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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2002

Commission file number 333-49397

Focal Communications Corporation
(Exact name of registrant as specified in its charter)

200 N. LaSalle Street
Suite 1100
Chicago, IL 60601
(Address of principal executive offices, including zip code)

(312) 895-8400
(Registrant's telephone number)

        Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or required 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 ý    No o

        The number of shares outstanding of the issuer's common stock, as of July 31, 2002:

        Common stock ($.01 par value) 4,935,829 shares

INDEX

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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

        We make statements in this Quarterly Report on Form 10-Q that are not historical facts. These "forward-looking statements" can be identified by the use of terminology such as "believes," "expects," "may," "will," "should," "anticipates" or comparable terminology. These forward-looking statements include, among others, statements concerning:

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Our business strategy and competitive advantages



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Our anticipation of potential revenues



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Statements regarding the growth of the telecommunications industry and our business



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The market for our services and products



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Forecasts of when we will enter particular markets or begin offering particular services



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Our anticipated capital expenditures and funding requirements



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Anticipated regulatory developments

        These statements are only predictions. You should be aware that these forward-looking statements are subject to risks and uncertainties, including financial and regulatory developments, industry growth and trend projections, that could cause actual events or results to differ materially from those expressed or implied by the statements. The most important factors that could prevent us from achieving our stated goals include, but are not limited to, our failure to:

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Maintain acceptance of our services by new and existing customers



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Attract and retain talented employees



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Successfully introduce and expand our data and voice service offerings on a timely and cost-effective basis



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Respond to competitors in our markets



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Design, provision and install our network infrastructure, including transport facilities, Internet transit services, and unbundled loops



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Execute and renew interconnection agreements with incumbent carriers on terms satisfactory to us



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Enter into and maintain our agreements for transport facilities and services



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Receive full and timely payments from customers



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Prevail in legal and regulatory proceedings regarding inter-carrier revenue or changes to laws and regulations that govern inter-carrier revenue



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Obtain and maintain any required governmental authorizations, franchises and permits, all in a timely manner, at reasonable costs and on satisfactory terms and conditions



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Respond effectively to regulatory, legislative and judicial developments



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Successfully respond to the current financial uncertainty facing other telecommunications carriers, which may affect our ability to receive full and timely payments and continued service from financially distressed carriers



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Manage administrative, technical and operational issues presented by our business plan



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Raise sufficient capital on acceptable terms on a timely basis

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Dollars in thousands, except per share amounts)

The accompanying condensed notes are an integral part
of these condensed consolidated financial statements.

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FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share amounts)

The accompanying condensed notes are an integral part
of these condensed consolidated financial statements.

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FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Dollars in thousands)

The accompanying condensed notes are an integral part
of these condensed consolidated financial statements.

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FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except share amounts)

1. Basis of Presentation

        The accompanying interim condensed consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, which we believe are necessary to present fairly the financial statements in accordance with generally accepted accounting principles for the respective periods presented. Certain information and footnote disclosures normally included in the annual consolidated financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission for Form 10-Q. These interim condensed consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2001, filed on March 27, 2002. The consolidated balance sheet at December 31, 2001 included herein was derived from our audited consolidated financial statements, but does not include all disclosures required under generally accepted accounting principles.

        Certain prior-year amounts have been reclassified to conform to the current period presentation. All periods have been restated to reflect the 35:1 reverse stock split that was effective March 11, 2002 (see Note 6).

2. Property, Plant and Equipment

        Long-lived assets are stated at cost, which includes direct costs and capitalized interest, and are depreciated once placed in service using the straight line method.

        Property, plant and equipment consists of the following:

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3. Debt

        Long-term debt consists of the following:

        We have borrowed a total of $93,000 under our $225,000 Senior Secured Credit Facility (the "Credit Facility") as of June 30, 2002. The interest on amounts drawn is variable based on our leverage ratio, as defined in the Credit Facility. The principal payments will begin on November 30, 2003. Our borrowing capacity under the Credit Facility is limited to $130,000 of the total $225,000 until after March 31, 2003. Provided we satisfy applicable covenants, as defined in the Credit Facility, through March 31, 2003 the remaining $95,000 will become available.

4. Restructuring

        During the second half of 2001, we revised our business plan to reflect several initiatives which included; (1) the consolidation of our voice and data business units; (2) a 22 market business plan; (3) a refinement of our managed Internet access strategy; and (4) the scale back of our DSL initiatives. In conjunction with this revised business plan, we recorded a charge of $26,498 in 2001 for the reduction of our workforce, the abandonment of excess network facilities, the write-off of related network assets and other related costs. The $26,498 was composed of $14,425 in network fixed asset write-downs, $9,897 in abandonment of excess network facilities, $1,328 in employee severance costs and $848 in other related charges. In the first quarter of 2002 we recorded an additional charge of $1,316 as a result of an adjustment to the previously estimated restructuring costs. The $1,316 is composed of $895 in cash paid for the abandonment of excess network facilities and $421 in network fixed asset write-downs. For the six months ended June 30, 2002 amounts paid associated with the abandonment of excess network facilities, employee severance, and other related charges totaled $2,744, $190, and $109, respectively. The remaining unpaid restructuring costs of $2,148 as of December 31, 2001 are included in accrued liabilities in our consolidated balance sheet. There are no unpaid restructuring costs remaining as of June 30, 2002.

5. Loss Per Share

        We compute basic loss per common share based on the weighted average number of shares of common stock outstanding for the period. This calculation excludes certain unvested shares of restricted common stock. Diluted earnings per common share are adjusted for the assumed exercise of dilutive stock options and unvested shares of restricted common stock, and as-converted preferred stock and notes. Since the results of the adjustments required for the diluted weighted average common

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shares outstanding are anti-dilutive for the three and six months ended June 30, 2002 and 2001, they have been excluded from the net loss per share calculation. Our basic and diluted weighted average number of shares outstanding for the three and six months ended June 30, 2002 and 2001 is as follows:

6. Equity Transactions

        On February 25, 2002, our Board of Directors approved a 35:1 reverse split of our common stock. Par value of our common stock remained at $.01 per share. The split was effective March 11, 2002. The effect of the stock split has been recognized retroactively in the shareholders' equity accounts on our consolidated balance sheets and in all share and per share data in the accompanying condensed consolidated financial statements and notes to condensed consolidated financial statements. Shareholders' equity accounts have been restated to reflect the reclassification of an amount equal to the par value of the decrease in issued common shares from the common stock account to the additional paid-in capital account.

        During the first quarter of 2002 we issued 352,857 shares of restricted common stock to certain management employees. The restricted stock grant resulted in total non-cash compensation of approximately $1,500 which will be ratably charged to income over the vesting period. The stock will vest 25% on January 1, 2003 and 12.5% every six months for the following three years.

        During March 2002, we granted 248,787 stock options to employees and executive officers under our 1998 Equity and Performance Plan. The stock options were granted at $4.53 per share, the fair market value on the date of the grant, and will vest 25% on January 1, 2003 and 12.5% every six months thereafter.

7. Segment Information

        We currently operate solely in the United States and are organized primarily on the basis of strategic geographic operating segments that provide communications services in each respective geographic region. All of our geographic operating segments have been aggregated into one reportable segment as of June 30, 2002 and December 31, 2001 and for the six months ended June 30, 2002 and 2001.

        Our chief operating decision-makers view earnings before interest, income taxes, depreciation and amortization ("EBITDA") as the primary measure of profit and loss. The following represents

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information about revenue, EBITDA (which excludes non-cash compensation and restructuring costs) and capital expenditures for the six months ended June 30, 2002 and 2001:

        The following reconciles our total segment EBITDA to our consolidated net loss for the six months ended June 30, 2002 and 2001:

        Total assets for the reportable segment were $489,929 and $518,825 as of June 30, 2002 and December 31, 2001, respectively. The following reconciles our total segment assets to our consolidated total assets as of June 30, 2002 and December 31, 2001:

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

        General.    We provide voice and data services to communications-intensive users in major cities. We began operations in 1996 and initiated service first in Chicago in May 1997. We completed our initial 22 market build-out in 2001. In April 2002 we announced that we plan to extend service into Connecticut which allows us to offer services in a total of 23 markets. We will leverage the investment we have already made in the New York metropolitan area to provide service in Connecticut, with minimal incremental capital expenditures. As of June 30, 2002 we had 718,997 lines installed and in service.

        Revenue.    Enterprise revenue includes all services sold to corporations, government entities and value added resellers. Internet Service Provider revenue includes all services sold to Internet Service Provider customers. Our Enterprise and Internet service provider service offerings include circuit switched lines, colocation, managed Internet access, and other broadband services. Enterprise and Internet service provider revenue is primarily composed of monthly recurring charges, private line sales, usage charges, and initial non-recurring charges. Monthly recurring charges include the fees paid by our customers for lines in service and additional features on those lines, the leasing of our facilities network and colocation space. Private lines are point-to-point circuits that do not necessarily utilize our circuit switches. The revenue for these sales is generally recognized on a monthly recurring basis. Usage charges consist of fees paid by our customers for minutes of use, fees paid by carriers for each call made, fees paid by ILECs and other CLECs as reciprocal compensation, and access charges paid by the Inter-Exchange Carriers for long distance traffic that we originate and terminate. Non-recurring revenue is typically derived from fees charged to install new customer lines and is deferred and amortized over estimated customer lives.

        Reciprocal compensation is the compensation exchanged between carriers for terminating local phone calls on one another's networks. The appropriate reciprocal compensation rate, particularly for calls placed to Internet Service Providers, has been declining during the past several years as the question has been repeatedly addressed by state and federal regulators and the courts.

        In an effort to stabilize revenue from reciprocal compensation Focal has entered into reciprocal compensation rate agreements for Internet Service Provider traffic with other carriers that exchange this type of traffic on a regular basis with Focal. These agreements are immune to any changes of law that might occur during their term. However, upon expiration of these agreements Focal will enter into new agreements consistent with the law in effect at that time.

        Currently, Focal has these types of reciprocal compensation rate agreements with Verizon, SBC Communications and Bell South. Because of the past legal and regulatory uncertainties regarding reciprocal compensation, Focal cannot predict the exact nature of any future agreements. If the future reciprocal compensation rates are different from the rates currently in effect, Focal may be affected either positively or negatively, depending on the direction and magnitude of the changes. Focal estimates that for every $0.0001 change in the reciprocal compensation per minute rate, revenue would change an average of $2.9 million on an annual basis. A $0.0001 change represents a 5.5% change from our current average reciprocal compensation billing rate.

        Expenses.    Our expenses are categorized as network expenses, excluding depreciation; selling, general and administrative, excluding amortization; depreciation and amortization; and restructuring costs. Network expenses are composed of leased transport charges, the cost of leasing space in ILEC central offices for colocating our transmission equipment, the cost of leasing our nationwide Internet network, reciprocal compensation payments and the cost of completing long distance calls. Leased transport charges are the lease payments we make for the use of fiber transport facilities connecting our customers to our switches and for our connection to the ILECs' and other CLECs' networks.

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Generally, we have been successful in negotiating lease agreements that match the duration of our customer contracts, thereby allowing us to avoid the risk of incurring expenses associated with transport facilities that are not being used by revenue generating customers.

        Our strategy of initially leasing rather than building our own fiber transport facilities has resulted in our cost of service being a significant component of total cost. Accordingly, our network expenses may be higher on a relative basis compared to CLECs that own a higher percentage of their transport network. However, compared to these same companies, our capital expenditures are significantly lower.

        A key aspect of our "smart-build" strategy is that we only operate in Tier-1 markets which are served by multiple fiber providers. When traffic volumes grow sufficiently to justify investing in our own network, we have purchased our own fiber capacity. As of June 30, 2002 we were operating our own fiber networks in 10 of our markets.

        Selling, general and administrative expense ("SG&A") consists of network and customer care personnel costs, sales force compensation, costs related to leasing office space, and promotional expenses as well as the cost of corporate activities related to regulatory, finance, human resources, legal, executive, and other administrative activities. Included in SG&A is non-cash compensation expense related to the following:

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shares issued to some of our executive officers in November 1996



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the September 30, 1998 amendments to vesting agreements with some of our executive officers



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stock options granted to employees, an outside consultant, and directors during 1999



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shares issued to a director during the first quarter of 1999



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restricted common stock issued to an executive in January 2000



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restricted common shares issued to management employees in March 2002

        We will continue to record non-cash compensation expense in future periods relating to these events through the first quarter of 2006.

Quarterly Results

        The following table sets forth unaudited financial, operating and statistical data for each of the specified quarters of 2002 and 2001. The unaudited quarterly financial information has been prepared on the same basis as our Consolidated Financial Statements and, in our opinion, contains all normal

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recurring adjustments necessary to fairly state this information. The operating results for any quarter are not necessarily indicative of results for any future period.