Back to GetFilings.com
1
================================================================================
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 0-20803
IXC COMMUNICATIONS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 74-2644120
(STATE OR OTHER JURISDICTION OF INCORPORATION (I.R.S. EMPLOYER IDENTIFICATION NO.)
OR ORGANIZATION)
1122 CAPITAL OF TEXAS HIGHWAY SOUTH, AUSTIN, TEXAS 78746
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (512) 328-1112
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
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. [ ]
The aggregate market value of the Common Stock of the Registrant held by
non-affiliates of the Registrant on February 27, 1998, based on the closing
price of the Common Stock on the Nasdaq National Market on such date, was
$940,746,077.
The number of shares of the Registrant's Common Stock outstanding as of
February 27, 1998 was 31,674,484 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement to be filed with the Securities
and Exchange Commission within 120 days of December 31, 1997 in connection with
the Annual Meeting of Stockholders are incorporated by reference into Part III
hereof.
================================================================================
2
IXC COMMUNICATIONS, INC.
FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
INDEX
PAGE
----
PART I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 27
Item 3. Legal Proceedings........................................... 28
Item 4. Submission of Matters to a Vote of Security Holders......... 28
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters....................................... 29
Item 6. Selected Financial Data..................................... 30
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 31
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 40
Item 8. Financial Statements and Supplementary Data................. 40
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 40
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 41
Item 11. Executive Compensation...................................... 41
Item 12. Security Ownership of Certain Beneficial Owners and
Management................................................ 41
Item 13. Certain Relationships and Related Transactions.............. 41
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K....................................................... 42
Signatures............................................................ 46
Glossary.............................................................. A-1
Financial Statements.................................................. F-1
i
3
PART I
Certain of the information contained in the Registrant's Form 10-K (the
"Form 10-K"), including information regarding the Registrant's expectations with
respect to its network expansion, related financings and fiber sale and
cost-saving agreements, future operations and other information, which can be
identified by the use of forward-looking terminology, such as "may," "will,"
"expect," "anticipate," "estimate," "believe," "seek" or "continue" or the
negative thereof or other variations thereon or comparable terminology, are
forward-looking statements which involve risk and uncertainty. The Registrant's
actual results may differ significantly from the results discussed in the
forward-looking statements. For a discussion of important factors that could
cause actual results to differ materially from the matters described in the
forward-looking statements, see "Business -- Risk Factors." Certain terms used
herein are defined in the Glossary at page A-1. As used herein, unless the
context otherwise requires, the term "Company" refers to IXC Communications,
Inc. ("IXC Communications") and its subsidiaries, including predecessor
corporations.
ITEM 1. BUSINESS
OVERVIEW
The Company
The Company is a leading provider of voice and data transmission services
to communications companies and end users. The Company owns and operates one of
the newest and most advanced coast-to-coast digital communications networks (the
"Network"), which is expected to include over 11,500 route miles of digital
transmission facilities ("digital route miles") by the end of the first quarter
of 1998. Substantial additions to the Network are currently under construction,
and the Company expects the Network to include over 18,000 digital route miles
by the end of 1998, and over 20,000 digital route miles by the end of 1999. The
Company's facilities also include seven long distance switches and 15 Frame
Relay-ATM switches, which the Company is using to capitalize on the growing
demand for Internet and electronic data transfer services. Through a combination
of its own facilities and the facilities of other carriers, the Company
originates and terminates long distance traffic in all 50 U.S. states, and
terminates long distance traffic in over 200 foreign countries. The Company's
revenues have grown rapidly, from $91.0 million in 1995 to $203.8 million in
1996 and $420.7 million in 1997.
The Company provides two principal products: transmission of voice and data
over dedicated circuits ("private lines") and transmission of long distance
traffic processed through the Company's switches ("long distance switched
services"), including Frame Relay and ATM-based switched data services. The
Company's customers include AT&T, MCI, Sprint, WorldCom, Cable & Wireless,
Excel, Frontier and over 300 other long distance companies, wireless companies,
cable television providers, Internet service providers, governmental agencies,
and, with the pending acquisition of Network Long Distance, Inc. ("NLD"), a long
distance company, small- and medium-sized businesses.
Private Line Business. The Company's private line customers include
non-facilities-based carriers requiring dedicated long distance transmission
capacity to carry their customers' long distance traffic and facilities-based
carriers that require long distance transmission capacity where they have
geographic gaps in their facilities, need additional capacity or require
geographically diverse routing. The Company has private line circuit contracts
with over 230 customers, including AT&T, MCI, Sprint, WorldCom, Cable &
Wireless, Frontier and LCI. Pursuant to these contracts, customers are required
to make fixed monthly payments, generally in advance. Many of the contracts
contain substantial "take or pay" commitments.
Long Distance Switched Services Business. The long distance switched
services that the Company provides are processed through the Company's digital
switches and carried over long distance circuits and other transmission
facilities owned or leased by the Company. The Company sells these services on a
per-call basis, charging by minutes of use ("MOUs"), with payment due monthly
after services are rendered. The Company's primary customers for switched
services include long distance resellers (both switchless resellers and switched
resellers that lack a switch in a geographic region) that use the Company's
network to provide long distance service to end-user customers. The Company has
long distance switched services contracts with over 100 long distance resellers.
1
4
The Company provides retail switched long distance services to small- and
medium-sized businesses through Telecom One, which it acquired in July 1997. The
Company believes that its planned acquisition of NLD, which had 1997 revenues of
over $100 million, will provide an important foundation for further growth in
the business retail long distance market. The Company seeks to make additional
targeted acquisitions of resellers that provide significant network or product
synergies. The Company has also entered into a joint venture with Unidial
Communications to sell communications services using the Company's network
through a full-time, national direct sales force.
Data Services. The Company's Network, which includes 15 Frame Relay-ATM
switches, has been built with SONET technology and broadband capabilities to
provide a platform to support advanced, capacity-intensive products such as
Frame Relay, ATM, multimedia, and Internet-related applications. The Company has
recently begun marketing a full line of data transport services to its
customers. Additionally, the Company recently announced the acquisition of
Network Evolutions, Inc. ("NEI"), a company that provides data consulting
services and designs internal and external data networking solutions for
corporations. In February 1998, the Company entered into a strategic alliance
with PSINet Inc. ("PSINet"), a major Internet service provider, whereby the
Company will provide transmission capacity for PSINet and will resell PSINet's
broad spectrum of Internet services. In addition, the Company acquired 20% of
PSINet's common stock.
Fiber Sales. The Company has sold excess fiber to MCI and LCI, and expects
to continue to use its excess fibers to lower the Company's effective network
construction cost by selling or swapping such fibers. In 1997, the Company
received cash proceeds of approximately $57.0 million from such sales, but
because of its accounting policies, only recorded $0.8 million as revenue from
fiber sales during the year. Instead of recognizing fiber sale revenues
immediately, the Company records such revenues over the term of the sale/use
agreements, usually 20 years or more. In addition to fiber sales, the Company
has swapped excess fibers on certain sections of its network with other carriers
and in 1997 acquired rights to routes being constructed from Los Angeles to San
Francisco, Las Vegas to Portland, and Washington, D.C. to Houston and New York
City to Washington, D.C. in such exchanges.
International Joint Ventures. The Company is involved in a joint venture
with Telenor AS, the Norwegian national telephone company, to provide
telecommunication services to carriers and resellers in 11 European countries.
The Company also indirectly holds a minority interest in Marca-Tel, a Mexican
telecommunications provider.
The principal executive offices of IXC Communications are located at 1122
Capital of Texas Highway South, Austin, Texas, 78746 and its telephone number is
(512) 328-1112.
INDUSTRY
Development and Regulation
The development of the long distance telecommunications industry was
strongly influenced by a 1982 court decree requiring the divestiture by AT&T of
its seven RBOCs and dividing the country into approximately 200 LATAs. The seven
RBOCs were allowed to provide local telephone service, local access service to
long distance carriers and intra-LATA long distance service (service within a
LATA), but were prohibited from providing inter-LATA service (service between
LATAs). The right to provide inter-LATA service was given to AT&T and the other
interexchange carriers, including the LECs that are not RBOCs. The FCC requires
all interexchange carriers to allow the resale of their inter-LATA services to
long distance carriers, and the 1982 court decree substantially eliminated
different access arrangements as distinguishing features among long distance
carriers. These and other legislative and judicial factors have helped smaller
long distance carriers emerge as alternatives to AT&T, MCI and Sprint for long
distance services.
In 1996, the federal government enacted the Telecommunications Act of 1996
(the "Telecom Act"), which, among other things, allows the RBOCs and others such
as electric utilities and cable television companies to enter the long distance
business. The Company expects that the Telecom Act will substantially alter the
way in which the telecommunications industry is regulated. Such changes are,
however, difficult to predict accurately, because FCC proceedings and appellate
review of the numerous administrative regulations
2
5
adopted to implement the Telecom Act, including universal service and access
charge reform, are still ongoing. Entry of the RBOCs or other entities such as
electric utilities, cable television companies or foreign companies into the
long distance business may result in reduced market shares for existing long
distance companies and additional pricing pressure on long distance providers
such as the Company. See "-- Risk Factors -- Competition," "-- Risk
Factors -- Recent Legislation and Regulatory Uncertainty" and "-- Regulation."
Market and Competition
General. The long distance market is highly competitive. Competition among
the Company's customers and other retail long distance providers for end-user
customers is based upon pricing, advertising, customer service, network quality
and value-added services. Industry observers estimate that over 400 smaller
companies have emerged to compete in the long distance business. See "-- Risk
Factors -- Competition."
Private Line Services. Long distance companies may be categorized as
facilities-based carriers and non-facilities-based carriers. Sellers of private
line services are generally facilities-based carriers that own long distance
transmission facilities, such as fiber optic cable or digital microwave
equipment. The first-tier and some second-tier long distance companies are
facilities-based carriers offering private line services nationwide.
Facilities-based carriers in the third tier of the market generally offer
private line services only in a limited geographic area. Customers using private
line services include: (i) facilities-based carriers that require long distance
transmission capacity where they have geographic gaps in their facilities, need
additional capacity or require geographically different alternative routing; and
(ii) non-facilities-based carriers requiring long distance transmission capacity
to carry their customers' long distance traffic. The Company's competitors in
the private line business include AT&T, MCI, Sprint, WorldCom, Qwest and certain
regional carriers. MCI and WorldCom have announced a planned merger, and
applications for approval of that merger are pending. If the MCI/WorldCom merger
is approved, the result would be an even larger, and potentially stronger,
entity with whom the Company would have to compete. Qwest is constructing a
coast-to-coast fiber optic network and Frontier has agreed to pay $500.0 million
for fibers in Qwest's network. Qwest is, and Frontier may become, a competitor
of the Company, in the private line business. In addition, Qwest and LCI have
also recently announced a planned merger. The Qwest/LCI merger would result in
another larger, and potentially stronger, competitor. Furthermore, Level 3, a
telecommunications and information service company, has announced that it will
spend approximately $3.0 billion to construct a 20,000 mile fiber optic
communications network entirely based on Internet technology. The Williams
Companies, a competitor of the Company, has also announced that it is
accelerating the expansion of its national fiber optic network with a $2.7
billion investment to create a 32,000 mile system by the end of 2001. Important
competitive factors in the private line business are price, customer service,
network location and quality, reliability and availability. See "-- Private Line
Services."
Long Distance Switched Services. Long distance companies may be
characterized as switched or switchless carriers. Sellers of long distance
switched services are generally switched carriers, such as the Company, that own
one or more switches that direct telecommunications traffic. Facilities-based
carriers are generally switched carriers. However, many non-facilities based
carriers (e.g., many long distance resellers) have switches. The Company's
customers for switched services are switchless carriers that depend on switched
carriers to provide long distance switched services to their end users. The
Company's competitors in the long distance switched services business include
AT&T, MCI, Sprint, WorldCom and Frontier and many non-facilities-based switched
carriers. Important competitive factors in the long distance switched services
business are price, customer service (particularly with respect to speed in
delivery of computer billing records and set-up of new end users with the LECs),
ability of the network to complete calls with a minimum of network-caused busy
signals, scope of services offered, reliability and transmission quality.
Call Routing
An inter-LATA long distance telephone call begins with the caller's LEC
transmitting the call by means of its local switched network to a point of
connection with an interexchange carrier. The interexchange carrier, through its
switches and long distance transmission network, transmits the call to the
called party's LEC,
3
6
which then completes the call over its local facilities. For each long distance
call, the originating LEC charges an access fee. The interexchange carrier also
charges a fee for its transmission of the call, a portion of which consists of a
fee charged by the LEC used to deliver the call. Under the Telecom Act, state
proceedings may in certain instances determine LEC access charge rates. Further,
ongoing access charge proceedings at the federal level may affect the access
charges long distance carriers pay to LECs. It is uncertain at this time what
effect such proceedings may have on such rates.
Technology
Long distance voice traffic generally is transmitted through digital
microwave or fiber optic systems. Long distance data traffic is generally
transmitted through fiber optic systems or satellites.
Fiber Optic Systems. Fiber optic systems use laser-generated light to
transmit voice and data in digital format through fine strands of glass. Fiber
optic systems are characterized by large circuit capacity, good sound quality,
resistance to external signal interference and direct interface with digital
switching equipment. A pair of modern fiber optic strands, using current
technology, is capable of carrying four OC-192s. Because fiber optic signals
disperse over distance, they must be regenerated at sites located along the
fiber optic cable (on older fiber optic systems the interval is 20 to 25 miles;
on newer systems that utilize modern fiber optic cable and splicing methods,
such as will be used in the expansion of the Company's digital
telecommunications network (the "Network"), it is approximately 50 to 75 miles).
Microwave Systems. Although limited in capacity in comparison with fiber
optic systems (generally, no more than 28 DS-3s can be transmitted by microwave
between two antennae), digital microwave systems offer an effective and reliable
means of transmitting voice and data signals over intermediate and longer
distances. Microwaves are very high frequency radio waves that can be reflected,
focused and beamed in a line-of-sight transmission path. Because of their
electro-physical properties, microwaves can be used to transmit signals through
the air, with relatively little power. To create a communications circuit,
microwave signals are transmitted through a focusing antenna, received by an
antenna at the next station in the network, then amplified and retransmitted.
Because microwaves attenuate as they travel through the air, this transmission
process must be repeated at repeater stations, which consist of radio equipment,
antennae and back-up power sources, located on average every 25 miles along the
transmission network.
BUSINESS STRATEGY
The Company's objective is to become the preferred provider of integrated
network-based information delivery solutions, utilizing its high-capacity,
state-of-the-art national fiber network. The Company's primary near-term goals
are to: (i) increase revenues by using the expanded Network to generate new
customers and increasing business from existing customers; (ii) improve
profitability by migrating traffic from circuits leased from other carriers onto
the Network; (iii) enter into additional cost-saving arrangements with other
carriers to reduce the cost of the existing Network construction and develop
additional Network expansion opportunities; (iv) leverage the relationship with
PSINet to generate new Internet services customers and large account customers
who require bundled voice, data and Internet transmission services; and (v)
complete the acquisition and integration of NLD, including the migration of its
traffic onto the Network.
In order to achieve these goals the Company intends to pursue the following
strategy:
Enter Into Cost-Saving Arrangements. The Company has included excess fiber
in its Network expansion which it is using to reduce the net cost of
construction through: (i) leasing or selling excess fiber to other carriers; and
(ii) exchanging excess fiber for fibers or capacity on other carriers' networks.
Additionally, the Company seeks to obtain the right to install Company-owned
fibers in new routes being constructed by other carriers along the proposed
Network expansion routes in exchange for the Company (a) sharing network
construction costs; (b) allowing the other carrier to use excess fiber along
certain routes in the Network; or (c) allowing the other carrier to add its own
fiber to certain segments of the Network.
4
7
The Company has already entered into cost-saving agreements with other
carriers that are expected to reduce the per-route-mile cost of construction,
including:
(i) a contract with WorldCom pursuant to which each company has
constructed a fiber route approximately 1,100 miles long and placed fibers
for both companies along the route;
(ii) contracts with LCI pursuant to which LCI has agreed to purchase
an IRU in fibers from Chicago to Los Angeles for approximately $97.9
million (the "Chicago-LA LCI Fiber Sale") and from Cleveland to New York
for approximately $20.0 million (the "Cleveland-NY LCI Fiber Sale");
(iii) a contract with MCI pursuant to which MCI has agreed to purchase
an IRU in fibers from New York to Los Angeles for approximately $121.0
million (the "MCI Fiber Sale");
(iv) a contract with Vyvx to exchange the use of certain fibers on the
Company's New York to Los Angeles route for the use of fibers on an
approximately 1,760-mile route under construction by Vyvx from Washington
D.C. to Houston;
(v) joint construction agreements with LCI, DTI and CCTS allowing the
Company to share the costs of constructing certain routes in Illinois, Ohio
and Missouri;
(vi) a contract with MFS pursuant to which MFS will include fibers for
the Company in a route it is constructing from Cleveland to New York;
(vii) contracts with GST and WorldCom providing for the sale of fiber
along certain routes;
(viii) a contract with FTV to exchange the use of certain fibers on
the Company's Las Vegas to Los Angeles route for the use of fibers on FTV's
Las Vegas to Portland route;
(ix) a contract with MFN to exchange the use of certain fibers on the
Company's Chicago to New York route for the use of fibers on MFN's
Washington D.C. to New York route; and
(x) a contract with GST to exchange the use of certain fibers on the
Company's Phoenix to Los Angeles route for the use of fibers on GST's route
from Los Angeles to Oakland (near San Francisco).
Reduce Operating Costs. The Company expects to achieve substantial
operating cost savings from the Network expansion by replacing a portion of the
capacity it leases from other carriers with its own Network capacity. The
Company incurred costs of approximately $92.2 million for leased off-net fiber
optic capacity from other carriers in 1997. Although revenue growth may result
in increased future off-net usage, the Company believes the Network expansion
will result in reduced expenditures for capacity currently leased off-net (as
well as reduced expenditures for future capacity otherwise required to support
revenue growth) and increased operating cash flow, because the new fiber routes
(i) are targeted for geographic areas that the Network currently does not reach
or is capacity limited or where the Company leases off-net capacity and (ii)
will allow the Company to enter into additional exchanges of fiber capacity on
new routes with other carriers.
Increase Private Line Revenues. Geographic limitations and nearly full
utilization of the then-existing Network previously limited the Company's
ability to expand its private line business. The Network expansion has added
high-capacity new routes and substantially increased the capacity of certain
existing routes, allowing the Company to lease additional circuits to its
customers, including high-capacity, high-margin circuits such as OC-3s, OC-12s
and OC-48s. The Company has already generated significant orders for capacity on
the new routes. The Company continues to seek significant new orders over the
Network expansion routes and believes that it is well positioned to obtain such
orders.
Additionally, the Company specifically designed the Network expansion along
routes geographically diverse from those of other facilities-based carriers. In
recent years, companies such as AT&T and MCI have used the Company to provide
alternative routes to help protect their networks in the event of a service
outage. Such companies prefer routes separated geographically from their own
networks to increase the possibility that the alternative route will be
functional in the event of a natural disaster. The Company believes that the
5
8
Network expansion greatly increases the attractiveness of the Company's Network
as an alternative routing network backup to the major carriers.
Expand the Long Distance Switched Services Business. The Company has
established itself as an alternative provider of long distance switched services
with nation-wide origination and domestic and international termination
capability with switched services revenues in 1997 of $258.3 million. The
Company currently has over 100 customers and believes that it is well positioned
to attract other long distance resellers for its long distance switched
services. The Company believes that the low embedded cost of its Network
provides a significant advantage when competing to provide long distance
switched traffic to resellers, cable companies, RBOCs, utility companies and
others which are permitted to enter the long distance business under recent
changes in telecommunications law. By the end of 1998, the Company intends to
add four additional long distance voice/data switches which, if installed, will
provide additional capacity to originate and terminate traffic. Although the
Company has not yet achieved positive EBITDA in its long distance switched
services business, the Company is seeking to improve the results in this
business by continuing to seek a more efficient customer traffic mix and by
increasing the scale and scope of traffic carried over its Network.
Specifically, the Company's focus is on (i) obtaining traffic that meets its
profitability requirements and aligns with the Company's current and planned
Network, (ii) identifying new products and customers with large capacity
requirements, (iii) identifying Internet, intranet and data traffic
opportunities and (iv) identifying joint venture and acquisition candidates that
will increase the flow and mix of traffic in the Company's Network and increase
its reach.
Expand Data and Internet Business. The Company is using advanced fiber
optic technology in its Network expansion. The expanded Network's SONET
technology and broadband capabilities provide a platform to support advanced,
capacity-intensive products such as Frame Relay, ATM, multimedia, and
Internet-related applications. The Company has equipped its network with 15 data
switches (8 more are expected by the end of 1998) and other equipment necessary
to enter into the Frame Relay and ATM transmission business. The Company has
agreed to acquire a small company with data communications expertise to increase
its data engineering capabilities. The acquisition, in which the Company will
issue approximately 42,000 shares of Common Stock, is scheduled to close in the
first half of 1998.
To enhance the Company's product and service offerings, in February 1998,
the Company consummated agreements with PSINet which allow each party to market
and sell the products and services of the other party. Under the terms of the
agreements, the Company will provide PSINet with a 20-year IRU in 10,000 miles
of OC-48 transmission capacity on its Network in exchange for approximately 10.2
million shares representing 20% (post-issuance) of PSINet's common stock.
Establish Long-Term Customer Relationships. The Company seeks to establish
a dependable revenue stream through long-term relationships with its customers.
The Company has private line contracts (generally on a long-term basis) with
over 230 long distance carriers, including AT&T, MCI, Sprint, WorldCom, Cable &
Wireless, Frontier and LCI. The Company has historically enjoyed a high customer
retention rate in its private line business. Although the Company's switches
first became fully operational in the first quarter of 1996, the Company has
already entered into contracts with over 100 long distance resellers.
Provide a Sophisticated Automated Software Interface. The Company seeks to
increase its attractiveness to existing and potential customers of switched long
distance services by providing a sophisticated automated interface to the
Company's computer system through its proprietary IXC Online software. Utilizing
IXC Online, customers are able to access up-to-date information regarding their
end-user customers and the calls made by such end-users. IXC Online is designed
to allow each of the Company's carrier customers to: (i) download call detail
records for its end-users for billing purposes; (ii) arrange with the
appropriate LEC to register the carrier as the designated long distance carrier
for its new end-users; and (iii) file trouble reports for resolution.
6
9
THE COMPANY'S NETWORK
Facilities
As of December 31, 1997, the Network included over 10,500 digital route
miles (including over 5,500 fiber route miles). The Network is expected to
include over 11,500 digital route miles (including over 6,500 fiber route miles)
by the end of the first quarter of 1998. Prior to beginning construction of the
Network expansion in late 1995, the Company owned a digital coast-to-coast
network containing over 1,900 route miles of fiber optic cable and over 5,000
route miles of digital microwave. As of December 31, 1997, the Company had over
3,600 route miles of advanced fiber optic cable and electronics in operation.
The Company is expected to have over 5,000 route miles of advanced fiber optic
cable and electronics in operation by the end of the first quarter of 1998.
The Company's owned facilities are supplemented with approximately 240,000
equivalent DS-3 miles of fiber capacity obtained from other carriers. Of such
capacity, over 200,000 DS-3 miles are leased by the Company. Approximately
39,000 DS-3 miles of such capacity are obtained by the Company through long-
term capacity-exchange agreements with MCI and WorldCom whereby the Company
trades capacity or fibers on its fiber network for capacity on the other
carriers' networks. In addition, the Company has agreements with CCTS and LCI to
exchange OC-48 capacity on certain routes. The Company has been able to
negotiate these significant exchange agreements because of the placement of the
Company's existing Network in locations where other facilities-based carriers
require additional capacity and the comparatively large expense to such other
carriers of constructing new fiber optic facilities. Such exchange agreements
increase the scope of the Network through the addition of the exchanged capacity
while reducing the Company's cash expenditures for off-net facilities.
The Network includes seven digital long distance voice/data switches
located in Los Angeles, Dallas, Chicago, Philadelphia, Atlanta, Joplin, Missouri
and New York, New York each directly connected over either on-net or off-net
private line circuits: (i) to at least two other switching centers; (ii) to
certain of the Company's over 50 Hubs (local connection points); and (iii) to
certain LEC Central Office switches. The Company plans to install four
additional voice/data switches in 1998. The Hubs are connected (generally by
off-net circuits) to LEC Central Office switches, which in turn are connected to
end-user telephone lines. The switches utilize common channel signaling (SS7),
which reduces connect time delays. The Network also includes 15 Frame Relay-ATM
data switches located in major cities. The Company's switched operations are
supplemented by agreements with Frontier and WorldCom. Under such agreements,
Frontier and WorldCom supply switched capacity to the Company on a per-minute
basis, automatically handling calls routed through LEC Central Offices not
connected to the Company's Hubs or switches and calls which exceed the capacity
of the Company's switched network.
The capacity of the Company's switches may be expanded with processor
upgrades, additional memory and ports. The Company plans to add more ports and
other equipment for its existing switches and to add additional switches as
required to accommodate customer demand, including 8 additional Frame Relay-ATM
switches by the end of 1998.
The new fiber optic routes are being constructed with fiber capable of
supporting bi-directional SONET rings for enhanced network reliability. As each
new route is completed and placed into service, it will be equipped with an
OC-48 in order to provide initial transmission capacity. The Company is
currently in the process of equipping certain of its routes with additional
OC-48s in order to meet customer demand for its services.
Network Reliability
The Network offers a reliable means of transmitting large volumes of voice
and data signals. To assist in providing reliable and high-quality transmission
service, all important functions of the network are monitored during regular
business hours from regional operations centers in Columbus, Kansas City, Fort
Worth and Tucson. Thereafter, monitoring is conducted from the Company's
national operations center in its Austin headquarters. The national center also
provides overall system monitoring on a 24-hour basis. This system
7
10
alerts the Company to situations which could affect customer transmission and
generally allows the Company to take remedial actions before customer service is
affected. In addition, at December 31, 1997, the Company employed approximately
83 operations personnel who are based along the Network to perform preventative
maintenance as well as repair functions on its private line network. Company
operations personnel conduct annual system performance testing and make periodic
unannounced visits to terminal sites to evaluate technician performance. At
December 31, 1997, the Company maintained a staff of 31 technicians to provide
maintenance and other technical support services for switched long distance
services.
Network Expansion
In 1995 the Company began a significant expansion of the Network. The
expanded Network is expected to deliver the following significant strategic and
financial benefits to the Company:
(i) substantial savings by allowing the Company to move on to its own
Network a significant portion of its traffic that it currently carries on
circuits which it leases from other carriers;
(ii) high-capacity new routes and substantially increased capacity on
certain existing routes, allowing the Company to increase revenues by
leasing additional circuits to its customers, including high-capacity
circuits such as OC-3s, OC-12s and OC-48s;
(iii) lower underlying transmission and network operating costs;
(iv) sufficient capacity to support increasing demand expected from
Internet and multimedia applications, Frame Relay and ATM; and
(v) reduced capital costs through sales and exchanges of excess fiber
which the Company is including in its Network expansion specifically for
that purpose.
The Network expansion is planned to add thousands of additional fiber route
miles to increase the geographic scope and capacity of the Company's previously
existing network. It will connect the Company's switches with high-capacity
private line circuits, utilizing advanced fiber optic technology capable of
efficiently transmitting capacity-intensive services, such as Internet, Intranet
and multimedia applications, Frame Relay and ATM. The routes of the Network
expansion are planned to be generally geographically diverse from the existing
fiber networks of AT&T, MCI, Sprint and WorldCom.
The Company expects that the Network expansion will produce additional cost
savings by supporting growth in its private line and long distance switched
services businesses which would otherwise require significant off-net capacity
usage. The Network expansion will enable the Company to avoid increased
expenditures for leasing off-net capacity because the new fiber routes: (i)
should carry much of the traffic that would otherwise be transmitted over
off-net circuits and (ii) may enable the Company to enter into additional
exchanges of fiber capacity with other carriers. In this way, the Company seeks
to improve cash flow through increasing revenues and reducing certain costs. The
Network expansion has already enabled the Company to obtain significant orders
for capacity on the new routes. The Company continues to seek significant new
orders over the Network expansion routes and believes that it is well positioned
to obtain such orders.
Frame Relay, ATM and Internet Services. During the first quarter of 1997,
the Company began providing Frame Relay and ATM-based switched data services in
order to capitalize on the growing demand for Internet and electronic data
transfer services. To enhance the Company's product and service offerings, in
February 1998, the Company consummated agreements with PSINet which allow each
party to market and sell the products and services of the other party. Under the
terms of the agreements, the Company will provide PSINet with a 20-year IRU in
10,000 miles of OC-48 transmission capacity on its Network in exchange for
approximately 10.2 million shares representing 20% (post-issuance) of PSINet
common stock. If the value of the PSINet common stock received by the Company is
less than $240.0 million at the earlier of one year after the final delivery of
the transmission capacity (scheduled for late-1999) or four years after the
transaction's closing, PSINet, at its option, will pay the Company cash and/or
deliver additional PSINet common stock to bring the value of the Company's
investment to $240.0 million. Upon delivery of the transmission capacity to
8
11
PSINet, the Company will begin to receive a maintenance fee which, as the full
capacity has been delivered, should increase to approximately $11.5 million per
year.
Construction. The Company has planned the Network expansion to cover, to
the greatest extent practicable, routes where one or more of the following
factors are present: (i) customer demand indicates a need for high-capacity
fiber network on the route; (ii) the route is attractive as a complement to the
routes of other carriers, which may enable the Company to lease its new capacity
on the route to other carriers or exchange a portion of its new capacity on the
route for capacity from other carriers; or (iii) the capacity will replace
capacity leased by the Company from other carriers.
Plans to complete the Network expansion along the following routes (the
routes and expected delivery dates are subject to change) are as follows:
(i) One route will consist of a fiber optic route to supplement the
Company's existing New York-Los Angeles route, which consists primarily of
digital microwave facilities which are now used to capacity. This
coast-to-coast route is to extend from New York to Los Angeles over new
fiber optic cable through upstate New York, Cleveland, Chicago, St. Louis,
Dallas, Phoenix and Las Vegas. This route, much of which is already
complete, is scheduled for completion during the first quarter of 1998.
(ii) An additional route is now under construction from Washington,
D.C. to Atlanta and then to Houston. The Washington-Atlanta portion of the
route will be constructed by Vyvx and is scheduled for completion in
mid-1998. Additions to the route, from New York to Washington, D.C. and
Houston to Dallas, are scheduled to be completed by the end of 1998.
(iii) Routes are also planned for construction from Los Angeles to San
Francisco, and to link Toledo, Detroit and Chicago.
Additional routes will be added to the Network expansion as opportunities
for advantageous cost sharing or exchange arrangements arise or as customer
demand requires.
The Company plans generally to light initially only two to four of the new
fibers in the route from New York to Los Angeles via St. Louis and the route
from New York to Houston via Atlanta. Certain of the remaining fibers will be
reserved and used as a platform to support emerging capacity-intensive data and
multimedia applications. The Company intends to light additional fibers as
needed in the future and may use the other additional fibers for sale or
exchange arrangements, such as the PSINet transaction. See "-- Business
Strategy" and "-- Risk Factors -- Risks Relating to the Network Expansion."
The Company has already entered into cost-saving agreements with other
carriers that have reduced the per-route-mile cost of construction, including:
(i) a contract with WorldCom pursuant to which each company has
constructed a fiber route approximately 1,100 miles long and placed fibers
for both companies along the route;
(ii) the Chicago-LA LCI Fiber Sale and Cleveland-NY LCI Fiber Sale;
(iii) the MCI Fiber Sale;
(iv) a contract with Vyvx to exchange the use of certain fibers on the
Company's New York to Los Angeles route for the use of fibers on a
1,600-mile route under construction by Vyvx from Washington D.C. to
Houston;
(v) joint construction agreements with LCI, DTI and CCTS allowing the
Company to share the costs of constructing certain routes in Illinois, Ohio
and Missouri;
(vi) a contract with MFS pursuant to which MFS will include fibers for
the Company in a route it is constructing from Cleveland to New York (MFS
has been acquired by WorldCom);
(vii) contracts with GST and WorldCom providing for the sale of fiber
along certain routes;
(viii) a contract with FTV to exchange the use of certain fibers on
the Company's Las Vegas to Los Angeles route for the use of fibers on FTV's
Las Vegas to Portland route;
9
12
(ix) a contract with MFN to exchange the use of certain fibers on the
Company's Chicago to New York route for the use of fibers on MFN's
Washington D.C. to New York route; and
(x) a contract with GST to exchange the use of certain fibers on the
Company's Phoenix to Los Angeles route for the use of fibers on GST's route
from Los Angeles to Oakland (near San Francisco).
Cost. The principal components of the cost of the Network expansion will
include: (i) fiber optic cable; (ii) engineering and construction; (iii)
electronics; and (iv) rights-of-way. The rights-of-way will be provided pursuant
to long-term leases or other arrangements (some of which may provide for
substantial continuing payments) entered into with railroads, highway
commissions, pipeline owners, utilities or others. Although the Company has not
yet obtained all the necessary rights-of-way along the planned routes, the
Company anticipates that the rights-of-way will be available.
Through the WorldCom fiber construction agreement, the Vyvx fiber exchange
and the other cost-saving arrangements described above, the Company has reduced
its expected cost of the Network expansion. The Company seeks to enter into
additional cost-saving arrangements such as: (i) leasing or selling excess fiber
to other carriers; and (ii) exchanging excess fiber for fibers or capacity on
other carriers' networks. Additionally, the Company seeks to obtain the right to
install Company-owned fibers in new routes being constructed by other carriers
along the proposed Network expansion routes in exchange for the Company (a)
sharing network construction costs; (b) allowing the other carrier to use excess
fiber along certain routes in the Network; or (c) allowing the other carrier to
add its own fiber to certain segments of the Network. See "-- Risk Factors --
Negative Cash Flow and Capital Requirements." The Company has had experience
with arrangements of this type with several major carriers, including MCI,
Sprint, Cable & Wireless, WorldCom and LCI.
PRIVATE LINE SERVICES
Overview
Substantially all of the Company's 1995 revenues, approximately 49% of its
revenues in 1996 and approximately 39% of its revenues in 1997 were generated by
its private line business. The Company has over 230 active private line
customers.
Strategy
The Company is seeking to increase revenues in its private line business
through meeting these primary objectives: (i) expanding its Network to provide
additional capacity on its existing routes and high-capacity new routes to
provide access to major population centers (including routes which may be
attractive to major carriers as backup routes); (ii) providing high-quality,
reliable private line services on a fixed-cost basis at rates generally below
those currently offered by AT&T and competitive with those offered by other
carriers; and (iii) using the expanded Network as a platform to support
increased private line circuit demand which is expected to result in the future
from Frame Relay, ATM, multimedia, Internet and other capacity-intensive
applications.
The Company anticipates decreased expenses in its private line business
through the Network expansion, which will allow the Company to move traffic from
circuits leased from other carriers to its own Network.
Customers and Marketing
The Company has over 230 active private line customers, including AT&T,
MCI, Sprint, WorldCom, Cable & Wireless, Frontier and LCI. The Company's private
line contracts provide for fixed monthly payments, generally in advance. Many of
such contracts contain substantial "take or pay" commitments. The Company has
historically enjoyed a high customer retention rate in its private line
business.
The Company markets its private line circuit capacity generally to: (i)
facilities-based carriers that require private line capacity where they have
geographic gaps in their facilities, need additional capacity or require
geographically different, alternative routing; and (ii) non-facilities-based
carriers requiring private line capacity to carry their customers' long distance
traffic. The Company focuses most of its direct sales efforts on
10
13
providing customer support services to existing customers and on adding new
customers. The Company's long-haul circuit sales force at December 31, 1997
consisted of 13 account managers based at the Company's headquarters in Austin
and at direct sales offices in or near Washington, D.C., New Haven, San
Francisco, Kansas City, Chicago, St. Louis, Houston and Sunrise Beach, Missouri.
During 1997, AT&T, Frontier and WorldCom, the Company's three largest
private line customers, accounted for approximately 6.4%, 4.2% and 4.1%,
respectively, of the Company's revenues. The five largest private line customers
during 1997 accounted for approximately 20% of the Company's total revenue. See
"-- Risk Factors -- Reliance on Major Customers."
Prices and Contracts
The Company's strategy is to offer prices generally lower than those of
AT&T and competitive with the prices of other carriers, to permit the Company's
customers, through a stable, long-term fixed pricing structure, to maintain
control over transmission costs. The Company's private line transmission
agreements with its customers generally provide for original terms of one to
three years and for monthly payment in advance on a fixed-rate basis, calculated
according to the capacity and length of the circuit. Many of such contracts
contain substantial "take or pay" commitments. Furthermore, circuit orders under
private line agreements are generally for a term of one year or more and may not
be cancelled by the customer. However, the agreements generally provide that the
customer may terminate the affected service without penalty "for cause" in the
event of substantial and prolonged outages arising from causes within the
Company's control, and for certain other defined causes. Generally, the lease
agreements further provide that the customer may terminate the agreement "for
convenience" at its discretion at any time upon notice to the Company. However,
termination for convenience generally requires either full payment of all
charges through the end of the lease term or the payment of substantial
termination fees intended to allow the Company to recover certain costs and, in
some cases, lost profits. Damages attributable to a customer's termination of
the agreement are generally reduced, however, by an offset for any income the
Company earns from re-leasing the terminated capacity during the remaining
portion of the lease term.
Competition
In providing private line capacity, the Company competes with AT&T, which
is the largest supplier of long distance voice and data transmission services in
the United States, MCI, WorldCom and Sprint, all of which have substantially
greater financial resources than the Company and a far more extensive
transmission network than the Network and numerous regional carriers. MCI and
WorldCom have announced a planned merger, and applications for approval of that
merger are pending. If the MCI/WorldCom merger is approved, the result would be
an even larger, and potentially stronger, entity with which the Company would
have to compete. In addition, as a result of the Telecom Act and an agreement
(the "WTO Agreement") announced in February 1997 by the United States Trade
Representative with the World Trade Organization countries to open world
telecommunications markets to competition which became effective on February 5,
1998, the Company and its customers will also face competition from the RBOCs,
GTE and others such as electric utilities, cable television companies and
foreign companies. Qwest is constructing a coast-to-coast fiber optic network
and Frontier has agreed to pay $500 million for fibers in Qwest's network. Qwest
is, and Frontier may become, a competitor of the Company. In addition, Qwest and
LCI have also recently announced a planned merger. The Qwest/LCI merger would
result in another larger, and potentially stronger, competitor. Furthermore,
Level 3 has announced that it will spend approximately $3.0 billion to construct
a 20,000 mile fiber optic communications network entirely based on Internet
technology. The Williams Companies, a competitor of the Company, has also
announced that it is accelerating the expansion of its national fiber optic
network with a $2.7 billion investment to create a 32,000 mile system by the end
of 2001. Important competitive factors in the long-haul business are price,
customer service, network location and quality, reliability and availability.
See "-- Private Line Services" and "-- Risk Factors -- Competition."
11
14
LONG DISTANCE SWITCHED SERVICES
Overview
In late 1995, the Company expanded into the business of selling long
distance switched services to long distance resellers in order to complement its
private line business and to capitalize on its ability to provide long distance
switched services over its own Network. Long distance switched services are
telecommunications services that are processed through the Company's digital
switches and carried over long-haul circuits and other transmission facilities
owned or leased by the Company. During 1995, the Company set up the
infrastructure for its long distance switched services business by installing
its switches, connecting them to its Network and to the LECs, acquiring
software, hiring personnel and entering into contracts with customers. The
Company's switched network became fully operational in February 1996. The
Company sells long distance switched services on a per-call basis, charging by
MOUs, with payment due monthly after services are rendered.
Strategy
The Company seeks to rapidly increase revenues from its long distance
switched services business through: (i) long-term arrangements with significant
customers and customers the Company considers likely to grow quickly; (ii)
providing a sophisticated automated software interface with its customers; (iii)
offering pricing which is generally lower than that charged by AT&T and
competitive with that of other long distance service providers; and (iv)
acquisitions. The Company seeks to increase the profitability of its long
distance switched services business by decreasing its average cost per MOU
through efficiencies achieved with higher volumes and through reducing network
costs through the Network expansion. See "-- Business Strategy."
Customers and Marketing
The Company focuses its sales efforts on directly contacting large reseller
customers with monthly volumes of at least $1.0 million, and growing resellers
with volumes between $50,000 and $250,000 per month that the Company expects to
be reasonably likely to grow to the $1.0 million per month level. The Company's
switched-products sales force at December 31, 1997 included 18 sales executives
based at the Company's headquarters in Austin and at direct sales offices in
Atlanta, Dallas, Denver and Los Angeles. Although sales of long distance
switched services to end-user customers do not currently account for a
significant portion of the Company's switched long distance business, Telecom
One, a company which the Company acquired in July 1997, and NLD, a company which
the Company expects to acquire in 1998, each sell directly to end users. In
addition, the Company may, from time to time, consider acquiring other long
distance resellers or end-user customer bases.
Excel. Excel, the Company's largest customer of switched long distance
services, is contractually obligated to utilize at least 70 million minutes of
traffic per month. Excel's commitment continues through the earlier of the date
on which Excel has routed 4.2 billion minutes over the Network or June 30, 2001.
The minimum commitment is subject to reduction or termination: (i) if Excel
installs its own switches and invites the Company to bid along with other
carriers (to win such bids, the Company would have to be the lowest bidder) to
provide Excel with the long-haul circuits utilized by such switches (even if
this did occur, Excel would still have to meet the minimum commitment of 70
million minutes per month until June 30, 1998); or (ii) for breach of contract
by the Company or for other reasons which the Company believes should be under
its control. Although Excel's minimum commitment is 70 million minutes per
month, its usage increased substantially above the minimum commitment by
December 1996. At December 31, 1997, Excel had routed approximately 2.0 billion
minutes over the Network. The Company is Excel's main or sole supplier of 1 Plus
Switched Service in over 50 LATAs.
Customer Contracts. The Company's rates for switched long distance services
generally vary with the duration of the call, the day and the time of day the
call was made and whether the traffic is intrastate, interstate or
international. The rates charged are not affected by which facilities are
selected by the Company's switching centers for transmission of the call or by
the distance of the call. Different rates are applied to combined origination
and termination services than are applied to termination services. The
agreements
12
15
between the Company and its customers for long distance switched services
generally provide for payment in arrears based on MOUs. The agreements generally
also provide that the customer may terminate the affected service without
penalty in the event of substantial and prolonged outages arising from causes
within the Company's control, and for certain other defined causes. Generally,
the agreements provide that the customer, in order to avoid being obligated to
pay higher rates (or, in some cases, penalties), must utilize at least a minimum
dollar amount (measured by dollars or MOUs) of long distance switched services
per month for the term of the agreement. In certain new contracts, the Company
is including provisions to provide for financial penalties for a customer's
failure to provide the expected traffic distributions.
Customer Care. The Company believes that customer support is an important
factor in attracting and retaining customers for its long distance switched
services. Customer service for long distance switched services includes
processing new accounts, responding to inquiries and disputes relating to
billing, credit adjustments and cancellations and conducting technical repair
and other support services. IXC Online is designed to allow each of the
Company's carrier customers to: (i) download current call detail records for its
end-users for billing purposes; (ii) arrange with the appropriate LEC to
register the carrier as the designated long distance carrier for its new end
users; and (iii) file trouble reports for resolution. The Company employed
approximately 65 people in its long distance switched services customer service
group as of December 31, 1997. See "-- Risk Factors -- Development Risks and
Dependence on Long Distance Switched Services Business."
Decreased Costs through Increased Volumes or Greater Efficiency
Large MOU volumes should enable the Company to spread its fixed costs over
more MOUs and to more efficiently configure its network, reducing the cost per
MOU. The Company seeks to efficiently configure the circuits available so that
calls are completed on a cost-effective basis. The Company periodically analyzes
calling patterns using mathematical formulas to determine the circuit capacity
required to cost-effectively service the expected call volume. For example, if
there is sufficient calling traffic available, the Company may upgrade
transmission circuitry in an area from DS-1 to DS-3. A similar analysis will be
made when deciding whether to install a new switch in a region. The Company is
continuing to develop procedures to better analyze its expected traffic patterns
in order to enhance Network efficiency and identifying customers generating an
unprofitable mix of traffic. The Company's strategy of enhancing profitability
through efficiency may have the effect of reducing MOU volume and gross revenue
in the long distance switched services business.
Services
The Company markets a variety of switched long distance services, including
operator services, directory assistance, international service and the
following:
1 Plus Switched Service. Provides direct-dial service over the Company's
Network.
1 Plus Dedicated Service. Provides direct-dial service over the Company's
Network for end users that have arranged to connect to the Company's nearest Hub
through a local loop. This service is less expensive than 1 Plus Switched
Service because the access charges of the end-user's LEC are reduced.
800/888 Switched Service. Provides 800/888 service over the Company's
Network.
800/888 Dedicated Service. Provides 800/888 service over the Company's
Network for end users that have arranged to connect to the Company's nearest Hub
through a local loop. This service is less expensive than 800/888 Switched
Service because the access charges of the end-user's LEC are reduced.
Calling Card Service. Provides telephone card service.
Debit Card Service. Provides prepaid telephone card service.
Switched Termination Service. Provides carrier customers having use of a
switch in one area with termination services in other areas.
13
16
Acquisitions
As part of its growth strategy, the Company acquired Telecom One in July
1997 using shares of its Common Stock as consideration and entered into an
agreement in December 1997 to acquire NLD using shares of its Common Stock as
consideration. In addition, the Company has agreed to acquire with Common Stock
a small company with data communications expertise to increase its data
engineering capabilities. The Company may, from time to time, acquire other
businesses, assets or securities of companies which it believes provide a
strategic fit with its business and network. Although the Company currently has
no other commitments or agreements with respect to any material acquisitions, it
has reviewed potential acquisition candidates and has held preliminary
discussions with a number of these candidates. The Company may use Common Stock
as consideration for other acquisitions.
The Company has agreed to acquire NLD, a long-distance reseller with over
$100.0 million in revenue in 1997, for approximately 4.3 million shares of
Common Stock (including approximately 300,000 shares issuable with respect to
NLD options and warrants). NLD has a national direct sales force selling
primarily to small and medium-sized businesses. The Company believes it can
improve the profitability of NLD because it can lower its costs of call
transmission. This acquisition is a part of a Company strategy to expand by
acquiring select resellers on advantageous terms as opportunities arise. The
Company believes that its acquisition of NLD will provide an important
foundation for growth in the business retail long distance market, however,
there can be no assurances that the acquisition, if consummated, will have such
effect. See "-- Risk Factors -- Integration of Acquired Businesses; Business
Combinations."
Competition
The Company competes with numerous facilities-based interexchange carriers,
some of which are substantially larger, have substantially greater financial,
technical and marketing resources and utilize larger transmission systems than
the Company. AT&T is the largest supplier of long distance switched services in
the United States inter-LATA market. The Company also competes in selling long
distance switched services with: (i) other facilities-based carriers, such as
MCI, Sprint, WorldCom, Quest, The Williams Companies and certain regional
carriers, and (ii) certain non-facilities-based carriers. MCI and WorldCom have
announced a planned merger, and applications for approval of that merger are
pending. If the MCI/WorldCom merger is approved, the result would be an even
larger, and potentially stronger, entity with whom the Company would have to
compete. Frontier has agreed to pay $500.0 million for fibers in Qwest's
network. Qwest is, and Frontier may become, a competitor of the Company. In
addition, Qwest and LCI have also recently announced a planned merger. The
Qwest/LCI merger would result in another larger, and potentially stronger,
competitor. Furthermore, Level 3 has announced that it will spend approximately
$3.0 billion to construct a 20,000 mile fiber optic communications network
entirely based on Internet technology. The Williams Companies has also announced
that it is accelerating the expansion of its national fiber optic network with a
$2.7 billion investment to create a 32,000 mile system by the end of 2001. As a
result of the Telecom Act and recent WTO Agreement, the Company will also now
face competition from the RBOCs, GTE and others such as electric utilities,
cable television companies and foreign companies. The Company believes that the
principal competitive factors affecting it are price, customer service
(particularly with respect to speed in delivery of computer billing records and
set-up of new end users with the LECs), ability of the network to complete calls
with a minimum of network-caused busy signals, scope of services offered,
reliability and transmission quality. The ability of the Company to compete
effectively will depend upon its ability to maintain high-quality services at
prices generally equal to or below those charged by its competitors. In the
United States, price competition in the long distance business has been
intensive over the last five years. In 1995, the FCC reclassified AT&T as a
"non-dominant" carrier, freeing AT&T from price regulation of its long distance
services. Since the Company believes that its customers generally price their
service offerings at or below the prices charged by AT&T for its
telecommunications services, reductions by AT&T in its rates may necessitate
similar price decreases by the Company. See "-- Risk Factors -- Competition."
14
17
REGULATION
Certain subsidiaries of the Company operate as communications common
carriers. These subsidiaries are subject to applicable FCC regulations under the
Communications Act of 1934, as amended (the "Communications Act"), some of which
may be affected by the Telecom Act of 1996 and regulations being promulgated
thereunder. See "-- Risk Factors -- Recent Legislation and Regulatory
Uncertainty." In addition, those subsidiaries which operate the Company's
microwave Network are subject to applicable FCC regulations for use of the radio
frequencies. The FCC issues licenses to use certain radio frequency spectrum at
transmitter site locations. Each license gives the Company the right to operate
the microwave radio station for the term of the license. Currently, the Company
holds licenses to operate the microwave sites in the Network. The licenses all
expire in 2001. These licenses are renewable upon application containing a
statement that they are used in compliance with the applicable FCC rules. The
Company expects that the FCC will renew its licenses in due course. The
Communications Act currently limits ownership of an entity holding such licenses
by non-U.S. citizens, foreign corporations and foreign governments. The Company
is subject to regulation by the Federal Aviation Administration with respect to
the construction of transmission towers and to certain local zoning regulation
affecting construction of towers and other facilities.
Recent court decisions (which were issued before the Telecom Act of 1996)
require the FCC to require carriers to file tariffs. However, the FCC currently
does not actively exercise its authority to regulate such carriers' rates and
services. Moreover, the Telecom Act of 1996 gives the FCC authority to forbear
from applying certain provisions of the Communications Act, including the
requirement that carriers file tariffs. The FCC has recently issued an order
implementing a mandatory detariffing policy that eliminates the tariff
requirements for non-dominant interstate, interexchange carriers. An appeal of
the FCC's order resulted in the order being stayed. The appeal is being held in
abeyance, pending the FCC's action on motions for reconsideration. Regardless of
the outcome of the detariffing proceeding, the FCC will retain jurisdiction to
act upon complaints against any common carrier for failure to comply with its
statutory obligations as a common carrier.
The FCCs reclassification of AT&T as a non-dominant carrier may affect the
Company, because it competes with AT&T. The FCC's current and future actions
could result in decreases in the rates charged to end-user customers by AT&T and
other competitors for their services. Thus, one effect of the FCC's action may
be to further intensify price competition among long distance companies.
The FCC regulates many of the rates, charges and services provided by the
LECs. Such regulation can also affect the costs of business for the Company, its
customers and its competitors, because carriers such as the Company must
purchase local access services from LECs to originate and terminate calls. The
FCC's current price cap regulation of the RBOCs and other LECs provides them
with considerable flexibility in pricing their services. The FCC recently issued
two orders regarding access charge reform and transport rate structure and
pricing. Both orders have been appealed and in the interim, on January 1, 1998,
LEC tariffs implementing the requirements of the FCC orders went into effect.
The outcomes of the appeals, and the outcomes of any subsequent FCC rulemaking
proceedings, are impossible to predict, but future changes with respect to
access charges are likely. Although some increases in certain elements of access
charges are anticipated in mid-1998, the overall effect of access charge reform
on the Company is currently uncertain. Further, on July 18, 1997, in Iowa
Utilities Board v. FCC, the United States Court of Appeals for the Eighth
Circuit invalidated key portions of the FCC's August 29, 1996 interconnection
order, which the FCC had adopted to facilitate the emergence of local exchange
competition. The Supreme Court recently agreed to hear an appeal of the Eighth
Circuit's ruling. The further emergence and development of local exchange
competition may likely be delayed as a result. Consequently, the Company and its
customers may not benefit as quickly from the lower access costs that might
otherwise have resulted had competition in the provision of local access
services not been thus delayed.
The Telecom Act directed the FCC to establish a system for compensating
payphone service providers ("PSPs") on a per-call basis for calls made from
payphones, including coinless calls, such as calling card, collect, and "800"
calls. On October 9, 1997, the FCC released an order that set a $0.284 per-call
"default" rate that long distance carriers are required to pay to PSPs for
certain coinless calls. Although the FCC's order
15
18
has gone into effect, it is being appealed, and the amount of compensation long
distance carriers will ultimately be required to pay to PSPs is currently
uncertain.
In addition, the Telecom Act allows the RBOCs and others to enter the long
distance business. Entry of the RBOCs or other entities such as electric
utilities and cable television companies into the long distance business may
have a negative impact on the Company or its customers. The Telecom Act also
establishes criteria for RBOC re-entry into in-region long distance markets, and
RBOCs are required to obtain FCC approval before they can begin providing such
services. To date, the FCC has rejected four such RBOC applications, at least
one of which is being appealed. However, on December 31, 1997, the U.S. District
Court for the Northern District of Texas ruled that the provisions of the
Telecom Act that apply specifically to RBOCs are unconstitutional. On February
11, 1998, the District Court stayed its order, and the order has been appealed.
While the outcome of the appeal is impossible to predict, if the district
court's order is upheld, the re-entry of the RBOCs into the in-region long
distance market would likely be hastened. Further, the FCC has indicated that it
is attempting to establish a "collaborative process" with the RBOCs to
facilitate the review and ultimately the approval of such applications.
The Telecom Act also provides that state proceedings may in certain
instances determine access charge rates the Company and its customers are
required to pay to the LECs. It is uncertain at this time what effect such
proceedings may have on such rates. There can be no assurance that such rates
will not be increased. Such increases could have a material adverse effect on
the Company and its customers. See "-- Risk Factors -- Recent Legislation and
Regulatory Uncertainty" and "Industry Overview."
The ability of the Company to provide long distance services within any
state is generally subject to regulation by a regulatory board in that State. As
of December 31, 1997, the Company is operating and has obtained the requisite
licenses and approvals in the 48 contiguous continental United States.
MEXICAN JOINT VENTURE
The Company is indirectly participating in the development of a long
distance network to engage in the telecommunications business in Mexico through
Marca-Tel S.A. de C.V. ("Marca Tel"). As of December 31, 1997, the Company
indirectly owned 24.5% of Marca-Tel through its ownership of 50% of Progress
International LLC ("Progress International"), which owned 49% of Marca-Tel. The
remaining 51% of Marca-Tel is owned by a Mexican individual and Fomento Radio
Beep, S.A. de C.V. The other 50% of Progress International is owned by Westel
International, Inc. ("Westel").
As of December 31, 1997, the Company and Westel have jointly contributed or
loaned Progress International a total of $48.7 million, of which $37.0 million
has been provided by the Company. Substantially all of such funds have been used
by Progress International to fund Marca-Tel. The Company is recognizing its
share of the Progress International losses in accordance with its pro rata share
of funds provided to Progress International. The net carrying value for the
Company's interest in Progress International was $11.6 million at December 31,
1997.
In September, 1995, Marca-Tel entered into an agreement with a third party
to construct a portion of Marca-Tel's telecommunications network in Mexico and
to provide significant financing for such construction and related equipment and
fiber purchases. Such third party has been granted security interests in all of
Marca-Tel's assets, including the telecommunications network, and the owners of
Marca-Tel, including Progress International, have pledged their interests in
Marca-Tel to collateralize payment to the third party. As of December 31, 1997,
approximately $49.1 million was owed by Marca-Tel to such third party.
In February, 1998, Marca-Tel announced that it was putting further
investment in new fiber routes on hold, awaiting more suitable regulatory and
market conditions. Because of the continuing adverse regulatory environment in
Mexico, Marca-Tel has determined to limit further investment and to reduce its
scope of operations. At the present time, the Company does not anticipate
significant additional funding to Progress International for investment in
Marca-Tel until the regulatory and market conditions in Mexico improve. The
Company is not obligated to continue to fund Progress International and the
Senior Notes Indenture and the terms of the Exchangeable Preferred Stock contain
significant limitations on the amount the Company may
16
19
invest in Progress International and other non-majority owned entities. However,
failure to provide further significant funding to Progress International is
likely to result in a default under Marca-Tel's financial arrangements and could
result in the foreclosure of the third party's security interest. The Company's
interest in Progress International, and thus its indirect interest in Marca-Tel,
therefore could be diluted or lost entirely.
The forward-looking statements set forth above with respect to the capital
needs of Progress International and of Marca-Tel and the successful completion
and operation of Marca-Tel's fiber optic system in Mexico are based on certain
assumptions as to future events. Important assumptions, which if not met, could
adversely affect Marca-Tel's ability to achieve satisfactory results include
that: (i) there will be no significant delays or cost overruns with respect to
the network expansion; (ii) the Company's contractors and partners in cost-
saving arrangements will perform their obligations; (iii) rights-of-way can be
obtained in a timely, cost-effective basis; (iv) the routes of the network
expansion are substantially completed on schedule; (v) Marca-Tel can
successfully operate its long distance switched services business on a cost
effective basis (including the provision of billing information in an accurate
and timely manner) for volumes that it has not previously handled; (vi)
Marca-Tel can obtain sufficient funds from debt or equity offerings, joint
venture arrangements, accounts, additional vendor financing, or otherwise and
(vii) regulatory and market conditions improve.
EMPLOYEES
As of December 31, 1997, the Company employed 712 people, of whom 349
provided operational and technical services, 67 provided engineering services
and the balance were engaged in administration and marketing. The Company's
employees are not represented by any labor union. The Company considers its
employee relations to be good and has not experienced any work stoppages.
RISK FACTORS
Statements contained in this Annual Report on Form 10-K regarding the
Company's expectations with respect to its network expansion, related financings
and fiber sale and cost-saving agreements, future operations and other
information, which can be identified by the use of forward-looking terminology,
such as "may," "will," "expect," "anticipate," "estimate," "believe," "seek" or
"continue" or the negative thereof or other variations thereon or comparable
terminology, are forward-looking statements. The discussions set forth below
constitute cautionary statements identifying important factors with respect to
such forward-looking statements, including risks and uncertainties, that could
cause actual results to differ materially from results referred to in the
forward-looking statements. There can be no assurance that the Company's
expectations regarding any of these matters will be fulfilled.
Negative Cash Flow and Capital Requirements
The Company's capital expenditures were $314.3 million and interest expense
and capitalized interest were $38.6 million for 1997. The Company's EBITDA was
$15.5 million, its cash flow provided by operating activities was $14.3 million
and its net loss was $94.6 million for 1997. The Company expects to make
substantial capital expenditures in excess of $500.0 million (subject to the
availability of capital) during 1998 and substantial amounts thereafter.
Accordingly, the Company needs and will continue to need a substantial amount of
cash from outside sources. The Company anticipates meeting the cash requirements
relating to such capital expenditures from cash on hand, cash flow from fiber
sales and its operations, other vendor financing, if available, and additional
equity and/or debt financings. The Company intends to incur a substantial amount
of additional indebtedness and may issue a substantial amount of additional
equity securities over the near term. The amount of actual capital expenditures
may vary materially as a result of cost-saving arrangements, increases or
decreases in the amount of traffic on the Network, unexpected costs, delays or
advances in the timing of certain capital expenditures and other factors. The
Company's ability to meet the cash costs of such capital expenditures is
dependent in part upon the Company's ability to complete the construction of the
Network expansion in a timely manner and otherwise perform its obligations to
the satisfaction of each of LCI and MCI so that it can complete the Chicago-LA
LCI Fiber Sale and the MCI Fiber Sale, to enter into cost-saving arrangements
with carriers or other large users of fiber capacity, to
17
20
otherwise raise significant capital and/or to significantly increase its cash
flow. The failure of the Company to accomplish any of the foregoing may
significantly delay or prevent such capital expenditures, which would have a
material adverse effect on the Company and the value of the Common Stock and its
other securities.
The Company's long distance switched services business will require cash to
meet operating expenses. In order to offer long distance switched services, the
Company installed switches, connected them to its Network and to the LECs (as
defined), acquired software and hired the personnel needed to establish a
national switched network. The Company's long distance switched services
business generated negative EBITDA for 1996 and 1997 and the Company believes it
may be negative during 1998, due to, among other things, access costs and uneven
traffic patterns creating high network overflow costs. Although the Company has
not yet achieved positive EBITDA in its long distance switched services
business, the Company is seeking to improve the results in this business by
increasing the scale and scope of traffic carried over its Network.
Specifically, the Company's focus is on (i) obtaining traffic that meets its
profitability requirements and aligns with the Company's current and planned
Network, (ii) identifying new products and customers with large capacity
requirements, (iii) identifying Internet, intranet and data traffic
opportunities and (iv) identifying joint venture and acquisition candidates that
will increase the flow and mix of traffic in the Company's Network and increase
its global reach. For a discussion of important factors that could cause the
Company's long distance switched services business to fail to generate positive
EBITDA, see "-- Risk Factors -- Development Risks and Dependence on Long
Distance Switched Services Business."
The Company is required to make annual interest payments of $35.6 million
with respect to the Company's outstanding $285.0 million principal amount of the
Senior Notes. The Company will also be required to make interest payments and,
beginning June 30, 1998, principal payments in connection with borrowings under
a secured equipment financing facility of up to $28.0 million (approximately
$18.0 million of which had been borrowed at March 1, 1998) entered into with
NTFC Capital Corporation and Export Development Corporation, in July 1997 (the
"NTFC Equipment Facility"). Delays in the Network expansion, larger than
anticipated capital expenditures for the Network or continued negative cash flow
from the long distance switched services business could impair the ability of
the Company to meet its obligations under the Senior Notes and other
indebtedness, to pay cash dividends on the Convertible Preferred Stock and the
Exchangeable Preferred Stock and to access additional sources of funding, any of
which would have a material adverse effect on the Company and the value of the
Common Stock and its other securities. See "-- Risk Factors -- Risks Relating to
the Network Expansion," and "-- Risk Factors -- Development Risks and Dependence
on Long Distance Switched Services Business."
The Company anticipates that in the event it is unable to obtain vendor
financing on acceptable terms, consummate the MCI Fiber Sale and the Chicago-LA
LCI Fiber Sale, or sell additional equity and/or debt securities in order to
complete its planned Network expansion, it may be required to curtail or delay
its planned Network expansion. Furthermore, before incurring additional
indebtedness, the Company may be required to obtain the consent of, or repay,
its debtholders. The Company's failure to obtain additional financing or, in the
alternative, its decision to curtail or delay its planned network expansion
could have a material adverse effect on its business, results of operations and
financial condition.
In October 1997, the Company formed a joint venture with Telenor AS, the
Norwegian national telephone company, to provide telecommunication services to
carriers and resellers in nine European countries. The joint venture is owned 40
percent by the Company, 40 percent by Telenor Global Services AS ("Telenor"),
and 20 percent by Clarion Resources Communications Corporation, a U.S.-based
telecommunications company in which Telenor owns a controlling interest.
Although the Company cannot accurately predict the capital that will be required
to implement such joint venture (the "European Joint Venture"), the Company
estimates that its 1997 funding of approximately $5.8 million will be sufficient
for 1998. However, there can be no assurance that the European Joint Venture
will not require more capital from the Company during 1998 and thereafter.
In December 1997, the Company formed Unidial Communications Services, LLC,
a joint venture with Unidial Incorporated ("Unidial"). The joint venture is
building a direct sales force to market and sell Unidial's and the Company's
products over the Company's Network. The joint venture is owned 80 percent by
18
21
Unidial and 20 percent by the Company. Subject to the terms of the joint venture
agreement, upon request of the President of the joint venture, the Company is
obligated to contribute up to an additional $7.5 million during 1998 and after
November 1, 1998, it may be obligated to contribute up to an additional $4.0
million. After its funding obligation is fulfilled, the Company is not required
to fund any future contributions to the joint venture, but to the extent Unidial
funds such contributions, the Company's interest in the joint venture may be
diluted.
The cash requirements described above do not include any cash which may be
required for acquisitions the Company may make. See "-- Risk
Factors -- Integration of Acquired Businesses; Business Combination."
Substantial Indebtedness
The Company is highly leveraged. As of December 31, 1997, the Company had
outstanding approximately $320.3 million of long-term debt and capital lease
obligations (including the current portion thereof) principally consisting of
its outstanding $285.0 million principal amount of the Senior Notes.
Furthermore, the Company may borrow an aggregate of up to $28.0 million
(approximately $18.0 million of which had been borrowed at March 1, 1998), under
the NTFC Equipment Facility. In addition, the Company is in discussions with
various investment bankers, vendors and lending institutions regarding several
substantial additional debt financings. If such additional debt financings
occur, they will substantially increase the Company's interest expense.
Furthermore, the Company will become more highly leveraged if it exchanges the
Exchangeable Preferred Stock for Exchange Debentures pursuant to the terms of
the Certificate of Designation in connection with the Exchangeable Preferred
Stock.
The Company's significant debt burden could have several important
consequences to the holders of the Common Stock, including, but not limited to:
(i) all or a significant portion of the Company's cash flow from operations must
be used to service its debt instead of being used in the Company's business (in
1997, the Company's cash flow from operations was $14.3 million and interest
expense was $31.3 million); (ii) the Company's significant degree of leverage
could increase its vulnerability to changes in general economic conditions or
increases in prevailing interest rates; (iii) the Company's flexibility to
obtain additional financing in the future, as needed to continue the Network
expansion or for any other reason, may be impaired by the amount of debt
outstanding and the restrictions imposed by the covenants contained in the
Senior Notes Indenture and in agreements relating to other indebtedness; and
(iv) the Company may be more leveraged than certain of its competitors, which
may be a competitive disadvantage. There can be no assurance that the Company's
cash flow from operations will be sufficient to meet its obligations under the
Senior Notes or other indebtedness or the Convertible Preferred Stock or the
Exchangeable Preferred Stock as payments become due or that the Company will be
able to refinance the Senior Notes or other indebtedness at maturity or the
Convertible Preferred Stock or the Exchangeable Preferred Stock upon mandatory
redemption.
The Company anticipates that earnings will be insufficient to cover fixed
charges and cash dividends on preferred stock for the next several years. In
order for the Company to meet its debt and dividend service obligations, and its
dividend and redemption obligations with respect to its preferred stock, the
Company will need to substantially improve its operating results. There can be
no assurance that the Company's operating results will be sufficient to enable
the Company to meet its debt service obligations, and its dividend and
redemption obligations with respect to its preferred stock. In the absence of a
substantial improvement in operating results, the Company would face substantial
liquidity problems and would be required to raise additional financing through
the issuance of debt or equity securities; however, there can be no assurance
that the Company would be successful in raising such financing.
Recent and Expected Losses
The Company reported a net loss of $37.4 million for the year ended
December 31, 1996 and a net loss of $94.6 million for the year ended December
31, 1997, primarily due to substantial depreciation related to capital
expenditures, interest expense associated with the Senior Notes and operational
expenses associated with the long distance switched services business. During
1998 and thereafter, the Company's ability to
19
22
generate operating income, EBITDA and net income will depend to a great extent
on demand for the private line circuits constructed in the Network expansion and
the success of the Company's switched long distance and data services. There can
be no assurance that the Company will return to profitability in the future.
Failure to generate operating income, EBITDA and net income will impair the
Company's ability to: (i) meet its obligations under the Senior Notes or other
indebtedness; (ii) pay cash dividends on the Convertible Preferred Stock and the
Exchangeable Preferred Stock; (iii) expand its long distance switched services
business; and (iv) raise additional equity or debt financing which will be
necessary to continue the Network expansion or which may be required for other
reasons. Such events could have a material adverse effect on the Company and the
value of the Common Stock and its other securities.
Risks Relating to the Network Expansion; Maintenance of Network, Rights-of-Way
and Permits
The continuing Network expansion is an essential element of the Company's
future success. The Company has, from time to time, experienced delays with
respect to the construction of certain portions of the Network expansion and may
experience similar delays in the future. These delays have postponed the
Company's ability to transfer long distance traffic from leased facilities to
owned facilities. Although the Company has made significant progress,
construction of the New York to Los Angeles via St. Louis route is not yet
complete. The Company has substantial existing commitments to purchase materials
and labor for construction of the Network expansion, and will need to obtain
additional materials and labor which may cost more than anticipated. Substantial
portions of the route from New York to Los Angeles via St. Louis and all of the
route from Washington to Houston via Atlanta are being constructed by
contractors or, pursuant to cost-saving arrangements, by third parties that will
include the Company's fiber in routes such carriers are constructing for their
own use. Difficulties or delays with respect to any of the foregoing may
significantly delay or prevent the completion of the Network expansion, which
would have a material adverse effect on the Company, its financial results and
the value of the Common Stock and its other securities.
The expansion of the Company's Network and its construction or acquisition
of new networks will be dependent, among other things, on its ability to acquire
rights-of-way and required permits from railroads, utilities and governmental
authorities on satisfactory terms and conditions and on its ability to finance
such expansion, acquisition and construction. Once expansion of the Network is
completed and requisite rights and permits are obtained, there can be no
assurance that the Company will be able to maintain all of its existing rights
and permits. Loss of substantial rights and permits or the failure to enter into
and maintain required arrangements for the Company's Network could have a
material adverse effect on the Company's business, financial condition and
results of operations and on the value of the Common Stock and its other
securities.
Dependence Upon Network Infrastructure; Risk of System Failure; Security Risks
The Company's success in marketing its services to business and government
users requires that the Company provide superior reliability, capacity and
security via its Network. The Company's Network and networks upon which it
depends are subject to physical damage, power loss, capacity limitations,
software defects, breaches of security (by computer virus, break-ins or
otherwise) and other disruptions which may cause interruptions in service or
reduced capacity for customers, which could have a material adverse effect on
the Company's business, financial condition and results of operations and on the
value of the Common Stock and its other securities.
Pricing Pressures and Risks of Industry Over-Capacity
The long distance transmission industry has generally been characterized by
over-capacity and declining prices since shortly after the AT&T divestiture in
1984. The Company believes that, in the last several years, increasing demand
has ameliorated the over-capacity and that pricing pressure has been reduced.
However, the Company anticipates that prices for its services will continue to
decline over the next several years. The Company is aware that certain long
distance carriers (WorldCom, MCI, LCI, Qwest and others) are expanding their
capacity and believes that other long distance carriers, as well as potential
new entrants to the industry, are considering the construction of new fiber
optic and other long distance transmission networks. If the MCI/WorldCom merger
or the Qwest/LCI merger is approved, the result would be even larger, and
20
23
potentially stronger, competitor (or competitors) with expanded capacity.
Although the Company believes that there are significant barriers to entry for
some new entrants that may consider building a new fiber optic network, such as
substantial construction costs and the difficulty and expense of securing
appropriate rights-of-way, establishing and maintaining a sufficient customer
base, recruiting and retaining appropriate personnel and maintaining a reliable
network, certain of these barriers may not apply to some new entrants (such as
Qwest, utility companies or railroads which already have significant
rights-of-way). In addition, Level 3 has announced that it will spend
approximately $3.0 billion to construct a 20,000 mile fiber optic communications
network entirely based on Internet technology. The Williams Companies has also
announced that it is accelerating the expansion of its national fiber optic
network with a $2.7 billion investment to create a 32,000 mile system by the end
of 2001. Since the cost of the actual fiber is a relatively small portion of the
cost of building new transmission lines, companies building such lines are
likely to install fiber that provides substantially more transmission capacity
than will be needed over the short or medium term. Further, recent technological
advances have shown the potential to greatly expand the capacity of existing and
new fiber optic cable. Although such technological advances may enable the
Company to increase its capacity, an increase in the capacity of the Company's
competitors could adversely affect the Company's business. If industry capacity
expansion results in capacity that exceeds overall demand in general or along
any of the Company's routes, severe additional pricing pressure could develop.
As a result, certain industry observers have predicted that, within a few years,
there may be dramatic and substantial price reductions and that long distance
calls will not be materially more expensive than local calls. In addition,
several companies (including AT&T and ICG Communications, Inc.) have announced
plans to offer long distance voice telephony over the Internet, at substantially
reduced prices. Price reductions could have a material adverse effect on the
Company and the value of the Common Stock. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Overview."
Development Risks and Dependence on Long Distance Switched Services Business
The success of the Company in the long distance switched services business
is dependent on the Company's ability to generate significant customer traffic,
to manage an efficient switched long distance network and related customer
service and the timely completion of the Network expansion. Prior to 1996 the
Company had not previously managed a switched long distance network and there
can be no assurance that its long distance switched services business can
generate positive EBITDA or net income. The failure of the Company to generate
increased customer traffic, to complete new routes in a timely manner, or to
effectively manage the switched network and related customer service or to
generate positive EBITDA or net income from the long distance switched services
business would have a material adverse effect on the Company. The Company's long
distance switched services business will require cash to meet its operating
expenses. The Company's long distance switched services business generated
negative EBITDA for each of the four quarters of 1996 and 1997 and the Company
believes it may be negative during 1998, due to access costs and uneven traffic
patterns creating high network overflow costs. Although the Company is
attempting to control such costs and improve EBITDA from long distance switched
services, there is no assurance it will be successful. The Company expects that
the Network expansion will result in an improvement in the gross margins and
EBITDA generated by its long distance switched services business. The Company
has experienced and expects to continue to experience difficulties in commencing
services for end users of carrier customers. Although the Company believes that
its performance with respect to these matters has met or exceeded industry
norms, such difficulties may adversely affect the Company's relationships with
its customers.
Important factors that could cause the Company's long distance switched
services business to fail to generate positive EBITDA include changes in the
businesses of the Company's reseller customers, an inability to attract new
customers or to quickly transfer new customers to its Network without problems,
the loss of existing customers, problems in the operation of the switched
network, the Company's lack of experience with long distance switched services,
increases in operating expenses or other factors affecting the Company's revenue
or expenses, including delays in the construction of the Network expansion and
increased expenses related to access charges and network overflow, not all of
which can be controlled by the Company. If traffic does not increase and costs
are not adequately controlled there can be no assurance that the long distance
switched services business will ever generate positive EBITDA. In addition, to
the extent that LECs grant
21
24
volume discounts with respect to local access charges, the Company may have a
cost disadvantage versus the larger carriers. Furthermore, the credit risk for
the Company's long distance switched services business is substantially greater
than the credit risk for the Company's private line business, because switched
long distance customers are charged in arrears on the basis of MOUs (which are
frequently subject to dispute), and because many switched long distance
customers (in particular, resellers of debit card services) are not as well
capitalized as most of the Company's private line customers. The Company's
provision for bad debt was $3.0 million in 1996 (when it had $104.0 million of
long distance switched services revenue) and $17.4 million in 1997 (when it had
$258.3 million of long distance switched services revenue). See "-- Switched
Long Distance Services."
Risks Inherent in Rapid Growth
Part of the Company's strategy is to achieve rapid growth through expanding
its long distance switched services business and through expanding the Network.
In addition, the Company may from time to time make acquisitions of resellers,
such as NLD and Telecom One, which it believes provide a strategic fit with its
business and Network. See "Risk Factors -- Integration of Acquired Businesses;
Business Combinations." The Company's rapid growth has placed, and its planned
future growth will continue to place, a significant and increasing strain on the
Company's financial, management, technical, information and accounting
resources. See "-- Risk Factors -- Dependence on Billing, Customer Services and
Information Systems." Continued rapid growth would require: (i) the retention
and training of new personnel; (ii) the satisfactory performance by the
Company's customer interface and billing systems; (iii) the development and
introduction of new products; and (iv) the control of the Company's expenses
related to the expansion into the long distance switched services business and
the Network expansion. The failure by the Company to satisfy these requirements,
or otherwise to manage its growth effectively, would have a material adverse
effect on the Company and the value of the Common Stock and its other
securities.
Dependence on Billing, Customer Services and Information Systems
Sophisticated information and processing systems are vital to the Company's
growth and its ability to monitor costs, bill customers, provision customer
orders and achieve operating efficiencies. Billing and information systems for
the Company's historical lines of business have been produced largely in-house
with partial reliance on third-party vendors. These systems have generally met
the Company's needs due in part to the low volume of customer billing. As the
Company's long distance operation continues to expand, the need for
sophisticated billing and information systems will increase significantly. For
example, during the first half of 1997, the Company had negative gross margins
in its long distance switched services business, due in part to certain
customers which were using the Company's services for termination in LATAs where
the Company's prices were too low relative to access costs in such LATAs. The
Company's plans for the development and implementation of its billing systems
rely, for the most part, on the delivery of products and services by third party
vendors. Failure of these vendors to deliver proposed products and services in a
timely and effective manner and at acceptable costs, failure of the Company to
adequately identify all of its information and processing needs, failure of the
Company's related processing or information systems or the failure of the
Company to upgrade systems as necessary could have a material adverse effect on
the ability of the Company to reach its objectives, on its financial condition
and on its results of operations and on the value of the Common Stock and its
other securities.
Year 2000 Risks
Certain of the Company's older computer programs identify years with two
digits instead of four. This is likely to cause problems because the programs
may recognize the year 2000 as the year 1900. These problems (the "Year 2000
Problems") could result in a system failure or miscalculations disrupting
operations, including a temporary inability to process transactions, send
invoices or engage in similar normal business activities. The Company has
completed an assessment identifying which programs will have to be modified or
replaced in order to function properly with respect to dates in the year 2000
and thereafter. The Company believes that the cost of modifying those systems
that were not already scheduled for replacement for business
22
25
reasons prior to 2000 is immaterial. Updating the current software to be Year
2000-compliant is scheduled to be completed by mid-1999, prior to any
anticipated impact on operating systems. Although the Company does not expect
Year 2000 Problems to have a material adverse effect on its internal operations,
it is possible that Year 2000 Problems could have a material adverse effect on
(i) the Company's suppliers and their ability to service the Company, to
accurately invoice for services rendered and to accurately process payments
received; and (ii) the Company's customers and their ability to continue to
utilize the Company's services, to collect from their customers and to pay the
Company for services received. The cumulative effect of such problems, if they
occur, could have a material adverse effect on the Company and the value of the
Common Stock and its other securities.
Integration of Acquired Businesses; Business Combinations
As part of its growth strategy, the Company may, from time to time, acquire
businesses, assets or securities of companies which it believes provide a
strategic fit with its business and the Network. Although the Company currently
has no commitments or agreements with respect to any material acquisitions
(other than with respect to NLD), it has reviewed potential acquisition
candidates and has held preliminary discussions with a number of these
candidates. The acquisition of NLD and any other companies will be accompanied
by the risks commonly associated with acquisitions. These risks include
potential exposure to unknown liabilities of acquired companies, the difficulty
and expense of integrating the operations and personnel of the companies, the
potential disruption to the business of the Company, the potential diversion of
management time and attention, the impairment of relationships with and the
possible loss of key employees and customers of the acquired business, the
incurrence of amortization expenses if an acquisition is accounted for as a
purchase and dilution to the stockholders of the Company if the acquisition is
made for stock. Any acquired businesses will need to be integrated with the
Company's existing operations. This will entail, among other things, integration
of switching, transmission, technical, sales, marketing, billing, accounting,
quality control, management, personnel, payroll, regulatory compliance and other
systems and operating hardware and software, some or all of which may be
incompatible with the Company's existing systems. The Company has limited
expertise dealing with these problems. There can be no assurance that services,
technologies or businesses of acquired companies will be effectively assimilated
into the business or product offerings of the Company or that they will
contribute to the Company's revenues or earnings to any material extent. In
particular, transferring substantial amounts of additional traffic to the
Network (as will be required in connection with the acquisition of NLD) can
cause service interruptions and integration problems. The risks associated with
acquisitions could have a material adverse effect on the Company and the value
of the Common Stock and its other securities.
Reliance on Major Customers
The Company's ten largest customers in 1997 accounted for approximately 61%
of its revenues, with Excel, AT&T, WorldCom and Frontier, its four largest
customers, accounting for approximately 28.6%, 6.4%, 4.2% and 4.1% of the
Company's revenue in 1997, respectively. Excel, WorldCom and Frontier, the
Company's three largest customers in 1996, accounted for 35%, 8% and 10% of the
Company's revenues in 1996, respectively.
Most of the Company's arrangements with large customers do not provide the
Company with guarantees that customer usage will be maintained at current
levels. In addition, construction by certain of the Company's customers of their
own facilities, construction of additional facilities by competitors or further
consolidations in the telecommunications industry involving the Company's
customers would lead such customers to reduce or cease their use of the
Company's services which could have a material adverse effect on the Company and
the value of the Common Stock and its other securities.
The Company's strategy for establishing and growing its long distance
switched services business is based in large part on its relationship with
Excel. The failure by the Company to fulfill its obligations to provide a
reliable switched network for use by Excel or the failure by Excel: (i) to
fulfill its obligations to utilize the Company's switched long distance services
(even though such failure could give rise in certain circumstances
23
26
to claims by the Company); (ii) to utilize the volume of MOUs that the Company
expects it to utilize or (iii) to maintain and expand its business, could result
in a material adverse effect on the Company.
Dependence Upon Sole and Limited Sources of Supply
The Company relies on other companies to supply certain key components of
its network infrastructure, including telecommunications services, network
capacity and switching and networking equipment, which, in the quantities and
quality demanded by the Company, are available only from sole or limited
sources. The Company is also dependent upon LECs to provide telecommunications
services and facilities to the Company and its customers. The Company has from
time to time experienced delays in receiving telecommunications services and
facilities, and there can be no assurance that the Company will be able to
obtain such services or facilities on the scale and within the time frames
required by the Company at an affordable cost, or at all. Any such difficulty in
obtaining such services or additional capacity on a timely basis at an
affordable cost, or at all, would have a material adverse effect on the
Company's business, financial condition and results of operations. The Company
also is dependent on its suppliers' ability to provide products and components
that comply with various Internet and telecommunications standards, interoperate
with products and components from other vendors and fulfill their intended
function as a part of the network infrastructure. Any failure of the Company's
suppliers to provide such products could have a material adverse effect on the
Company's business, financial condition and results of operations.
Competition
The telecommunications industry is highly competitive. Many of the
Company's competitors and potential competitors have substantially greater
financial, personnel, technical, marketing and other resources than those of the
Company and a far more extensive transmission network than the Company. Such
competitors may build additional fiber capacity in the geographic areas to be
served by the Network or to be served by the Network expansion. Qwest is
building a new nationwide long distance fiber optic network and Frontier has
agreed to pay $500.0 million to obtain fibers in Qwest's network. If the
MCI/WorldCom merger or the Qwest/LCI merger is approved, the result would be
even larger, and potentially stronger, competitor (or competitors). In addition,
Level 3 has announced that it will spend approximately $3.0 billion to construct
a 20,000 mile fiber optic communications network entirely based on Internet
technology. The Williams Companies, a competitor of the Company, has also
announced that it is accelerating the expansion of its national fiber optic
network with a $2.7 billion investment to create a 32,000 mile system by the end
of 2001. Furthermore, many telecommunications companies are acquiring switches
and the Company's reseller customers will have an increasing number of
alternative providers of switched long distance services. The Company competes
primarily on the basis of pricing, availability, transmission quality, customer
service (including the capability of making rapid additions to add end users and
access to end-user traffic records) and variety of services. The ability of the
Company to compete effectively will depend on its ability to maintain
high-quality services at prices generally equal to or below those charged by its
competitors.
An alternative method of transmitting telecommunications traffic is through
satellite transmission. Satellite transmission is superior to fiber optic
transmission for distribution communications, for example, video broadcasting.
Although satellite transmission is not preferred to fiber optic transmission for
voice traffic in most parts of the United States because it exhibits a slight
(approximately one-quarter-second) time delay, such delay is not important for
many data-oriented uses. In the event the market for data transmission grows,
the Company will compete with satellite carriers in such market. Also, at least
one satellite company, Orion Network Systems, Inc., has announced its intention
to provide Internet access services to businesses through satellite technology.
The Company competes with large and small facilities-based interexchange
carriers as well as with other coast-to-coast and regional fiber optic network
providers. There are currently four principal facilities-based long distance
fiber optic networks (AT&T, MCI, Sprint and WorldCom) and Qwest is building
another. The Company anticipates that each of Qwest and Frontier will have a
fiber network similar in geographic scope and potential operating capability to
that of the Company. The Company also sells long distance switched services to
both facilities-based carriers and nonfacilities-based carriers (switchless
resellers), competing with
24
27
facilities-based carriers such as AT&T, MCI, Sprint, WorldCom and certain
regional carriers. The Company competes in its markets on the basis of price,
transmission quality, network reliability and customer service and support. The
ability of the Company to compete effectively in its markets will depend upon
its ability to maintain high quality services at prices equal to or below those
charged by its competitors many of whom have extensive experience in the long
distance market. In addition, the Telecom Act of 1996 (as defined) will allow
the RBOCs and others to enter the long distance market. When RBOCs enter the
long distance market, they may acquire, or take substantial business from, the
Company's reseller customers. There can be no assurance that the Company will be
able to compete successfully with existing competitors or new entrants in its
markets. Failure by the Company to do so would have a material adverse effect on
the Company's business, financial condition and results of operations. See
"-- Risks Related to Technological Change" and "-- Regulation."
On February 15, 1997, the United States Trade Representative designate
announced that an agreement had been reached with World Trade Organization
("WTO") countries to open world telecommunications markets to competition. The
agreement, known as the WTO Basic Telecommunications Services Agreement, became
effective on February 5, 1998. The WTO Agreement will provide U.S. companies
with foreign market access for local, long distance, and international services,
either on a facilities basis or through resale of existing network capacity. The
WTO Agreement also provides that U.S. companies can