UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended December 31, 1997
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________________ to _____________________
Commission file number 0-16560
VANGUARD CELLULAR SYSTEMS, INC.
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(Exact name of registrant as specified in its charter)
North Carolina 56-1549590
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation organization)
2002 Pisgah Church Road, Suite 300,
Greensboro, North Carolina 27455-3314
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(address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (336) 282-3690
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, par value $.01 per share
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES |X| NO |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|
The aggregate market value of the registrant's Common Stock held by those
other than executive officers and directors at March 26, 1998, based on the
NASDAQ closing sale price for the Registrant's Common Stock as of such date, was
approximately $550,262,374.
The number of shares outstanding of the issuer's common stock as of
March 26, 1998 was 37,232,053.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive proxy statement relating to its
1998 annual meeting of stockholders are incorporated by reference into Part III
as set forth herein. Such proxy statement will be filed with the Securities and
Exchange Commission not later than 120 days after the registrant's fiscal year
ended December 31, 1997.
TABLE OF CONTENTS
PART I
Item 1. Business ........................................................... 1
Item 2. Properties ......................................................... 17
Item 3. Legal Proceedings .................................................. 17
Item 4. Submission of Matters to a Vote of Security Holders ................ 17
Item 4.(a) Executive Officers of the Registrant ............................ 17
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder
Matters ............................................................ 19
Item 6. Selected Consolidated Financial Data ............................... 20
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations .............................................. 22
Item 8. Financial Statements and Supplementary Data ........................ 29
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure ............................................... 29
PART III
Item 10. Directors and Executive Officers of the Registrant ................ 30
Item 11. Executive Compensation ............................................ 30
Item 12. Security Ownership of Certain Beneficial Owners and Management .... 30
Item 13. Certain Relationships and Related Transactions .................... 30
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K ............................................................... 31
Signatures ................................................................. 32
Index to Consolidated Financial Statements and Schedules ................... F-1
Exhibit Index
Item 1. Business
For definitions of certain terms used in this Form 10-K, see "Certain
Definitions" beginning on Page 15 hereof.
Overview
Vanguard Cellular Systems, Inc. ("the Company") is an independent operator
of cellular telephone systems in the United States with 7.9 million aggregate
POPs as of December 31, 1997. The Company serves over 645,000 subscribers
located in five "metro-clusters," or contiguous groups of cellular markets,
comprised of 29 markets in the Eastern United States, including the Mid-Atlantic
and Ohio Valley SuperSystems and the Florida, Carolinas and New England
metro-clusters. The Mid-Atlantic SuperSystem, which is contiguous to the New
York, Philadelphia and Baltimore/Washington MSAs and the New England
metro-cluster, which is contiguous to the Boston MSA, (four of the nation's
seven largest MSAs) collectively represent approximately 71% of the Company's
operating POPs. The Company's wireless products and services are distributed
under the CellularONE(R) brand name, one of the most recognized brand names in
the wireless industry.
In March, 1998, the Company entered into an agreement to sell for $160
million in cash its investment in the Myrtle Beach, South Carolina RSA.
Additionally, the Company entered into an agreement in February 1998 to sell for
$30 million its interest in the Eastern North Carolina Cellular Joint Venture
which includes the Wilmington and Jacksonville, NC markets. These transactions,
which are expected to close in the third quarter of 1998, are subject to
approval by regulatory authorities, including the FCC. The Company is also
pursuing various divestiture alternatives related to its Florida Metro-Cluster
and other non-core cellular properties in which it owns minority interests.
The Company's markets are located in predominantly suburban and rural
areas proximate to major urban areas, which the Company believes affords it
several advantages over traditional urban wireless operations, including (i)
greater network capacity, (ii) greater roaming revenue opportunities, (iii)
lower distribution costs and (iv) higher barriers to entry. Because there are
limits to the number of signals that can be transmitted simultaneously in a
given area, the Company's less densely populated suburban and rural locations
allow for greater frequency reuse, resulting in greater overall network capacity
than in high density urban markets. The Company is able to provide high quality
voice transmission with reduced instances of blocked or dropped calls. In
addition to these network advantages, the Company's metro-clusters enjoy greater
roaming revenue opportunities by virtue of their proximity to large urban
centers. This benefit is best exemplified in the Mid-Atlantic SuperSystem, which
is located in the heavily traveled corridor between New York, Philadelphia and
Baltimore/Washington D.C. Roaming revenue requires minimal incremental
administrative and marketing expenditures, and the Company believes that it is
well positioned to benefit from both cellular roaming and eventual roaming by
users of personal communication services ("PCS"). The Company has signed an
agreement with AT&T Wireless and Sprint Spectrum to provide roaming services to
both companies' PCS customers who roam into the Company's markets with dual
frequency phones. The Company also believes that it experiences lower
distribution costs due to its internal distribution channels such as direct
sales, retail stores and kiosks, which are more economical outside of urban
areas. Finally, the Company believes that the lower population density and
greater geographic coverage of its suburban and rural metro-clusters act as
barriers to entry given the relatively higher per-subscriber costs of building
competing wireless systems.
Since its inception until the introduction of PCS, the cellular industry
had two entities competing as facilities based carriers in each market.
Licensing for PCS broadband spectrum is complete, and the Company is currently
competing with PCS operators in six markets and is aware of site acquisition,
zoning and construction of infrastructure by other competitive PCS providers in
several of its other markets. The Company is preparing for increased competition
by building out and converting its cellular telephone systems to digital
networks, increasing the quality of coverage in its service areas, offering new
features, products and services to its customers and expanding its service areas
through selected acquisitions of adjacent and nearby cellular systems. The
Company believes its management team's operating experience, developed
distribution channels and customer service orientation will be significant
components in providing effective competition to these new entrants. In
addition, the Company believes its extensive system footprint and the location
of its operations in suburban and rural markets provide significant barriers to
early competition from PCS competitors.
Business Strategy
The Company's overall goal is to continue to pursue strong growth of
subscribers, revenues and EBITDA. The Company intends to achieve this goal
through its operating strategy of providing a broad range of high quality
integrated wireless communications products and services. Key elements of the
Company's strategy include:
o Development of Core Metro-Cluster Service Areas. The Mid-Atlantic
SuperSystem, Ohio Valley SuperSystem and New England Metro-Cluster,
which the Company considers to be its core metro-cluster service
areas, represent 88% of the Company's subscribers and 86% of the
Company's POPs at December 31, 1997. The Company plans to continue a
strategy of developing and supplementing its core regional
metro-clusters to enable it to serve its customers better and to
achieve cost efficiencies through economies of scale. By operating
in contiguous markets, the Company can provide broad areas of
seamless service and achieve economies of scale in marketing and
operations as well as cost efficiencies in deploying its network
infrastructure. The Company continually evaluates opportunities for
acquisitions of new cellular properties in proximate suburban and
rural markets that will expand its core metro-clusters. Given the
Company's focus on its core metro-cluster service areas, the Company
has entered into or is pursuing agreements to divest of its
interests in the Florida and Carolinas metro-clusters as well as its
minority interests in all other non-core cellular properties.
o Continuous Cellular Network Buildout. The Company continuously
improves its systems. In 1994, the Company began a cellular network
expansion and upgrade program in order to increase geographic
coverage and provide for additional portable usage in the Company's
cellular markets. In 1995, 1996 and 1997 combined, the Company added
274 new cell sites and replaced or upgraded 108 others, bringing its
total number of cell sites to 458 as of December 31, 1997. The
Company plans to add 86 cell sites in 1998 as it continues to
enhance its network. The Company believes that its networks have
sufficient capacity in its spectrum to serve the Company's growing
subscriber base in the near future but plans to implement a gradual
transition to digital technology before analog capacity constraints
become a significant concern. The Company's networks are currently
digital-ready, with dual mode analog/Time Division Multiple Access
("TDMA") digital radio technology already built-in such that
individual transmitters may be converted to digital mode with
minimal additional investment. See " -- Expansion of Product
Offerings" and "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations."
o Investment in Brand Identity. The Company's wireless products and
services are distributed under the CellularONE(R) brand name, one of
the most recognized brand names in the wireless industry. The
CellularONE(R) brand name currently is used by cellular systems
covering more than 11,000 cities and towns, representing total POPs
of over 129 million. The Company has a minority ownership interest
in the partnership that owns the CellularONE(R) brand name and that
controls the promotion and management of the brand. In addition to
benefitting from local advertising by licensees, the CellularONE(R)
brand name is advertised on a national basis by the partnership that
owns the brand with funding provided by licensing fees.
o Emphasis on Customer Service and Advanced Billing Systems. The
Company provides on-line customer support, 24 hours a day, seven
days a week. The Company's internally developed, proprietary
Flexcell(R) billing and management information system enables the
Company to provide quality services to its expanding customer base
and affords it access to customer data, which it uses to facilitate
its marketing efforts. One such service is Rapid Activation, which
enables the Company to complete credit checks, order entry, and
subscriber activation within five minutes. See " -- Customer
Service."
o Growth of Internal Distribution Channels. The Company distributes
its products and services through both its internal distribution
network (direct sales force, sales and service centers, and retail
stores) and external distribution channels (national retailers,
local agents and automotive dealers). The Company is continuing its
long-term emphasis on internal distribution channels, particularly
its own retail outlets, which the Company believes offer substantial
benefits. These benefits include lower cost, higher effectiveness in
selling to high margin customers, and a consistent point of customer
contact, resulting in greater ongoing satisfaction for both
internally and externally generated customers. The Company is
therefore building additional retail outlets, as well as upgrading
existing outlets. See " -- Marketing and Distribution."
o Expansion of Product Offerings. The Company continues to offer new
and innovative products and services in order to increase the value
of the basic voice product to the customer and to increase airtime
revenues. In addition to enhanced cellular voice service packages,
the Company has begun to offer data transmission, and Cellular
Digital Packet Data ("CDPD") services are being deployed. The
Company has also begun reselling paging and Internet services.
With the integration of digital technology, the Company will be able
to offer a variety of additional services such as caller
identification, short messaging and call encryption.
2
Markets and Clusters
The following table sets forth as of December 31, 1997, (i) the markets in
which the Company owns an interest in a cellular system by region and by
cluster, (ii) the Company's ownership percentage of the system, (iii) the total
POPs (as derived from 1997 population estimates) and (iv) the Company's POPs
based on its ownership percentage.
Company Total Net
Ownership POPs POPs
--------- ------- -------
Mid-Atlantic SuperSystem:
Allentown, PA/NJ ................ 100.00% 713,438 713,438
Wilkes-Barre/Scranton, PA ....... 100.00 653,817 653,817
Harrisburg, PA .................. 100.00 499,402 499,402
Lancaster, PA ................... 100.00 453,348 453,348
York, PA ........................ 100.00 456,861 456,861
Reading, PA ..................... 100.00 353,650 353,650
Williamsport, PA ................ 100.00 118,681 118,681
State College, PA ............... 100.00 131,962 131,962
Wayne, PA (PA-5 RSA) ............ 100.00 84,292 84,292
Chambersburg, PA (PA-10 East RSA) 100.00 141,875 141,875
Mifflin, PA (PA-11 RSA) ......... 100.00 113,933 113,933
Lebanon, PA (PA-12 RSA) ......... 100.00 117,361 117,361
Union, PA (PA-8 RSA) ............ 100.00 408,709 408,709
Altoona, PA ..................... 100.00 131,287 131,287
Binghamton, NY/PA ............... 100.00 293,703 293,703
Elmira, NY ...................... 100.00 92,820 92,820
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Subtotal .................... 4,765,139
---------
Ohio Valley SuperSystem:
Huntington, WV/KY/OH ............ 100.00 316,929 316,929
Charleston, WV .................. 100.00 254,889 254,889
Parkersburg, WV /OH ............. 100.00 157,364 157,364
Chillecothe, OH (OH-9 RSA) ...... 100.00 248,993 248,993
Athens, OH (OH-10-South RSA) .... 100.00 112,256 112,256
Logan, WV (WV-6 RSA) ............ 100.00 182,128 182,128
Ripley, WV (WV-1 RSA) ........... 100.00 77,008 77,008
---------
Subtotal .................... 1,349,567
---------
New England Metro-cluster:
Portland, ME .................... 100.00 288,136 288,136
Portsmouth, NH/ME ............... 100.00 280,193 280,193
Bar Harbor, ME (ME-4 RSA) ....... 100.00 86,052 86,052
Bangor, ME ...................... 5.31 144,777 7,681
Other ........................... 15,558
---------
Subtotal ................... 677,620
---------
Florida Metro-cluster:
Pensacola, FL ................... 100.00 390,989 390,989
Fort Walton Beach, FL ........... 100.00 168,283 168,283
Panama City, FL ................. 18.28 146,713 20,184
Columbus, GA .................... 13.69 250,931 34,361
Albany, GA ...................... 10.29 117,662 12,105
Pascagoula, MS .................. 3.99 129,421 5,164
Other ........................... 9,445
---------
Subtotal .................... 640,531
---------
Carolinas Metro-cluster:
* Myrtle Beach, SC (SC-5 RSA) ... 100.00 253,351 253,351
* + Wilmington, NC ................ 47.97 211,278 101,345
* + Jacksonville, NC .............. 47.79 144,614 69,112
Petersburg, VA ................ 12.44 129,786 16,141
---------
Subtotal ..................... 439,949
---------
Other Minority Interests .......... 38,664
---------
TOTAL POPs ........................ 7,911,470
=========
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+ Jointly controlled through the Company's 50% ownership of a joint venture.
* The Company has entered into agreements to divest of these interests in
1998.
3
Subscribers
Management believes that the Company generates the majority of its revenue
from subscribers who are business users. Historically, the Company's business
users were individuals in such professions as construction and real estate who
worked extensively from their cars and utilized cellular telephone service to
improve productivity. As a result of the growing acceptance of cellular
communications and the declining cost of portable and transportable phones, as
well as the Company's marketing efforts, the Company is attracting larger
numbers of customers who are nonbusiness users and business users now are drawn
from a wider range of occupations. Business users normally generate more revenue
than nonbusiness consumers. While the Company anticipates increasing nonbusiness
consumer acceptance of cellular telephone service, business users are expected
to generate the majority of the Company's revenue for the foreseeable future.
The following table sets forth the aggregate number of subscribers in the
Company's majority-owned markets at the end of the periods indicated.
Quarter 1995 1996 1997
------- ------- ------- -------
First ........... 280,000 405,000 540,000
Second .......... 314,000 430,000 580,000
Third ........... 340,000 461,000 610,000
Fourth .......... 381,000 513,000 645,000
The incremental subscriber growth and the rate of incremental subscriber
growth in the Company's majority-owned markets is set forth in the following
table for the periods indicated.
1995 1996 1997
------- ------- -------
Incremental Subscriber Growth ....... 136,000 132,000 132,000
Rate of Incremental Subscriber Growth 56% 35% 26%
The following table sets forth the number of subscribers and the
penetration percentages in majority-owned markets as of the dates indicated.
December 31,
-------------------------------------------------------------------------------
1995 1996 1997
----------------------- ----------------------- -----------------------
Subscribers Penetration* Subscribers Penetration* Subscribers Penetration*
----------------------- ----------------------- -----------------------
Mid-Atlantic SuperSystem 254,500 5.01% 324,500 6.81% 408,000 8.56%
Ohio Valley SuperSystem 45,500 7.31 78,500 5.79 98,500 7.26
New England ............ 35,500 5.50 48,500 8.61 60,000 9.25
Florida ................ 29,000 5.33 39,000 7.00 48,000 8.58
Carolinas .............. 16,500 6.82 22,500 9.05 30,500 12.04
------- ------- -------
Total ................ 381,000 5.34 513,000 6.77 645,000 8.51
======= ======= =======
- ----------
* Penetration represents total year-end subscribers divided by year-end
total POPs in the Company's majority-owned markets.
The decrease in penetration from 1995 to 1996 in the Ohio Valley
SuperSystem was due entirely to the acquisition in 1996 of certain markets in
which the penetration was significantly lower than the Company's existing
markets. The Company expects this region to add subscribers at rates consistent
with its other operating regions in the future. The Company believes subscriber
growth and increased penetration in 1995, 1996 and 1997 were a product of the
growing acceptance of cellular communications and the Company's efforts to
capitalize on this increasing acceptance of cellular communications and an
expanded distribution network. In addition, 1995 and 1996 subscriber growth was
augmented by approximately 9,000 and 5,000, subscribers, respectively,
associated with the acquisition of certain cellular markets.
Products and Services
The Company's primary line of business is the provision of cellular
telephone services. Customers are offered several pricing options combining
different monthly access and usage charges and fees for related services.
The Company provides regional service among its contiguous markets, such
as those within the Mid-Atlantic SuperSystem. A customer in these regions can
place and receive calls throughout the network without any additional daily fee
and often at the same incremental rate per minute as in the customer's home
market. In certain adjacent cellular markets not owned by the Company, the
4
Company offers similar regional pricing options to its subscribers. The Company
has entered into agreements with other cellular companies that allow its
subscribers to roam in substantially all of the MSAs and RSAs in the country.
These agreements allow the Company's subscribers to be pre-registered in
cellular systems outside the Company's operating regions and to receive service
while they are outside their home systems, typically for a per minute usage
charge, and in most cases, an additional daily fee.
The Company has offered and will continue to offer new and innovative
products and services in order to increase the value of the basic voice product
to the customer and to increase airtime revenues. Recent service additions
include enhanced voice mail, which alerts the customer when a message has been
left, and single number service, which allows a customer to use the same phone
number in several locations. Other recent service additions include call
management, which directs incoming calls to a succession of locations until the
customer is reached, and voice dialing, which lets the customer make calls by
spoken command without having to touch the keypad.
The Company now offers digital data transmission over its existing
cellular network, which allows the rapid transfer of data to and from personal
computers, personal digital assistants, and other devices. During 1997, the
Company completed testing of its TDMA digital voice and features network in
conjunction with Northern Telecom. Vanguard was selected to serve as the test
site for Northern Telecom's TDMA hardware and software. The tests were
successful and led to the introduction of IS-136 TDMA digital voice using the
new 13 Kb vocoders (voice encoders) and features in Myrtle Beach, South Carolina
and the Southern Pennsylvania region in the fourth quarter of 1997. The
remaining markets are expected to offer digital service by the second quarter of
1998.
The digital upgrades will allow the Company to offer a full range of
digital services to its customers. Among the new opportunities are full digital
voice communication, short message service, caller ID, and paging. Additionally,
Cellular Digital Packet Data ("CDPD") and Wireless Intelligent Network ("WIN")
services are being deployed. See "--Cellular Technology."
During 1997, other new product offerings included extensive voice-mail and
call-tracking options. The Company has begun reselling paging services in its
regional metro-clusters. To maintain its access to quality paging for its
customers in its Mid-Atlantic SuperSystem, the Company has entered into an
agreement to purchase NationPage, a leading regional paging provider in
Pennsylvania and New York for approximately $28.5 million. The acquisition of
NationPage will minimize future capacity constraints, eliminate variations in
reselling prices and margins, and create synergies with the Vanguard sales and
network infrastructure. The Company also expanded its product offering into
Internet services as a reseller.
During 1998, the Company's transition to digital service will allow the
Company to offer a full range of digital services to customers as discussed
above. Additionally, the Company intends to offer long distance telephone
service on a reselling basis.
Marketing and Distribution
The Company markets its services under the CellularONE(R) brand name, one
of the most recognized brand names in the wireless communications industry. In
addition to benefiting from local advertising by licensees, the CellularONE(R)
brand name is advertised on a national basis by the partnership that owns the
brand using the proceeds of licensing fees. The CellularONE(R) brand name
currently is used by cellular systems covering more than 11,000 cities and towns
with total POPs of more than 129 million. The Company is one of three owners of
the CellularONE(R) brand name. The Company currently has an option to increase
its ownership interest in the partnership that owns the brand name, at a cost of
approximately $6.1 million, to one-third from the 2.5% interest it currently
owns. As an owner of the CellularONE(R) name, the Company exercises influence
over the promotion and future services offered under the brand. As part of an
ongoing strategy to enhance the value of the CellularONE(R) brand, the owners of
the brand currently plan to continue to license new carriers to operate under
the CellularONE(R) name, both for cellular, as well as for paging, PCS, long
distance and for resellers of these services. Where CellularONE(R) is licensed,
existing licensees currently have the exclusive right to use the brand name for
cellular and other services.
The Company uses multiple distribution channels in each of its service
areas to provide effective and extensive marketing of its products and services
and to reduce its reliance on any single distribution source. These distribution
channels fall into two broad categories: internally developed and controlled
channels, and external channels.
The Company is continuing its long-term focus on internal distribution
channels as a means to reduce the cost and improve the quality of new
subscribers. The Company's retail stores have been a historically low-cost
distribution channel.
5
The Company believes that cellular customers prefer to deal directly with sales
representatives employed by the Company. In addition, Company stores provide an
ongoing point of contact for service to subscribers regardless of whether the
point of purchase was internal or external. The Company plans to expand its base
of retail stores and kiosks and upgrade its existing retail outlets. The Company
had over 110 retail locations as of December 31, 1997 and intends to add 10
locations in 1998.
The Company's direct sales force consists of approximately 850 sales and
administrative employees, who target small-to-medium sized companies, a
high-margin area of business. In order to maintain a knowledgeable,
customer-oriented sales force, the Company developed and administers its own
sales training program designed to educate sales representatives for its
markets. The program offers a curriculum that highlights mobile technologies,
cellular equipment prospecting, sales techniques, and the customer service
process, and the Company believes that, following the program, sales
representatives are better able to address existing and potential customers'
needs in a professional, knowledgeable and productive manner.
The Company sells and rents cellular telephone equipment to its customers
in order to encourage use of its services. The Company continues its practice,
typical in the industry, of selling telephones at or below cost in response to
competitive pressures. The magnitude of the losses experienced in connection
with providing cellular telephone equipment reflects the Company's increased
subscriber growth. The Company also offers an equipment rental program that many
subscribers have found to be an economical means of acquiring the use of
cellular equipment. Under the terms of the rental program, subscribers obtain
the use of a cellular telephone for a monthly charge. Although the Company
retains ownership of this equipment, subscribers have the option to purchase
their cellular telephones at any time during the rental period. The Company
often utilizes a promotion under which the first year's rental charge is waived
when the subscriber agrees to a one-year service contract.
The Company also utilizes a telemarketing program as part of its sales and
customer service efforts. This program is intended to aid the customer by
providing sales follow-up and support, and helps the Company in securing
additional and better sales referrals, upgrading existing subscribers to higher
rate plans and promoting new custom-calling features.
External distribution channels include national retailers such as WalMart,
automobile dealers, and local agents and resellers. The Company enters into
exclusive short-term contracts with each of its external distribution channels.
Rapid growth in the wireless communications business, especially from customers
contracted through external channels, reduced the percentage of
internally generated customers from 70% in 1992 to 52% in 1995. While the
Company benefitted from the increased success of external distribution channels,
the Company continues to emphasize internal distribution channels, which it
believes result in higher long-term profit margins, and as a result, the
percentage of internally generated customers increased to 70% and 75% in 1996
and 1997, respectively.
Customer Service
The Company places a high priority on providing consistently high quality
customer service. The central customer service department located in Greensboro,
North Carolina, is open 24 hours daily, including weekends and holidays, and is
available to handle all types of customer service inquiries. In 1996, the
Company opened regional call centers in each of its metro-clusters to handle
certain types of customer issues. The benefits of regional call centers include
having service delivery as close to the customer as possible to cover specific
regional circumstances, being a more significant local employer in the regions
and reducing the risk of encountering a lack of experienced customer service
employees in the Greensboro, North Carolina area. The central customer service
facility continues to provide service as backup and overflow for the regional
centers, as primary service provider in certain instances and for the critical
evening, night and weekend duty. All customer service personnel are trained in
certain key areas such as general mobile telephone technology, available
cellular equipment, cellular billing and roaming. The Company believes that this
training provides these employees with the requisite knowledge to handle
customer inquiries quickly and competently, resulting in greater customer
satisfaction. The Company's training program, which was developed and is
administered internally, requires employees to demonstrate competency through
testing.
The Company has developed a proprietary billing and management information
system, Flexcell(R), which it believes provides several service advantages to
its customers. Using Flexcell(R), customer service representatives are able to
access current billing information quickly in order to respond promptly to
customer inquiries. In addition, this system allows for integration of
customer-related data from various operations within the Company into a single
database. Using this database, service calls are systematically analyzed each
month to highlight key customer issues. The customer database also provides the
basis for customer satisfaction information. The Company has entered into a
contract to provide Flexcell(R) software and support to American Mobile
Satellite Corporation, but is not currently marketing Flexcell(R) to third
parties in order to ensure that it can meet the needs of the Company and
American Mobile Satellite Corporation.
6
To supplement the Company's customer service operations, Company
telemarketers contact customers periodically to determine their satisfaction
with the Company's service and to identify problems that can lead to subscriber
cancellations. The Company has developed an integrated feature called "Rapid
Activation," designed to reduce the time required to activate service for a new
customer. Rapid Activation allows the Company to perform a credit check,
complete order entry and activate a cellular subscriber in approximately five
minutes.
To ensure quality installation for automotive customers and overall
customer satisfaction, the Company has established its own installation and
repair centers in most of its markets. These CellularONE(R) installation and
repair centers provide one-stop shopping for the Company's customers and enable
the Company to control installation quality and scheduling and inventory levels.
These centers are also authorized to perform warranty repair work for certain
cellular telephone manufacturers.
Cellular Telephone Technology
Cellular telephone service is a form of telecommunications capable of
delivering high quality, high capacity mobile and portable telephone services.
Cellular systems are engineered so that a service area is divided into multiple
cells approximately one to five miles in radius. Each cell contains a relatively
low power transmitter, a receiver and signaling equipment (the base station).
The base station in each cell is connected by microwave or telephone line to the
mobile telephone switching office ("MTSO"). The MTSO controls the automatic
transfer of calls from cell to cell as a subscriber travels, coordinates calls
to and from a mobile unit, allocates calls among the cells within the system,
and connects calls to the local landline telephone system or to a long-distance
telephone network. Each conversation in a cellular system involves a radio
transmission between a subscriber unit and a base station and the transmission
of the call between the base station and the MTSO.
The MTSO and base stations periodically monitor the signal strength of
calls in progress. The signal strength of the transmission between a subscriber
unit and the base station in any cell declines as the unit moves away from the
base station. When the signal strength of a call declines to a predetermined
level, the MTSO hands off the call in a fraction of a second to the base station
of another cell where the transmission strength is greater. If the subscriber
unit leaves the service area of the cellular system, the call is disconnected
unless an appropriate technical interface has been established with an adjacent
system.
The FCC has allocated the cellular telephone systems frequencies in the
800 MHz band of the radio spectrum. Each of the two licenses in a cellular
market is assigned 416 frequency pairs. Each conversation on a cellular system
occurs on a pair of radio talking paths, thus providing full duplex (i.e.,
simultaneous two-way) service. Two significant features of cellular telephone
systems are: (i) frequency reuse, enabling the simultaneous use of the same
frequency in two adequately separated cells, and (ii) call hand-off. A cellular
telephone system's frequency reuse and call hand-off features result in
efficient use of available frequencies and enable cellular telephone systems to
process more simultaneous calls and service more users over a greater area than
conventional mobile telephone systems.
A cellular telephone system's capacity can be increased in various ways.
Within certain limitations, increasing demand may be met by simply adding
available frequency capacity to cells as required or, by using directional
antennas, dividing a cell into discrete multiple sectors or coverage areas,
thereby facilitating frequency reuse. Furthermore, an area within a system may
be served by more than one cell through procedures that utilize available
channels in adjacent cells. When all possible channels are in use, further
growth can be accomplished through a process known as "cell splitting." Cell
splitting entails dividing a single cell into a number of smaller cells serviced
by lower-power transmitters, thereby increasing the reuse factor and the number
of calls that can be handled in a given area. Digital transmission technologies
are expected to provide cellular licensees with additional capacity to handle
calls on cellular frequencies.
There are limits to the number of signals that can be transmitted
simultaneously in a given area. In highly populated MSAs, the level of demand
for mobile and portable service is often large in relation to the existing
capacity of most systems. Based on the demographics of its markets, the Company
does not anticipate that the provision of mobile and portable service within its
networks will require as large a proportion of the systems' capacities as is
required in higher density MSAs. Therefore, the Company's systems are expected
to have more capacity with which to pursue data applications and other expanded
cellular services, which the Company believes may enhance its revenue potential
and limit market opportunities for competitive mobile data systems.
All cellular telephones are designed to be compatible with cellular
systems in all market areas within the United States so that a cellular
telephone may be used wherever a subscriber is located. Changes of cellular
telephone numbers or other technical adjustments to mobile units by the
manufacturer or local cellular telephone service businesses are generally
required to enable the subscriber to change from one cellular service provider
to another within a service area. Cellular system operators may provide service
to roamers
7
temporarily located in, or traveling through, their service area. The cellular
system providing service to the roamer generally receives 100% of the revenues
from such service and such roaming charges are billed to the roamer's local
service provider.
The cellular mobile telephone services available to customers and the
sources of revenue available to a system operator are similar to those available
with standard home and office telephones. For example, cellular systems can
offer a variety of features, including call forwarding, call waiting, conference
calling, voice message and retrieval, and data transmission. Because cellular
systems are fully interconnected with the landline telephone network,
subscribers can receive and originate both local and long distance calls from
their cellular telephones. The subscribers generally are charged separately for
monthly access, air time, toll calls and custom calling features.
Cellular telephone systems operate under interconnection agreements with
various local exchange carriers ("LECs") and interexchange (long distance)
carriers ("IXCs"). The interconnection agreements establish the manner in which
the cellular telephone system integrates with other telecommunications systems.
The cellular operator and the local landline telephone Company must cooperate in
the interconnection between the cellular and landline telephone systems to
permit cellular subscribers to call landline subscribers and vice versa. The
technical and financial details of such interconnection arrangements are subject
to negotiation and vary from system to system.
There are a number of recent technical developments in the cellular
industry. Currently, while most of the MTSOs process information digitally, the
radio transmission of cellular telephone calls is done predominantly on an
analog basis. Digital technology offers advantages, including improved voice
quality, larger system capacity, and perhaps lower incremental costs for
additional subscribers. The conversion from analog to digital radio technology
is expected to be an industry-wide process that will take a number of years.
There are currently two principal digital technologies used by cellular
operators in the United States, Time Division Multiple Access ("TDMA") and Code
Division Multiple Access ("CDMA"). All leading telecommunications handset
manufacturers are producing digital dual-mode phones and preparing for the
rollout of TDMA which is presently in commercial service. CDMA is currently
operating in a limited number of markets. CDMA technology is expected to
increase system capacity significantly relative to that provided by analog
systems albeit at a higher unit cost than TDMA.
During 1997, the Company completed testing of its TDMA digital voice and
features network in conjunction with Northern Telecom. Vanguard was selected to
serve as the test site for North Telecom's TDMA hardware and software. The tests
were successful and led to the introduction of IS-136 TDMA digital voice using
new 13Kb vocoders (voice encoders) and features in Myrtle Beach, South Carolina
and the Southern Pennsylvania region in the fourth quarter of 1997. The
remaining markets are expected to offer digital service by the second quarter of
1998. The substantial majority of the cellular equipment currently employed by
the Company in its systems is "TDMA ready" and can work in either an analog or
digital mode. As a result, the Company should be able to transition from analog
to digital mode with minimal expense. At the time of any conversion, the
Company's subscribers may not have digital handsets and, as a result, the
Company may have to provide such devices to some of its subscribers. If this is
necessary the Company will analyze usage patterns to determine the most
effective means of distributing these handsets to a small segment of its
subscribers who have disproportionately high use. However, one or more of the
technologies currently utilized by the Company or implemented in the future may
not be preferred by its customers or may become obsolete. If either event
occurs, it could result in the Company undergoing a conversion which could
involve significant expense. Pending such a conversion, the Company could be at
a competitive disadvantage.
Competition
Other Cellular Competition. The cellular telephone business is a regulated
duopoly. Until 1994, the FCC provided for only two licenses in each market
(although certain markets have been subdivided as a result of voluntary
settlements), one to a nonwireline company and one to a wireline company, which
is usually the local telephone company or its affiliate. Each licensee has the
exclusive grant of a defined frequency band within each market. The Company
holds exclusively nonwireline licenses. The primary competition, therefore, for
the Company's cellular service in any market has traditionally come from the
wireline licensee in that market. Competition is principally on the basis of
services and enhancements offered (including the provision of cellular equipment
at or below cost), the technical quality of the system, price and the quality
and responsiveness of customer service.
8
In the Company's majority-owned markets, its cellular competitors are
affiliates of the following companies:
Market Cellular Competitor
------ -------------------
Allentown, PA/NJ Bell Atlantic Mobile
Altoona, PA 360(degree) Communications Company
Harrisburg, PA 360(degree) Communications Company
Lancaster, PA 360(degree) Communications Company
Reading, PA Bell Atlantic Mobile
State College, PA 360(degree) Communications Company.
Wilkes Barre/Scranton, PA 360(degree) Communications Company
Williamsport, PA 360(degree) Communications Company
York, PA 360(degree) Communications Company
Wayne, PA (PA-5 RSA) 360(degree) Communications Company
Union, PA (PA-8 RSA) 360(degree) Communications Company
Chambersburg, PA (PA-10 East RSA) 360(degree) Communications Company
Mifflin, PA (PA-11 RSA) Bell Atlantic Mobile
Lebanon, PA (PA-12 RSA) 360(degree) Communications Company
Binghamton, NY/PA Frontier/Bell Atlantic Mobile
Elmira, NY Frontier/Bell Atlantic Mobile
Charleston, WV 360(degree) Communications Company
Huntington, WV/OH/KY 360(degree) Communications Company
Parkersburg/Marietta WV/OH 360(degree) Communications Company
Jackson, WV (WV-l East RSA) Bell Atlantic Mobile
Logan, WV (WV-6 RSA) 360(degree) Communications Company
Athens, Ohio (OH-10 RSA) 360(degree) Communications Company
Chillicothe, Ohio (OH-9 RSA) U.S. Cellular Corp.
Pensacola, FL GTE Mobilnet
Fort Walton Beach, FL 360(degree) Communications Company
Myrtle Beach, SC (SC-5 RSA) 360(degree) Communications Company
Portland, ME Northeast Cellular/U.S. Cellular Corp.
Portsmouth, NH/ME Saco River Cellular, Inc./U.S.
Cellular Corp.
Bar Harbor, ME (ME-4 RSA) U.S. Cellular Corp.
Recently, Alltel announced that it would merge with 360(degree)
Communications Company, subject to receipt of regulatory approvals.
Competition from Other Technologies. In addition to competition from the
other cellular carrier in each of its markets, the Company faces or will face
competition from PCS, Enhanced Specialized Mobile Radio ("ESMR") system
operators, and resellers of cellular and other facilities-based services.
Licensing for broadband PCS has been divided by the FCC into 51 Major
Trading Areas ("MTAs") and 493 Basic Trading Areas ("BTAs") based upon
geographic boundaries described in the 1992 Rand McNally Commercial Atlas &
Marketing Guide. Two licensees each will hold 30 MHz of PCS spectrum in each
MTA, one licensee will hold 30 MHz of PCS spectrum in each BTA and three
licensees will hold 10 MHz of PCS spectrum in each BTA. The FCC's rules limit a
cellular licensee to 45 MHz of aggregate spectrum in an area in which the
cellular licensee provides cellular services to 10% or more of the population.
The FCC's imposed 45 MHz cap for combined PCS/cellular spectrum means that
cellular carriers may acquire two 10 MHz PCS licenses now. Cellular licensees
are not limited by the two 10 MHz PCS license limitations outside of the areas
in which they operate cellular systems.
PCS services include wireless two-way telecommunications for voice, data
and other transmissions employing digital micro-cellular technology. PCS
operates in the 1850 to 1990 MHz band. PCS requires a network of small,
low-powered transceivers placed throughout a neighborhood, business office or
office complex, city or metropolitan area. PCS customers communicate using
digital devices similar to portable cellular telephones. The Company believes
that digital service technology offers similar services on the 800 MHz cellular
frequencies.
During all of 1997, the Company competed with a PCS operator in its Myrtle
Beach RSA. In addition, during the year, the construction of towers and other
wireless infrastructure by other competitive PCS providers occurred in many of
the Company's other markets. The Company is currently competing with PCS
operators in six of its majority-owned markets. The Company's active PCS
competitors are affiliates of the following companies:
9
Market PCS Competitor
------ --------------
Allentown, PA/NJ Omnipoint
Harrisburg, PA Omnipoint
Chillicothe, Ohio (OH-9 RSA) Chillicothe Telephone
Myrtle Beach, SC (SC-5 RSA) BellSouth/Horry Telephone
Portland, ME Sprint Spectrum
Portsmouth, NH/ME Sprint Spectrum
The specialized mobile radio ("SMR") industry provides customers,
principally business users such as taxicabs and construction firms with two-way
radio dispatch services. The FCC has licensed Enhanced SMR ("ESMR") system
operators to construct digital mobile communications systems on existing SMR
frequencies in many metropolitan areas throughout the United States. ESMR
systems are permitted by the FCC to be interconnected to the public switched
telephone network and are significantly less expensive to build and operate than
other wireless telephone systems. The systems are, however, licensed to operate
on substantially fewer channels per system than cellular or PCS systems, and
currently lack the ability to expand capacity through frequency re-use by using
low-power transmitters and by handing off calls. However, in 1994, the FCC
licensed ESMR systems in the 800-MHz bands for wide-area use, thus increasing
the potential competition with cellular networks. The FCC has also decided to
license SMR spectrum in contiguous blocks via the competitive bidding process.
ESMR systems have been built out in most MSAs and some RSAs and offer both
traditional dispatch services and cellular like services.
Cellular system licensees are required by FCC policy to provide wholesale
cellular service to qualified resellers. A reseller provides cellular service to
customers but is not itself an FCC cellular license holder. A reseller typically
buys capacity on a cellular telephone network and is assigned a block of
cellular telephone numbers from a cellular carrier. The reseller markets provide
wireless telephone service through their own distribution channels to the
public. In this way, a reseller is not only a customer of the cellular telephone
licensee's service, but also competes with the licensee for customers.
The Company intends to explore mutually advantageous relationships with
resellers to supplement its existing distribution channels. MCI Communications,
Inc. and other large communications companies have begun negotiating resale
agreements in certain larger markets throughout the country. The Company
believes that it will receive increasing interest from persons interested in
reselling the Company's cellular service but there can be no assurance that this
will occur or that pursuing any such opportunities will be profitable.
Plans to construct and launch Low Earth Orbit satellites ("LEOs"), such as
Motorola's Iridium project, are viewed as a feasible means of providing wireless
phone service to remote areas that would otherwise be unattractive to other
wireless operators. The service can therefore be viewed as complementary (not
competitive with cellular), particularly since LEOs are expected to eventually
offer their connection services to wireless operators in their service areas.
In February 1997, the U.S. entered into a World Trade Organization treaty
stipulating global telecommunications standards. The agreement requires the U.S.
to permit foreign investors to hold indirect ownership of commercial mobile
radio services ("CMRS") licenses in the U.S. These changes will permit
additional foreign investment and participation in the U.S. wireless marketplace
and therefore may enhance competition.
Despite increasing competition from PCS, SMR and other technologies,
cellular service is expected to maintain its dominant position in the wireless
communications industry in the near future. While the new PCS operators are
forcing operators to digitize their networks at a faster pace, cellular
operators have a considerable head start relative to future entrants into the
wireless communications industry. As a result, competing technologies will have
to address the cellular industry's considerable coverage, marketing advantage
and other barriers to entry. In the meantime, the cellular industry's
increasingly rapid pace of conversion to digital will provide it with the
ability to offer expanded services, improved quality and lower pricing to its
customer base.
The Company is preparing for the more competitive environment represented
by the introduction of PCS and other digitally based communications technologies
by building out and enhancing its cellular telephone networks including the
conversion of its own networks to digital technology, increasing the quality of
coverage in its service areas, expanding its service areas by selected
acquisitions of adjacent and nearby cellular systems and by offering new
features, products and services to its customers that the Company believes will
be competitive with future communications providers that may utilize digital
technology. See " -- Products and Services." The Company believes that it can
effectively compete by utilizing its experience in developing and operating
cellular networks and by virtue of the barriers imposed by its extensive
existing system footprint. The Company believes that it has developed strong
distribution channels and customer service capabilities overseen by an
experienced management team.
10
The Company will offer roaming services to PCS customers and has already entered
into several roaming contracts to do so.
Regulation of Cellular Systems
Federal Regulation. The Company is subject to extensive regulation by the
Federal Government as a provider of cellular communications services. Pursuant
to the Communications Act of 1934, as amended (the "Communications Act"), the
licensing, construction, operation, acquisition and transfer of cellular
communications systems in the United States are regulated by the FCC. The FCC
has promulgated rules governing the construction and operation of cellular
communications systems and licensing and technical standards for the provision
of cellular telephone service ("FCC Rules"). For licensing purposes, the United
States is divided into 734 discrete geographically defined market areas
comprised of 306 MSAs and 428 RSAs.
In each market, the frequencies allocated for cellular telephone use are
divided into two equal 25 MHZ blocks and designated as Block A and Block B.
Block A licenses were initially reserved for nonwireline entities, such as the
Company. Block B licensees were initially reserved for entities affiliated with
a wireline telephone company. Under current FCC Rules, a Block A or Block B
License may be transferred with FCC approval without restriction as to wireline
affiliation, but generally, no entity may own a substantial interest in both
block A and Block B in any one MSA or RSA. The FCC may prohibit or impose
conditions on sales or transfers of licenses.
Cellular service providers must satisfy a variety of FCC requirements
relating to technical and reporting matters. One such requirement is the
coordination of proposed frequency usage with adjacent cellular users, permitees
and licensees in order to avoid interference between adjacent systems. In
addition, the height and power of base station transmitting facilities and the
type of signals they emit must fall within specified parameters. The FCC also
regulates cellular service resale practices and the terms under which certain
ancillary services may be provided through cellular facilities.
The Company also regularly applies for FCC authority to use additional
frequencies, to modify the technical parameters of existing licenses, to expand
its service territory and to provide new services. The Communications Act
requires prior FCC approval for transfers to or from the Company of a
controlling interest in any license or construction permit, or any rights
thereunder. Although there can be no assurance that any future requests for
approval of applications filed will be approved or acted upon in a timely manner
by the FCC, the Company has no reason to believe such requests or applications
would not be approved or granted in due course.
Initial operating licenses are generally granted for terms of up to 10
years, beginning on the dates of the grant of the initial operating authority
and are renewable upon application to the FCC. Licenses may be revoked and
license renewal applications denied for cause after appropriate notice and
hearing. The FCC generally grants current licensees a license renewal if they
have complied with their obligations under the Communications Act during their
license terms. A potential challenger would bear a heavy burden to demonstrate
that a license should not be renewed if the licensee's performance merits
renewal expectancy.
Near the conclusion of the license term, licensees must file applications
for renewal of licenses to obtain authority to operate for up to an additional
10-year term. Applications for license renewal may be denied if the FCC
determines that the grant of an application would not serve the public interest.
In addition, at license renewal time, other parties may file competing
applications for authorization. In the event that qualified competitors file,
the FCC may be required to hold a hearing to determine whether the incumbent or
the competitor will receive the license. In 1993, the FCC adopted specific
standards to apply to cellular renewals, concluding that it will award a renewal
expectancy to a cellular licensee that meets certain standards of past
performance. If the existing licensee receives a renewal expectancy, it is
likely that the existing licensee's cellular license will be renewed without a
full comparative hearing. To receive a renewal expectancy, a licensee must show
that it (i) has provided "substantial" service during its past license term, and
(ii) has substantially complied with applicable FCC Rules and policies and the
Communications Act. "Substantial" service is defined as service which is sound,
favorable and substantially above a level of mediocre service that might only
minimally warrant renewal.
In 1994, the Company filed for renewal of one expiring license (for the
Allentown-Bethlehem-Easton, PA/NJ MSA) which was originally granted by the FCC
in 1985. In 1995, the Company filed for renewal of two expiring licenses (for
the Northeast Pennsylvania, PA and Harrisburg, PA MSAs) which were originally
granted by the FCC in 1986. In 1997, the Company filed for renewal of eight
additional MSA licenses which were originally granted in 1987. All license
renewals were granted without challenge. The Company believes that it has met
and will continue to meet all requirements necessary to secure renewal of its
remaining cellular licenses which are scheduled to expire between 1998 and 2006.
However, there can be no assurances that any such licenses will be renewed.
11
In July 1994, the FCC issued a notice proposing a requirement whereby all
cellular carriers would have to provide interexchange carriers with equal
access. Currently, only AT&T-affiliated cellular carriers and the cellular
affiliates of the Regional Bell Operating Companies ("RBOCs") are required to
provide equal access. The FCC also proposed requiring all commercial mobile
radio service providers to provide interconnection to other mobile service
providers. In April 1995, however, the FCC concluded that it would be premature
to adopt such a requirement. The Telecommunications Act of 1996 (the "Telecom
Act") provides that a cellular carrier need not provide equal access unless such
denial is contrary to the public interest.
The Telecommunications Act of 1996. The Telecom Act makes changes to the
Communications Act and the antitrust consent decree applicable to the RBOCs,
affecting the cellular industry. This legislation, among other things, affects
competition for local telecommunications services, interconnection arrangements
for carriers, universal service funding and the provision of interexchange
services by the RBOCs' wireless systems.
The Telecom Act requires state public utilities commissions and/or the FCC
to implement policies that mandate cost-based reciprocal compensation between
cellular carriers and local exchange carriers for interconnection services. The
Company believes that implementation of these policies has resulted in a
substantial decrease in interconnection expenses incurred by the Company.
Pursuant to the requirements of the Act, the Company entered into negotiations
with all of the local exchange carriers who provide interexchange service to the
Company and its customers. These negotiations have resulted in contracts
containing significant decreases in the rates charged by many of the LECs and
have also provided for the LEC to pay reciprocal compensation to the Company for
calls the Company terminates to its customers. The Company has not yet concluded
negotiations with all of these LECs. These contractual arrangements must be
reviewed by state public utility commissions within 90 days of submission, or
the agreements will become effective automatically.
The Telecom Act also eases the restrictions on provision of interexchange
telephone services by wireless carriers affiliated with RBOCs. RBOC-related
wireless carriers have interpreted the legislation to permit immediate provision
of long distance call delivery for their cellular customers and have begun
providing this service.
State and Local Approvals. Congress amended the Communications Act to
preempt, as of August 10, 1994, state or local regulation of the entry of, and
the rates charged by, any commercial mobile service or any private mobile
service, which includes cellular telephone service. The Company is free to
establish rates and offer new products and services with a minimum of regulatory
requirements. Several of the nine states in which the Company operates still
maintain nominal oversight jurisdiction, primarily focusing upon resolution of
customer complaints.
The location and construction of cellular transmitter towers and antennas
are subject to Federal Aviation Administration ("FAA") regulations and may be
subject to Federal, state and local environmental regulation as well as state or
local zoning, land use and other regulation. Before a system can be put into
commercial operation, the grantee of a construction permit must obtain all
necessary zoning and building permit approvals for the cell sites and MTSO
locations and must secure state certification and tariff approvals, if required.
The time needed to obtain zoning approvals and requisite site permits varies
from market to market and state to state. Similarly, variations exist in local
zoning processes. There can be no assurance that any state or local regulatory
requirements currently applicable to the systems in which the Company's
affiliates have an interest will not be changed in the future or that regulatory
requirements will not be adopted in those states and localities which currently
have none.
Zoning and planning regulation is becoming more restrictive with the
addition of PCS carriers which are seeking sites for network construction as
well. The industry is seeking relief from local laws which arbitrarily restrict
the expansion of cellular networks. The Telecom Act provides potential limited
relief by permitting the FCC to preempt states and localities from applying
regulations in a manner which has the effect of prohibiting construction and
operation of new cell sites. Members of the Vermont Congressional delegation
have announced plans to introduce legislation to strip the FCC of the power to
preempt states and localities.
The Communications Act prohibits the issuance of a license to, or the
holding of a license by, any corporation of which more than 20% of the capital
stock is owned of record or voted by non-U.S. citizens or their representatives
or by a foreign government or a representative thereof, or by any corporation
organized under the laws of a foreign country. The Communications Act also
prohibits the issuance of a license to, or the holding of a license by, any
corporation directly or indirectly controlled by any other corporation of which
more than 25% of the capital stock is owned of record or voted by non-U.S.
citizens or their representatives or by a foreign government or representative
thereof, or by any corporation organized under the laws of a foreign country.
The FCC does however have the power to waive these restrictions in appropriate
circumstances and a recent World Trade Organization treaty has had the effect of
easing these restrictions further. The FCC has interpreted these restrictions to
apply to partnerships and other business entities as well as corporations,
subject to certain modifications. Failure to comply with these requirements may
result in denial or revocation of licenses.
12
Other Investments
International Wireless Communications Holdings, Inc. and Foreign
Investments. The Company believes that foreign markets offer significant
opportunities for wireless communications providers because of the limited
availability of traditional landline telephone systems in many countries and the
increasing demand for communications services. The Company's strategy is to
pursue opportunities in the international arena as they arise without diverting
the Company's financial and personnel resources from its primary business.
Accordingly, the Company has primarily pursued such opportunities through joint
ventures with local entities and others and its investment in International
Wireless Communications Holdings, Inc. ("IWC").
As of December 31, 1997, the Company had invested approximately $13.8
million and owned a 36% equity interest in IWC. IWC is a development stage
company specializing in securing, building and operating wireless businesses,
primarily in Asia and Latin America.
During 1997, the Company loaned $966,000 to IWC under the $7 million
Senior Exchangeable Debt Facility in which the Company participated along with
Toronto Dominion Capital and certain other IWC shareholders. The Company also
received warrants to purchase IWC certain stock valued at $486,000 in connection
with the Company's guarantee and funding of certain loans to IWC affiliates Star
Digitel Limited and Pakistan Wireless Holdings, Inc., discussed below. In March
1998, the Company made an additional $10 million equity investment in IWC. As
the result of equity financing transactions completed by IWC thus far during
1998, the Company's ownership in IWC has been reduced to approximately 29%. See
"Item 7. Management's Discussion and Analysis of Financial Conditions and
Results of Operations."
During the first quarter of 1997, the Company entered into a stock
purchase agreement to purchase from an unrelated third party 7% of the
outstanding shares of Star Digitel Limited ("SDL"), a Hong Kong company whose
principal business activities relate to the provision and development of
cellular telecommunications services in the People's Republic of China. Pursuant
to the stock purchase agreement, the Company's purchase of such shares will
occur in two closings, which are subject to the satisfaction of certain
conditions, for an aggregate cash consideration of $8.4 million. IWC also
acquired and maintains a 40% ownership interest in SDL. Through December 31,
1997, the Company had invested $5.3 million in SDL. In addition, the Company has
guaranteed obligations of SDL totaling $14.1 million, which includes guarantees
of $7.2 million on behalf of IWC. If the Company must eventually fund these
guarantees, the funding will be in the form of loans to SDL. See "Item 7.
Management's Discussion and Analysis of Financial Conditions and Results of
Operations."
During 1997 the Company acquired a 12% equity interest in International
Wireless Communications Pakistan Ltd. (IWCPL) for $7.0 million. At the same
time, IWC's 100% owned subsidiary, Pakistan Wireless Holdings, Inc. (PWH), also
acquired a 39% ownership interest in IWCPL, thereby increasing the Company's
total direct and indirect ownership interest in IWCPL to approximately 26%.
IWCPL owns 51% of the equity in Pakistan Mobile Communications (Pvt.) Ltd., a
Pakistan Company that owns and operates the cellular license in Pakistan.
Through December 31, 1997, the Company had invested $8.2 million in IWCPL. In
addition, the Company has provided debt financing to PWH in the amount of $3
million. See "Item 7. Management's Discussion and Analysis of Financial
Conditions and Results of Operations."
There is no assurance that the Company's international activities will
prove successful.
Inter*Act Systems, Incorporated. The Company has invested approximately
$10.0 million in Inter*Act Systems, Incorporated ("Inter*Act") common stock for
an aggregate ownership interest of approximately 26%. In addition, during 1996
the Company purchased for $12.0 million a total of 18,000 units consisting of
$18.0 million principal amount at maturity of 14% Senior Discount Notes Due 2003
and warrants to purchase 132,012 shares of common stock at $.01 per share,
subject to certain adjustments. Effective September 30, 1997 and in accordance
with the warrant agreement, the shares of common stock eligible to be purchased
with the warrants held by the Company increased from 132,012 to 169,722. The
shares issuable upon the exercise of these warrants currently represent
approximately 2% of Inter*Act's outstanding common stock. In addition, an
existing warrant held by the Company was restructured whereby the Company has
the right to acquire at any time prior to May 5, 2005 an aggregate of 900,113
shares of common stock for $23.50 per share, which shares presently represent
approximately 10% of the outstanding common stock of Inter*Act. Inter*Act is a
development stage company that provides consumer product manufacturers and
retailers (currently supermarkets) the ability to offer targeted promotions to
retail customers at the point of entry of a retail outlet through an interactive
multi-media system utilizing ATM-like terminals. In addition to the current
ownership held by the Company, certain officers, directors and entities
affiliated with certain directors of the Company maintain an additional 27%
ownership interest in Inter*Act. See "Item 13. Certain Relationships and
Related Transactions" and "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations".
13
Geotek Communications, Inc. In 1994, the Company purchased for $30 million
from Geotek Communications Inc. ("Geotek") 2.5 million shares of its common
stock and options to invest up to $167 million for an aggregate of 10 million
additional shares and also entered into a five-year management consulting
agreement to provide operational and marketing support to Geotek in exchange for
300,000 shares of Geotek common stock per year. Geotek is a telecommunications
Company that is developing a wireless communications network in certain
metropolitan markets in the United States based on its FHMA(R) digital
technology. Its common stock is traded on the NASDAQ National Market System. In
September 1995, the Company purchased for $5.0 million in cash 531,463 shares of
convertible preferred stock of Geotek with a stated value of $9.408 per share.
The stock options previously granted to the Company by Geotek in 1994 have all
expired unexercised and, as a result, the management consulting agreement also
expired. See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations."
Employees
As of December 31, 1997, the Company had approximately 2,000 full-time
employees, including approximately 850 employees associated with its direct
sales force. None of those employees are represented by a labor organization.
Management considers its employee relations to be good.
14
CERTAIN DEFINITIONS
Certain terms used in this report are defined with particular
meanings as used herein.
Analog: Transmission method employing a continuous (rather than pulsed or
digital) electrical signal that varies in amplitude or frequency in response to
changes in sound, light or position.
Bandwidth: (1) Difference between the top and bottom limiting frequencies
of a continuous frequency band. (2) Indicates the information-carrying capacity
of a channel. FCC-licensed cellular operators have been allocated a continuous
25 MHz bandwidth in the 824-849 MHz band or 869-894 MHz band.
BTA: One of the 493 Basic Trading Areas, which are smaller than MTAs, into
which the licensing for broadband PCS has been divided based on the geographic
divisions in the 1992 Rand McNally Commercial Atlas & Marketing Guide.
CDMA: Code Division Multiple Access digital technology. Technique that
spreads a signal over a frequency band that is larger than the signal to enable
the use of a common band by many users and to achieve signal security and
privacy.
CDPD: Cellular Digital Packet Data, a new packet data network protocol
which offers fast and reliable data transmission without using large amounts of
network capacity.
Cell site: The entire infrastructure and radio equipment associated with a
cellular transmitting and receiving station, including the land, building,
tower, antennas and electrical equipment.
Clusters: A group of contiguous markets, the provision of which
facilitates wide areas of uninterrupted cellular service, reduced airtime rates,
automatic delivery of inbound calls and simplified dialing patterns.
Communications Act: The Communications Act of 1934, as amended.
Controlled markets: Markets in which the Company's ownership interest is
greater than 50% as well as the Wilmington and Jacksonville, North Carolina
markets which are jointly controlled by the Company and a subsidiary of GTE
Corporation.
CTIA: The Cellular Telecommunications Industry Association.
Digital: Transmission system in which information is transmitted in a
series of pulses.
ESMR: Enhanced Specialized Mobile Radio communications services, supplied
by converting analog SMR services into an integrated, digital transmission
system providing for call hand-off, frequency reuse and wide-call delivery
networks.
FAA: The United States Federal Aviation Administration.
FCC: The United States Federal Communications Commission.
FCC Rules: The rules promulgated by the FCC governing the construction and
operation of cellular communications systems and licensing and technical
standards for the provision of cellular communications service.
IXC: Usually referred to as inter-exchange carriers or long-distance
providers. There are many facilities-based IXCs including AT&T, MCI, WorldCom,
Sprint and Frontier, as well as competitive access providers that are authorized
for IXC services.
LEC: A Company providing local telephone services.
Market: An MSA or RSA.
Metro-cluster: A group of contiguous markets, the provision of which
facilitates wide areas of uninterrupted cellular service, reduced airtime rates,
automatic delivery of inbound calls and simplified dialing patterns.
MSA: One of the Metropolitan Statistical Areas for which the FCC licensed
cellular communications systems.
MTA: One of the 51 Major Trading Areas into which the licensing for
broadband PCS has been divided based on the geographic divisions in the 1992
Rand McNally Commercial Atlas & Marketing Guide.
15
MTSO: A mobile telephone switching office, through which cell sites are
connected to the local landline telephone network.
Net POPs: The estimated population with respect to a given service area
multiplied by the percentage interest that the Company owns in the entity
licensed by the FCC to operate a cellular communications system within that
service area.
Nonwireline license: The license for a market initially awarded to a
Company or group that was not affiliated with a local landline telephone carrier
in such market.
PCS: Personal Communications Services. Emerging technologies providing
wireless access to the local and long distance telephone system. Most PCS plans
call for low-powered, light weight pocket phones with individual, personal
telephone numbers that can be accessed without geographic restriction.
Penetration: Customers divided by POPs in a given area.
POPs: The estimate of the 1997 population of a MSA or RSA, as derived from
the 1997 population estimates prepared by Strategic Mapping, Inc.
RBOCs: The Regional Bell Operating Companies.
Reseller: A Company that provides cellular service to customers but does
not hold an FCC cellular license or own cellular facilities. A reseller secures
blocks of cellular telephone numbers from a licensed carrier and, in turn, sells
service through its own distribution network to the public.
RF: Radio frequency.
Roamer: A cellular customer who makes or receives calls when traveling in
another cellular company's market using his/her home cellular phone.
Roaming: The ability of cellular customers to make or receive calls when
traveling in another cellular company's market. Occurs when a cellular customer
leaves the cellular carrier's home area and uses his cellular phone.
Roaming agreement: Agreement entered into with other domestic cellular
companies that allow the Company's customers to make or receive calls when
traveling in another cellular Company's market.
RSA: One of the Rural Service Areas for which the FCC licensed cellular
communications systems.
Service area: An MSA or RSA.
SMR: Specialized Mobile Radio communications services.
TDMA: Time Division Multiple Access digital technology, which designates a
time frame for cellular users to transmit within a frequency.
Wireline license: The license for a market initially awarded to a Company
or group that was affiliated with a local landline telephone carrier in such
market.
16
Item 2. Properties
The Company owns or leases certain properties in addition to the interests
in cellular licenses presently owned by the Company. The Company leases its
principal executive offices located in Greensboro, North Carolina, consisting of
approximately 128,000 square feet of office space. The Company either owns or
leases under long-term contracts 458 cell site locations, eight cellular switch
locations and certain office and retail space in its operating cellular markets.
Rent expense under operating leases was $12.9 million in 1997.
Item 3. Legal Proceedings
The only legal proceedings pending against the Company or any of its
subsidiaries are routine filings with the FCC and state regulatory authorities
and customary regulatory proceedings pending in connection with acquisitions and
interconnection rates and practices, proceedings concerning the
telecommunications industry generally and other proceedings arising in the
ordinary course of business which management believes, even if resolved
unfavorably to the Company, would not have a materially adverse effect on the
company's business.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters that were submitted to a vote of security holders of
the Company during the quarter ended December 31, 1997.
Item 4 (a). Executive Officers of the Registrant
The following table sets forth certain information about each of the
Company's executive officers:
Name Age Position
---- --- --------
Haynes G. Griffin 51 Chairman of the Board of
Directors, Co-Chief Executive
Officer
Stephen R. Leeolou 42 President, Co-Chief Executive
Officer, Director
Stuart S. Richardson 51 Vice Chairman of the Board of
Directors
L. Richardson Preyer, Jr. 50 Vice Chairman of the Board of
Directors, Executive Vice
President, Treasurer
Stephen L. Holcombe 41 Executive Vice President, Chief
Financial Officer
Richard C. Rowlenson 48 Executive Vice President, General
Counsel
Timothy G. Biltz 39 Executive Vice President,
Marketing and Customer Service,
President of U.S. Wireless
Operations
S. Tony Gore, III 51 Executive Vice President --
Acquisitions and Corporate
Development
Dennis B. Francis 46 Executive Vice President --
Technical Services
Haynes G. Griffin is a co-founder of the Company and has been a director
since 1985 and was elected Chairman of the Board of Directors in November, 1996.
Mr. Griffin is Co-Chief Executive Officer and served as Chief Executive Officer
from the Company's inception until November, 1996. Mr. Griffin is Chairman of
the Board of International Wireless Communications Holdings, Inc. and is a
member of the Boards of Directors of Lexington Global Asset Managers, Inc.,
Inter*Act Systems, Inc. and Geotek Communications, Inc. Mr. Griffin currently
serves on the United States Advisory Council on the National Information
Infrastructure. He is a past Chairman of the Cellular Telecommunications
Industry Association.
Stephen R. Leeolou is President and Co-Chief Executive Officer, a director
and a co-founder of the Company. Prior to becoming President in November 1996,
Mr. Leeolou served as Executive Vice President, Chief Operating Officer and
Secretary and a director of the Company. Mr. Leeolou is the Chairman of the
Board of Inter*Act Systems, Inc. and is a director and former Chairman of the
Board of International Wireless Communications, Inc. Prior to joining the
Company, from 1983 to 1984, Mr. Leeolou was President and Secretary of Caro-Cell
Communications, Inc., and from 1978 to 1983 was a television news anchorman with
three successive network-affiliated stations.
17
Stuart S. Richardson has been a director since 1985 and was elected
Chairman of the Board of Directors in 1986 and currently serves as Vice Chairman
of the Board of Directors. Since 1995, Mr. Richardson has been Chairman of the
Board of Lexington Global Asset Managers, Inc., a diversified financial services
holding company. From 1985 to 1995, Mr. Richardson was an executive of Piedmont
Management Company, Inc., formerly the parent corporation of Lexington Global
Asset Managers, Inc., and served as its Vice Chairman from 1986 to 1995. Mr.
Richardson also serves as a director of Chartwell Reinsurance Co. and Inter*Act
Systems, Inc. and is the former Chairman of the Board of Richardson-Vicks, Inc.
Mr. Richardson's second cousin, L. Richardson Preyer, Jr., and Mr. Preyer's
father, L. Richardson Preyer, Sr., are also directors.
L. Richardson Preyer, Jr. is Vice Chairman of the Board, Executive Vice
President, Treasurer and a co-founder of the Company. Mr. Preyer serves as
Administrative Trustee of Piedmont Associates and Southeastern Associates,
investment partnerships, and is a director of Inter*Act Systems, Inc.
Stephen L. Holcombe is Executive Vice President and Chief Financial
Officer of the Company. From 1978 to 1985, Mr. Holcombe served in various
positions with KPMG Peat Marwick and was a senior audit manager when he left to
join the Company in 1985. Mr. Holcombe is a member of the North Carolina
Association of Certified Public Accountants.
Richard C. Rowlenson is Executive Vice President and General Counsel of
the Company. From 1975 until joining the Company in 1987, Mr. Rowlenson was
engaged in the practice of communications law in Washington, D.C. Mr. Rowlenson
is a member of the Federal Communications Bar Association.
Timothy G. Biltz joined the Company as Vice President -- Marketing and
Customer Service in August 1989 and was promoted to Senior Vice President in
November 1990 and Executive Vice President in November 1996. Prior to joining
the Company, Mr. Biltz was Regional Manager for Providence Journal Cellular
Management Services, Inc. in Raleigh, N.C. from 1987 to 1989, and was
responsible for the development of regional marketing and operations programs
for several markets.
S. Tony Gore, III is Executive Vice President of Acquisitions and
Corporate Development. He is presently a task force member of the North Carolina
International Commission on Economic Development. Prior to joining the Company
in 1985, Mr. Gore was Chief Executive Officer of Atlantic Coast Entertainment
Systems, Inc.
Dennis B. Francis joined the Company as Director of Technical Services in
September 1992 and was promoted to Vice President in 1993, Senior Vice President
in 1995 and Executive Vice President in November 1996. Prior to joining the
Company, Mr. Francis was with Southwestern Bell Mobile Systems for nine years,
most recently as Vice President of Network Operations for the
Washington/Baltimore cellular system.
18
PART II
Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters
Price Range of Common Stock
1997 1996
--------------- ---------------
High Low High Low
------ ------ ------ ------
First Quarter .................. $16.25 $11.13 $23.50 $18.00
Second Quarter ................. 14.50 9.25 24.66 20.00
Third Quarter .................. 16.00 13.38 23.75 17.50
Fourth Quarter ................. 16.94 11.38 19.38 14.25
The high and low bid prices are as reported by the NASDAQ National Market
System. These price quotations reflect inter-dealer prices, without mark-down or
commissions, and may not necessarily represent actual transactions. On March 1,
1998, there were approximately 889 shareholders of record.
As discussed in Note 4 to the Consolidated Financial Statements in Item 8
and Management's Discussion and Analysis of Financial Condition and Results of
Operations in Item 7, the covenants under the Company's long-term credit
facility and its Senior Debentures due 2006 limit the payment of cash dividends
on common stock. The Company has not paid any cash dividends on its common stock
since its inception and does not anticipate paying dividends in the foreseeable
future.
19
Item 6. Selected Consolidated Financial Data
For the Years Ended December 31,
-------------------------------------------------------------
1997 1996 1995 1994 1993
-------------------------------------------------------------
(Amounts in thousands, except per share data)
Statement of Operations Data:
Revenue:
Service revenue (a) .................................. $ 349,638 $ 282,694 $ 217,440 $ 146,417 $ 98,960
Cellular telephone equipment revenue ................. 23,328 15,120 15,647 18,529 9,929
Other ................................................ 1,552 4,240 2,984 3,055 175
--------- --------- --------- --------- ---------
374,518 302,054 236,071 168,001 109,064
--------- --------- --------- --------- ---------
Costs and expenses:
Cost of service ...................................... 34,443 31,678 27,043 21,008 14,461
Cost of cellular telephone equipment ................. 40,223 25,372 25,605 29,933 13,410
General and administrative ........................... 100,913 80,057 60,489 44,019 34,218
Marketing and selling ................................ 75,794 62,384 54,906 37,102 21,693
Depreciation and amortization (b) .................... 73,881 48,635 36,170 24,073 25,160
--------- --------- --------- --------- ---------
325,254 248,126 204,213 156,135 108,942
--------- --------- --------- --------- ---------
Income from operations .................................. 49,264 53,928 31,858 11,866 122
Interest expense ........................................ (57,257) (46,199) (38,293) (22,126) (15,389)
Unrealized holding loss (c).............................. (32,757) -- -- -- --
Net earnings (losses) from unconsolidated investments (d) (13,367) (9,344) (2,261) 206 500
Other, net (d) .......................................... 1,390 3,955 1,683 (3,891) (516)
--------- --------- --------- --------- ---------
Income (loss) before income taxes ....................... (52,727) 2,340 (7,013) (13,945) (15,283)
Income tax benefit (e) .................................. 42,700 4,109 -- -- --
--------- --------- --------- --------- ---------
Income (loss) before extraordinary item ................. (10,027) 6,449 (7,013) (13,945) (15,283)
Extraordinary charge (f) ................................ -- -- -- (8,402) (3,715)
--------- --------- --------- --------- ---------
Net income (loss) ....................................... $ (10,027) $ 6,449 $ (7,013) $ (22,347) $ (18,998)
========= ========= ========= ========= =========
Net income (loss) per common share:
Basic (g) ............................................ $ (0.25) $ 0.16 $ (0.17) $ (0.58) $ (0.50)
Diluted (g) .......................................... $ (0.25) $ 0.15 $ (0.17) $ (0.58) $ (0.50)
Common shares used in computing per share amounts:
Basic ................................................ 40,224 41,320 41,100 38,628 38,038
Diluted............................................... 40,224 41,898 41,100 38,628 38,038
Other Data:
Capital expenditures (h) ............................. $ 121,662 $ 130,805 $ 129,894 $ 62,632 $ 21,009
EBITDA (i) .............................................. 123,145 102,563 68,028 35,939 25,282
Total subscribers in majority owned markets at year end 645.0 513.0 381.0 245.0 132.3
Balance Sheet Data (end of period):
Working capital (deficiency) ............................ $ 64,328 $ (5,962) $ 4,997 $ (1,778) $ 4,696
Property and equipment, net ............................. 371,343 313,800 225,206 120,325 71,716
Total assets ............................................ 827,961 730,581 596,577 431,711 284,429
Long-term debt........................................... 768,967 629,954 522,143 348,649 238,153
Shareholders' equity .................................... 910 33,451 29,048 39,207 21,898
- ----------
(a) In 1994, in order to conform to industry practice, the Company
reclassified certain pass-through items previously recognized as service
revenue to offset the related cost of service expenses. These reclassified
items relate to charges associated with the Company's subscribers roaming
into adjacent cellular markets. Appropriate reclassifications have been
made in each period presented.
(b) Effective January 1, 1994, the Company changed its depreciation expense
period for approximately 30% of its property and equipment from seven
years to a 10 to 20 year schedule. The effect of this change was to
reduce depreciation for the year ended December 31, 1994 by $4.5 million.
(c) The Company owns 3.3 million shares of Geotek Common Stock. In 1997, this
investment was written down to $5.0 million, based on the year-end stock
price of $1.53 per share, as quoted on the NASDAQ National Market System.
(d) Certain amounts in the periods prior to 1997 have been reclassified to
conform to the 1997 presentation.
(e) In 1997 and 1996, the Company recognized a deferred income tax benefit of
$42.7 million and $5.0 million, respectively, net of current income tax
expense of $0 and $891,000, respectively. In prior years, the Company made
the determination that it was uncertain that its net
20
deferred income tax assets would be realized. See Item 7. Management's
Discussion and Analysis of Results of Operations and Financial Position.
(f) The extraordinary charges for the years ended December 31, 1994 and 1993
of $8.4 million and $3.7 million, respectively, reflect the write-off of
deferred financing costs associated with the Company's credit facilities
that were replaced during 1994 and 1993.
(g) Adjusted to reflect the Company's three-for-two Class A common stock
split effected August 24, 1994.
(h) Capital expenditures excluded acquisitions.
(i) EBITDA consists of income (loss) from operations before depreciation and
amortization. Although EBITDA is not a measure of performance calculated
in accordance with Generally Accepted Accounting Principles ("GAAP"),
management believes that it is useful to a prospective investor because it
is a measure widely used in the cellular industry to evaluate a Company's
operating performance. EBITDA, however, should not be considered in
isolation or as a substitute for net income, cash flows from operating
activities and other income or cash flow statement data prepared in
accordance with GAAP or as a measure of liquidity or profitability.
21
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following is a discussion and analysis of the historical financial
condition and results of operations of the Company and factors affecting the
Company's financial resources. This discussion should be read in conjunction
with the Company's consolidated financial statements, including the notes
thereto.
Years Ended December 31, 1997 and 1996
Service revenue in 1997 rose 24% to $349.6 million from $282.7 million in
1996. This increase was primarily the result of a 132,000 or 26% increase in the
number of subscribers in majority-owned markets to approximately 645,000 in
1997, as compared to approximately 513,000 in 1996. Penetration, computed as a
percentage of the Company's subscribers to total POPs in majority owned cellular
markets, increased to 8.5% in 1997 from 6.8% in 1996. The increase in
subscribers is the result of the growing acceptance of cellular
communications and the Company's efforts to capitalize on this
increasing acceptance through an expanded sales and distribution
network. Churn, the monthly rate of customer deactivations expressed as
a percentage of the subscriber base, remained constant between years at
2.2%.
Service revenue attributable to the Company's own subscribers (local
revenue) increased 26% during 1997 to $297.5 million as compared to $236.1
million in 1996. Average monthly local revenue per subscriber declined 5% to $43
in 1997 compared to $45 in the prior year. This decline was primarily due to the
continued pattern of increased incremental penetration into the segment of
consumers who generally use their cellular phones less frequently. Service
revenue generated by nonsubscribers roaming into the Company's markets increased
12% to $52.1 million in 1997 as compared to $46.6 million in the prior year.
This increase was the result of increased usage partially offset by continued
reductions in daily access and usage rates. The reduced rates affect the Company
as both a provider and a purchaser of roaming services. Local revenue combined
with roaming revenue resulted in overall average monthly revenue per subscriber
for the year of $50, a decline of 7% from $54 in the prior year.
Cost of service as a percentage of service revenue decreased to 10% during
1997 from 11% during 1996. The Company expects cost of service as a percentage
of service revenue to remain stable in the foreseeable future.
General and administrative expenses increased 26% or $20.9 million during
1997 as compared to 1996. General and administrative expenses as a percentage of
service revenue increased from 28% to 29% in 1997. This increase is due
primarily to compensation expense resulting from increases in the Company's
employee base, generally in the areas of technical services, customer operations
and new product development. General and administrative expenses as a percentage
of service revenue are expected to stabilize and then decline slowly as the
Company adds more subscribers without commensurate increases in general and
administrative overhead and experiences higher utilization of the Company's
existing personnel and systems.
Marketing and selling expenses increased 21% to $75.8 million during 1997,
compared to $62.4 million in 1996. As a percentage of service revenue, these
expenses remained constant at 22% in both years. During 1997, marketing and
selling expenses including the net loss on cellular equipment ("Combined
Marketing and Selling Expenses") increased to $92.7 million from $72.6 million
in 1996. Combined Marketing and Selling Expenses per gross subscriber addition
increased to $330 in 1997 from $301 in 1996 as a result of increased advertising
and fixed costs for new stores that were opened in 1997. While the Company has
benefited from the increased success of external distribution channels, the
Company continues to emphasize internal distribution channels, which it believes
will result in higher long-term profit margins.
Depreciation and amortization expenses increased $25.2 million or 52%
during 1997 as compared to 1996. Property and equipment placed in service in
1997 of approximately $121.7 million, which included $22.0 million of cellular
telephones held for rental that have relatively short depreciable lives,
together with property and equipment placed in service in 1996 of $130.8
million, which had its first complete year of depreciation in 1997, accounted
for substantially all of this increase.
Interest expense increased $11.1 million or 24% during 1997. This increase
primarily resulted from an increase in average borrowings of approximately
$137.0 million. Interest rates remained fairly constant between years.
Net losses from unconsolidated investments increased by $4.0 million. This
increase resulted primarily from higher operating, amortization and interest
expenses incurred by Inter*Act Systems, Incorporated ("Inter*Act") offset
somewhat by the suspension of the Company's recognition of losses attributable
to its equity method investments in International Wireless Communications
Holdings, Inc. ("IWC"). The Company continues to recognize its share of the
income and losses of its equity method investments in Inter*Act, Eastern North
Carolina Cellular Joint Venture (ENCCJV), Star Digitel Limited ("SDL") and
International Wireless Communications Pakistan, Ltd. ("IWCPL"). See "Liquidity
and Capital Resources."
22
During 1997, the Geotek Communications, Inc. ("Geotek") common stock
price, as quoted on the NASDAQ National Market System, declined from $7.13 per
share at December 31, 1996 to $1.53 per share at December 31, 1997. Based on
Geotek's historical performance, including the significant current year decline
in the market value of Geotek's common stock, the Company's management made the
determination that the decline in Geotek's common stock price during 1997 was
other than temporary. Accordingly, the Company recognized an unrealized holding
loss of $32.8 million in the 1997 consolidated statement of operations in
recording the Company's investment in Geotek common stock at its market value at
December 31, 1997. This treatment is in accordance with the guidance provided by
Statement of Financial Accounting Standards ("SFAS") No. 115. Previously,
unrealized holding losses related to the investment in Geotek common stock were
recorded as a component of stockholders' equity in accordance with SFAS No. 115.
The Company recognized a deferred income tax benefit of $42.7 million in
1997 and a deferred income tax benefit of $5.0 million, net of current income
tax expense of $891,000 in 1996. The Company has entered into agreements to sell
its investment in the Myrtle Beach, South Carolina RSA as well as its interest
in the ENCCJV. See "Liquidity and Capital Resources." These sales transactions
are expected to generate substantial capital gains which will utilize an
equivalent amount of the Company's accumulated net operating loss carryforwards.
Based on these anticipated gains, management has assessed that it is more likely
than not that a significant portion of the Company's deferred income tax assets
are realizable, and, accordingly, the Company has recognized a total of $52.6
million of net deferred income tax assets as of December 31, 1997. Prior to
1996, the Company made the assessment that realization of its net deferred
income tax assets was uncertain due primarily to its history of operating
losses. See "Liquidity and Capital Resources -- Income Taxes."
The Company reported a net loss of $10.0 million or $0.25 basic net
loss per common share for 1997 as compared to net income of $6.5 million
or $0.16 basic net income per common share for 1996. This $16.5 million
decline in net income is due primarily to the recognition of the
unrealized holding loss on the Geotek investment and increases in
depreciation and interest expense and losses from unconsolidated
investments from the prior year, partially offset by the increase in the
deferred income tax benefit as compared to the prior year.
Years Ended December 31, 1996 and 1995
Service revenue in 1996 rose 30% to $282.7 million from $217.4 million in
1995. This increase was primarily the result of a 132,000 or 35% increase in the
number of subscribers in majority-owned markets to approximately 513,000 in
1996, including 5,000 added as a result of acquisitions, as compared to
approximately 381,000 in 1995. Penetration, computed as a percentage of the
Company's subscribers to total POPs in majority owned cellular markets,
increased to 6.8% in 1996 from 5.3% in 1995. The increase in subscribers was the
result of the growing acceptance of cellular communications and the Company's
efforts to capitalize on this increasing acceptance through an expanded sales
and distribution network. This increase was offset slightly by an increase in
"churn" in 1996 to 2.2% from 2.1% in the same period in 1995 due to economic
concerns felt by certain segments of the Company's subscriber base and by
increased price competition at lower end rate plans. Churn is the monthly rate
of customer deactivations expressed as a percentage of the subscriber base.
Service revenue attributable to the Company's own subscribers (local
revenue) increased 34% during 1996 to $236.1 million as compared to $175.9
million in 1995. Average monthly local revenue per subscriber declined 4% to $45
in 1996 compared to $47 in the prior year. This decline was primarily due to the
continued pattern of increased incremental penetration into the segment of
consumers who generally use their cellular phones less frequently. Service
revenue generated by nonsubscribers roaming into the Company's markets increased
12% to $46.6 million in 1996 as compared to $41.5 million in the prior year.
This increase was the result of increased usage and was partially offset by
continued reductions in daily access and usage rates which is occurring in the
industry with increasing frequency. The reduced rates affected the Company both
as a provider and purchaser of roaming services. The revenue from the Company's
customers combined with roaming revenue resulted in overall average monthly
revenue per subscriber for the year of $54, a decline of 7% from $58 in the
prior year.
Cellular telephone equipment revenue decreased $527,000 or 3.4% to $15.1
million in 1996 as compared to 1995. Cost of cellular telephone equipment
decreased 1% to $25.4 million during the same period. Net loss on cellular
equipment was $10.3 million, an increase of 3% from $10.0 million net loss on
cellular equipment experienced in 1995. The Company continues to sell telephones
at or below cost for marketing purposes in response to competitive pressures and
also continues the availability of its rental program.
Cost of service as a percentage of service revenue decreased to 11% during
1996 from 12% during 1995 primarily as a result of the Company's continuing
effort to reduce the charges associated with roamer fraud. The Company estimates
that charges associated with roamer fraud included in cost of service decreased
from approximately 4% of service revenue in the fourth quarter of 1995 to
approximately 1% during 1996. Cellular fraud is expected to be a significant
industry issue for the foreseeable future.
23
General and administrative expenses increased 32% or $19.5 million during
1996 as compared to 1995, but as a percentage of service revenue remained
constant at approximately 28% during both years. This increase is due primarily
to compensation expense resulting from increases in the Company's employee base.
Marketing and selling expenses increased 14% to $62.4 million during 1996,
compared to $54.9 million in 1995. As a percentage of service revenue, these
expenses decreased from 25% in 1995 to 22% in 1996. During 1996, marketing and
selling expenses including the net loss on cellular equipment ("Combined
Marketing and Selling Expenses") increased to $72.6 million from $64.9 million
in 1995. Combined Marketing and Selling Expenses per gross subscriber addition
(excluding subscribers gained through acquisitions) decreased to $301 in 1996
from $327 in 1995. The decline in the gross subscriber costs was primarily a
result of lower sales commissions paid for activations through internal
distribution channels.
Depreciation and amortization expenses increased $12.5 million or 34%
during 1996 as compared to 1995. Property and equipment placed in service in
1996 of approximately $130.8 million together with property and equipment placed
in service in 1995 of $129.9 million, which had its first complete year of
depreciation in 1996, accounted for substantially all of this increase.
Interest expense increased $7.9 million or 21% during 1996. This increase
primarily resulted from an increase in average borrowings of approximately
$110.6 million, and an increase in interest rates on $200 million of borrowings
represented by the Debentures, offset slightly by a decrease in average interest
rates charged.
Net losses from unconsolidated investments increased by $11.6 million.
This increase resulted primarily from higher operating, amortization and
interest expenses incurred by Inter*Act and IWC as a result of expanding
operations which were made possible by high yield debt financings completed
during the third quarter of 1996 by each company aggregating approximately $200
million. Due to the increased losses by IWC the Company has recognized an amount
of losses equal to its investment in IWC and accordingly has suspended
recognition of losses on IWC as of December 31, 1996 until such time that equity
method income is available to offset the Company's share of IWC's future losses
or the Company makes further investments in IWC. See "Liquidity and Capital
Resources."
In 1996, the Company recognized a deferred income tax benefit of $5.0
million, net of current income tax expense of $891,000. Management concluded at
December 31, 1996 that it was "more likely than not" that $5.0 million of the
Company's net deferred income tax assets will be realized. This assessment
considered the Company's historical operating trends, current forecasts and
certain other factors. Prior to 1996, the Company made the assessment that
realization of its net deferred income tax assets was uncertain due primarily to
its history of operating losses. See "Liquidity and Capital Resources -- Income
Taxes."
The Company reported net income of $6.4 million or $0.16 basic net income
per common share for 1996 as compared to a net loss of $7.0 million or $0.17
basic net loss per common share for 1995. This $13.4 million positive change
in net income was due primarily to the rate of revenue growth exceeding the rate
of growth in related operating expenses and due to the recognition of a $4.1
million net income tax benefit in 1996.
Liquidity and Capital Resources
The Company requires capital to acquire, construct, operate and expand its
cellular systems. The Company also explores, on an ongoing basis, possible
acquisitions of cellular systems and properties as well as other investment
opportunities, some of which may involve significant expenditures or
commitments. In addition, although the initial buildout of its cellular system
is complete, the Company will continue to construct additional cell sites and
purchase cellular equipment to increase capacity as subscribers are added and
usage increases, to expand geographic coverage, to provide for increased
portable usage and to upgrade its cellular system for digital conversion and the
implementation of new services. In 1997, the Company spent approximately $17.8
million primarily in connection with acquisitions of investments and loans to
unconsolidated affiliates and approximately $121.7 million on total capital
expenditures. In 1996, the Company spent approximately $38.8 million and
exchanged certain cellular assets in connection with acquisitions and spent
$130.8 million on total capital expenditures.
The specific capital requirements of the Company will depend primarily on
the timing and size of any additional acquisitions and other investments as well
as property and equipment needs. EBITDA has been a growing source of internal
funding in recent years, and although the Company anticipates that in 1999
EBITDA will be sufficient to cover property and equipment and debt service
requirements, the Company does not expect EBITDA to grow sufficiently to meet
both its property and equipment and debt service requirements during 1998. The
Company has met its capital requirements primarily through bank financing,
issuance of public debentures, private issuances of its Class A Common Stock and
internally generated funds and the Company intends to continue to use external
financing sources in the future. Subsequent to December 31, 1997, the Company
entered into agreements to sell its investment in the Myrtle Beach, South
Carolina RSA for approximately $160 million in cash and its interest in the
ENCCJV for approximately $30 million in cash. The transactions, which are
expected to close in the third quarter of 1998, are subject to approval
24
by regulatory authorities, including the FCC. The Company is also pursuing
opportunities to sell its Pensacola and Fort Walton Beach, FL markets as well as
minority interests in other non-core cellular properties. The proceeds from
these sales will be used to pay down the Company's existing debt.
EBITDA does not represent and should not be considered as an alternative
to net income or operating income as determined by generally accepted accounting
principles. It should not be considered in isolation from other measures of
performance according to such principles, including operating results and cash
flows. EBITDA increased to $123.1 million in 1997 from $102.6 million in 1996
and net cash provided by operating activities as shown on the Statement of Cash
Flows decreased to $46.1 million in 1997 from $60.4 million in 1996 primarily
due to a change in billing procedures during the second quarter of 1997.
Historically, the Company billed subscriber access fees in advance. To reduce
customer confusion upon receipt of the first bill and to remain competitive, the
Company changed its billing policy and now bills access fees in arrears. This
change had no impact on the Company's revenue recognition, bud did affect the
in-flow of cash from bill payments. Net cash provided by operating activities in
1997 reflects an $11.1 million increase in interest expense and an increase in
working capital items of $22.8 million. Investing activities, primarily
purchases of property and equipment and acquisitions of investments, used net
cash of $154.9 million and $152.9 million in 1997 and 1996, respectively.
Financing activities provided net cash of $100.0 million and $95.6 million in
1997 and 1996, respectively.
Financing Agreements. At December 31, 1997 the Company's long-term debt
consisted primarily of a $675 million credit facility (the "Credit Facility")
with various lenders led by The Toronto-Dominion Bank and The Bank of New York
and $200 million of 9 3/8% Senior Debentures due 2006 (the "Debentures"). The
Credit Facility consists of a $325 million term loan ("Term Loan") and a $350
million revolving loan ("Revolving Loan"). As of the end of 1997, $569.0 million
had been borrowed under the Credit Facility. The Term Loan and the Revolving
Loan bore interest at a rate equal to the Company's choice of the Prime Rate (as
defined) or Eurodollar Rate (as defined) plus an applicable margin based upon a
leverage ratio for the most recent fiscal quarter. As of December 31, 1997, the
applicable margins on the borrowings were 0.125% and 1.375% per annum for the
Prime Rate and Eurodollar Rate, respectively.
On April 10, 1996, the Company issued $200 million aggregate principal
amount of 9-3/8% Senior Debentures due 2006 through an underwritten public
offering. The Credit Facility requires the structural subordination of the
Debentures by making a subsidiary the primary obligor of the Credit Facility and
all liabilities of the Company (other than the Debentures) and the owner of all
stock and partnership interests of the Company's operating subsidiaries. The net
proceeds of the sale of the Debentures were approximately $194.8 million.
The Debentures mature in 2006 and are redeemable at the Company's option,
in whole or in part, at any time on or after April 15, 2001. There are no
mandatory sinking fund payments for the Debentures. Interest is payable
semi-annually. Upon a Change of Control Triggering Event (as defined in the
Indenture for the Debentures), the Company will be required to make an offer to
purchase the Debentures at a purchase price equal to 101% of the principal
amount thereof plus accrued and unpaid interest, if any, to the date of
purchase.
In February 1998, the Company completed the closing of an amendment to the
Credit Facility, increasing the facility to $1.0 billion pursuant to the Third
Amended and Restated Facility A Loan Agreement (Facility A Loan) and the
Facility B Loan Agreement (Facility B Loan) (collectively, the 1998 Loan
Agreements) with various lenders led by The Toronto-Dominion Bank, The Bank of
New York and NationsBank of Texas, N.A.
The Facility A and Facility B Loans are available to provide the Company
with additional financial and operating flexibility and to enable it to pursue
business opportunities that may arise in the future. The Facility A Loan
consists of a $750 million senior secured reducing revolving credit facility
which allows for the issuance of up to $25 million of standby letters of credit.
The Facility B Loan consists of a $250 million 364-day revolving credit facility
which may be extended for an additional 364-day period upon the approval of the
lenders or converted to a term loan according to the terms and subject to
certain conditions of the Facility B Loan Agreement.
Borrowings under the Facility A and Facility B Loans bear interest at a
rate equal to the Company's choice of the Prime Rate or Eurodollar Rate plus an
applicable margin based upon a leverage ratio for the most recent fiscal
quarter. The ranges for this applicable margin are 0.0% to 0.25% for the Prime
Rate and 0.5% to 1.5% for the Eurodollar Rate. Based upon the leverage ratio,
the applicable margins for the first quarter of 1998 are 0.00% and 1.25% for the
Prime Rate and Eurodollar Rate, respectively.
The outstanding amount of the Facility A Loan as of September 30, 2000 is
to be repaid in increasing quarterly installments commencing on September 30,
2000 and terminating at the maturity date of December 31, 2005. The quarterly
installment payments begin at 2.5% of the outstanding principal amount at
September 30, 2000 and gradually increase to 6.875% of the outstanding
25
principal amount. The maturity date for borrowings under the Facility B Loan is
February 18, 1999. However, at the Borrower's request and the Lenders' approval,
as set forth in the Facility B Loan Agreement, the maturity date of the Facility
B Loan may be extended to February 16, 2000. Under the terms and subject to
certain conditions of the Facility B Loan Agreement, the Company has the option
to convert the borrowings outstanding under the Facility B Loan as of the
Facility B maturity date to a term loan maturing on December 31, 2005. Upon
conversion to a term loan, the principal balance of the Facility B Loan
outstanding on September 30, 2000 shall be repaid in quarterly installments
commencing on September 30, 2000 and terminating at the maturity date of
December 31, 2005. The quarterly repayments begin at 2.5% of the outstanding
principal amount at September 30, 2000 and gradually increase to 6.875% of the
outstanding principal amount.
Among other restrictions, the 1998 Loan Agreements limit the payment of
cash dividends, the use of borrowings and the creation of additional long-term
indebtedness and require the maintenance of certain financial ratios. The
requirements of the 1998 Loan Agreements were established in relation to the
Company's projected capital needs, projected results of operations and cash
flow. These requirements were generally designed to require continued
improvement in the Company's operating performance such that EBITDA would be
sufficient to continue servicing the debt as repayments are required. The
Indenture for the Debentures contains limitations on, among other things, (i)
the incurrence of additional indebtedness, (ii) the payment of dividends and
other distributions with respect to the capital stock of the Company, (iii) the
incurrence of certain liens, (iv) the ability of the Company to allow
restrictions on distributions by subsidiaries, (v) asset sales, (vi)
transactions with affiliates and (vii) certain consolidations, mergers and
transfers of assets. The Company is currently in compliance with all
requirements of the 1998 Loan Agreements and the Indenture.
Borrowings under the 1998 Loan Agreements are secured by the stock of
Vanguard Cellular Financial Corp. and Vanguard Cellular Operating Corp., direct
or indirect wholly owned subsidiaries of the Company. The Debentures are
unsecured obligations of the Company.
Investments in Cellular Entities. The Company explores, on an ongoing
basis, possible acquisitions of additional cellular systems and licenses. The
Company currently has no agreements in principle regarding any such cellular
acquisition. The Company also explores possible acquisition of companies that
will facilitate new service offerings to its customer base, such as paging and
Internet access. The Company has entered into an agreement to purchase
NationPage, a leading regional paging provider in Pennsylvania and New York, for
approximately $28.5 million. The NationPage acquisition will minimize future
paging service capacity constraints and will be financed through borrowings
under the 1998 Loan Agreements.
Other Investments. As of December 31, 1997, the Company had invested $13.8
million in IWC and owned approximately 36% of the outstanding stock of IWC. IWC
is a development stage company specializing in securing, building and operating
wireless businesses, primarily in Asia and Latin America.
During 1997, the Company loaned $966,000 to IWC under the $7 million
Senior Exchangeable Debt Facility in which the Company participated as a lender
along with Toronto Dominion Capital and other IWC shareholders. The Company also
received warrants to purchase IWC common stock valued at $486,000 in connection
with the Company's guarantee and funding of certain loans to SDL and Pakistan
Wireless Holdings, Inc. (PWH), discussed below. The Company recorded losses of
$1.5 million during 1997 related to these additional investments in IWC.
IWC's existing and new projects are in the network buildout phase.
Accordingly, the losses of IWC are expected to grow significantly in future
years. The Company records its proportionate share of these losses under the
equity method of accounting. During 1995 and 1996, the Company recognized on the
equity method an amount of losses from IWC that is equal to the Company's equity
investment in IWC. As a result, the Company has suspended the recognition of
losses attributable to IWC until such time that equity method income is
available to offset the Company's share of IWC's future losses or the Company
makes further investments in IWC.
In March 1998, the Company made an additional $10 million equity
investment in IWC. Accordingly, the Company will recognize losses equal to the
amount of this additional equity investment during the first quarter of 1998. As
the result of equity financing transactions completed by IWC during the first
quarter of 1998, the Company's ownership in IWC has been reduced to
approximately 29%.
During the first quarter of 1997, the Company entered into a stock
purchase agreement to purchase from an unrelated third party 7% of the
outstanding shares of SDL, a Hong Kong company whose principal business
activities relate to the provision and development of cellular
telecommunications services in the People's Republic of China. Pursuant to the
stock purchase agreement, the Company's purchase of such shares will occur in
two closings, which are subject to the satisfaction of certain conditions, for
an aggregate cash consideration of $8.4 million. IWC also recently acquired and
maintains a 40% ownership interest in SDL. Through
26
December 31, 1997, the Company had invested $5.3 million in SDL. The Company
expects to fund its remaining $3.1 million in July 1998. In addition, the
Company has guaranteed obligations of SDL totaling $14.1 million, which includes
guarantees of $7.2 million on behalf of IWC. If the Company must eventually fund
these guarantees, the funding will be in the form of loans to SDL.
During 1997, the Company acquired a 12% equity interest in IWCPL for $7.0
million. At the same time, IWC's 100% owned subsidiary, PWH, also acquired a 39%
equity interest in IWCPL, thereby increasing the Company's total direct and
indirect ownership interest in IWCPL to approximately 26%. IWCPL owns 51% of the
equity in Pakistan Mobile Communications (Pvt) Ltd., a Pakistan company that
owns and operates the cellular license in Pakistan. Through December 31, 1997,
the Company had invested $8.2 million in IWCPL. In addition, the Company has
provided debt financing to PWH in the amount of $3 million.
As of December 31, 1997, the Company had invested $10.0 million in
Inter*Act for an ownership interest of approximately 26% of Inter*Act's
outstanding common stock and $12.0 million in Inter*Act notes and warrants.
Inter*Act is a development stage company that provides consumer products
manufacturers and retailers (currently supermarkets) the ability to offer
targeted promotions to retail customers at the point of entry of a retail outlet
through an interactive multi-media system utilizing ATM-like terminals.
Inter*Act has incurred net losses since its inception. Inter*Act received
approximately $91 million in net proceeds in 1996 from the sale of senior
discount notes and warrants which are being used to accelerate the roll-out of
its systems in retail supermarkets and, as a result, the net losses incurred by
Inter*Act are expected to grow significantly in future years. The Company
records its proportionate share of these losses under the equity method of
accounting. The Company's equity and warrant investments in Inter*Act were
reduced to zero through the recognition of equity method losses during 1997.
However, the Company will continue to recognize equity method losses related to
its investment in the notes until such investment is reduced to zero.
Both Inter*Act and IWC are currently seeking long-term financing. Although
the Company may continue to support IWC and Inter*Act through bridge financing
until more permanent financing can be obtained, the Company does not anticipate
making any further significant long-term investments.
The Company owns 3.3 million shares of common stock of Geotek. As
of December 31, 1997, this investment had been written down to $5.0
million, based on the year-end stock price of $1.53 per share, as quoted
on the NASDAQ National Market System.
Capital Expenditures. As of December 31, 1997, the Company had $500.0
million of property and equipment in service. The Company historically has
incurred capital expenditures primarily based upon capacity needs in its
existing markets resulting from continued subscriber growth. In order to
increase geographic coverage and provide for additional portable usage the
Company intends to increase the number of sites and add additional capacity to
existing sites as it has done over the past few years. As a result of this
accelerated network buildout and the continued growth of the Company's
subscriber base, capital expenditures were $121.7 million during 1997. During
1998, the Company plans to continue this accelerated buildout. Capital
expenditures for 1998 are estimated to be approximately $100.0 million and are
expected to be funded primarily through internally generated funds and
borrowings under the 1998 Loan Agreements. Approximately $75.0 million of those
capital expenditures will be for cellular and paging network equipment, and the
remainder will be primarily for rental telephones and computer equipment.
Stock Repurchases. The Company's Board of Directors has authorized the
repurchase of up to 7,500,000 shares of its Class A Common Stock from time to
time in open market or other transactions. During 1997 and 1996, the Company
repurchased 2,810,000 and 255,000 shares, respectively, at an average price per
share of approximately $13.00 in 1997 and $17.00 in 1996. At March 26, 1998, the
Company had repurchased 1,080,000 shares thus far in 1998 at an average price
per share of approximately $17.00.
Income Taxes. The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standards No. 109--"Accounting for Income
Taxes." This standard requires, among other things, the recognition of future
tax benefits, measured by enacted tax rates, attributable to deductible
temporary differences between financial statement and income tax bases of assets
and liabilities and to tax NOLs, to the extent that realization of such benefits
is more likely than not. Prior to 1996, the Company incurred significant
financial reporting and tax losses primarily as a result of substantial
depreciation, amortization and interest expenses associated with acquiring and
developing its cellular markets and substantial marketing and other operating
costs associated with building its subscriber base. Although substantial net
deferred income tax assets were generated, these assets and the associated
income were not recognized for financial reporting purposes and a valuation
allowance equal to the unrecognized asset was established. Management's
assessment was that the Company's historical operating results did not make
future profitability certain enough for it to recognize any part of the asset
and related income.
27
Historically, the Company's strategy has been to enhance shareholder value
by investing in growth initiatives. These efforts have resulted in steadily
increasing levels of subscribers, revenues and EBITDA; however, these
initiatives in the form of market acquisitions, capital expenditures, and
expansion of the Company's sales and marketing and customer service functions
have resulted in significant interest, depreciation, amortization and marketing
costs. In addition, the Company has explored strategic investment opportunities
in international telecommunications ventures and alternative lines of business,
all of which are in the early development stages and are generating significant
losses to the Company. As a result, although the Company achieved profitability
in 1996 for financial reporting purposes, the continued costs of its investment
strategy prevented the Company from generating profitable financial results in
1997.
During the fourth quarter of 1997, management revised its strategy from
one of growth and expansion to enhancing shareholder value through profitable
operations in its core cellular properties in Pennsylvania, West Virginia and
New England. This revised strategy incorporates dispositions of non-core
properties over the course of the next several years. As part of this
Board-approved strategy, in the first quarter of 1998, the Company entered into
agreements to dispose of its cellular properties in the Carolinas Metro-cluster,
which include the Myrtle Beach, South Carolina RSA and ownership interest in the
ENCCJV. Additionally, the Company has begun active efforts to dispose of its
operations in Western Florida and anticipates reaching an agreement with a
potential buyer during 1998. Based on negotiated sales prices for the Myrtle
Beach cellular market and its ownership interests in ENCCJV, the Company expects
to generate capital gains approximating $140 million in 1998. Additionally, the
Company's anticipated sales price, based on recent transactions in the cellular
industry and the two transactions discussed above, for the disposition of its
Western Florida markets, is expected to generate a substantial capital gain.
The gains to be generated on these transactions will utilize an equivalent
amount of the Company's accumulated NOLs. Based on these anticipated gains,
management has assessed that it is more likely than not that a significant
portion of the Company's deferred income tax assets are realizable. Accordingly,
the Company has recognized a total of $52.6 million of net deferred income tax
assets as of December 31, 1997. Of the amount recognized, $42.7 million was
recognized as a deferred income tax benefit in 1997, $5.0 million was recognized
as a deferred income tax benefit in 1996 and $4.9 million related to acquired
NOLs was recognized through a reduction in investments in domestic cellular
entities in 1997.
A valuation allowance remains on certain deferred income tax assets due
to uncertainties as to when and whether these assets will be realized in the
future. To the extent that the income tax benefit of these amounts is realized
in future years, the benefit will be recorded as a direct addition to
shareholders' equity as these assets relate to additional income tax deductions
arising from restricted stock bonuses, stock options and stock purchase
warrants.
The transactions discussed above which will create the taxable income upon
which management based its deferred income tax asset recognition decisions have
been approved by the Company's Board of Directors and are represented by
definitive agreements among the parties to the transactions; however, ultimate
consummation of these transactions is dependent on the parties reaching final
agreement on terms and financing and the Company obtaining standard regulatory
approvals. There can be no assurance that these transactions will be
consummated.
For Federal income tax reporting purposes, the Company had net operating
loss carryforwards of approximately $323 million at December 31, 1997. These
losses may be used to reduce future taxable income, if any, and expire through
2012. The primary differences between the accumulated deficit for financial
reporting purposes and the income tax loss carryforwards relate to the
differences in the treatment of certain deferred cellular license acquisition
costs, certain gains on dispositions of cellular interests, partnership losses,
depreciation methods, estimated useful lives and compensation earned under stock
compensation plans. These carryforwards may be subject to annual limitation in
the future in accordance with the Tax Reform Act of 1986 and the ability to use
these carryforwards could be significantly impacted by a future "change in
control" of the Company. The limitations, if any, arising from such future
"change in control" cannot be known at this time. See Note 6 to the Company's
Consolidated Financial Statements for further information regarding the
Company's income tax status.
General. Although no assurance can be given that such will be the case,
the Company believes that its internally generated funds and available borrowing
capacity under the 1998 Loan Agreements will be sufficient during the next
several years to complete its planned network expansion, to fund debt service,
to provide flexibility, to repurchase shares, to pursue acquisitions and other
business opportunities that might arise in the future, and to meet working
capital and general corporate needs. The Company also may issue additional
shares of Class A Common Stock.
28
The Year 2000 Issues
Many existing computer programs use only two digits to identify a year in
the date field. These programs were designed and developed without considering
the impact of the upcoming change in the century. If not corrected, many
computer applications could fail or create erroneous results by or at the Year
2000. The Year 2000 issue affects virtually all companies and organizations.
The Company's cellular operations are heavily dependent on computer
applications. System failures caused by Year 2000 issues could have a material
adverse impact on the Company. The Company has begun efforts to assess its Year
2000 compliance issues. However, the assessment is not yet complete and a
detailed plan for addressing Year 2000 issues has not been finalized. Until the
assessment is completed, management is unable to determine the magnitude of
effort and cost that will be required to bring the Company's computer systems
into compliance. The Company expects to complete its overall Year 2000
assessment and any required remediation prior to any anticipated impact on its
operations.
Inflation
The Company believes that inflation affects its business no more than it
generally affects other similar businesses.
"Safe Harbor" Statement under Section 27A of the Securities Act of 1933,
as amended, and Section 21E of the Securities Exchange Act of 1934, as amended:
Except for the historical information presented, the matters disclosed in
this report include forward-looking statements. These statements represent the
Company's judgment on the future and are subject to risks and uncertainties that
could cause actual results to differ materially. Such factors include, without
limitation: (i) the substantial leverage of the Company which may adversely
affect the Company's ability to finance its future operations, to compete
effectively against better capitalized competitors and to withstand downturns in
its business or the economy generally; (ii) a change in economic conditions in
the markets served by the Company which could affect demand for cellular
services; (iii) greater than anticipated competition from PCS and ESMR companies
that provide services and features in addition to those currently provided by
cellular companies, and the risk that the Company will not be able to provide
such services and features or that it will not be able to do so on a timely or
profitable basis; (iv) technological developments that make the Company's
existing analog networks and planned digital networks uncompetitive or obsolete
such as the risk that the Company's choice of Time Division Multiple Access
("TDMA") as its digital technology leaves it at a competitive disadvantage if
other digital technologies, including Code Division Multiple Access ("CDMA"),
ultimately provide substantial advantages over TDMA or analog technology and
competitive pressures force the Company to implement CDMA or another digital
technology at substantially increased cost; and (v) higher than anticipated
costs due to unauthorized use of its networks and the development and
implementation of measures to curtail such fraudulent use; and (vi) greater than
anticipated losses attributable to its equity interests in other companies.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements and notes to consolidated financial
statements of the Registrant and its subsidiaries are included in this Form 10-K
following the Index to Financial Statements and Schedules. In addition,
Financial Statements of the Registrant's 50% or less owned significant
subsidiaries are included.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
29
PART III
Item 10. Directors and Executive Officers of the Registrant
Information with respect to directors appearing under the heading,
"Election of Directors" in the Registrant's proxy statement for the Annual
Meeting of Shareholders to be held May 19, 1998, is incorporated herein by
reference. Other information with respect to executive officers is contained in
Part I -- Item 4 (a) Executive Officers of the Registrant.
Item 11. Executive Compensation
Information with respect to executive compensation appearing under the
heading "Executive Compensation" in the Registrant's proxy statement for the
Annual Meeting of Shareholders to be held May 19, 1998, is incorporated herein
by reference.
Item 12. Securities Ownership of Certain Beneficial Owners and Management
Information with respect to securities ownership of certain beneficial
owners and management appearing under the headings "Voting Securities
Outstanding" and "Security Ownership of Management" in the Registrant's proxy
statement for the Annual Meeting of Shareholders to be held May 19, 1998, is
incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
Information with respect to certain transactions appearing under the
heading "Certain Transactions" in the Registrant's proxy statement for the
Annual Meeting of Shareholders to be held May 19, 1998, is incorporated herein
by reference.
30
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a)(1) and (2) Financial Statements and Financial Statement Schedules. The
financial statements and supplemental schedules listed in the
accompanying Index to Financial Statements and Schedules are
filed as a part of this report.
(a)(3) Exhibits. Exhibits to this report are listed in the accompanying
Index to Exhibits.
(b) Reports on Form 8-K. There were no reports filed on Form 8-K
during the fourth quarter of 1997.
31
SIGNATURES
Pursuant to the requirements of the Section 13 and 15(d) of the Securities
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
VANGUARD CELLULAR SYSTEMS, INC.
By: /s/ HAYNES G. GRIFFIN
------------------------------
Haynes G. Griffin
Chairman of the Board of Directors
and Co-Chief Executive Officer
Date: March 31, 1998
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed by the following persons on behalf of the registrant
and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ HAYNES G. GRIFFIN Chairman of the Board of March 31, 1998
- -------------------------------- Directors, Co-Executive
Haynes G. Griffin Officer
/s/ STEPHEN R. LEEOLOU President, Co-Chief Executive March 31, 1998
- -------------------------------- Officer, Director
Stephen R. Leeolou
/s/ Stuart S. Richardson Vice Chairman of the Board March 31, 1998
- -------------------------------- of Directors
Stuart S. Richardson
/s/ L. RICHARDSON PREYER, JR. Vice Chairman of the Board March 31, 1998
- -------------------------------- of Directors
L. Richardson Preyer, Jr.
/s/ STEPHEN L. HOLCOMBE Chief Financial Officer March 31, 1998
------------------------------- (Principal accounting
Stephen L. Holcombe and principal financial
officer)
/s/ F. COOPER BRANTLEY Director March 31, 1998
- --------------------------------
F. Cooper Brantley
/s/ DORIS R. BRAY Director March 31, 1998
- --------------------------------
Doris R. Bray
/s/ ROBERT M. DEMICHELE Director March 31, 1998
- --------------------------------
Robert M. DeMichele
/s/ L. RICHARDSON PREYER, SR. Director March 31, 1998
- --------------------------------
L. Richardson Preyer, Sr.
/s/ ROBERT A. SILVERBERG Director March 31, 1998
- --------------------------------
Robert A. Silverberg
32
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Page
----
Vanguard Cellular Systems, Inc. and Subsidiaries
Consolidated Balance Sheets, December 31, 1997 and 1996 ............. F-2
Consolidated Statements of Operations for the Years ended December
31, 1997, 1996 and 1995 ........................................... F-3
Consolidated Statements of Changes in Shareholders' Equity for the
Years ended December 31, 1997, 1996 and 1995 ...................... F-4
Consolidated Statements of Cash Flows for the Years ended December
31, 1997, 1996 and 1995 ........................................... F-5
Notes to Consolidated Financial Statements .......................... F-6
Report of Independent Public Accountants ............................ F-26
Schedule I -- Condensed Financial Information of the Registrant ..... F-27
Schedule II -- Valuation and Qualifying Accounts .................... F-31
Financial Statements of Certain Significant 50% or less Owned
Subsidiaries ......................................................... F-32*
All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are not
required under the related instructions or are inapplicable and therefore have
been omitted.
- --------
*Financial statements for Pt Rajasa Hazanah Perkasa, a foreign business,
will be filed by June 30, 1998 as permitted by Rule 3-09.
------------------------
F-1
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollar amounts in thousands)
December 31,
----------------------
1997 1996
--------- ---------
Assets
CURRENT ASSETS:
Cash .......................................................... $ 2,487 $ 11,180
Accounts receivable, net of allowances for doubtful
accounts of $8,184 and $4,617 ............................. 54,340 29,907
Cellular telephone inventories ................................ 18,826 15,921
Deferred income tax asset ..................................... 43,139 2,149
Prepaid expenses .............................................. 3,620 2,057
--------- ---------
Total current assets ..................................... 122,412 61,214
--------- ---------
INVESTMENTS ..................................................... 307,718 333,371
--------- ---------
PROPERTY AND EQUIPMENT, at cost:
Land .......................................................... 2,432 2,432
Buildings ..................................................... 557 584
Cellular telephones held for rental ........................... 33,505 30,040
Cellular telephone systems .................................... 382,012 295,376
Office furniture and equipment ................................ 81,160 62,866
--------- ---------
499,666 391,298
Less -- Accumulated depreciation .............................. 166,230 119,470
--------- ---------
333,436 271,828
Construction in progress ...................................... 37,907 41,972
--------- ---------
371,343 313,800
--------- ---------
NON-CURRENT DEFERRED INCOME TAX ASSET ........................... 9,447 2,851
--------- ---------
OTHER ASSETS, net of accumulated amortization
of $10,701 and $6,965 ..................................... 17,041 19,345
--------- ---------
Total assets .............................................. $ 827,961 $ 730,581
========= =========
Liabilities and Shareholders' Equity
CURRENT LIABILITIES -- Accounts payable and accrued expenses .... $ 58,084 $ 67,176
--------- ---------
LONG-TERM DEBT .................................................. 768,967 629,954
--------- ---------
COMMITMENTS AND CONTINGENCIES (Note 5)
SHAREHOLDERS' EQUITY:
Preferred stock -- $.01 par value, 1,000,000 shares
authorized, no shares issued ....... ...................... -- --
Common stock, Class A -- $.01 par value, 250,000,000
shares authorized, and 38,307,623 and 41,084,522
shares issued and outstanding ............................. 383 411
Common stock, Class B -- $.01 par value, 30,000,000
shares authorized, no shares issued ....................... -- --
Additional capital in excess of par value ..................... 221,624 237,640
Net unrealized holding loss ................................... -- (14,570)
Accumulated deficit ........................................... (221,097) (190,030)
--------- ---------
Total shareholders' equity .................................... 910 33,451
--------- ---------
Total liabilities and shareholders' equity ................ $ 827,961 $ 730,581
========= =========
The accompanying notes to consolidated financial statements
are an integral part of these balance sheets.
F-2
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data)
For the Years Ended December 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------
REVENUE:
Service revenue .................................. $ 349,638 $ 282,694 $ 217,440
Cellular telephone equipment revenue ............. 23,328 15,120 15,647
Other ............................................ 1,552 4,240 2,984
--------- --------- ---------
374,518 302,054 236,071
--------- --------- ---------
COSTS AND EXPENSES:
Cost of service .................................. 34,443 31,678 27,043
Cost of cellular telephone equipment ............. 40,223 25,372 25,605
General and administrative ....................... 100,913 80,057 60,489
Marketing and selling ............................ 75,794 62,384 54,906
Depreciation and amortization .................... 73,881 48,635 36,170
--------- --------- ---------
325,254 248,126 204,213
--------- --------- ---------
INCOME FROM OPERATIONS ............................. 49,264 53,928 31,858
INTEREST EXPENSE ................................... (57,257) (46,199) (38,293)
UNREALIZED HOLDING LOSS ............................ (32,757) -- --
NET LOSSES FROM UNCONSOLIDATED INVESTMENTS ......... (13,367) (9,344) (2,261)
OTHER, net ......................................... 1,390 3,955 1,683
--------- --------- ---------
INCOME (LOSS) BEFORE INCOME TAXES .................. (52,727) 2,340 (7,013)
INCOME TAX BENEFIT ................................. 42,700 4,109 --
--------- --------- ---------
NET INCOME (LOSS) .................................. $ (10,027) $ 6,449 $ (7,013)
========= ========= =========
NET INCOME (LOSS) PER COMMON SHARE:
BASIC ........................................... $ (0.25) $ 0.16 $ (0.17)
========= ========= =========
DILUTED ......................................... $ (0.25) $ 0.15 $ (0.17)
========= ========= =========
COMMON SHARES USED IN COMPUTING PER SHARE AMOUNTS:
BASIC............................................ 40,224 41,320 41,100
========= ========= =========
DILUTED ......................................... 40,224 41,898 41,100
========= ========= =========
The accompanying notes to consolidated financial statements
are an integral part of these statements.
F-3
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollar amounts in thousands)
For the Years Ended December 31, 1995, 1996 and 1997
--------------------------------------------------------------------------------------
Common Stock Additional
Class A Capital in Total
-------------------------- Excess of Net Unrealized Accumulated Shareholders'
Shares Amount Par Value Holding Loss Deficit Equity
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, January 1, 1995 ............... 40,529,334 $ 405 $ 234,731 $ (9,310) $ (186,619) $ 39,207
Shares issued upon exercise of stock
options .............................. 755,906 8 3,294 -- -- 3,302
Shares issued for cash ................. 26,813 -- 637 -- -- 637
Net unrealized holding loss ............ -- -- -- (7,085) -- (7,085)
Net loss ............................... -- -- -- -- (7,013) (7,013)
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, December 31, 1995 ............. 41,312,053 413 238,662 (16,395) (193,632) 29,048
Shares issued upon exercise of stock
options .............................. 27,190 -- 448 -- -- 448
Shares issued for cash ................. 279 -- 6 -- -- 6
Shares repurchased and retired ......... (255,000) (2) (1,476) -- (2,847) (4,325)
Net unrealized holding gain ............ -- -- -- 1,825 -- 1,825
Net income ............................. -- -- -- -- 6,449 6,449
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, December 31, 1996 ............. 41,084,522 411 237,640 (14,570) (190,030) 33,451
Shares issued upon exercise of stock
options .............................. 17,550 -- 58 -- -- 58
Shares issued for cash ................. 15,551 -- 178 -- -- 178
Shares repurchased and retired ......... (2,810,000) (28) (16,252) -- (21,040) (37,320)
Net unrealized holding losses recognized
through operations ................. -- -- -- 14,570 -- 14,570
Net loss ............................... -- -- -- -- (10,027) (10,027)
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, December 31, 1997 ............. 38,307,623 $ 383 $ 221,624 $ -- $ (221,097) $ 910
=========== =========== =========== =========== =========== ===========
The accompanying notes to consolidated financial statements
are an integral part of these statements.
F-4
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollar amounts in thousands)
For the Years Ended December 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .................................... $ (10,027) $ 6,449 $ (7,013)
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Depreciation and amortization ..................... 73,881 48,635 36,170
Amortization of deferred financing costs .......... 1,983 1,587 1,322
Net losses from unconsolidated investments ........ 13,367 9,344 2,261
Minority interests ................................ -- (31) 3
Net gains on dispositions ....................... (317) (2,958) (1,787)
Deferred income tax benefit ....................... (42,700) (5,000) --
Unrealized holding loss ........................... 32,757 -- --
Stock received for management consulting services . -- (2,087) (2,436)
Changes in current items:
Accounts receivable, net .......................... (24,433) 1,363 (8,250)
Cellular telephone inventories .................... (2,905) (6,964) 1,649
Accounts payable and accrued expenses ............. 6,071 10,627 8,799
Other, net ........................................ (1,563) (550) (757)
--------- --------- ---------
Net cash provided by operating activities ......... 46,114 60,415 29,961
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment .................. (136,825) (119,077) (136,149)
Proceeds from dispositions of property and equipment . 53 540 380
Payments for acquisitions of investments ............. (13,728) (38,790) (69,908)
Proceeds from dispositions of investments ............ 395 4,644 1,413
Loans to unconsolidated affiliates ................... (4,045) -- --
Capital contributions to unconsolidated affiliates ... (706) (221) (318)
--------- --------- ---------
Net cash used in investing activities ............. (154,856) (152,904) (204,582)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments of long-term debt ................. -- (193,007) --
Proceeds of long-term debt ........................... 138,993 300,802 173,494
Debt issuance costs .................................. -- (6,914) (124)
Repurchases of common stock .......................... (37,320) (4,325) --
Net proceeds from issuance of common stock ........... 236 454 3,939
Increase in other assets ............................. (1,860) (1,426) (348)
--------- --------- ---------
Net cash provided by financing activities ......... 100,049 95,584 176,961
--------- --------- ---------
NET INCREASE (DECREASE) IN CASH ......................... (8,693) 3,095 2,340
CASH, beginning of year ................................. 11,180 8,085 5,745
--------- --------- ---------
CASH, end of year ....................................... $ 2,487 $ 11,180 $ 8,085
========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH PAID DURING THE YEAR FOR:
INTEREST, net of amounts capitalized ................. $ 52,812 $ 42,579 $ 32,597
INCOME TAXES ......................................... -- 891 --
========= ========= =========
The accompanying notes to consolidated financial statements
are an integral part of these statements.
F-5
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 -- ORGANIZATION
Vanguard Cellular Systems, Inc. ("Vanguard") (a North Carolina
corporation) through its only direct subsidiary, Vanguard Cellular Financial
Corp. ("VCFC"), is a provider of cellular telephone service to various markets
in the eastern United States. The majority of Vanguard's operations are
conducted in the Mid-Atlantic SuperSystem covering areas of Pennsylvania, New
York and New Jersey. The primary activities of Vanguard, VCFC, its wholly owned
subsidiaries and its majority owned cellular entities (collectively referred to
as the Company) include acquiring interests in entities that have been granted
nonwireline Federal Communications Commission ("FCC") permits to construct or
authorizations to operate cellular telephone systems, and constructing and
operating cellular telephone systems.
All of the Company's cellular entities operate under the trade name of
CellularONE(R), which is the trade name many nonwireline carriers have adopted
to provide uniformity throughout the industry. The trade name is owned by a
partnership in which the Company holds a minority ownership interest.
Vanguard is a holding company which is the 100% shareholder of VCFC. This
organization was created to structurally subordinate Vanguard's $200 million in
Senior Debentures to VCFC's Credit Facility. (See Note 4 -- Long-Term Financing
Arrangements.)
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of Vanguard,
VCFC, its wholly owned subsidiaries and the entities in which it has a majority
ownership interest. Investments in which the Company exercises significant
influence but does not exercise control through majority ownership have been
accounted for using the equity method of accounting. Investments in which the
Company does not exercise significant influence or control through majority
ownership have been accounted for using the cost method of accounting. All
significant intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of these consolidated financial statements and footnote
disclosures required the use of certain estimates by management in determining
the Company's financial position and results of operations. Actual results could
differ from those estimates.
Cellular Telephone Inventories
Inventories, consisting primarily of cellular telephones held for resale,
are valued at the lower of first-in, first-out (FIFO) cost or market.
Investments
Investments in Domestic Cellular Entities -- Investments in domestic
cellular entities consist of the costs incurred to acquire FCC licenses or
interests in entities that have been awarded FCC licenses to provide cellular
service net of the Company's share of the fair value of the net assets acquired,
payments of other acquisition related expenses and capital contributions to
unconsolidated cellular entities. The Company's investments in consolidated
cellular entities are being amortized over forty years. Exchanges of minority
ownership interests in cellular entities are recorded based on the fair value of
the ownership interests acquired.
Investments in Other Entities -- Investments in other entities consist of
the Company's investments in International Wireless Communications Holdings,
Inc. ("IWC"), Star Digitel Limited ("SDL"), International Wireless
Communications Pakistan Ltd. ("IWCPL"), Inter*Act Systems, Incorporated
("Inter*Act") and Geotek Communications, Inc. ("Geotek"). The investments in
IWC, SDL, IWCPL and Inter*Act are recorded using the equity method. The
investment in Geotek common stock is considered to be "available for sale" under
the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115,
"Accounting for Certain Investments in Debt and Equity Securities." Accordingly,
the Company's investment in the marketable common stock of Geotek is recorded at
its fair value and the investment in other securities of Geotek is recorded at
cost.
F-6
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES -- Continued
The Company recognizes its pro rata share of the net income or losses
generated by the unconsolidated cellular and noncellular entities carried on the
equity method of accounting in its consolidated statements of operations.
Property and Equipment
Property and equipment are recorded at cost. Depreciation is calculated on
a straight-line basis for financial reporting purposes over the following
estimated useful lives:
Buildings ............................................. 20 years
Cellular telephones held for rental ................... 3 years
Cellular telephone systems ............................ 7-20 years
Office furniture and equipment ........................ 3-10 years
At December 31, 1997 and 1996, construction in progress was composed
primarily of the cost of uncompleted additions to the Company's cellular
telephone systems in majority owned cellular markets. The Company capitalized
interest costs of $1.3 million in 1997, 1996 and 1995, as part of the cost of
cellular telephone systems.
Maintenance, repairs and minor renewals are charged to operations as
incurred. Gains or losses at the time of disposition of property and equipment
are reflected in the statements of operations currently.
Cellular telephones are rented to certain customers generally with
a contract for a minimum length of service. Such customers have the
option to purchase the cellular telephone at any time during the term of
the agreement.
Long-Lived Assets
In accordance with SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of", the Company
reviews for the impairment of long-lived assets and certain identifiable
intangibles whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Under SFAS No. 121, an
impairment loss would be recognized when estimated future cash flows expected to
result from the use of the asset and its eventual disposition is less than its
carrying amount. No such impairment losses have been identified by the Company.
Other Assets
Other assets consist of the following at December 31, 1997 and 1996 (in
thousands):
1997 1996
-------- --------
Deferred financing costs $ 16,016 $ 16,016
Acquired customer bases 8,190 8,190
Interest rate cap agreements 1,569 413
Other 1,967 1,691
-------- ---------
27,742 26,310
Accumulated amortization (10,701) (6,965)
-------- --------
$ 17,041 $ 19,345
======== ========
Deferred financing costs are being amortized over the period of the
related agreements. Amortization of $2.0 million, $1.6 million and $1.3 million
has been included in interest expense in each of the accompanying December 31,
1997, 1996 and 1995 consolidated statements of operations, respectively. The
acquired customer bases relate to the acquisitions of the Logan, WV (WV-6) RSA
in August 1996, the Union, PA (PA-8) RSA in January 1995, and the Binghamton, NY
and Elmira, NY MSAs in December 1994. The customer bases are being amortized
over a four-year period and, accordingly, amortization of $2.1 million, $1.8
million and
F-7
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES -- Continued
$1.7 million has been included in the accompanying December 31, 1997, 1996 and
1995 consolidated statements of operations, respectively. The Company maintains
certain interest rate cap agreements with certain major financial institutions.
These costs are being amortized over the lives of the agreements, and
accordingly, amortization of $243,000, $242,000 and $323,000 has been included
in interest expense in the accompanying December 31, 1997, 1996 and 1995
consolidated statements of operations, respectively.
Revenue Recognition
Service revenue is recognized at the time cellular services are provided
and service fees related to prebilled services are not recognized until earned.
Cellular telephone equipment revenues consist primarily of sales of cellular
telephones to subscribers and are recognized at the time equipment is delivered
to the subscriber.
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes", which requires the use of the "asset and
liability method" of accounting for income taxes. Accordingly, deferred income
tax assets and liabilities are determined based on the difference between the
financial statement and income tax bases of assets and liabilities, using
enacted income tax rates in effect for the year in which the differences are
expected to reverse.
Derivative Financial Instruments
Derivative financial instruments in the form of interest rate cap and swap
agreements are used by the Company in the management of its interest rate
exposures. Interest rate swap agreements modify the interest characteristics of
a portion of the Company's debt. Amounts paid or received under interest rate
swap agreements are accrued as interest rates change and are recognized over the
life of the swap agreements as an adjustment to interest expense. The related
receivable from, or amounts payable to the counter-parties are included in
accounts receivable or accounts payable and accrued expenses. Interest rate caps
are used to lock in a maximum rate if rates rise, but enable the Company to
otherwise pay lower market rates. The costs of interest rate cap agreements are
included in interest expense ratably over the lives of the agreements. Payments
to be received as a result of the cap agreements are accrued as a reduction of
interest expense. The unamortized costs of the cap agreements are included in
other assets. The Company does not hold or issue financial instruments for
trading purposes.
Net Income (Loss) per Common Share
Basic net income (loss) per common share is computed based upon the
weighted average number of common shares outstanding during the year. Diluted
net income per common share for 1996 reflects the potential dilution that could
occur if the Company's outstanding options to issue common stock were exercised
and converted into common shares that then shared in the earnings of the
Company. Diluted net income (loss) per common share is computed in accordance
with the guidance provided by SFAS No. 128, "Earnings Per Share". The
calculation of diluted net loss per common share for 1997 and 1995 does not
include the effect of outstanding stock options, as their effect would be
antidilutive.
Outstanding options to purchase 2,314,750 common shares with exercise
prices ranging from $21.50 to $25.13 were not included in the 1996 calculation
of diluted net income per common share because the options' exercise prices were
greater than the average market price of the common shares. Options to purchase
3,903,102 and 4,870,802 shares at a weighted average exercise price of $18.96
and $7.11 were outstanding as of December 31, 1995 and 1997, respectively, but
were not included in the computation of diluted net loss per common share
because the effect would be antidilutive.
Statements of Cash Flows
Additional required disclosures of noncash investing and financing
activities for the years ended December 31, 1997, 1996 and 1995 are as follows:
F-8
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES -- Continued
The Company acquired ownership interests in certain cellular entities and
other investments for cash and noncash consideration, as follows (in thousands):
1997 1996 1995
--------- --------- ---------
Fair value of investments acquired ................ $ 13,728 $ 57,272 $ 79,710
--------- --------- ---------
Fair value of noncash consideration given up:
Cellular licenses and interests ................. -- 16,395 7,366
Stock received for management consulting services -- 2,087 2,436
--------- --------- ---------
-- 18,482 9,802
--------- --------- ---------
Cash acquisitions of investments .................. $ 13,728 $ 38,790 $ 69,908
========= ========= =========
The Company acquired property and equipment for
cash and noncash consideration, as follows:
Cash .............................................. $ 136,825 $ 119,077 $ 136,149
Increase (decrease) in accounts payable ........... (15,163) 11,728 (6,255)
--------- --------- ---------
$ 121,662 $ 130,805 $ 129,894
========= ========= =========
Reclassification
Certain amounts in the 1996 and 1995 financial statements have been
reclassified to conform to the 1997 presentation.
F-9
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS
Investments consist of the following as of December 31, 1997 and
1996 (in thousands):
1997 1996
--------- ---------
Investments in domestic cellular entities:
Consolidated entities:
License cost ................................... $ 297,142 $ 300,780
Accumulated amortization ....................... (43,696) (36,113)
--------- ---------
253,446 264,667
--------- ---------
Entities carried on the equity method:
Cost ........................................... 10,193 10,193
Accumulated share of earnings .................. 1,960 2,056
--------- ---------
12,153 12,249
--------- ---------
Entities carried on the cost method ............... 9,592 9,993
--------- ---------
275,191 286,909
--------- ---------
Investments in other entities:
Entities carried on the equity method:
Investment in equity securities ................ 40,794 26,924
Investment in debentures, net of discount of
$6,449 and $8,389........................... 11,551 9,611
Loans .......................................... 4,045 --
Accumulated share of losses .................... (33,842) (18,239)
--------- ---------
22,548 18,296
--------- ---------
Investments carried as "available for sale":
Cost ........................................... 37,736 37,736
Net unrealized holding losses .................. (32,757) (14,570)
--------- ---------
4,979 23,166
--------- ---------
Other investments, at cost ........................ 5,000 5,000
--------- ---------
32,527 46,462
--------- ---------
$ 307,718 $ 333,371
========= =========
Investments in Domestic Cellular Entities
The Company's significant activity relating to its investments in domestic
cellular entities is discussed below.
Consolidated Entities
In January 1995, the Company purchased the Union, PA (PA-8) RSA for a cash
price of $51.3 million. The PA-8 RSA lies in the center of the Company's
Mid-Atlantic SuperSystem and is an operational cellular system. Pro forma
consolidated results of operations, are as follows (in thousands, except per
share data):
Year ended December 31,
------------------------
1995 1994
----------- -----------
Revenue .................................... $ 236,578 $ 173,735
Net loss before extraodinary item .......... (7,254) (18,155)
Net loss ................................... (7,254) (26,557)
Net loss per common share:
Basic ................................... (0.18) (0.69)
Diluted ................................. (0.18) (0.69)
In December 1995, the Company completed the acquisition of the remaining
13.24% ownership interests in the Harrisburg, PA MSA in exchange for ownership
interests in cellular markets outside its regional metro-clusters and $2.9
million in cash.
F-10
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
In August 1996, the Company acquired the Logan, WV RSA ("WV-6 RSA") for a
cash purchase price of $16.7 million. The WV-6 RSA is contiguous to the
Company's West Virginia markets and its operations are managed as part of its
West Virginia metro-cluster.
Pro forma results of operations, as if the acquisition of the WV-6 RSA
had occurred January 1, 1995 are as follows (in thousands, except per share
data):
Year Ended
December 31,
--------------------------
1996 1995
--------- ---------
Revenue ................................. $ 304,196 $ 239,412
Net income (loss) ....................... 4,774 (8,790)
Net income (loss) per common share:
Basic ................................ 0.12 (0.21)
Diluted .............................. 0.11 (0.21)
In the third quarter of 1996, the Company acquired the remaining portions
of the State College, PA and Williamsport, PA MSAs and the PA-10 East RSA in
exchange for $2.8 million in cash. These markets are now 100% owned by the
Company.
In October 1996, the Company exchanged certain cellular properties for
four cellular markets contiguous to its Ohio Valley SuperSystem. In this
transaction, the Company received four markets, OH-9 RSA, OH-10 RSA (excluding
Perry and Hocking counties), Parkersburg-Marietta, WV-OH MSA, and the remaining
county in the WV-1 RSA, in exchange for the Company's Orange County, NY cellular
market and ownership interests in several minority owned cellular markets. The
Company surrendered 324,000 POPs in Orange County and 76,000 POPs in minority
owned markets, and added 542,000 POPs to the Ohio Valley SuperSystem. This
transaction was treated principally as an exchange of similar productive assets
and, therefore, the cellular markets received have been recorded at the
historical cost of the Orange County, NY cellular market, increased for the fair
value of the additional minority ownership interests given up.
In March 1998, the Company entered into an agreement to sell for
$160 million in cash its investment in the Myrtle Beach, SC RSA. This
transaction is expected to close in the third quarter of 1998.
Additionally, the Company is pursuing various alternatives for divesting
of its Florida metro-cluster and other non-core cellular properties in
which it owns minority interests.
The Company also explores, on an ongoing basis, possible acquisitions of
companies that will facilitate new service offerings to its customers, such as
paging and Internet access. The Company entered into an agreement in December,
1997 to purchase NationPage, a leading regional paging provider in Pennsylvania
and New York, for approximately $28.5 million in cash.
Cellular Entities on the Equity Method
The Company holds a 50% investment in a joint venture known as Eastern
North Carolina Cellular Joint Venture ("ENCCJV"), created to acquire, own and
operate various cellular markets located primarily in eastern North Carolina.
The underlying net assets of the joint venture consist principally of its
investment in the FCC licenses in the Wilmington, NC and Jacksonville, NC MSA
cellular markets. The Company recognized $(95,000), $1.9 million, and $284,000
as its proportionate share of the ENCCJV earnings (losses) during the years
ended December 31, 1997, 1996 and 1995, respectively.
In February 1998, the Company entered into an agreement to sell for $30
million in cash its ownership interest in the ENCCJV. This transaction is
expected to close in the third quarter of 1998.
Cellular Entities on the Cost Method
The investment balance of approximately $9.6 million at December 31, 1997
represents the Company's investment in approximately 28 cellular markets with
ownership interests ranging from 0.27% to 13.76%. The Company holds these
ownership interests for investment purposes.
F-11
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
Noncellular Investments
International Wireless Communications Holdings, Inc. and Foreign Investments
At December 31, 1997, the Company owned approximately 36% of the
outstanding stock of IWC and had invested an aggregate of $13.8 million. IWC is
a development stage company specializing in securing, building and operating
wireless businesses, primarily in Asia and Latin America.
During 1996, IWC completed the sale of 14% Senior Secured Discount Notes
due 2001, which have been exchanged for identical notes registered with the
Securities and Exchange Commission ("SEC"), and warrants to purchase shares of
IWC common stock. IWC received approximately $100 million in net proceeds from
this financing which was used to fund existing projects and the exploration of
other opportunities. As existing and new projects are in the network buildout
phase, the losses of IWC are expected to grow significantly in future years. The
Company records its proportionate share of these losses under the equity method
of accounting. During 1995 and 1996, the Company recognized an amount of losses
on the equity method from IWC that is equal to the Company's equity investment
in IWC. As a result, the Company has suspended the recognition of losses
attributable to IWC until such time that the equity method income is available
to offset the Company's share of IWC's future losses or the Company makes
further investments in IWC.
During 1997, the Company loaned $966,000 to IWC under the $7
million Senior Exchangeable Debt Facility in which the Company
participated as a lender with Toronto Dominion Capital and other IWC
shareholders. The Company also received warrants to purchase IWC common
stock valued at $486,000 in connection with the Company's guarantee and
funding of certain loans to SDL and Pakistan Wireless Holdings, Inc., as
discussed below. As these transactions are subject to the equity method,
the Company recorded losses of $1.5 million during 1997 related to these
additional investments in IWC. Total equity method losses recorded by
the Company in 1996 and 1995 were $11.5 million and $2.3 million,
respectively.
In March 1998, the Company made an additional $10.0 million equity
investment in IWC. Accordingly, the Company will recognize losses equal to the
amount of this additional equity investment during the first quarter of 1998. As
a result of equity financing transactions completed by IWC thus
far during 1998, the Company's ownership in IWC has been reduced to
approximately 29%.
During the first quarter of 1997, the Company entered into a stock
purchase agreement to purchase from an unrelated third party 7% of the
outstanding shares of SDL, a Hong Kong company whose principal business
activities relate to the provision and development of cellular
telecommunications services in the People's Republic of China. Pursuant
to the stock purchase agreement, the Company's purchase of such shares
will occur in two closings, which are subject to the satisfaction of
certain conditions, for an aggregate cash consideration of $8.4 million.
IWC also acquired and maintains a 40% ownership interest in SDL. Through
December 31, 1997, the Company has invested $5.3 million in SDL and
expects to fund its remaining $3.1 million in July 1998. The Company
accounts for its investment using the equity method of accounting, and
recognized equity method losses of $629,000 during 1997. In addition,
the Company has guaranteed obligations of SDL totaling $14.1 million,
which includes guarantees of $7.2 million on behalf of IWC. If the
Company must eventually fund these guarantees, the funding will be in
the form of loans to SDL.
During 1997, the Company acquired a 12% equity interest in IWCPL
for $7.0 million. At the same time, IWC's 100% owned subsidiary,
Pakistan Wireless Holdings, Inc. (PWH), also acquired a 39% equity
interest in IWCPL, thereby increasing the Company's total direct and
indirect ownership interest in IWCPL to approximately 26%. IWCPL owns
51% of the equity in Pakistan Mobile Communications (Pvt) Ltd., a
Pakistan company that owns and operates the cellular license in
Pakistan. Through December 31, 1997, the Company has invested $8.2
million in IWCPL. Through a loan facility arranged by PWH with the
Company and Toronto Dominion Capital, the Company loaned to PWH $3
million during 1997. The proceeds of the loan facility were used by PWH
to fund its equity investment in IWCPL. The loan facility is secured by
all assets of
F-12
PWH, and loans under the facility have a term of 5 years. The Company records
its proportionate share of the losses of IWCPL under the equity method of
accounting, and recognized equity method losses of $246,000 in 1997,
accordingly.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
Inter*Act Systems, Incorporated.
As of December 31, 1997, the Company had invested $10.0 million in
Inter*Act for an ownership interest of approximately 26%. Inter*Act is a
development stage company that provides consumer product manufacturers and
retailers (currently supermarkets) the ability to offer targeted promotions to
retail customers at the point of entry of a retail outlet through an interactive
multi-media system utilizing ATM-like terminals.
During 1996, Inter*Act completed the sale of 142,000 units ("Units") of
14% Senior Discount Notes due 2003, which have been exchanged for identical
notes registered with the SEC and warrants to purchase shares of common stock at
$.01 per share. The Company purchased for $12.0 million a total of 18,000 Units
consisting of $18.0 million principal amount at maturity of these 14% Senior
Discount Notes and warrants to purchase 132,012 shares of common stock. At
issuance, the Company allocated, based upon the estimated fair values, $8.9
million and $3.1 million to the debentures and warrants purchased by the
Company, respectively. Effective September 30, 1997 and in accordance with the
warrant agreement, the shares of common stock eligible to be purchased with the
warrants held by the Company increased from 132,012 to 169,722. The shares
issuable upon the exercise of these warrants currently represent approximately
2% of Inter*Act's outstanding common stock. In addition, an existing warrant
held by the Company was restructured whereby the Company has the right to
acquire at any time prior to May 5, 2005 an aggregate of 900,113 shares of
common stock for $23.50 per share, which shares presently represent
approximately 10% of the outstanding common stock of Inter*Act.
Inter*Act has incurred net losses since its inception. Inter*Act received
approximately $91 million in net proceeds from the above financing which are
being used to accelerate the roll-out of its systems in retail supermarkets and,
as a result, the net losses incurred by Inter*Act are expected to grow
significantly in future years. The Company records its proportionate share of
these losses under the equity method of accounting. The Company's equity and
warrant investment was reduced to zero through the recognition of equity method
losses during 1997. However, Vanguard will continue to recognize equity method
losses related to its investment in bonds until such investment is reduced to
zero.
In addition to the current ownership held by the Company certain officers,
directors and entities affiliated with certain directors of the Company maintain
an additional 27% ownership interest in Inter*Act.
Total equity method losses related to Inter*Act were $11.0 million, $4.2
million and $257,000 during 1997, 1996 and 1995, respectively.
Geotek Communications, Inc.
In 1994, the Company purchased from Geotek 2.5 million shares of Geotek
common stock for $30 million and received a series of options to purchase
additional shares and entered into a management consulting agreement to provide
operational and marketing support in exchange for 300,000 shares of Geotek
common stock per year. Geotek is a telecommunications company that is developing
a wireless communications network using its FHMA(R) digital technology. Under
the management agreement, the Company earned and recorded as revenue
approximately 201,370 shares with an aggregate value of $2.1 million in 1996,
and approximately 300,000 shares with an aggregate value of $2.4 million in
1995. The stock options previously granted to the Company by Geotek in 1994 have
all expired unexercised. The expiration of the options also resulted in the
termination of the management agreement. The Company currently owns less than 5%
of Geotek's outstanding common stock.
The investment in Geotek common shares is accounted for as
"available for sale" pursuant to SFAS No. 115. As such, the investment
is recorded at its market value, and a net unrealized holding loss of
$14.6 million was recorded as a component of shareholders' equity as of
December 31, 1996. During 1997, the Geotek common stock price, as quoted
on the NASDAQ National Market System, declined from $7.13 per share at
December 31, 1996 to $1.53 per share at December 31, 1997. Based on
Geotek's historical performance, including the significant current year
decline in the market value of Geotek's common stock, the Company's
management made the determination that the decline in Geotek's common
stock price during 1997 was
F-13
other than temporary and, accordingly, recognized an unrealized holding loss of
$32.8 million in the accompanying 1997 consolidated statement of operations to
record the Company's investment in Geotek common stock at its market value at
December 31, 1997. In September 1995, the Company purchased, for $5.0 million in
cash, 531,463 shares of convertible preferred stock of Geotek with a stated
value of $9.408 per share. The preferred stock investment is accounted for at
cost and is included in Other Equity Investments.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
in the above table.
Financial Information of Equity Method Investees
Combined financial position and operating results of the Company's equity
method investees, ENCCJV, IWC, Inter*Act, SDL and IWCPL, as well as certain
significant investees of IWC, for the last three years are as follows
(in thousands):
1997 (1) 1996 (2) 1995 (3)
--------- --------- ---------
Current assets ....................... $108,774 $ 161,974 $ 30,040
Non-current assets ................... 445,925 237,507 119,528
Current liabilities .................. 249,354 48,397 19,318
Non-current liabilities .............. 311,747 254,073 2,701
Redeemable convertible preferred stock 209,412 103,021 98,845
Minority interest .................... 11,624 7,360 335
Revenues ............................. 40,544 29,583 14,050
Gross profit ......................... 8,697 2,769 10,418
Loss from operations ................. (229,651) (54,386) (12,787)
Net loss ............................. (319,708) (71,730) (15,081)
- --------
Information for each investee is summarized from the available financial
information for each entity and is presented only for the years in which the
Company maintained an investment.
(1) Includes information for ENCCJV, Inter*Act, IWC, SDL, IWCPL and certain of
IWC's investees for which the Company's attributable indirect ownership
was determined to be significant.
(2) Includes information for ENCCJV, Inter*Act, IWC and certain of IWC's
investees for which the Company's attributable indirect ownership was
determined to be significant.
(3) Includes information for ENCCJV, IWC and Inter*Act.
F-14
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS
At December 31, 1997 the Company's long-term financing arrangements
consist primarily of a $675 million Credit Facility with various lenders led by
The Toronto-Dominion Bank and The Bank of New York, and $200 million of Senior
Debentures due 2006. The Credit Facility is senior to the Senior Debentures
through the use of structured subordination whereby Vanguard is the borrower on
the Senior Debentures and VCFC, Vanguard's only direct subsidiary, is the
primary obligor on the Credit Facility. As discussed below, the Company's Credit
Facility was refinanced subsequent to December 31, 1997.
Long-term debt consists of the following as of December 31, 1997 and 1996
(in thousands):
1997 1996
-------- --------
Debt of VCFC:
Borrowings under the Credit Facility:
Term Loan ......................................... $325,000 $325,000
Revolving Loan .................................... 244,000 105,000
Other Long-Term Debt ................................. 130 137
-------- --------
569,130 430,137
Debt of Vanguard:
Senior Debentures due 2006, net of
unamortized discount of $163 and $183 ............ 199,837 199,817
-------- --------
$768,967 $629,954
======== ========
Credit Facility of VCFC
The Credit Facility consisted of a $325 million "Term Loan" and a
"Revolving Loan". As of December 31, 1997, $244 million had been borrowed under
the Revolving Loan. The Term Loan and the Revolving Loan bear interest at a rate
equal to the Company's choice of the Prime Rate or Eurodollar Rate plus an
applicable margin based upon a leverage ratio for the most recent fiscal
quarter. At December 31, 1997, the applicable margins on the borrowings were
0.125% and 1.375% per annum for the Prime Rate and Eurodollar Rate,
respectively. At December 31, 1997, the Company's effective interest rate on its
outstanding borrowings was 7.26%.
In February 1998, the Company completed the closing of an amendment to the
Credit Facility, increasing the facility to $1.0 billion pursuant to the Third
Amended and Restated Facility A Loan Agreement (Facility A Loan) and the
Facility B Loan Agreement (Facility B Loan) (collectively, the 1998 Loan
Agreements), with various lenders led by The Toronto-Dominion Bank, The
Bank of New York and NationsBank of Texas, N.A.
The Facility A and Facility B Loans are available to provide the Company
with additional financial and operating flexibility and enable it to pursue
business opportunities that may arise in the future. The Facility A Loan
consists of a $750 million senior secured reducing revolving credit facility
which allows for the issuance of up to $25 million of standby letters of credit.
The Facility B Loan consists of a $250 million 364-day revolving credit facility
which may be extended for an additional 364-day period upon the approval of the
lenders or converted to a term loan according to the terms and subject to
certain conditions of the Facility B Loan Agreement.
F-15
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS -- Continued
Borrowings under the Facility A and Facility B Loans bear interest
at a rate equal to the Company's choice of the Prime Rate or Eurodollar
Rate plus an applicable margin based upon a leverage ratio for the most
recent fiscal quarter. The ranges for this applicable margin are 0.0% to
0.25% for the Prime Rate and 0.5% to 1.5% for the Eurodollar Rate. Based
on the leverage ratio, computed as the ratio of Total Debt (as defined)
to Adjusted Cash Flow (as defined), as of December 31, 1997, the
Company's applicable margins on borrowings under the Facility A and
Facility B Loans are 0.00% and 1.25% per annum for the first quarter of
1998 for the Prime Rate and Eurodollar Rate, respectively. Upon the
occurrence of an event of default as defined in the 1998 Loan
Agreements, the applicable margin added to both the Eurodollar Rate and
the Prime Rate becomes 2.0%.
The outstanding amount of the Facility A Loan as of September 30, 2000 is
to be repaid in increasing quarterly installments commencing on September 30,
2000 and terminating at the maturity date of December 31, 2005. The quarterly
installment payments begin at 2.5% of the outstanding principal amount at
September 30, 2000 and gradually increase to 6.875% of the outstanding principal
amount. The maturity date for borrowings under the Facility B Loan is February
18, 1999. However, at the Borrower's request and the Lenders' approval, as set
forth in the Facility B Loan Agreement, the maturity date of the Facility B Loan
may be extended to February 16, 2000. Under the terms and subject to certain
conditions of the Facility B Loan Agreement, the Company has the option to
convert the borrowings outstanding under the Facility B Loan as of the Facility
B maturity date to a term loan maturing on December 31, 2005. Upon conversion to
a term loan, the principal balance of the Facility B Loan outstanding on
September 30, 2000 shall be repaid in quarterly installments commencing on
September 30, 2000 and terminating at the maturity date of December 31, 2005.
The quarterly repayments begin at 2.5% of the outstanding principal amount at
September 30, 2000 and gradually increase to 6.875% of the outstanding principal
amount.
The outstanding commitment under the Facility A Loan is reduced and the
outstanding borrowings under the Facility B term loan, if converted, are due
quarterly as follows:
Percentage of
Outstanding Loans
-----------------
1998........................................................... --
1999........................................................... --
2000........................................................... 5.0
2001........................................................... 15.0
2002........................................................... 15.0
2003........................................................... 17.5
2004........................................................... 20.0
2005........................................................... 27.5
----
100.0%
=====
Upon closing of the 1998 Loan Agreements, the Company paid fees of
approximately $4.0 million to the lenders. These fees and other costs
incurred in the refinancing will be recorded as a long-term asset in
1998 and amortized over the lives of the agreements. Remaining
unamortized deferred financing costs of $6.8 million at December 31,
1997 related to the 1994 Credit Facility will be expensed in 1998. The
Company must pay to the lenders a commitment fee equal to either 0.375%
or 0.25% of the aggregate unborrowed balance of the available Facility A
commitment and 0.2% or 0.15% of the aggregate unborrowed balance of the
Facility B commitment during the terms of the loans based upon the
Leverage Ratio for the most recent fiscal quarter.
Borrowings under the 1998 Loan Agreements are secured by the stock of VCFC
and Vanguard Cellular Operating Corp., direct or indirect wholly owned
subsidiaries of the Company. Among other restrictions, the 1998 Loan Agreements
and the 1994 Credit Facility limit the payment of cash dividends, limit the use
of borrowings, limit the creation of additional long-term indebtedness and
require the maintenance of certain financial ratios. The requirements of the
1998 Loan Agreements were established in relation to projected capital needs and
projected results of operations and cash flow. These requirements generally were
designed to require continued improvement in operating performance such that its
cash flow would be sufficient to continue servicing the debt as repayments are
required. As of December 31, 1997, VCFC is in compliance with all loan
covenants.
F-16
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS
Senior Debentures of Vanguard
On April 10, 1996, Vanguard issued $200 million aggregate principal amount
of 9 3/8% Senior Debentures due 2006 (the "Debentures") through an underwritten
public offering. The Debentures were issued at a price to the public of 99.901
for a yield of 9.384%. The net proceeds from the sale of the Debentures of
approximately $194.8 million were used to reduce borrowings under the Revolving
Loan portion of the Credit Facility and pay approximately $844,000 of expenses
in connection with an amendment to the Credit Facility. The Credit Facility was
amended to permit issuance of the Debentures and to require the structural
subordination of the Debentures by making VCFC the primary obligor of the Credit
Facility and all liabilities of the Company (other than the Debentures) and the
owner of all stock and partnership interests of the Company's operating
subsidiaries. The Debentures mature in 2006 and are redeemable at the Company's
option, in whole or in part, at any time on or after April 15, 2001. There are
no mandatory sinking fund payments for the Debentures. Interest is payable
semi-annually. Upon a Change of Control Triggering Event (as defined in the
Indenture for the Debentures), the Company will be required to make an offer to
purchase the Debentures at a purchase price equal to 101% of the principal
amount thereof plus accrued and unpaid interest, if any, to the date of
purchase.
The Debentures require that the Company limit, among other things, the
incurrence of additional indebtedness, the payment of dividends or the
repurchase of Capital Stock, certain distributions and transfers, and certain
asset sales.
The future maturities of the principal amount outstanding of all long-term
financing arrangements at December 31, 1997 are as follows (in thousands):
1998.......................................................... $ 0
1999.......................................................... 0
2000.......................................................... 28,580
2001.......................................................... 85,350
2002.......................................................... 85,350
Thereafter.................................................... 569,687
-------
$768,967
========
Interest Rate Protection Agreements
The Company maintains interest rate swaps and interest rate caps which
provide protection against interest rate risk. At December 31, 1997 and 1996,
the Company had interest rate cap agreements in place covering a notional amount
of $500 million and $100 million, respectively. The interest rate cap agreements
provide protection to the extent that LIBOR exceeds the strike level through the
expiration date as follows (in thousands):
1997 1996
------------------------------------------------- ------------------------------------------------
Strike Level Notional Amount Expiration Date Strike Level Notional Amount Expiration Date
-------------------------------------------------- ------------------------------------------------
7.5% $ 50,000 February, 1999 9.00% $ 50,000 December, 1997
7.5 50,000 February, 1999 9.75 50,000 December, 1997
-----------
8 25,000 August, 1999 $ 100,000
9.5 100,000 October, 2002 ===========
9.5 100,000 October, 2002
8.5 100,000 November, 2002
7.5 75,000 November, 2002
--------
$500,000
========
The total cost of the interest rate cap agreements in place at December
31, 1997 of $1.6 million has been recorded in other assets in the accompanying
1997 consolidated balance sheet and is being amortized over the lives of the
agreements as a component of interest expense. The total cost of interest rate
cap agreements in place at December 31, 1996 of $413,000 has been fully
amortized as of December 31, 1997.
F-17
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS -- Continued
Additionally, at December 31, 1997 the Company maintains interest rate
swap agreements that fix the LIBOR interest rate at 6.10% on a notional amount
of $50 million through October 1998. At December 31, 1996, the Company had
interest rate swap agreements outstanding that fixed the LIBOR interest at 6.01%
on a notional amount of $50 million through July 1997. Under these swap
agreements, the Company benefits if LIBOR interest rates increase above the
fixed rates and incurs additional interest expense if rates remain below the
fixed rates. Any amounts received or paid under these agreements are reflected
as interest expense over the period covered.
On December 9, 1996, the Company entered into two 10 year reverse interest
rate swaps with notional amounts totaling $75 million. The reverse swaps
effectively convert $75 million of the Debentures into floating rate debt with
interest payable at the six month LIBOR rate plus 3.1%. Simultaneous with this
transaction, the Company purchased an interest rate cap that limits the total
interest on the $75 million to 10% for the first three years should interest
rates rise. The Company's average effective interest rate under these agreements
during 1997 was 8.93%, or 0.45% below the coupon rate for the Debentures.
Additionally, during the first quarter of 1997, the Company entered into two 9
year reverse interest rate swaps with notional amounts totaling $25 million. The
reverse swaps effectively convert $25 million of the Debentures into floating
rate debt with interest payable at the six-month LIBOR rate plus 2.61%.
Simultaneously with this transaction, the Company purchased an interest rate cap
that limits the total interest rate on the $25 million to 10% for the first
three years of the 9 year agreement. The Company's average effective interest
rate under those agreements during 1997 was 8.57%, which is 0.81% below the
coupon rate for the Debentures.
The effect of interest rate protection agreements on the operating results
of the Company was to increase interest expense by $16,000, $464,000, and
$82,000, in 1997, 1996 and 1995, respectively.
Subsequent to December 31, 1997 the Company entered into two additional
interest rate swap agreements covering a notional amount of $100 million that
fix LIBOR at 5.62% and have an expiration date of January 2003.
F-18
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 5 -- COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases office space, furniture, equipment, vehicles and land
under noncancelable operating leases expiring through 2019. As of December 31,
1997, the future minimum rental payments under these lease agreements having an
initial or remaining term in excess of one year were as follows (in thousands):
1998 ............................................................ $ 10,941
1999 ............................................................ 10,371
2000 ............................................................ 9,745
2001 ............................................................ 9,076
2002 ............................................................ 8,410
Thereafter ...................................................... 89,440
---------
$ 137,983
=========
Rent expense under operating leases was $12.9 million, $9.3 million and
$6.6 million for the years ended December 31, 1997, 1996 and 1995, respectively.
Construction and Capital Commitments
Capital expenditures for 1998 are estimated to be approximately $100.0
million for the Company, and are expected to be funded primarily with internally
generated funds.
Note 6 -- INCOME TAXES
Deferred income taxes are provided for the temporary differences
between the financial reporting and income tax basis of the Company's
assets and liabilities. The components of net deferred income taxes as
of December 31, 1997 and 1996 were as follows (in thousands):
1997 1996
--------- ---------
Deferred income tax assets:
Net operating loss carryforwards ......... $ 122,926 $ 125,135
Alternative minimum tax credits .......... 891 891
Other liabilities and reserves ........... 6,280 3,660
Valuation allowance ...................... (31,439) (74,208)
--------- ---------
Total deferred income tax assets .... 98,658 55,478
--------- ---------
Deferred income tax liabilities:
Investments and other intangibles ........ (45,630) (49,823)
Property and equipment ................... (442) (655)
--------- ---------
Total deferred income tax liabilities (46,072) (50,478)
--------- ---------
Net deferred income taxes .................. $ 52,586 $ 5,000
========= =========
Prior to 1996, the Company incurred significant financial reporting and
tax losses primarily as a result of substantial depreciation, amortization and
interest expenses associated with acquiring and developing its cellular markets
and substantial marketing and other operating costs associated with building its
subscriber base. Although substantial net deferred income tax assets were
generated during these periods, a valuation allowance was established because in
management's assessment the historical operating results made it uncertain
whether the net deferred income tax assets would be realized.
As of December 31, 1997, the Company has cumulative net deferred
income tax assets totaling approximately $84.0 million. The net deferred
income tax asset is composed of $130.1 million of gross deferred income
tax assets and $46.1 million of gross deferred income tax liabilities.
The gross deferred income tax assets consist primarily of the income tax
effect of Federal net operating loss
F-19
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 6 -- INCOME TAXES -- Continued
carryforwards of approximately $323 million, at December 31, 1997. These
losses may be used to reduce future taxable income and expire
periodically through 2012. Gross deferred income tax assets also include
timing differences related to reserves and accruals, basis differences
in property and equipment, cumulative losses on unconsolidated
investments and the cumulative unrealized holding loss on the Company's
investment in Geotek. Deferred income tax liabilities consist primarily
of basis differences in cellular licenses and the excess of income tax
depreciation over book depreciation.
Included in the Federal NOL carryforward are additional income tax
deductions arising from restricted stock bonuses, stock options and stock
purchase warrants. To the extent the income tax benefit of these amounts is
realized in future years, the benefit will be recorded as a direct addition to
shareholders' equity. Prior to 1997, net deferred income tax assets also
included assets related to the net unrealized holding loss on the investment in
Geotek. This unrealized loss had been recorded as a reduction in shareholders'
equity. During 1997, the Company recognized the unrealized loss through
earnings.
Historically, the Company's strategy has been to enhance shareholder value
by investing in growth initiatives. These efforts have resulted in steadily
increasing levels of subscribers, revenues and EBITDA; however, these
initiatives in the form of market acquisitions, capital expenditures, and
expansion of the Company's sales and marketing and customer service functions
have resulted in significant interest, depreciation, amortization and marketing
costs. In addition, the Company has explored strategic investment opportunities
in international telecommunications ventures and alternative lines of business,
all of which are in the early development stages and are generating significant
losses to the Company. As a result, although the Company achieved profitability
in 1996 for financial reporting purposes, the continued costs of its investment
strategy prevented the Company from generating profitable financial results in
1997.
During the fourth quarter of 1997, management revised its strategy
from one of growth and expansion to enhancing shareholder value through
profitable operations in its core cellular properties in Pennsylvania,
West Virginia and New England. This revised strategy incorporates
dispositions of non-core properties over the course of the next several
years. As part of this Board-approved strategy, in the first quarter of
1998, the Company entered into agreements to dispose of its cellular
properties in the Carolinas Metro-cluster, which include the Myrtle
Beach, South Carolina RSA and ownership interest in the ENCCJV. Additionally,
the Company has begun active efforts to dispose of its operations in Western
Florida and anticipates reaching an agreement with a potential buyer during
1998. Based on negotiated sales prices for the Myrtle Beach cellular market and
its ownership interests in ENCCJV, the Company expects to generate capital gains
approximating $140 million in 1998. Additionally, the Company's anticipated
sales price, based on recent transactions in the cellular industry and the two
transactions discussed above, for the disposition of Western Florida markets, is
expected to generate a substantial capital gain.
The gains to be generated on these transactions will utilize an equivalent
amount of the Company's accumulated NOLs. Based on these anticipated gains,
management has assessed that it is more likely than not that a significant
portion of the Company's deferred income tax assets are realizable. Accordingly,
the Company has recognized a total of $52.6 million of net deferred income tax
assets as of December 31, 1997. Of the amount recognized, $42.7 million was
recognized as a deferred income tax benefit in 1997, $5.0 million was recognized
as a deferred income tax benefit in 1996 and $4.9 million related to acquired
NOLs was recognized through a reduction in investments in domestic cellular
entities in 1997.
A valuation allowance remains on certain deferred income tax assets due to
uncertainties as to when and whether these assets will be realized in the
future. To the extent that the income tax benefit of these amounts is realized
in future years, the benefit will be recorded as a direct addition to
shareholders' equity as these assets relate to additional income tax deductions
arising from restricted stock bonuses, stock options and stock purchase
warrants.
The transactions discussed above, which will create the taxable income
upon which management based its deferred income tax asset recognition decisions,
have been approved by the Company's Board of Directors and are represented by
definitive agreements among the parties to the transactions; however, ultimate
consummation of these transactions is dependent on the parties
F-20
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 6 -- INCOME TAXES -- Continued
reaching final agreement on terms and financing and the Company obtaining
required lender approval and standard regulatory approvals. There can be no
assurance that these transactions will be consummated.
The Company's 1996 income tax benefit of $4.1 million includes a current
provision of $891,000 for Federal alternative minimum taxes offset by the
deferred income tax benefit discussed above. In 1995, the Company reported no
Federal income tax provision because of the reported losses for financial
reporting and income tax purposes. State income tax planning strategies have
been implemented such that no state income tax provision has been required for
any period.
A reconciliation between income taxes computed at the statutory Federal
rate of 35% and the reported income tax benefit is as follows (in thousands):
December 31,
--------------------------------
1997 1996 1995
-------- -------- --------
Amount at statutory Federal rate ..... $(18,454) $ 808 $ (2,454)
Net benefit of tax planning strategies 0 (6,616) (9,877)
Change in valuation allowance ........ (32,805) (638) 9,552
Other ................................ 8,559 2,337 2,779
-------- -------- --------
Income tax benefit ................... $(42,700) $ (4,109) $ --
======== ======== ========
In 1996 and 1995, the Company executed certain tax planning strategies
that had the effect of increasing the total net deferred income tax assets.
These transactions generally resulted in the current utilization of net
operating loss carryforwards in exchange for the creation of income tax basis
that will be deductible in future periods.
The net unrealized holding losses on the investment in Geotek and the
additional income tax deductions arising from the exercise of stock options
created additional net deferred income tax assets of $10.4 million in 1995. The
1996 change in the unrealized holding loss reduced net deferred income tax
assets by $818,000. The valuation allowance was adjusted in these years to fully
offset these changes in the net deferred income tax asset.
The primary differences between the accumulated deficit for financial
reporting purposes and the income tax loss carryforwards relate to the
differences in the treatment of certain deferred cellular license acquisition
costs, certain gains on dispositions of cellular interests, partnership losses,
depreciation methods, estimated useful lives and compensation earned under the
stock compensation plan. These carryforwards may be subject to annual limitation
in the future in accordance with the Tax Reform Act of 1986 and the ability to
use these carryforwards could be significantly impacted by a future "change of
control" of the Company. The limitations, if any, arising from such future
"change in control" cannot be known at this time.
Note 7 -- CAPITAL STOCK
Acquisition of Cellular Interests
The Company has registered 4,500,000 shares of its Class A common stock
and 3,000,000 shares of its Class B common stock. The shares may be offered in
connection with the acquisition of entities which have received or may receive
an authorization or license from the FCC to provide cellular service. Through
December 31, 1997, 2,707,957 of these registered shares of Class A common stock
have been issued in conjunction with the acquisition of certain cellular
markets.
F-21
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 7 -- CAPITAL STOCK -- Continued
Stock Compensation Plans
During 1994, the Board adopted the 1994 Long-Term Incentive Plan (the 1994
Plan). In May 1997, an additional 3,000,000 shares of the Company's Class A
Common Stock were authorized for grant under the 1994 Plan. Under the provisions
of the 1994 Plan, the Company may now grant up to 6,000,000 shares of the
Company's Class A common stock to officers, directors and key employees in the
form of nonqualified stock options, incentive stock options, stock appreciation
rights, unrestricted stock, restricted stock and performance shares. All stock
options must require exercise prices of not less than the fair market value of
the Company's Class A common stock on the date of the grant, except that certain
incentive stock options must require exercise prices of not less than 110% of
fair market value of the Company's Class A common stock on the date of the
grant. Options granted under the 1994 Plan may not have a term greater than ten
years from the date of grant and are not transferable except upon death. As of
December 31, 1997, 3,334,690 shares were available for future grants.
Upon adoption of the 1994 Plan, the Company's previously adopted stock
option and stock compensation plans were terminated. Options granted and
outstanding under these previous plans are still exercisable, but no further
grants may be made under these plans.
Restricted Stock Bonuses
During 1987, the Board granted restricted stock bonuses for a total of
3,469,554 shares of Class A common stock (i) to three key officers for 1,077,768
shares each and (ii) to a director and a key employee for an aggregate of
236,250 shares. In the event of a change in control of the Company prior to
December 31, 1998, the participants will be reimbursed for certain individual
income tax payments, as defined, on the shares vesting after February 1991. As
of December 31, 1997, all of the shares have vested.
Stock Options
Under the terms of the Company's previous and current stock compensation
plans, the Board has granted incentive stock options and nonqualified stock
options requiring exercise prices approximating the fair market value of the
Company's Class A common stock on the date of the grant.
In January 1997, the Board of Directors authorized the cancellation of
certain options with higher exercise prices and the issuance of fewer options at
a lower exercise price. Options for 2,299,750 shares with exercise prices
ranging from $21.50 to $25.125 were canceled and new options for 1,980,575
shares with an exercise price of $15.69 were issued. The exercise price for all
of these new options reflected the fair market value at the time of issuance. In
April 1997, the Board of Directors authorized the amendment of certain options,
nearly all of which were these newly issued options approved in January 1997, to
lower the exercise price to $10.00, the fair market value at that time.
Stock option activity under the plans was as follows:
Number of Shares Weighted Average
Under Option Exercise Price
---------------- ----------------
Balance, January 1, 1995 .......... 3,777,117 $14.57
Granted ........................... 907,500 25.12
Exercised ......................... (760,765) 4.36
Forfeited ......................... (20,750) 19.06
---------
Balance, December 31, 1995 ....... 3,903,102 18.96
---------
Granted ........................... 1,331,925 18.40
Exercised ......................... (27,190) 16.56
Forfeited ......................... (6,450) 24.57
---------
Balance, December 31, 1996 ........ 5,201,387 18.82
---------
Granted ........................... 2,012,075 10.02
Exercised ......................... (17,470) 3.32
Forfeited ......................... (24,940) 14.91
Canceled ......................... (2,300,250) 22.95
---------
Balance, December 31, 1997 ........ 4,870,802 13.31
==========
F-22
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 7 -- CAPITAL STOCK -- Continued
Of the total options outstanding at December 31, 1997, 4,278,796
have an exercise price in the range of $10.00 and $15.75 with a
weighted-average exercise price of $12.60 and a weighted-average
contractual life of 7.4 years. Of the 4,278,796 options, 1,986,758 are
exercisable at December 31, 1997. Of the total outstanding
options at December 31, 1997, 582,006 have an exercise price in the range of
$17.17 and $19.25 with a weighted-average exercise price of $18.50 and a
weighted-average contractual life of 5.2 years, and 495,124 of those options
are exercisable at December 31, 1997. The remaining 10,000 options have
an exercise price of $22.38 and an 8.4 years remaining contractual life.
All of those options are exercisable at December 31, 1997.
In October 1995, SFAS No. 123, "Accounting for Stock-Based Compensation"
was issued. SFAS No. 123 is effective for fiscal years beginning after December
15, 1995. SFAS No. 123 encourages companies to adopt the fair value method for
compensation expense recognition related to employee stock options. Existing
accounting requirements of Accounting Principles Board Opinion No. 25 ("APB No.
25") use the intrinsic value method in determining compensation expense which
represents the excess of the market price of the stock over the exercise price
on the measurement date. The Company elected to remain under the APB No. 25
rules for stock options, and is required to provide pro forma disclosures of
what net income and earnings per share would have been had the Company adopted
the new fair value method for recognition purposes. The following information is
presented as if the Company had adopted SFAS No. 123 and restated its results
(in thousands, except per share data):
1997 1996 1995
---------- ---------- ----------
Net income (loss):
As reported ............... $ (10,027) $ 6,449 $ (7,013)
Pro forma ................. $ (19,309) $ 163 $ (11,056)
Net income (loss) per common share:
Basic:
As reported ............... $ (0.25) $ 0.16 $ (0.17)
Pro forma ................. $ (0.48) $ (0.27) $ (0.27)
Net income (loss) per common share:
Diluted:
As reported ............... $ (0.25) $ 0.15 $ (0.17)
Pro forma ................. $ (0.48) $ (0.27) $ (0.27)
For the above information, the fair value of each option grant was
estimated on the date of grant using the Black-Scholes option pricing model with
the following assumptions used for grants in fiscal 1997, 1996 and 1995,
respectively: risk free rates of 6.5% to 6.8%, 6.0% to 6.6% and 6.5% to 7.4%,
expected volatility of 45%, 35% and 30%, and expected lives of 7 years in each
year. The weighted-average grant date fair value of options granted during
1997, 1996 and 1995 was $7.27, $9.19 and $12.45, respectively.
Because the SFAS No. 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the above pro forma amounts may not be
representative of the compensation costs to be expected in future years.
Shares Reserved for Issuance
At December 31, 1997, 8,205,492 shares of the Company's Class A common
stock are reserved for exercise and grant under the Company's stock compensation
plans. In addition, 1,792,043 shares of Class A common stock and 3,000,000
shares of Class B common stock are reserved for issuance in conjunction with the
acquisition of cellular interests discussed above.
Share Repurchase
The Company's Board of Directors has authorized the repurchase of up
to 7,500,000 shares of its Class A Common Stock from time to time in
open market or other transactions. During 1997 and 1996, the Company
repurchased 2,810,000 and 255,000 shares, respectively, of its Class A
Common Stock at an average price of approximately $13.00 in 1997 and
$17.00 in 1996. As of March 26, 1998, the Company had repurchased
1,080,000 shares at an average price of approximately $17.00 in 1998.
F-23
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 8 -- ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses were composed of the following
at December 31, 1997 and 1996 (in thousands):
1997 1996
------- -------
Accounts payable ................. $26,594 $42,775
Accrued expenses:
Interest ....................... 8,763 6,279
Payroll and commissions ........ 13,578 10,449
Taxes .......................... 3,543 2,977
Other .......................... 5,606 4,696
------- -------
$58,084 $67,176
======= =======
Note 9 -- DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value
of each category of financial instruments for which it is practicable to
estimate that value:
Cellular entities carried on the cost method -- The fair value of these
instruments is estimated based upon recent transactions from this portfolio.
Investment in Geotek -- The fair value of publicly-traded securities is
based upon quoted market price. The fair value of the remaining securities
approximates the carrying value.
Inter*Act debentures and warrants -- The fair value of the combined
investment in Inter*Act debentures and warrants is based upon the quoted market
price.
Interest rate protection agreements -- The fair value of interest rate cap
and swap agreements is based on quoted market prices as if the agreements were
entered into on the measurement date.
Borrowings under Credit Facility -- The fair value of the borrowings under
the VCFC Credit Facility approximates the carrying value.
Vanguard Senior Debentures -- The fair value of the Vanguard Senior
Debentures is based upon quoted market price.
The estimated fair values of the Company's financial assets (liabilities)
are summarized as follows (in thousands):
December 31, 1997 December 31, 1996
------------------------- -------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------------------------- -------------------------
Cellular entities carried on the cost method $ 9,592 $ 27,907 $ 9,993 $ 21,038
Investment in Geotek ........................ 9,979 9,979 28,166 28,166
Inter*Act debentures and warrants ........... 8,300 10,800 12,712 9,000
Interest rate protection agreements ......... 1,464 (868) 137 (2,114)
Borrowings under Credit Facility ............ (569,000) (569,000) (430,000) (430,000)
Senior Debentures of Vanguard ............... (199,837) (208,000) (199,817) (202,000)
F-24
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 10 -- QUARTERLY INFORMATION (UNAUDITED; IN THOUSANDS EXCEPT PER SHARE
AMOUNTS)
1997 Quarters First Second Third Fourth Total
- ------------- --------- --------- --------- --------- ---------
Revenue ................... $ 80,315 $ 94,148 $ 101,317 $ 98,738 $ 374,518
Income from operations .... 10,882 13,047 18,780 6,555 49,264
Net income (loss) ......... 228 74 1,068 (11,397) (10,027)
Net income (loss) per
common share:
Basic ................. 0.01 0.00 0.03 (0.29) (0.25)
Diluted ............... 0.01 0.00 0.03 (0.29) (0.25)
1996 Quarters First Second Third Fourth Total
- ------------- --------- --------- --------- --------- ---------
Revenue ................... $ 66,017 $ 75,621 $ 79,623 $ 80,793 $ 302,054
Income from operations .... 11,872 16,861 17,600 7,595 53,928
Net income (loss) ......... 2,621 4,772 2,888 (3,832) 6,449
Net income (loss) per
common share:
Basic ................. 0.06 0.12 0.07 (0.09) 0.16
Diluted ............... 0.06 0.11 0.07 (0.09) 0.15
The income from operations amounts reported above for the first three quarters
of 1997 differ from the amounts previously reported in the Company's 1997
Form 10-Q Quarterly Reports due to the reclassification of certain expenses
from Other, net to Depreciation and amortization. Income from operations amounts
previously reported in the Company's 1997 Form 10-Q Quarterly Reports were as
follows (in thousands):
First quarter .......... $11,082
Second quarter......... 15,293
Third quarter.......... 19,919
F-25
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Vanguard Cellular Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Vanguard
Cellular Systems, Inc. (a North Carolina corporation) and subsidiaries as of
December 31, 1997 and 1996, and the related consolidated statements of
operations, changes in shareholders' equity and cash flows for each of the three
years in the period ended December 31, 1997. These financial statements and
schedules referred to below are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Vanguard Cellular Systems,
Inc. and subsidiaries as of December 31, 1997 and 1996 and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedules listed in the index to
consolidated financial statements and schedules are presented for purposes of
complying with the Securities and Exchange Commission's rules and are not part
of the basic financial statements. The schedules have been subjected to the
auditing procedures applied in the audit of the basic financial statements and,
in our opinion, fairly state in all material respects the financial data
required to be set forth therein in relation to the basic financial statements
taken as a whole.
ARTHUR ANDERSEN, LLP
Greensboro, North Carolina,
February 18, 1998.
F-26
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
CONDENSED PARENT COMPANY BALANCE SHEETS
(Dollar amounts in thousands)
December 31, December 31,
1997 1996
----------- ------------
ASSETS
Cash ................................................ $ 1,110 $ 586
Prepaid expenses .................................... 6 --
Investments ......................................... 198,542 230,970
Other Assets, net of accumulated
amortization of $1,050 and $450 .................. 4,951 5,552
--------- ---------
Total assets ................................. $ 204,609 $ 237,108
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Accrued interest .................................... $ 3,862 $ 3,840
Long-Term Debt, net of discount of $163 and $183 .... 199,837 199,817
--------- ---------
Total liabilities ............................ 203,699 203,657
--------- ---------
Shareholders' Equity:
Preferred stock -- $.01 par value, 1,000,000
shares authorized, no shares issued ........... -- --
Common stock, Class A -- $.01 par value,
250,000,000 shares authorized, 38,307,623 and
41,084,522 shares issued and outstanding ....... 383 411
Common stock, Class B -- $.01 par value, 30,000,000
shares authorized, no shares issued ............ -- --
Additional capital in excess of par value ......... 221,624 237,640
Net unrealized holding loss ....................... -- (14,570)
Accumulated deficit ............................... (221,097) (190,030)
--------- ---------
Total shareholders' equity ................... 910 33,451
--------- ---------
Total liabilities and shareholders' equity ... $ 204,609 $ 237,108
========= =========
The accompanying notes to condensed parent company financial statements
are an integral part of these balance sheets.
F-27
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
CONDENSED PARENT COMPANY STATEMENTS OF OPERATIONS
(Dollar amounts in thousands)
For the years ended December 31,
---------------------------------
1997 1996 1995
-------- -------- --------
General and administrative expense ......... $ (73) $ -- $ --
Interest expense ........................... (19,025) (13,940) --
Equity in earnings (losses) of Vanguard
Cellular Financial Corp. ............. 9,071 20,389 (7,013)
-------- -------- --------
Net income (loss) .......................... $(10,027) $ 6,449 $ (7,013)
======== ======== ========
The accompanying notes to condensed parent company financial statements
are an integral part of these statements.
F-28
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
CONDENSED STATEMENTS OF CASH FLOWS
(Dollar amounts in thousands)
For the years ended December 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) ............................. $ (10,027) $ 6,449 $ (7,013)
Adjustments to reconcile net income (loss) to
net cash used in operating activities:
Amortization of deferred debt issuance costs 600 450 --
Equity in losses (earnings) of Vanguard Cellular
Financial Corp. ........................... (9,071) (20,389) 7,013
Amortization of bond investment discount ... 20 15 --
Change in prepaid expenses ................. (6) -- --
Change in accrued interest ................. 22 3,840 --
--------- --------- ---------
Net cash used in operating activities .... (18,462) (9,635) --
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from dividends of investee ........... 56,070 13,960 --
Investment in Vanguard Cellular Financial Corp. -- (193,668) (3,939)
--------- --------- ---------
Net cash provided by (used in) investing
activities ............................ 56,070 (179,708) (3,939)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock .... 236 454 3,939
Repurchase of common stock .................... (37,320) (4,325) --
Proceeds from issuance of long-term debt ...... -- 199,802 --
Debt issuance costs ........................... -- (6,002) --
--------- --------- ---------
Net cash provided by (used in) financing
activities............................ $ (37,084) 189,929 3,939
--------- --------- ---------
NET INCREASE IN CASH ............................ 524 586 --
CASH, BEGINNING OF YEAR ......................... 586 -- --
--------- --------- ---------
CASH, END OF YEAR ............................... $ 1,110 $ 586 $ --
========= ========= =========
The accompanying notes to condensed parent company financial statements
are an integral part of these statements.
F-29
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
NOTES TO CONDENSED FINANCIAL STATEMENTS
1. PRESENTATION
These condensed financial statements have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission. Certain
information and note disclosures normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to those rules and regulations, although
the Company believes that the disclosures made are adequate to make the
information presented not misleading.
2. ORGANIZATION
Vanguard Cellular Systems, Inc. ("Vanguard") is a holding company which is
the 100% shareholder of Vanguard Cellular Financial Corp. ("VCFC"). This
organization was created in April 1996 to structurally subordinate Vanguard's
$200 million in Senior Debentures to VCFC's Credit Facility. Prior to that time,
operations of the Company were conducted by Vanguard. For purposes of this
condensed financial information, the reorganization has been treated in a manner
similar to a pooling-of-interests. As a result, this condensed financial
information has been prepared as if Vanguard were a holding company in all
periods.
3. LONG-TERM DEBT
On April 10, 1996, Vanguard issued $200 million aggregate principal amount
of 9 3/8% Senior Debentures due 2006 (the "Debentures") through an underwritten
public offering. The Debentures were issued at a price to the public of 99.901
for a yield of 9.384%. The net proceeds from the sale of the Debentures of
approximately $194.8 million were contributed to VCFC primarily to reduce
borrowings under the VCFC Credit Facility and were used by Vanguard to pay other
expenses. The VCFC Credit Facility was amended to permit issuance of the
Debentures and require the structural subordination of the Debentures by making
VCFC the primary obligor of the Credit Facility and all liabilities of Vanguard
(other than the Debentures) and the owner of all stock and partnership interests
of Vanguard's operating subsidiaries. The Debentures mature in 2006 and are
redeemable at Vanguard's option, in whole or in part, at any time on or after
April 15, 2001. There are no mandatory sinking fund payments for the Debentures.
Interest is payable semi-annually. Upon a Change of Control Triggering Event (as
defined in the Indenture for the Debentures), Vanguard will be required to make
an offer to purchase the Debentures at a purchase price equal to 101% of the
principal amount thereof plus accrued and unpaid interest, if any, to the date
of purchase. The Debentures require that Vanguard and its subsidiaries limit,
among other things, the incurrence of additional indebtedness, the payments of
dividends or the repurchase of Capital Stock, certain distributions and
transfers, and certain asset sales.
4. SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL DISCLOSURES.
F-30
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 and 1997
(Dollar amounts in thousands)
Balance Provision
at charged to Balance at
beginning costs and end of
of period expenses Deductions(1) Other(2) period
--------- ---------- ------------- ------- ----------
Allowance for doubtful accounts:
Year ended December 31, 1995 $ 2,761 $ 6,166 $(3,154) $ 50 $ 5,823
Year ended December 31, 1996 5,823 5,860 (7,113) 47 4,617
Year ended December 31, 1997 4,617 11,288 (7,721) -- 8,184
- ----------
(1) Accounts written off during the period.
(2) Represents allowance for doubtful accounts for entities acquired during
the period.
F-31
Eastern North Carolina Cellular Joint Venture
And Subsidiaries
Consolidated Financial Statements
as of December 31, 1997 and 1996
Together With
Auditors' Report
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Eastern North Carolina Cellular Joint Venture:
We have audited the accompanying consolidated balance sheets of EASTERN NORTH
CAROLINA CELLULAR JOINT VENTURE (a Delaware partnership) AND SUBSIDIARIES as of
December 31, 1997 and 1996, and the related consolidated statements of
operations, changes in partners' capital, and cash flows for each of the three
years in the period ended December 31, 1997. These financial statements are the
responsibility of the Partnership's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Eastern North Carolina Cellular
Joint Venture and subsidiaries as of December 31, 1997 and 1996, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 1997 in conformity with generally accepted accounting
principles.
Atlanta, Georgia
March 27, 1998
F-32
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1997 AND 1996
(In Thousands)
ASSETS 1997 1996
- --------------------------------------------------------- ------- -------
CURRENT ASSETS:
Cash $ 2 $ 2
Accounts receivable--trade, net of allowance for
doubtful accounts of $229 and $199 in 1997 and
1996, respectively 1,842 2,424
Inventories 46 484
Deferred income tax assets 75 92
Other current assets 248 277
------- -------
Total current assets 2,213 3,279
------- -------
PROPERTY AND EQUIPMENT, at cost:
Land 393 393
Buildings and towers 6,186 5,623
Equipment 15,458 13,596
Furniture and fixtures 188 188
Assets under construction 42 771
------- -------
22,267 20,571
Less accumulated depreciation 7,913 6,052
------- -------
Net property and equipment 14,354 14,519
------- -------
OTHER ASSETS, net:
FCC license, net of accumulated amortization of $7,951
and $6,884 in 1997 and 1996, respectively 34,735 35,802
Other 4 4
------- -------
Total other assets, net 34,739 35,806
------- -------
Total assets $51,306 $53,604
======= =======
LIABILITIES AND PARTNERS' CAPITAL
-------
CURRENT LIABILITIES:
Accounts payable--construction and trade 606 439
Accounts payable--affiliates 71 314
Due to managing partner 2,199 5,119
Federal income taxes payable 341 188
Accrued software license fee 300 --
Other accrued liabilities 540 565
------- -------
Total current liabilities 4,057 6,625
------- -------
LONG-TERM OBLIGATIONS:
Postretirement benefit obligation 70 69
Deferred income tax liabilities 1,182 893
------- -------
Total long-term obligations 1,252 962
------- -------
MINORITY INTERESTS 481 435
------- -------
PARTNERS' CAPITAL 45,516 45,582
------- -------
Total liabilities and partners' capital $51,306 $53,604
======= =======
The accompanying notes are an integral part
of these consolidated balance sheets.
F-33
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(In Thousands)
1997 1996 1995
-------- -------- --------
REVENUES:
Service $ 13,842 $ 15,023 $ 12,975
Equipment 559 605 583
Other 460 604 382
-------- -------- --------
Total revenues 14,861 16,232 13,940
-------- -------- --------
OPERATING EXPENSES:
Sales and marketing 5,476 3,857 4,484
Cost of equipment 1,598 1,966 1,797
Operations support 1,114 1,785 1,380
Network 3,502 2,771 2,014
General and administrative 1,259 1,857 1,437
Amortization 1,067 1,067 1,067
-------- -------- --------
Total operating expenses 14,016 13,303 12,179
-------- -------- --------
OPERATING INCOME 845 2,929 1,761
INTEREST EXPENSE, NET (149) (235) (180)
-------- -------- --------
NET INCOME BEFORE INCOME TAXES AND
MINORITY INTERESTS 696 2,694 1,581
MINORITY INTERESTS (46) (100) (80)
-------- -------- --------
NET INCOME BEFORE INCOME TAXES 650 2,594 1,501
PROVISION FOR INCOME TAXES (716) (1,386) (785)
-------- -------- --------
NET (LOSS) INCOME $ (66) $ 1,208 $ 716
======== ======== ========
The accompanying notes are an integral part
of these consolidated statements.
F-34
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERS' CAPITAL
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(In Thousands)
GTE Mobilnet North Carolina
of Eastern Cellular Vanguard
North Carolina Holding Cellular
Incorporated Corp. Systems, Inc. Total
============== =============== ============= =========
BALANCE, December 31, 1994 $ 21,829 $ -- $ 21,829 $ 43,658
Net income for the year ended
December 31, 1995 358 -- 358 716
-------- -------- -------- --------
BALANCE, December 31, 1995 22,187 -- 22,187 44,374
Transfer of partnership interests -- 22,634 (22,634) --
Net income for the year ended
December 31, 1996 604 157 447 1,208
-------- -------- -------- --------
BALANCE, December 31, 1996 22,791 22,791 -- 45,582
Net loss for the year ended
December 31, 1997 (33) (33) -- (66)
-------- -------- -------- --------
BALANCE, December 31, 1997 $ 22,758 $ 22,758 $ -- $ 45,516
======== ======== ======== ========
The accompanying notes are an integral part
of these consolidated statements.
F-35
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(In Thousands)
1997 1996 1995
------- ------- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) income $ (66) $ 1,208 $ 716
Adjustments to reconcile net (loss) income to net cash
provided by operating
activities:
Depreciation and amortization 2,994 2,663 2,095
Deferred income tax expenses 306 686 379
Minority interests in earnings 46 100 80
Changes in current assets and current liabilities:
Accounts receivable 582 5 (957)
Inventories 438 (319) 297
Other current assets 29 (88) (111)
Accounts payable, net of capital expenditures (34) 11 (73)
Other current liabilities 428 (50) 291
Other, net 3 (23) 41
------- ------- -------
Net cash provided by operating activities 4,726 4,193 2,758
------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures (1,806) (3,597) (4,735)
Purchase of minority interest -- -- (146)
------- ------- -------
Net cash used in investing activities (1,806) (3,597) (4,881)
------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Change in due to managing partner (2,920) (595) 2,123
------- ------- -------
Net cash (used in) provided by financing activities (2,920) (595) 2,123
------- ------- -------
INCREASE IN CASH -- 1 --
CASH AT BEGINNING OF YEAR 2 1 1
CASH AT END OF YEAR $ 2 $ 2 $ 1
======= ======= =======
SUPPLEMENTAL CASH FLOWS DISCLOSURES:
Cash payments for income taxes $ 347 $ 791 $ 261
======= ======= =======
The accompanying notes are an integral part
of these consolidated statements.
F-36
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
1. ORGANIZATION AND MANAGEMENT
Eastern North Carolina Cellular Joint Venture (the "Joint Venture") was
formed on July 10, 1990 and operates in accordance with the provisions of
the Delaware Revised Uniform Limited Partnership Act. The Joint Venture
provides cellular telephone services for the Jacksonville and Wilmington,
North Carolina Metropolitan Statistical Areas ("MSAs").
The partners and their respective ownership percentages as of December 31,
1997 were as follows:
Managing General Partner:
GTE Mobilnet of Eastern North Carolina Incorporated 50%
General Partner:
North Carolina Cellular Holding Corp. 50%
Effective September 27, 1996, Vanguard Cellular Systems, Inc. assigned its
interest in the Joint Venture to a subsidiary, North Carolina Cellular
Holding Corp.
Effective January 22, 1996, W&J Metronet, Inc. changed its name to GTE
Mobilnet of Eastern North Carolina Incorporated.
The Joint Venture's ownership interest in the Wilmington, North Carolina
MSA was 95.9% as of December 31, 1997 and 1996. The Joint Venture's
ownership interest in the Jacksonville, North Carolina MSA was 95.6% as of
December 31, 1997 and 1996.
The managing partner is responsible for managing and operating the Joint
Venture. The partners make capital contributions to, share in the
operating results of and receive distributions from the Joint Venture in
accordance with their respective ownership percentage.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The Joint Venture prepares its financial statements in accordance with
generally accepted accounting principles which require that management
make estimates and assumptions that affect reported amounts. Actual
results could differ from these estimates.
F-37
Certain prior year amounts have been reclassified to conform to the
current year presentation.
Principles of Consolidation
The accompanying financial statements include the accounts of the Joint
Venture and its majority-owned corporations and partnerships. All
significant intercompany balances and transactions have been eliminated in
consolidation.
Revenue Recognition
The Joint Venture earns service revenues primarily by providing access to
the cellular network (access revenue) and for usage of the cellular
network (airtime and toll revenues). Access revenues are recognized when
earned. Airtime (including roaming) and toll revenues are recognized when
the services are rendered. Other service revenues are recognized after
services are performed and include activation and custom calling feature
revenues. Equipment sales are recognized upon delivery of the equipment to
the customer. Other revenues include landline call termination revenues
and paging revenues, which are recognized when services are rendered.
In 1996 and 1995, the Joint Venture also earned revenue by leasing its
switch to an affiliate. In September 1996, the affiliate discontinued its
switch sharing agreement with the Joint Venture. These revenues were based
on a charge per port and are included in other revenues in the
accompanying statements of operations. Refer to Note 4 for additional
discussion of affiliated transactions.
Operating Expenses
Operating expenses include expenses incurred directly by the Joint
Venture, as well as an allocation of area administrative expenses and
other costs incurred by the managing partner or its affiliates. Refer to
Note 4 for additional discussion of allocated and affiliated expenses.
Customer Acquisition Costs
The Joint Venture defers certain customer acquisition costs for
approximately two weeks and recognizes these costs when the associated
revenue stream begins. These deferred costs were $85 thousand and $169
thousand at December 31, 1997 and 1996, respectively, and are included in
other current assets in the accompanying balance sheets.
Advertising Costs
The Joint Venture expenses the cost of advertising as incurred.
Advertising expense was $701 thousand, $375 thousand and $413 thousand for
1997, 1996 and 1995, respectively, and is included as a component of sales
and marketing expense in the accompanying statements of operations.
F-38
Interest Expense, Net
The statements of operations reflect total interest expense, net of
interest expense capitalized during construction and interest income as
follows (in thousands):
1997 1996 1995
----- ----- -----
Interest expense $(394) $(311) $(299)
Interest capitalized 4 40 115
Interest income 241 36 4
----- ----- -----
Interest expense, net $(149) $(235) $(180)
===== ===== =====
Interest expense and income include charges to the Joint Venture and its
subsidiaries for funds advanced by the managing partner and credits to the
Joint Venture and its subsidiaries for funds advanced to the managing
partner. The interest rate on funds advanced to or from the Joint Venture
is equivalent to the managing partner's incremental borrowing rate, which
fluctuated between 5.44% and 5.80% in 1997, 5.44% and 6.07% in 1996 and
5.98% and 6.26% in 1995.
Income Taxes
A provision for income taxes is recorded on the subsidiary corporations of
the Joint Venture relating to income of these corporations. The
consolidated financial statements also include certain partnerships for
which, according to the Internal Revenue Code and applicable state
statutes, income and expenses are not separately taxable to the
partnerships, but rather accrue directly to the partners. Accordingly, no
provision for income taxes is made for such entities.
Deferred income taxes are recorded using enacted tax law and rates for the
years in which the taxes are expected to be paid. Deferred income taxes
are provided for items when there is a temporary difference in recording
such items for financial reporting and income tax reporting.
Inventories
Inventories include cellular telephones, pagers and accessories held for
sale and are valued at the lower of cost or market. Cost is determined
using the specific identification method. Inventories are net of reserves
for obsolescence.
Property and Equipment
Property and equipment are recorded at cost. The Joint Venture records
depreciation using the straight-line method over the estimated useful
lives of the assets, which are primarily twenty years for buildings and
towers, seven to ten years for cell and switching equipment and three to
five years for furniture and fixtures and other equipment. When property
is retired, the cost of the property and the related accumulated
depreciation are removed from the balance sheet and any gain or loss on
the transaction is included in income.
F-39
Assets under construction represent costs incurred for the construction of
cell sites and include, if applicable, capitalized interest. When these
assets are placed in service, the costs are recorded to the appropriate
property and equipment accounts and depreciation begins. Depreciation
expense for the years ended December 31, 1997, 1996 and 1995 was $1,927
thousand, $1,596 thousand and $1,028 thousand.
Other Assets, Net
Other assets, net, consist primarily of deferred cellular license costs,
which represent the fair value of the cellular market ownership interest
contributed to the Joint Venture by the partners, which is being amortized
over forty years.
Long-Lived Assets
The Joint Venture periodically reviews the values assigned to long-lived
assets, such as cellular license costs and property and equipment, to
determine whether any impairments exist that are other than temporary.
Management believes that the long-lived assets in the accompanying balance
sheets are appropriately valued.
Credit Risk
The Joint Venture's accounts receivable subject the Joint Venture to
credit risk, as collateral is generally not required. The Joint Venture's
risk of loss is limited due to advance billings to certain customers for
services and the ability to terminate access on delinquent accounts. The
concentration of credit risk is mitigated by the large number of customers
comprising the customer base. The carrying amount of the Joint Venture's
receivables approximates their fair value.
Sources of Supplies
The Joint Venture relies on local telephone companies and other companies
to provide certain communication services. Although management feels
alternative telecommunications facilities could be found in a timely
manner, any disruption of these services could potentially have an adverse
effect on operating results.
Although the Joint Venture attempts to maintain multiple vendors for each
required product, its inventory and equipment, which are important
components of its operations, are each currently acquired from only a few
sources. If the suppliers are unable to meet the Joint Venture's needs as
it builds out its network infrastructure and sells service and equipment,
delays and increased costs in the expansion of the Joint Venture's network
infrastructure or losses of potential customers could result, which would
adversely affect operating results.
F-40
3. COMMITMENTS AND CONTINGENCIES
Leases
The Joint Venture leases office space and network sites under long-term
operating leases. These leases have options for renewal with provisions
for increased rent upon renewal. Rent expense for the years ended December
31, 1997, 1996 and 1995 was $355 thousand, $288 thousand and $190
thousand, respectively, and is included in sales and marketing costs,
operation support costs, network costs and general and administrative
costs in the accompanying statements of operations.
As of December 31, 1997, future minimum lease payments under noncancelable
operating leases with initial or remaining periods in excess of one year
were as follows (in thousands):
1998 $ 276
1999 270
2000 266
2001 161
2002 110
Subsequent years 272
--------
Total $ 1,355
========
Contingencies
In July 1997, a class action lawsuit was filed on behalf of all former and
present GTE cellular subscribers nationwide. The plaintiffs claim that GTE
committed fraud by its practice of charging for airtime in full minute
increments. The complaint alleges violations of federal RICO laws, fraud,
and violation of Florida's Unfair and Deceptive Trade Practices Act. The
plaintiffs seek to maintain the suit as class action and request
compensatory damages, treble damages, injunctive relief, costs and
attorneys' fees.
The ultimate outcome of the preceding litigation cannot be determined at
the present time. Accordingly, no provision for any liability that might
result from this matter has been made in the accompanying financial
statements.
The Joint Venture and managing partner face exposure from actual and
potential claims and legal proceedings arising in the normal course of
business. As of December 31, 1997, the managing partner is not aware of
any other asserted or pending litigation or claims that could potentially
have a material adverse effect on the Joint Venture's financial position
or results of operations.
4. RELATED-PARTY TRANSACTIONS
All transactions of the Joint Venture are authorized by the managing
partner. Many management and administrative services are performed by an
affiliated service corporation (the "Service Corporation") and GTE
Wireless Incorporated. Services provided to the Joint Venture include
support in major functional areas, such as accounting, information and
cash management, human resources, legal, marketing,
F-41
technology planning, billing and customer care. In accordance with a
management agreement, only certain area costs that are attributable to
these support functions are included in sales and marketing costs,
operation support costs, network costs and general and administrative
costs. Costs allocated to the Joint Venture for these services were $1,076
thousand, $1,534 thousand and $1,254 thousand in 1997, 1996 and 1995,
respectively.
Amounts paid by the Joint Venture to the Service Corporation for inventory
purchases, net of transfers, amounted to $1,160 thousand, $1,497 thousand
and $1,463 thousand in 1997, 1996 and 1995, respectively.
The managing partner either advances funds to or borrows funds from the
Joint Venture and its subsidiaries. Funds advanced to the Joint Venture
are used to cover construction and working capital requirements. The
advances and borrowings are netted and are reflected in due to managing
partner in the accompanying balance sheets. Interest is calculated on this
balance as described in Note 2.
Prior to September 1996, the Joint Venture recorded revenue from an
affiliate for use of its switch. This revenue amounted to $209 thousand
and $254 thousand in 1996 and 1995, respectively.
The Joint Venture makes payments to an affiliate of the managing partner
for construction of cell sites and other system property. The amounts
capitalized were $376 thousand and $371 thousand in 1997 and 1996,
respectively, and are included in assets under construction and other
property and equipment.
The Joint Venture purchases roamer administration, advertising and other
operating services from affiliates whose business is the provision of such
services. The managing partner believes the cost of these services to the
Joint Venture of $414 thousand, $145 thousand and $154 thousand in 1997,
1996 and 1995, respectively, was equivalent to the cost charged by the
affiliates to any of their customers.
5. INCOME TAXES
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes as well as
tax credit and loss carryforwards. The significant components of the Joint
Venture's deferred tax assets and liabilities at December 31, 1997 and
1996 were as follows (in thousands):
F-42
1997 1996
------ ------
Deferred tax assets:
Loss carryforwards $ 270 $ 414
AMT credit carryforwards 844 667
Provision for bad debts 63 85
Postretirement and other benefits 30 29
Other 176 37
------ ------
Total deferred tax assets 1,383 1,232
Deferred tax liabilities:
Accelerated depreciation 2,490 2,033
------ ------
Net deferred tax liabilities 1,107 801
Deferred tax asset--current 75 92
------ ------
Deferred tax liability--noncurrent $1,182 $ 893
====== ======
The federal net operating loss carryforwards expire from 2003 to 2009
unless utilized. All state net operating loss carryforwards were utilized
as of December 31, 1997. The alternative minimum tax ("AMT") credit
carryforwards do not expire. Based on recent operating results, no
valuation allowance has been recorded as of December 31, 1997. Although
realization is not assured, management believes it is more likely than not
that the related deferred tax assets will be realized through future
taxable earnings.
The provision for income taxes consists of the following (in thousands):
1997 1996 1995
------- ------- -------
Current taxes $ 410 $ 866 $ 771
Deferred taxes 306 686 379
Reversal of valuation allowance -- (166) (365)
------- ------- -------
Provision for income taxes $ 716 $ 1,386 $ 785
======= ======= =======
A reconciliation of the income tax provision computed at the statutory tax
rate to the Joint Venture's effective tax rate is as follows for the years
ended December 31, 1997, 1996 and 1995:
1997 1996 1995
----- ----- -----
Income tax provision at the statutory rate 35.0% 35.0% 35.0%
FCC license amortization 57.4 14.4 24.9
State income taxes, net of U.S. federal benefit 13.8 8.1 5.0
Minority interests 4.6 2.2 2.1
Other taxes -- -- 4.8
Other, net (0.6) 0.1 4.8
Reduction in valuation allowance -- (6.4) (24.3)
----- ----- -----
Provision for income tax 110.2% 53.4% 52.3%
===== ===== =====
F-43
6. SUBSEQUENT EVENT
In March 1998, North Carolina Cellular Holding Corp. entered into an
agreement with United States Cellular to sell its interest in the cellular
operations of the Wilmington and Jacksonville, North Carolina MSAs.
F-44
Inter*Act
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To INTER*ACT SYSTEMS, INCORPORATED:
We have audited the accompanying consolidated balance sheets of Inter*Act
Systems, Incorporated (a North Carolina corporation) and Subsidiaries as of
December 31, 1997 and December 31, 1996, and the related consolidated statements
of operations, stockholders' equity (deficit) and cash flows for the year ended
December 31, 1997, the three month period ended December 31, 1996 and the fiscal
years ended September 28, 1996 and September 30, 1995. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Inter*Act Systems,
Incorporated and Subsidiaries as of December 31, 1997 and December 31, 1996, and
the results of their operations and their cash flows for the year ended December
31, 1997, the three month period ended December 31, 1996 and the fiscal years
ended September 28, 1996 and September 30, 1995, in conformity with generally
accepted accounting principles.
ARTHUR ANDERSEN LLP
New York, New York
March 17, 1998
F-45
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, DECEMBER 31,
1997 1996
------------ ------------
(IN THOUSANDS, EXCEPT SHARE
DATA)
ASSETS
Current assets:
Cash and cash equivalents................................................... $ 45,211 $ 88,306
Receivables, net............................................................ 813 617
Other current assets........................................................ 3,067 807
------------ ------------
Total current assets................................................... 49,091 89,730
Property, plant and equipment, net............................................... 26,900 11,690
Bond issuance costs, net......................................................... 3,302 3,720
Patents, licenses and trademarks, net............................................ 1,687 227
Other noncurrent assets.......................................................... 43 398
------------ ------------
Total assets........................................................... $ 81,023 $105,765
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable............................................................ $ 3,204 $ 1,243
Accrued expenses............................................................ 6,870 1,778
Deferred revenue............................................................ 539 479
------------ ------------
Total current liabilities.............................................. 10,613 3,500
Long-term debt, net of discount.................................................. 91,406 76,866
Other noncurrent liabilities..................................................... -- 292
------------ ------------
Total liabilities...................................................... 102,019 80,658
------------ ------------
Common stock purchase warrants................................................... 27,436 24,464
------------ ------------
Stockholders' equity (deficit):
Preferred stock, no par value, authorized 5,000,000 shares; none
outstanding............................................................... -- --
Common stock, no par value, authorized 20,000,000 shares; 7,728,555, and
7,668,555 shares issued and outstanding at December 31, 1997 and December
31, 1996, respectively.................................................... 28,251 27,651
Additional paid-in capital................................................ 768 768
Deferred compensation....................................................... (570) (723)
Cumulative translation adjustments.......................................... (14) --
Accumulated deficit......................................................... (76,867) (27,053)
------------ ------------
Total stockholders' equity (deficit)................................... (48,432) 643
------------ ------------
Total liabilities and stockholders' equity (deficit)................... $ 81,023 $105,765
------------ ------------
------------ ------------
The accompanying notes are an integral part of these consolidated statements.
F-46
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTH
PERIOD FISCAL YEAR ENDED
YEAR ENDED ENDED ------------------------------
DECEMBER 31, DECEMBER 31, SEPTEMBER 28, SEPTEMBER 30,
1997 1996 1996 1995
------------ ------------ ------------- -------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Gross sales......................................... $ 1,672 $ 408 $ 492 $ 255
Less: Retailer reimbursements.................. (964) (240) (287) (144)
------------ ------------ ------------- -------------
Net sales................................. 708 168 205 111
------------ ------------ ------------- -------------
Operating expenses:
Direct costs................................... 5,784 939 2,298 903
Selling, general and administrative expenses... 26,352 3,077 6,911 3,391
Depreciation and amortization of intangibles... 3,934 468 821 191
------------ ------------ ------------- -------------
Total operating expenses.................. 36,070 4,484 10,030 4,485
------------ ------------ ------------- -------------
Operating loss...................................... (35,362) (4,316) (9,825) (4,374)
------------ ------------ ------------- -------------
Other income (expense)
Interest income................................ 3,892 1,249 1,009 35
Interest expense............................... (18,033) (4,263) (2,743) (187)
Other expense.................................. (301) -- -- --
------------ ------------ ------------- -------------
Total other expense....................... (14,442) (3,014) (1,734) (152)
------------ ------------ ------------- -------------
Income (loss) before income taxes................... (49,804) (7,330) (11,559) (4,526)
Income taxes........................................ (10) -- -- --
------------ ------------ ------------- -------------
Net loss....................................... $(49,814) $ (7,330) $ (11,559) $(4,526)
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Per share information:
Net loss per common share:
Basic.......................................... $ (6.48) $ (0.96) $ (1.91) $ (1.27)
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Diluted........................................ $ (6.48) $ (0.96) $ (1.91) $ (1.27)
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Common shares used in computing per share amounts:
Basic.......................................... 7,692 7,669 6,038 3,556
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Diluted........................................ 7,692 7,669 6,038 3,556
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
The accompanying notes are an integral part of these consolidated statements.
F-47
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTH
PERIOD FISCAL YEAR ENDED
YEAR ENDED ENDED ------------------------------
DECEMBER 31, DECEMBER 31, SEPTEMBER 28, SEPTEMBER 30,
1997 1996 1996 1995
------------ ------------ ------------- -------------
(IN THOUSANDS)
Cash flows from operating activities:
Net loss........................................ $(49,814) $ (7,330) $ (11,559) $(4,526)
Items not affecting cash and cash equivalents:
Depreciation and amortization of intangible
assets.................................... 3,934 468 821 191
Loss on disposal of assets.................. 1,097 -- 74 10
Non-cash interest on discounted bonds....... 17,972 4,217 2,626 --
Equity in earnings of affiliate, net........ 301 -- -- --
Other items, net............................ 319 38 381 --
Changes in working capital:
Receivables, net............................ (196) (373) (169) (59)
Accounts payable and accrued expenses....... 6,416 1,038 1,208 588
Other current assets........................ (2,260) (866) (255) (45)
Deferred revenues........................... 60 250 207 22
------------ ------------ ------------- -------------
Net cash used in operating activities... (22,171) (2,558) (6,666) (3,819)
------------ ------------ ------------- -------------
Cash flows from investing activities:
Expenditures for property, plant and
equipment................................. (20,110) (2,584) (8,739) (1,702)
Proceeds from disposal of assets............ -- -- 57 --
Patent acquisition costs.................... (800) -- -- --
------------ ------------ ------------- -------------
Net cash used in investing activities... (20,910) (2,584) (8,682) (1,702)
------------ ------------ ------------- -------------
Cash flows from financing activities:
Net proceeds from issuance of 14% Senior
Notes..................................... -- -- 90,865 --
Long-term debt repayments................... -- (32) (20) --
Proceeds from common stock issuance, net.... -- -- 18,256 5,033
Net amount due to stockholders.............. -- -- -- 148
Net amount due (from) to related parties.... -- -- (339) 200
------------ ------------ ------------- -------------
Net cash (used in) provided by financing
activities............................ -- (32) 108,762 5,381
------------ ------------ ------------- -------------
Foreign exchange effects on cash and cash
equivalents....................................... (14) -- -- --
------------ ------------ ------------- -------------
Net (decrease) increase in cash and cash
equivalents....................................... (43,095) (5,174) 93,414 (140)
Cash and cash equivalents at beginning of period.... 88,306 93,480 66 206
------------ ------------ ------------- -------------
Cash and cash equivalents at end of period.......... $ 45,211 $ 88,306 $ 93,480 $ 66
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest........................................ $ 39 $ 10 $ 94 $ 79
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Supplemental disclosures of non-cash investing and
financing activities:
Deferred compensation related to stock options
granted....................................... $ -- $ -- $ 768 $--
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Issuance of common stock in consideration of
certain obligations........................... $ 600 $ -- $ 2,141 $--
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
Issuance of common stock purchase warrants in
connection with the issuance of 14% Senior
Notes......................................... $ 2,972 $ -- $ 24,464 $ --
------------ ------------ ------------- -------------
------------ ------------ ------------- -------------
The accompanying notes are an integral part of these consolidated statements.
F-48
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
TOTAL
COMMON STOCK ADDITIONAL CUMULATIVE STOCKHOLDERS'
----------------- PAID-IN DEFERRED ACCUMULATED TRANSLATION EQUITY
SHARES AMOUNT CAPITAL COMPENSATION DEFICIT ADJUSTMENTS (DEFICIT)
------ ------- ---------- ------------ ----------- ----------- -------------
(IN THOUSANDS)
Balance at September 30,
1994.................... 2,917 $2,222 -$- $-- $ (3,638) $-- $ (1,416)
Issuance of common
stock............... 1,032 5,172 -- -- -- 5,172
Forfeiture of common
stock............... (18) (140) -- -- -- (140)
Net loss.............. -- -- -- -- (4,526) (4,526)
------ ------- ----- ----- ----------- --- -------------
Balance at September 30,
1995.................... 3,931 7,254 -- -- (8,164) -- (910)
Issuance of common
stock............... 3,329 18,311 -- -- -- -- 18,311
Conversion of certain
obligations to
common stock........ 409 2,086 -- -- -- -- 2,086
Deferred Compensation
related to stock
options granted..... -- -- 768 (768) -- -- --
Amortization of
deferred
compensation........ -- -- -- 6 -- -- 6
Net loss.............. -- -- -- -- (11,559) -- (11,559)
------ ------- ----- ----- ----------- --- -------------
Balance at September 28,
1996.................... 7,669 27,651 768 (762) (19,723) -- 7,934
Amortization of
deferred
compensation........ -- -- -- 39 -- -- 39
Net loss.............. -- -- -- -- (7,330) -- (7,330)
------ ------- ----- ----- ----------- --- -------------
Balance at December 31,
1996.................... 7,669 27,651 768 (723) (27,053) -- 643
Issuance of common
stock............... 60 600 -- -- -- -- 600
Amortization of
deferred
compensation........ -- -- -- 153 -- -- 153
Translation
Adjustment.......... -- -- -- -- (14) (14)
Net loss.............. -- -- -- -- (49,814) -- (49,814)
------ ------- ----- ----- ----------- --- -------------
Balance at December 31,
1997.................... 7,729 $28,251 $768 $ (570) $ (76,867) $ (14) $ (48,432)
------ ------- ----- ------ ----------- ----- -------------
------ ------- ----- ------ ----------- ----- -------------
The accompanying notes are an integral part of these consolidated statements.
F-49
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
1. BUSINESS DESCRIPTION
Inter*Act Systems, Incorporated (the 'Company') is one of the nation's
largest in-store operators of customer-interactive electronic marketing systems.
The Company's patented technologies enable consumer products manufacturers
('Manufacturers') and supermarket retailers ('Retailers') to offer
shopper-specific purchase incentives and messages to customers moments before
shopping begins. The Company's proprietary system, called the Inter*Act Loyalty
Network'tm' ('ILN'), utilizes patented, multimedia touch-screen terminals, or
Smart Kiosks'tm', located in the entrance area of retail grocery stores. These
terminals are connected to each store's point-of-sale scanning system which
allows the electronic promotions to be immediately redeemed at the check-out.
This fully automated process virtually eliminates misredemption and fraud
associated with paper coupons, estimated by industry sources to cost
manufacturers hundreds of millions of dollars per year.
Certain factors could affect Inter*Act's actual future financial results.
These factors include: (i) the Company's limited operating history, significant
losses, accumulated deficit and expected future losses, (ii) the dependence of
the Company on its ability to establish, maintain and expand relationships with
manufacturers to promote brands on the ILN and the uncertainty of market
acceptance for the ILN, (iii) the uncertainty as to whether the Company will be
able to manage its growth effectively, (iv) the early stage of the Company's
products and services and technical and other problems that the Company has
experienced and may experience, (v) risks related to the Company's substantial
leverage and debt service obligations, (vi) the Company's dependence on third
parties such as those who manufacture ILN terminals, (vii) the intensely
competitive nature of the consumer product and promotional industry and (viii)
risks that the Company's rights related to patents, proprietary information and
trademarks may not adequately protect its business, and (ix) the possible
inability of new management to perform their respective roles and the possible
conflicts of interest of the Company's directors, officers and principal
shareholders in certain transactions with the Company.
From inception to December 31, 1997, the Company has had minimal revenues,
incurred recurring losses and experienced negative operating cash flow and there
is no assurance that the product the Company has developed will achieve success
in the marketplace. The Company intends to raise additional equity or debt
capital to fund its ongoing 1998 and 1999 expansion plans. In addition, the
Company has received several multi-year equipment leasing proposals from
equipment manufacturers for future purchases of ILN equipment. There is no
assurance that such additional capital or equipment financing can be obtained.
In the event that such additional financing is not obtained, the Company
believes that existing cash and cash equivalents, along with reduced or delayed
operating and capital expenditures, will be sufficient to meet the Company's
operating requirements into the first quarter of 1999.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The financial statements include the consolidated accounts of the Company
and its wholly and majority-owned subsidiaries: Network Licensing, Inc. ('NLI'),
Inter*Act International Holdings, Inc. ('Inter*Act International'), Inter*Act
Holdings, Ltd., ('Inter*Act Holdings') and Inter*Act U.K. Ltd. ('Inter*Act
U.K.'). Inter*Act International, Inter*Act Holdings and Inter*Act U.K. were
incorporated during 1997. All intercompany accounts and transactions have been
eliminated in consolidation.
FISCAL YEAR
On February 13, 1997, the Company elected to change its fiscal year end
from the last Saturday in September to December 31, effective December 31, 1996.
The Company's 1996 and 1995 fiscal years
F-50
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
ended on the Saturday closest to September 30. The financial statements for
fiscal 1996 and 1995 each contain activity for fifty-two weeks.
REVENUE RECOGNITION
The Company recognizes revenue as electronic discounts are redeemed at
store cash registers. Manufacturers pay a fee to the Company for each
redemption. The fee is composed of 1) a retailer processing fee, 2) a redemption
fee and 3) the face value of the coupon. The Company, in turn, passes through
both the retailer processing fee, which is included in direct operating
expenses, and the face value of the coupon to the Retailer, while retaining the
redemption fee. The Company records as net sales the redemption fee and the
retailer processing fee paid by the Manufacturers. Certain Manufacturers pay the
Company in advance for a portion of anticipated redemptions, and these amounts
are recorded as deferred revenue until earned through redemptions.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents, which at December 31, 1997 and December 31, 1996
were primarily comprised of money market funds and overnight repurchase
agreements, are stated at cost, which approximates market value. Highly liquid
investments with original maturities of three months or less are considered cash
equivalents.
RECEIVABLES, NET
Accounts receivable included in current assets are stated net of allowances
for doubtful accounts of approximately $30,000 and $10,000 at December 31, 1997
and at December 31, 1996, respectively. The Company recorded approximately
$30,000 and $10,000 for bad debt expense for the year ended December 31, 1997
and the three month period ended December 31, 1996, respectively. The Company
did not record an allowance for doubtful accounts or bad debt expense for the
fiscal years ended September 28, 1996 or September 30, 1995.
PROPERTY, PLANT AND EQUIPMENT
Depreciation is generally provided on the straight-line method for
financial reporting purposes over the estimated useful lives of the underlying
assets. Machinery and equipment are depreciated over a period ranging from 3 to
5 years and leasehold improvements are amortized using the straight-line method
over the term of the lease or the estimated useful life of the improvements,
whichever is shorter. In-store machinery and equipment are depreciated over five
years. Repairs and maintenance are charged to expense as incurred.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs incurred by the Company are included in
selling, general and administrative expenses. Such costs for the year ended
December 31, 1997, the three month period ended December 31, 1996 and the fiscal
years ended September 28, 1996 and September 30, 1995 were $646,000, $121,000,
$800,000 and $623,000, respectively.
BOND ISSUANCE COSTS
Bond issuance costs incurred by the Company are costs associated with a
private placement offering of 14% Senior Discount Notes during fiscal 1996 (the
'Private Placement') (See Note 6) and are being amortized over seven years using
the effective interest rate method. Accumulated
F-51
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
amortization was $633,000 and $169,000 at December 31, 1997 and at December 31,
1996, respectively. The Company recorded amortization expense on the bond
issuance costs of $464,000, $102,000 and $67,000 for the year ended December 31,
1997, the three month period ended December 31, 1996 and the fiscal year ended
September 28, 1996, respectively.
PATENTS, LICENSES AND TRADEMARKS
Acquisition costs for patents, licenses and trademarks and legal fees
incurred for the improvement and protection of the Company's patents, licenses
and trademarks have been deferred and are being amortized over fifteen years or
the remaining life of the patent, license or trademark, whichever is less, using
the straight-line method. Accumulated amortization was $95,000 and $34,000 at
December 31, 1997 and December 31, 1996, respectively. The Company recorded
amortization expense of $131,000, $10,000, $22,000 and $2,000 for the year ended
December 31, 1997, the three month period ended December 31, 1996 and the fiscal
years ended September 28, 1996 and September 30, 1995, respectively.
FOREIGN CURRENCY TRANSLATION
Assets and liabilities of foreign entities have been translated using the
exchange rates in effect at the balance sheet dates. Results of operations of
foreign entities are translated using the average exchange rates prevailing
throughout the period. Local currencies are considered functional currencies of
the Company's foreign operating entities. Translation effects are accumulated as
part of the cumulative foreign translation adjustment in equity. Gains and
losses from foreign currency transactions are included in net loss for the
period. The Company did not incur material foreign exchange gains or losses
during any period presented. The Company has not entered into any derivative
transactions to hedge foreign currency exposure.
LONG-LIVED ASSETS
Statement of Financial Accounting Standards ('SFAS') No. 121, 'Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of,' requires that long-lived assets be reviewed for impairment whenever events
or changes in circumstances indicate that the carrying amount of the asset in
question may not be recoverable. The adoption of SFAS No. 121 in the three-month
period ended December 31, 1996 did not have a material effect on the Company's
results of operations, cash flows or financial position.
INCOME TAXES
The Company accounts for income taxes in accordance with SFAS No. 109,
'Accounting for Income Taxes.' SFAS No. 109 requires an asset and liability
approach for financial reporting for income taxes. It also requires the company
to adjust its deferred tax balances in the period of enactment for the effect of
enacted changes in tax rates and to provide a valuation allowance against such
deferred tax assets that are not, more likely than not, to be realized.
STOCK-BASED COMPENSATION
During the three month period ended December 31, 1996, the Company adopted
the provisions of SFAS No. 123, 'Accounting for Stock-Based Compensation,' by
continuing to apply the provisions of Accounting Principles Board ('APB')
Opinion No. 25, 'Accounting for Stock Issued to Employees,' while providing the
required pro forma disclosures as if the fair value method had been applied.
(See Note 13)
F-52
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
NET LOSS PER SHARE
Effective December 31, 1997, the Company adopted SFAS No. 128, 'Earnings
Per Share.' (See Note 9.) In accordance with SFAS No. 128, net loss per common
share amounts ('basic EPS') were computed by dividing net loss by the weighted
average number of common shares outstanding and contingently issuable shares
(which satisfy certain conditions) and excluded any potential dilution. Net loss
per common share amounts -- assuming dilution ('diluted EPS') were computed by
reflecting potential dilution from the exercise of stock options and warrants.
SFAS No. 128 requires the presentation of both basic EPS and diluted EPS on the
face of the income statement. Net loss per share amounts for the same prior-year
periods have been restated to conform with the provisions of SFAS No. 128;
however, the result of that restatement was not material. In all periods
presented, the impact of stock options and warrants was anti-dilutive.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets (specifically with
respect to the lives of in-store machinery and equipment) and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
RECLASSIFICATIONS
Certain prior year financial statement amounts have been reclassified to
conform with the current year presentation.
3. PROPERTY, PLANT AND EQUIPMENT, NET
Property, plant and equipment consisted of the following (in thousands):
DECEMBER 31, DECEMBER 31,
1997 1996
------------ ------------
Land and buildings........................................... $ 77 $ 16
------------ ------------
Machinery and equipment
In-Store................................................ 28,383 11,286
Other................................................... 3,067 1,784
------------ ------------
Total machinery and equipment........................... 31,450 13,070
------------ ------------
31,527 13,086
Less: accumulated depreciation............................... (4,627) (1,396)
------------ ------------
Property, plant and equipment, net........................... $ 26,900 $ 11,690
------------ ------------
------------ ------------
Depreciation expense was approximately $3.8 million, $456,000, $786,000 and
$180,000 for the year ended December 31, 1997, the three month period ended
December 31, 1996 and the fiscal years ended September 28, 1996 and September
30, 1995, respectively.
4. LEASES
The Company leases office facilities and equipment under various operating
lease agreements expiring through year 2002. Future minimum lease payments under
noncancelable operating leases at December 31, 1997 were as follows:
F-53
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
OPERATING
LEASES
--------------
(IN THOUSANDS)
1998............................. $ 911
1999............................. 932
2000............................. 330
2001............................. 99
2002............................. 11
-------
$2,283
-------
-------
Rent expense of $383,000, $57,000, $222,000 and $219,000 was recognized for the
year ended December 31, 1997, the three month period ended December 31, 1996 and
the fiscal years ended September 28, 1996 and September 30, 1995, respectively,
and is included in selling, general and administrative expenses.
5. RELATED PARTY TRANSACTIONS
On April 14, 1993, the Company entered into an agreement with Clearing
Systems, Inc. ('CSI'), a Delaware corporation, whereby approximately 817,000
shares of the Company's common stock were exchanged for certain assets,
consisting primarily of acquired technology and research and development, at the
then estimated fair market value of $612,000, and assumption of certain
liabilities of CSI. The agreement provided that CSI would consult on matters
pertaining to the Company's technology, vendor relations, customer contacts and
strategic planning and be paid a fee when, and if, the Company installed 50 ILN
terminals or achieved $1,000,000 in revenues. During December 1995, in
anticipation of the Company's limited cash resources, the parties amended the
consulting agreement to provide that CSI would receive a $375,000 note,
convertible into shares of the Company's common stock at a rate of $5.50 per
share and bearing interest at the rate of 8.5% per annum, in satisfaction of the
amounts due under the consulting agreement. The Company has paid $138,500 of the
note and the remaining portion of $236,500 is due December 28, 1998. The entire
consulting fee of $375,000 was recorded as an expense during the fiscal year
ended September 28, 1996.
The Company is party to various agreements with Vanguard Cellular Financial
Corp. (together with its subsidiaries, 'Vanguard'). As of December 31, 1997,
Vanguard has beneficial ownership of approximately 3.1 million shares of
common stock of the Company and holds 18,000 units issued in the Private
Placement (See Note 6). Stephen R. Leeolou, Chairman and Chief Executive Officer
of the Company, is also co-founder and Co-Chief Executive Officer of Vanguard.
On June 17, 1996, the Company entered into a management consulting
agreement with Vanguard for a period of two years. Under the agreement, Vanguard
will assist the Company in developing accounting, human resources, information
management, legal compliance, sales training, research and development, business
development and operations procedures, systems and programs. For services
rendered under the agreement, the Company issued 10,000 shares of its common
stock upon execution of the agreement and issued 10,000 shares in June 1997. In
addition, the Company will reimburse Vanguard for any expenses incurred in the
course of providing consulting services. This agreement terminated the previous
consulting agreements dated January 30, 1996, the Company had with Vanguard.
Under the January 30, 1996 agreement, Vanguard was to provide one of its
executive employees to serve in the role of Chief Operating Officer (the 'COO')
of the Company and to provide other consulting services as necessary. All
expenses, including related compensation expenses of such individuals based on
time rendered on the Company's activities, would be paid by the Company. This
agreement was terminated upon execution of the management consulting agreement
with Vanguard on June 17, 1996. The Company has paid Vanguard under such
consulting agreements, approximately
F-54
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
$218,000, $42,000 and $29,000 during the year ended December 31, 1997, the three
month period ended December 31, 1996 and the fiscal year ended September 28,
1996, respectively.
In May 1995, the Company issued 400,000 shares of common stock to Vanguard
at a Purchase price of $5.00 per share. In connection with this issuance,
Vanguard also received a warrant (the 'Vanguard Warrant') to purchase up to an
additional 400,000 shares of the Company's common stock at the agreed-upon fair
market value of such stock at the time of exercise. This warrant agreement
contains an anti-dilution clause which provides for adjustments to the number of
shares eligible to be purchased to maintain the number of shares at
approximately 10.3% of the Company's outstanding common stock. The warrant
expires on the earlier of (i) May 5, 2005 or (ii) the consummation of an initial
public offering by the Company. The terms of the Vanguard Warrant were
restructured immediately prior to the consummation of the private placement
transaction (see Note 7) to provide that Vanguard has the right to buy 900,113
shares at any time before May 5, 2005 at $23.50 per share, which was, in the
opinion of management, the fair market value of the related common stock at the
date of restructuring. The restructured Vanguard Warrant also provides that
Vanguard may pay the exercise price either in cash or, if the fair market value
of the common stock at the time of exercise is greater than the exercise price,
by surrendering any unexercised portion of the Vanguard Warrant and receiving
the number of shares equal to (i) the excess of fair market value per share at
the time of exercise over the exercise price per share multiplied by (ii) the
number of shares surrendered.
On May 5, 1995, the Company entered into a Registration Rights Agreement
with Vanguard relating to certain warrants and shares of common stock of the
Company owned by Vanguard. The agreement provides that Vanguard may at any time
after six months from the date the first registration statement filed by the
Company under the Securities Act of 1933 becomes effective, request the Company
to effect the registration of certain securities held by Vanguard as
expeditiously as may be practicable. However, the Company is entitled to decline
such request, if, in the Company's judgment, such demand registration would not
be in the Company's best interest. The Company may only decline such request
once and will only be effective for a three-month period. In addition, the
agreement allows Vanguard certain piggyback registration rights on any security
offerings the Company may undertake, provided, however, the Company's
underwriter determines, in their sole discretion, such shares will not
jeopardize the success of the proposed offering by the Company. The agreement
terminates the earlier of five years from date of the Company's first
registration statement becomes effective or such time as Vanguard may sell its
securities pursuant to Rule 144 under the Securities Act.
6. LONG-TERM DEBT
Long-term debt consisted of the following:
DECEMBER 31, DECEMBER 31,
1997 1996
------------ ------------
14% Senior Discount Notes(1).................................... $ 91,406 $ 76,866
Less: Current portion of long-term debt......................... -- --
------------ ------------
Total long-term debt.................................. $ 91,406 $ 76,866
------------ ------------
------------ ------------
- ------------
(1) In August 1996, the Company, through the Private Placement, issued 142,000
units, each consisting of a 14% senior discount note due 2003 (collectively,
the 'Notes') with a principal amount at maturity of $1,000 and a warrant to
purchase 7.334 shares (adjusting to 9.429 shares at September 30, 1997 if
the Company did not complete a qualified initial public offering of common
stock by that date) of common stock of the Company at $.01 per share. The
gross proceeds of $94.8
(footnotes continued on next page)
F-55
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
(footnotes continued from previous page)
million were allocated by the Company to the value of the warrants of
approximately $24.5 million and to the discounted notes of approximately
$70.2 million. Expenses of the offering of approximately $3.8 million were
capitalized as bond issuance costs and are being amortized over the
remaining term of the Notes. The Company did not complete a qualified
initial public offering of common stock by September 30, 1997; therefore,
the Company recorded additional common stock purchase warrants of $3.0
million reflecting the valuation of an additional 297,490 shares, or 2.095
shares issuable per warrant.
No cash interest will be payable on the Notes prior to February 1, 2000.
The Notes will accrue cash interest at a rate of 14% per annum, commencing on
August 1, 1999, payable semi-annually on February 1 and August 1 of each year
commencing on February 1, 2000. The debt discount related to the difference
between the face value of the notes ($142 million) and the proceeds of the
Private Placement ($94.8 million) is being accreted over the period to August 1,
1999. The debt discount related to the portion of the Private Placement
allocated to the value of the warrants ($27.4 million, $24.5 million and $24.5
million at December 31, 1997, December 31, 1996 and September 30, 1996,
respectively) is being accreted over the full term of the Notes to August 1,
2003. Interest expense on the notes, including the accretion of debt discount
and amortization of issuance costs, is being recognized at a constant rate of
interest over the life of the Notes. Discount accretion of $17.5 million, $4.1
million and $2.6 million and amortization of bond issuance costs of
approximately $464,000, $102,000 and $67,000 have been recognized as interest
expense during the year ended December 31, 1997, the three month period ended
December 31, 1996 and the fiscal year ended September 28, 1996, respectively. If
additional funds are raised through debt financing, such financing will increase
the financial leverage of the Company and earnings would be reduced by the
associated interest expense. There is no assurance that the Company will be able
to meet its financial obligations under the Notes or other commitments.
7. COMMON STOCK
During the year ended December 31, 1997, the Company issued 60,000 shares
of Common Stock, 50,000 shares for partial consideration in the acquisition of a
patent and 10,000 shares issued pursuant to the management service agreement the
Company has with Vanguard. (See Note 5) The issuance of such shares was recorded
at $10.00 per share, which management believes approximates the fair market
value of the shares on date of issuance.
During the fiscal year ended September 28, 1996, the Company issued
approximately 3,738,000 shares of Common Stock of which approximately 3,418,000
shares were issued at a purchase price of $5.50 per share and approximately
320,000 were issued at a purchase price of $5.00 per share. Approximately
3,319,000 shares were issued as part of a private offering of common stock at a
purchase price of $5.50 per share. In connection with this offering, purchasers
of $250,000 or more of common stock received warrants to purchase a number of
shares of common stock equal to 5% of the shares purchased in the offering and
purchasers of $1,000,000 or more of common stock received warrants to purchase a
number of shares of common stock equal to 10% of the shares purchased in the
offering. The exercise price of all warrants issued or sold in connection with
this offering will equal the sales price of the next $2 million of common stock
issued and sold by the Company. Purchasers of common stock in this offering who
were also purchasers of common stock in certain earlier offerings were also
offered warrants (at a purchase price of $.01 per warrant share) to purchase
common stock. Approximately 323,216 warrants were issued under this offering and
expire on December 31, 2000. Also during the year ended September 30, 1996,
10,000 shares of common stock were issued pursuant to the management service
agreement the Company has with Vanguard at the then estimated fair market value
of $5.50 per share. In addition, the Company converted approximately $2.1
million in debt, notes payable and related accrued interest due to stockholders
into 409,000 shares of common stock. Notes
F-56
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
payable to stockholders of $1.6 million bearing interest at 8.5%, maturing on
February 1, 1998 were converted into approximately 320,000 shares of common
stock at a conversion price of $5.00 per share. Fifty percent of accrued
interest on such notes payable were converted into approximately 13,000 shares
at a conversion price of $5.50 per share, the remaining fifty percent of accrued
interest was paid in cash. Other notes payable to stockholders with a principal
amount of approximately $371,000 and related accrued interest of approximately
$47,000 were converted into approximately 76,000 shares of common stock at $5.50
per share.
During the fiscal year ended September 30, 1995, the Company issued
1,032,000 shares of common stock. Vanguard, through a subsidiary, purchased
400,000 shares of common stock of the Company at a purchase price of $5.00 per
share. In connection with such investment, Vanguard received a warrant to
purchase up to an additional 10.27% of the common stock of the Company at an
exercise price equal to the fair market value of the common stock at the time of
the exercise (the 'Vanguard Warrant'). The Vanguard Warrant was exercisable at
any time prior to the earlier of an underwritten initial public offering or May
5, 2005. The Vanguard Warrant was restructured immediately prior to consummation
of the Private Placement to provide that Vanguard has the right to buy 900,113
shares at any time before May 5, 2005 at $23.50 per share. The restructured
Vanguard Warrant also provides that Vanguard may pay the exercise price either
in cash or, if the fair market value of the common stock at the time of exercise
is greater than the exercise price, by surrendering any unexercised portion of
the Vanguard Warrant and receiving the number of shares equal to (i) the excess
of fair market value per share at the time of exercise over the exercise price
per share multiplied by (ii) the number of shares surrendered.
Of the remaining 632,000 shares issued during the fiscal year ended
September 30, 1995, approximately 607,000 shares were issued at $5.00 per share
and approximately 25,000 shares were issued at $5.50 per share.
On September 30, 1994, a stockholder agreed to forfeit 10,000 shares of the
Company's common stock for failure to fulfill an obligation to invest additional
capital in the Company. The forfeiture did not reduce the amount of the
stockholder's financial investment in the Company at that time, but did reduce
the number of shares issued to this individual. These shares were subsequently
reissued to two other individuals at $5.00 per share. In December 1994, the same
stockholder agreed to forfeit an additional 18,000 shares of the Company's
common stock for failure to fulfill an obligation to invest additional capital
in the Company. Upon this forfeiture, the investor's equity in the Company was
reduced in the total amount of $140,000, representing the value of 28,000 shares
of common stock at $5.00 per share. The original forfeiture of 10,000 shares and
subsequent reissuance of the same 10,000 shares at $5.00 per share was recorded
during the fiscal year ended September 30, 1994. The additional forfeiture of
18,000 shares and the entire value of the September 1994 and December 1994
forfeitures of $140,000 was recorded during the fiscal year ended September 30,
1995.
8. COMMON STOCK PURCHASE WARRANTS
In addition to the Vanguard Warrant to purchase 900,113 shares and the
warrants to purchase an aggregate of 323,216 shares issued in the private
offering described in Note 7, the Company has issued and outstanding other
warrants described below. In August 1996, the Company, through the Private
Placement, issued 142,000 units, each consisting of a 14% senior discount note
due 2003 (collectively, the 'Notes') with a principal amount at maturity of
$1,000 and a warrant to purchase 7.334 shares (adjusting to 9.429 shares at
September 30, 1997 if the Company did not complete a qualified initial public
offering of common stock by that date) of common stock of the Company at $.01
per share. The Company did not complete a qualified public offering of common
stock by September 30, 1997, therefore, the Company recorded additional common
stock purchase warrants of $3.0 million reflecting the valuation of an
additional 297,490 shares, or 2.095 shares issuable per warrant. These warrants
shall be exercisable on or after the earliest to occur of (i) August 1, 2000,
(ii) a change of control, (iii) (a) 90
F-57
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
days after the closing of an initial public offering or (b) upon the closing of
the initial public offering but only in respect of warrants required to be
exercised to permit the holders thereof to sell shares in the initial public
offering, (iv) a consolidation, merger or purchase of assets involving the
Company or any of its subsidiaries that results in the common stock of the
Company becoming subject to registration, (v) an extraordinary cash dividend or
(vi) the voluntary or involuntary dissolution, liquidation or winding up of the
affairs of the Company. The number of shares of the common stock for which a
warrant is exercisable is subject to adjustment upon the occurrence of certain
events.
Holders of warrants (or common stock issued in respect thereof) will be
entitled to include the common stock issued or issuable upon the exercise of the
warrants (the 'Underlying Common Stock') in a registration statement whenever
the Company or any shareholder proposes to effect a public equity offering with
respect to common stock of the Company (other than redeemable stock), except to
the extent the managing underwriter for such offering determines that such
registration and sale would materially adversely affect the price, timing or
distribution of the shares to be sold in such public equity offering. Following
the occurrence of an initial public offering, holders of warrants and Underlying
Common Stock representing not less than 25% of all the outstanding warrants and
Underlying Common Stock, taken together, will have the right, on one occasion,
to require the Company to register these securities pursuant to an effective
registration statement.
After August 1, 2001, the Company may be required, under certain
circumstances, to purchase, at fair market value, the outstanding warrants and
underlying common stock issued. Depending on the fair market value at that time,
there may be a charge to earnings in connection with the repurchase of warrants
and underlying common stock.
Management of the Company believes, based on independent third party
valuations, that the value of the Company's common stock at the date of the
initial issuance of these warrants was $23.50 per share and, accordingly,
allocated $24.5 million of the proceeds of the Private Placement to the value of
these warrants based on 142,000 units consisting of warrants to purchase 7.334
shares of common stock per unit with an exercise price of $.01 per share.
Effective September 30, 1997, the Company recorded additional Common Stock
Purchase Warrants of approximately $3.0 million reflecting the valuation of an
additional 297,490 shares, or 2.095 shares issuable per warrant. This aggregate
amount is classified between liabilities and stockholders' equity (deficit) in
the accompanying consolidated balance sheet as of December 31, 1997. The value
of the original warrants and the incremental value of the 2.095 (9.429 less
7.334) warrants issued per unit of the Notes effective September 30, 1997 have,
since their issuance, been accounted for as an additional debt discount subject
to accretion as described in Note 6.
F-58
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
9. NET LOSS PER SHARE
A reconciliation between the net loss and common shares of the basic and
diluted EPS computations is as follows:
YEAR ENDED THREE MONTH PERIOD FISCAL YEAR ENDED
DECEMBER 31, 1997 ENDED DECEMBER 31, 1996 SEPTEMBER 28, 1996
-------------------------- -------------------------- --------------------------
PER PER PER
SHARE SHARE SHARE
NET LOSS SHARES AMOUNT NET LOSS SHARES AMOUNT NET LOSS SHARES AMOUNT
-------- ------ ------ -------- ------ ------ -------- ------ ------
Basic EPS
Net loss attributable to common
stock........................... $(49,814) 7,692 $(6.48) $(7,330) 7,669 $(0.96) $(11,559) 6,038 $(1.91)
Effect on Dilutive Securities:
Warrants........................ -- -- --
Stock Options................... -- -- --
-------- ------ ------ -------- ------ ------ -------- ------ ------
Diluted EPS
Net loss attributable to common
stock and assumed option
exercise........................ $(49,814) 7,692 $(6.48) $(7,330) 7,669 $(0.96) $(11,559) 6,038 $(1.91)
-------- ------ ------ -------- ------ ------ -------- ------ ------
-------- ------ ------ -------- ------ ------ -------- ------ ------
FISCAL YEAR ENDED
SEPTEMBER 30, 1995
--------------------------
PER
SHARE
NET LOSS SHARES AMOUNT
-------- ------ ------
Basic EPS
Net loss attributable to common
stock........................... $(4,526) 3,556 $(1.27)
Effect on Dilutive Securities:
Warrants........................ --
Stock Options................... --
-------- ------ ------
Diluted EPS
Net loss attributable to common
stock and assumed option
exercise........................ $(4,526) 3,556 $(1.27)
-------- ------ ------
-------- ------ ------
There were no reconciling items to be reported by the Company in the
calculation for basic EPS and diluted EPS for the year ended December 31, 1997,
three month period ended December 31, 1996 and the fiscal years ended September
28, 1996 and September 30, 1995. Inclusion of the Company's outstanding common
stock purchase warrants and stock options (See Note 13) would have an
antidilutive effect on earnings per share and, therefore, they are not included
in the calculation of diluted EPS per SFAS No. 128.
10. DEFERRED COMPENSATION
In September 1996, the Company issued options to purchase 48,000 shares of
common stock at an exercise price of $7.50 per share under the 1996 Nonqualified
Stock Option Plan (See Note 13), which was an exercise price below the
then-estimated fair market value of the Company's common stock on the date of
grant. Accordingly, the Company has recorded a deferred compensation charge of
$768,000, which will be amortized ratably over the five year vesting period of
the related options. Accumulated amortization was $198,000, $45,000 and $6,000
at December 31, 1997, December 31, 1996 and September 28, 1996, respectively.
Amortization expense of deferred compensation was $153,000, $39,000 and $6,000
for the year ended December 31, 1997, the three month period ended December 31,
1996 and for the fiscal year ended September 28, 1996, respectively.
11. LITIGATION
During the year ended September 28, 1996, a lawsuit was filed and settled
against the Company alleging certain patent infringement. The Company expressly
denied any wrongdoing and entered into such agreement to avoid lengthy
litigation costs. Under the settlement agreement, the Company was required to
pay $400,000, and in return, received, among other things, the worldwide,
perpetual right to use such patent, dismissal with prejudice and release of all
related claims. The cost of the settlement of $400,000 was expensed during the
fiscal year ended September 28, 1996.
In February 1996, the Company filed suit against Catalina Marketing
Corporation alleging that Catalina has infringed United States Letters Patent
No. 4,554,446 (the '446 Patent') under which the Company is licensee. The
Company alleges that Catalina is infringing the patent by making, using and
offering for sale devices and systems that incorporate and employ inventions
covered by the '446 Patent. The Company is seeking an injunction against
Catalina to stop further infringement of the patent, treble damages and the
costs and expenses incurred in connection with the suit. The complaint has been
amended to add additional detail, and Catalina has answered denying the
allegations, raising certain
F-59
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
affirmative defenses, and seeking declaratory judgment of non-infringement,
invalidity or unenforceability of the '446 Patent. In May 1997, Catalina
asserted a second counterclaim alleging that the Company is infringing a newly
issued Catalina Patent U.S. Patent No. 5,612,868. The Company has answered
denying the allegations, raising affirmative defenses and seeking declaratory
judgment of non-infringement, invalidity and unenforceability of U.S. Patent No.
5,612,868. Discovery on the claims and counterclaims is proceeding and various
motions are pending before the United States District Court in the District of
Connecticut. As with any litigation, the ultimate outcome of these actions
cannot be predicted. However, the Company intends to assert its claims
vigorously.
In January 1998, Catalina Marketing International, Inc. ('Catalina
International,' a subsidiary of Catalina) filed suit against the Company
alleging that the Company has infringed United States Patent No. 4,674,041 (the
'041 Patent') which Catalina International Inc. acquired by assignment in
December 1997. Catalina International alleges that the Company is infringing the
'041 Patent by making, using and offering for sale devices and systems that
incorporate and employ inventions covered by the '041 Patent. Also in February
1998, Catalina International amended its complaint to join as additional parties
defendant Thermo Information Solutions, Inc. and Coleman Research Corporation
who have manufactured kiosk pursuant to an agreement with the Company. Catalina
International seeks injunctive and declaratory relief as well as unspecified
money damages against all defendants, and has filed a motion for preliminary
injunction against the Company seeking to stop further alleged infringement of
the '041 Patent pending trial. Various other motions are pending in the United
States District Court in the District of Connecticut, including the Company's
motion for a more definite statement. The Company intends to defend against
Catalina International's claims vigorously, and to pursue available remedies
against Catalina International, which may include the filing of appropriate
counterclaims.
12. INCOME TAXES
The components of cumulative deferred tax assets and liabilities were as
follows (in thousands):
DECEMBER 31, DECEMBER 31,
1997 1996
----------------- -----------------
Cumulative Amounts:
Deferred Tax Assets:
Accrued Bonus/Deferred
Compensation/other............................. $ 174 $ 26
Amortization of Warrant Expense.................. 1,545 384
Interest Accretion............................... 4,464 1,242
Other............................................ 13 5
Bond Issuance Cost Amortization.................. 222 59
Net Operating Loss Carryforward.................. 24,294 8,720
----------------- -----------------
Total Deferred Tax Assets................... 30,712 10,436
----------------- -----------------
Deferred Tax Liabilities:
Depreciation..................................... (1157) (527)
----------------- -----------------
Total Deferred Tax Liabilities.............. (1157) (527)
----------------- -----------------
Net Deferred Tax Asset before Valuation
Allowance...................................... 29,555 9,909
----------------- -----------------
Valuation Allowance.............................. (29,555) (9,909)
----------------- -----------------
Net Deferred Tax Asset...................... $-- $--
----------------- -----------------
----------------- -----------------
In accordance with the provisions of Internal Revenue Code Section 382,
utilization of the Company's net operating loss carryforwards could be limited
in years following a change in the Company's ownership. In general, a change in
ownership occurs if a shareholder's (or the combined
F-60
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
group of the shareholders each owning less than 5%) ownership increases 50
percentage points over a three year period. This change could occur at the time
of an Initial Public Offering. The net operating loss limitation is computed by
applying a percentage (approximately 5%, as determined by the Internal Revenue
Code) to the value of the Company on the date of the change. The Section 382
limitation limits the use of the net operating loss carryforward as computed on
the date of the change in ownership. Net operating losses incurred after the
date of the change of ownership are not limited unless another change in
ownership occurs. At December 31, 1997 the amount of net operating loss
carryforward is approximately $54.4 million. These losses begin to expire in the
2008 tax year.
Creditable foreign taxes paid by the Company or its subsidiaries will be
subject to Internal Revenue Code Section 904, Limitation on Foreign Tax Credit,
because the Company does not have a Federal Income Tax liability. The Foreign
Tax Credit limitation may be carried back two years and forward five years. The
Company has the option of deducting these foreign taxes in lieu of the credit.
In general, since the Company does not have a federal tax liability, the
deduction method will increase the amount of net operating losses which are
available to be carried forward fifteen years. As of December 31, 1997 the
Company has not paid or accrued foreign taxes.
SFAS No. 109 requires a valuation allowance to be recorded when it is more
likely than not that some or all of the deferred tax assets may not be realized.
At each of the balance sheet dates, a valuation allowance for the full amount of
the net deferred tax asset was recorded. This valuation allowance is recorded
due to both the uncertainty of future income and the possible application of
Internal Revenue Code Section 382 limitations on the use of the net operating
loss carryforwards.
13. STOCK OPTION PLANS
The Company has in place the 1994 Stock Compensation Plan which provides
for the issuance of shares of Common Stock to key employees, consultants and
directors pursuant to stock options that meet the requirements of Section 422 of
the Internal Revenue Code of 1986, as amended (incentive stock options), options
that do not meet such requirements (nonqualified stock options) and stock
bonuses. All options under the plan must be granted at an exercise price not
less than fair market value. Stock bonuses may be in the form of grants of
restricted stock. The aggregate number of shares of Common Stock that may be
issued pursuant to the plan may not exceed 330,000 shares, subject to adjustment
upon occurrence of certain events affecting the Company's capitalization. As of
December 31, 1997 an aggregate of 17,900 shares remain available for future
grants under the 1994 Stock Compensation Plan.
The Company also has in place the 1996 Nonqualified Stock Option Plan which
provides for the issuance of shares of Common Stock to key employees,
consultants and directors pursuant to nonqualified stock options. All options
must be granted at an exercise price not less than $5.50 per share. The
aggregate number of shares of Common Stock that may be issued pursuant to the
plan may not exceed 600,000 shares of Common Stock, subject to adjustment upon
occurrence of certain events affecting the Company's capitalization. This plan
is subject to shareholder approval. As of December 31, 1997 an aggregate of
17,000 shares remain available for future grants under the 1996 Nonqualified
Stock Option Plan.
On May 20, 1997, the Company established the 1997 Long-term Incentive Plan
('Long-term Incentive Plan') for the purpose of promoting the long-term
financial performance of the Company by providing incentive compensation
opportunities to officers, supervisory employees, directors or consultants of
the Company or any subsidiary. The plan allows for the Company to grant Stock
Options for the purchase of shares of Stock to Grantees under the Plan in such
amounts as the Compensation Committee of the Board of Directors, in its sole
discretion, determines. The Stock Options granted under the Plan will be
designated as either: (i) Incentive Stock Options or (ii) Nonqualified Stock
Options. The purchase price for shares acquired pursuant to the exercise, will
be determined at the time
F-61
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
of grant; however, it will not be less than the fair market value of the shares
at the time of the grant. The Long-term Incentive Plan also allows the Company
to grant Stock Appreciation Rights in any amount, at its sole discretion, either
alone or in combination with other Awards granted under the Plan. As of December
31, 1997, 367,900 of 500,000 total available options have been issued under the
Long-term Incentive Plan at an exercise price of $10.00 per share. Management
believes that these options were granted at fair market value of common stock at
the date of grant. No Stock Appreciation Rights were awarded as of December 31,
1997. The awards vest annually over five years from the date of grant with the
exception of 63,500 options, which became immediately exercisable.
The Company accounts for these plans under APB Opinion No. 25, under which
no compensation cost has been recognized. Had compensation cost for these plans
been determined consistent with SFAS No. 123 (See Note 2), the Company's net
loss and net loss per share would have been changed to the following pro forma
amounts:
THREE MONTH
YEAR ENDED PERIOD ENDED FISCAL YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1996 SEPTEMBER 28, 1996
----------------- ----------------- ------------------
Net Loss: As Reported $ (49,814) $(7,330) $(11,559)
Pro Forma (50,353) (7,355) (11,832)
Net Loss Per Share: Basic As Reported (6.48) (.96) (1.91)
Diluted As Reported (6.48) (.96) (1.91)
Basic Pro Forma (6.55) (.96) (1.96)
Diluted Pro Forma (6.55) (.96) (1.96)
Because the SFAS No. 123 method of accounting has not been applied to
options granted prior to January 1, 1995, the resulting pro forma compensation
cost may not be representative of that to be expected in future years. A summary
of the status of the Company's stock option plans for the year ended December
31, 1997, the three month period ended December 31, 1996 and the fiscal year
ended September 28, 1996 is presented in the table and narrative below:
THREE MONTH
YEAR ENDED PERIOD ENDED FISCAL YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1996 SEPTEMBER 28, 1996
-------------------- ------------------ ------------------
WTD AVG WTD AVG WTD AVG
EX EX EX
SHARES PRICE SHARES PRICE SHARES PRICE
--------- ------- ------- ------- ------- -------
Outstanding at beginning of year.............. 821,100 $ 5.40 844,100 $5.40 266,600 $4.77
Granted....................................... 543,400 10.00 -- -- 617,500 5.65
Exercised..................................... -- -- -- -- -- --
Forfeited..................................... 2,200 5.23 (3,000) 5.50 (7,000) 5.00
Expired....................................... 102,400 5.91 (20,000) 5.50 (33,000) 5.08
Outstanding at end of year.................... 1,259,900 7.34 821,100 5.40 844,100 5.40
Exercisable at end of year.................... 571,250 6.16 332,400 5.15 320,200 5.16
Weighted average fair value of options
granted..................................... N/A 7.34 N/A 5.40 N/A 5.40
821,100 of the options outstanding at December 31, 1996 have exercise
prices between $1.86 and $7.50, with a weighted average exercise price of $5.40
and a weighted average remaining contractual life of 8.2 years. 332,400 of these
options are exercisable. The remaining options have exercise prices between
$1.86 and $7.50, with a weighted average exercise price of $5.56 and a weighted
average remaining contractual life of 6 years. 332,400 of these options are
exercisable; their weighted average exercise price is $5.15.
1,259,900 of the options outstanding at December 31, 1997, have exercise
prices between $1.86 and 10.00, with a weighted average exercise price of $7.34
and a weighted average remaining contractual life
F-62
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31,
1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
of 8.7 years. 571,250 of these options are exercisable. The remaining options
have exercise prices between $1.86 and 10.00 with a weighted average price of
$8.48 and a weighted average remaining contractual life of 9.1 years. 571,250 of
these options are exercisable; their weighted average exercise price is $6.16.
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes Option Pricing Model with the following weighted-average
assumptions used for grants in the year ended December 31, 1997, the three month
period ended December 31, 1996, and the fiscal year ended September 28, 1996
respectively: risk free interest rates of 6.49%, 6.45%, and 6.60%; and expected
dividend yields of 0%, expected lives of 5 years, and expected stock volatility
of 0 for each respective period.
The foregoing plans are administered by the Compensation and Stock Option
Committee of the Board of Directors, which is authorized, subject to the
provisions of the plans, to determine to whom and at what time options and
bonuses may be granted and the other terms and conditions of the grant.
14. COMMITMENTS AND CONTINGENCIES
COMMITMENTS FOR TECHNOLOGY
The Company is party to several patent licensing agreements relating to its
in-store consumer product promotion and couponing business. With respect to one
license agreement under which the Company is assignee, the Company is required
to pay a royalty of 2% of the gross collected revenues of the Company, to the
extent derived from the Company's exploitation of the patent, with such royalty
decreasing to 1% of such revenues after $10 million in aggregate royalties have
been paid to the licensors. This license agreement requires that certain minimum
monthly payments be made to the licensors, and be exceeded within approximately
two years, in order to avoid triggering a termination right on the part of the
licensors. With respect to another license agreement, the Company is required to
pay the licensor a royalty of .8% of the gross collected revenues of the Company
to the extent derived from the Company's exploitation of the patent, until such
time as the licensor has received the aggregate sum of $600,000 after which no
additional royalty payments are required. Under a third agreement, the Company
is required to pay the licensor a royalty of 1% of the gross revenues related to
the Company's exploitation of the patent subject to certain minimum annual
payments, should the Company wish to maintain exclusive rights under such
patent. Under these agreements, the Company recorded royalty payments of
$398,000, $99,000, $333,000 and $274,000 for the year ended December 31, 1997,
the three month period ended December 31, 1996, and for the fiscal years ended
September 28, 1996 and September 30, 1995, respectively.
COMMITMENTS FOR FIXED ASSET PURCHASES
On September 9, 1996, the Company sold its manufacturing operations to
Coleman Research Corporation ('Coleman') for approximately $2.6 million and
entered into an exclusive supply agreement whereby Coleman is to fulfill the
Company's anticipated requirements for terminals for the next three years with
fixed pricing for the first 5,000 terminals. No material gain or loss was
realized in this transaction. As of March 24, 1998, the Company terminated its
three-year exclusive terminal supply relationship with Coleman and its
subsidiary, Thermo Information Solutions, Inc. ('Thermo') (collectively, the
'Vendors'). As part of this mutual termination agreement, the Company agreed to
pay $4.5 million in installments to pay balances on previously purchased ILN
equipment, to acquire certain inventory and to obtain early release from the
exclusivity provision of the original contract to allow the Company to pursue
relationships with new vendors. Of this amount, $4.1 million was charged to
operating expense during 1997. The Vendors have agreed to return supplies and
terminal parts to the Company, for which approximately $400,000 was reflected in
other current assets of the Company as of December 31, 1997. Further, the
Vendors will supply the Company with 350 additional kiosks.
F-63
INDEX TO EXHIBITS
Sequential
Exhibit No. Description Page No.
- ----------- ----------- --------
* 3(a) Articles of Incorporation of Registrant as
amended through July 25, 1995, filed as
Exhibit 1 to the Registrant's Form 8-A/A
dated July 25, 1995.
* 3(b) Bylaws of Registrant (compilation of July
25, 1995), filed as Exhibit 2 to the
Registrant's Form 8-A/A dated July 25, 1995.
* 4(a) Specimen Common Stock Certificate, filed as
Exhibit 4(a) to the Registrant's
Registration Statement on Form S-1 (File No.
33-18067).
* 4(b)(1) Amended and Restated Loan Agreement between
the Registrant and various lenders led by
The Bank of New York and The oronto-Dominion
Bank as agents, dated as of December 23,
1994, filed as Exhibit 2(a) to the
Registrant's Current Report on Form 8-K
dated as of December 23, 1994.
* 4(b)(2) Security Agreement between the Registrant
and various lenders led by The Bank of New
York and The Toronto-Dominion Bank, as
Secured Party, dated as of December 23,
1994, filed as Exhibit 2(b) to the
Registrant's Current Report on Form 8-K
dated as of December 23, 1994.
* 4(b)(3) Master Subsidiary Security Agreement between
the Registrant, certain of its subsidiaries
and various lenders led by The Bank of New
York and The Toronto-Dominion Bank, as
Secured Party, dated as of December 23,
1994, filed as Exhibit 2(c) to the
Registrant's Current Report on Form 8-K
dated as of December 23, 1994.
* 4(b)(4) Second Amended and Restated Loan Agreement
between Vanguard Cellular Operating Corp.
and various lenders led by The Bank of New
York and The Toronto-Dominion Bank as
agents, dated as of April 10, 1996, filed as
Exhibit 4(d)(1) to the Registrant's Form
10-Q/A dated March 31, 1996.
* 4(b)(5) VCOC Security Agreement between Vanguard
Cellular Operating Corp. and various lenders
led by The Bank of New York and The
Toronto-Dominion Bank as Secured Party,
dated as of April 10, 1996, filed as Exhibit
4(d)(2) to the Registrant's Form 10-Q/A
dated March 31, 1996.
* 4(b)(6) Second Amended and Restated Master
Subsidiary Security Agreement between
certain subsidiaries of the Registrant and
various lenders led by The Bank of New York
and The Toronto-Dominion Bank, as Secured
Party, dated as of April 10, 1996, filed as
Exhibit 4(d)(3) to the Registrant's Form
10-Q/A dated March 31, 1996.
* 4(b)(7) Assignment, Bill of Sale and Assumption
Agreement by and between Registrant and
Vanguard Cellular Financial Corp., dated as
of April 10, 1996, filed as Exhibit 4(d)(4)
to the Registrant's Form 10-Q/A dated March
31, 1996.
* 4(b)(8) Indenture dated as of April 1, 1996 between
Registrant and The Bank of New York as
Trustee, filed as Exhibit 4(e)(1) to the
Registrant's Form 10-Q/A dated March 31,
1996.
* 4(b)(9) First Supplemental Indenture, dated as of
April 1, 1996 between registrant and The
Bank of New York as Trustee, filed as
Exhibit 4(e)(2) to the Registrant's Form
10-Q/A dated March 31, 1996.
* 4(b)(10) First Amendment to Second Amended and
Restated Loan Agreement between Vanguard
Operation Corp. and various lenders led by
the Bank of New York and The
Toronto-Dominion Bank as agents, dated as of
July 31, 1996, filed as Exhibit 4(d)(5) to
the Registrant's Form 10-Q dated September
30, 1996 and confirmed electronically as
Exhibit 4(d)(5) to the Registrant's 10-Q/A
dated September 30, 1996.
* (11) Second Amendment to Second Amended and
Restated Loan Agreement between Vanguard
Cellular Operating Corp. and various lenders
led by the Bank of New York and The
Toronto-Dominion Bank as agents, dated as of
October 30, 1996 and confirmed
electronically as Exhibit 4(d)(6) to the
Registrant's 10-Q/A dated September 30,
1996.
* (12) Third Amendment to Second Amended and
Restated Loan Agreement between Vanguard
Cellular Operating Corp. and various lenders
led by the Bank of New York and The
Toronto-Dominion Bank as agents, dated as of
March 31, 1997 and filed as Exhibit 4(b)(7)
to the Registrant's Form 10-Q dated
September 30, 1996.
* 4(b)(9) First Supplemental Indenture, dated as of
April 1, 1996 between Registrant and The
Bank of New York as Trustee, filed as
Exhibit 4(e)(2) to the Registrant's Form
10-Q/A dated March 31, 1996.
* 10(a)(1) Amended and Restated Stock Compensation Plan
of the Registrant approved April 22, 1987 by
the Shareholders of the Registrant, with
forms of stock bonus and stock option
agreements attached, filed as Exhibit 10 (a)
to the Registrant's Registration Statement,
on Form
S-1 (File No. 33-18067).
* 10(a)(2) Amendment to Amended and Restated Stock
Compensation Plan of the Registrant approved
May 2, 1989 by the Shareholders of the
Registrant, filed as Exhibit 4(h)(2) to the
Registrant's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1989.
* 10(a)(3) Form of Restricted Stock Bonus Agreements
dated March 23, 1987 between the Registrant
and Stuart S. Richardson, Haynes G. Griffin,
L. Richardson Preyer, Jr., Stephen R.
Leeolou and Stephen L. Holcombe, and form of
amendments dated October 12, 1987 to
agreements with Messrs. Richardson, Griffin,
Preyer and Leeolou, filed as Exhibit
10(a)(3) to the Registrant's Annual Report
on Form 10-K for the fiscal year ended
December 31, 1988.
* 10(a)(4) Form of Restricted Stock Bonus Agreements
dated October 12, 1987 between the
Registrant and Haynes G. Griffin, Stephen R.
Leeolou and L. Richardson Preyer, Jr., filed
as Exhibit 10(a)(4) to the Registrant's
Annual Report on Form 10-K for the fiscal
year ended December 31, 1988.
* 10(1)(5) Form of Amendment to Restricted Stock Bonus
Plan Agreements dated as of March 1, 1990 by
and between Haynes G. Griffin, L. Richardson
Preyer, Jr., Stephen R. Leeolou, and Stephen
L. Holcombe and the Registrant, amending the
Restricted Stock Bonus Plan Agreements dated
as March 23, 1987, filed as Exhibit 10(a)(5)
to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31,
1990.
* 10(1)(6) Form of Amendment to Restricted Stock Bonus
Plan Agreements dated as of March 1, 1990 by
and between Haynes G. Griffin, L. Richardson
Preyer, Jr. and Stephen R. Leeolou and the
Registrant, amending the Restricted Stock
Bonus Plan Agreements dated as October 12,
1987, filed as Exhibit 10(a)(6) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1990.
* 10(a)(7) Form of Second Amendment to Restricted Stock
Bonus Plan Agreements dated February 22,
1991 between the Registrant and Haynes G.
Griffin, Stephen R. Leeolou, and L.
Richardson Preyer, Jr., amending the
Restricted Stockx Bonus Agreements dated
October 12, 1987, filed as Exhibit 10(a)(7)
to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31,
1990.
* 10(a)(8) Form of Third Amendment to Restricted Stock
Bonus Plan Agreements dated February 22,
1991 between the Registrant and Haynes G.
Griffin, Stephen R. Leeolou, L. Richardson
Preyer, Jr., and Stephen L. Holcombe,
amending the Restricted Stock Bonus
Agreements dated March 23, 1987, filed as
Exhibit 10(a)(8) to the Registrant's Annual
Report on Form 10-K for the fiscal year
ended December 31, 1990.
* 10(a)(9) Form of Third Amendment to Restricted Stock
Bonus Plan Agreement dated February 22, 1991
between the Registrant and Stuart S.
Richardson, amending the Restricted Stock
Bonus Plan Agreement dated March 23, 1987,
filed as Exhibit 10(a)(9) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1990.
* 10(a)(10) Employment Agreement dated March 1, 1995 by
and between the Registrant and Haynes G.
Griffin, filed as Exhibit 10(a)(10) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1994.
* 10(a)(11) Employment Agreement dated March 1, 1995 by
and between the Registrant and L. Richardson
Preyer, Jr., filed as Exhibit 10(a)(11) to
the Registrant's Annual Report on Form 10-K
for the fiscal year ended December 31, 1994.
* 10(a)(12) Employment Agreement dated March 1, 1995 by
and between the Registrant and Stephen R.
Leeolou, filed as Exhibit 10(a)(12) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1994.
* 10(a)(13) Executive Officer Long-Term Incentive
Compensation Plan adopted October 1, 1990 by
the Registrant, filed
as Exhibit 10(a)(13) to the Registrant's
Annual Report on Form 10-K to the fiscal
year ended December 31, 1990.
* 10(a)(14) Form on Nonqualified Option Agreements dated
October 12, 1987 between the Registrant and
Stephen L. Holcombe, Ralph E. Hiskey, John
F. Dille, Jr., Charles T. Hagel, L.
Richardson Preyer, Sr. and Robert A.
Silverberg, filed as Exhibit 10(a)(5) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1988.
* 10(a)(15) Nonqualified Option Agreements dated October
12, 1987 between the Registrant and Robert
M. DeMichele, John F. Dille, Jr., L.
Richardson Preyer, Sr., Robert A. Silverberg
and Thomas I. Storrs, filed as Exhibit
10(a)(8) to the Registrant's Annual Report
on Form 10-K for the fiscal year ended
December 31, 1988.
* 10(a)(16) Form of Incentive Stock Option Agreements
dated March 3, 1988 between the Registrant
and Stephen L. Holcombe and Richard C.
Rowlenson, filed as Exhibit 10(a)(9) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1988.
* 10(a)(17) Form of Incentive Stock Option Agreements
dated June 23, 1988 between the Registrant
and Charles T. Hagel, Haynes G. Griffin, L.
Richardson Preyer, Jr., and Stephen R.
Leeolou, filed as Exhibit 10(a)(10) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1988.
10(a)(18) Amended and restated 1994 Long-Term
Incentive Plan, approved by the Registrant's
Board of Directors on February 26, 1997.
* 10(a)(19) Senior Management Severance Plan of the
Registrant adopted March 8, 1995, filed as
Exhibit 10(a)(19) to the Registrant's Annual
Report on Form 10-K for the fiscal year
ended December 31, 1994.
* 10(a)(20) Form of Severance Agreement for Senior
Management Employees of the Registrant,
filed as Exhibit 10(a)(20) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1994.
* 10(a)(21) Form of Incentive Stock Agreement dated
March 7, 1995 between the Registrant and
Haynes G. Griffin, Steven L. Holcombe,
Richard C. Rowlenson and Stuart S.
Richardson filed as Exhibit 10(a)(21) to the
Registrant's Quarterly Report on Form 10-Q
for the quarterly period ended March 31,
1995.
* 10(a)(22) Form of Nonqualified Option Agreement dated
March 7, 1995 between the Registrant and
Haynes G. Griffin, Stephen R. Leeolou, L.
Richardson Preyer, Jr., Stephen L. Holcombe,
Richard C. Rowlenson and Stuart S.
Richardson, filed as Exhibit 10(a)(22) to
the Registrant's Quarterly Report on Form
10-Q for the quarterly period ended March
31, 1995.
* 10(b))(1) Loan Agreement between the Registrant and
various lenders led by The Bank of New York
and The Toronto-Dominion Bank as agents,
dated as of December 23, 1994, filed as
Exhibit 2(a) to the Registrant's Current
Report on Form 8-K dated as of December 23,
1994.
* 10(b)(2) Security Agreement between the Registrant
and various lenders led by The Bank of New
York and The Toronto-Dominion Bank, as
Secured Party, dated as of December 23,
1994, filed as Exhibit 2(b) to the
Registrant's Current Report on Form 8-K
dated as of December 23, 1994.
* 10(b)(3) Master Subsidiary Security Agreement between
the Registrant, certain of its subsidiaries
and various lenders led by The Bank of New
York and The Toronto-Dominion Bank, as
Secured Party, dated as of December 23, 1994
filed as Exhibit 2(c) to the Registrant's
Current Report on Form 8-K dated as of
December 23, 1994.
* 10(d))(1) 1989 Stock Option Plan of the Registrant
approved by the Board of Directors of the
Registrant on December 21, 1989, and
approved by Shareholders at a meeting held
on May 10, 1990, filed as Exhibit 10(h)(1)
to the Registrant's Annual Report on Form
10-K for the fiscal year ended December 31,
1989.
* 10(d)(2) Form of Nonqualified Stock Option Agreements
dated March 1, 1990 between the Registrant
and Haynes G. Griffin, L. Richardson Preyer,
Jr., Stephen R. Leeolou, Stephen L. Holcombe
and Stuart S. Richardson, filed as Exhibit
10(h)(2) to the Registrant's annual Report
on Form 10-K for the fiscal year ended
December 31, 1989.
* 10(d)(3) Form of Incentive Stock Option Agreement
dated March 1, 1990 between the Registrant
and Richard C. Rowlenson, filed as Exhibit
10(h)(2) to the Registrant's Annual Report
on Form 10-K for the fiscal year ended
December 31, 1989.
* 10(d)(4) Form of Incentive Stock Option Agreement
dated July 30, 1990 between the Registrant
and Stephen L. Holcombe, Richard C.
Rowlenson, Sunir Kochhar and Timothy G.
Biltz, filed as Exhibit 10(f)(4) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1990.
* 10(d)(5) Stock Option Agreement dated November 28,
1990 between the Registrant and Stuart Smith
Richardson, filed as Exhibit 10(f)(5) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1990.
* 10(d)(6) Form of Stock Option Agreements dated
November 28, 1990 between the Registrant and
Haynes G. Griffin, Stephen R. Leeolou, L.
Richardson Preyer, Jr. and Stephen L.
Holcombe, filed as Exhibit 10(f)(6) to the
Registrant's Annual Report on Form 10-K for
the fiscal year ended December 31, 1990.
* 10(d)(7) Incentive Stock Option Agreements dated
November 28, 1990 between the Registrant and
Richard C. Rowlenson, filed as Exhibit
10(f)(7) to the Registrant's December 31,
1990.
* 10(e)(1) Joint Venture Agreement by and among W&J
Metronet, Inc., Vanguard Cellular Systems of
Coastal Carolina, Inc., Providence Journal
Telecommunications and the Registrant dated
as of January 19, 1990,
filed as Exhibit 10(j) to the Registrant's
Registration Statement on Form S-4 (File No.
33-35054).
* 10(e)(2) First Amendment and Assumption Agreement
dated as of the 28th day of December, 1990
to Joint Venture Agreement by and among W&J
Metronet, Inc., Vanguard Cellular Systems of
Coastal Carolina, Inc., Providence Journal
Telecommunications and the Registrant dated
as of January 19, 1990, filed as Exhibit
10(g)(2) to the Registrant's Annual Report
on Form 10-K for the fiscal year ended
December 31, 1990.
* 10(f)(1) Stockholders Voting Agreement dated as of
February 23, 1994, filed as Exhibit 7 to
Amendment 1 of Schedule 13D dated February
23, 1994 with respect to the Common Stock of
Geotek Communications,
* 10(g)(1) Nonqualified Deferred Compensation Plan with
Form of Salary Reduction Agreement filed as
Exhibit 10(g(1) to the Registrant's Annual
Report on Form 10-K for the fiscal year
ended December 31, 1996.
11 Calculation of diluted net income per
share for the years ended December 31, 1997,
1996, and 1995.
22 Subsidiaries of the Registrant.
23 Consent of Arthur Andersen LLP
27 Financial Data Schedule.
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* Incorporated by reference to the statement or report indicated.