- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
- ---
|x| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- --- EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 1999
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period ______________ to ________________
Commission file number 0-20763
McLEODUSA INCORPORATED
(Exact name of registrant as specified in its charter)
Delaware 42-1407240
(State of Incorporation) (IRS Employer Identification No.)
McLeodUSA Technology Park
6400 C Street SW
P.O. Box 3177
Cedar Rapids, Iowa 52406-3177
(Address of principal executive office) (Zip Code)
319-364-0000
(Registrant's telephone number,
including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
---
filing requirements for the past 90 days. Yes |x| No
---
The number of shares outstanding of each class of the issuer's common stock
as of November 2, 1999:
Common Stock Class A: ($.01 par value)......... 155,298,043 shares
Common Stock Class B: ($.01 par value)......... None
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INDEX
Page
----
PART I. Financial Information
- ------- ---------------------
Item 1. Financial Statements............................................... 3
Consolidated Balance Sheets, September 30, 1999 (unaudited)
and December 31, 1998.............................................. 3
Unaudited Consolidated Statements of Operations and Comprehensive
Income for the three and nine months ended
September 30, 1999 and 1998........................................ 4
Unaudited Consolidated Statements of Cash Flows for the nine months
ended September 30, 1999 and 1998.................................. 5
Notes to Consolidated Financial Statements (unaudited)............. 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.............................................. 11
PART II. Other Information
- -------- -----------------
Item 1. Legal Proceedings.................................................. 20
Item 2. Changes in Securities and Use of Proceeds.......................... 20
Item 6. Exhibits and Reports on Form 8-K................................... 22
Signatures.................................................................. 23
2
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
McLEODUSA INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In millions, except shares)
September 30, December 31,
1999 1998
--------------- --------------
(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents........................ $ 885.2 $ 455.1
Investment in available-for-sale securities...... 577.8 136.6
Trade receivables, net........................... 180.7 116.4
Inventory........................................ 32.0 12.8
Deferred expenses................................ 36.6 26.7
Prepaid expenses and other....................... 39.2 45.6
---------- ----------
TOTAL CURRENT ASSETS............................ 1,751.5 793.2
---------- ----------
Property and Equipment
Land and building................................ 81.8 60.3
Telecommunications networks...................... 535.3 307.3
Furniture, fixtures and equipment................ 242.3 138.3
Networks in progress............................. 374.6 185.5
Building in progress............................. 3.2 12.6
---------- ----------
1,237.2 704.0
Less accumulated depreciation.................... 142.2 74.3
---------- ----------
1,095.0 629.7
---------- ----------
Investments, Intangible and Other Assets
Other investments................................ 34.6 35.9
Goodwill, net.................................... 931.9 289.6
Other intangibles, net........................... 283.5 112.4
Other............................................ 76.6 64.4
---------- ----------
1,326.6 502.3
---------- ----------
$ 4,173.1 $ 1,925.2
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt............. $ 18.7 $ 8.2
Contracts and notes payable...................... 0.2 4.5
Accounts payable................................. 91.3 62.0
Accrued payroll and payroll related expenses..... 27.4 13.6
Other accrued liabilities........................ 87.5 63.8
Deferred revenue, current portion................ 20.2 11.0
Customer deposits................................ 26.4 16.8
---------- ----------
TOTAL CURRENT LIABILITIES....................... 271.7 179.9
Long-term Debt, less current maturities........... 1,801.2 1,245.2
Deferred Revenue, less current portion............ 15.5 16.8
Other long-term liabilities....................... 19.2 20.5
---------- ----------
2,107.6 1,462.4
---------- ----------
Redeemable convertible preferred stock
Preferred, Series B, redeemable, convertible,
$.01 par value, authorized, issued and
outstanding 1999 275,000 shares; 1998 none 687.5 ---
Preferred, Series C, redeemable, convertible,
$.01 par value, authorized, issued and
outstanding 1999 125,000 shares; 1998 none 312.5 ---
---------- ----------
1,000.0 ---
---------- -----------
Stockholders' Equity
Capital Stock:
Preferred, Series A, $.01 par value:
authorized, issued and outstanding 1999
1,150,000 shares; 1998 none --- ---
Common, Class A, $.01 par value; authorized
250,000,000 shares; issued and outstanding
1999 155,010,573 shares; 1998 127,358,350
shares......................................... 1.5 1.3
Common, Class B, convertible, $.01 par value;
authorized 22,000,000 shares; issued and
outstandin g 1999 and 1998 none................ --- ---
Additional paid-in capital....................... 1,472.6 716.5
Accumulated deficit.............................. (424.7) (253.3)
Accumulated other comprehensive income (loss).... 16.1 (1.7)
---------- ----------
1,065.5 462.8
---------- ----------
$ 4,173.1 $ 1,925.2
========== ==========
* Class A common stock and accumulated deficit are presented after giving
effect for the two-for-one stock split effected in the form of a stock
dividend as described in Note 7.
The accompanying notes are an integral part of these consolidated financial
statements
3
McLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(In millions, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- -------------------
1999 1998 1999 1998
--------- --------- --------- --------
Revenues:
Telecommunications:
Local and long distance........................................ $125.9 $ 69.9 $ 313.3 $196.7
Local exchange services........................................ 20.3 16.8 57.7 49.3
Private line and data.......................................... 20.6 10.1 55.0 28.6
Network maintenance and equipment.............................. 9.4 9.0 25.9 24.1
Other telecommunications....................................... 7.7 7.1 21.9 20.9
------ ------ ------- ------
Total telecommunications revenue.............................. 183.9 112.9 473.8 319.6
Directory....................................................... 51.9 30.6 157.2 104.1
Telemarketing................................................... 5.3 5.1 13.9 14.9
------ ------ ------- ------
TOTAL REVENUES................................................. 241.1 148.6 644.9 438.6
Operating expenses:
Cost of service................................................. 121.9 81.1 327.4 239.2
Selling, general and administrative............................. 104.0 63.8 282.4 189.5
Depreciation and amortization................................... 51.9 23.2 130.6 63.7
Other........................................................... --- 1.8 --- 5.6
------ ------ ------- ------
TOTAL OPERATING EXPENSES....................................... 277.8 169.9 740.4 498.0
------ ------ ------- ------
OPERATING LOSS................................................. (36.7) (21.3) (95.5) (59.4)
Nonoperating income (expense):
Interest income................................................. 8.1 6.7 23.1 19.1
Interest (expense).............................................. (36.8) (19.4) (102.5) (54.6)
Other income.................................................... 7.0 1.0 7.6 1.8
------ ------ ------- ------
TOTAL NONOPERATING INCOME (EXPENSE)............................ (21.7) (11.7) (71.8) (33.7)
------ ------ ------- ------
LOSS BEFORE INCOME TAXES....................................... (58.4) (33.0) (167.3) (93.1)
Income Taxes..................................................... --- --- --- ---
------ ------ ------- ------
NET LOSS....................................................... $(58.4) $(33.0) $(167.3) $(93.1)
Preferred stock dividend......................................... (4.1) --- (4.1) ---
------ ------ ------- ------
NET LOSS APPLICABLE TO COMMON SHARES........................... $(62.5) $(33.0) $(171.4) $(93.1)
====== ====== ======= ======
Loss per common share............................................ $(0.41) $(0.26) $ (1.18) $(0.74)
====== ====== ======= ======
Weighted average common shares outstanding....................... 152.7 125.9 145.0 125.2
====== ====== ======= ======
Other comprehensive income (loss), net of tax:
Unrealized gains on securities:
Unrealized holding gains (losses) arising during the
period........................................................ 8.8 (0.9) 26.6 1.4
Less: reclassification adjustment for gains included in
net income.................................................... (8.1) (1.0) (8.8) (2.0)
------ ------ ------- ------
TOTAL OTHER COMPREHENSIVE INCOME (LOSS)........................ 0.7 (1.9) 17.8 (0.6)
------ ------ ------- ------
COMPREHENSIVE LOSS............................................. $(61.8) $(34.9) $(153.6) $(93.7)
====== ====== ======= ======
* Loss per common share and weighted average common shares outstanding are
presented after giving effect for the two-for-one stock split effected in the
form of a dividend as described in Note 7.
The accompanying notes are an integral part of these consolidated financial
statements
4
MCLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------------------------
1999 1998
----------------- ----------------
Cash Flows from Operating Activities
Net Loss............................................................................... $ (167.3) $ (93.1)
Adjustments to reconcile net loss to net cash provided by (used in) operating
activities:
Depreciation.......................................................................... 74.3 38.1
Amortization.......................................................................... 56.3 25.6
Accretion of interest on senior discount notes........................................ 28.8 26.0
Changes in assets and liabilities, net of effects of acquisitions:
(Increase) in trade receivables....................................................... (19.1) (10.1)
(Increase) in inventory............................................................... (17.3) (0.3)
(Increase) in deferred expenses....................................................... (1.4) ---
Decrease (increase) in prepaid expenses and other..................................... 28.7 (4.7)
(Decrease) in deferred line installation costs........................................ (19.5) (9.0)
Increase (decrease) in accounts payable and accrued expenses.......................... (35.7) 10.7
Increase in deferred revenue.......................................................... 6.8 3.0
Increase in customer deposits......................................................... 5.5 2.9
--------- -------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES.................................. (59.9) (10.9)
--------- -------
Cash Flows from Investing Activities
Purchases of property and equipment.................................................... (394.1) (204.7)
Available-for-sale securities:
Purchases............................................................................. (821.9) (516.3)
Sales................................................................................. 135.9 246.1
Maturities............................................................................ 262.5 132.9
Acquisitions........................................................................... (231.1) (27.6)
Other.................................................................................. (1.6) (3.6)
--------- -------
NET CASH (USED IN) INVESTING ACTIVITIES (1,050.3) (373.2)
--------- -------
Cash Flows from Financing Activities
Payments on contracts and notes payable................................................ (21.7) (3.1)
Net proceeds from preferred stock - Series B and C...................................... 999.9 ----
Net proceeds from long-term debt....................................................... 485.6 291.7
Payments on long-term debt............................................................. (211.0) (7.8)
Net proceeds from preferred stock - Series A............................................ 278.1 ----
Net proceeds from issuance of common stock............................................. 9.4 2.4
--------- -------
NET CASH PROVIDED BY FINANCING ACTIVITIES............................................ 1,540.3 283.2
--------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS................................. 430.1 (100.9)
Cash and cash equivalents:
Beginning.............................................................................. 455.1 331.9
--------- -------
Ending................................................................................. $ 855.2 $ 231.0
========= =======
Supplemental Disclosure of Cash Flow Information:
Cash payment for interest, net of interest capatalized 1999 $15.6 million;
1998 $6.5 million..................................................................... $ 77.3 $ 29.5
========= =========
Supplemental Schedule of Noncash Investing and Financing Activities
Capital leases incurred for the acquisition of property and equipment.................. $ 9.4 $ 5.9
========= =========
The accompanying notes are an integral part of these consolidated financial
statements
5
MCLEODUSA INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of and for the Three and Nine Months Ended
September 30, 1999 and 1998 is Unaudited)
NOTE 1: Basis of Presentation
Interim Financial Information (unaudited): The financial statements and
notes related thereto as of September 30, 1999, and for the three and nine month
periods ended September 30, 1999 and 1998, are unaudited, but in the opinion of
management include all adjustments, consisting only of normal recurring
adjustments, necessary for a fair presentation of the company's financial
position and results of operations. The operating results for the interim
periods are not indicative of the operating results to be expected for a full
year or for other interim periods. Certain information and footnote disclosure
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to
instructions, rules and regulations prescribed by the Securities and Exchange
Commission ("SEC"). Although the Company believes that the disclosures provided
are adequate to make the information presented not misleading, it recommends
that these consolidated condensed financial statements be read in conjunction
with the audited consolidated financial statements and the footnotes thereto
included in the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 1998, filed with the SEC on March 24, 1999.
Reclassifications: Certain items in the unaudited statement of operations for
the three and nine month periods ended September 30, 1998 have been reclassified
to be consistent with the presentation in the September 30, 1999 unaudited
financial statements.
Note 2: Supplemental Asset Data
Cash and cash equivalents: for purposes of reporting cash flows, the Company
considers all highly liquid debt instruments purchased with a maturity of three
months or less and all certificates of deposit, regardless of maturity, to be
cash equivalents.
Trade Receivables: The composition of trade receivables, net is as follows:
SEPTEMBER 30, DECEMBER 31,
1999 1998
-------------- -------------
(IN MILLIONS)
Trade Receivables:
Billed.......................................... $ 160.0 $ 110.6
Unbilled........................................ 59.5 21.3
-------- ---------
219.5 131.9
Allowance for doubtful accounts and discounts.... (38.8) (15.5)
-------- ---------
$ 180.7 $ 116.4
======== =========
Inventory: Inventory is carried principally at the lower of average cost or
market and consists primarily of new and reusable parts required to maintain
fiber optic networks and parts and equipment used in the maintenance and
installation of telephone systems.
Goodwill: Goodwill resulting from the Company's acquisitions is being
amortized over a range of 15 to 30 years using the straight-line method and is
periodically reviewed for impairment based upon an assessment of future
operations to ensure that it is appropriately valued. Accumulated amortization
on goodwill totaled $40.0 million and $16.4 million, at September 30, 1999 and
December 31, 1998, respectively.
6
Other intangibles: Other intangibles consist of customer lists and
noncompete agreements related to the Company's acquisitions, deferred line
installation costs incurred in the establishment of local access lines for
customers and franchise rights to provide cable services to customers in three
Illinois counties and in a Michigan City. The customer lists and noncompete
agreements are being amortized using the straight-line method over periods
ranging from 3 to 15 years. The deferred line installation costs are being
amortized using the straight-line method over 36 to 60 months, which
approximates the average lives of residential and business customer contracts.
The franchise rights are being amortized using the straight-line method over
periods ranging from 10 to 15 years. Accumulated amortization on the other
intangibles totaled $48.6 million and $25.1 million at September 30, 1999 and
December 31, 1998, respectively.
Note 3: Long-Term Debt
On February 22, 1999, the Company completed a private offering of $500
million aggregate principal amount of 81/8% Senior Notes due February 15, 2009
(the "Senior Notes"). The Company received net proceeds of approximately $485.8
million from the Senior Notes offering. Interest on the Senior Notes will be
payable in cash semi-annually in arrears on August 15 and February 15 of each
year at a rate of 81/8% per annum, commencing August 15, 1999. The Senior Notes
rank pari passu in right of payment with all existing and future senior
unsecured indebtedness of the Company and rank senior in right of payment to all
existing and future subordinated indebtedness of the company. As of September
30, 1999, the Company had no outstanding subordinated indebtedness and had $1.2
billion in outstanding indebtedness that would rank pari passu with the Senior
Notes. The indenture related to the Senior Notes contains certain covenants
which, among other things, restrict the ability of the Company to incur
additional indebtedness, pay dividends or make distributions of the Company's or
its subsidiaries' stock, make other restricted payments, enter into sale and
leaseback transactions, create liens, enter into transactions with affiliates or
related persons, or consolidate, merge or sell all or substantially all of its
assets.
Note 4: Acquisitions
Talking Directories, Inc. (Talking Directories) and Info America Phone
Books, Inc. (Info America): On February 10, 1999, the Company acquired Talking
Directories in exchange for 5.2 million shares of its Class A common stock, par
value $.01 per share ("Class A common stock") after giving effect to the
two-for-one stock split described in Note 7. In a related and concurrent
transaction, on February 10, 1999, the Company acquired Info America in exchange
for 2.4 million shares of its Class A common stock. The Company also paid
outstanding obligations of Talking Directories and Info America of approximately
$27 million.
Dakota Telecommunications Group, Inc. (DTG): On March 5, 1999, the Company
acquired DTG in exchange for approximately two million shares of its Class A
common stock, after giving effect to the two-for-one stock split described in
Note 7, and the assumption of approximately $31 million in DTG debt.
Ovation Communications, Inc. (Ovation): On March 31, 1999, the Company
acquired Ovation in exchange for approximately 11.2 million shares of its Class
A common stock, after giving effect to the two-for-one stock split described in
Note 7, and the payment of approximately $121.3 million in cash to the
stockholders of Ovation. The total purchase price was approximately $310.2
million based on the average closing price of the Company's Class A common stock
five days before and after the date of the acquisition agreement. The Company
also assumed approximately $105.6 million in Ovation debt.
Access Communications Holding, Inc. (Access) and S.J. Investments Holdings,
Inc. (SJIH): On August 14, 1999, the Company acquired Access and SJIH in
exchange for approximately 3.87 million shares of its Class A common stock,
after giving effect to the two-for-one stock split described in Note 7, and the
payment of $48.3 million in cash to the stockholders of Access and SJIH. The
Company also assumed approximately $96.2 million in Access and SJIH debt.
7
The following table summarizes the purchase price allocations for the
Company's business acquisitions incurred in the nine months ended September 30,
1999 and 1998 (in millions):
Transaction Year: 1999 1998
- ----------------- --------- --------
Cash purchase price $ 231.1 $ 27.4
Acquisition costs 0.7 0.2
Promissory notes 7.7 9.7
Stock issued 452.3 9.2
Option agreements 0.9 --
Note receivable (1.6) --
-------- -------
$ 691.1 $ 46.5
======== =======
Working capital acquired, net $ (116.1) $ (0.2)
Fair value of other assets acquired 132.5 13.0
Intangibles 831.9 36.0
Liabilities assumed (157.2) (2.3)
-------- -------
$ 691.1 $ 46.5
======== =======
These acquisitions have been accounted for as purchases and the results of
operations are included in the consolidated financial statements since the dates
of acquisition. All 1999 purchase price allocations are preliminary and subject
to revisions.
The unaudited consolidated results of operations for the nine months ended
September 30, 1999 on a pro forma basis as though the above entities had been
acquired as of the beginning of the period is as follows (in millions, except
per share data):
1999
--------
Revenue............................................ $ 727.6
Net loss applicable to common shares............... (177.7)
Loss per common share.............................. (1.16)
The pro forma financial information is presented for informational purposes
only and is not necessarily indicative of the operating results that would have
occurred had the acquisitions been consummated as of the above dates, nor are
such operating results necessarily indicative of future operating results.
Note 5: Redeemable Convertible Preferred Stock
Pursuant to a Stock Purchase Agreement dated August 30, 1999 (the "Stock
Purchase Agreement"), the Company issued on September 15, 1999 (the "Issue
Date") 275,000 shares of Series B preferred stock, par value $.01 per share
("Series B preferred stock"), and 125,000 shares of Series C preferred stock,
par value $.01 per share ("Series C preferred stock," and together with the
Series B preferred stock, the "B&C Preferred") through a private offering. Net
proceeds from the financing amounted to approximately $1 billion. The B&C
Preferred are redeemable on a proportionally equal basis, in whole or in
part, by the Company at any time following the seventh anniversary of the Issue
Date; or by the holders within 180 days following the tenth anniversary of the
Issue Date. The B&C Preferred are convertible on a proportionally equal basis,
at the Series B holders option, in whole or in part at any time into Class A
common stock. Shares of each series have a liquidation preference of
$2,500.00 per share plus accrued and unpaid dividends, if any, and are
convertible into shares of the Company's Class A common stock at a rate of (a)
the liquidation preference divided by (b) $36.50. Each share of Series B
preferred stock is entitled to receive a quarterly dividend of approximately
$31.82. Dividends are cumulative and payable quarterly on March 31, June 30,
September 30, and December 31. If prior to the fifth anniversary of the Issue
Date the Company pays a dividend on its Class A common stock, holders of the B&C
Preferred shall be entitled to receive an equivalent dividend calculated on a
common stock equivalent basis as if the B&C Preferred had been converted into
Class A common stock. Except as required by law, holders of Series B preferred
stock are not entitled to voting rights other than the right to vote as a series
for the election of two members to the Board of Directors. Such Board
representation decreases as
8
the outstanding shares of the Series B preferred stock decreases. Except as
required by law, holders of Series C preferred stock are not entitled to voting
rights other than the right to vote as a series for the election of one observer
to the Board of Directors. Such Board representation also decreases as the
outstanding shares of the Series C preferred stock decreases. The B & C
Preferred rank on a parity with the Company's 6.75% Series A cumulative
convertible preferred stock, par value $.01 per share (the "Series A preferred
stock"), with respect to dividend rights and rights on liquidation.
Note 6: Cumulative Convertible Preferred Stock
The Company issued one million shares of its Series A preferred stock on
August 11, 1999 and an additional 150,000 shares on August 23, 1999. Holders of
Series A preferred stock are entitled to receive cumulative dividends at an
annual rate of 6.75% of the liquidation preference of the Series A preferred
stock, which is currently $250.00 per share. This dividend is payable quarterly
on each November 15, February 15, May 15 and August 15, commencing on November
15, 1999. The quarterly dividend will be $4.21875 per share, payable at the
Company's option in cash or shares of its Class A common stock. Series A
preferred stock is convertible at the option of its holder, unless previously
redeemed, at any time after the issue date, into shares of its Class A common
stock at a conversion rate of 8.60289 shares of Class A common stock for each
share of Series A preferred stock (representing a conversion price of $29.06 per
share of Class A common stock), subject to adjustment in certain events. In
addition, if on or after August 15, 2002, the closing price of its Class A
common stock has equaled or exceeded 135% of the conversion price for at least
20 out of 30 consecutive business days, the Company will have the option to
convert all of the Series A preferred stock into Class A common stock at the
then current conversion rate. The holders of the Series A preferred stock will
not be entitled to any voting rights unless payments of dividends on the Series
A preferred stock are in arrears and unpaid for an aggregate of six or more
quarterly dividend payments.
Note 7: Common Stock Split
On June 30, 1999, the Company announced a two-for-one stock split in the
form of a stock dividend on the Company's Class A common stock. The record date
for the stock split was July 12, 1999 and the distribution of the additional
shares took place on July 26, 1999. All share data in the consolidated financial
statements and notes to the financial statements have been adjusted to reflect
the stock split.
Note 8: Information by Business Segment
The Company operates predominantly in the business of providing local, long
distance and related communications services to end users and the sale of
advertising space in telephone directories. The two business segments have
separate management teams and infrastructures that offer different products and
services. The principal elements of these segments are to (1) provide integrated
communications services, provide outstanding customer service, expand fiber
optic network, expand intra-city fiber network build, and (2) publish and
distribute directories to local area subscribers.
The Company evaluates the performance of its operating segments based on
earnings before interest, taxes, depreciation and amortization, excluding
general corporate expenses ("EBITDA"). The accounting policies of the
reportable segments are the same as those described in Note 1 of the Company's
Annual Report on Form 10-K for the fiscal year ended December 31, 1998.
Intersegment transfers are accounted for on an arm's length pricing basis.
Identifiable assets (excluding intersegment receivables) are the Company's
assets that are identified in each business segment. Corporate assets primarily
include cash and cash equivalents, investments in available-for-sale securities,
administrative headquarters and goodwill recorded primarily as a result of the
acquisition of Consolidated Communications, Inc. in 1997 and the acquisition of
DTG and Ovation in 1999.
In the three months and nine months ended September 30, 1999 and 1998, no
single customer or group under common control represented 10% or more of the
Company's sales.
9
Segment information for the three and nine months ended September 30, 1999 and
1998 was as follows (in millions):
Telecommunications Media Corporate Total
------------------- -------- ---------- ----------
Three months ended September 30, 1999
Revenues $ 189.0 $ 52.1 $ -- $ 241.1
=====================================================
EBITDA $ 12.2 $ 7.6 $ (4.6) $ 15.2
Depreciation and amortization (33.9) (6.3) (11.7) (51.9)
Interest Revenue 0.5 -- 7.6 8.1
Interest Expense (1.9) (0.7) (34.2) (36.8)
Taxes and Other 8.1 -- (1.1) 7.0
-----------------------------------------------------
Net Income (Loss) $ (15.0) $ 0.6 $ (44.0) $ (58.4)
=====================================================
Nine months ended September 30, 1999
Revenues $ 487.2 $ 157.7 $ -- $ 644.9
=====================================================
EBITDA $ 26.6 $ 24.9 $ (16.4) $ 35.1
Depreciation and amortization (78.9) (23.5) (28.2) (130.6)
Interest Revenue 1.3 -- 21.8 23.1
Interest Expense (4.9) (0.7) (96.9) (102.5)
Taxes and Other 9.0 (0.1) (1.3) 7.6
-----------------------------------------------------
Net Income (Loss) $ (46.9) $ 0.6 $ (121.0) $ (167.3)
=====================================================
As of September 30, 1999
Total assets $1,578.4 $ 433.4 $2,161.3 $4,173.1
Nine months ended September 30, 1999
Capital expenditures $ 513.4 $ 207.0 $ 351.1 $1,071.5
- ---------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------
Telecommunications Media Corporate Total
------------------ ------- --------- ---------
Three months ended September 30, 1998
Revenues $ 118.0 $ 30.6 $ -- $ 148.6
=====================================================
EBITDA $ 4.5 $ 2.6 $ (3.4) $ 3.7
Depreciation and amortization (14.8) (2.5) (5.9) (23.2)
Interest Revenue 0.2 -- 6.5 6.7
Interest Expense (1.4) -- (18.0) (19.4)
Taxes and Other 1.0 -- (1.8) (0.8)
-----------------------------------------------------
Net Income (Loss) $ (10.5) $ 0.1 $ (22.6) $ (33.0)
=====================================================
Nine months ended September 30, 1998
Revenues $ 334.5 $ 104.1 $ -- $ 438.6
======================================================
EBITDA $ 6.7 $ 11.7 $ (8.5) $ 9.9
Depreciation and amortization (39.4) (7.2) (17.1) (63.7)
Interest Revenue 0.6 -- 18.5 19.1
Interest Expense (3.9) -- (50.7) (54.6)
Taxes and Other 1.8 -- (5.6) (3.8)
-----------------------------------------------------
Net Income (Loss) $ (34.2) $ 4.5 $ (63.4) $ (93.1)
=====================================================
As of September 30, 1998
Total assets $ 567.7 $ 198.3 $ 855.6 $1,621.6
Nine months ended September 30, 1998
Capital expenditures $ 195.2 $ 22.7 $ 51.2 $ 269.1
- ---------------------------------------------------------------------------------------------------------
10
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Statements included in this discussion relating, but not limited to, future
revenues, operating expenses, capital requirements, growth rates, cash flows,
operational performance, sources and uses of funds, acquisitions, technological
changes and development of a PCS system, are forward-looking statements that
involve certain risks and uncertainties. Factors that may cause the actual
results, performance, achievements or investments expressed or implied by such
forward-looking statements to differ materially from any future results,
performance, achievements or investments expressed or implied by such forward-
looking statements include, among other things, the availability of financing
and regulatory approvals, the number of potential customers in a target market,
the existence of strategic alliances and relationships, technological,
regulatory or other developments in the Company's business, the ability of the
Company and its third party vendors to make their computer software Year 2000
compliant by the projected deadlines and on budgeted costs, changes in the
competitive climate in which the Company operates and the emergence of future
opportunities and other factors more fully described under the caption
"Business--Risk Factors" in the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1998, filed with the Securities and Exchange
Commission on March 24, 1999 and which section is incorporated herein by
reference.
Unless otherwise indicated, all dollar amounts in the following
Management's Discussion and Analysis of Financial Condition and Results of
Operations that exceed $1 million have been rounded to one decimal place and all
dollar amounts less than $1 million have been rounded to the nearest thousand.
All share data in the consolidated financial statements and notes to the
financial statements have been adjusted to reflect the July 26, 1999 two-for-one
stock split of our Class A common stock.
Overview
We derive our revenue from:
. our core business of providing local, long distance and related
communications services to end users, typically in a bundled package
. the sale of advertising space in telephone directories
. traditional local telephone company services in east central Illinois and
southeast South Dakota
. special access, private line and data services
. communications network maintenance services and telephone equipment
sales, leasing, service and installation
. telemarketing services
. other communications services, including video, computer networking,
cellular, operator, payphone, mobile radio and paging services
We began providing traditional local telephone company services and other
communications services as a result of our acquisition of Consolidated
Communications, Inc. in September 1997, telephone directory advertising as a
result of our acquisition of TelecomUSA Publishing in September 1996, and
telemarketing services as a result of our acquisition of Ruffalo Cody in July
1996. The table set forth below summarizes our percentage of revenues from
these sources:
Quarter Ended September 30,
---------------------------
1999 1998
--------- --------
Local and long distance communications services....... 52% 47%
Telephone directory advertising....................... 22 21
Traditional local telephone company services.......... 8 11
Special access, private line and data services........ 9 7
Network maintenance and equipment services............ 4 6
Telemarketing services................................ 2 3
Other communications services......................... 3 5
---- ----
100% 100%
==== ====
11
We began offering local and long distance services to business customers in
January 1994. At the end of 1995, we began offering, on a test basis, long
distance services to residential customers. In June 1996, we began marketing
and providing to residential customers in Cedar Rapids, Iowa and Iowa City, Iowa
an integrated package of communications services that includes local and long
distance service, voice mail, Internet access and travel card services. Since
June 1996, we have expanded the states in which we offer service to business
customers to include Iowa, Illinois, Indiana, Michigan, Minnesota, Nebraska,
Wisconsin, North Dakota, South Dakota, Colorado, Missouri and Wyoming. We also
expanded our residential service to additional cities in Iowa and Illinois and
began offering the service to customers in North Dakota, South Dakota,
Wisconsin, Wyoming, Colorado, Missouri and Michigan. We plan to continue our
efforts to market and provide local, long distance and other communications
services to business customers and market our service to residential customers.
Our principal operating expenses consist of cost of service; selling,
general and administrative expenses ("SG&A"); and depreciation and amortization.
Cost of service primarily includes local services purchased from regional Bell
operating companies, costs to terminate the long distance calls of our customers
through long distance carriers, costs of printing and distributing telephone
directories and costs associated with maintaining the Iowa Communications
Network. The Iowa Communications Network is a fiber optic communications
network that links many of the State of Iowa's schools, libraries and other
public buildings. SG&A consist of sales and marketing, customer service and
administrative expenses, including the costs associated with operating our
communications network. Depreciation and amortization include depreciation of
our telecommunications network and equipment; amortization of goodwill and other
intangibles related to our acquisitions, amortization expense related to the
excess of estimated fair market value in aggregate of options over the aggregate
exercise price of such options granted to some of our officers, other employees
and directors; and amortization of one-time installation costs associated with
transferring customers' local line service from the regional Bell operating
companies to our local telecommunications service.
As we expand into new markets, both cost of service and SG&A will increase.
We expect to incur cost of service and SG&A expenses before achieving
significant revenues in new markets. Fixed costs related to leasing of central
office facilities needed to provide telephone services must be incurred prior to
generating revenue in new markets, while significant levels of marketing
activity may be necessary in the new markets in order for us to build a customer
base large enough to generate sufficient revenue to offset such fixed costs and
marketing expenses.
We have experienced operating losses since our inception as a result of
efforts to build our customer base, develop and construct our communications
network infrastructure, build our internal staffing, develop our systems and
expand into new markets. We expect to continue to focus on increasing our
customer base and geographic coverage and bringing our customer base onto our
communications network. Accordingly, we expect that our cost of service, SG&A
and capital expenditures will continue to increase significantly, all of which
may have a negative impact on operating results.
In addition, our projected increases in capital expenditures will continue
to generate negative cash flows from construction activities during the next
several years while we install and expand our fiber optic communications network
and develop wireless services. We may also be forced to change our pricing
policies to respond to a changing competitive environment, and we cannot assure
you that we will be able to maintain our operating margin. We cannot assure you
that growth in our revenue or customer base will continue or that we will be
able to achieve or sustain profitability or positive cash flows.
We have generated net operating losses since our inception and,
accordingly, have incurred no income tax expense. We have reduced the net
deferred tax assets generated by these losses by a valuation allowance which
offsets the net deferred tax asset due to the uncertainty of realizing the
benefit of the tax loss carry forwards. We will reduce the valuation allowance
when, based on the weight of available evidence, it is more likely than not that
some portion or all of the deferred tax assets will be realized.
Three Months Ended September 30, 1999 Compared with Three Months Ended September
30, 1998
Total revenue increased from $148.6 million for the three months ended
September 30, 1998 to $241.1 million for the three months ended September 30,
1999, representing an increase of $92.5 million or 62%. Revenue from the sale of
local and long distance telecommunications services accounted for $56 million of
the increase, including $30.6 million contributed by Dakota Telecommunications
Group, Inc. ("DTG"), Ovation Communications, Inc. ("Ovation"), and Access
Communications Holding, Inc. and S.J.
12
Investments Holdings, Inc. (collectively, "Access") which we acquired on March
5, 1999, March 31, 1999 and August 13, 1999, respectively. Local exchange
services generated $3.5 million in additional revenues over the same period in
1998, including $2.5 million contributed by DTG. Private line and data revenues
accounted for $10.5 million of increased revenues over 1998, including $5.7
million contributed by DTG, Ovation and Access. Network maintenance and
equipment revenue increased $0.4 million over 1998, which was due almost
entirely to the DTG acquisition. Other telecommunications revenue increased $0.6
million when compared to the same period in 1998, which was primarily
attributable to the DTG, Ovation and Access acquisitions. Directory revenues
increased $21.3 million from the third quarter of 1998 to the third quarter of
1999 due to revenues from new directories acquired in the last quarter of 1998
and the first three quarters of 1999. Telemarketing revenues in the third
quarter of 1999 increased $0.2 million when compared to the same period in 1998.
Cost of service increased from $81.1 million for the three months ended
September 30, 1998, to $121.9 million for the three months ended September 30,
1999, representing an increase of $40.8 million or 50%. This increase in cost of
service was due primarily to the growth in the our local and long distance
telecommunications and to the acquisitions of DTG, Ovation and Access which
contributed an aggregate of $17.7 million to the increase. Cost of service as a
percentage of revenue decreased from 55% for the three months ended September
30, 1998 to 51% for the three months ended September 30, 1999, primarily due to
the realization of benefits associated with new wholesale line cost rate
agreements with the Regional Bell Operating Companies and reduced long distance
costs resulting from migration of over 60% of customer long distance traffic to
our fiber optic communications network.
SG&A increased from $63.8 million for the three months ended September 30,
1998 to $104 million for the three months ended September 30, 1999, an increase
of $40.2 million or 63%. Our acquisitions of Talking Directories Inc. and Info
America Phone Books, Inc. (collectively, "Talking Directories"), DTG, Ovation
and Access contributed an aggregate of $23.6 million to the increase. Also
contributing to this increase were increased costs of $16.6 million related
primarily to expansion of selling, customer support and administrative
activities to support our growth.
Depreciation and amortization expenses increased from $23.2 million for the
three months ended September 30, 1998 to $51.9 million for the three months
ended September 30, 1999, representing an increase of $28.7 million or 124%.
This increase consisted of $14.5 million related to the acquisitions of Talking
Directories, DTG, Ovation and Access and $14.2 million due primarily to the
growth of the our network.
Interest income increased from $6.7 million for the three-month period ended
September 30, 1998, to $8.1 million for the same period in 1999. This increase
resulted from increased earnings on investments made with the remaining proceeds
from our preferred stock issuances in August and September 1999.
Gross interest expense increased from $22.5 million for the third quarter of
1998 to $42.8 million for the third quarter of 1999. This increase was primarily
a result of an increase in the accretion of interest on our 10 1/2% senior
discount notes of $0.9 million and an increase of interest of $17.3 million
primarily as the result of the issuance of our 9 1/2% senior notes and 8 1/8%
senior notes. Interest expense of approximately $6.0 and $3.1 million was
capitalized as part of our construction of fiber optic network during the
third quarter of 1999 and 1998, respectively.
Net loss applicable to common shares increased from $33 million for the
three months ended September 30, 1998 to $62.5 million for the three months
ended September 30, 1999, an increase of $29.5 million. This increase resulted
primarily from the following three factors: the expansion of our local and
long distance services, which requires significant expenditures, a substantial
portion of which is incurred before the realization of revenues; the increased
depreciation expense related to the construction and expansion of our
networks and amortization of intangibles related to acquisitions; and net
interest expense on indebtedness to fund market expansion, network development
and acquisitions.
Nine Months Ended September 30, 1999 Compared with Nine Months Ended September
30, 1998
Total revenue increased from $438.6 million for the nine months ended
September 30, 1998 to $644.9 million for the nine months ended September 30,
1999, representing an increase of $206.3 million or 47%. Revenue from the sale
of local and long distance telecommunications services accounted for $116.6
million of this increase, including $52.1 million contributed by DTG, Ovation
and Access. Local
13
exchange services generated $8.4 million additional revenues over the same
period in 1998, including $5.8 million contributed by DTG. Private line and data
revenues accounted for $26.4 million of increased revenues over 1998, including
$12.7 million contributed by DTG, Ovation and Access. Network maintenance and
equipment revenue increased $1.8 million over 1998, which was primarily due to
the DTG acquisition. Other telecommunications revenue increased $1 million when
compared to the same period in 1998 which was primarily attributable to the DTG,
Ovation and Access acquisitions. Directory revenues increased $53.1 million from
the first nine months of 1998 to the first nine months of 1999 due to revenues
from new directories acquired in the last quarter of 1998 and the first three
quarters of 1999. Telemarketing revenues decreased $1.0 million for the nine
months ended September 30, 1999 when compared to the nine months ended September
30, 1998.
Cost of service increased from $239.2 million for the nine months ended
September 30, 1998, to $327.4 million for the nine months ended September 30,
1999, representing an increase of $88.2 million or 37%. This increase in cost of
service was due primarily to the growth in our local and long distance
telecommunications. Cost of service as a percentage of revenue decreased from
55% for the nine months ended September 30, 1998 to 51% for the nine months
ended September 30, 1999, primarily due to the realization of benefits
associated with new wholesale line cost rate agreements with the Regional Bell
Operating Companies and reduced long distance costs resulting from migration of
over 60% of customer long distance traffic to our fiber optic network.
SG&A increased from $189.5 million for the nine months ended September 30,
1998 to $282.4 million for the nine months ended September 30, 1999, an increase
of $92.9 million or 49%. Our acquisitions of Talking Directories, DTG, Ovation
and Access contributed an aggregate of $48.7 million to the increase. Also
contributing to this increase were increased costs of $44.2 million primarily
related to expansion of selling, customer support and administration activities
to support our growth.
Depreciation and amortization expenses increased from $63.7 million for the
nine months ended September 30, 1998 to $130.6 million for the nine months ended
September 30, 1999, representing an increase of $66.9 million or 105%. This
increase consisted of $33.8 million related to our acquisitions of Talking
Directories, DTG, Ovation and Access, and $33.1 million due primarily to the
growth of our network.
Interest income increased from $19.1 million for the nine-month period
ended September 30, 1998, to $23.1 million for the same period in 1998. This
increase resulted from increased earnings on investments made with the remaining
proceeds from our preferred stock issuance in August and September 1999.
Gross interest expense increased from $61.1 million for the first nine
months of 1998 to $118.1 million for the first nine months of 1999. This
increase was primarily a result of an increase in the accretion of interest on
our 10 1/2% senior discount notes of $2.8 million and an increase of interest of
$51.2 million primarily as the result of the issuance of our 8 3/8% senior
notes, 9 1/2% senior notes and 8 1/8% senior notes. Interest expense of
approximately $15.6 and $6.5 million was capitalized as part of our construction
of fiber optic network during the third quarter of 1999 and 1998, respectively.
Net loss applicable to common shares increased from $93.1 million for the
nine months ended September 30, 1998 to $171.4 million for the nine months ended
September 30, 1999, an increase of $78.3 million. This increase resulted
primarily from the following three factors: the expansion of our local and long
distance services, which requires significant expenditures, a substantial
portion of which is incurred before the realization of revenues; the increased
depreciation expense related to the construction and expansion of our networks
and amortization of intangibles related to acquisitions; and net interest
expense on indebtedness to fund market expansion, network development and
acquisitions.
Liquidity and Capital Resources
Our total assets increased from $1.9 billion at December 31, 1998 to $4.2
billion at September 30, 1999. The increase is primarily due to net proceeds of
approximately $485.8 million from our offering of the 8 1/8% senior notes in
February 1999, net proceeds of approximately $1 billion from our placement of
Series B and C preferred stock in September 1999, net proceeds of approximately
$278 million from our offering of Series A preferred stock in August 1999, and
to the net assets of approximately $624.5 million acquired from Talking
Directories, DTG, Ovation and Access. At September 30, 1999, our current assets
of $1,751.5 million exceeded our current liabilities of $271.7 million,
providing
14
working capital of $1,479.8 million, which represents an increase of $866.5
million compared to December 31, 1998. At December 31, 1998, our current assets
of $793.2 million exceeded current liabilities of $179.9 million, providing
working capital of $613.3 million.
The net cash used in operating activities totaled $59.9 million for the nine
months ended September 30, 1999 and net cash provided by operating activities
totaled $10.9 million for the nine months ended September 30, 1998. During the
nine months ended September 30, 1999, cash used in operating activities was used
primarily to fund our net loss of $167.3 million for such period. As a result of
the expansion of our local and long distance communications services, we also
required cash to fund:
. growth in trade receivables of $19.1 million
. growth in inventory of $17.3 million
. increase in deferred expenses of $1.4 million
. deferred line installation costs of $19.5 million
. decreases in accounts payable and accrued expenses of $35.7 million
These amounts were partially offset by:
. decreases in prepaid and other expenses of $28.7 million
. increases in deferred revenue of $6.8 million
. increases in customer deposits of $5.5 million
. cumulative non-cash expenses of $159.4 million
During the nine months ended September 30, 1998, cash for operating activities
was used primarily to fund our net loss of $93.1 million for such period. We
also required cash to fund the growth in trade receivables, inventory and
prepaid expenses of $10.1 million, $0.3 million and $4.7 million, respectively,
and to decrease deferred line installation costs of $9 million. These uses of
cash for operating activities during the nine months ended September 30, 1998,
were offset by increases in accounts payable and accrued expenses, deferred
revenue and customer deposits of $10.7 million, $3 million and $2.9 million,
respectively, and cumulative non-cash expenses of $89.7 million.
Our investing activities used cash of $1,050.3 million during the nine
months ended September 30, 1999 and $373.2 million during the nine months ended
September 30, 1998. The equipment required for the expansion of our local and
long distance telecommunications services, our development and construction of
its fiber optic telecommunications network and other capital expenditures
resulted in purchases of equipment and fiber optic cable and other property and
equipment totaling $394.1 million and $204.7 million during the nine months
ended September 30, 1999 and 1998, respectively. We also used cash of $821.9
million and $516.3 million to acquire available-for-sale securities during the
first nine months of 1999 and 1998, respectively, offset by proceeds from sales
and maturities of available-for-sale securities of $398.4 million and $379
million, respectively, during those periods.
During the nine months ended September 30, 1999, we used an aggregate of
$231.1 million cash to acquire:
. the capital stock of Talking Directories in February 1999
. the capital stock of DTG in March 1999
. the capital stock of Ovation in March 1999
. the capital stock of Access in August 1999
We used an aggregate of $27.6 million cash during the nine months
ended September 30, 1998 to acquire various directories and in our acquisition
of QST Communications, Inc.'s capital stock.
Net cash received from financing activities was $1,540.3 million during the
nine months ended September 30, 1999, primarily as a result of our offering of
our 8 1/8% senior notes, our offering of Series B and C redeemable, convertible
preferred stock, and our offering of Series A preferred stock. Net cash received
from financing activities during the nine months ended September 30, 1998 was
$283.2 million and was primarily obtained from our offering of our 8 3/8% senior
notes in March 1998.
15
On February 22, 1999, we completed an offering of $500 million aggregate
principal amount of our 8 1/8% senior notes in which we received net proceeds of
approximately $485.8 million. Interest on the 8 1/8% senior notes accrues at the
rate of 8 1/8% per annum and is payable in cash semi-annually in arrears on
February 15 and August 15, starting August 15, 1999.
Our 10 1/2% senior discount notes, 9 1/4% senior notes, 8 3/8% senior notes,
9 1/2% senior notes and 8 1/8% senior notes are senior unsecured obligations of
McLeodUSA ranking pari passu in right of payment with all other existing and
future senior unsecured obligations of McLeodUSA and senior to all existing and
future subordinated debt of McLeodUSA. The 10 1/2% senior discount notes, 9 1/4%
senior notes, 8 3/8% senior notes, 9 1/2% senior notes and 8 1/8% senior notes
are effectively subordinated to all existing and future secured indebtedness of
McLeodUSA and our subsidiaries to the extent of the value of the assets securing
such indebtedness. The 10 1/2% senior discount notes, 9 1/4% senior notes, 8
3/8% senior notes, 9 1/2% senior notes and 8 1/8% senior notes also are
effectively subordinated to all existing and future third-party indebtedness and
other liabilities of our subsidiaries.
The indentures governing our 10 1/2% senior discount notes, 9 1/4% senior
notes, 8 3/8% senior notes, 9 1/2% senior notes and 8 1/8% senior notes impose
operating and financial restrictions on our subsidiaries and us. These
restrictions affect, and in many cases significantly limit or prohibit, among
other things, our and our subsidiaries' ability to:
. incur additional indebtedness
. pay dividends or make distributions in respect of our or our
subsidiaries' capital stock
. redeem capital stock
. make other restricted payments
. enter into sale and leaseback transactions
. create liens upon assets
. enter into transactions with affiliates or related persons
. sell assets
. consolidate, merge or sell all or substantially all of our assets
We cannot assure you that such covenants will not adversely affect our ability
to finance our future operations or capital needs or to engage in other business
activities that may be in our interests.
We issued one million shares of our Series A preferred stock on
August 11, 1999 and an additional 150,000 shares on August 23, 1999. Holders of
Series A preferred stock are entitled to receive cumulative dividends at an
annual rate of 6.75% of the liquidation preference of the Series A preferred
stock, which is currently $250.00 per share. This dividend is payable quarterly
on each November 15, February 15, May 15 and August 15, commencing on November
15, 1999. The quarterly dividend will be $4.21875 per share, payable at our
option in cash or shares of our Class A common stock. Series A preferred stock
is convertible at the option of its holder, unless previously redeemed, at any
time after the issue date, into shares of our Class A common stock at a
conversion rate of 8.60289 shares of Class A common stock for each share of
Series A preferred stock (representing a conversion price of $29.06 per share of
Class A common stock), subject to adjustment in certain events. In addition, if
on or after August 15, 2002, the closing price of our Class A common stock has
equaled or exceeded 135% of the conversion price for at least 20 out of 30
consecutive business days, we will have the option to convert all of the Series
A preferred stock into Class A common stock at the then current conversion rate.
The holders of the Series A preferred stock will not be entitled to any voting
rights unless payments of dividends on the Series A preferred stock are in
arrears and unpaid for an aggregate of six or more quarterly dividend payments.
Pursuant to a Stock Purchase Agreement dated August 30, 1999 (the "Stock
Purchase Agreement"), we issued on September 15, 1999 (the "Issue
Date") 275,000 shares of Series B preferred stock, par value $.01 per share
("Series B preferred stock"), and 125,000 shares of Series C preferred stock,
par value $.01 per share ("Series C preferred stock," and together with the
Series B preferred stock , the "B&C Preferred") through a private offering.
Net proceeds from the financing amounted to approximately $1 billion. The B&C
Preferred are redeemable on a proportionally equal basis, in whole or in part,
by us at any time following the seventh anniversary of the Issue Date; or by the
holders within 180 days following the tenth anniversary of the Issue Date. The
B&C Preferred are convertible on a proportionally equal basis, at the Series B
holders option, in whole or in part at any time into Class A common stock.
Shares of each series will have a liquidation preference of $2,500.00 per share
plus accrued and unpaid dividends, if any, and will be convertible into shares
of our Class A common stock at a rate of (a) the liquidation preference divided
by (b) $36.50. Each share of Series B preferred stock is entitled to receive a
quarterly dividend of approximately $31.82. Dividends are cumulative and payable
quarterly on March 31, June 30, September 30, and December 31. If prior to the
fifth anniversary of the Issue Date we pay a dividend on our Class A common
stock,
16
holders of the B&C Preferred shall be entitled to receive an equivalent dividend
calculated on a common stock equivalent basis as if the B&C Preferred had been
converted into Class A common stock. Except as required by law, holders of
Series B preferred stock are not entitled to voting rights other than the right
to vote as a series for the election of two members to the Board of Directors.
Such Board representation decreases as the outstanding shares of the Series B
preferred stock decrease. Except as required by law, holders of Series C
preferred stock are not entitled to voting rights other than the right to vote
as a series for the election of one observer to the Board of Directors. Such
Board representation also decreases as the outstanding shares of the Series C
preferred stock decrease. The B&C Preferred rank on a parity with our Series A
preferred stock with respect to dividend rights and rights on liquidation.
As of September 30, 1999 based on our business plan, capital requirements
and growth projections as of that date, we estimated that we would require
approximately $1.2 billion through 2001. Our estimated aggregate capital
requirements include the projected costs of:
. building our fiber optic communications network, including intra-city
fiber optic networks
. expanding operations in existing and new markets
. developing wireless services
. funding general corporate expenses
. integrating acquisitions
. constructing, acquiring, developing or improving telecommunications
assets
The estimated costs and incremental capital needs associated with the
acquisitions of Talking Directories, DTG, Ovation and Access are included in our
estimated aggregate capital requirements.
We expect to use the following to address our capital needs:
. approximately $1.5 billion of cash and investments on hand at
September 30, 1999
. additional issuances of debt or equity securities
. projected operating cash flow
Our estimate of future capital requirements is a forward-looking statement
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. The actual amount and timing of our future
capital requirements may differ substantially from our estimate due to factors
such as:
. strategic acquisition costs and effects of acquisitions on our
business plan, capital requirements and growth projections
. unforeseen delays
. cost overruns
. engineering design changes
. changes in demand for our services
. regulatory, technological or competitive developments
. new opportunities
We also expect to evaluate potential acquisitions, joint ventures and
strategic alliances on an ongoing basis. We may require additional financing if
we pursue any of these opportunities. Accordingly, we may need additional
capital to continue to expand our markets, operations, facilities, network and
services.
We may meet any additional capital needs by issuing additional debt or
equity securities or borrowing funds from one or more lenders. We cannot assure
you that we will have timely access to additional financing sources on
acceptable terms.
Failure to generate or raise sufficient funds may require us to delay or
abandon some of our expansion plans or expenditures, which could have a material
adverse effect on our business, results of operations or financial condition.
See "Business--Risk Factors--Failure to Raise Necessary Capital
17
Could Restrict Our Ability to Develop Our Network and Services and Engage in
Strategic Acquisitions" in our Annual Report on Form 10-K.
Market Risk
At September 30, 1999, we recorded the marketable equity securities that we
hold at a fair value of $39.8 million. These securities have exposure to price
risk. A hypothetical ten percent adverse change in quoted market prices would
amount to a decrease in the recorded value of investments of approximately $4
million. We believe our exposure to market price fluctuations on all other
investments is nominal due to the short-term nature of our investment portfolio.
We have no material future earnings or cash flow exposures from changes in
interest rates on our long-term debt obligations, as substantially all of our
long-term debt obligations are fixed rate obligations.
Year 2000 Date Conversion
We have verified system readiness for the processing of date-sensitive
information by our computerized information systems. The Year 2000 problem
impacts computer programs and hardware timers using two digits (rather than
four) to define the applicable year. Some of our programs and timers that have
time-sensitive functions may recognize a date using "00" as the year 1900 rather
than 2000, which could result in miscalculations or system failures.
We have reviewed our IT and non-IT computer systems and programs to
determine which are not capable of recognizing the Year 2000 and to verify
system readiness for the millennium date. The review covered all of our
operations and was, and continues to be, centrally managed. The review
included:
1. increasing employee awareness and communication of Year 2000 issues
2. inventorying hardware, software and data interfaces and confirming Year
2000 readiness of key vendors
3. identifying mission-critical components for internal systems, vendor
relations and other third parties
4. estimating costs for remediation
5. estimating completion dates
6. testing and verifying systems
7. remediating any identified problems by correcting or replacing systems
or components
8. implementing the remediation plan
9. developing contingency plans
10. training for contingency plans
Except with respect to pending or recently completed acquisitions, we have
completed the activities required to carry out our review, which included
developing contingency plans to handle our most reasonably likely worst case
Year 2000 scenarios, including rehearsing these plans. The review and related
Year 2000 activities have not caused us to defer or forego, to any material
degree, any other critical IT project.
We continue to review systems related to pending or recently completed
acquisitions. We plan to complete the review, including testing, remediation and
contingency planning within 30 days. Based on our initial review of available
information, we believe there will be no material adverse effect on our
business.
We estimate that our Year 2000 costs will not exceed $6.5 million.
We generally expense these costs as incurred. As of October 31, 1999, we had
incurred costs of $5.8 million in connection with our Year 2000 readiness
activities.
Our estimate of our Year 2000 readiness costs is a forward-looking statement
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Costs, results, performance and effects of Year
2000 activities described in those forward-looking statements may differ
18
materially from actual costs, results, performance and effects in the
future due to the interrelationship and interdependence of our computer systems
and those of our vendors, material service providers, customers and other third
parties.
If we, our major vendors, our material service providers or our customers
fail to address Year 2000 issues in a timely manner, such failure could have a
material adverse effect on our business, results of operations and financial
condition. We depend on local exchange carriers, primarily the regional Bell
operating companies, to provide most of our local and some of our long distance
services. To the extent U S WEST, Ameritech or Southwestern Bell fail to address
Year 2000 issues which might interfere with their ability to fulfill their
obligations to us, such interference could have a material adverse effect on our
future operations. If other telecommunications carriers are unable to resolve
Year 2000 issues, it is likely that we will be affected to a similar degree as
others in the telecommunications industry.
There also may be Year 2000 issues in customer premises equipment (CPE).
Although the customer generally is responsible for CPE, customers could
attribute a Year 2000 disruption in their CPE to a malfunction of our network
service. Because we sell CPE, we have taken steps to encourage many of our
customers potentially at risk to undertake the necessary assessment and remedial
activities to avoid a Year 2000 problem with their equipment and systems.
Our Year 2000 office will continue its operations through the end of the
year. The Project Office continues to respond to inquiries and to assess new
general Year 2000 information as it becomes available, responding as appropriate
when necessary. We continue to conduct "dry run" practice sessions and to work
with key management employees on the communications plans for December 31, 1999
and January 1, 2000. Plans are in place to keep key management informed and to
have key management personnel available, up to and including the President of
McLeodUSA, to make critical decisions on December 31, 1999 and January 1,
2000, if necessary.
Effects of New Accounting Standards
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"). SFAS 133 establishes accounting and reporting standards requiring that
every derivative instrument (including derivative instruments embedded in other
contracts) be recorded in the balance sheet as either an asset or liability
measured at its fair value. SFAS 133 requires that changes in the derivative's
fair value be recognized currently in earnings unless specific hedge accounting
criteria are met. Special accounting for qualifying hedges allows a
derivative's gains and losses to offset related results on the hedged item in
the income statement, and requires that a company must formally document,
designate and assess the effectiveness of transactions that receive hedge
accounting.
SFAS 133 is effective for fiscal years beginning after June 15, 2000. A
company may also implement SFAS 133 as of the beginning of any fiscal quarter
after issuance (that is, fiscal quarters beginning June 16, 1998 and
thereafter). SFAS 133 cannot be applied retroactively. SFAS 133 must be
applied to (a) derivative instruments and (b) derivative instruments embedded in
hybrid contracts that were issued, acquired or substantively modified after
December 31, 1997 (and, at our election, before January 1, 1998).
We do not expect the impact of the adoption of SFAS 133 to be material to
our results of operations as we do not currently hold any derivative instruments
or engage in hedging activities.
Inflation
We do not believe that inflation has had a significant impact on our
consolidated operations.
19
PART II
OTHER INFORMATION
Item 1. Legal Proceedings
We are not aware of any material litigation against McLeodUSA. We are
involved in numerous regulatory proceedings before various public utility
commissions and the FCC, particularly in connection with actions by the regional
Bell operating companies. For example, on February 5, 1996, U S WEST filed
tariffs and other notices with the public utility commissions in its fourteen-
state service region to limit future Centrex access to its switches. Under the
terms of these tariffs and other notices, U S WEST would permit us to use its
central office switches until April 2005, but would not allow us to expand to
new cities and would severely limit the number of new lines we could partition
onto U S WEST's switches in cities we serve.
We challenged, or are challenging, this action by U S WEST in many of
the states where we do business or plan to do business. We succeeded in
blocking this action in Iowa, Minnesota, South Dakota, North Dakota and
Colorado, although U S WEST could take further legal action in some of these
states. In Montana, Nebraska and Idaho, however, similar challenges to this
action have not succeeded. In Wyoming and Utah, challenges to this action remain
pending.
U S WEST has introduced other measures that may make it more difficult or
expensive for us to use Centrex service. In January 1997, U S WEST proposed
interconnection surcharges in several of the states in its service region. In
February 1997, we joined other parties in filing a petition with the FCC
objecting to this proposal based on our belief that it violates several
provisions of the Telecommunications Act of 1996. The matter remains pending
before the FCC and various state public utility commissions.
We anticipate that U S WEST will also pursue legislation in states within
our target market area to reduce state regulatory oversight over its rates and
operations. If adopted, these initiatives could make it more difficult for us to
challenge U S WEST's actions in the future.
We cannot assure you we will succeed in our challenges to these or other
actions by U S WEST that would prevent or deter us from using U S WEST's Centrex
service or network elements. If U S WEST successfully withdraws or limits our
access to Centrex services in any jurisdiction, we may not be able to offer
integrated communications services in that jurisdiction, which could have a
material adverse effect on our business, results of operations and financial
condition. See "Business--Risk Factors--Our Dependence on Regional Bell
Operating Companies to Provide Most of Our Communications Services Could Make it
Harder for Us to Offer Our Services at a Profit" and "Business--Risk Factors--
Actions by U S WEST May Make it More Difficult for Us to Offer Our
Communications Services" in the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1998.
Item 2. Changes in Securities and Use of Proceeds
During the period from July 1, 1999 through September 30, 1999, the Company
has issued and sold the following equity securities:
(1) On August 13, 1999, pursuant to the terms and conditions of an
Agreement and Plan of Merger dated June 1, 1999 with Access Communications
Holding, Inc. ("Access"), a Utah corporation, and certain of the stockholders of
Access, we issued 1,939,839 shares of our Class A common stock, after giving
effect to the two-for-one stock split in July 1999, and paid $23.3 million in
cash to the stockholders of Access in exchange for all the outstanding capital
stock of Access. We also assumed approximately $48.7 million in Access debt. In
a related transaction, on August 13, 1999, pursuant to the terms and conditions
of an Agreement and Plan of Merger dated June 1, 1999 with S.J. Investments
Holdings, Inc. ("SJIH"), a Utah corporation, and certain of the stockholders of
SJIH, we issued 1,939,864 shares of its Class A common stock, after giving
effect to the two-for-one stock split in July 1999, and paid $25 million in cash
to the stockholders of SJIH in exchange for all the outstanding capital stock of
SJIH. We also assumed approximately $47.5 million in SJIH debt.
(2) On September 28, 1999, we issued 43,700 shares of Class A
common stock in connection with our acquisition of Millennium Group
Telemanagement, LLC ("Millennium"). We had previously agreed on June
8, 1999, to purchase certain assets of Millennium and assume certain liabilities
of Millennium for a total purchase price of $7.0 million. The purchase price
consisted of $3.5 million in cash and the issuance or commitment to issue
128,530 shares of Class A common stock, after
20
giving effect for the two-for-one stock split in July 1999, of which 69,406
shares were issued June 8, 1999. We expect to issue the remaining shares in
December 1999.
(3) Pursuant to a Stock Purchase Agreement dated as of August 30, 1999, we
issued and sold on September 15, 1999 to Forstmann Little & Co. Equity
Partnership V, L.P. ("Forstmann V"), Forstmann Little & Co. Subordinated Debt
and Equity Management Buyout Partnership VI, L.P. ("Forstmann VI"), and
Forstmann Little & Co. Subordinated Debt and Equity Management Buyout
Partnership VII, L.P. ("Forstmann VII") (a) an aggregate of 275,000 shares of
our Series B preferred stock, par value $.01 (the "Series B preferred stock")
for an aggregate purchase price of $693,125,000, and (b) an aggregate of
125,000 shares of our Series C preferred stock, par value $.01 (the "Series C
preferred stock") for an aggregate purchase price of $321,875,000. The total
purchase price was approximately $1 billion.
Specifically, Forstmann V acquired 125,000 shares of Series C preferred
stock for $321,875,000; Forstmann VI acquired 85,752.78 shares of Series B
preferred stock for $216,135,985; and Forstmann VII acquired 189,247.22 shares
of Series B preferred stock for $476,989,015.
Each of the Series B preferred stock and the Series C preferred stock are a
new series of preferred stock. Shares of each series will have a liquidation
preference of $2,500.00 per share plus accrued and unpaid dividends, if any, and
will be convertible into shares of our Class A common stock at a rate
of (a) the liquidation preference divided by (b) $36.50.
The issuances of securities described above were made in reliance upon the
exemption from registration provided by Section 4(2) of the Securities Act or
Regulation D promulgated thereunder for transactions by an issuer not involving
any public offering. The recipients of securities in each such transaction
represented their intention to acquire the securities for investment only and
not with a view to or for distribution in connection with such transactions.
All recipients had adequate access to information about us through their
relationship with us or through information about us made available to them.
21
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit
--------
Number
--------
Exhibit Description
-------------------
11.1 Statement regarding computation of loss per common share.
27.1 Financial Data Schedule.
(b) Reports on Form 8-K
On July 2, 1999, we filed a Current Report on Form 8-K to announce that on
June 30, 1999 our Board of Directors had declared a two-for-one stock split of
our Class A common stock to be effected in the form of a stock dividend.
On July 8, 1999, we filed a Current Report on Form 8-K to report that shares
of Class A common stock that we had previously registered for resale on a
Registration Statement on Form S-3 for certain selling stockholders (File No.
333-78561) had been resold by them into the public markets.
On August 4, 1999, we filed a Current Report on Form 8-K to report the
election of Anne K. Bingaman to the Board of Directors and to report our
financial and operating results for the second quarter 1999.
On August 9, 1999, we filed a Current Report on Form 8-K to report the sale
of 1,000,000 shares of our 6.75% Series A cumulative convertible preferred
stock.
On August 20 1999, we filed a Current Report on Form 8-K to report our
August 13, 1999 acquisition of Access Communications Holdings, Inc., a Utah
corporation and S.J. Investments Holdings, Inc., a Utah corporation.
On September 23, 1999, we filed a Current Report on Form 8-K to report that
pursuant to a stock purchase agreement dated August 30, 1999 between us and
three partnerships affiliated with Forstmann Little & Co., we issued and sold on
September 15, 1999 approximately $1 billion of our convertible, redeemable
preferred stock.
22
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
McLEODUSA INCORPORATED
(registrant)
Date: November 15, 1999 By: /s/ Stephen C. Gray
--------------------------------------
Stephen C. Gray
President and Chief Operating Officer
Date: November 15, 1999 By: /s/ J. Lyle Patrick
--------------------------------------
J. Lyle Patrick
Chief Financial Officer
23
INDEX TO EXHIBITS
Sequentially
Exhibit Numbered
Number Exhibit Description Page
- --------- ------------------- ------------
11.1 Statement regarding computation of loss per common share.
27.1 Financial Data Schedule.
24