1
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 from ______________________ to _______________________
Commission File No. 333-53467
Pathnet, Inc.
(Exact name of registrant as specified in its charter)
Delaware 52-1941838
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1015 31st Street, N.W.
Washington, DC 20007
(Address of principal executive offices) (Zip Code)
(202) 625-7284
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last
report)
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 [ ]
As of November 4, 1999, there were 2, 977,593 shares of the Issuer's common
stock, par value $.01 per share, outstanding.
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PATHNET, INC. AND SUBSIDIARIES
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1999
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Unaudited Consolidated Financial Statements
Consolidated Balance Sheets as of September 30, 1999 (unaudited) and
December 31, 1998 3
Unaudited Consolidated Statements of Operations for the three and
nine months ended September 30, 1999 and 1998 and for the period
August 25, 1995 (date of inception) to September 30, 1999 4
Unaudited Consolidated Statements of Comprehensive Income (Loss) for
the three and nine months ended September 30, 1999 and 1998 and for
the period August 25, 1995 (date of inception) to September 30, 1999 5
Unaudited Consolidated Statements of Cash Flows for the nine months
ended September 30, 1999 and 1998 and for the period August 25, 1995
(date of inception) to September 30, 1999 6
Notes to Unaudited Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk 19
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 20
Item 2. Changes in Securities and Use of Proceeds 20
Item 3. Defaults Upon Senior Securities 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 5. Other Information 20
Item 6. Exhibits and Reports on Form 8-K 20
Signatures 21
Exhibits Index 22
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3
PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
1999 1998
-------------- --------------
(UNAUDITED)
ASSETS
Cash and cash equivalents $ 98,896,417 $ 57,321,887
Note receivable - 3,206,841
Interest receivable 1,957,216 3,848,753
Marketable securities available for sale, at market 69,420,476 97,895,773
Prepaid expenses and other current assets 453,541 205,505
-------------- --------------
Total current assets 170,727,650 162,478,759
Property and equipment, net 106,123,850 47,971,336
Deferred financing costs, net 9,695,423 10,508,251
Restricted cash 3,952,769 10,731,353
Marketable securities available for sale, at market 5,103,435 71,899,757
Pledged marketable securities held to maturity 42,379,701 61,824,673
Other assets 591,727 -
-------------- --------------
Total assets $ 338,574,555 $ 365,414,129
============== ==============
LIABILITIES, MANDATORILY REDEEMABLE PREFERRED STOCK
AND STOCKHOLDERS' EQUITY (DEFICIT)
Accounts payable $ 12,378,214 $ 10,708,263
Accrued interest 19,651,047 8,932,294
Accrued expenses and other current liabilities 1,093,897 639,688
-------------- --------------
Total current liabilities 33,123,158 20,280,245
12 1/4% Senior Notes, net of unamortized bond discount of $3,480,750 and $3,787,875
respectively 346,519,250 346,212,125
Other non-current liabilities 263,734 -
-------------- --------------
Total liabilities 379,906,142 366,492,370
-------------- --------------
Series A convertible preferred stock, $0.01 par value, 1,000,000 shares authorized, issued
and outstanding at September 30, 1999 and December 31, 1998, respectively (liquidation
preference $1,000,000) 1,000,000 1,000,000
Series B convertible preferred stock, $0.01 par value, 1,651,046 shares authorized, issued
and outstanding at September 30, 1999 and December 31, 1998, respectively (liquidation
preference $5,033,367) 5,008,367 5,008,367
Series C convertible preferred stock, $0.01 par value, 2,819,549 shares authorized, issued
and outstanding at September 30, 1999 and December 31, 1998, respectively (liquidation
preference $30,000,052) 29,961,272 29,961,272
--------------- --------------
Total mandatorily redeemable preferred stock 35,969,639 35,969,639
--------------- --------------
Common stock, $0.01 par value, 60,000,000 shares authorized at June 30, 1999 and
December 31, 1998, respectively; 2,977,593 and 2,902,358 shares issued and
outstanding at September 30, 1999 and December 31, 1998, respectively 29,776 29,024
Deferred compensation (575,836) (978,064)
Additional paid-in capital 6,162,866 6,156,406
Accumulated other comprehensive (loss) income (45,465) 208,211
Deficit accumulated during the development stage (82,872,567) (42,463,457)
-------------- --------------
Total stockholders' equity (deficit) (77,301,226) (37,047,880)
-------------- --------------
Total liabilities, mandatorily redeemable preferred stock and stockholders' equity (deficit) $ 338,574,555 $ 365,414,129
============== ==============
The accompanying notes are an integral part of these consolidated financial
statements.
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4
PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE PERIOD
AUGUST 25, 1995
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED (DATE OF INCEPTION)
SEPTEMBER 30, SEPTEMBER 30, TO SEPTEMBER 30,
--------------------------------- -------------------------------
1999 1998 1999 1998 1999
------------- ------------- ------------- ------------- -------------
Revenue $ 584,084 $ 475,000 $ 2,275,003 $ 1,050,000 $ 4,022,042
------------- ------------- ------------- ------------- -------------
Operating expenses:
Cost of revenue 4,258,609 1,621,211 9,579,064 5,385,718 17,126,684
Selling, general and administrative 3,197,164 2,694,505 9,500,235 6,721,862 25,125,584
Depreciation expense 2,143,238 203,725 3,714,170 315,247 4,503,001
------------- ------------- ------------- ------------- -------------
Total operating expenses 9,599,011 4,519,441 22,793,469 12,422,827 46,755,269
------------- ------------- ------------- ------------- -------------
Net operating loss (9,014,927) (4,044,441) (20,518,466) (11,372,827) (42,733,227)
Interest expense (9,987,494) (11,151,467) (30,318,331) (21,862,169) (63,306,142)
Interest income 3,318,719 4,728,582 10,511,464 9,574,286 24,626,700
Write-off of initial public offering costs - (1,354,534) - (1,354,534) (1,354,534)
Other income (expense), net (243,504) 1,661 (83,777) 500 (86,364)
--------- ------------- ------------- ------------- -------------
Net loss $ (15,927,206) $ (11,820,199) $ (40,409,110) $ (25,014,744) $ (82,853,567)
============= ============= ============= ============= =============
Basic and diluted loss per
common share $ (5.44) $ (4.07) $ (13.88) $ (8.62) $ (28.54)
============= ============= ============= ============= =============
Weighted average number of
common shares outstanding 2,926,081 2,902,358 2,911,512 2,901,917 2,902,594
============= ============= ============= ============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
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PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------------- ----------------------------------
1999 1998 1999 1998
---------------- --------------- --------------- --------------
Net loss $ (15,927,206) $ (11,820,199) $ (40,409,110) $ (25,014,744)
Other comprehensive income (loss):
Net unrealized gain (loss) on marketable
securities available for sale 75,759 488,345 (253,676) 436,490
---------------- --------------- --------------- --------------
Comprehensive loss $ (15,851,447) $ (11,331,854) $ (40,662,786) $ (24,578,254)
================ =============== =============== ==============
FOR THE PERIOD
AUGUST 25, 1995
(DATE OF INCEPTION)
TO SEPTEMBER 30,
1999
----------------
Net loss $ (82,853,567)
Other comprehensive income (loss):
Net unrealized gain (loss) on marketable
securities available for sale (45,465)
----------------
Comprehensive loss $ (82,899,032)
================
The accompanying notes are an integral part of these consolidated financial
statements.
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PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE PERIOD
AUGUST 25, 1995
FOR THE NINE MONTHS ENDED (DATE OF INCEPTION)
SEPTEMBER 30, TO SEPTEMBER 30,
--------------------------------
1999 1998 1999
-------------- --------------- ----------------
Cash flows from operating activities:
Net loss $ (40,409,110) $ (25,014,744) $ (82,853,567)
Adjustment to reconcile net loss to net cash used in operating activities
Depreciation expense 3,714,170 315,247 4,503,001
Amortization of deferred financing costs 853,563 558,785 1,696,353
Loss on disposal of fixed assets 8,345 - 13,845
Gain on disposal of investments (157,983) - (157,983)
Write-off of deferred financing costs - 613,910 581,334
Interest expense resulting from amortization of discount on the
bonds payable 307,125 204,750 614,250
Amortization of premium on pledged securities (288,643) - (288,643)
Stock based compensation 402,228 489,435 1,103,523
Interest expense for beneficial conversion feature of bridge loan - - 381,990
Accrued interest satisfied by conversion of bridge loan to
Series B convertible preferred stock - - 33,367
Changes in assets and liabilities:
Interest receivable 1,891,537 (3,936,127) (2,955,415)
Prepaid expenses and other assets (839,763) (119,796) (1,045,268)
Accounts payable (2,140,999) 53,711 (1,633,385)
Accrued interest 10,718,753 20,484,724 19,651,047
Accrued expenses and other liabilities 717,943 1,808,548 1,357,630
-------------- --------------- ----------------
Net cash used in operating activities (25,222,834) (4,541,557) (58,997,921)
-------------- --------------- ----------------
Cash flows from investing activities:
Expenditures for network in progress (57,461,993) (9,183,109) (92,821,117)
Expenditures for property and equipment (607,101) (8,548,737) (3,812,994)
Proceeds on disposal of fixed assets 5,015 - 5,015
Sale of marketable securites held for sale 95,175,926 - 95,175,926
Purchase of marketable securities available for sale - (191,232,621) (169,587,319)
Purchase of marketable securities - pledged as collateral - (83,224,243) (83,097,655)
Maturity and sale of marketable securities - pledged as collateral 19,733,615 - 42,004,796
Restricted cash 6,778,584 (9,887,042) (3,952,769)
Repayment of note receivable 3,206,841 9,000 9,000
-------------- --------------- ----------------
Net cash provided by (used in) investing activities 66,830,887 (302,066,752) (216,077,117)
-------------- --------------- ----------------
Cash flows from financing activities:
Issuance of voting and non-voting common stock - - 1,000
Proceeds from sale of preferred stock - 19,999,998 35,000,052
Proceeds from sale of Series B convertible preferred stock representing
the conversion of committed but undrawn portion of bridge loan to Series
B convertible preferred stock - - 300,000
Proceeds from bond offering - 350,000,000 350,000,000
Proceeds from bridge loan - - 700,000
Exercise of employee common stock options 7,212 81 7,293
Payment of issuance costs for preferred stock offerings - - (63,780)
Payment of deferred financing costs (40,735) (11,664,523) (11,973,110)
-------------- --------------- ----------------
Net cash provided by (used in) financing activities (33,523) 358,335,556 373,971,455
-------------- --------------- ----------------
Net increase in cash and cash equivalents 41,574,530 51,727,247 98,896,417
Cash and cash equivalents at the beginning of period 57,321,887 7,831,384 -
-------------- --------------- ----------------
Cash and cash equivalents at the end of period $ 98,896,417 $ 59,558,631 $ 98,896,417
============== =============== ================
The accompanying notes are an integral part of these consolidated financial
statements.
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7
PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY
Pathnet, Inc. (Company) is a facilities based wholesale
telecommunications services provider that targets under-served and second and
third tier U.S. markets. Pathnet offers telecommunications service to
inter-exchange carriers, local exchange carriers, internet service providers,
Regional Bell Operating Companies, cellular operators and resellers.
During the third quarter of 1999, Pathnet continued to construct and
deploy digital networks utilizing both wireless and fiber-optic technologies.
Pursuant to its agreement with Worldwide Fiber USA (WFI), the Company began to
construct and market a multi-conduit fiber-optic network between Chicago,
Illinois and Denver, Colorado during the second quarter. In addition, in August
the Company announced it will co-develop a 400 mile fiber network connecting
Grand Junction, Colorado to Albequerque, New Mexico with Tri State Generation
and Transmission Association, Inc. (See note 9 to these Financial Statements).
As of September 30, 1999, the Company had approximately 6,100 route
miles of completed network and approximately 1,400 route miles of network under
construction.
The Company's business is funded primarily through equity investments
by the Company's stockholders and $350.0 million aggregate principal amount of
12 1/4% Senior Notes due 2008 (Senior Notes) which have been registered under
the Securities Act of 1933, as amended.
A substantial portion of the Company's initial activities involved
developing strategic relationships with co-developers such as railroads,
pipelines and utilities and building its network. Accordingly, a large portion
of its revenues to date reflect only certain consulting and advisory services in
connection with the design, development and construction of digital microwave
infrastructure. The remainder of its revenues to date (approximately 47%) has
been derived from the sale of bandwidth along the Company's digital network. The
Company has experienced significant operating and net losses and negative
operating cash flow to date and expects to continue to experience operating and
net losses and negative operating cash flow until such time as it is able to
generate revenue sufficient to cover its operating expenses.
2. BASIS OF PRESENTATION
The Company recently commenced providing telecommunication services
to customers and recognizing the revenue from the sale of such telecommunication
services, its principal activities to date have been securing contractual
alliances with its co-development partners, designing and constructing
networkpaths, obtaining capital and planning its proposed service. Accordingly,
the Company's consolidated financial statements are presented as a development
stage enterprise, as prescribed by Statement of Financial Accounting Standards
No. 7, "Accounting and Reporting by Development Stage Enterprises." As a
development stage enterprise, the Company has been relying on the issuance of
equity and debt securities, rather than recurring revenues, for its primary
sources of cash since inception.
In June 1997, the Financial Accounting Standards Board issued SFAS
No.131, "Disclosures About Segments of an Enterprise and Related
Information"("SFAS No. 131"). SFAS No. 131 changes
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PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
the way public companies report segment information in annual financial
statements and also requires those companies to report selected segment
information in interim financial reports to stockholders. It also establishes
standards for related disclosures about products and services, geographic areas,
and major customers. Management believes the Company's current operations
comprise only one segment, the sale of telecommunications capacity, and as such,
adoption of SFAS No. 131 does not impact the disclosures made in the Company's
financial statements.
In the opinion of management, the accompanying unaudited consolidated
financial statements of the Company and its subsidiaries contain all adjustments
(consisting only of normal recurring accruals) necessary to present fairly the
Company's consolidated financial position as of September 30, 1999, and the
results of operations and cash flows for the periods indicated. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted. These unaudited consolidated financial statements should
be read in conjunction with the financial statements and notes thereto included
in the Company's Annual Report on Form 10-K for the period ended December 31,
1998 filed with the Securities and Exchange Commission. The results of
operations for the three and nine months ended September 30, 1999 are not
necessarily indicative of the operating results to be expected for the full
year.
3. REVENUE RECOGNITION
The Company earns revenue from the sale of telecommunications
capacity and for project management and consulting services. Revenue from the
sale of telecommunications capacity is earned when the service is provided.
Revenue for project management and consulting services is recognized based on
the percentage of the services completed. The Company defers revenue when
contractual payments are received in advance of the performance of services.
Revenue from the sale of telecommunications capacity includes revenue
earned under indefeasible right of use agreements. The Company recognizes
revenue under such agreements on a straight-line basis over their term.
4. LOSS PER SHARE
Basic earnings (loss) per share is computed by dividing net income
(loss) by the weighted average number of shares of Common Stock outstanding
during the applicable period. Diluted earnings (loss) per share is computed by
dividing net income (loss) by the weighted average common and potentially
dilutive common equivalent shares outstanding during the applicable period. For
each of the periods presented, basic and diluted loss per share are the same.
The exercise of 3,119,434 employee Common Stock options, the exercise of
warrants to purchase 1,116,500 shares of Common Stock, and the conversion of
5,470,595 shares of Series A, B and C convertible preferred stock into
15,864,715 shares of Common Stock as of September 30, 1999, which could
potentially dilute basic earnings per share in the future, were not included in
the computation of diluted loss per share for the periods presented because to
do so would have been antidilutive in each case.
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PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
5. MARKETABLE SECURITIES
Certain of the Company's marketable securities are considered
"available for sale," and, as such, are stated at market value. The net
unrealized gains and losses on marketable securities are reported as part of
accumulated other comprehensive income (loss). Realized gains or losses from the
sale of marketable securities are based on the specific identification method.
The following is a summary of the investments in marketable
securities at September 30, 1999:
GROSS UNREALIZED
--------------------------------
COST GAINS LOSSES MARKET VALUE
------------------ ------------- --------------- ------------------
Available for sale securities:
U.S. Treasury securities and debt securities
of U.S. Government agencies $ 28,398,072 $ -- $ 45,760 $ 28,352,312
Corporate debt securities 44,660,067 43,212 33,750 44,669,529
Debt Securities issued by foreign
governments 1,511,237 -- 9,167 1,502,070
------------------ ------------- --------------- ------------------
$ 74,569,376 $ 43,212 $ 88,677 $ 74,523,911
================== ============= =============== ==================
Gross realized gains on sales of available for sale securities were
approximately $0 and $158,000 during the three and nine months ended September
30, 1999 respectively. Gross realized gains and gross realized losses on sales
of available for sale securities were immaterial during the three and nine
months ended September 30, 1998.
The amortized cost and estimated fair value of available for sale
securities by contractual maturity at September 30, 1999 is as follows:
COST MARKET VALUE
----------------- ------------------
Due in one year or less $ 69,428,897 $ 69,420,476
Due after one year through two years 5,140,479 5,103,435
----------------- ------------------
$ 74,569,376 $ 74,523,911
================= ==================
Expected maturities may differ from contractual maturities because
the issuers of the securities may have the right to prepay obligations without
prepayment penalties.
In addition to marketable securities, the Company has investments in
pledged marketable securities that are pledged as collateral for repayment of
interest on the Company's Senior Notes through April 2000 and are classified as
non-current assets on the consolidated balance sheet. As of September 30, 1999,
pledged marketable securities consisted of U.S. Treasury securities classified
as held to maturity with an amortized cost of approximately $20.9 million and
cash and cash equivalents of approximately $21.5 million. All of the investments
contractually mature by March 31, 2000.
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PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
6. PROPERTY AND EQUIPMENT
Property and equipment, stated at cost, is comprised of the following
at September 30, 1999 and December 31, 1998:
SEPTEMBER 30, DECEMBER 31,
1999 1998
---------------- ----------------
Network in progress $ 37,793,073 $ 38,669,088
Communications network 68,974,361 6,890,686
Office and computer equipment 2,053,485 2,267,647
Furniture and fixtures 1,484,068 766,013
Leasehold improvements 301,407 166,733
---------------- ----------------
110,606,394 48,760,167
Less: accumulated depreciation (4,482,544) (788,831)
---------------- ----------------
Property and equipment, net $ 106,123,850 $ 47,971,336
================ ================
Network in progress includes (i) all direct material and labor costs
incurred on the construction of the network together with related allocable
interest costs, necessary to construct components of a high capacity digital
network which is owned and maintained by the Company, and (ii) network related
inventory parts and equipment. The network in progress balance on September 30,
1999 includes approximately $15.2 million for costs incurred under the Company's
agreement with WFI to construct a digital fiber optic network and $2.5 million
for a right of use under a agreement with Northern Border Pipeline for microwave
access. When a portion of the network has been completed and made available for
use by the Company, the accumulated costs are transferred from network in
process to communications network and depreciated over time. As of September 30,
1999, the Company incurred non-cash capital expenditure of approximately $14.0
million.
7. RESTRICTED CASH
Restricted cash comprises amounts held in escrow to secure the
Company's obligations under certain of its Fixed Point Microwave Services
Agreements. The funds in each escrow account are available only to fund the
project to which the escrow is related until such project has been completed, at
which time surplus funds will be returned to the Company. Generally, funds are
released from escrow to pay project costs when such costs are incurred and
agreed upon under the contract. During the three and nine months ended September
30, 1999, approximately $4.0 million and $7.1 million were released from escrow,
respectively.
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11
PATHNET, INC. AND SUBSIDIARIES
(DEVELOPMENT STAGE ENTERPRISES)
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
8. COMMITMENTS AND CONTINGENCIES
As of September 30, 1999, the Company had commitments of up to
approximately $79.9 million relating to purchases of telecommunication and
transmission equipment and its agreement with WFI. (See note 9 to these
Financial Statements).
9. FIBER AGREEMENTS
On March 31, 1999, the Company signed two agreements with WFI to
construct and market a multi-conduit fiber-optic network between Chicago,
Illinois and Denver, Colorado. The total shared projected cost for this project
is in excess of $100 million. The 1,100-mile network between Chicago and Denver
will pass through Des Moines, Iowa; Omaha, Nebraska; and Lincoln, Nebraska. WFI
will lead-manage the project with construction to be completed in two segments.
The first segment, Chicago to Omaha, is expected to be complete in late 1999
with the second segment, Omaha to Denver, scheduled to be completed in the first
quarter of 2000.
On August 6, 1999, the Company announced a co-development agreement
with Tri-State Generation and Transmission Association, Inc. (Tri-State), to
construct a 400-mile fiber network connecting Grand Junction, Colorado to
Albuquerque, New Mexico. The total projected combined cost for this route is
approximately $40 million. Tri-State and some of its member cooperatives will
contribute up to 50% of the network build costs.
10. SUBSEQUENT EVENT
The Company announced on November 9, 1999 that it had entered into
agreements providing for strategic investments from Colonial Pipeline Company,
Burlington Northern and Sante Fe Corporation and CSX Corporation. Upon the
closing of these investments, the Company will receive the right to develop over
12,000 miles of the investors' rights of way holdings in return for preferred
stock. In addition to providing a portion of the right of way access, Colonial
Pipeline will also make a $64 million cash investment in Pathnet equity, $39
million at closing with an additional $25 million due upon completion of the
Omaha to Denver segment. The new investors collectively will receive an
approximate one-third equity stake in Pathnet, as well as proportionate
representation on the Pathnet Board of Directors. As part of this transaction
and the reconstitution of the Pathnet Board, Dave Schaeffer, former Chairman of
Pathnet and an existing director, resigned from the Company's Board of Directors
effective November 4, 1999.
The terms of the strategic investment transaction require that
consents be obtained from the holders of a majority of the Company's existing
Senior Notes. Pathnet is planning the consent process with its legal and
financial advisors, and expects promptly to take the necessary steps to seek the
required consent. The Company will distribute further information concerning the
consents to the holders of its Senior Notes in the near future. Pathnet expects
to close this transaction immediately following receipt of the required consents
and other required regulatory approvals.
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12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Since inception on August 25, 1995, our principal activities have
included:
- Developing and pursuing our business plans;
- developing leading edge products and services;
- entering into strategic relationships with owners of
telecommunications assets and co-development partners;
- raising capital and hiring management and other key personnel;
- negotiating collocation and interconnection agreements and
installing collocations and interconnections off our backbone
network;
- constructing and developing our digital backbone network;
- working on the design and development of our network
architecture and operations support systems, including the
buildout and launch of our 24-hour Network Operations Center;
and
- procuring governmental authorizations.
As of September 30, 1999 we had completed 6,100 route miles of our
digital backbone network and had an additional 1,400 route miles of network
under construction. We began offering wholesale transport services with the
"turn up" of our first route in the first quarter of 1998 and currently offer
wholesale transport services on the operating portion of our digital network.
In addition to wholesale transport services and backbone services including the
sale of dark fiber and conduit, we intend to deploy our other services
including local access services, virtual points of presence, virtual backbone,
DSL-based services and other services in our target second and third tier
markets during 2000.
Pathnet entered into two agreements with Worldwide Fiber USA
(formerly known as Pacific Fiber Link, LLC) ("WFI") in March 1999 to construct
and market a multi-conduit fiber-optic network between Chicago, Illinois and
Denver, Colorado. The 1,100-mile network will pass through Des Moines, Iowa;
Omaha, Nebraska; and Lincoln, Nebraska.
On August 6, 1999, we entered into a co-development agreement with
Tri-State Generation and Transmission Association, Inc. ("Tri-State"), to
construct a 400-mile fiber network connecting Grand Junction, Colorado to
Albuquerque, New Mexico. The total projected combined cost for this route is
approximately $40 million. Pursuant to this agreement, Tri-State and some of its
member cooperatives will contribute up to 50% of the network build costs.
In addition, we announced on November 9, 1999 that we had entered
into agreements providing for strategic investments from Colonial Pipeline
Company, Burlington Northern and Sante Fe Corporation and CSX Corporation. Upon
the closing of these investments, the Company will receive the right to develop
over 12,000 miles of the investors' rights of way holdings. In addition to
providing a portion of the right of way access, Colonial Pipeline will also make
a $64 million cash investment in equity, $39 million at closing with an
additional $25 million due upon completion of the Omaha to Denver segment. The
new investors collectively will receive an approximate one-third equity stake,
as well as proportionate representation on the Board of Directors. The terms of
the strategic investment
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transaction require that consents be obtained from the holders of a majority of
our existing Senior Notes. We expect to close this transaction immediately
following receipt of the required consents and other required regulatory
approvals, although there can be no assurance that we will be able to obtain
these consents and approvals or that this transaction will close on the terms
described above, or at all.
As a result of our development activities, we have experienced
operating losses. We expect to experience continuing operating losses as we
expand our operations and the continued prosecution of our business plan will
require significant capital expenditures. See "--- Liquidity and Capital
Resources."
Financial performance will vary from market to market, and the time
when we will achieve positive EBITDA, if at all, will depend on factors such as:
- the size of the addressable market;
- timely completion of backbone routes, collocations and
interconnections;
- the cost of the necessary infrastructure;
- the timing of market entry; and
- the commercial acceptance of our products and services.
SOURCES OF REVENUE
Backbone Services. We use a "smart build" strategy to identify high
demand routes and develop the fiber portion of our network. Our strategy allows
multiple participants to purchase, obtain indefeasible rights of use or lease
fiber or conduit along a segment of our network at a fixed price. Our dark fiber
and conduit sale business is becoming increasingly competitive as other carriers
build and expand their networks. To expedite route development or decrease
development risk, we have and in the future will continue to seek co-developers,
to share the project construction costs. We have sought and in the future may
also enter into co-marketing arrangements with our co-developers to facilitate
selling the assets along the build.
Management Services. To date we have primarily generated revenues
from services related to the construction of our digital network. We will
continue to construct our digital networks with co-development partners and for
third parties on a contract basis when these networks will allow us to retain
bandwidth, fiber or conduit assets on routes that complement and reduce the
costs of completing our network. We anticipate that, as we proceed with the
development of our network, the percentage of revenues which we receive from the
construction services will decline as we near the completion of our network.
Carrier Services. We provide inter-city and local wholesale transport
services and local access services to our customers on a long-term, individual
circuit, or month-to-month basis. We intend to bundle our wholesale transport
services with local access services to provide low cost, value added, end-to-end
solutions for our customers. Our service agreements with customers are generally
leases of capacity which provide for monthly payments due in advance on a
fixed-rate basis. Contracts are priced according to the capacity, the length of
the circuit used, the term of the contract and the extent of value added
services provided. Nonrecurring revenues include installation and activation
charges for new
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customers. We seek to price our services competitively in relation to those of
the Incumbent Local Exchange Carriers ("ILECs") and other competitive
telecommunications companies in our targeted underserved and second and third
tier markets.
Although pricing will be an important part of our strategy, we
believe that customer relationships, customer care and consistent quality will
be the key to generating customer loyalty. During the past several years, market
prices for many telecommunications services have been declining, which is a
trend that we believe will likely continue. As prices decline for any given
service, we expect that the total number of customers and the proportion of our
customers purchasing our convergent, total solution value added services will
increase.
OPERATING EXPENSES.
Cost of Revenue. The largest components of our cost of revenue to
date have been costs in connection with network engineering, operations and
maintenance. With our expected growth of our telecommunications services, we
expect components such as access costs (including loop fees, rent, power and
other fees charge by ILECs, competitive telecommunications companies and other
providers), and costs associated to the provision of services to comprise a
greater portion of our cost of service.
Selling, Operations and Administration. Our selling, marketing,
general and administrative expenses primarily consist of costs related to
selling, marketing, customer care, billing, regulatory and corporate
administration. Additionally, we incur other costs associated with
administrative overhead and office leases. We expect that our selling,
marketing, general and administrative costs will grow significantly as we expand
our operations and that administrative overhead will be a large portion of these
expenses. However, we expect these expenses to decline as a percentage of our
revenue as we build our customer base and the number of customers connected to
our networks increases.
Depreciation and Amortization. Because we are primarily a
facilities-based wholesale provider, depreciation of property, plant and
equipment will be a significant ongoing expense for us. We expect depreciation
and amortization expense to increase significantly as more of our network
becomes operational and as we increase capital expenditures to expand our
network. Depreciation and amortization expense will include:
- depreciation of network infrastructure equipment;
- depreciation of improvements to central offices and other
collocations and the related equipment;
- amortization of rights of way;
- depreciation of network control center facilities, furniture,
fixtures and corporate facilities;
- and amortization of software.
RESULTS OF OPERATIONS
During the three months ended September 30, 1999, we continued to
focus on (i) developing relationships and strategic alliances with owners of
valuable telecommunications assets such as rights of way and with co-development
partners, (ii) the buildout of our network, (iii) obtaining the regulatory
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status and entering into interconnection agreements in each of our target
markets so that we can obtain unbundled network elements and central office
space from the ILECs and (iv) the development of our infrastructure including
the hiring of key management personnel.
REVENUE
For the three months ended September 30, 1999 and 1998, we generated
revenues of approximately $584,000 and $475,000, respectively. For the three
months ended September 30, 1999, we generated revenue from the sale of
telecommunications services of approximately $584,000. For the three months
ended September 30, 1998, our revenue consisted primarily of revenue from
consulting and advisory services. For the nine months ended September 30, 1999
and 1998, we generated revenue of approximately $2.3 million and $1.1 million,
respectively. This increase is attributable to revenues from telecommunications
services, which were $1.7 million in 1999 with no corresponding revenue in 1998.
We expect that the majority of future revenue will be generated from the sale of
wholesale transport services and backbone services.
Operating Expenses
For the three months ended September 30, 1999 and 1998, we incurred
operating expenses of approximately $9.6 million and $4.5 million, respectively.
For the nine months ended September 30, 1999 and 1998, we incurred operating
expenses of approximately $22.8 million and $12.4 million, respectively. The
increase in both periods is primarily a result of the continued activity in the
buildout of our network and additional staff costs incurred as part the
development of our infrastructure. Included in operating expenses for the three
months ended September 30, 1999 is a one time provision of approximately $1.9
million related to the sale of radios on one of our wireless backbone routes. We
expect selling, general and administrative expenses to continue to increase in
the remainder of 1999 as additional staff is added. Cost of revenue reflects
direct costs associated with performance of project management and consulting
services and costs incurred in connection with the provision of
telecommunications services.
Interest Expense
Interest expense for the three months ended September 30, 1999 and
1998 was approximately $10.0 million and $11.2 million, respectively. Interest
expense for the nine months ended September 30, 1999 and 1998 was approximately
$30.3 million and $21.9 million, respectively. Interest expense primarily
represents interest on the Senior Notes together with the amortization expense
related to the deferred financing costs of the Senior Notes.
Interest Income
Interest income for the three months ended September 30, 1999 and
1998 was approximately $3.3 million and $4.7 million, respectively. The decrease
in interest income reflects a decrease in cash, cash equivalents and marketable
securities as those funds were used in building our network and funding
operations, and a decrease in pledged marketable securities used in making the
interest payments on the Senior Notes. Interest income for the nine months ended
September 30, 1999 and 1998 was
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approximately $10.5 million and $9.6 million, respectively. The increase in
interest income is a result of the funds from the Notes generating income over a
nine month period versus a six month period in 1998.
CAPITAL EXPENDITURES
Our operations have required significant capital investment for the
construction and deployment of our digital network. We intend to continue to
expand our network and to add local access services and virtual services to our
existing products such as dark fiber and conduit sales and inter-city and local
wholesale transport services. This will require us to fund our initial operating
losses and we will require significant capital to:
- continue construction and development of our nationwide network
infrastructure;
- install electronics and transmission equipment along the
network;
- procure, design and construct central office and other
collocation sites;
- purchase equipment and other components needed for
interconnection of our network;
- purchase and install electronic and other equipment needed to
establish our products and services platform;
- and continue development of our corporate infrastructure.
Capital expenditures were approximately $24.3 million and $61.8
million for the three and nine months ended September 30, 1999, respectively. We
expect that our capital expenditures will be substantially higher in future
periods in connection with the expansion of our network and our services in our
target markets.
As of September 30, 1999, we had capital commitments of approximately
$79.9 million relating to telecommunications and transmission equipment and our
agreements with our co-development partners.
LIQUIDITY AND CAPITAL RESOURCES
From inception through September 30, 1999 we financed our operations
primarily through private placements of $36.0 million of equity securities and
$339.5 million of net proceeds raised from the issuance of the Senior Notes in
April 1998. As of September 30, 1999, we had approximately $173.4 million of
cash, cash equivalents and marketable securities to fund future operations.
Pursuant to the recently announced transaction with Burlington
Northern Sante Fe Railway Company, CSX Transportation, Inc. and Colonial
Pipeline, Colonial Pipeline will be contributing $64.0 million in cash to us
bringing our total cash equity investment to $100.0 million.
In addition, we may elect to finance the cost on certain of our
equipment through vendor financing arrangements. In this regard, pursuant to a
Commitment Letter between Lucent Technologies, Inc. ("Lucent") and us that we
executed in connection with the fiber supply agreement between Lucent and the
Company (the "Commitment Letter"), Lucent may provide financing for fiber
purchases for the
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construction of our network and may provide or arrange financing for future
phases of such network. We have been reviewing with Lucent certain material
terms of our agreements, including the terms of the Commitment Letter. There can
be no assurance that the transactions, including the financing contemplated by
Commitment Letter, will be consummated at all or consummated on the terms
described above. In addition, we may require additional capital in the future to
fund operating deficits and net losses and for potential strategic alliances,
joint ventures and acquisitions.
We estimate that our current available resources will be sufficient
to fund the implementation of our business plan, as currently contemplated,
including the capital commitments described above, operating losses in new
markets and working capital needs into the first quarter of 2001. In the event
the strategic investment from Colonial Pipeline is not consummated or is
consummated on different terms, this projection regarding available resources
may change.
After such time, we expect to be required to procure additional
financing which may include commercial bank borrowings, additional vendor
financing or the sale or issuance of equity or debt securities.
Our expectations of our future capital requirements and cash flows
from operations are based on current estimates. If our plans or assumptions
change or prove to be inaccurate we may be required to seek additional sources
of capital or seek additional capital sooner than anticipated.
YEAR 2000
The Year 2000 issue exists because many computer systems and software
applications use two digits rather than four digits to designate an applicable
year. As a result, the systems and applications may not properly recognize the
Year 2000, or process data that includes that date, potentially causing data
miscalculations or inaccuracies or operational malfunctions or failures.
In the fourth quarter of 1998, we began a corporate-wide program to
ready our technology systems and non-technology systems and software
applications for the Year 2000. Our objective is to target Year 2000 compliance
for all of our systems, including network and customer interfacing systems, and
we have grouped these systems into one of six compliance areas: Network
Architecture, Internal Infrastructure, Software Applications, Financial
Relationships, Supply-Chain Relationships and Customer Relationships. Because we
have operated for only a few years, few legacy systems or applications exist. We
identified all systems and applications that needed to be modified or
reprogrammed in order to achieve Year 2000 compliance and implemented the
necessary changes.
Inventory, assessment and remediation of mission critical hardware
systems and software applications, including network computing and network
systems engineering, is substantially complete. We completed our testing and
deployment of upgrades necessary to complete the remediation of mission-critical
systems on September 30, 1999. We are currently formulating contingency plans in
the event that certain of our suppliers or service providers may not be Year
2000 compliant. We will continue to developed and test these plans throughout
the remainder of 1999.
As part of our Year 2000 plan, we have requested confirmation from
our communications equipment vendors and other key suppliers, financial
institutions and customers that their systems will
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be Year 2000 compliant. Responses received to date indicate a high level of Year
2000 compliance at these companies, however, there can be no assurance that the
systems of companies with which we do business will be Year 2000 compliant. We
expect to continue to receive additional responses in the next quarter. If the
vendors important to us fail to provide needed products and services, our
network build-out and operations could be affected and thereby have a material
adverse effect on our results of operations, liquidity and financial condition.
Moreover, to the extent that significant customers are not Year 2000 compliant
and that affects their network needs, our sales could be lower than otherwise
anticipated.
We have hired outside consultants to assist us with its Year 2000
compliance, however, we have relied primarily on our existing employees to
develop and implement our Year 2000 compliance strategy. And because its
existing systems are relatively new, we have not had to replace any significant
portion of its of our systems. As a result, our expenditures to implement its
Year 2000 plan have not been material to date and it does not believe its future
expenditures on this matter will be material (remediation costs incurred to date
have been less than $100,000). Such expenditures represent less than 1% of 1999
projected capital expenditures and will be funded out of cash flow from
operations. To the extent we would have had to replace a significant portion of
its technology systems, our expenditures could have material adverse effect on
us. As a result, our expenditures to ensure Year 2000 compliance have not been
material to date. We expect to continue to use existing employees for the
significant part of our Year 2000 compliance efforts.
The discussion of our efforts and management's expectations, relating
to year 2000 compliance are forward-looking statements and the dates on which we
believe it will complete such efforts are based upon management's best
estimates. These estimates were derived using numerous assumptions regarding
future events, including the continued availability of certain resources and
other factors. We cannot assure you that these estimates will prove to be
accurate, and our actual results could differ materially from those currently
anticipated. Specific factors that could cause such material differences
include, but are not limited to, the availability and cost of personnel trained
in year 2000 issues, the ability to identify, assess, remediate and test all
relevant computer codes and embedded technology and similar uncertainties. In
addition, variability of definitions of "compliance with year 2000" relating to
products and services sold by us may lead to claims whose impact on us is
currently not estimable. We cannot assure you that the aggregate cost of
defending and resolving such claims, if any, will not materially adversely
affect our results of operations.
FORWARD-LOOKING STATEMENTS
Certain statements in this Report, in future filings by the Company
with the Securities and Exchange Commission, in the Company's press releases and
in oral statements made by or with the approval of an authorized executive
officer of the Company constitute forward-looking statements, including
statements which can be identified by the use of forward-looking terminology
such as "believes," "anticipates," "expects," "may," "will," or "should" or the
negative of such terminology or other variations on such terminology or
comparable terminology, or by discussions of strategies that involve risks and
uncertainties. All statements other than statements of historical fact in this
Report, including, without limitation, such statements under the caption
"Management's Discussion and Analysis
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of Financial Condition and Results of Operations," regarding the Company or any
of the transactions described in this Report or the timing, financing,
strategies and effects of such transaction, are forward-looking statements.
Although the Company believes that the expectations reflected in such
forward-looking statements are reasonable, it can give no assurance that such
expectations will prove to be correct. Important factors that could cause actual
results to differ materially from expectations include, without limitation,
those described in conjunction with the forward-looking statements in this
Report, as well as the amount of capital needed to deploy the Company's network;
the Company's substantial leverage and its need to service its indebtedness; the
restrictions imposed by the Company's current and possible future financing
arrangements; the ability of the Company to successfully manage the
cost-effective and timely completion of its network and its ability to attract
and retain customers for its products and services; the ability of the Company
to implement its newly expanded business plan; the ability of the Company to
retain and attract relationships with the incumbent owners of the
telecommunications assets with which the Company expects to build its network;
the ability of the Company to obtain and maintain rights-of-way for the
deployment of its network; the Company's ability to retain and attract key
management and other personnel as well as the Company's ability to manage the
rapid expansion of its business and operations; the Company's ability to compete
in the highly competitive telecommunications industry in terms of price,
service, reliability and technology; the Company's dependence on the reliability
of its network equipment, its reliance on key suppliers of network equipment and
the risk that its technology will become obsolete or otherwise not economically
viable; and the Company's ability to conduct its business in a regulated
environment. The Company does not intend to update these forward-looking
statements. These and other risks and uncertainties affecting the Company are
discussed in greater detail in the Company's 1998 Annual Report on Form 10-K and
its Interim Reports on Form 10-Q.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to minimal market risks. We manage sensitivity of our
results of operations to these risks by maintaining a conservative investment
portfolio, which primarily consists of debt securities, typically maturing
within one year, and entering into long-term debt obligations with appropriate
pricing and terms. We do not hold or issue derivative, derivative commodity or
other financial instruments for trading purposes. Financial instruments held for
other than trading purposes do not impose a material market risk on us.
We are exposed to interest rate risk, as additional debt financing is
periodically needed due to the large operating losses and capital expenditures
associated with establishing and expanding our network coverage. The interest
rate that we will be able to obtain on debt financing will depend on market
conditions at that time, and may differ from the rates we have secured on our
current debt.
While all of our long-term debt bears fixed interest rates, the fair
market value of our fixed rate long-term debt is sensitive to changes in
interest rates. We have no cash flow or earnings exposure due to market interest
rate changes for our fixed long-term debt obligations.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The Company announced on November 9, 1999 that it had entered into
agreements providing for strategic investments from Colonial Pipeline Company,
Burlington Northern and Sante Fe Corporation and CSX Corporation. In connection
with this contemplated investment, the Company has entered into agreements with
all of its stockholders providing for the exchange of their shares in the
Company for shares of Pathnet Telecommunications, Inc., a Delaware corporation.
The closing of both the new investment and the share exchange transaction are
subject to certain conditions, including a requirement that the Company obtain
consents from the holders of the Senior Notes. Following the closing of the
investment contribution and share exchange transaction, the Company will become
the wholly-owned subsidiary of Pathnet Telecommunications, Inc. In connection
with the closing of this investment contribution and share exchange this
transaction, the Company expects that Pathnet Telecommunications, Inc. will
elect to convert the shares of the Company's Series A Convertible Preferred
Stock, Series B Convertible Preferred Stock, and Series C Convertible Preferred
Stock received in the exchange transaction into shares of the Company's common
stock, in accordance with the Company's certificate of incorporation.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit Index
(b) REPORTS ON FORM 8-K
None
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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.
PATHNET, INC.,
a Delaware corporation
(Registrant)
Date: November 15, 1999 By: /S/ Richard A. Jalkut
--------------------------------
Richard A. Jalkut
President and Chief Executive Officer
Date: November 15, 1999 By: /S/ James M. Craig
--------------------------------
James M. Craig
Executive Vice-President, Chief
Financial Officer (Principal Accounting
& Financial Officer)
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EXHIBIT INDEX
Pursuant to Item 601 of Regulation S-K
EXHIBIT NO. DESCRIPTION OF EXHIBIT
----------- ----------------------
10.1 Contribution Agreement by and among the Company, Pathnet
Telecommunications, Inc. and The Burlington Northern Sante Fe
Railway, dated November 4, 1999.
10.2 Contribution Agreement by and among the Company, Pathnet
Telecommunications, Inc. and Colonial Pipeline Company, dated
November 4, 1999.
10.3 Contribution Agreement by and among the Company, Pathnet
Telecommunications, Inc. and CSX Transportation, Inc., dated
November 4, 1999.
10.4 Contribution Agreement by and among the Company, Pathnet
Telecommunications, Inc. and The Preferred Stockholders of the
Company, dated November 4, 1999.
10.5 Contribution Agreement by and among the Company, Pathnet
Telecommunications, Inc. and the Common Stockholders of the
Company, dated November 4, 1999.
10.6 Contribution Agreement by and among the Company, Pathnet
Telecommunications, Inc. and David Schaeffer.
10.7* Dark Fiber Agreement between the Company and Tri-State Generator and
Transmission Association, Inc., Empire Electric Association, Inc., La Plata
Electric Association, Inc., Delta-Montrose Electric Association,
Inc., and San Miguel Power Association, Inc., dated August 5, 1999.
27.1 Financial Data Schedule for the nine months ended September 30, 1999.
99.1 Press release dated November 9, 1999 announcing the Company's results
for the third quarter of 1999.
* Certain portions of this exhibit have been omitted based on a request for
confidential treatment filed separately with the Securities and Exchange
Commission