1 - ------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1998 -------------- 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 number: 0-11258 ------------------------------- WORLDCOM, INC. (Exact name of registrant as specified in its charter) ------------------------------- Georgia 58-1521612 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 515 East Amite Street, Jackson, Mississippi 39201-2702 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code : (601) 360-8600 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 outstanding shares of the registrant's Common Stock, par value $.01 per share, was 1,032,087,418 on April 30, 1998. - ------------------------------------------------------------------------------- 2 QUARTERLY REPORT ON FORM 10-Q TABLE OF CONTENTS Page Number ------ PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets as of March 31, 1998 and December 31, 1997................................. 3 Consolidated Statements of Operations for the three months ended March 31, 1998 and March 31, 1997................................................... 4 Consolidated Statements of Cash Flows for the three months ended March 31, 1998 and March 31, 1997....................................................... 5 Notes to Consolidated Financial Statements........................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................ 12 Item 3. Quantitative and Qualitative Disclosure About Market Risk ........... 20 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 Securities Holders................................................ 20 Item 5. Other Information.................................................... 20 Item 6. Exhibits and Reports on Form 8-K..................................... 21 Signature ..................................................................... 22 Exhibit Index ..................................................................... 23 Page 2 3 PART I. FINANCIAL INFORMATION Item 1. Financial Statements. WORLDCOM, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In Thousands of Dollars, Except Per Share Data) March 31, December 31, 1998 1997 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 93,119 $ 154,591 Marketable securities 746 53,516 Accounts receivable, net of allowance for bad debts of $222,862 in 1998 and $203,076 in 1997 1,614,489 1,240,731 Income taxes receivable 15,928 5,422 Other current assets 458,556 419,727 ------------ ------------ Total current assets 2,182,838 1,873,987 ------------ ------------ Property and equipment: Transmission equipment 4,998,451 4,156,319 Communications equipment 2,618,912 2,493,363 Furniture, fixtures and other 1,124,451 919,687 ------------ ------------ 8,741,814 7,569,369 Less - accumulated depreciation (1,010,087) (855,168) ------------ ------------ 7,731,727 6,714,201 ------------ ------------ Goodwill and other intangible assets 14,718,248 13,881,505 Deferred tax asset 452,222 404,864 Other assets 830,342 721,229 ------------ ------------ $ 25,915,377 $ 23,595,786 ============ ============ LIABILITIES AND SHAREHOLDERS' INVESTMENT Current liabilities: Short-term debt and current maturities of long-term debt $ 6,318 $ 10,779 Accounts payable 413,553 470,389 Accrued line costs 925,656 867,588 Accrued interest 133,738 119,262 Deferred tax liability 45,254 59,442 Other current liabilities 785,551 546,175 ------------ ------------ Total current liabilities 2,310,070 2,073,635 ------------ ------------ Long-term liabilities, less current portion: Long-term debt 8,331,536 7,413,333 Other liabilities 451,312 307,906 ------------ ------------ Total long-term liabilities 8,782,848 7,721,239 ------------ ------------ Commitments and contingencies Shareholders' investment: Series A preferred stock, par value $.01 per share; authorized, issued and outstanding: 94,992 shares in 1998 and 1997 (variable liquidation preference) 1 1 Series B preferred stock, par value $.01 per share; authorized, issued and outstanding: 12,237,025 shares in 1998 and 12,421,858 shares in 1997 (liquidation preference of $1.00 per share plus unpaid dividends) 122 124 Preferred stock, par value $.01 per share; authorized: 34,905,008 shares in 1998 and 1997; none issued -- -- Common stock, par value $.01 per share; authorized: 2,500,000,000 shares; issued and outstanding: 1,028,976,222 shares in 1998 and 981,615,661 shares in 1997 10,290 9,816 Additional paid-in capital 16,950,898 15,530,551 Unrealized holding gain on marketable equity securities 50,328 33,883 Retained earnings (deficit) (2,189,180) (1,773,463) ------------ ------------ Total shareholders' investment 14,822,459 13,800,912 ------------ ------------ $ 25,915,377 $ 23,595,786 ============ ============ The accompanying notes are an integral part of these statements Page 3 4 WORLDCOM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands, Except Per Share Data) For the Three Months Ended March 31, ------------------------------------ 1998 1997 --------------- --------------- Revenues $ 2,349,967 $ 1,696,794 ----------- ----------- Operating expenses: Line costs 1,146,949 921,477 Selling, general and administrative 478,131 388,199 Depreciation and amortization 298,580 231,639 Brooks Fiber merger costs 69,490 -- Charge for in-process research and development 429,000 -- ----------- ----------- Total 2,422,150 1,541,315 ----------- ----------- Operating income (loss) (72,183) 155,479 Other income (expense): Interest expense (102,248) (90,160) Miscellaneous 12,247 13,481 ----------- ----------- Income (loss) before income taxes and extraordinary item (162,184) 78,800 Provision for income taxes 118,200 53,802 ----------- ----------- Net income (loss) before extraordinary item (280,384) 24,998 Extraordinary item (net of income taxes of $77,568 in 1998) (128,731) -- ----------- ----------- Net income (loss) (409,115) 24,998 Preferred dividend requirement 6,602 6,610 ----------- ----------- Net income (loss) applicable to common shareholders $ (415,717) $ 18,388 =========== =========== Earnings (loss) per common share - Net income (loss) applicable to common shareholders before extraordinary item: Basic $ (0.28) $ 0.02 =========== =========== Diluted $ (0.28) $ 0.02 =========== =========== Extraordinary item $ (0.13) $ -- =========== =========== Net income (loss): Basic $ (0.41) $ 0.02 =========== =========== Diluted $ (0.41) $ 0.02 =========== =========== The accompanying notes are an integral part of these statements. Page 4 5 WORLDCOM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands) For the Three Months Ended March 31, ------------------------------------ 1998 1997 -------------- ---------------- Cash flows from operating activities: Net income (loss) $ (409,115) $ 24,998 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Extraordinary item 128,731 -- Brooks Fiber merger costs 69,490 -- Charge for in-process research and development 429,000 -- Depreciation and amortization 298,580 231,639 Provision for losses on accounts receivable 24,200 24,965 Provision for deferred income taxes 117,571 43,845 Accreted interest on debt 15,462 42,237 Change in assets and liabilities, net of effect of business combinations: Accounts receivable (316,484) (140,679) Income taxes, net (10,506) 3,848 Other current assets (6,913) (30,781) Accrued line costs 22,371 4,225 Accounts payable and other current liabilities (87,428) (22,036) Other (944) 1,798 ----------- ----------- Net cash provided by operating activities 274,015 184,059 ----------- ----------- Cash flows from investing activities: Capital expenditures (961,526) (575,274) Sale of short-term investments, net 52,770 729,693 Acquisitions and related costs (40,237) (290,477) Increase in intangible assets (43,855) (28,000) Proceeds from disposition of long-term assets 55,746 8,103 Increase in other assets (196,385) (65,100) Decrease in other liabilities (31,724) (25,959) ----------- ----------- Net cash used in investing activities (1,165,211) (247,014) ----------- ----------- Cash flows from financing activities: Borrowings 916,930 -- Principal payments on debt (200,291) (217,749) Common stock issuance 119,687 59,936 Dividends paid on preferred stock (6,602) (6,610) Other -- 3,286 ----------- ----------- Net cash provided by (used in) financing activities 829,724 (161,137) ----------- ----------- Net decrease in cash and cash equivalents (61,472) (224,092) Cash and cash equivalents at beginning of period 154,591 484,609 ----------- ----------- Cash and cash equivalents at end of period $ 93,119 $ 260,517 =========== =========== The accompanying notes are an integral part of these statements. Page 5 6 WORLDCOM, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (A) GENERAL The financial statements of WorldCom, Inc. (the "Company" or "WorldCom") included herein, are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial reporting and Securities and Exchange Commission ("SEC") regulations. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the financial statements reflect all adjustments (of a normal and recurring nature) which are necessary to present fairly the financial position, results of operations and cash flows for the interim periods. These financial statements should be read in conjunction with the Annual Report of the Company on Form 10-K for the year ended December 31, 1997. The results for the three month period ended March 31, 1998, are not necessarily indicative of the results that may be expected for the year ending December 31, 1998. (B) BUSINESS COMBINATIONS On January 31, 1998, WorldCom acquired CompuServe Corporation, a Delaware corporation ("CompuServe"), pursuant to the merger (the "CompuServe Merger") of a wholly owned subsidiary of WorldCom with and into CompuServe. Upon consummation of the CompuServe Merger, CompuServe became a wholly owned subsidiary of WorldCom. As a result of the CompuServe Merger, each share of CompuServe common stock was converted into the right to receive 0.40625 shares of WorldCom common stock, par value $.01 per share (the "Common Stock") or approximately 37.6 million WorldCom common shares in the aggregate. Prior to the CompuServe Merger, CompuServe operated primarily through two divisions: Interactive Services and Network Services. Interactive Services offered worldwide online and Internet access services for consumers, while Network Services provided worldwide network access, management and applications, and Internet service to businesses. The CompuServe Merger was accounted for as a purchase; accordingly, operating results for CompuServe have been included from the date of acquisition. On January 31, 1998, WorldCom also acquired ANS Communications, Inc., a Delaware corporation ("ANS"), from America Online, Inc. ("AOL") and has entered into five year contracts with AOL under which WorldCom and its subsidiaries will provide network services to AOL (collectively, the "AOL Transaction"). As part of the AOL Transaction, AOL acquired CompuServe's Interactive Services division and received a $175 million cash payment from WorldCom. WorldCom retained the CompuServe Network Services ("CNS") division. ANS provides Internet access to AOL and AOL's subscribers in the United States, Canada, the United Kingdom, Sweden and Japan, and also designs, develops and operates high performance wide-area networks for business, research, education and governmental organizations. The AOL Transaction was accounted for as a purchase; accordingly, operating results for ANS have been included from the date of acquisition. On January 29, 1998, WorldCom acquired Brooks Fiber Properties, Inc., a Delaware corporation ("BFP"), pursuant to the merger (the "BFP Merger") of a wholly owned subsidiary of WorldCom, with and into BFP. Upon consummation of the BFP Merger, BFP became a wholly owned subsidiary of WorldCom. BFP is a leading facilities-based provider of competitive local telecommunications services, commonly referred to as a competitive local exchange carrier in selected cities within the United States. BFP acquires and constructs its own state-of-the-art fiber optic networks and facilities and leases network capacity from others to provide long distance carriers ("IXCs") Internet Service Providers ("ISPs"), wireless carriers and business, government and institutional end users with an alternative to the incumbent local exchange carriers ("ILECs") for a broad array of high quality voice, data, video transport and other telecommunications services. Page 6 7 As a result of the BFP Merger, each share of BFP common stock was converted into the right to receive 1.85 shares of Common Stock or approximately 72.6 million WorldCom common shares in the aggregate. The BFP Merger was accounted for as a pooling-of-interests and, accordingly, the Company's financial statements for periods prior to the BFP Merger have been restated to include the results of BFP for all periods presented. Separate and combined unaudited results of operations for the three months ended March 31, 1997 are as follows (in thousands, except per share data): For the Three Months Ended March 31, 1997 -------------------- Revenues: BFP $ 20,550 WorldCom 1,677,239 Intercompany elimination (995) ----------- Combined $ 1,696,794 =========== Net income (loss) before extraordinary items: BFP $ (24,666) WorldCom 49,664 ----------- Combined $ 24,998 =========== Combined earnings per share: Basic $ 0.02 =========== Diluted $ 0.02 =========== On November 9, 1997, WorldCom entered into an Agreement and Plan of Merger (the "MCI/WorldCom Merger Agreement") with MCI Communications Corporation ("MCI") and a wholly owned acquisition subsidiary of WorldCom ("MCI Merger Sub"), providing for the merger (the "MCI/WorldCom Merger") of MCI with and into MCI Merger Sub, with MCI Merger Sub surviving as a wholly owned subsidiary of WorldCom. As a result of the MCI/WorldCom Merger, the separate corporate existence of MCI will cease, and MCI Merger Sub (which will be renamed "MCI Communications Corporation") will succeed to all the rights and be responsible for all the obligations of MCI in accordance with the Delaware General Corporation Law. Subject to the terms and conditions of the MCI/WorldCom Merger Agreement, each share of MCI common stock, par value $0.10 per share ("MCI Common Stock"), outstanding immediately prior to the effective time of the MCI/WorldCom Merger (the "MCI/WorldCom Effective Time") will be converted into the right to receive that number of shares of Common Stock equal to the MCI Exchange Ratio (as defined below), and each share of MCI Class A common stock, par value $.10 per share ("MCI Class A Common Stock"), outstanding immediately prior to the MCI/WorldCom Effective Time will be converted into the right to receive $51.00 in cash, without interest thereon. The "MCI Exchange Ratio" means the quotient (rounded to the nearest 1/10,000) determined by dividing $51.00 by the average of the high and low sales prices of Common Stock (the "MCI/WorldCom Average Price") as reported on The Nasdaq National Market on each of the 20 consecutive trading days ending with the third trading day immediately preceding the MCI/WorldCom Effective Time; provided, however, that the MCI Exchange Ratio will not be less than 1.2439 or greater than 1.7586. Cash will be paid in lieu of the issuance of any fractional share of WorldCom Common Stock in the MCI/WorldCom Merger. Based on the number of shares of MCI Common Stock outstanding as of January 20, 1998 and assumed MCI Exchange Ratios of 1.2439 and 1.7586, approximately 710,554,160 shares and 1,004,566,722 shares, respectively, of Common Stock would be issued in the MCI/WorldCom Merger. In addition, as of December 31, 1997, outstanding options to purchase shares of MCI Common Stock would be converted in the MCI/WorldCom Merger to options to acquire an aggregate of approximately 86,491,688 shares and 122,280,154 shares, respectively, of Common Stock, and the exercise price would be adjusted to reflect the MCI Exchange Ratio, so that, on exercise, the holders would receive, in the aggregate, the same number of shares of Common Stock as they would have received had they exercised prior to the MCI/WorldCom Merger, at the same exercise price. The MCI/WorldCom Merger was approved by the MCI stockholders and the WorldCom shareholders at separate meetings held on March 11, 1998. The MCI/WorldCom Merger is also subject to approvals from the Federal Page 7 8 Communications Commission ("FCC"), the Department of Justice ("DOJ") and various state government bodies. In addition, the MCI/WorldCom Merger is subject to approval by the Commission of the European Communities (the "European Commission"). WorldCom anticipates that the MCI/WorldCom Merger will close mid-year 1998. Termination of the MCI/WorldCom Merger Agreement by MCI or WorldCom under certain conditions will require MCI to pay WorldCom $750 million as a termination fee and to reimburse WorldCom the $450 million alternative transaction fee and certain related expenses paid by WorldCom to British Telecommunications plc ("BT"). Further, termination of the MCI/WorldCom Merger Agreement by MCI or WorldCom under certain conditions, will require WorldCom to pay MCI $1.635 billion as a termination fee. Pursuant to an agreement (the "BT Agreement") among MCI, WorldCom and BT, the prior merger agreement between BT and MCI (the "BT/MCI Merger Agreement") was terminated, and WorldCom agreed to pay BT an alternative transaction fee of $450 million and expenses of $15 million payable to BT in accordance with the BT/MCI Merger Agreement. These fees were paid on November 12, 1997. WorldCom also agreed to pay to BT an additional payment of $250 million in the event that WorldCom is required to make the $1.635 billion payment to MCI in accordance with the MCI/WorldCom Merger Agreement. In addition, pursuant to the BT Agreement, BT voted (or caused to be voted) its shares of MCI Class A Common Stock in favor of the MCI/WorldCom Merger Agreement and the approval of the other transactions contemplated by the MCI/WorldCom Merger Agreement. (C) EARNINGS PER SHARE Earnings per share are calculated in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128 "Earnings Per Share." The following is a reconciliation of the numerators and the denominators of the basic and diluted per share computations (in thousands, except per share data): For the Three Months Ended March 31, ---------------------------- 1998 1997 ----------- ----------- Basic Net income (loss) before extraordinary items $ (280,384) $ 24,998 Preferred stock dividends 6,602 6,610 ----------- ----------- Net income (loss) applicable to common shareholders before extraordinary items $ (286,986) $ 18,388 =========== =========== Weighted average shares outstanding 1,011,662 947,761 =========== =========== Basic earnings (loss) per share before extraordinary items $ (0.28) $ 0.02 =========== =========== Diluted Net income (loss) applicable to common shareholders before extraordinary items $ (286,986) $ 18,388 Add back: Preferred stock dividends -- 6,610 ----------- ----------- Net income (loss) applicable to common shareholders $ (286,986) $ 24,998 =========== =========== Weighted average shares outstanding 1,011,662 947,761 Common stock equivalents -- 30,168 Common stock issuable upon conversion of: Preferred stock -- 33,940 ----------- ----------- Diluted shares outstanding 1,011,662 1,011,869 =========== =========== Diluted earnings (loss) per share before extraordinary items $ (0.28) $ 0.02 =========== =========== Page 8 9 (D) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Interest paid by the Company during the three months ended March 31, 1998 and 1997 amounted to $152.9 million and $61.7 million, respectively. Income taxes paid during the three months ended March 31, 1998 and 1997 were $0.7 million and $6.9 million, respectively. In conjunction with business combinations during the three months ended March 31, 1998 and 1997, assumed assets and liabilities were as follows (in thousands): For the Three Months Ended March 31, ---------------------------- 1998 1997 ----------- ----------- Fair value of assets acquired $ 401,816 $ 19,598 Excess of cost over net tangible assets acquired 1,343,963 97,675 Liabilities paid (assumed) (443,641) 188,932 Common stock issued (1,261,901) (15,728) ----------- ----------- $ 40,237 $ 290,477 =========== =========== (E) BROOKS FIBER MERGER COSTS In the first quarter of 1998, the Company recorded a one-time charge for employee severance, alignment charges and direct merger costs associated with the BFP Merger. The following table reflects the components of the significant items shown as Brooks Fiber merger costs for the three months ended March 31, 1998 (in thousands): Direct merger costs $17,217 Severance costs 8,349 Alignment charges 43,924 ------- $69,490 ======= (F) LONG-TERM DEBT In connection with the BFP Merger, the Company announced on February 27, 1998 that it had commenced an offer (the "Tender Offers") to purchase for cash each of the following series of debt: the 10-7/8% Senior Discount Notes of BFP due 2006, the 11-7/8% Senior Discount Notes of BFP due 2006 and the 10% Senior Discount Notes of BFP due 2007 (collectively, the "BFP Notes"). WorldCom offered to pay each registered holder of the BFP Notes, in the case of the 10-7/8% Senior Discount Notes, 118.586% of their accreted value as of the date of the purchase, in the case of the 11-7/8% Senior Discount Notes, 127.104% of their accreted value as of the date of purchase, and in the case of the 10% Senior Notes, 117.615% of their principal amount, plus accrued interest to the date of purchase. The accreted value per $1,000 principal amount at stated maturity as of the tender purchase date of March 27, 1998, was $733.42 for the 10-7/8% Senior Discount Notes, and $660.57 for the 11-7/8% Senior Discount Notes. The accrued interest of the 10% Senior Notes per $1,000 principal amount at stated maturity to such date was $32.22. Concurrently with the Tender Offers, WorldCom obtained the requisite consents to eliminate certain restrictive covenants and amend certain other provisions of the respective indentures of the BFP Notes. On March 27, 1998, the Company accepted all BFP Notes validly tendered. As of the expiration of the offers at 11:59 p.m., New York City time, March 26, 1998, WorldCom had received valid tenders and consents from holders of approximately $424.9 million of principal amount at stated maturity of 10-7/8% Senior Discount Notes due 2006 of BFP (or approximately 99.96% of total outstanding), from holders of $400.0 million of principal amount at stated maturity of 11-7/8% Senior Discount Notes due 2006 of BFP (or 100% of total outstanding), and from holders of approximately $241.0 million of principal amount at stated maturity of 10% Senior Notes due 2007 of BFP (or approximately 96.4% of total outstanding). Page 9 10 The funds required to pay all amounts required under the Tender Offers were obtained by WorldCom from available working capital and lines of credit. Such lines of credit included a new $1.25 billion 364-day revolving credit facility which became effective in February 1998. In connection with the Tender Offers and related refinancings, WorldCom recorded an extraordinary accounting item of $128.7 million, net of income tax benefit of $77.6 million in the first quarter of 1998. (G) CHARGE FOR IN-PROCESS RESEARCH AND DEVELOPMENT In the first quarter of 1998, the Company recorded a $429 million charge for in-process research and development related to the CompuServe Merger and AOL Transaction. The charge is based on a valuation analysis of CNS and ANS technologies including the companies' virtual private data networks, application hosting products, security systems, next generation network architectures, and certain other identified research and development projects purchased in the CompuServe Merger and AOL Transaction. At the date of the CompuServe Merger and AOL Transaction, the technological feasibility of the acquired technology had not yet been established and the technology had no future alternative uses. (H) COMPREHENSIVE INCOME Effective January 1, 1998, WorldCom adopted SFAS No. 130 "Reporting Comprehensive Income." This statement requires the reporting of comprehensive income in addition to net income from operations. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income. The following table reflects the calculation of comprehensive income (loss) for WorldCom for the three months ended March 31, 1998 and 1997 (in thousands): For the Three Months Ended March 31, ------------------------ 1998 1997 --------- --------- Net income (loss) applicable to common shareholders $(415,717) $ 18,388 --------- --------- Other comprehensive income (loss): Foreign currency translation losses (8,862) (16,939) Unrealized holding gains (losses) 26,354 (14,819) --------- --------- Other comprehensive income (loss) before tax 17,492 (31,758) Income tax (expense) benefit (9,909) 5,572 --------- --------- Other comprehensive income (loss) 7,583 (26,186) --------- --------- Comprehensive loss applicable to common shareholders $(408,134) $ (7,798) ========= ========= (I) CONTINGENCIES FEDERAL REGULATION. On February 8, 1996, President Clinton signed the Telecom Act, which permits the Bell System Operating Companies ("BOCs") to provide domestic and international long distance services to customers located outside of the BOCs' home regions; permits a petitioning BOC to provide domestic and international long distance services to customers within its operating area on a state by state basis upon a finding by the FCC that a petitioning BOC has satisfied certain criteria for opening up its local exchange network to competition and that its provision of long distance services would further the public interest; and removes existing barriers to entry into local service markets. Additionally, there were significant changes in: the manner in which carrier-to-carrier arrangements are regulated at the federal and state level; procedures to revise universal service standards; and penalties for unauthorized switching of customers. The FCC has instituted and, in most instances completed, proceedings addressing the implementation of this legislation. In implementing the Telecom Act, the FCC established nationwide rules designed to encourage new entrants to participate in the local services markets through interconnection with the ILECs, resale of ILEC's retail services and Page 10 11 use of individual and combinations of unbundled network elements. These rules set the groundwork for the statutory criteria governing BOC entry into the long distance market. Appeals of the FCC order adopting those rules were consolidated before the United States Court of Appeals for the Eighth Circuit (the "Eighth Circuit"). The Eighth Circuit found constitutional challenges to certain practices implementing cost provisions of the Telecom Act that were ordered by certain Public Utility Commissions ("PUCs") to be premature, but vacated significant portions of the FCC's nationwide pricing rules and vacated an FCC rule requiring that unbundled network elements be provided on a combined basis. In response to requests by the Solicitor General, on behalf of the FCC, and certain other parties, including WorldCom, the United States Supreme Court has agreed to review the decision of the Eighth Circuit. Certain BOCs have also raised constitutional challenges to provisions of the Telecom Act restricting BOC provision of long distance services, manufacturing of telecommunications equipment, electronic publishing and alarm monitoring services. On December 31, 1997, the United States District Court for the Northern District of Texas (the "Texas District Court") ruled that these restrictions violate the Bill of Attainder Clause of the U.S. Constitution. Currently, this decision only applies to SBC Corporation ("SBC"), US WEST Communications Group ("US WEST"), and Bell Atlantic Corporation ("Bell Atlantic"). At the request of various parties, on February 11, 1998 the Texas District Court issued a stay of its decision pending appeal. AT&T, MCI, the Department of Justice, the FCC and other parties have appealed the decision to the United States Court of Appeals for the Fifth Circuit. BellSouth Corporation ("BellSouth") raised the Bill of Attainder issue in its appeal before the United States Court of Appeals for the Fifth Circuit of the electronic publishing restrictions imposed under the Telecom Act. A decision on that appeal is pending. WorldCom cannot predict either the ultimate outcome of these or future challenges to the Telecom Act, any related appeals of regulatory or court decisions, or the eventual effect on WorldCom's business or the industry in general. The FCC has denied applications filed by Ameritech Corporation ("Ameritech"), SBC and BellSouth seeking authority to provide interLATA long distance service in Michigan, Oklahoma, Louisiana and South Carolina, respectively. SBC appealed the FCC's denial of its application covering Oklahoma to the United States Court of Appeals for the District of Columbia Circuit. The court has affirmed the FCC's denial of that application. In its denial of an Ameritech application and a BellSouth application, the FCC provided detailed guidance to applicants regarding the obligations of the applicants, the format of future applications, the content of future applications, and the review standards that it will apply in evaluating any future applications. The National Association of Regulatory Utility Commissioners and several state regulatory commissions have appealed jurisdictional aspects of that Ameritech application denial to the Eighth Circuit. WorldCom cannot predict either the outcome of these appeals, or the BOCs' willingness to abide by these FCC guidelines, or the timing or outcome of future applications submitted to the FCC. Additionally, several Regional Bell Operating Companies ("RBOCs") have filed petitions requesting that the FCC forbear from imposing the line of business restrictions upon their data service offerings and data network deployment. Other BOCs have announced their intention to file applications at the FCC for authority to provide interLATA services. Additionally, the FCC and several PUCs are considering a proposal that would allow BOCs electing to create separate wholesale network and retail organizations to enter the long distance market on an accelerated basis. WorldCom cannot predict the outcome of these proceedings or whether the outcome will have a material impact upon its consolidated financial position or results of operations. On May 7, 1997, the FCC announced that it will issue a series of orders that will reform Universal Service Subsidy allocations and adopted various reforms to the existing rate structure for interstate access services provided by the ILECs that are designed to reduce access charges, over time, to more economically efficient levels and rate structures. It also affirmed that information service providers (including, among others, ISPs) should not be subject to existing access charges ("ISP Exemption"). Petitions for reconsideration of, among other things, the access service and ISP Exemption related actions were filed before the FCC and appeals taken to various United States Courts of Appeals. On reconsideration, the FCC in significant part affirmed the access charge and ISP Exemption actions and the court appeals have been consolidated before the Eighth Circuit. Also, several state agencies have started proceedings to address the reallocation of implicit subsidies contained in the access rates and retail service rates to state universal service funds. Access charges are a principal component of WorldCom's telecommunications expense. Additionally, modification of the ISP Exemption could have an adverse effect on the Company's Internet-related services business. WorldCom cannot predict either the outcome of these appeals or whether or not the result(s) will have a material impact upon its consolidated financial position or results of operations. The FCC issued on December 24, 1996 a Notice of Inquiry to seek comment on whether it should consider various actions relating to interstate information services and the Internet. The FCC recognized that these services and recent Page 11 12 technological advances may be constrained by current regulatory practices that have their foundations in traditional circuit switched telecommunications services and technologies. Based upon this and other proceedings, the FCC may permit telecommunications companies, BOCs, or others to increase the scope or reduce the cost of their Internet access services. WorldCom cannot predict the effect that the Notice of Inquiry, the Telecom Act or any future legislation, regulation or regulatory changes may have on its consolidated financial position or results of operations. INTERNATIONAL. In December 1996, the FCC adopted a new policy that will make it easier for United States international carriers to obtain authority to route international public switched voice traffic to and from the United States outside of the traditional settlement rate and proportionate return regimes. In February 1997, the United States entered into a World Trade Organization Agreement (the "WTO Agreement") that should have the effect of liberalizing the provision of switched voice telephone and other telecommunications services in scores of foreign countries over the next several years. The WTO Agreement became effective in February 1998. In order to comply with United States commitments to the WTO Agreement, the FCC implemented new rules in February 1998 that liberalize existing policies regarding (i) the services that may be provided by foreign affiliated United States international common carriers, including carriers controlled or more than 25 percent owned by foreign carriers that have market power in their home markets, and (ii) the provision of international switched voice services outside of the traditional settlement rate and proportionate return regimes. The new rules make it much easier for foreign affiliated carriers to enter the United States market for the provision of international services. In August 1997, the FCC adopted mandatory settlement rate benchmarks. These benchmarks are intended to reduce the rates that United States carriers pay foreign carriers to terminate traffic in their home countries. The FCC will also prohibit a United States carrier affiliated with a foreign carrier from providing facilities-based service to the foreign carrier's home market until and unless the foreign carrier has implemented a settlement rate within the benchmark. The FCC also adopted new rules that will liberalize the provision of switched services over private lines to World Trade Organization member countries, by allowing such services on routes where 50% or more of United States billed traffic is being terminated in the foreign country at or below the applicable settlement rate benchmark or where the foreign country's rules concerning provision of international switched services over private lines deemed equivalent to United States rules. Although the FCC's new policies and implementation of the WTO Agreement may result in lower costs to WorldCom to terminate international traffic, there is a risk that the revenues that WorldCom will receive from inbound international traffic may decrease to an even greater degree. The implementation of the WTO Agreement may also make it easier for foreign carriers with market power in their home markets to offer United States and foreign customers end-to-end services to the disadvantage of WorldCom, which may continue to face substantial obstacles in obtaining from foreign governments and foreign carriers the authority and facilities to provide such end-to-end services. Further, many foreign carriers have challenged, in court and at the FCC, the FCC's order adopting mandatory settlement rate benchmarks. If the FCC's settlement rate benchmark order was overturned, it could accelerate the full-fledged entry of foreign carriers into the United States, and make it more advantageous for foreign carriers to route international traffic into the United States at low, cost-based termination rates, while United States carriers would continue to have little choice but to route international traffic into most foreign countries at much higher, above cost, settlement rates. The Company is involved in other legal and regulatory proceedings generally incidental to its business. In some instances, rulings by regulatory authorities in some states may result in increased operating costs to the Company. While the results of these various legal and regulatory matters contain an element of uncertainty, the Company believes that the probable outcome of these matters should not have a material adverse effect on the Company's consolidated results of operations or financial position. ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This Management's Discussion and Analysis of Financial Condition and Results of Operations may be deemed to include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that involve risk and uncertainty, including financial, regulatory environment and trend projections. Although the Company believes that its expectations are Page 12 13 based on reasonable assumptions, it can give no assurance that its expectations will be achieved. The important factors that could cause actual results to differ materially from those in the forward-looking statements herein (the "Cautionary Statements") include, without limitation, the Company's degree of financial leverage, risks associated with debt service requirements and interest rate fluctuations, risks associated with acquisitions and the integration thereof, risks of international business, dependence on availability of transmission facilities, regulation risks including the impact of the Telecom Act, contingent liabilities, and the impact of competitive services and pricing, as well as other risks referenced from time to time in the Company's filings with the SEC, including the Company's Form 10-K for the year ended December 31, 1997 (the "Form 10-K"). All subsequent written and oral forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by the Cautionary Statements. The Company does not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. The following discussion and analysis relates to the financial condition and results of operations of the Company for the three months ended March 31, 1998 and 1997 after giving effect to the BFP Merger, which was accounted for as a pooling-of-interests. The information should be read in conjunction with the consolidated financial statements and notes thereto contained herein and in the Form 10-K and with Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Form 10-K. Unless otherwise defined, capitalized terms used herein have the meanings assigned to them in the Notes to Consolidated Financial Statements contained herein. GENERAL The Company is one of the largest telecommunications companies in the United States, serving local, long distance and Internet customers domestically and internationally. The Company's operations have grown significantly in each year of its operations as a result of internal growth, the selective acquisition of smaller telecommunications companies with limited geographic service areas and market shares, the consolidation of certain third tier long distance carriers with larger market shares, and international expansion. On January 31, 1998, WorldCom, through a wholly owned subsidiary, merged with CompuServe. Prior to the CompuServe Merger, CompuServe operated primarily through two divisions: Interactive Services and Network Services. Interactive Services offered worldwide online and Internet access services for consumers, while Network Services provided worldwide network access, management and applications, and Internet service to businesses. The CompuServe Merger is being accounted for as a purchase; accordingly, operating results for CompuServe will be included from the date of acquisition. On January 31, 1998, WorldCom also acquired ANS from AOL, and has entered into five year contracts with AOL under which WorldCom and its subsidiaries will provide network services to AOL (collectively, the "AOL Transaction"). As part of the AOL Transaction, AOL acquired CompuServe's Interactive Services Division and received a $175 million cash payment from WorldCom. WorldCom retained the CNS division. ANS provides Internet access to AOL and AOL's subscribers in the United States, Canada, the United Kingdom, Sweden and Japan, and also designs, develops and operates high performance wide-area networks for business, research, education and governmental organizations. On January 29, 1998, WorldCom, through a wholly owned subsidiary, merged with BFP. BFP is a leading facilities-based provider of competitive local telecommunications services, commonly referred to as a competitive local exchange carrier ("CLEC"), in selected cities within the United States. BFP acquires and constructs its own state-of-the-art fiber optic networks and facilities and leases network capacity from others to provide IXCs, ISPs, wireless carriers and business, government and institutional end users with an alternative to the ILECs for a broad array of high quality voice, data, video transport and other telecommunications services. On November 9, 1997, WorldCom entered into the MCI/WorldCom Merger Agreement with MCI and MCI Merger Sub, providing for the MCI/WorldCom Merger, pursuant to which MCI would merge with and into MCI Merger Sub, with MCI Merger Sub surviving as a wholly owned subsidiary of WorldCom. Subject to the terms and conditions of the MCI/WorldCom Merger Agreement, each share of MCI Common Stock outstanding immediately Page 13 14 prior to the MCI/WorldCom Effective Time will be converted into the right to receive that number of shares of WorldCom Common Stock equal to the MCI Exchange Ratio, and each share of MCI Class A Common Stock outstanding immediately prior to the MCI/WorldCom Effective Time will be converted into the right to receive $51.00 in cash, without interest thereon. The "MCI Exchange Ratio" means the quotient (rounded to the nearest 1/10,000) determined by dividing $51.00 by the MCI/WorldCom Average Price as reported on The Nasdaq National Market on each of the 20 consecutive trading days ending with the third trading day immediately preceding the MCI/WorldCom Effective Time; provided, however, that the MCI Exchange Ratio will not be less than 1.2439 or greater than 1.7586. Cash will be paid in lieu of the issuance of any fractional share of WorldCom Common Stock in the MCI/WorldCom Merger. Based on the number of shares of MCI Common Stock outstanding as of January 20, 1998 and assumed MCI Exchange Ratios of 1.2439 and 1.7586, approximately 710,554,160 shares and 1,004,566,722 shares, respectively, of WorldCom Common Stock would be issued in the MCI/WorldCom Merger. In addition, as of December 31, 1997, outstanding options to purchase shares of MCI Common Stock would be converted in the MCI/WorldCom Merger to options to acquire an aggregate of approximately 86,491,688 shares and 122,280,154 shares, respectively, of WorldCom Common Stock, and the exercise price would be adjusted to reflect the MCI Exchange Ratio, so that, on exercise, the holders would receive, in the aggregate, the same number of shares of WorldCom Common Stock as they would have received had they exercised prior to the MCI/WorldCom Merger, at the same exercise price. The MCI/WorldCom Merger was approved by the MCI stockholders and the WorldCom shareholders at separate meetings held on March 11, 1998. The MCI/WorldCom Merger is also subject to approvals from the FCC, the DOJ and various state government bodies. In addition, the MCI/WorldCom Merger is subject to approval by the European Commission. WorldCom anticipates that the MCI/WorldCom Merger will close in mid-year 1998. Termination of the MCI/WorldCom Merger Agreement by MCI or WorldCom under certain conditions will require MCI to pay WorldCom $750 million as a termination fee and to reimburse WorldCom the $450 million alternative transaction fee and certain related expenses paid by WorldCom to BT. Further, termination of the MCI/WorldCom Merger Agreement by MCI or WorldCom under certain conditions, will require WorldCom to pay MCI $1.635 billion as a termination fee. Pursuant to the BT Agreement among MCI, WorldCom and BT, the prior BT/MCI Merger Agreement was terminated, and WorldCom agreed to pay BT an alternative transaction fee of $450 million and expenses of $15 million payable to BT in accordance with the BT/MCI Merger Agreement. These fees were paid on November 12, 1997. WorldCom also agreed to pay to BT an additional payment of $250 million in the event that WorldCom is required to make the $1.635 billion payment to MCI in accordance with the MCI/WorldCom Merger Agreement. In addition, pursuant to the BT Agreement, BT voted (or caused to be voted) its shares of MCI Class A Common Stock in favor of the MCI/WorldCom Merger Agreement and the approval of the other transactions contemplated by the MCI/WorldCom Merger Agreement. WorldCom is in the process of developing its plan to integrate the operations of MCI which may include certain exit costs. As a result of this plan, a charge, which may be material but which cannot now be quantified, is expected to be recognized in the period in which such a restructuring occurs. WorldCom has also undertaken a study to determine the allocation of the total purchase price to the various assets to be acquired, including in-process research and development, and the liabilities assumed. To the extent that a portion of the purchase price is allocated to in-process research and development projects of MCI, a charge, which may be material, would be recognized in the period in which the MCI/WorldCom Merger occurs. The Company's strategy is to become a fully integrated communications company that would be well positioned to take advantage of growth opportunities in global telecommunications. Consistent with this strategy, the Company believes that transactions such as the CompuServe Merger, the AOL Transaction and, if consummated, the MCI/WorldCom Merger enhance the combined entity's opportunities for future growth, create a stronger competitor in the changing telecommunications industry, allow provision of end-to-end bundled service over global networks, and provide the opportunity for significant cost savings and operating efficiencies for the combined organization. Page 14 15 The Company's profitability is dependent upon, among other things, its ability to achieve line costs that are less than its revenues. The principal components of line costs are access charges and transport charges and the most significant portion of the Company's line costs is access charges, which are highly regulated. The FCC revised its rules regarding access charges in a manner that will, over time, revamp the access rate element structure and, over the near term, reduce the overall access revenues collected by the ILECs. The FCC's rate element restructuring is intended to align costs with the manner in which they are incurred by the ILECs. As a result, the usage based system has been replaced with a system composed of a combination of flat rate charges and usage based charges. The FCC has also implemented subsidy systems for local telephone services and services to schools, libraries, and hospitals. The subsidy systems will result in additional charges being placed on all telecommunications providers, which charges may be directly recovered from the end users. In addition, various state regulatory agencies are considering adoption of subsidy systems that could cause rate adjustments to the access services obtained by the Company and to retail rates. The Company cannot predict what effect continued regulation and increased competition between LECs and other IXCs will have on future access charges or the Company's business. However, the Company believes that it will be able to continue to reduce transport costs through effective utilization of its network, favorable contracts with carriers and network efficiencies made possible as a result of expansion of the Company's customer base by acquisitions and internal growth. RESULTS OF OPERATIONS The following table sets forth for the periods indicated the Company's statement of operations as a percentage of its operating revenues. For the Three Months Ended March 31, --------------------- 1998 1997 ------ ------ Revenues ...................................................................... 100% 100% Line costs .................................................................... 48.8 54.3 Selling, general and administrative ........................................... 20.4 22.9 Depreciation and amortization ................................................. 12.7 13.6 Brooks Fiber merger costs ..................................................... 3.0 -- Charge for in-process research and development ................................ 18.3 -- ------ ------ Operating income (loss) ....................................................... (3.2) 9.2 Other income (expense): Interest expense .......................................................... (4.3) (5.3) Miscellaneous ............................................................. 0.5 0.8 ------ ------ Income (loss) before income taxes and extraordinary item ...................... (7.0) 4.7 Provision for income taxes .................................................... 4.9 3.2 ------ ------ Net income (loss) before extraordinary item ................................... (11.9) 1.5 Extraordinary item ............................................................ (5.5) -- ------ ------ Net income (loss) ............................................................. (17.4) 1.5 Preferred dividend requirement ................................................ 0.3 0.4 ------ ------ Net income (loss) applicable to common shareholders ........................... (17.7)% 1.1% ====== ====== THREE MONTHS ENDED MARCH 31, 1998 VS. THREE MONTHS ENDED MARCH 31, 1997 Revenues for the three months ended March 31, 1998 increased 38% to $2.35 billion on 11.80 billion revenue minutes as compared to $1.70 billion on 8.59 billion revenue minutes for the three months ended March 31, 1997. The increase in total revenues and minutes is primarily attributable to the internal growth of the Company, the CompuServe Merger and the AOL Transaction as outlined in the next paragraph. Prior year results have been restated to reflect the BFP Merger, which was accounted for as a pooling-of-interests. The following table highlights the source of WorldCom's internal growth by major line of business. The pro forma and actual revenue increases for the three months ended March 31, 1998 and 1997 reflect the following increases by category (dollars in millions): Page 15 16 Three Months Ended March 31, ------------------------------------- Actual Pro Forma 1998 1997 Change -------- -------- -------- REVENUES Domestic switched $1,161.8 $ 962.7 21% Domestic private line 496.4 359.5 38% International 259.7 163.8 59% Internet 392.2 216.0 82% -------- -------- CORE REVENUES 2,310.1 1,702.0 36% -------- -------- Other 39.9 99.5 (60%) -------- -------- TOTAL REVENUES $2,350.0 $1,801.5 30% ======== ======== The following discusses the results of operations for the three months ended March 31, 1998 as compared to pro forma results for the comparable prior year period. The pro forma results assume that the CompuServe Merger and the AOL Transaction occurred at the beginning of 1997. Changes in actual results of operations are shown in the Consolidated Statements of Operations and the foregoing tables and, as noted above, primarily reflect the CompuServe Merger, AOL Transaction and the internal growth of the Company. Domestic switched services revenue increased 21% for the three months ended March 31, 1998. Strong long distance volume gains in all domestic sales channels, combined with an increasing mix of local, were the primary contributors to this increase. The strong volume growth was offset partially by access charge reform pass throughs and changing product mix. Domestic switched revenues include both long distance and local switched revenues. While the Company continues to show significant percentage gains in switched local, it is still a relatively small component of total Company revenues. However, the Company expects that due to its local initiatives, and, if consummated, the MCI/WorldCom Merger, revenues attributable to local switched services will grow rapidly during the remainder of 1998 and beyond. Domestic private line revenues increased 38% for the three months ended March 31, 1998. The particularly strong revenue growth for private line and frame relay services continues to be fueled by tremendous commercial end-user demand for high-speed data and by Internet-related growth on both a local and long-haul basis. Domestic private line includes both long distance and local dedicated bandwidth sales. As of March 31, 1998, the Company had 11.7 million domestic local voice grade equivalents and 27,185 connected buildings. Local route miles of connected fiber are in excess of 6,500 and domestic long distance route miles are in excess of 20,000. The combination of MCI and WorldCom's operations is expected to enhance WorldCom's local presence. International revenues - those revenues originating outside of the U.S. - were up 59% to $260 million for the three months ended March 31, 1998. During the first quarter of 1998, over 4,000 miles of transatlantic cable was commissioned for service and now provides WorldCom the capability to connect from end-to-end over 4,000 buildings in Europe with over 27,000 buildings in the U.S. - all over Company-owned high capacity circuits. In Europe, the Company has over 400 route miles of local fiber and over 1,500 long distance route miles. Internet revenues for the first quarter were $392 million. CNS and ANS revenues were included following the completion of the transactions on January 31, 1998. On a pro forma basis, including CNS/ANS for the same time period in both years, Internet revenues increased 82%. On an internal growth basis, Internet revenues would have been $230 million, up 107% year-over-year. Other revenues for the first quarter of 1998 were $40 million, down 60% compared with first quarter 1997. Other revenues include MFS Network Technologies of $32 million and systems and consulting sales of $8 million. Operator services and broadcast operations were sold in the third quarter 1997. On a recast basis, excluding the results of the operator services and broadcast operations divisions in both periods, other revenues were down 32% for the first quarter due to the timing of transportation construction contracts within the Network Technologies group. In April 1998, the Company entered into an Agreement and Plan of Merger, pursuant to which WorldCom will sell the Network Technologies group to Able Telcom Holding Corp. The transaction is conditioned upon, among other Page 16 17 things, the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. Closing is expected to occur as soon as practicable after satisfaction or waiver of customary closing conditions. Line costs as a percentage of revenues for the three months ended March 31, 1998 was 48.8% as compared to 54.3% reported for the same period of the prior year. These decreases are attributable to changes in the product mix and synergies and economies of scale resulting from network efficiencies achieved from the assimilation of CNS and ANS into the Company's operations and were offset in part by universal service fund costs recorded in the first quarter of 1998. Additionally, access charge reductions beginning in July 1997 reduced total line cost expense by approximately $29 million for the first three months in 1998. While access charge reductions were primarily passed through to the customer, line costs as a percentage of revenues was positively affected by more than half of a percentage point. Selling, general and administrative expenses for the first quarter of 1998 were $478.1 million or 20.4% of revenues as compared to $388.2 million or 22.9% of revenues as reported for same period of the prior year. The decrease in selling, general and administrative expenses as a percentage of revenues for the first quarter of 1998 results from the assimilation of recent acquisitions into the Company's strategy of cost control. Depreciation and amortization expense for 1998 increased to $298.6 million or 12.7% of revenues from $231.6 million or 13.6% of revenues for the first quarter of 1997. This increase reflects increased amortization associated with the CompuServe Merger and AOL Transaction and additional depreciation related to capital expenditures. As a percentage of revenues, these costs decreased due to the higher revenue base. In the first quarter of 1998, the Company recorded a $69.5 million pre-tax charge for employee severance, alignment charges and direct merger costs associated with the BFP Merger. On an after-tax basis, this charge was $47.1 million and is reflected in operating loss for the three months ended March 31, 1998. In the first quarter of 1998, the Company also recorded a $429 million charge for in-process research and development related to the CompuServe Merger and AOL Transaction. The charge is based on a valuation analysis of CNS and ANS technologies including the companies' virtual private data networks, application hosting products, security systems, next generation network architectures, and certain other identified research and development projects purchased in the CompuServe Merger and AOL Transaction. At the date of the CompuServe Merger and AOL Transaction, the technological feasibility of the acquired technology had not yet been established and the technology had no future alternative uses. For the three months ended March 31, 1998, interest expense was $102.2 million or 4.3% of revenues, as compared to $90.2 million or 5.3% of revenues for the three months ended March 31, 1997. The increase in interest expense is attributable to higher debt levels as the result of higher capital expenditures and the 1997 fixed rate debt financings, offset by lower interest rates in effect on the Company's variable rate long-term debt. For the three months ended March 31, 1998 and 1997, weighted average annual interest rates on the Company's total long-term debt were 7.3% and 7.4%, respectively, while weighted average annual levels of borrowing were $7.88 billion, and $5.29 billion, respectively. In the first quarter of 1998, the Company recorded an extraordinary item totaling $128.7 million, net of income tax benefit of $77.6 million. The charge was recorded in connection with the tender offers and related refinancings of outstanding debt of BFP discussed below. For the three months ended March 31, 1998, net income, before non-recurring charges, increased to $192.7 million from $25.0 million in the comparable prior year period. Diluted earnings per common share, before non-recurring charges increased to $0.18 per share versus $0.02 per share for the comparable 1997 period. Including the non-recurring, after-tax charges, the Company reported a net loss of $415.7 million or $0.41 per share for the first three months of 1998. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 1998, the Company's total debt was $8.34 billion, an increase of $913.7 million from December 31, Page 17 18 1997 as a result of the BFP Tender Offers and related refinancings (discussed below) and increased capital expenditures. In connection with the BFP Merger, the Company announced on February 27, 1998 that it had commenced an offer (the "Tender Offers") to purchase for cash each of the following series of debt: the 10-7/8% Senior Discount Notes of BFP due 2006, the 11-7/8% Senior Discount Notes of BFP due 2006 and the 10% Senior Notes of BFP due 2007 (collectively, the "BFP Notes"). WorldCom offered to pay each registered holder of the BFP Notes, in the case of the 10-7/8% Senior Discount Notes, 118.586% of their accreted value as of the date of the purchase, in the case of the 11-7/8% Senior Discount Notes, 127.104% of their accreted value as of the date of purchase, and in the case of the 10% Senior Notes, 117.615% of their principal amount, plus accrued interest to the date of purchase. The accreted value per $1,000 principal amount at stated maturity as of the tender purchase date of March 27, 1998, was $733.42 for the 10-7/8% Senior Discount Notes, and $660.57 for the 11-7/8% Senior Discount Notes. The accrued interest of the 10% Senior Notes per $1,000 principal amount at stated maturity to such date was $32.22. Concurrently with the Tender Offers, WorldCom obtained consents to eliminate certain restrictive covenants and amend certain other provisions of the respective indentures of the BFP Notes. On March 27, 1998, the Company accepted all BFP Notes validly tendered. As of the expiration of the offers at 11:59 p.m., New York City time, March 26, 1998, WorldCom had received valid tenders and consents from holders of approximately $424.9 million of principal amount at stated maturity of 10-7/8% Senior Discount Notes due 2006 of BFP (or approximately 99.96% of total outstanding), from holders of $400.0 million of principal amount at stated maturity of 11-7/8% Senior Discount Notes due 2006 of BFP (or 100% of total outstanding), and from holders of approximately $241.0 million of principal amount at stated maturity of 10% Senior Notes due 2007 of BFP (or approximately 96.4% of total outstanding). The funds required to pay all amounts required under the Tender Offers were obtained by WorldCom from available working capital and lines of credit. Such lines of credit included a new $1.25 billion 364-day revolving credit facility which became effective in February 1998. In connection with the Tender Offers and related refinancings, WorldCom recorded an extraordinary accounting item of $128.7 million, net of income tax benefit of $77.6 million in the first quarter of 1998. As of March 31, 1998, the Company had available liquidity of $1.42 billion under its existing credit facilities (which are described in the Form 10-K) and from available cash and marketable securities. For the three months ended March 31, 1998, the Company's cash flow from operations was $274.0 million, increasing 49% from $184.1 million in the comparable period for 1997. The increase in cash flow from operations was primarily attributable to internal growth and synergies and economies of scale resulting from network efficiencies and selling, general and administrative cost savings achieved from the assimilation of recent acquisitions into the Company's operations. In 1998, the Company's existing receivables purchase agreement generated additional proceeds of $34.5 million, bringing the total amount outstanding to $451.3 million. The Company used these proceeds to reduce outstanding debt under the Company's existing credit facilities. As of March 31, 1998, the purchaser owned an undivided interest in a $1.08 billion pool of receivables which includes the $451.3 million sold. Cash used in investing activities for the three months ended March 31, 1998 totaled $1.17 billion and included capital expenditures of $961.5 million and acquisition and related costs of $40.2 million. Primary capital expenditures include purchases of switching, transmission, communication and other equipment. At least $3.3 billion is currently anticipated for transmission and communications equipment, construction and other capital expenditures in 1998 without regard to pending or other possible future acquisitions. Acquisition and related costs includes the costs associated with the CompuServe Merger and AOL Transaction. Included in cash flows from financing activities are payments of $6.6 million for preferred dividend requirements. The Company has never paid cash dividends on its Common Stock. The depositary shares ("Depository Shares"), each representing 1/100th interest in a share of Series A 8% Cumulative Convertible Preferred Stock of WorldCom Page 18 19 ("WorldCom Series A Preferred Stock"), are entitled to receive dividends, when, as, and if they are declared by the Board of Directors, accruing at the rate of $2.68 per share per annum, payable quarterly in arrears on each February 28, May 31, August 31 and November 30. Dividends are payable in cash or in shares of WorldCom Common Stock, at the election of the Company. The Company paid the dividends for the first quarter of 1998 and will pay the dividends for the second quarter of 1998 in cash. Dividends on the Series B Convertible Preferred Stock of WorldCom ("WorldCom Series B Preferred Stock") accrue at the rate per share of $0.0775 per annum and are payable in cash. Dividends will be paid only when, as and if declared by the Board of Directors of the Company. The Company anticipates that dividends on the WorldCom Series B Preferred Stock will not be declared but will continue to accrue. Upon conversion, accrued but unpaid dividends are payable in cash or shares of WorldCom Common Stock at the Company's election. On May 15, 1998, the Company announced that it has elected to redeem on May 31, 1998 (the "Redemption Date"), all of the outstanding shares of WorldCom Series A Preferred Stock and related Depositary Shares. On the Redemption Date, each Depositary Share will be redeemed for 0.79511 shares of Common Stock. The Company will pay cash in lieu of any fractional share of Common Stock. The Depositary Shares are convertible into 3.44274 shares of Common Stock for each Depositary Share plus payment of unpaid dividends at any time prior to the close of business on the Redemption Date. Accordingly, WorldCom expects that all of the holders of Depositary Shares will convert their shares into Common Stock prior to redemption. From and after the Redemption Date, (i) dividends on the WorldCom Series A Preferred Stock and the Depositary Shares shall cease to accrue, (ii) the WorldCom Series A Preferred Stock and the Depositary Shares shall no longer be deemed to be outstanding and (iii) all rights of the holders of Receipts evidencing Depositary Shares shall cease (except the rights to receive the shares of Common Stock and cash in lieu of any fractional shares thereof payable upon such redemption, without interest thereon, upon surrender and endorsement of Receipts evidencing Depositary Shares). The Call Price per Share of WorldCom Series A Preferred Stock and the Current Market Price per share of Common Stock used for purposes of determining the exchange rate were $3,417.00 and $42.975 respectively. The Current Market Price is the lesser of (i) the average of the high and low sales prices of the Common Stock as reported on The Nasdaq National Market for the 10 consecutive trading days ending on and including the date of determination, which was May 14, 1998, or (ii) the closing price of the Common Stock on The Nasdaq National Market on the date of determination. The number of shares of Common Stock to be exchanged for each outstanding share of WorldCom Series A Preferred Stock is the result of dividing the Call Price by the Current Market Price. In connection with the MCI/WorldCom Merger, WorldCom has agreed to pay BT $51.00 in cash without interest for each of the Class A Shares of MCI stock it owns, or $6.94 billion in the aggregate. Additionally, WorldCom paid BT a fee of $465 million to induce BT to terminate the previously signed BT/MCI Merger Agreement and to enter into the BT Agreement. WorldCom expects to fund the remaining commitment through a combination of commercial bank and public debt financings. The MCI/WorldCom Merger is expected to close by mid-year 1998, and therefore funding of this commitment is not expected to occur until the second half of 1998. Increases in interest rates on WorldCom's debt would have an adverse effect upon WorldCom's reported net income and cash flow. WorldCom believes that the combined operations of WorldCom, CNS, ANS, and, upon consummation of the MCI/WorldCom Merger, MCI, will generate sufficient cash flow to service WorldCom's debt and capital requirements; however, economic downturns, increased interest rates and other adverse developments, including factors beyond WorldCom's control, could impair its ability to service its indebtedness. In addition, the cash flow required to service WorldCom's debt may reduce its ability to fund internal growth, additional acquisitions and capital improvements. The Company has historically utilized a combination of cash flow from operations and debt to finance capital expenditures and a mixture of cash flow, debt and stock to finance acquisitions. The Company expects to experience increased capital intensity due to network expansion and merger related expenses as noted above and believes that funding needs in excess of internally generated cash flow and the Company's existing credit facilities will be met by accessing the debt markets. The Company has filed shelf registration statements on Form S-3 with the SEC for the sale, from time to time, of one or more series of unsecured debt securities having an aggregate value of $6.0 billion. The Company expects to utilize the shelf registrations in connection with the MCI/WorldCom Merger and the $6.94 billion payment to BT during 1998. No assurance can be given that any public financing will be available on terms acceptable to the Company. Page 19 20 The Company believes that the CompuServe Merger and the AOL Transaction will generate sufficient cash flow to adequately fund the capital requirements of these businesses. As a result of the CompuServe Merger, the AOL Transaction and, if consummated, the MCI/WorldCom Merger, the Company believes that the operating and capital synergies from the integration of these acquisitions into WorldCom's operations will further enhance the cash flow contribution for the Company. Absent significant capital requirements for other acquisitions, the Company believes that cash flow from operations and available liquidity, including $1.32 billion under its existing credit facilities, and funds anticipated to be received from commercial bank debt and debt to be issued under the shelf registration statements will be more than adequate to meet the Company's capital needs for the remainder of 1998. YEAR 2000 ISSUES The Company is aware of the complexity and the significance of the "Year 2000" issue. The Company has created a project team comprised of internal resources to help identify products and systems where the Year 2000 problem may exist, and to renovate, replace or retire those products or systems. At this time, the Company believes that the cost of addressing Year 2000 issues is not material to its future operating results or financial position. The Company is gathering information concerning the Year 2000 compliance status of its suppliers. In the event that any of the Company's significant suppliers do not successfully and timely achieve Year 2000 compliance, the Company's business or operations could be adversely affected. ITEM 3. Quantitative and Qualitative Disclosure About Market Risk No material changes from December 31, 1997 to March 31, 1998. PART II. OTHER INFORMATION Item 1. Legal Proceedings. None Item 2. Changes in Securities and Use of Proceeds. None Item 3. Defaults upon Senior Securities. None Item 4. Submission of Matters to a Vote of Security Holders. On March 11, 1998, the Company held a Special Meeting of Shareholders for the purpose of considering and voting upon a proposal to approve the issuance of Common Stock to shareholders of MCI in connection with the MCI/WorldCom Merger. The tabulation of the voting is as follows: For 718,873,666 Against 2,296,105 Abstentions and Broker Non-Votes 2,607,853 Item 5. Other Information. None Page 20 21 Item 6. Exhibits and Reports on Form 8-K. A. Exhibits See Exhibit Index B. Reports on Form 8-K (i) Current Report on Form 8-K/A-1 dated November 9, 1997 (filed January 27, 1998) reporting under Item 5, Other Events, information related to the MCI/WorldCom Merger, the CompuServe Merger, the AOL Transaction and the BFP Merger, as well as the management and shareholders of WorldCom. (ii) Current Report on Form 8-K/A-2 dated November 9, 1997 (filed January 28, 1998) reporting under Item 5, Other Events, information relating to MCI under Item 7(a) Financial Statements of Businesses Acquired, the following financial statements: MCI Communications Corporation and Subsidiaries - for the fiscal years ended December 31, 1994, 1995, and 1996: Consolidated Income Statements Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Stockholders' Equity Management's Discussion and Analysis of Financial Condition and Results of Operations MCI Communications Corporation and Subsidiaries - for the nine month periods ended September 30, 1996 and 1997 (unaudited): Consolidated Statements of Operations Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Stockholders' Equity Notes to Interim Consolidated Financial Statements Management's Discussion and Analysis of Financial Condition and Results of Operations WorldCom, Inc. - for the nine month period ended September 30, 1997 and for the fiscal year ended December 31, 1996: Pro Forma Financial Information Pro Forma Condensed Combined Balance Sheet as of September 30, 1997 Pro Forma Condensed Combined Statement of Operations for the nine months ended September 30, 1997 Pro Forma Condensed Combined Statement of Operations for the fiscal year ended December 31, 1996 Notes to Pro Forma Financial Statements Additional Pro Forma Presentation (iii) Current Report on Form 8-K dated August 22, 1997 (filed February 12, 1998) reporting under Item 2, Acquisition or Disposition of Assets, Item 5, Other Events, and Item 7, Financial Statements and Exhibits, information related to the completion of the BFP Merger, the CompuServe Merger and the AOL Transaction. Page 21 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report on Form 10-Q to be signed on its behalf by Scott D. Sullivan, thereunto duly authorized to sign on behalf of the registrant and as the principal financial officer thereof. WORLDCOM, INC. By: /s/ Scott D. Sullivan -------------------------------------- Scott D. Sullivan Dated: May 15, 1998 Chief Financial Officer Page 22 23 EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 2.1 Agreement and Plan of Merger dated as of November 9, 1997 among WorldCom., Inc., TC Investments Corp. and MCI Communications Corporation (incorporated by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K dated November 9, 1997 (filed November 12, 1997))* 2.2 Agreement dated as of November 9, 1997 among British Telecommunications plc, WorldCom, Inc. and MCI Communications Corporation (incorporated by reference to Exhibit 99.1 to the Company's Current Report on Form 8-K dated November 9, 1997 (filed November 12, 1997))*))* 2.3 Agreement and Plan of Merger, dated as of September 7, 1997, by and among H&R Block, Inc., H&R Block Group, Inc., CompuServe Corporation, WorldCom, Inc., and Walnut Acquisition Company, L.L.C. (incorporated herein by reference to Exhibit 2.1 to the Company's Current Report on Form 8-K dated September 7, 1997 (File No. 0-11258))* 2.4 Purchase and Sale Agreement by and among America Online, Inc., ANS Communications, Inc. and WorldCom, Inc., dated as of September 7, 1997 (incorporated herein by reference to Exhibit 2.4 to the Company's Current Report on Form 8-K dated September 7, 1997 (File No. 0-11258))* 2.5 Amended and Restated Agreement and Plan of Merger dated as of October 1, 1997 by and among WorldCom, Inc., BV Acquisition, Inc. and Brooks Fiber Properties, Inc. ("BFP") (incorporated by reference to Exhibit 2.1 to WorldCom's Registration Statement on Form S-4 (File No. 333-43253))* 4.1 Second Amended and Restated Articles of Incorporation of WorldCom, Inc. (including preferred stock designations) as of December 31, 1996 (incorporated herein by reference to Exhibit 3.1 to the Company's Current Report on Form 8-K dated December 31, 1996 (File No. 0-11258)) 4.2 Restated Bylaws of WorldCom, Inc. (incorporated by reference to Exhibit 4.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996 (File No. 0-11258)) 10.1 364-Day Revolving Credit and Term Loan Agreement among WorldCom, Inc., Borrower, NationsBank of Texas N.A., Administrative Agent and the lenders name therein, dated as of February 19, 1998 (incorporated by reference to Exhibit 10.3 to WorldCom's Annual Report on Form 10-K for the fiscal year ended December 31, 1997)* 27.1 Financial Data Schedule 27.2 Restated Financial Data Schedule - March 31, 1997 *The registrant hereby agrees to furnish supplementally a copy of any omitted schedules to this Agreement to the Securities and Exchange Commission. page 23