preferred Stock into an equal number of shares of Series C
Preferred Stock.
COMMON STOCK
Holders of Common Stock of the Company are entitled to one vote for each share
held on all matters submitted to a vote of stockholders, except with respect to
the election of Directors. Except as otherwise required by law, actions at the
Company's stockholders meetings (held at least annually), require the
affirmative vote of a majority of the shares represented at the meeting, a
quorum being present. Holders of Common Stock are entitled, subject to the
preferences of preferred stock, to receive such dividends, if any, as may be
declared by the Board of Directors out of funds legally available therefor. The
Senior Discount Note Indenture and the Company's other indebtedness restrict the
ability of the Company to pay dividends on its Common Stock. Without the prior
consent of two-thirds of the shares of Series A Preferred Stock and two-thirds
of the shares of Series C Preferred Stock, the Company may not declare or pay
any dividends on its Common Stock. Except as discussed under "Redemption Rights"
below, the holders of Common Stock have no preemptive, redemption or conversion
rights.
Pursuant to provisions contained in the Company's Certificate of Incorporation
and an Amended and Restated Stockholders Agreement dated as of October 31, 1997,
among the Company, Kamine, Nassau, AT&T Credit Corporation ("AT&T Credit"),
GECC, and CoreStates (the "Stockholders' Agreement"), until Kamine and Nassau
cease to own Common Stock or preferred stock convertible into Common Stock
representing at least five percent of the outstanding shares of Common Stock,
assuming all convertible securities are converted, Kamine and Nassau have
special rights entitling each to elect three Directors. A Director elected by
Kamine's shares or Nassau's shares may not be removed except with the
affirmative vote of a majority of the applicable shares of capital stock. If
Kamine or Nassau transfer their shares of capital stock, the number of Directors
their shares are entitled to elect decreases. The number of Directors which
Kamine is entitled to elect would be reduced to two if the number of shares
owned by him were to fall below two-thirds of the number of shares of the
Company initially issued to him, and to one if the number of shares owned by him
were to fall below one-third of the number of shares initially issued to him. If
his ownership were to fall below 5% of the number of shares initially issued to
him, Kamine would no longer be entitled to elect any Directors pursuant to such
provisions. Comparable reductions would be made to the number of Directors which
Nassau is entitled to elect if its ownership were to fall below the specified
percentages. Directors other than those elected by vote of Kamine's shares or
Nassau's shares are elected by holders of Common Stock and holders of preferred
stock that are entitled to vote in the election of Directors. If a default
relating to payment occurs under the Senior Secured Credit Facility and
continues uncured for 90 days, the holders of Series C Preferred Stock
(currently Nassau, GECC and CoreStates) are entitled to elect two additional
Directors, who will serve until the default is cured.
REDEMPTION RIGHTS
Pursuant to the Stockholders' Agreement, each of Nassau, AT&T Credit, GECC and
CoreStates has a "put right" entitling it to have the Company repurchase its
preferred and common shares for the fair market value of such shares if no
Liquidity Event (defined as (i) an initial public offering with gross proceeds
of at least $40 million, (ii) the sale of substantially all of the stock or
assets of the Company or (iii) the merger or consolidation of the Company with
one or more other corporations) has taken place by the later of (x) October 22,
2003 or (y) 90 days after the final maturity date of the Senior Discount Notes
(issued in January 1998, with a stated maturity date of February 15, 2008).
CoreStates, GECC and AT&T Credit may not exercise such put rights unless Nassau
has exercised its put right. The Senior Discount Note Indenture limits the
Company's ability to repurchase such shares. All of the shares of preferred and
common stock subject to such "put right" are presented as redeemable equity in
the accompanying balance sheets.
The redeemable preferred stock, redeemable common stock and redeemable common
stock warrants (described below) are being accreted to their fair market values
from their respective issuance dates to their earliest potential redemption date
(October 22, 2003). At December 31, 1998, the aggregate redemption value of the
redeemable equity was approximately $152 million, reflecting per share
redemption amounts of $630 for the Series A Preferred Stock, $248 for the Series
C Preferred Stock and $130 for the redeemable common stock and redeemable common
stock warrants. Accordingly, $8,246,000 and $17,861,000 of accretion have been
charged to additional paid-in-capital in 1997 and 1998, respectively.
WARRANTS
In connection with KMC Telecom's 1996 Loan and Security Agreement, warrants
representing a 2.5% ownership interest in the fully diluted common voting
capital stock of KMC Telecom, including anti-dilution protection, were granted
to the lenders. These warrants, at an exercise price of $.01 per share, were
issued on January 21, 1997, concurrent with the initial borrowing under the AT&T
Facility, at which date the fair value of such warrants was determined to be
$1.5 million, which was reflected as a charge to deferred financing costs and
credited to redeemable equity in January 1997. On September 22, 1997, such
warrants were exercised, and an aggregate of 28,000 shares of Class A Common
Stock of KMC Telecom were issued to the warrant holders. These shares were
subsequently exchanged for an equal number of shares of Common Stock of KMC
Holdings.
In connection with the AT&T Facility, warrants to purchase 10,000 shares of
Common Stock were issued to GECC in 1997. These warrants, at an exercise price
of $.01 per share, are exercisable from issuance through January 21, 2005. The
fair value of such warrants was determined to be $525,000, which was reflected
as a charge to deferred financing costs and credited to redeemable equity.
Pursuant to the Stockholders' Agreement, GECC may put the shares of Common Stock
issuable upon the exercise of such warrants back to the Company. These warrants
have been presented as redeemable common stock warrants in the accompanying
balance sheet at December 31, 1998.
In connection with the sale of Senior Discount Notes in January 1998, the
Company issued warrants to purchase an aggregate of 100,385 shares of Common
Stock at an exercise price of $.01 per share. The net proceeds of $10,446,000
represented the fair value of the warrants at the date of issuance. The warrants
are exercisable through January 2008.
OPTIONS
Prior to the establishment of the present holding company structure, during 1996
and 1997, KMC Telecom granted options to purchase shares of its common stock,
par value $.01 per share ("KMC Telecom Common Stock"), to employees pursuant to
the KMC Telecom Stock Option Plan.
In order to reflect the establishment of the holding company structure, on June
26, 1998, the Board of Directors adopted a new stock option plan, the KMC
Holdings Stock Option Plan (the "1998 Plan"), which authorizes the grant of
options to purchase Common Stock of the Company. The 1998 Plan was approved by
the stockholders, effective July 15, 1998. In September 1998, the Company
replaced the options to purchase KMC Telecom Common Stock previously granted
under the KMC Telecom Stock Option Plan with options to purchase Common Stock of
the Company granted under the 1998 Plan and granted options to additional
employees of the Company under the 1998 Plan.
The 1998 Plan, which is administered by the Compensation Committee of the Board
of Directors of KMC Holdings, provides for various grants to key employees,
directors, affiliated members or other persons having a unique relationship with
the Company excluding Kamine and any person employed by Nassau Capital or any
Nassau affiliate. Grants may include, without limitation, incentive stock
options, non-qualified stock options, stock appreciation rights, dividend
equivalent rights, restricted stocks, purchase stocks, performance shares and
performance units. The Compensation Committee has the power and authority to
designate recipients of the options and to determine the terms, conditions, and
limitations of the options.
Under the 1998 Plan, options to purchase 262,750 shares of Common Stock of KMC
Holdings are available for grant, all of which were allocated to the Plan as of
December 31, 1998. No individual may receive options for more than 75,000
shares. The exercise price of all incentive stock options granted under the 1998
Plan must be at least equal to the fair market value of the shares on the date
of grant. The exercise price of all non-qualified stock options granted under
the 1998 Plan must be at least 50% of the fair market value of the shares on the
date of grant.
Options granted pursuant to the 1998 Plan will have terms not to exceed 10 years
and become exercisable over a vesting period as specified in such options. The
1998 Plan will terminate no later than 2008. Options granted under the 1998 Plan
are nontransferable, other than by will or by the laws of descent and
distribution, and may be exercised during the optionee's lifetime, only by the
optionee.
The 1998 Plan provides for an adjustment of the number of shares exercisable in
the event of a merger, consolidation, recapitalization, change of control, stock
split, stock dividend, combination of shares or other similar changes, exchange
or reclassification of the Common Stock at the discretion of the Compensation
Committee. Pursuant to the agreements adopted under the 1998 Plan, the greater
of 25% of the shares granted or fifty percent of all unvested options granted
become fully vested upon a change-in-control of the Company, as defined. Under
certain circumstances, such percentages may increase.
The holders of options to acquire shares of Common Stock of KMC Holdings are
required to enter into agreements with KMC Holdings which place certain
restrictions upon their ability to sell or otherwise transfer such shares. In
the event of termination of employment of the option holder by the Company or
the affiliates, the Company can repurchase all of the shares or options held by
such individuals, generally for an amount equal to the fair value of such shares
or the excess of the fair value of such options over their exercise price.
Information on stock options is as follows:
Weighted
Number of Shares Average Exercise
--------------------------------------------------------
Outstanding Exercisable Price of Options
--------------------------------------------------------
Balances, January 1, 1996.. - -
Granted.................. 95,385 - $65
Became exercisable....... - -
---------------------------
Balances, December 31, 1996 95,385 - $65
Granted.................. 63,115 - $65
Became exercisable....... - 22,000
Cancelled................ (17,000) (3,000) $(65)
---------------------------
Balances, December 31, 1997 141,500 19,000 $65
Granted.................. 262,500 - $26
Became exercisable....... - 117,000
Cancelled................ (141,500) (19,000) $(65)
----------------------------
Balances, December 31, 1998... 262,500 117,000 $26
===========================
The weighted-average exercise price of options exercisable at December 31, 1997
and 1998 is $50 and $22, respectively, and the weighted-average fair value of
options granted during 1996, 1997 and 1998 were $30, $49 and $114 per share,
respectively. Exercise prices for options outstanding as of December 31, 1998
ranged from $20 to $40. The weighted-average remaining contractual life of those
options is 9.7 years.
During the year ended December 31, 1998, non-qualified options to purchase an
aggregate of 262,500 shares were granted at exercise prices of $20 (157,500
options), $30 (52,500 options) and $40 (52,500 options). The options granted
during 1998 are comprised of 230,500 options granted to employees and 32,000
options granted to individuals employed by certain affiliates of the Company.
All such options have 10 year terms. The $20 options become exercisable over a
three year period in six month intervals commencing six months after the grant
date in increments of 26,250 options each. The $30 options become exercisable in
two increments of 26,250 options each, forty-two and forty-eight months after
the grant date. The $40 options become exercisable in two increments of 26,250
options each, fifty-four and sixty months after the grant date. For purposes of
vesting, options granted in 1998 under the 1998 Plan to replace options granted
in 1997 and 1996 under the KMC Telecom Stock Option Plan are deemed to have been
granted on the date of grant of the options which they replace.
As a result of certain anti-dilution provisions governing the conversion of
shares of Class C Common Stock into shares of Class A Common Stock, KMC Telecom
was required to account for the KMC Telecom Stock Option Plan as a variable
stock option plan. Additionally, as a result of restrictions upon the holders of
options granted under the 1998 Plan, including their ability to sell or
otherwise transfer the related shares, the 1998 Plan is required to be accounted
for as a variable stock option plan. Generally accepted accounting principles
for variable stock option plans require the recognition of a non-cash
compensation charge for these options (amortized over the vesting period of the
employee options and recognized in full as of the grant date for the
non-employee options). Such charge is determined by the difference between the
fair value of the common stock underlying the options and the option price as of
the end of each period. Accordingly, compensation expense will be charged or
credited periodically through the date of exercise or cancellation of such stock
options, based on changes in the value of the Company's stock as well as the
vesting schedule of such options. These compensation charges or credits are
non-cash in nature, but could have a material effect on the Company's future
reported results of operations.
The Company, upon cancellation of the outstanding options under the KMC Telecom
Stock Option Plan, reversed all compensation expense previously recorded with
respect to such options. Additionally, to the extent the fair value of the
Common Stock of the Company exceeded the exercise price of the options granted
under the 1998 Plan, the Company recognized compensation expense related to such
options over their vesting period.
Based on the estimated fair value of the Common Stock of KMC Telecom at December
31, 1996 and 1997, and KMC Holdings at December 31, 1998, cumulative deferred
compensation obligations of $1,283,000, $15,579,000 and $27,906,000,
respectively, have been established. The Company has recognized compensation
expense aggregating $240,000, $13,870,000 and $7,080,000 for the years ended
December 31, 1996, 1997 and 1998, respectively. The 1998 stock option
compensation expense of $7,080,000 reflects charges of $7,236,000 under the KMC
Telecom Stock Option Plan through its termination in September 1998 and charges
of $21,190,000 related to the 1998 Plan, partially offset by a credit as a
result of the September 1998 cancellation of the KMC Telecom stock options,
reflecting the reversal of $21,346,000 of cumulative compensation previously
recognized for options granted under the KMC Telecom Stock Option Plan.
In accordance with the provisions of Statement 123, the Company applies APB 25
and related interpretations in accounting for its stock option plan. If the
Company had elected to recognize compensation expense based on the fair value of
the options granted at grant date as prescribed by Statement 123, net loss and
net loss per common share would have been the following:
December 31
1996 1997 1998
------------------------------------------
(In thousands)
Net loss:
As reported....................... $(4,495) $(32,685) $(76,753)
===========================================
Pro forma......................... $(4,453) $(20,542) $(76,869)
===========================================
Net loss per common share:
As reported....................... $(7.49) $(64.93) $(114.42)
============================================
Pro forma......................... $(7.42) $(45.97) $(114.56)
============================================
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions:
1996 1997 1998
------------------------------------------
Expected dividend yield............. 0% 0% 0%
Expected stock price volatility..... 50% 50% 50%
Risk-free interest rate............. 6% 6% 6%
Expected life of options............ 7 years 7 years 7 years
The expected stock price volatility factors were determined based on an average
of such factors as disclosed in the financial statements of peer companies. The
Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
8. INCOME TAXES
As of December 31, 1998, the Company and its subsidiaries had consolidated net
operating loss carryforwards for United States income tax purposes ("NOLs") of
approximately $59 million which expire through 2013. Under Section 382 of the
Internal Revenue Code of 1986, as amended, if the Company undergoes an
"ownership change," its ability to use its preownership change NOLs (NOLs
accrued through the date of the ownership change) would generally be limited
annually to an amount equal to the product of (i) the long-term tax-exempt rate
for ownership changes prescribed monthly by the Treasury Department and (ii) the
value of the Company's equity immediately before the ownership change, excluding
certain capital contributions. Any allowable portion of the preownership change
NOLs that is not used in a particular taxable year following the ownership
change could be carried forward to subsequent taxable years until the NOLs
expire, usually 15 years after they are generated. As a result of the cumulative
effect of issuances of preferred and common stock through September 22, 1997,
KMC Telecom has undergone an ownership change.
For financial reporting purposes, the Company has an aggregate of approximately
$38 million and $109 million of loss carryforwards and net temporary differences
at December 31, 1997 and 1998, respectively. At existing federal and state tax
rates, the future benefit of these items approximates $15 million at December
31, 1997 and $42 million at December 31, 1998. Valuation allowances have been
established equal to the entire net tax benefit associated with all
carryforwards and temporary differences at both December 31, 1997 and 1998 as
their realization is uncertain.
The composition of expected future tax benefits at December 31, 1997 and 1998 is
as follows:
1997 1998
------------------------------
(in thousands)
Net operating loss carryforwards.................. $ 8,894 $ 22,914
Temporary differences
Stock option compensation...................... 5,502 8,264
Interest accretion............................. - 9,797
Other, net..................................... 523 1,513
------------------------------
Total deferred tax assets......................... 14,919 42,488
Less valuation allowance.......................... (14,919) (42,488)
------------------------------
Net deferred tax assets........................... $ - $ -
==============================
A reconciliation of the expected tax benefit at the statutory federal rate of
34% is as follows:
1996 1997 1998
---------------------------------------------
Expected tax benefit at statutory rate....... (34.0)% (34.0)% (34.0)%
State income taxes, net of federal benefit... (4.0) (2.9) (2.6)
Non-deductible interest expense.............. - - 2.0
S Corporation losses not benefited........... 4.1 - -
Other........................................ .1 .1 .1
Change in valuation allowance................ 33.8 36.8 34.5
-------------------------------------------
-% -% -%
===========================================
9. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases various facilities and equipment under operating leases.
Minimum rental commitments are as follows (in thousands):
Year ending December 31:
1999............................... $ 2,247
2000............................... 2,222
2001............................... 2,169
2002............................... 2,120
2003............................... 1,615
Thereafter........................... 1,334
-----------------
$11,707
=================
Rent expense under operating leases was $98,000, $478,000 and $1,299,000 for the
years ended December 31, 1996, 1997 and 1998,
respectively.
LITIGATION
By letter dated August 29, 1997, KMC Telecom notified I-Net, Inc. ("I-NET") that
KMC Telecom considered I-NET to be in default under a Master Telecommunications
System Rollout Agreement, dated as of October 1, 1996 (the "I-Net Agreement"),
as a result of I-NET's failure to provide design plans and specifications for
several systems for which it had agreed to provide such plans and
specifications, to properly supervise construction of the systems or to provide
personnel with the necessary expertise to manage the projects. On February 12,
1998, the Company received a demand for arbitration from Wang Laboratories, Inc.
("Wang"), the successor to I-NET. The demand seeks at least $4.1 million. The
Company believes that it has meritorious defenses to Wang's claims and has
asserted counterclaims seeking in excess of $2.5 million as a result of I-NET's
defaults under the I-NET Agreement. The arbitration proceedings are currently
underway. The Company believes that resolution of this matter will not have a
material adverse impact on its financial condition. No assurance can be given,
however, as to the ultimate resolution of this matter.
There are a number of lawsuits and regulatory proceedings related to the
Telecommunications Act of 1996, decisions of the Federal Communications
Commission related thereto and rules and regulations issued thereunder which may
affect the rights, obligations and businesses of incumbent local exchange
carriers, competitive local exchange carriers and other participants in the
telecommunications industry in general, including the Company.
PURCHASE COMMITMENTS
As of December 31, 1998, the Company has outstanding commitments aggregating
approximately $30.6 million related to purchases of telecommunications equipment
and fiber optic cable and its obligations under its agreements with certain
suppliers and service providers.
EMPLOYMENT AGREEMENTS
The Company has entered into employment agreements with certain of its
executives. In addition to a base salary, these agreements also provide for
certain incentive compensation payments, based upon completion of construction
and attainment of specified revenues for additional networks. The Company has
also agreed to make similar incentive compensation payments to certain other key
employees.
10. ACQUISITION
On July 11, 1997, KMC Telecom acquired a network in Melbourne, Florida for a
purchase price of $2 million in cash. The acquisition was accounted for under
the purchase method and the purchase price approximated the fair value of the
fixed assets acquired. Assuming the Melbourne Network had been acquired as of
January 1, 1997, the Company's pro forma consolidated revenue and net loss for
the year ended December 31, 1997 would have been $3,655,000 and $33,212,000,
respectively.
11. RELATED PARTY TRANSACTIONS
During 1996, KMC Telecom had borrowings from Kamine. The proceeds of such loans
were used to fund the construction of the network in Huntsville, Alabama, and to
fund operating cash flow requirements. These loans were payable on demand and,
through April 30, 1996, bore interest at the prime rate. Interest expense
charged by Kamine under these loans amounted to $120,000 for the year ended
December 31, 1996. Effective May 1, 1996, Kamine elected not to charge interest
on these loans. However, for financial reporting purposes, $180,000 of interest
expense was imputed on these loans for the period from May 1, 1996 to their
repayment on November 12, 1996, and a corresponding credit has been recorded to
additional paid-in capital.
The Company and certain affiliated companies owned by Kamine share certain
administrative services. The entity which bears the cost of the service is
reimbursed by the other for the other's proportionate share of such expenses.
The Company reimbursed Kamine-affiliated companies for these shared services an
aggregate of approximately $488,000, $281,000 and $136,000 of expense for the
years ended December 31, 1996, 1997 and 1998, respectively.
From May 1, 1996 through January 29, 1998, an affiliate of the Company was paid
a fee at an annual rate of $266,000 as reimbursement for the services of Kamine
as Chairman of the Board of the Company. The amount of this fee was reduced to
$100,000 per annum as of January 29, 1998 and it was terminated effective
December 31, 1998. The fees paid for these services are included in the shared
services payment described in the immediately preceding paragraph. Effective
January 1, 1999, Kamine became an employee of the Company and he is currently
paid a salary at the rate of $450,000 per annum for his services as Chairman of
the Board.
The Company leases its headquarters office through January 2007 from an entity
controlled by Kamine. The lease provides for a base annual rental cost of
approximately $217,000, adjusted periodically for changes in the consumer price
index, plus operating expenses. Rent expense recognized under this lease for the
years ended December 31, 1996, 1997 and 1998 was $97,000, $207,000 and $217,000,
respectively.
As of December 31, 1998, the Company has made loans aggregating $760,000, to
certain of its executives. Such loans bear interest at a rate of 6% per annum
and are included in other assets.
KMC Services LLC, a limited liability company wholly-owned by Kamine ("KMC
Services"), has entered into a five year agreement with the Company pursuant to
which KMC Services will offer to the Company financial and energy services which
are related to the Company's business. KMC Services may also offer its services
to third parties in jurisdictions in which the Company is not offering
telecommunications services; provided that such third parties are not
competitors of the Company. Initially, KMC Services will offer a leasing program
for equipment physically installed at a customer's premises ("CPE Equipment")
for the Company to integrate into its ClearStarSM Advantage program, whereby the
Company will be able to offer CPE Equipment for lease or sale to its customers.
The equipment will be owned by KMC Services, and the Company will have no
liability for the cost of the equipment, the financing related to it or the
obligation for any lease charges. Any such sale or lease will be between the
Company's customer and KMC Services. The Company will advance to KMC Services
each year on a monthly basis, pursuant to an approved annual budget, KMC
Services' estimated operating expenses for the year. In exchange, the Company
will receive, on a quarterly basis, eighty percent (80%) of the net pre-tax cash
flow received by KMC Services (after payment of all costs of KMC Services other
than those advanced by the Company). For 1999, the estimated operating expenses
of KMC Services are approximately $1.2 million. The Company is not responsible
for KMC Services' capital costs or financing costs. The Company will invoice KMC
Services for its allocable costs incurred in connection with this program,
including such items as sales commissions and administrative support, and
recover these costs, together with any amounts advanced to KMC Services for its
annual operating costs, from the Company's eighty percent (80%) share of the net
pre-tax cash flow received from KMC Services. The Company and KMC Services have
mutual rights of audit to insure proper allocation of costs and accounting. If
at any time Mr. Kamine, including his immediate family, and Nassau collectively
own less than twenty percent (20%) of the Company, the Company has the right to
cancel this agreement; subject to either a buyout of the Company's customer
portfolio from KMC Services or the assumption or guarantee by the Company of
eighty percent (80%) of the outstanding financing relating to the equipment
previously purchased by KMC Services.
Effective January 1, 1999, the Company is entitled to utilize a Citation III
business jet, chartered by Bedminster Aviation, LLC, a limited liability company
wholly-owned by Kamine, for a fixed price per hour of flight time. The Company
has agreed to use its best efforts to utilize the Citation III fifty hours per
quarter during 1999. The Company is under no obligation to do so and has not
guaranteed any financial arrangements with respect to the aircraft or to
Bedminster Aviation, LLC.
Pursuant to an agreement among the Company, Kamine and Nassau, for 1997 and 1998
Nassau received $100,000 as a financial advisory fee and as compensation for the
Nassau designees who served on the Board of Directors of the Company. Nassau
will be paid $450,000 as a financial advisory fee for 1999.
12. NET LOSS PER COMMON SHARE
The following table sets forth the computation of net loss per common share:
1996 1997 1998
--------------------------------------------------------
(in thousands)
Numerator:
Net loss................................ $(4,495) $(32,686) $(76,753)
Dividends and accretion on redeemable
preferred stock........................ - (8,904) (18,285)
--------------------------------------------------------
Numerator for net loss per common share $(4,495) $(41,590) $(95,038)
========================================================
Denominator:
Denominator for net loss per common
share - weighted average number of
common shares outstanding.............. 600 641 831
========================================================
Net loss per common share............... $ ( 7.49) $(64.93) $(114.42)
========================================================
Options and warrants to purchase an aggregate of 242,768 and 372,885 shares of
common stock were outstanding as of December 31, 1997 and 1998, respectively,
but a computation of diluted net loss per common share has not been presented,
as the effect of such securities would be anti-dilutive.
13. SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Information with respect to noncash investing and financing activities is as
follows:
In 1996, Kamine contributed a loan and related imputed interest totaling
$2,267,000 to equity.
In 1997, the Convertible Notes, including accrued interest, aggregating
approximately $12,380,000 were converted into 123,800 shares of Series A
Cumulative Convertible Preferred Stock of KMC Telecom.
In 1997, warrants with a fair value of $1.5 million were granted to
Newcourt Capital and warrants with a fair value of $525,000 were granted to
GECC.
In connection with the Senior Discounts Notes, the Company recognized noncash
interest expense of $29.6 million in 1998.
In connection with options granted to employees under the KMC Telecom Stock
Option Plan in 1996 and 1997, and under the KMC Holdings Stock Option Plan in
1998, cumulative deferred compensation obligations of $1,283,000, $15,579,000
and $27,906,000 have been established in 1996, 1997 and 1998, respectively, with
offsetting credits to additional paid-in capital. Noncash compensation expense
of $44,000, $9,014,000 and $23,758,000 in 1996, 1997 and 1998, respectively, was
recognized in connection with such options. In connection with options granted
to individuals employed by certain affiliates of the Company in 1996, 1997 and
1998, the Company recognized noncash compensation expense of $196,000,
$4,856,000 and $4,668,000, respectively. In addition, during 1998 the Company
cancelled all of the then outstanding options granted under the KMC Telecom
Stock Option Plan, resulting in the reversal of previously recognized
compensation expense of $21.3 million.
14. FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of
each class of financial instruments.
CASH AND CASH EQUIVALENTS
The carrying amounts approximate fair value because of the short-term maturity
of the instruments.
INVESTMENTS HELD FOR FUTURE CAPITAL EXPENDITURES
The carrying amounts and fair value are reported at amortized cost since these
securities are to be held to maturity.
LONG-TERM DEBT
The carrying amount of floating-rate long-term debt approximates its fair value.
The fair value of the Company's fixed-rate long-term debt is estimated using
discounted cash flows at the Company's incremental borrowing rates.
REDEEMABLE EQUITY
The fair values of the Company's redeemable equity instruments are estimated to
be the amounts at which the holders may require the Company to redeem such
securities, adjusted using discounted cash flows.
The carrying amounts and estimated fair values of the Company's financial
instruments are as follows (in millions):
1997 1998
---------------------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
---------------------------------------------------
Cash and cash equivalents...................... $15.6 $ 15.6 $ 21.1 $ 21.1
Investments held for future capital expenditures - - 27.9 27.9
Long-term debt:
Floating rate................................ 61.3 61.3 41.4 41.4
Fixed rate................................... - - 267.8 249.6
Redeemable equity instruments:
Series A Preferred Stock..................... 18.9 28.4 30.4 38.9
Series C Preferred Stock..................... 14.7 13.5 21.6 21.6
Series D Preferred Stock..................... 2.4 2.3 - -
Redeemable common stock...................... 11.2 6.3 22.3 14.5
Redeemable common stock warrants............. .5 .5 .7 .7
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash investments and
accounts receivable. The Company places its cash investments with major
financial institutions. With respect to accounts receivable, the Company
performs ongoing credit evaluations of its customers' financial conditions and
generally does not require collateral. No individual customer accounted for more
than 10% of revenue, excluding reciprocal compensation revenue, as described
below, for the years ended December 31, 1997 and 1998.
The Company maintains interconnection agreements with incumbent local exchange
carriers ("ILECs") in each state in which it operates. Among other things, these
contracts govern the reciprocal amounts to be billed by competitive carriers for
terminating local traffic of Internet service providers ("ISPs") in each state.
The Regional Bell Operating Companies have advised competitive local exchange
carriers, such as the Company, that they do not consider calls in the same local
calling area which are placed by their customers to competitive local exchange
carrier customers which are Internet service providers to be local calls under
the interconnection agreements. The Regional Bell Operating Companies claim that
these calls are exchange access calls, which the Federal Communications
Commission exempted from payment of access charges. The Regional Bell Operating
Companies claim that, as a result, they do not owe any compensation to
competitive local exchange carriers for transporting and terminating these
calls. The Regional Bell Operating Companies have threatened to withhold, and in
many cases have withheld, reciprocal compensation to competitive local exchange
carriers for the transport and termination of these calls. During 1998, the
Company recognized revenue from these ILECs of approximately $2.9 million, or
12.9% of 1998 revenue, for these services. Payments of approximately $135,000
were received from the ILECs during 1998.
Management believes reciprocal compensation for Internet traffic to be an
industry-wide matter that will ultimately be resolved on a state-by-state basis.
To date, twenty-nine state commissions have ruled on the issue and found that
ILECs must pay compensation to competitive carriers for local calls to ISPs
located on competitive carriers' networks. A number of other state commissions
currently have proceedings pending to consider this matter. The Federal
Communications Commission has concluded that calls to ISPs are interstate calls
and therefore exempt from local termination charges. However, the Commission
also stated that existing interconnection agreements providing for such
termination charges must be honored by the ILECs.
The Company accounts for reciprocal compensation with the ILECs, including the
activity associated with the disputed ISP traffic, as local traffic pursuant to
the terms of its interconnection agreements. Accordingly, revenue is recognized
in the period that the traffic is terminated. The circumstances surrounding the
disputes are considered by management periodically in determining whether
reserves against unpaid balances are warranted. As of December 31, 1998, no
reserves have been considered necessary by management.
15. SUBSEQUENT EVENTS
LUCENT AGREEMENT
KMC Telecom III entered into a Loan and Security Agreement (the "Lucent
Facility") dated February 4, 1999 with Lucent Technologies Inc. ("Lucent") which
provides for borrowings to be used to fund the acquisition of certain
telecommunications equipment and related expenses. The Lucent Facility provides
for an aggregate commitment of up to $600 million, of which $125 million is
immediately available to purchase Lucent products and an additional $125 million
will become available upon KMC Telecom III's receipt of an additional $35
million of funded equity or qualified intercompany loans, as defined in the
agreement. Further, up to an additional $350 million will be available upon (a)
additional lenders participating in the Lucent Facility and making commitments
to make loans so that Lucent's aggregate commitment does not exceed $250 million
and (b) the Company satisfying certain other requirements, the most significant
of which is KMC Holdings raising and contributing at least $300 million in high
yield debt or equity (other than disqualified stock) to KMC Telecom III. The
Lucent Facility places certain restrictions upon KMC Telecom III's ability to
purchase non-Lucent equipment with proceeds from such facility.
Interest on borrowings under the Lucent Facility is charged, at the option of
KMC Telecom III, at a floating rate of LIBOR plus the "Applicable LIBOR Margin",
or at an alternative base rate plus the "Applicable Base Rate Margin" (as
defined). Such margins will be increased by 0.25% until KMC Telecom III and its
subsidiaries have completed systems in fourteen markets. If KMC Telecom III
defaults on any payment due under the Lucent Facility, the interest rate will
increase by four percentage points. If any other event or default shall occur,
the interest rate will be increased by two percentage points. Interest on each
LIBOR loan is payable on each LIBOR interest payment date in arrears and
interest on each base rate loan is payable quarterly in arrears. KMC Telecom III
must pay an annual commitment fee on the unused portion of the Lucent Facility
of 1.25%.
Loans borrowed under the Lucent Facility amortize in amounts based upon the
following percentages of the aggregate amount of the loans drawn under the
Lucent Facility:
Payment Dates Amortization
- - --------------------------------------------- ---------------------
May 1, 2002 - February 1, 2003 2.5% per quarter
May 1, 2003 - February 1, 2006 5.0% per quarter
May 1, 2006 - February 1, 2007 7.5% per quarter
KMC Holdings has unconditionally guaranteed the repayment of up to $250.0
million under the Lucent Facility when such repayment is due, whether at
maturity, upon acceleration, or otherwise. KMC Telecom III Holdings, Inc., which
owns the shares of KMC Telecom III and is wholly-owned by KMC Holdings, has
pledged the shares of KMC Telecom III to Lucent to collateralize its obligations
under the guaranty. In addition, KMC Telecom III has pledged all of its assets
to Lucent.
The Lucent Facility contains a number of affirmative and negative covenants
including, among others, covenants restricting the ability of KMC Telecom III to
consolidate or merge with any person, sell or lease assets not in the ordinary
course of business, sell or enter into any long term leases of dark fiber,
redeem stock, pay dividends or make any other payments (including payments of
principal or interest on loans) to KMC Holdings, create subsidiaries, transfer
any permits or licenses, or incur additional indebtedness or act as guarantor
for the debt of any other person, subject to certain conditions.
KMC Telecom III is required to comply with certain financial tests and maintain
certain financial ratios, including, among others, a ratio of total debt to
contributed capital, certain minimum revenues, maximum EBITDA losses and minimum
EBITDA, maximum capital expenditures and minimum access lines, a maximum total
leverage ratio, a minimum debt service coverage ratio, a minimum fixed charge
coverage ratio and a maximum consolidated leverage ratio. The covenants become
more restrictive upon the earlier of (i) July 1, 2002 and (ii) after KMC Telecom
III achieves positive EBITDA for two consecutive fiscal quarters.
Failure to satisfy any of the financial covenants will constitute an event of
default under the Lucent Facility, permitting the lenders to terminate the
commitment and/or accelerate payment of outstanding indebtedness. The Lucent
Facility also includes other customary events of default, including, without
limitation, a cross-default to other material indebtedness, material
undischarged judgments, bankruptcy, loss of a material franchise or material
license, breach of representations and warranties, a material adverse change,
and the occurrence of a change of control.
SERIES E PREFERRED STOCK
On February 4, 1999, the Company issued 25,000 shares of Series E Senior
Redeemable, Exchangeable, PIK Preferred Stock (the "Series E Preferred Stock")
to Newcourt Commercial Finance Corporation ("Newcourt Finance"), generating
aggregate gross proceeds of $22.9 million. The Series E Preferred Stock has a
liquidation preference of $1,000 per share and an annual dividend equal to 14.5%
of the liquidation preference, payable quarterly. On or before January 15, 2004,
the Company may pay dividends in cash or in additional fully paid and
nonassessable shares of Series E Preferred Stock. After January 15, 2004,
dividends must be paid in cash, subject to certain conditions. Unpaid dividends
accrue at the dividend rate of the Series E Preferred Stock, compounded
quarterly.
The Series E Preferred Stock must be redeemed on February 1, 2011, subject to
the legal availability of funds therefor, at a redemption price, payable in
cash, equal to the liquidation preference thereof on the redemption date, plus
all accumulated and unpaid dividends to the date of redemption. After April 15,
2004, the Series E Preferred Stock may be redeemed, in whole or in part, at the
option of the Company, at a redemption price equal to 110% of the liquidation
preference of the Series E Preferred Stock plus all accrued and unpaid dividends
to the date of redemption. The redemption price declines to an amount equal to
100% of the liquidation preference as of April 15, 2007.
In addition, on or prior to April 15, 2002, the Company may, at its option,
redeem up to 35% of the aggregate liquidation preference of Series E Preferred
Stock with the proceeds of sales of its capital stock at a redemption price
equal to 110% of the liquidation preference on the redemption date plus accrued
and unpaid dividends.
The holders of Series E Preferred Stock have voting rights in certain
circumstances. Upon the occurrence of a Change of Control, the Company will be
required to make an offer to repurchase the Series E Preferred Stock for cash at
a purchase price of 101% of the liquidation preference thereof, together with
all accumulated and unpaid dividends to the date of purchase.
The Series E Preferred Stock is not convertible. The Company may, at the sole
option of the Board of Directors (out of funds legally available), exchange all,
but not less than all, of the Series E Preferred Stock then outstanding,
including any shares of Series E Preferred Stock issued as payment for
dividends, for a new series of subordinated debentures (the "Exchange
Debentures") issued pursuant to an exchange debenture indenture. The holders of
Series E Preferred Stock are entitled to receive on the date of any such
exchange, Exchange Debentures having an aggregate principal amount equal to (i)
the total of the liquidation preference for each share of Series E Preferred
Stock exchanged, plus (ii) an amount equal to all accrued but unpaid dividends
payable on such share.
SERIES F PREFERRED STOCK
On February 4, 1999, the Company issued 40,000 shares of Series F Senior
Redeemable, Exchangeable, PIK Preferred Stock (the "Series F Preferred Stock")
to Lucent and Newcourt Finance, generating aggregate gross proceeds of $38.9
million. The Series F Preferred Stock has a liquidation preference of $1,000 per
share and an annual dividend equal to 14.5% of the liquidation preference,
payable quarterly. The Company may pay dividends in cash or in additional fully
paid and nonassessable shares of Series F Preferred Stock.
The Series F Preferred Stock may be redeemed at any time, in whole or in part,
at the option of the Company, at a redemption price equal to 110% of the
liquidation preference on the redemption date plus an amount in cash equal to
all accrued and unpaid dividends thereon to the redemption date. Upon the
occurrence of a Change of Control, the Company will be required to make an offer
to purchase the Series F Preferred Stock for cash at a purchase price of 101% of
the liquidation preference thereof, together with all accumulated and unpaid
dividends to the date of purchase.
The holders of Series F Preferred Stock have voting rights under certain
circumstances.
Upon the earlier of (i) the date that is sixty days after the date on which the
Company closes an underwritten primary offering of at least $200 million of its
Common Stock, pursuant to an effective registration statement under the
Securities Act or (ii) February 4, 2001, any outstanding Series F Preferred
Stock will automatically convert into Series E Preferred Stock, on a one for one
basis.
The Company may, at the sole option of the Board of Directors (out of funds
legally available), exchange all, but not less than all, of the Series F
Preferred Stock then outstanding, including any shares of Series F Preferred
Stock issued as payment for dividends, for Exchange Debentures. The holders of
Series F Preferred Stock are entitled to receive on the date of any such
exchange, Exchange Debentures having an aggregate principal amount equal to (i)
the total of the liquidation preference for each share of Series F Preferred
Stock exchanged, plus (ii) an amount equal to all accrued but unpaid dividends
payable on such share.
WARRANTS
In connection with the February 4, 1999 issuances of the Series E Preferred
Stock and the Series F Preferred Stock, warrants to purchase an aggregate of
24,660 shares of Common Stock were sold to Newcourt Finance and Lucent. The
aggregate gross proceeds from the sale of these warrants was approximately $3.2
million. These warrants, at an exercise price of $.01 per share, are exercisable
from February 4, 2000 through February 1, 2009.
In addition, the Company also delivered to the Warrant Agent certificates
representing warrants to purchase an aggregate of an additional 107,228 shares
of Common Stock at an exercise price of $.01 per share (the "Springing
Warrants"). The Springing Warrants may become issuable under the circumstances
described in the following paragraph.
If the Company fails to redeem all shares of Series F Preferred Stock prior to
the date (the "Springing Warrant Date") which is the earlier of (i) the date
that is sixty days after the date on which the Company closes an underwritten
primary offering of at least $200 million of its Common Stock pursuant to an
effective registration statement under the Securities Act or (ii) February 4,
2001, the Warrant Agent is authorized to issue the Springing Warrants to the
Eligible Holders (as defined in the warrant agreement) of the Series E and
Series F Preferred Stock. In the event the Company has redeemed all outstanding
shares of Series F Preferred Stock prior to the Springing Warrant Date, the
Springing Warrants will not be issued and the Warrant Agent will return the
certificates to the Company. To the extent the Company exercises its option to
exchange all of the Series F Preferred Stock for Exchange Debentures prior to
the Springing Warrant Date, the Springing Warrants will not become issuable.
Therefore, as the future issuance of the Springing Warrants is entirely within
the control of the Company and the likelihood of their issuance is deemed to be
remote, no value has been ascribed to the Springing Warrants.
Independent Auditors' Report on Schedules
The Board of Directors and Stockholders
KMC Telecom Holdings, Inc.
We have audited the consolidated balance sheets of KMC Telecom Holdings, Inc. as
of December 31, 1997 and 1998 and the related consolidated statements of
operations, redeemable and nonredeemable equity and cash flows for the years
then ended. Our audit report issued thereon dated February 2, 1999 is included
elsewhere in this Form 10-K. Our audit also included the financial statement
schedules listed in Item 14(a) of this Form 10-K. These schedules are the
responsibility of the Company's management. Our responsibility is to express an
opinion based on our audits.
In our opinion, the financial statement schedules referred to above, when
considered in relation to the basic financial statements taken as a whole,
present fairly, in all material respects the information set forth therein.
/s/ ERNST & YOUNG LLP
MetroPark, New Jersey
February 2, 1999
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
KMC Telecom Holdings, Inc.
(Parent Company)
Condensed Balance Sheets
(in thousands)
December 31
---------------------------
1997 1998
---- ----
ASSETS
Current assets:
Cash and cash equivalents...................... $ -- $ 1,221
Amounts due from subsidiaries.................. -- 20,922
Prepaid expenses and other current assets...... -- 332
---------------------------
Total current assets.............................. -- 22,475
Loans receivable from subsidiaries................ 25,148 265,713
Networks and equipment, net....................... -- 4,775
Intangible assets, net............................ 506 625
Deferred financing costs.......................... 732 12,055
Other assets...................................... -- 1,952
---------------------------
$26,386 $307,595
===========================
LIABILITIES, REDEEMABLE AND NONREDEEMABLE
EQUITY (deficiency)
Current liabilities:
Accounts payable.............................. $ -- $ 2,043
Accrued expenses.............................. -- 5,838
---------------------------
Total current liabilities........................ -- 7,881
Senior discount notes payable.................... -- 267,811
Losses of subsidiaries in excess of basis........ 5,408 61,244
---------------------------
Total liabilities................................ 5,408 336,936
Redeemable equity:
Redeemable cumulative convertible
preferred stock, par value $.01 per share;
599 shares authorized; shares issued and
outstanding:
Series A, 124 shares in 1997 and 1998 ($12,380
liquidation preference).. 18,879 30,390
Series C, 150 shares in 1997 and 175 shares in
1998 ($17,500 liquidation preference in 1998).. 14,667 21,643
Series D, 25 shares in 1997 and 0 shares in 1998. 2,379 --
Redeemable common stock, shares issued and
outstanding, 133 in 1997 and 224 in 1998....... 11,187 22,305
Redeemable common stock warrants................. 539 674
------------------------
Total redeemable equity............................. 47,651 75,012
Nonredeemable equity (deficiency):
Common stock, par value $.01 per share, 3,000
shares authorized, 614 shares issued and
outstanding................................... 6 6
Additional paid-in capital....................... 8,853 13,750
Unearned compensation............................ -- (5,824)
Accumulated deficit.............................. (35,532) (112,285)
--------------------------
Total nonredeemable equity (deficiency)............. (26,673) (104,353)
--------------------------
$ 26,386 $307,595
==========================
SEE ACCOMPANYING NOTES.
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
KMC Telecom Holdings, Inc.
(Parent Company)
Condensed Statements of Operations
(in thousands)
September 22,
1997 Year ended
(formation) to December
December 31, 31, 1998
1997
----------------------------
Operating expenses:
Selling, general and administrative.................... $ -- $ 19,624
Stock option compensation expense...................... -- 21,190
Depreciation and amortization.......................... -- 1,197
----------------------------
Total operating expenses.................................. -- 42,011
----------------------------
Loss from operations...................................... -- (42,011)
Intercompany charges...................................... -- 20,922
Interest income........................................... -- 8,575
Interest expense.......................................... -- (23,104)
Equity in net loss of subsidiaries........................ (21,860) (41,135)
----------------------------
Net loss.................................................. (21,860) (76,753)
Dividends and accretion on redeemable preferred stock..... (8,904) (18,285)
----------------------------
Net loss applicable to common shareholders................ $ (30,764) $(95,038)
============================
SEE ACCOMPANYING NOTES.
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
KMC Telecom Holdings, Inc.
(Parent Company)
Condensed Statements of Cash Flows
(in thousands)
September
22, 1997 Year
(formation) ended
to December December
31, 1997 31, 1998
----------------------------
OPERATING ACTIVITIES
Net loss................................................................. $ (21,860) $ (76,753)
Adjustments to reconcile net loss to net cash used in operating
activities:
Equity in net loss of subsidiaries.................................. 21,860 41,135
Depreciation and amortization....................................... -- 1,197
Non-cash interest expense........................................... -- 23,104
Non-cash stock option compensation expense.......................... -- 21,190
Changes in assets and liabilities:
Prepaid expenses and other current assets........................ -- (332)
Accounts payable................................................. -- 2,043
Accrued expenses................................................. -- 5,838
Amounts due from subsidiaries.................................... -- (20,922)
Other assets..................................................... -- (1,952)
----------------------------
Net cash used in operating activities.................................... -- (5,452)
----------------------------
INVESTING ACTIVITIES
Loans receivable from subsidiaries....................................... (24,623) (233,685)
Purchases of equipment................................................... -- (5,845)
Acquisitions of intangible assets........................................ (506) (166)
----------------------------
Net cash used in investing activities.................................... (25,129) (239,696)
----------------------------
FINANCING ACTIVITIES
Proceeds from issuance of common stock and warrants, net of
issuance costs 9,363 20,446
Proceeds from issuance of preferred stock, net of issuance costs......... 16,498 --
Proceeds from issuance of senior discount notes, net of issuance costs... (732) 225,923
----------------------------
Net cash provided by financing activities................................ 25,129 246,369
----------------------------
Net increase in cash and cash equivalents................................ -- 1,221
Cash and cash equivalents, beginning of year............................. -- --
----------------------------
Cash and cash equivalents, end of year................................... $ -- $ 1,221
============================
SEE ACCOMPANYING NOTES.
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
KMC Telecom Holdings, Inc.
(Parent Company)
Notes to Financial Statements
December 31, 1998
1. BASIS OF PRESENTATION
In the parent company only financial statements, KMC Telecom Holdings, Inc.'s
(the "Company") investment in subsidiaries is stated at cost less equity in
losses of subsidiaries since date of formation. These parent company financial
statements should be read in conjunction with the Company's consolidated
financial statements. The Company's operating subsidiaries are KMC Telecom Inc.
("KMC Telecom"), KMC Telecom II, Inc. ("KMC Telecom II"), KMC Telecom III, Inc.
("KMC Telecom III") and KMC Telecom of Virginia, Inc.
On September 22, 1997, the stockholders of KMC Telecom exchanged all of their
KMC Telecom common and preferred stock for equal numbers of shares of common and
preferred stock of the Company.
Pursuant to a management agreement among the Company and its subsidiaries, the
Company provides management and other services and incurs certain operating
expenses on behalf of its subsidiaries. Such costs are allocated to the
subsidiaries by the Company and reimbursed on a current basis. At December 31,
1998, an aggregate of $20.9 million was due from the subsidiaries for such costs
and is included in the accompanying condensed balance sheet at December 31, 1998
as a current receivable. Such reimbursements are permitted under the debt
agreements of the Company's subsidiaries.
2. GUARANTEE
On December 22, 1998, KMC Telecom, KMC Telecom II and KMC Telecom of Virginia,
Inc. (the "Borrowers"), entered into a Loan and Security Agreement (the "Senior
Secured Credit Facility") with AT&T Commercial Finance Corporation, First Union
National Bank, General Electric Capital Corporation and Canadian Imperial Bank
of Commerce (the "Lenders").
The Company has unconditionally guaranteed the repayment of the Senior Secured
Credit Facility when such repayment is due, whether at maturity, upon
acceleration, or otherwise. The Company has agreed to pay all amounts
outstanding under the Senior Secured Credit Facility, on demand, upon the
occurrence and during the continuation of any event of default (as defined
therein). The Company has pledged the shares of each of the Borrowers to the
Lenders to collateralize its obligations under the guaranty. In addition, the
Borrowers have pledged all of their assets to the Lenders. Accordingly, if there
were an event of default under the Senior Secured Credit Facility, the lenders
thereunder would be entitled to payment in full and could foreclose on the
assets of the Borrowers, and the holders of the Senior Discount Notes would have
no right to share in such assets. At December 31, 1998, an aggregate of $41.4
million was outstanding under this facility.
Additionally, the Senior Secured Credit Facility restricts the ability of the
Borrowers to pay dividends to, or to pay principal or interest on loans from,
the Company. Such restrictions could adversely affect the Company's liquidity
and ability to meet its cash requirements, including its ability to repay the
Senior Discount Notes.
At December 31, 1998, an aggregate of $265.7 million has been loaned by the
Company to the Borrowers to be used for the construction and expansion of fiber
optic telecommunications networks and for working capital and general corporate
purposes.
3. SENIOR DISCOUNT NOTES
On January 29, 1998, the Company sold 460,800 units, each consisting of a 12
1/2% senior discount note with a principal amount at maturity of $1,000 due 2008
pursuant to the Senior Discount Note Indenture between the Company and the Chase
Manhattan Bank, as trustee (the "Senior Discount Notes") and one warrant to
purchase .21785 shares of Common Stock of the Company at an exercise price of
$.01 per share. The gross and net proceeds of the offering were approximately
$250.0 million and $236.4 million, respectively. A substantial portion of the
net proceeds of the offering have been loaned by the Company to its
subsidiaries. On August 11, 1998, the Company consummated an offer to exchange
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
the notes issued on January 29, 1998 for $460.8 million aggregate principal
amount at maturity of notes that had been registered under the Securities Act of
1933 (as used below and elsewhere herein, "Senior Discount Notes" includes the
original notes and the exchange notes).
The Senior Discount Notes are unsecured, unsubordinated obligations of the
Company and mature on February 15, 2008. The Senior Discount Notes will fully
accrete to face value on February 15, 2003. From and after February 15, 2003,
the Senior Discount Notes will bear interest, which will be payable in cash, at
the rate of 12.5% per annum on February 15 and August 15 of each year,
commencing August 15, 2003. The Company is accreting the initial carrying value
of the Senior Discount Notes to their aggregate face value over the term of the
debt at its effective interest rate of 13.7%.
The indebtedness evidenced by the Senior Discount Notes ranks pari passu in
right of payment with all existing and future unsubordinated, unsecured
indebtedness of the Company and senior in right of payment to all existing and
future subordinated indebtedness of the Company. However, the Company is a
holding company and the Senior Discount Notes are, therefore, effectively
subordinated to all existing and future liabilities (including trade payables)
of its subsidiaries.
The Senior Discount Notes restrict, among other things, the ability of the
Company to incur additional indebtedness, create liens, engage in sale-leaseback
transactions, pay dividends or make distributions in respect of capital stock,
make investments or certain other restricted payments, sell assets of the
Company, redeem capital stock, issue or sell stock of restricted subsidiaries,
enter into transactions with stockholders or affiliates or effect a
consolidation or merger.
4. REDEEMABLE EQUITY
Pursuant to provisions contained in the Company's Certificate of Incorporation
and an Amended and Restated Stockholders' Agreement dated as of October 31,
1997, among the Company, Harold N. Kamine, Nassau Capital Partners L.P. and NAS
Partners I L.L.C. (collectively referred to as "Nassau"), AT&T Credit
Corporation ("AT&T Credit"), General Electric Capital Corporation ("GECC"), and
CoreStates Bank, N.A. ("CoreStates"), (the "Stockholders' Agreement"), each of
Nassau, CoreStates, AT&T Credit and GECC has a "put right" entitling it to have
the Company repurchase its preferred and common shares for the fair market value
of such shares if no Liquidity Event (defined as (i) an initial public offering
with gross proceeds of at least $40.0 million, (ii) the sale of substantially
all of the stock or assets of the Company or (iii) the merger or consolidation
of the Company with one or more other corporations) has taken place by the later
of (x) October 22, 2003 or (y) 90 days after the final maturity date of the
Senior Discount Notes (issued in January 1998, with a stated maturity date of
February 15, 2008). CoreStates, GECC and AT&T Credit may not exercise such put
rights unless Nassau has exercised its put right. The restrictive covenants of
the Senior Discount Notes limit the Company's ability to repurchase such shares.
All of the shares of preferred and common stock subject to such "put right" are
presented as redeemable equity in the accompanying condensed balance sheets at
December 31, 1997 and 1998.
The redeemable preferred stock, redeemable common stock and redeemable common
stock warrants (described below) are being accreted up to their fair market
values from their respective issuance dates to their earliest potential
redemption date (October 22, 2003). At December 31, 1998, the aggregate
redemption value of the redeemable equity was approximately $152 million,
reflecting per share redemption amounts of $630 for the Series A Preferred
Stock, $248 for the Series C Preferred Stock and $130 for the redeemable common
stock and redeemable common stock warrants.
Warrants to purchase 10,000 shares of Common Stock were issued to GECC in 1997.
These warrants, at an exercise price of $.01 per share, are exercisable from
issuance through January 2005. Pursuant to the Stockholders' Agreement, GECC may
put the shares of Common Stock issuable upon the exercise of such warrants back
to the Company. These warrants have been presented as redeemable common stock
warrants in the accompanying condensed balance sheets at December 31, 1997 and
1998.
5. CONTINGENCIES
By letter dated August 29, 1997, KMC Telecom notified I-NET, Inc. ("I-NET") that
KMC Telecom considered I-NET to be in default under a Master Telecommunications
Systems Rollout Agreement dated as of October 1, 1996 (the "I-NET Agreement"),
as a result of I-NET's failure to provide design plans and specifications for
several systems for which it had agreed to provide such plans and
specifications, to properly supervise construction of the systems or to provide
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
personnel with the necessary expertise to manage the projects. On February 12,
1998, the Company received a demand for arbitration from Wang Laboratories, Inc.
("Wang") the successor to I-NET. The demand seeks at least $4.1 million. The
Company believes that it has meritorious defenses to Wang's claims and has
asserted counterclaims seeking in excess of $2.5 million as a result of I-NET's
defaults under the I-NET Agreement. The arbitration proceedings are currently
underway. The Company believes that resolution of this matter will not have a
material adverse impact on its financial condition. No assurance can be given,
however, as to the ultimate resolution of this matter.
There are a number of lawsuits and regulatory proceedings related to the
Telecommunications Act of 1996, decisions of the Federal Communications
Commission related thereto and rules and regulations issued thereunder which may
affect the rights, obligations and businesses of incumbent local exchange
carriers, competitive local exchange carriers and other participants in the
telecommunications industry in general, including the Company.
6. SUBSEQUENT EVENTS
LUCENT AGREEMENT
KMC Telecom III entered into a Loan and Security Agreement (the "Lucent
Facility") dated February 4, 1999 with Lucent Technologies, Inc. ("Lucent")
which provided for borrowings up to $600 million (of which $125 million is
immediately available) to be used to fund the acquisition of certain
telecommunications equipment and related expenses.
The Company has unconditionally guaranteed the repayment of up to $250 million
under the Lucent Facility when such repayment is due, whether at maturity, upon
acceleration, or otherwise. KMC Telecom III Holdings, Inc., which owns the
shares of KMC Telecom III and is wholly-owned by the Company, has pledged the
shares of KMC Telecom III to Lucent to collateralize its obligations under the
guaranty. In addition, KMC Telecom III has pledged all of its assets to Lucent.
Accordingly, if there were an event of default under the Lucent Facility, Lucent
thereunder would be entitled to payment in full and could foreclose on the
assets of the Borrower and the holders of the Senior Discount Notes would have
no right to share in such assets.
Additionally, the Lucent Facility restricts the ability of KMC Telecom III to
pay dividends to, or to pay principal or interest on loans from, the Company.
Such restrictions could adversely affect the Company's liquidity and ability to
meet its cash requirements, including its ability to repay the Senior Discount
Notes.
SERIES E PREFERRED STOCK
On February 4, 1999, the Company issued 25,000 shares of Series E Senior
Redeemable, Exchangeable, PIK Preferred Stock (the "Series E Preferred Stock")
to Newcourt Commercial Finance Corporation ("Newcourt Finance"), generating
aggregate gross proceeds of $22.9 million. The Series E Preferred Stock has a
liquidation preference of $1,000 per share and an annual dividend equal to 14.5%
of the liquidation preference, payable quarterly. On or before January 15, 2004,
the Company may pay dividends in cash or in additional fully paid and
nonassessable shares of Series E Preferred Stock. After January 15, 2004,
dividends must be paid in cash, subject to certain conditions. Unpaid dividends
accrue at the dividend rate of the Series E Preferred Stock, compounded
quarterly.
The Series E Preferred Stock must be redeemed on February 1, 2011, subject to
the legal availability of funds therefor, at a redemption price, payable in
cash, equal to the liquidation preference thereof on the redemption date, plus
all accumulated and unpaid dividends to the date of redemption.
The Series E Preferred Stock is not convertible. The Company may, at the sole
option of the Board of Directors (out of funds legally available), exchange all,
but not less than all, of the Series E Preferred Stock then outstanding, for a
new series of subordinated debentures (the "Exchange Debentures") issued
pursuant to an exchange debenture indenture.
SERIES F PREFERRED STOCK
On February 4, 1999, the Company issued 40,000 shares of Series F Senior
Redeemable, Exchangeable, PIK Preferred Stock (the "Series F Preferred Stock")
to Lucent and Newcourt Finance, generating aggregate gross proceeds of $38.9
million. The Series F Preferred Stock has a liquidation preference of $1,000 per
share and an annual dividend equal to 14.5% of the liquidation preference,
payable quarterly. The Company may pay dividends in cash or in additional fully
paid and nonassessable shares of Series F Preferred Stock.
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
Upon the earlier of (i) the date that is sixty days after the date on which the
Company closes an underwritten primary offering of at least $200 million of its
Common Stock, pursuant to an effective registration statement under the
Securities Act or (ii) February 4, 2001, any outstanding Series F Preferred
Stock will automatically convert into Series E Preferred Stock, on a one for one
basis.
The Company may, at the sole option of the Board of Directors (out of funds
legally available), exchange all, but not less than all, of the Series F
Preferred Stock then outstanding for Exchange Debentures.
WARRANTS
In connection with the February 4, 1999 issuances of the Series E Preferred
Stock and the Series F Preferred Stock, warrants to purchase an aggregate of
24,660 shares of Common Stock were sold to Newcourt Finance and Lucent. The
aggregate gross proceeds from the sale of these warrants was approximately $3.2
million. These warrants, at an exercise price of $.01 per share, are exercisable
from February 4, 2000 through February 1, 2009.
In addition, the Company also delivered to the Warrant Agent certificates
representing warrants to purchase an aggregate of an additional 107,228 shares
of Common Stock at an exercise price of $.01 per share (the "Springing
Warrants"). The Springing Warrants may become issuable under the circumstances
described in the following paragraph.
If the Company fails to redeem all shares of Series F Preferred Stock prior to
the date (the "Springing Warrant Date") which is the earlier of (i) the date
that is sixty days after the date on which the Company closes an underwritten
primary offering of at least $200 million of its Common Stock pursuant to an
effective registration statement under the Securities Act or (ii) February 4,
2001, the Warrant Agent is authorized to issue the Springing Warrants to the
Eligible Holders (as defined in the warrant agreement) of the Series E and
Series F Preferred Stock. In the event the Company has redeemed all outstanding
shares of Series F Preferred Stock prior to the Springing Warrant Date, the
Springing Warrants will not be issued and the Warrant Agent will return the
certificates to the Company. To the extent the Company exercises its option to
exchange all of the Series F Preferred Stock for Exchange Debentures prior to
the Springing Warrant Date, the Springing Warrants will not become issuable.
Therefore, as the future issuance of the Springing Warrants is entirely within
the control of the Company and the likelihood of their issuance is deemed to be
remote, no value has been ascribed to the Springing Warrants.
KMC Telecom Holdings, Inc.
SCHEDULE II - Valuation and Qualifying Accounts
(in thousands)
Additions
----------------------------------
Charged to
Balance at Charged to Other
Beginning Costs and Accounts - Deductions - Balance at
Description of Period Expenses Describe Describe End of Period
- - ----------------------------------------- ----------------- ---------------- ----------------- ---------------- -----------------
Year ended December 31, 1996:
Allowance for doubtful accounts $ -- $ -- $ -- $ -- $--
================= ================ ================= ================ =================
Year ended December 31, 1997:
Allowance for doubtful accounts $ -- $ 34 $ -- $ -- $ 34
================= ================ ================= ================ =================
Year ended December 31, 1998:
Allowance for doubtful accounts $ 34 $ 370 $ -- $ 54(1) $350
================= ================ ================= ================ =================
(1) Uncollectible accounts written-off.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth certain information with respect to the
persons who are members of the Board of Directors or are executive officers of
the Company as of March 24, 1999.
Name Age Position
---- --- --------
Harold N. Kamine...... 42 Chairman of the Board of Directors
Gary E. Lasher........ 63 Vice Chairman of the Board of Directors
Michael A. Sternberg.. 54 President, Chief Executive Officer and Director
Roscoe C. Young II... 48 Chief Operating Officer
James D. Grenfell..... 47 Executive Vice President, Chief
Financial Officer and Secretary
Charles Rosenblum..... 48 Senior Vice President - Human Resources
James L. Barwick...... 66 Senior Vice President - Technology
Tricia Breckenridge... 52 Senior Vice President - Business Development
John G. Quigley....... 45 Director
Richard H. Patterson.. 40 Director
Randall A. Hack....... 51 Director
William H. Stewart.... 32 Director
The business experience of each of the directors and executive officers
of the Company is as follows:
HAROLD N. KAMINE is the Chairman of the Board of the Company and its
founder and has been a director of the Company since 1994. He is also chief
executive officer and sole owner of Kamine Development Corp. and associated
companies in the independent power industry. Mr. Kamine has successfully
financed a number of unregulated non-utility power generation projects.
Companies owned by Mr. Kamine owned substantial interests in and managed six
power generation plants in the Northeastern United States. Mr. Kamine devotes
approximately eighty percent of his time to the affairs of the Company. Mr.
Kamine and Mr. Rosenblum are first cousins.
GARY E. LASHER joined the Company as its Vice Chairman of the Board
effective November 1, 1997. He was the founder, Chief Executive Officer and
President of Eastern TeleLogic Corporation ("ETC") from 1987 to 1997. ETC was a
leading competitive local exchange carrier operating in greater Philadelphia,
Delaware and southern New Jersey before its purchase by TCG (Teleport
Communications Group) in October 1996. Prior to ETC, from 1984-1986, Mr. Lasher
was Chief Operating Officer of Private Satellite Network, a company which built
and operated video satellite networks for major corporations. Mr. Lasher spent
20 years with Continental Telephone ("Contel") holding various positions
including Corporate Vice President, President of the International Engineering
and Construction Company, and various senior positions with Contel's regulated
subsidiaries. Mr. Lasher is one of the founding members of the Association for
Local Telecommunications Services ("ALTS") and served for three years as
Chairman of the Association.
MICHAEL A. STERNBERG has spent 29 years in telecommunications,
including business development, marketing, sales and general management. Prior
to joining the Company in July 1996 as President and Chief Executive Officer,
Mr. Sternberg was a co-founder and Chief Operating Officer, from April 1991 to
July 1996, of RimSat, a privately owned satellite company which from January
1993 to July 1996 owned and operated two Russian-built satellites which provided
television, voice and data capacity to Asian operators. From March 1990 to April
1991, Mr. Sternberg served as Chief Executive Officer of Sternberg & Associates,
Inc., a company he founded. From 1988 to 1990, Mr. Sternberg served as Senior
Vice President-Marketing and Sales with MFS Communications. Previously, Mr.
Sternberg had served as President of Stantel Telecommunications, a division of
STC, a digital telecommunications transmissions products company based in Falls
Church, Virginia; Senior Vice President-Marketing and Corporate Development at
CIT-Alcatel in Reston, Virginia; Vice President-Marketing at General Dynamics
Communications Company in St. Louis; Executive Vice President-Marketing and
Sales of OKI Electronics of America in Fort Lauderdale; and Chief Operating
Officer of National Telephone Company in Hartford, Connecticut. He has served as
a director of the Company since August 1996. Mr. Sternberg is a member of the
Executive Committee of ALTS.
ROSCOE C. YOUNG II has approximately 20 years experience in the field
of telecommunications with both new venture and Fortune 500 companies. Prior to
joining the Company in November 1996, Mr. Young served as Vice President,
Network Component Services for Ameritech Corporation from June 1994 to October
1996. From March 1988 to June 1994, Mr. Young served as Senior Vice President,
Network Services for MFS Communications. From October 1977 to March 1988, Mr.
Young served in a number of senior operations, sales and marketing, engineering,
financial management, and human resource positions for AT&T Corp.
JAMES D. GRENFELL has over 20 years experience in the
telecommunications industry. He joined the Company as its Executive Vice
President, Chief Financial Officer and Secretary in March 1999. From August 1998
to March 1999 he was an independent consultant. Previously, he served as
Executive Vice President and Chief Financial Officer of ICG Communications,
Inc., a competitive local exchange carrier headquartered in Denver, Colorado
from November 1995 to July 1998. Prior to joining ICG, Mr. Grenfell served as
Director of Financial Planning for BellSouth Corporation and Vice President and
Assistant Treasurer of BellSouth Capital Funding. He was with BellSouth from
1985 through November 1995, serving previously as Finance Manager of Mergers and
Acquisitions. Prior to BellSouth, Mr. Grenfell spent two years as a Project
Manager with Utility Financial Services and six years with GTE of the South, a
subsidiary of GTE Corporation, including four years as Assistant Treasurer. Mr.
Grenfell is a Chartered Financial Analyst.
CHARLES ROSENBLUM has over 20 years experience in human resources,
primarily in human resources planning, staffing and development. He joined the
Company in January 1997. From May 1995 to January 1997 he served as Vice
President-Human Resources of Kamine Development Corp. Previously he had held the
positions of Director, Management Development with KPMG Peat Marwick and Manager
of Management Education with Dun & Bradstreet Corporation. Earlier he had served
in various human resource positions with Allstate Insurance Company. Mr.
Rosenblum and Mr. Kamine are first cousins.
JAMES L. BARWICK has 39 years of experience in the telecommunications
industry. Mr. Barwick joined the Company in March 1997. Prior to joining the
Company, Mr. Barwick had been self-employed since 1986 as a telecommunications
consultant with expertise in equipment application engineering, radio path
engineering, analog and digital Mux, switching and transport systems in the long
distance carrier and incumbent local exchange carrier areas, technical writing,
project management and computer assisted design systems.
TRICIA BRECKENRIDGE joined the Company in April 1995. From January 1993
to April 1995 she was Vice President and General Manager of FiberNet USA's
Huntsville, Alabama operations. Previously she had served as Vice President,
External Affairs and later Vice President, Sales and Marketing of Diginet, Inc.
She was co-founder of Chicago Fiber Optic Corporation, the predecessor of
Metropolitan Fiber Systems. Earlier she was Director of Regulatory Affairs for
Telesphere Corporation.
JOHN G. QUIGLEY has served as a director of the Company since August
1996. Mr. Quigley is a founding member of Nassau Capital L.L.C., which is the
general partner of Nassau Capital Partners. Between 1980 and the formation of
Nassau Capital in 1995, Mr. Quigley was an attorney with the law firm of
Kirkland & Ellis in Chicago; a partner at Adler & Shaykin; and a partner at
Clipper Capital Partners.
RICHARD H. PATTERSON has served as a director of the Company since May
1997. From May 1986 to January 1999, Mr. Patterson served as a Partner of Waller
Capital Corporation, a media and communications investment banking firm. Since
August 1997, he has served as a Vice President of Waller-Sutton Media LLC and
Vice President of Waller-Sutton Management Group, Inc., two entities which
manage a media and telecommunications private equity fund. Mr. Patterson is a
member of the Board of Directors of Regent Communications, Inc., which owns and
operates radio stations in mid-to-small size markets.
RANDALL A. HACK has served as a director of the Company since August
1996. Since January 1995, Mr. Hack has been a member of Nassau Capital L.L.C.,
an investment management firm. From 1990 to 1994, he was the President and Chief
Executive Officer of Princeton University Investment Company, which manages the
endowment for Princeton University. Mr. Hack also serves on the Boards of
Directors of Sweetwater, Inc., OmniCell Technologies, Inc., Castle Tower Holding
Corp., Mezzanine Capital Property Investors, Inc.
and Shape Global Technologies, Inc.
WILLIAM H. STEWART has served as a director of the Company since
August 1997. Mr. Stewart is Managing Director of Nassau Capital L.L.C. and
joined that firm in June 1995. From 1989 until joining Nassau, Mr. Stewart was a
portfolio manager and equity analyst at the Bank of New York. Mr. Stewart also
serves on the board of Signius Corporation. He is a Chartered Financial Analyst
and a member of the New York Society of Security Analysts.
Pursuant to provisions contained in both the Company's certificate of
incorporation and an Amended and Restated Stockholders Agreement, dated as of
October 31, 1997, by and among KMC Telecom Holdings, Inc., Nassau Capital
Partners, L.P., NAS Partners I L.L.C., Harold N. Kamine, Newcourt Communications
Finance Corporation (then known as AT&T Credit Corporation), General Electric
Capital Corporation, CoreStates Bank, N.A. and CoreStates Holdings, Inc., Mr.
Kamine and the Nassau entities are currently entitled to elect all of the
Directors, three of whom are nominated by Mr. Kamine (one of whom must be the
President and Chief Executive Officer), three of whom are nominated by Nassau
and one of whom is nominated by agreement of Mr. Kamine, Nassau and either
Newcourt Communications Finance Corporation or the holders of a majority of the
outstanding shares of the Company's Series C Cumulative Convertible Preferred
Stock. The number of Directors which Mr. Kamine is entitled to elect would be
reduced to two if the number of shares owned by him were to fall below
two-thirds of the number of shares of the Company initially issued to him, and
to one if the number of shares owned by him were to fall below one-third of the
number of shares initially issued to him. If his ownership were to fall below 5%
of the number of shares initially issued to him, Mr. Kamine would no longer be
entitled to elect any Directors pursuant to such provisions. Comparable
reductions would be made to the number of Directors which Nassau is entitled to
elect if its ownership were to fall below the specified fractions. If a default
relating to payment occurs under our Senior Secured Credit Facility, and
continues uncured for 90 days, the holders of Series C Cumulative Convertible
Preferred Stock (currently Nassau, General Electric Capital Corporation and
CoreStates) will be entitled to elect two additional Directors, who will serve
until the default is cured.
Kamine/Besicorp Allegany L.P., an independent power company 50% owned
by corporations which Mr. Kamine owns, filed a voluntary petition to reorganize
its business under Chapter 11 of the Federal Bankruptcy Code in November 1995.
In October 1998, the bankruptcy court confirmed a plan of liquidation for this
entity. The United States Bankruptcy Court for the Northern District of Indiana
appointed a receiver for RimSat, a company which Mr. Sternberg co-founded and
for which he formerly served as Chief Operating Officer, and a petition for
bankruptcy under Chapter 11 of the Federal Bankruptcy Code with respect to
RimSat was filed in 1996.
That proceeding is ongoing.
Directors hold office until the next Annual Meeting of stockholders or
until their successors are duly elected and qualified. Executive officers are
elected annually by the Board of Directors and serve at the discretion of the
Board of Directors.
COMMITTEES OF THE BOARD
The Board of Directors of the Company has authorized a Compensation
Committee to be composed of three members. The present members of the
Compensation Committee are Messrs. Kamine, Quigley and Patterson. The Board of
Directors has created an Executive Committee consisting of Mr. Kamine and Mr.
Quigley, or, in Mr. Quigley's absence, Mr. Stewart. The Board of Directors has
also created an Audit Committee consisting of Messrs. Lasher, Patterson and
Quigley.
Item 11. EXECUTIVE COMPENSATION.
SUMMARY COMPENSATION TABLE
The following table sets forth information concerning compensation for
services in all capacities awarded to, earned by, or paid to, any person acting
as the Company's Chief Executive Officer during 1998, regardless of the amount
of compensation paid, and the other four most highly compensated executive
officers of the Company whose aggregate cash and cash equivalent compensation
exceeded $100,000 during the fiscal year ended December 31, 1998 (collectively,
the "Named Executive Officers"):
Annual Compensation Long Term
Compensation
------------------------------------------------------ ------------
Other Annual Securities
Compensation Underlying
Name and Position Year Salary ($) Bonus ($) ($)(1) Options (#)(2)
- - ----------------- ---- ---------- --------- ------ --------------
Michael A. Sternberg .............. 1998 $275,000 $407,500 - 65,000
President and Chief Executive 1997 $240,385 $187,500 $45,909 9,228
Officer
Roscoe C. Young II................ 1998 $218,270 $497,500 $52,189 32,500
Chief Operating Officer 1997 $180,000 $182,046 $198,180 2,309
Cynthia Worthman(3)................ 1998 $200,000 $187,500 - 32,500
Vice President, Chief Financial 1997 $175,000 $200,000 - 3,461
Officer, Secretary and
Treasurer
Charles Rosenblum.................. 1998 $168,270 $96,750 - 5,000
Senior Vice President - Human 1997 $150,000 $77,500 - 691
Resources
Tricia Breckenridge................ 1998 $155,577 $75,000 - 5,000
Senior Vice President - 1997 $104,138 $49,000 - 691
Business Development
- - -----------------------
(1) The amount reported in this column for Mr. Sternberg in 1997 includes
relocation related expenses of $39,662 and personal use of a Company
automobile of $6,247. The amounts reported in this column for Mr. Young
include relocation related expenses of $47,344 and personal use of a
Company automobile of $6,919 for 1998, and relocation related expenses of
$196,029 and personal use of a Company automobile of $2,151 for 1997. The
aggregate value of the perquisites and other personal benefits, if any,
received by Mr. Sternberg in 1998 and by each of Ms. Worthman, Mr.
Rosenblum and Ms. Breckenridge in 1998 and 1997 have not been reflected in
this table because the amount was below the Securities and Exchange
Commission's threshold for disclosure (i.e., the lesser of $50,000 or 10%
of the total of annual salary and bonus for the executive officer for the
year).
(2) The options granted in 1997 were options to purchase shares of common stock
of the Company's principal operating subsidiary KMC Telecom Inc. All of the
options shown as granted in 1997 were cancelled during the third quarter of
1998 and replaced by options to purchase Common Stock of the Company. See
"Stock Option Grants." All options granted during 1998 are options to
purchase shares of Common Stock of the Company.
(3) Ms. Worthman served in the capacities indicated throughout the year ended
December 31, 1998. James D. Grenfell became Executive Vice President, Chief
Financial Officer and Secretary in March, 1999.
STOCK OPTION GRANTS
The Company was formed as a holding company in September 1997. Prior to
the establishment of the present holding company structure, during 1996 and
1997, KMC Telecom Inc. (now one of the Company's principal operating
subsidiaries) granted options to purchase shares of its common stock, par value
$.01 per share, to employees, including the Named Executive Officers, and
selected employees of certain affiliated companies owned by Mr. Kamine pursuant
to the KMC Telecom Stock Option Plan.
In order to reflect the establishment of the Company's holding company
structure, on June 26, 1998, the Board of Directors of the Company adopted,
effective upon stockholder approval, a new stock option plan, the KMC Holdings
Stock Option Plan, which authorizes the grant of options to purchase Common
Stock of the Company. During the third quarter of 1998, the Company replaced the
options to purchase shares of KMC Telecom Inc. Common Stock previously granted
under the KMC Telecom Stock Option Plan (including all options shown as granted
during 1997 in the preceding table) with options to purchase shares of Common
Stock of the Company granted under the KMC Holdings Stock Option Plan and
granted options to additional employees of the Company, including Mr. Lasher,
under the KMC Holdings Stock Option Plan. The Company may subsequently grant
additional options, although it has no specific plans in this regard.
The following table sets forth information regarding grants of options
to purchase shares of Common Stock made by the Company during 1998 to each of
the Named Executive Officers.
Option Grants in Fiscal Year 1998
Individual Grants
---------------------------------------------------------
Percent of
Number of Total Potential Realizable Value At
Securities Options Assumed Annual Rates of Stock
Underlying Granted to Market Price Price Appreciation For
Options Employees Exercise or Of Common Option Term(3)
Granted In Fiscal Base Price Stock on Date Expiration ------------------------------------------
Name (#)(1) 1998 ($/Share) Of Grant (2) Date (0%) (5%) (10%)
- - ---- ------ ---- --------- ------------ ---- ---- ---- -----
Michael A. Sternberg ..... 39,000 $20.00 $130 9/30/08 $4,290,000 $7,478,496 $12,370,274
13,000 24.8% $30.00 $130 9/30/08 $1,300,000 $2,362,832 $ 3,993,425
13,000 $40.00 $130 9/30/08 $1,170,000 $2,232,832 $ 3,863,425
Roscoe C. Young II....... 19,500 $20.00 $130 9/30/08 $2,145,000 $3,739,248 $ 6,185,137
6,500 12.4% $30.00 $130 9/30/08 $ 650,000 $1,181,416 $ 1,996,712
6,500 $40.00 $130 9/30/08 $ 585,000 $1,116,416 $ 1,931,712
Cynthia Worthman.......... 19,500 $20.00 $130 9/30/08 $2,145,000 $3,739,248 $ 6,185,137
6,500 12.4% $30.00 $130 9/30/08 $ 650,000 $1,181,416 $ 1,996,712
6,500 $40.00 $130 9/30/08 $ 585,000 $1,116,416 $ 1,931,712
Charles Rosenblum......... 3,000 $20.00 $130 9/30/08 $ 330,000 $ 575,269 $ 951,560
1,000 1.9% $30.00 $130 9/30/08 $ 100,000 $ 181,756 $ 307,187
1,000 $40.00 $130 9/30/08 $ 90,000 $ 171,756 $ 297,187
Tricia Breckenridge....... 3,000 $20.00 $130 9/30/08 $ 330,000 $ 575,269 $ 951,560
1,000 1.9% $30.00 $130 9/30/08 $ 100,000 $ 181,756 $ 307,187
1,000 $40.00 $130 9/30/08 $ 90,000 $ 171,756 $ 297,187
- - -----------
(1) 10% of the aggregate amount of each such option vests on each subsequent
six-month anniversary of the date of grant with options with the lowest
exercise price vesting first followed by others in ascending order of
exercise price. For purposes of vesting, options granted in 1998 under the
KMC Holdings Stock Option Plan to replace options granted in 1996 or 1997
under the KMC Telecom Stock Option Plan are deemed to have been granted on
the date of grant of the options which they replace.
(2) There is no active trading market for the Company's Common Stock. The
market price shown is based upon management's estimate of the fair value of
the Company's Common Stock on the date in September 1998 when these options
were granted under the new KMC Holdings Stock Option Plan. The grant prices
were based on the grant prices of the options previously granted in 1996
and 1997 under the KMC Telecom Stock Option plan which were cancelled and
replaced by the options reflected in this table. The grant prices of the
options granted in 1996 and 1997 had been based on the fair value of the
shares of KMC Telecom common stock on the respective dates of their grants.
(3) Amounts reported in these columns represent amounts that may be realized
upon exercise of options immediately prior to the expiration of their term
assuming the specified compounded rates of appreciation (0%, 5% and 10%) on
Common Stock over the term of the options. These assumptions are based on
rules promulgated by the Securities and Exchange Commission and do not
reflect the Company's estimate of future stock price appreciation. Actual
gains, if any, on the stock option exercises and Common Stock holdings are
dependent on the timing of such exercises and the future value of the
Common Stock. There can be no assurance that the rates of appreciation
assumed in this table can be achieved or that the amounts reflected will be
received by the option holders.
OPTION EXERCISES AND OPTION YEAR-END VALUE TABLE
No options were exercised during 1998 by any of the Named Executive
Officers. The following table sets forth information regarding the number and
year-end value of unexercised options to purchase shares of Common Stock held at
December 31, 1998 by each of the Named Executive Officers.
Fiscal 1998 Year-End Option Values
Number of Securities Value of Unexercised
Underlying Unexercised "In-the-Money"
Shares Value Options at Options at
Acquired On Realized December 31, 1998 December 31, 1998
Name Exercise(#) ($) Exercisable/Unexercisable Exercisable/Unexercisable(1)
---- ----------- --- ------------------------- ----------------------------
Michael A. Sternberg -- -- 32,500/32,500 $3,575,000/$3,185,000
Roscoe C. Young II -- -- 16,250/16,250 $1,787,500/$1,592,500
Cynthia Worthman -- -- 16,250/16,250 $1,787,500/$1,592,500
Charles Rosenblum -- -- 3,500/1,500 $380,000/$140,000
Tricia Breckenridge -- -- 3,500/1,500 $380,000/$140,000
- - -----------
(1) Options are "In-the-Money" if the fair market value of the underlying
securities exceeds the exercise price of the options. There is no
active trading market for the Company's Common Stock. The fair market
value of the option grants at December 31, 1998 was determined on the
basis of management's estimate of the fair value of the Company's
Common Stock on that date.
DIRECTOR COMPENSATION
The Company's Directors do not currently receive any compensation for
their services in such capacity, except that Mr. Lasher receives $40,000 per
year in connection with his services as Vice Chairman of the Board and Mr.
Patterson receives $25,000 per year in connection with his services as a
Director.
EXECUTIVE EMPLOYMENT CONTRACTS
The Company has an employment contract with Harold N. Kamine, the
Chairman of its Board of Directors. The Company's employment agreement with Mr.
Kamine provides for a term of four years, effective as of January 1, 1999. Under
the agreement, Mr. Kamine's base salary is $450,000 per annum, and Mr. Kamine is
required to devote at least fifty percent of his time and attention to the
performance of his duties under the agreement. Mr. Kamine is entitled to receive
benefits generally received by senior executives of the Company, including
reimbursement of expenses incurred on behalf of the Company, and participation
in group plans. If Mr. Kamine's employment agreement is terminated as a result
of Mr. Kamine's death or permanent disability, or upon the Company's breach of
the agreement, he, or his estate, is entitled to a severance payment in an
amount equal to the lesser of (i) two times his annual base salary and (ii) the
aggregate unpaid base salary that would have been paid to him during the
remaining balance of the term of the employment contract, subject to a minimum
of one-half of his annual base salary.
The Company has an employment contract with Michael A. Sternberg, its
President and Chief Executive Officer. The Company's employment agreement with
Mr. Sternberg provides for a term of four years, effective as of January 1,
1999. Under the agreement, Mr. Sternberg's base salary is $500,000 per annum and
he is entitled to be considered for an annual bonus in an amount to be
determined by the Compensation Committee of the Company's Board of Directors.
Mr. Sternberg is entitled to receive benefits generally received by Company
officers, including options to purchase Company stock, reimbursement of expenses
incurred on behalf of the Company, and a leased automobile. Upon termination of
the agreement, Mr. Sternberg is subject to a confidentiality covenant and a
twenty-four month non-competition agreement. If the Company terminates Mr.
Sternberg's employment without cause, he is entitled to a severance payment in
an amount equal to the lesser of (i) two times his annual base salary and (ii)
the aggregate unpaid base salary that would have been paid to him during the
remaining balance of the term of the employment contract, subject to a minimum
of one-half of his annual base salary.
The Company has an employment contract with Roscoe C. Young, II, its
Executive Vice President and Chief Operating Officer. The Company's employment
agreement with Mr. Young provides for a term of four years, effective as of
January 1, 1999. Under the agreement, Mr. Young's base salary is $450,000 per
annum and he is entitled to be considered for an annual bonus in an amount to be
determined by the Compensation Committee of the Company's Board of Directors.
Mr. Young is entitled to receive benefits generally received by Company
officers, including options to purchase Company Stock, reimbursement of expenses
incurred on behalf of the Company, and a leased automobile. Upon termination of
the agreement, Mr. Young is subject to a confidentiality covenant and a
twenty-four month non-competition agreement. If the Company terminates Mr.
Young's employment without cause, he is entitled to a severance payment in an
amount equal to the lesser of (i) two times his annual base salary and (ii) the
aggregate unpaid base salary that would have been paid to him during the
remaining balance of the term of the employment contract, subject to a minimum
of one-half of his annual base salary.
EMPLOYEE PLANS
KMC HOLDINGS STOCK OPTION PLAN. Employees, directors or other persons
having a unique relationship with the Company or any of its affiliates are
eligible to participate in the KMC Holdings Stock Option Plan. However, neither
Mr. Kamine nor any person employed by Nassau or any affiliate of Nassau is
eligible for grants under the plan. The KMC Holdings Stock Option Plan is
administered by the Compensation Committee of the Board of Directors of the
Company. The Compensation Committee is authorized to grant (i) options intended
to qualify as Incentive Options, (ii) Non-Qualified Options, (iii) stock
appreciation rights, (iv) restricted stock, (v) performance units, (vi)
performance shares and (vii) certain other types of awards.
The number of shares of Company Common Stock available for grant under
the KMC Holdings Stock Option Plan is 262,750. No participant may receive more
than 75,000 shares of Company Common Stock under the KMC Holdings Stock Option
Plan.
The Compensation Committee has the power and authority to designate
recipients of grants under the KMC Holdings Stock Option Plan, to determine the
terms, conditions and limitations of grants under the plan and to interpret the
provisions of the plan. The exercise price of all Incentive Options granted
under the KMC Holdings Stock Option Plan must be at least equal to the Fair
Market Value (as defined in the plan) of Company Common Stock on the date the
options are granted and the exercise price of all Nonqualified Options granted
under the KMC Holdings Stock Option Plan must be at least equal to 50% of the
Fair Market Value of Company Common Stock on the date the options are granted.
The maximum term of each Option granted under the KMC Holdings Stock Option Plan
will be 10 years. Options will become exercisable at such times and in such
installments as the Compensation Committee provides in the terms of each
individual Option.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Mr. Kamine, the Chairman of the Board of the Company, and Mr. John G.
Quigley, a Director of the Company, served as members of the Compensation
Committee of the Board of Directors during 1998. Mr. Quigley is also a member of
Nassau Capital Partners L.P. which, through its affiliates, beneficially owns
more than five percent (5%) of the Company's voting securities.
The Company and certain affiliated companies owned by Mr. Kamine share
certain administrative services. The entity which bears the cost of the service
is reimbursed by the other for the other's proportionate share of such expenses.
These shared services do not include the rent paid by the Company for its
headquarters offices to an affiliate of Mr. Kamine under the lease described in
the next succeeding paragraph. The Company reimbursed Kamine-affiliated
companies for these shared services an aggregate of approximately $136,000, for
1998.
From May 1, 1996 through January 29, 1998, Kamine Development Corp., an
affiliate of the Company, was paid a fee at an annual rate of $266,000 as
reimbursement for the services of Mr. Kamine as Chairman of the Board of the
Company. The amount of this fee was reduced to $100,000 per annum as of January
29, 1998 and it was terminated effective December 31, 1998. The amount of the
fee paid in 1998 is included in the shared services payment described in the
first paragraph above. Effective January 1, 1999, Mr. Kamine became an employee
of the Company and he is currently paid a salary at the rate of $450,000 per
annum for his services as Chairman of the Board.
Effective June 1, 1996, the Company entered into a lease agreement with
Kamine Development Corp. (an entity controlled by Mr. Kamine) pursuant to which
the Company leases its headquarters office in Bedminster, New Jersey. The lease
expires in January 2007. The lease provides for a base annual rental of
approximately $217,000 (adjusted periodically for changes in the consumer price
index), plus operating expenses.
KMC Services LLC, a limited liability company wholly owned by Mr.
Kamine, has entered into a five year agreement with the Company pursuant to
which KMC Services LLC will offer to the Company financial and energy services
which are related to the Company's business. KMC Services LLC may also offer its
services to third parties in jurisdictions in which the Company is not offering
telecommunications services; provided that such third parties are not
competitors of the Company. Initially, KMC Services LLC will offer a leasing
program for equipment physically installed at a customer's premises, known as
CPE Equipment, for the Company to integrate into its ClearStarsm Advantage
program, whereby the Company will be able to offer CPE Equipment for lease or
sale to its customers. The equipment will be owned by KMC Services LLC and the
Company will have no liability for the cost of the equipment, the financing
related to it or the obligation for any lease charges. Any such sale or lease
will be between the Company's customer and KMC Services LLC. The Company will
advance to KMC Services LLC each year on a monthly basis, pursuant to an
approved annual budget, KMC Services LLC's estimated operating expenses for the
year. In exchange, the Company will receive, on a quarterly basis, eighty
percent (80%) of the net pre-tax cash flow received by KMC Services LLC (after
payment of all costs of KMC Services LLC other than those advanced by the
Company). For 1999 the estimated operating expenses of KMC Services LLC are
approximately $1.2 million. The Company is not responsible for KMC Services
LLC's capital costs or financing costs. The Company will invoice KMC Services
LLC for its allocable costs incurred in connection with this program, including
such items as sales commissions and administrative support, and recover these
costs, together with any amounts advanced to KMC Services LLC for its annual
operating costs, from the Company's eighty percent (80%) share of the net
pre-tax cash flow received from KMC Services LLC. The Company and KMC Services
LLC have mutual rights of audit to insure proper allocation of costs and
accounting. If at any time Mr. Kamine, including his immediate family, and
Nassau collectively own less than twenty percent (20%) of the Company, the
Company has the right to cancel this agreement; subject to either a buyout of
the Company's customer portfolio from KMC Services LLC or the assumption or
guarantee by the Company of eighty percent (80%) of the outstanding financing
relating to the equipment previously purchased by KMC Services LLC.
Pursuant to an agreement dated as of January 1, 1999, the Company is
entitled to utilize a Citation III business jet chartered by Bedminster
Aviation, LLC, a limited liability company wholly owned by Mr. Kamine, for a
fixed price of $2,600 per hour of flight time. The Citation III will enable up
to eight employees, guests or representatives of the Company to utilize local
airfields and visit multiple cities in which the Company either has an operating
system or is building a system, without the necessity of returning to commercial
hubs such as Atlanta or St. Louis. The Company has agreed to use its best
efforts to utilize the Citation III fifty hours per quarter during 1999.
However, the Company is under no obligation to do so and has not guaranteed any
financial arrangements with respect to the aircraft or to Bedminster Aviation,
LLC.
Upon closing of its offering of 12 1/2% Senior Discount Notes in
January 1998, the Company paid to Nassau approximately $600,000 for dividend
arrearages on the Series A Cumulative Convertible Preferred Stock of KMC
Telecom, Inc. which Nassau had exchanged for its shares of Series A Cumulative
Convertible Preferred Stock of the Company.
Pursuant to an Agreement among the Company, Mr. Kamine and Nassau, for
1998 Nassau received $100,000 as a financial advisory fee and as compensation
for the Nassau designees who served on the Board of Directors of the Company.
Nassau will be paid $450,000 as a financial advisory fee for 1999.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information regarding the
beneficial ownership of the Common Stock, as of March 24, 1999, by (i) each
person known to the Company to be the beneficial owner of more than 5% of the
Common Stock, (ii) each of the Company's directors, (iii) each of the Named
Executive Officers, and (iv) all directors and executive officers as a group.
All information with respect to beneficial ownership has been furnished to the
Company by the respective stockholders of the Company.
Number of Percentage
Name and Address of Beneficial Owner Shares (1) Ownership (1)
------------------------------------ ---------- -------------
Harold N. Kamine.............................. 573,835 67.3%
c/o Kamine Development Corp.
1545 Route 206
Bedminster, NJ 07921
Nassau Capital Partners L.P................... 661,454(2) 44.1%
c/o Nassau Capital L.L.C.
22 Chambers Street
Princeton, NJ 08542
Newcourt Capital, Inc......................... 221,515.5(3) 25.4%
2 Gate Hall Drive
Parsipany, NJ 07054
CoreStates Holdings, Inc...................... 102,155.5(4) 10.8%
1339 Chestnut St.
Philadelphia, PA 19107
General Electric Capital Corporation.......... 200,476(5) 19.0%
120 Long Ridge Road
Stamford, CT 06927
Michael A. Sternberg ......................... 32,500(6) 3.7%
c/o KMC Telecom Holdings, Inc.
1545 Route 206, Suite 300
Bedminster, New Jersey 07921
Gary E. Lasher................................ 4,000(6) 0.5%
c/o KMC Telecom Holdings, Inc.
1545 Route 206, Suite 300
Bedminster, New Jersey 07921
John G. Quigley............................... 661,454(7) 44.1%
c/o Nassau Capital L.L.C.
22 Chambers Street
Princeton, NJ 08542
Richard H. Patterson.......................... 1,200(6) 0.1%
c/o Waller Capital Corporation
30 Rockefeller Center
Suite 4350
New York, NY 10112
Randall A. Hack............................... 661,454(7) 44.1%
c/o Nassau Capital L.L.C.
22 Chambers Street
Princeton, NJ 08542
William H. Stewart............................ 661,454(8) 44.1%
c/o Nassau Capital L.L.C.
22 Chambers Street
Princeton, NJ 08542
Roscoe C. Young II........................... 16,250(6) 1.9%
c/o KMC Telecom Holdings, Inc.
1545 Route 206, Suite 300
Bedminster, NJ 07921
Cynthia Worthman.............................. 16,250(6) 1.9%
c/o KMC Telecom Holdings, Inc.
1545 Route 206, Suite 300
Bedminster, NJ 07921
Charles Rosenblum............................. 3,500(6) 0.4%
c/o KMC Telecom Holdings, Inc.
1545 Route 206, Suite 300
Bedminster, NJ 07925
Tricia Breckenridge........................... 3,500(6) 0.4%
c/o KMC Telecom Holdings, Inc.
1545 Route 206, Suite 300
Bedminster, NJ 07921
Directors and Officers of the Company
as a Group (11 persons)...................... 1,313,989(2) 83.2%
- - -----------
(1) Beneficial ownership is determined in accordance with the rules of the
Commission. In computing the number of shares beneficially owned by a
person and the percentage ownership of that person, shares subject to
options, warrants and convertible securities held by that person that are
currently exercisable or exercisable within 60 days of March 24, 1999 are
deemed outstanding. Such shares, however, are not deemed outstanding for
the purposes of computing the percentage ownership of any other person.
Except as indicated in the footnotes to this table, each shareholder named
in the table has sole voting and investment power with respect to the
shares set forth opposite such shareholder's name.
(2) Includes 600,000 shares of Common Stock which Nassau and NAS Partners I
L.L.C., of which Messrs. Quigley, Hack and Stewart are members, have the
right to acquire upon conversion of 122,708 and 1,092 shares of Series A
Cumulative Convertible Preferred Stock, respectively, and 47,619 shares of
Common Stock which Nassau and NAS Partners I, L.L.C. have the right to
acquire upon conversion of 24,778 and 222 shares of Series C Cumulative
Convertible Preferred Stock, respectively. These are the same shares listed
for Messrs. Quigley, Hack and Stewart.
(3) Includes 203,288.5 shares of Common Stock held by Newcourt Communications
Finance Corporation, a subsidiary of Newcourt Capital, Inc. and 18,227
shares of Common Stock which Newcourt Commercial Finance Corporation, also
a subsidiary of Newcourt Capital, Inc., has the right to acquire upon the
exercise of warrants.
(4) Includes 95,238 shares of Common Stock which CoreStates has the right to
acquire upon conversion of 50,000 shares of Series C Cumulative Convertible
Preferred Stock of the Company.
(5) Includes 190,476 shares of Common Stock which General Electric Capital
Corporation has the right to acquire upon conversion of 100,000 shares of
Series C Cumulative Convertible Preferred Stock of the Company and 10,000
shares of Common Stock which General Electric Capital Corporation has the
right to acquire upon exercise of a warrant.
(6) Represents shares of Common Stock which the holder has the right to acquire
upon the exercise of options that are exerciseable within sixty days of
March 24, 1999 pursuant to the KMC Holdings Stock Option Plan.
(7) Messrs. Quigley and Hack, Directors of the Company, are members of Nassau
Capital L.L.C., the general partner of Nassau; accordingly Messrs. Quigley
and Hack may be deemed to be beneficial owners of such shares and for
purposes of this table they are included. Messrs. Quigley and Hack disclaim
beneficial ownership of all such shares within the meaning of Rule 13d-3
under the Exchange Act. Messrs. Quigley and Hack are also members of NAS
Partners I, L.L.C.; accordingly Messrs. Quigley and Hack may be deemed to
be beneficial owners of such shares and for purposes of this table they are
included. Messrs. Quigley and Hack disclaim beneficial ownership of all
such shares within the meaning of Rule 13d-3 under the Exchange Act.
(8) All of the shares indicated as owned by Mr. Stewart are owned directly or
indirectly by Nassau and are included because of Mr. Stewart's affiliation
with Nassau. Mr. Stewart is also a member of NAS Partners I, L.L.C.;
accordingly, Mr. Stewart may be deemed to be the beneficial owner of such
shares and for purposes of this table they are included. Mr. Stewart
disclaims beneficial ownership of all of these shares within the meaning of
Rule 13d-3 under the Exchange Act.
STOCKHOLDERS AGREEMENT. The Amended and Restated Stockholders
Agreement, dated as of October 31, 1997, restricts the ability of the parties to
that agreement to transfer shares in the Company to persons not affiliated with
or related to such parties. Pursuant to such Stockholders Agreement and the
Company's certificate of incorporation, Mr. Kamine and Nassau are currently
entitled to elect all of the Directors, three of whom are nominated by Mr.
Kamine (one of whom must be the President and Chief Executive Officer), three of
whom are nominated by Nassau and one of whom is nominated by agreement of Mr.
Kamine, Nassau and either Newcourt Communications Finance Corporation or the
holders of a majority of the outstanding shares of the Company's Series C
Cumulative Convertible Preferred Stock. The number of Directors which Mr. Kamine
is entitled to elect would be reduced to two if the number of shares owned by
him were to fall below two-thirds of the number of shares of the Company
initially issued to him, and to one if the number of shares owned by him were to
fall below one-third of the number of shares initially issued to him. If his
ownership were to fall below 5% of the number of shares initially issued to him,
Mr. Kamine would no longer be entitled to elect any Directors pursuant to such
provisions. Comparable reductions would be made to the number of Directors which
Nassau is entitled to elect if its ownership were to fall below the specified
percentages. If a default relating to payment occurs under the Senior Secured
Credit Facility, and continues uncured for 90 days, the holders of Series C
Cumulative Convertible Preferred Stock (currently Nassau, NAS Partners I,
L.L.C., General Electric Capital Corporation and CoreStates) will be entitled to
elect two additional Directors, who will serve until the default is cured.
Each of Nassau, NAS Partners I, L.L.C, CoreStates, General Electric
Capital Corporation and Newcourt Communications Finance Corporation has a "put
right" entitling it to have the Company repurchase its shares for the fair
market value of such shares if no Liquidity Event (defined as (i) an initial
public offering with gross proceeds of at least $40.0 million, (ii) the sale of
substantially all of the stock or assets of the Company or (iii) the merger or
consolidation of the Company with one or more other corporations) has taken
place by the later of (x) October 22, 2003 or (y) 90 days after the final
maturity date of the Company's 12 1/2% Senior Discount Notes. CoreStates,
General Electric Capital Corporation and Newcourt Communications Finance
Corporation may not exercise such put rights unless Nassau has exercised its put
right. The indenture applicable to the Company's 12 1/2% Senior Discount Notes
and the Company's other indebtedness will limit the Company's ability to
repurchase such shares.
Certain of the current stockholders have demand registration rights
with respect to their shares of Common Stock of the Company commencing on the
earlier of June 5, 2000 (in the case of Mr. Kamine or Nassau) and the date on
which the Company completes an initial public offering of Common Stock (and any
related holdback period expires). Each of the holders of registrable securities
also has certain piggyback registration rights. The parties to the Stockholders
Agreement have agreed not to effect any public sale or distribution of Common
Stock of the Company, or securities convertible into such Common Stock, within
180 days of the effective date of any demand or piggyback registration.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
In February, 1998, the Company loaned to Roscoe C. Young II, the
Company's Chief Operating Officer, the principal sum of $350,000. The loan is
evidenced by a promissory note which bears interest at the rate of 6% per annum.
Interest and principal are payable at maturity on February 13, 2003. In June
1998, the Company loaned Mr. Young an additional $110,000, of which $55,000 was
repaid within thirty (30) days. The balance of this loan is evidenced by a
promissory note which bears interest at the rate of 6% per annum. It is payable
in July 1999. The largest aggregate amount of loans outstanding to Mr. Young at
any time during 1998 was $460,000. The aggregate amount of loans outstanding to
Mr. Young at March 24, 1999 was $405,000.
In March, 1998, the Company made a bridge loan to Tricia Breckenridge
in the principal amount of $150,000. Mrs. Breckenridge is Senior Vice
President-Business Development of the Company. The loan which bore interest at
the rate of 6% per annum, was repaid in full in 1998 and no amount was
outstanding at March 24, 1999.
Pursuant to agreements entered into in September and October 1997,
between the Company and each of the holders of Series A Cumulative Convertible
Preferred Stock and Series C Cumulative Convertible Preferred Stock each such
holder has agreed to forego the payment of accumulated dividends on its shares
of Series A Cumulative Convertible Preferred Stock and Series C Cumulative
Convertible Preferred Stock of the Company from the date of such Dividend
Agreement through the date on which such holder disposes of its interest in the
Company; provided, that, upon such disposition, such holder realizes not less
than a ten percent (10%) compound rate of return on its investment for the
period from the date of such Dividend Agreement to the date of such disposition.
Mr. Kamine, Nassau, Newcourt Communications Finance Corporation
(formerly known as AT&T Credit Corporation), CoreStates and General Electric
Capital Corpoation are parties to the Stockholders Agreement. Pursuant to the
Stockholder's Agreement and the Company's certificate of incorporation, Mr.
Kamine and Nassau are currently entitled to elect all of the Company's seven
Directors, with each entitled to nominate three Directors, and the seventh to be
nominated by agreement of Mr. Kamine, Nassau and either Newcourt Communications
Finance Corporation or the holders of a majority of the outstanding shares of
the Company's Series C Cumulative Convertible Preferred Stock. The number of
Directors which Mr. Kamine is entitled to elect would be reduced to two if the
number of shares owned by him were to fall below two-thirds of the number of
shares of the Company initially issued to him, and to one if the number of
shares owned by him were to fall below one-third of the number of shares
initially issued to him. If his ownership were to fall below 5% of the number of
shares initially issued to him, Mr. Kamine would no longer be entitled to elect
any Directors pursuant to such provisions. Comparable reductions would be made
to the number of Directors which Nassau is entitled to elect if its ownership
were to fall below the specified fractions.
Newcourt Commercial Finance Corporation (an affiliate of Newcourt
Capital, Inc. ) has provided financing for the Company as one of the lenders
under the Senior Secured Credit Facility. Pursuant to the Senior Secured Credit
Facility, the lenders have agreed to make available, subject to certain
conditions, up to a total of $250.0 million, for construction and development of
the Company's twenty-three existing networks. The Company paid Newcourt Capital
and its affiliates an aggregate of $1,717,000 in fees, discounts and commissions
during the year ended December 31, 1998.
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(A) 1. FINANCIAL STATEMENTS.
The financial statements are included in Part II, Item 8. of this
Report.
2. FINANCIAL STATEMENT SCHEDULES AND SUPPLEMENTARY INFORMATION
REQUIRED TO BE SUBMITTED.
Independent Auditors' Report on Schedules
Schedule I - Condensed Financial Information of Registrant
Schedule II - Valuation and Qualifying Accounts
These schedules are included in Part II, Item 8. of this Report. All
other schedules have been omitted because they are inapplicable or the
required information is shown in the consolidated financial statements
or notes.
(B) REPORTS ON FORM 8-K.
None.
(C) INDEX TO EXHIBITS.
The following is a list of all Exhibits filed as part of this Report:
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
------ -----------------------
*3.1 Amended and Restated Certificate of Incorporation of KMC Telecom
Holdings, Inc. (incorporated herein by reference to Exhibit 3.1 to KMC
Telecom Holdings, Inc.'s Registration Statement on Form S-4, dated
April 20, 1998, Registration No. 333-50475 ("KMC Holdings' S-4")
*3.2 Certificate of Amendment of the Certificate of Incorporation of KMC
Telecom Holdings, Inc. (incorporated herein by reference to Exhibit
3.2 to KMC Holdings' S-4).
**3.3 Certificate of Amendment of the Certificate of Incorporation of KMC
Telecom Holdings, Inc. dated as of February 4, 1999
**3.4 KMC Telecom Holdings, Inc. Amended and Restated Certificate of the
Powers, Designations, Preferences and Rights of the Series A
Cumulative Convertible Preferred Stock, Par Value $.01 per Share,
dated November 4, 1997.
**3.5 KMC Telecom Holdings, Inc. Certificate of the Powers, Designations,
Preferences and Rights of the Series C Cumulative Convertible
Preferred Stock, Par Value $.01 per Share, dated November 4, 1997.
**3.6 KMC Telecom Holdings, Inc. Certificate of the Powers, Designations,
Preferences and Rights of the Series D Cumulative Convertible
Preferred Stock, Par Value $.01 per Share, dated November 4, 1997.
**3.7 Certificate of Voting Powers, Designations, Preferences and Relative
Participating, Optional or Other Special Rights and Qualifications,
Limitations and Restrictions Thereof of the Series E Senior
Redeemable, Exchangeable, PIK Preferred Stock of KMC Telecom Holdings,
Inc., dated as of February 4, 1999
**3.8 Certificate of Voting Powers, Designations, Preferences and Relative
Participating, Optional or Other Special Rights and Qualifications,
Limitations and Restrictions Thereof of the Series F Senior
Redeemable, Exchangeable, PIK Preferred Stock of KMC Telecom Holdings,
Inc., dated as of February 4, 1999
*3.9 By-Laws of KMC Telecom Holdings, Inc. (incorporated herein by
reference to Exhibit 3.6 to KMC Holdings' S-4).
*4.1 Amended and Restated Stockholders Agreement dated as of October 31,
1997 by and among KMC Telecom Holdings, Inc., Nassau Capital Partners,
L.P., NAS Partners I L.L.C., Harold N. Kamine, KMC Telecommunications
L.P., Newcourt Communications Finance Corporation (formerly known as
AT&T Credit Corporation), General Electric Capital Corporation,
CoreStates Bank, N.A. and CoreStates Holdings, Inc. (incorporated
herein by reference to Exhibit 4.1 to KMC Holdings' S-4).
*4.2 Amendment No. 1 dated as of January 7, 1998 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 and among
KMC Telecom Holdings, Inc., Nassau Capital Partners, L.P., NAS
Partners I L.L.C., Harold N. Kamine, KMC Telecommunications L.P.,
Newcourt Communications Finance Corporation (formerly known as AT&T
Credit Corporation), General Electric Capital Corporation, CoreStates
Bank, N.A. and CoreStates Holdings, Inc. (incorporated herein by
reference to Exhibit 4.2 to KMC Holdings' S-4).
*4.3 Amendment No. 2 dated as of January 26, 1998 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 by and
among KMC Telecom Holdings, Inc. , Nassau Capital Partners, L.P., NAS
Partners I L.L.C., Harold N. Kamine, KMC Telecommunications L.P.,
Newcourt Communications Finance Corporation (formerly known as AT&T
Credit Corporation), General Electric Capital Corporation, CoreStates
Bank, N.A. and CoreStates Holdings, Inc. (incorporated herein by
reference to Exhibit 4.3 to KMC Holdings' S-4).
*4.4 Amendment No. 3 dated as of February 25, 1998 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 by and
among KMC Telecom Holdings, Inc. , Nassau Capital Partners, L.P., NAS
Partners I L.L.C., Harold N. Kamine, KMC Telecommunications L.P.,
Newcourt Communications Finance Corporation (formerly known as AT&T
Credit Corporation), General Electric Capital Corporation, CoreStates
Bank, N.A. and CoreStates Holdings, Inc. (incorporated herein by
reference to Exhibit 4.4 to KMC Holdings' S-4).
**4.5 Amendment No. 4 dated as of February 4, 1999 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 among KMC
Telecom Holdings, Inc., Nassau Capital Partners, L.P., NAS Partners I
L.L.C., Harold N. Kamine, Newcourt Communications Finance Corporation
(formerly known as AT&T Credit Corporation), General Electric Capital
Corporation, CoreStates Bank, N.A. and CoreStates Holdings, Inc.
*4.6 Indenture dated as of January 29, 1998 between KMC Telecom Holdings,
Inc. and The Chase Manhattan Bank, as Trustee, including specimen of
KMC Telecom Holdings, Inc.'s 12 1/2% Senior Discount Note due 2008
(incorporated herein by reference to Exhibit 4.5 to KMC Holdings'
S-4).
*4.7 Registration Rights Agreement dated January 26, 1998 between KMC
Telecom Holdings, Inc. and Morgan Stanley & Co. Incorporated
(incorporated herein by reference to Exhibit 4.6 to KMC Holdings'
S-4).
*4.8 Warrant Agreement between KMC Telecom Holdings, Inc. and The Chase
Manhattan Bank, as Warrant Agent, dated as of January 29, 1998
including a specimen of Warrant Certificate (incorporated herein by
reference to Exhibit 4.7 to KMC Holdings' S-4).
*4.9 Warrant Registration Rights Agreement dated as of January 26, 1998
between KMC Telecom Holdings, Inc. and Morgan Stanley & Co.
Incorporated (incorporated herein by reference to Exhibit 4.8 to KMC
Holdings' S-4).
*10.1 Purchase Agreement dated January 26, 1998 by and between KMC Telecom
Holdings, Inc. and Morgan Stanley & Co. Incorporated (incorporated
herein by reference to Exhibit 10.1 to KMC Holdings' S-4).
**10.2 Loan and Security Agreement dated as of December 22, 1998 among KMC
Telecom Inc., KMC Telecom II, Inc., KMC Telecom of Virginia, Inc., KMC
Telecom Leasing I, LLC, KMC Telecom Leasing II, LLC, the additional
subsidiaries from time to time parties thereto, the financial
institutions signatory thereto from time to time as "Lenders", First
Union National Bank as Administrative Agent for the Lenders and
Newcourt Commercial Finance Corporation (formerly known as AT&T
Commercial Corporation), as Collateral Agent for the Lenders.
**10.3 Amendment No. 1, dated as of March 3, 1999, to Loan and Security
Agreement dated as of December 22, 1998, among KMC Telecom Inc., KMC
Telecom II, Inc., KMC Telecom of Virginia, Inc., KMC Telecom Leasing
I, LLC, KMC Telecom Leasing II, LLC, the additional subsidiaries from
time to time parties thereto, the financial institutions signatory
thereto from time to time as "Lenders", First Union National Bank as
Administrative Agent for the Lenders and Newcourt Commercial Finance
Corporation (formerly known as AT&T Commercial Corporation), as
Collateral Agent for the Lenders.
*10.4 General Agreement between KMC Telecom Inc., KMC Telecom II, Inc. and
Lucent Technologies, Inc. dated September 24, 1997, as amended on
October 15, 1997 (incorporated herein by reference to Exhibit 10.7 to
KMC Holdings' S-4).
*10.5 Professional Services Agreement between KMC Telecom Inc. and Lucent
Technologies, Inc. dated September 4, 1997 (incorporated herein by
reference to Exhibit 10.8 to KMC Holdings' S-4).
**10.6 Memorandum of Agreement between KMC Telecom Holdings, Inc. and EFTIA
OSS Solutions Inc., dated as of October 26, 1998.
**10.7 Master License Agreement dated December 31, 1998 by and between
Billing Concepts Systems, Inc. and KMC Telecom Holdings, Inc.
**10.8 Lease Agreement dated January 1, 1996 between Cogeneration Services
Inc. (now known as Kamine Development Corp.) and KMC Telecom Inc.
*10.9 1998 Stock Purchase and Option Plan for Key Employees of KMC Telecom
Holdings, Inc. and Affiliates (incorporated herein by reference to
Exhibit 4 to KMC Holdings, Inc.'s Form 10-Q for the fiscal quarter
ended September 30, 1998).+
**10.10 Specimen of Non-Qualified Stock Option Agreement for options granted
under the 1998 Stock Purchase and Option Plan for Key Employees of KMC
Telecom Holdings, Inc. and Affiiliates.+
**21.1 Subsidiaries of KMC Telecom Holdings, Inc.
**24.1 Powers of Attorney (Appears on signature page).
**27.1 Financial Data Schedule.
- - ------------------------
* Incorporated herein by reference.
** Filed herewith.
+ Management contract or compensatory plan or arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the Town of
Bedminster, State of New Jersey, on the 31st day of March, 1999.
KMC TELECOM HOLDINGS, INC.
By: /s/ MICHAEL A. STERNBERG
---------------------------------------
Michael A. Sternberg
President and Chief Executive Officer
KNOW BY ALL MEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Michael A. Sternberg and James D.
Grenfell his true and lawful attorney-in-fact and agent, with full power of
substitution and resubstitution, for him and in his name, place and stead, in
any and all capacities, to sign any and all amendments to this Annual Report on
Form 10-K, and to file the same, with all exhibits thereto and other documents
in connection therewith, with the Securities and Exchange Commission, granting
unto said attorney-in-fact and agent, full power and authority to do and perform
each and every act and thing requisite and necessary to be done in and about the
premises, as fully as he might or could do in person, hereby ratifying and
confirming all that said attorney-in-fact and agent or their or his substitutes
or substitute, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities indicated on the 31st day of March, 1999.
Signature Title(s)
--------- --------
President, Chief Executive Officer
/s/ MICHAEL A. STERNBERG and Director (Principal Executive
- - ---------------------------------- Officer)
Michael A. Sternberg
Executive Vice President, Chief
/s/ JAMES D. GRENFELL Financial Officer (Principal
- - ---------------------------------- Financial Officer)
James D. Grenfell
/s/ ROBERT F. HAGAN Vice President, Controller
- - ---------------------------------- (Principal Accounting Officer)
Robert F. Hagan
/s/ HAROLD N. KAMINE Chairman of the Board of Directors
- - ---------------------------------
Harold N. Kamine
/s/ GARY E. LASHER Vice Chairman of the Board of
- - --------------------------------- Directors
Gary E. Lasher
/s/ RICHARD H. PATTERSON
- - --------------------------------- Director
Richard H. Patterson
/s/ RANDALL A. HACK Director
- - ---------------------------------
Randall A. Hack
/s/ WILLIAM H. STEWART Director
- - ---------------------------------
William H. Stewart
INDEX OF EXHIBITS
Exhibit
Number Description
- - ------ -----------
*3.1 Amended and Restated Certificate of Incorporation of KMC Telecom
Holdings, Inc.
*3.2 Certificate of Amendment of the Certificate of Incorporation of KMC
Telecom Holdings, Inc.
3.3 Certificate of Amendment of the Certificate of Incorporation of KMC
Telecom Holdings, Inc. dated as of February 4, 1999.
3.4 KMC Telecom Holdings, Inc. Amended and Restated Certificate of the
Powers, Designations, Preferences and Rights of the Series A
Cumulative Convertible Preferred Stock, Par Value $.01 per Share,
dated November 4, 1997.
3.5 KMC Telecom Holdings, Inc. Certificate of the Powers, Designations,
Preferences and Rights of the Series C Cumulative Convertible
Preferred Stock, Par Value $.01 per Share, dated November 4, 1997.
3.6 KMC Telecom Holdings, Inc. Certificate of the Powers, Designations,
Preferences and Rights of the Series D Cumulative Convertible
Preferred Stock, Par Value $.01 per Share, dated November 4, 1997.
3.7 Certificate of Voting Powers, Designations, Preferences and Relative
Participating, Optional or Other Special Rights and Qualifications,
Limitations and Restrictions Thereof of the Series E Senior
Redeemable, Exchangeable, PIK Preferred Stock of KMC Telecom Holdings,
Inc., dated as of February 4, 1999.
3.8 Certificate of Voting Powers, Designations, Preferences and Relative
Participating, Optional or Other Special Rights and Qualifications,
Limitations and Restrictions Thereof of the Series F Senior
Redeemable, Exchangeable, PIK Preferred Stock of KMC Telecom Holdings,
Inc., dated as of February 4, 1999.
*3.9 By-Laws of KMC Telecom Holdings, Inc.
*4.1 Amended and Restated Stockholders Agreement dated as of October 31,
1997 by and among KMC Telecom Holdings, Inc., Nassau Capital Partners,
L.P., NAS Partners I L.L.C., Harold N. Kamine, KMC Telecommunications
L.P., Newcourt Communications Finance Corporation (formerly known as
AT&T Credit Corporation), General Electric Capital Corporation,
CoreStates Bank, N.A. and CoreStates Holdings, Inc.
*4.2 Amendment No. 1 dated as of January 7, 1998 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 and among
KMC Telecom Holdings, Inc., Nassau Capital Partners, L.P., NAS
Partners I L.L.C., Harold N. Kamine, KMC Telecommunications L.P.,
Newcourt Communications Finance Corporation (formerly known as AT&T
Credit Corporation), General Electric Capital Corporation, CoreStates
Bank, N.A. and CoreStates Holdings, Inc.
*4.3 Amendment No. 2 dated as of January 26, 1998 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 by and
among KMC Telecom Holdings, Inc. , Nassau Capital Partners, L.P., NAS
Partners I L.L.C., Harold N. Kamine, KMC Telecommunications L.P.,
Newcourt Communications Finance Corporation (formerly known as AT&T
Credit Corporation), General Electric Capital Corporation, CoreStates
Bank, N.A. and CoreStates Holdings, Inc.
*4.4 Amendment No. 3 dated as of February 25, 1998 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 by and
among KMC Telecom Holdings, Inc. , Nassau Capital Partners, L.P., NAS
Partners I L.L.C., Harold N. Kamine, KMC Telecommunications L.P.,
Newcourt Communications Finance Corporation (formerly known as AT&T
Credit Corporation), General Electric Capital Corporation, CoreStates
Bank, N.A. and CoreStates Holdings, Inc.
4.5 Amendment No. 4 dated as of February 4, 1999 to the Amended and
Restated Stockholders Agreement dated as of October 31, 1997 among KMC
Telecom Holdings, Inc., Nassau Capital Partners, L.P., NAS Partners I
L.L.C., Harold N. Kamine, Newcourt Communications Finance Corporation
(formerly known as AT&T Credit Corporation), General Electric Capital
Corporation, CoreStates Bank, N.A. and CoreStates Holdings, Inc.
*4.6 Indenture dated as of January 29, 1998 between KMC Telecom Holdings,
Inc. and The Chase Manhattan Bank, as Trustee, including specimen of
KMC Telecom Holdings, Inc.'s 12 1/2% Senior Discount Note due 2008.
*4.7 Registration Rights Agreement dated January 26, 1998 between KMC
Telecom Holdings, Inc. and Morgan Stanley & Co. Incorporated.
*4.8 Warrant Agreement between KMC Telecom Holdings, Inc. and The Chase
Manhattan Bank, as Warrant Agent, dated as of January 29, 1998
including a specimen of Warrant Certificate.
*4.9 Warrant Registration Rights Agreement dated as of January 26, 1998
between KMC Telecom Holdings, Inc. and Morgan Stanley & Co.
Incorporated.
*10.1 Purchase Agreement dated January 26, 1998 by and between KMC Telecom
Holdings, Inc. and Morgan Stanley & Co. Incorporated.
10.2 Loan and Security Agreement dated as of December 22, 1998 among KMC
Telecom Inc., KMC Telecom II, Inc., KMC Telecom of Virginia, Inc., KMC
Telecom Leasing I, LLC, KMC Telecom Leasing II, LLC, the additional
subsidiaries from time to time parties thereto, the financial
institutions signatory thereto from time to time as "Lenders", First
Union National Bank as Administrative Agent for the Lenders and
Newcourt Commercial Finance Corporation (formerly known as AT&T
Commercial Corporation), as Collateral Agent for the Lenders.
10.3 Amendment No. 1, dated as of March 3, 1999, to Loan and Security
Agreement dated as of December 22, 1998, among KMC Telecom Inc., KMC
Telecom II, Inc., KMC Telecom of Virginia, Inc., KMC Telecom Leasing
I, LLC, KMC Telecom Leasing II, LLC, the additional subsidiaries from
time to time parties thereto, the financial institutions signatory
thereto from time to time as "Lenders", First Union National Bank as
Administrative Agent for the Lenders and Newcourt Commercial Finance
Corporation (formerly known as AT&T Commercial Corporation), as
Collateral Agent for the Lenders.
*10.4 General Agreement between KMC Telecom Inc., KMC Telecom II, Inc. and
Lucent Technologies, Inc. dated September 24, 1997, as amended on
October 15, 1997.
*10.5 Professional Services Agreement between KMC Telecom Inc. and Lucent
Technologies, Inc. dated September 4, 1997.
10.6 Memorandum of Agreement between KMC Telecom Holdings, Inc. and EFTIA
OSS Solutions Inc., dated as of October 26, 1998.
10.7 Master License Agreement dated December 31, 1998 by and between
Billing Concepts Systems, Inc. and KMC Telecom Holdings, Inc.
10.8 Lease Agreement dated January 1, 1996 between Cogeneration Services
Inc. (now known as Kamine Development Corp.) and KMC Telecom Inc.
*10.9 1998 Stock Purchase and Option Plan for Key Employees of KMC Telecom
Holdings, Inc. and Affiliates.
10.10 Specimen of Non-Qualified Stock Option Agreement for options granted
under the 1998 Stock Purchase and Option Plan for Key Employees of KMC
Telecom Holdings, Inc. and Affiliates.
21.1 Subsidiaries of KMC Telecom Holdings, Inc.
24.1 Powers of Attorney (Appears on signature page).
27.1 Financial Data Schedule.
- - ------------------------
* Exhibits filed previously.