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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1999 Commission File Number: 0-20763
MCLEODUSA INCORPORATED
(Exact name of registrant as specified in its charter)
DELAWARE 42-1407240
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
McLeodUSA Technology Park
6400 C Street SW, P.O. Box 3177
Cedar Rapids, IA 52406-3177
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (319) 364-0000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OFTHE ACT:
Not applicable
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Class A common stock, par value $0.01 per share
6.75% Series A preferred stock, par value
$0.01 per share
(Title of Classes)
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 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 voting stock held by non-affiliates of the
registrant, based upon the closing price of the registrant's common stock as of
March 17, 2000 is $11,278,547,249.*/
The number of shares outstanding of each of the registrant's classes of common
stock, as of the latest practicable date is:
o Class A common stock, par value $.01 per share, outstanding as of
March 17, 2000: 160,512,447 shares
- -------------
*/ Solely for the purposes of this calculation, all directors and executive
officers of the registrant and all stockholders beneficially owning more than 5%
of the registrant's common stock that have representation on the registrant's
Board of Directors are considered to be affiliates.
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents incorporated by reference and the Part of
the Form 10-K into which the document is incorporated: Portions of the
definitive proxy statement for the Annual Meeting of Stockholders to be held on
May 31, 2000, to be filed within 120 days after the end of the registrant's
fiscal year, are incorporated by reference into Part III, Items 10-13 of this
Form 10-K.
TABLE OF CONTENTS
PAGE
PART I Item 1. Business ....................................................................... 1
Item 2. Properties.......................................................................38
Item 3. Legal Proceedings................................................................39
Item 4. Submission of Matters to a Vote of Security Holders..............................39
PART II Item 5. Market for Registrant's Common Equity and
Related Stockholder Matters......................................................40
Item 6. Selected Financial Data..........................................................41
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations..............................................43
Item 7A. Quantitative and Qualitative Disclosures
About Market Risk................................................................54
Item 8. Financial Statements and Supplementary Data......................................54
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure..............................................56
PART III Item 10. Directors and Executive Officers of the Registrant...............................56
Item 11. Executive Compensation...........................................................56
Item 12. Security Ownership of Certain Beneficial Owners
and Management...................................................................56
Item 13. Certain Relationships and Related Transactions...................................56
PART IV Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K..............................................................56
GLOSSARY .....................................................................................................67
SIGNATURES ...................................................................................................71
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS....................................................................F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
ON THE FINANCIAL STATEMENT SCHEDULES..........................................................................F-2
References in this Form 10-K to "we," "us," "our" and "McLeodUSA" mean
McLeodUSA Incorporated and our subsidiaries and predecessors, unless the
context suggests otherwise. Dollar amounts over $1 million have been
rounded to one decimal place and dollar amounts less than $1 million have
been rounded to the nearest thousand, unless otherwise indicated. Some of
the statements contained in this Form 10-K discuss future expectations,
contain projections of results of operations or financial condition or
state other forward-looking information. These statements are subject to
known and unknown risks, uncertainties and other factors that could cause
the actual results to differ materially from those contemplated by the
statements. The forward-looking information is based on various factors
and was derived using numerous assumptions. In some cases, you can
identify these so-called "forward-looking statements" by words like
"may," "will," "should," "expect," "plan," "anticipate," "believe,"
"estimate," "predict," "project," "intend" or "potential" or the negative
of those words and other comparable words. You should be aware that those
statements only reflect our predictions. Actual events or results may
differ substantially. Important factors that could cause our actual
results to be materially different from the forward-looking statements
are disclosed under the heading "Business--Risk Factors" and throughout
this Form10-K. SEE THE "GLOSSARY" APPEARING AT PAGE 67 FOR DEFINITIONS OF
SOME OF THE TERMS USED IN THIS FORM 10-K.
PART I
ITEM 1. BUSINESS.
OVERVIEW
We provide communications services to business and residential customers
in the Midwestern and Rocky Mountain regions of the United States. We
offer local, long distance, Internet access, data and voice mail, all
from a single company on a single bill. We believe we were the first
communications provider in many of our markets to offer one-stop shopping
for communications services tailored to customers' specific needs.
Our approach makes it easier for both our business and our residential
customers to satisfy their communications needs. It also allows
businesses to receive customized services, such as competitive long
distance pricing and enhanced calling features, that might not otherwise
be directly available on a cost-effective basis. As of December 31, 1999,
we served 679,000 local lines in 592 cities and towns.
We derive most of our revenue from:
o our core business of providing competitive local, long distance and
related communications services in competition with the existing
telephone companies
o sale of advertising space in telephone directories
o traditional local telephone company services in east central
Illinois and southeast South Dakota
o communications facilities and services dedicated for a particular
customer's use
We also derive revenue from:
o communications network maintenance services
o telephone equipment sales, leasing, service and installation
o video services
o telemarketing services
o computer networking services
o other communications services, including cellular, operator,
payphone, and paging services
1
In most of our markets, we compete with the incumbent local phone company
by leasing its lines and switches. In other markets, primarily in Iowa,
Illinois, South Dakota, Wisconsin, Indiana, Missouri, Minnesota and
Michigan, we operate our own switches and lease lines from the incumbent
phone company. In a limited number of markets in Iowa, South Dakota and
Minnesota, we use our own switches and lines to provide service. We
provide long distance services by using our own communications network
facilities and leasing capacity from long distance and local
communications providers. We are actively developing fiber optic
communications networks throughout most of our 21 state target market
area to carry additional communications traffic on our own network.
The following chronology highlights some of the important events in the
development of our business:
DATE EVENT
November 1992 Began providing fiber optic maintenance
services for the Iowa Communications
Network, a fiber optic communications
network that links many schools, libraries
and other public buildings in the State of
Iowa.
December 1993 Received regulatory approvals
in Iowa and Illinois to offer local
and long distance services.
June 1996 Completed our initial public
offering of Class A common stock.
July 1996 Acquired Ruffalo, Cody & Associates, Inc.,
a telemarketing company.
September 1996 Acquired TelecomUSA Publishing Group,
Inc., a telephone directory company.
April and June 1997 The Federal Communications Commission
awarded McLeodUSA a total of 26 "D" and
"E" block frequency personal
communications services ("PCS") licenses
for approximately $32.8 million.
July 1997 The FCC awarded McLeodUSA four wireless
communications services ("WCS") licenses.
September 1997 Acquired Consolidated Communications Inc.
("CCI"), a diversified telecommunications
company offering a variety of products and
services, including local exchange and
long distance services and telephone
directory publishing.
February 1999 Acquired Talking Directories, Inc. and
Info America Phone Books, Inc., related
companies publishing and distributing
telephone directories primarily in
Michigan and Northwestern Ohio.
2
March 1999 Acquired Dakota Telecommunications Group,
Inc. ("DTG"), a diversified communications
company offering a variety of products and
services, including local exchange, long
distance and data services and cable
television operations.
Acquired Ovation Communications, Inc.
("Ovation"), a diversified
telecommunications company offering a
variety of products and services,
including local and network access, local
and long distance telephone services and
Internet access.
August 1999 Acquired Access Communications Holdings,
Inc. ("Access"), a telecommunications
company providing switch-based commercial
and residential services, including
traditional long distance service and an
enhanced - 800# product.
As of March 21, 2000, we offer communications services to business and
residential customers in Iowa, Illinois, North Dakota, South Dakota,
Wisconsin, Wyoming, Michigan and Colorado. We also offer communications
services to business customers in a number of markets in Minnesota,
Missouri, Indiana, Utah, Nebraska, Washington and Ohio. Over the next few
years, depending on competitive and other factors, we intend to offer
communications services in Idaho, Montana, Arizona, New Mexico, Oregon,
and Kansas. We offer long distance service in 48 states in the
continental United States.
We plan to offer PCS or other wireless services as part of our
communications services by building a wireless network, entering into
strategic acquisitions or alliances, or employing a combination of these
methods. We intend to use the frequency blocks covered by these licenses
to provide fixed services. SEE "--PROPOSED WIRELESS SERVICES," "--
REGULATION" AND "--RISK FACTORS--WE MAY NOT SUCCEED IN DEVELOPING OR
MAKING A PROFIT FROM WIRELESS SERVICES."
The statements in the foregoing paragraphs about our expansion plans and
proposed wireless services are forward-looking statements within the
meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. These plans may be revised, and our actual
geographic expansion and services may differ materially from that
indicated by our current plans, in each case as a result of a variety of
factors, including, among others: the availability of financing and
regulatory approvals, the existence of strategic alliances or
relationships and technological, regulatory or other developments in our
business.
Our principal executive offices are located at McLeodUSA Technology Park,
6400 C Street SW, P.O. Box 3177, Cedar Rapids, Iowa 52406-3177, and our
main phone number is (319) 364-0000.
RECENT TRANSACTIONS
THE SPLITROCK MERGER AGREEMENT AND HIRING OF ROY WILKENS. On January 7,
2000 we announced that we had reached an agreement to acquire Splitrock
Services, Inc. (Nasdaq: SPLT) and that Roy A. Wilkens would join
McLeodUSA as the head of our Data Services operations with Splitrock as
the core of those operations. Wilkens has extensive experience in the
competitive telecommunications segment, most notably during his tenure at
WilTel where he was founder and CEO of WilTel Network Services from 1985
to 1997 as WilTel constructed and operated the first nationwide broadband
fiber optic network.
3
The pending acquisition of Splitrock provides for a merger, whereby
Splitrock will become a wholly owned subsidiary of McLeodUSA. As a result
of the merger, each share of Splitrock common stock will be converted
into the right to receive 0.5347 of a share of McLeodUSA Class A common
stock. Splitrock stockholders will own approximately 12.6 percent of the
outstanding shares of McLeodUSA Class A common stock on a fully converted
basis. The share data has not been adjusted to reflect the McLeodUSA
three-for-one stock split scheduled to be distributed on April 24, 2000.
Splitrock is a facilities-based provider of advanced data communications
services. Splitrock markets its services to Internet service providers,
telecommunications carriers and other businesses throughout the United
States. The Splitrock services include an array of Internet access and
data communications services delivered over its high capacity,
facilities-based network. The combination of the Splitrock existing
network with its pending acquisition of significant fiber optic
facilities positions Splitrock to deliver a broad range of end-to-end
data communications services on its network, including:
o dial and dedicated Internet access
o Internet access for higher bandwidth services, such as digital
subscriber line and cable modem
o value-added services such as virtual private networks and web
hosting
o bandwidth leasing and collocation services
The completion of the Splitrock transaction is subject to the approval of
stockholders. McLeodUSA and Splitrock expect that this transaction will
be completed promptly after the stockholders' meetings for McLeodUSA and
Splitrock scheduled for March 30, 2000.
The completion of this transaction will enable us to offer data services,
including Internet access services, to customers in our existing markets
using the newly-acquired network platform and to achieve enhanced data
margins and improved control over the quality of our data services. In
addition, through Splitrock, we will be able to offer those same services
on a national basis (initially on a wholesale basis) outside our current
market area. The transaction will also allow us to accelerate our
delivery of data services, while reducing to a certain degree the capital
expenditure required for network construction, and to save costs for
terminating calls from our markets to areas outside our target market
region. The transaction also will increase the number of our
communications services customers.
We have obtained information regarding Splitrock from Splitrock. Although
we believe this information is reliable, it has not been independently
verified. Additional information about Splitrock and about the proposed
merger is publicly available in our registration statement on Form S-4,
as amended (File No. 333-95941), filed with the SEC on February 2, 2000
and other reports filed by McLeodUSA and Splitrock with the SEC.
THREE-FOR-ONE STOCK SPLIT. We announced on February 29, 2000 a
three-for-one stock split in the form of a stock dividend. The record
date for the stock split will be April 4, 2000. Stockholders of record at
market close on that date will receive two additional shares of McLeodUSA
Class A common stock for each share of Class A common stock held.
Distribution of the additional shares will take place on April 24, 2000.
The three-for-one split is subject to stockholder approval of an
amendment to the McLeodUSA certificate of incorporation to increase the
number of authorized shares. An amendment to accomplish this increase is
scheduled to be considered at the March 30, 2000 special meeting of
McLeodUSA stockholders.
4
MCLEODUSA BUSINESS STRATEGY
We want to be the leading and most admired provider of communications
services in our markets. To achieve this goal, we are:
o aggressively capturing customer share and generating revenue
using leased communications network capacity
o concurrently building our own communications network
o migrating customers to our communications network to provide
enhanced services and reduce operating costs
The principal elements of our business strategy are to:
PROVIDE INTEGRATED COMMUNICATIONS SERVICES. We believe we can rapidly
penetrate our target markets and build customer loyalty by providing an
integrated product offering to business and residential customers.
BUILD CUSTOMER SHARE THROUGH BRANDING. We believe we will create and
strengthen brand awareness in our target markets by branding our
communications services with the trade name McLeodUSA in combination with
the distinctive black-and-yellow motif of our telephone directories.
PROVIDE OUTSTANDING CUSTOMER SERVICE. Our customer service
representatives are available 24 hours a day, seven days a week, to
answer customer calls. Our customer-focused software and systems allow
our representatives immediate access to our customer and network data,
enabling a rapid and effective response to customer requests.
EMPHASIZE SMALL AND MEDIUM SIZED BUSINESSES. We primarily target small
and medium sized businesses because we believe we can rapidly capture
customer share by providing face-to-face business sales and strong
service support to these customers.
EXPAND OUR FIBER OPTIC COMMUNICATIONS NETWORK. We are building a
state-of-the-art fiber optic communications network to deliver multiple
services and reduce operating costs.
EXPAND OUR INTRA-CITY FIBER OPTIC COMMUNICATIONS NETWORK. Within selected
cities, we plan to extend our network directly to our customers'
locations. This will allow us to provide expanded services and reduce the
expense of leasing communications facilities from the local exchange
carrier.
EXPLORE ACQUISITIONS AND STRATEGIC ALLIANCES. We plan to pursue
acquisitions, joint ventures and strategic alliances to expand or
complement our business.
LEVERAGE PROVEN MANAGEMENT TEAM. Our executive management team consists
of veteran telecommunications managers who successfully implemented
similar customer-focused telecommunications strategies in the past.
MARKET POTENTIAL
The telecommunications industry is undergoing substantial changes due to
statutory, regulatory and technological developments. We believe that we
are well-positioned to take advantage of these fundamental changes.
5
WIRELINE SERVICES. The market for local exchange services consists of a
number of distinct service components, including:
o local network services, which generally include basic dial tone,
local area charges, enhanced calling features and private line
services (dedicated for a customer's use between locations)
o network access services, which consist of access provided by local
exchange carriers to long distance communications network carriers
o short-haul long distance communications network services, which
include intraLATA long distance calls and private lines
o other varied services, including operator services, Internet
access, calling cards, publication of "white page" and "yellow
page" telephone directories and the sale of business telephone
equipment
Industry sources have estimated that the 1999 aggregate revenues of all
local exchange carriers were approximately $102 billion. Until recently,
there was little competition in the local exchange markets, particularly
for local network and network access services.
Before 1984, AT&T largely monopolized local and long distance telephone
services in the United States. In 1984, as the result of a court order
approving a settlement agreement in an antitrust action, AT&T was
required to divest its local telephone systems (the "Divestiture"). The
Divestiture and subsequent related proceedings divided the country into
201 Local Access and Transport Areas ("LATAs"). As part of the
Divestiture, AT&T's former local telephone systems were organized into
seven independent regional Bell operating companies. The original seven
regional Bell operating companies are now concentrated into four large
incumbent "MegaBells." Those companies have the authority to provide
local telephone service, local access service and intraLATA long distance
service, but cannot provide in-region interLATA service unless they
demonstrate that certain competitive conditions have been met.
Opportunities to compete in the local exchange market expanded
substantially on February 8, 1996, when the Telecommunications Act of
1996 was signed into law. The Telecommunications Act of 1996 eliminated
state legal barriers to local exchange competition and requires incumbent
local exchange carriers to allow other providers of telecommunications
services to purchase elements of their local communications network
offerings and to interconnect with their communications facilities and
equipment. Most significantly, it requires the incumbent local exchange
carriers to complete local calls originated by our customers and
transferred or connected by us using our own communications network
facilities, and to deliver inbound local calls to us for connection to
our customers, assuring our customers unimpaired local calling ability.
In addition, local exchange carriers are obligated to provide local
number portability and dialing parity upon request and make their local
services available for resale by competitors. Local exchange carriers
also are required to allow competitors non-discriminatory access to local
exchange carrier poles, conduit space and other rights-of-way.
We believe that these requirements are likely, when fully implemented, to
increase competition among providers of local communications services and
simplify the process of switching from incumbent local exchange carrier
services to those offered by competitive local exchange carriers. The
Telecommunications Act of 1996 also offers important benefits to the
MegaBells, however, such as the ability to provide interLATA long
distance services under specified conditions. The process of implementing
the Telecommunications Act of 1996 is still incomplete, and important
questions remain unresolved. SEE "--REGULATION".
A number of states have also taken additional regulatory and legislative
action to open local communications markets to various degrees of
competition. We expect that continuing pro-competitive regulatory
changes, together with increasing customer demand, will create more
opportunities for competitive service providers to introduce additional
services, expand their
6
networks and address a larger customer base. We cannot assure you
however, that government actions to implement local telephone competition
will be as complete or as timely as we require to implement our business
plans.
WIRELESS SERVICES. Demand for wireless communications has grown rapidly
over the past decade. According to the Cellular Telecommunications
Industry Association ("CTIA"), the number of wireless telephone
subscribers nationwide has grown from approximately 680,000 in 1986 to an
estimated 76 million as of June 30, 1999, with annual growth of
approximately 25% from 1998 through 1999. Wireless communication revenues
for the 12-month period ended June 30, 1999 are estimated by CTIA to have
totaled over $37.2 billion, a 26% increase over the prior 12-month
period. We believe that the demand for wireless communications will
continue to grow dramatically, and that PCS will capture a significant
share of the wireless market, due to anticipated declines in costs of
service, increased function versatility, and increased awareness of the
productivity, convenience and safety benefits associated with such
services. We also believe the rapid growth of notebook computers and
personal digital assistants, combined with emerging software applications
for wireless delivery of electronic mail, fax and internet access, will
further stimulate demand for wireless service. In addition, we expect
future competition between wireline local exchange carriers and wireless
service providers as "wireless local loop" technology and reduced
wireless rates facilitate migration of wireline minutes to wireless
carriers.
CURRENT PRODUCTS AND SERVICES
We derive most of our revenue from:
o our core business of providing local, long distance and related
communications services to end users, typically in a bundled
package
o the sale of advertising space in telephone directories
o traditional local telephone company services through the
operation of Illinois Consolidated Telephone Company ("ICTC") in
east central Illinois and Dakota Telecommunications Group, Inc.
in southeast South Dakota
o communications facilities and services dedicated for a
particular customer's use
We also derive revenue from:
o communications network maintenance services
o telephone equipment sales, leasing, service and installation
o video services
o telemarketing services
o computer networking services
o other communications services, including cellular, operator,
payphone and paging services
For the year ended December 31, 1999, we derived 50% of our total
revenues from our core business of providing local, long distance and
related communications services, 23% from the sale of advertising space
in telephone directories, 9% from traditional local telephone company
services and 9% from communications facilities and services dedicated for
a particular customer's use. SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS--OVERVIEW."
Splitrock reported revenues for 1999 of $89.6 million from its provision
of facilities-based network services to internet service providers,
telecommunication companies and business enterprise companies.
SEE "--RECENT TRANSACTIONS."
7
INTEGRATED COMMUNICATIONS SERVICES.
OVERVIEW. As of December 31, 1999, we provided service, on a retail
basis, to 679,000 local lines in our markets, primarily to small and
medium sized business customers and to residential customers. Since
beginning sales activities in January 1994, we have increased our revenue
from the sale of local and long distance telecommunications services from
$4.6 million for the year ended December 31, 1994 to $456.0 million for
the year ended December 31, 1999.
In order to provide local communications services to most of our business
and residential customers, we purchase "Centrex" services through various
agreements with U S WEST Communications, Inc., for our customers located
in U S WEST's service territories, and with Ameritech Corporation for
most of our customers located in Ameritech's service territories. These
"Centrex" agreements allow us to partition part of the central office
switching equipment serving the communities in which we provide local
services, which allows us to aggregate lines, have control over several
characteristics of those lines and provide a set of standard features on
them. Our customers' telephone lines and numbers are assigned to our
portion of the switch. U S WEST or Ameritech, as the case may be, bills
us for all the lines assigned to our customers and provides us with call
detail reports, which enable us to verify our customers' bills for both
local and long distance service. These Centrex agreements protect us from
unilateral rate increases until 2002 or 2003, depending on the state. We
believe that our Centrex-based local services are superior to a standard
business or residential telephone line, since we can offer features, such
as three-way calling, consultation hold and call transfer, at no extra
charge. Other custom calling features are available at additional cost.
Because we also purchase the "Centrex Management System" and the "Centrex
Mate Service" from U S WEST and Ameritech, respectively, our personnel
have on-line access to U S WEST and Ameritech facilities and may make
changes to the customers' services electronically and quickly.
In certain markets in which we will move relatively quickly from
reselling retail services of the MegaBell to offering services using our
own switching facilities, we are reselling standard retail business
services. We currently offer standard resold business services as an
interim measure in certain markets in Missouri, Washington, Nebraska,
Utah, Idaho and Indiana. This strategy allows us to aggressively capture
customer share and generate revenue in a market with little up-front cost
in comparison to establishing Centrex service, while we complete our own
communications network.
We have interconnection agreements with MegaBells in Iowa, Minnesota,
South Dakota, North Dakota, Nebraska, Illinois, Indiana, Michigan,
Wisconsin, Utah and Missouri that allow us to provide local service by
leasing individual lines and switches from the MegaBells. These
agreements provide us a wholesale discount on services that we resell. We
also have interconnection agreements with GTE in certain markets in which
GTE is the incumbent local exchange company. In certain markets in
Illinois, Minnesota, Wisconsin, Michigan, and Indiana, we use our own
switching equipment and communications network facilities together with
unbundled local "loop" elements purchased from U S WEST or SBC/Ameritech
through interconnection agreements. In Cedar Rapids, Iowa, southwest
Minnesota and southeast South Dakota, we also provide competitive
communications services to some of our business and residential customers
using only our own lines and communications network facilities.
We provide most of our long distance service by purchasing communications
network capacity, in bulk, from national long distance carriers, and
routing our customers' long distance traffic over this capacity. In some
service areas, we also carry long distance traffic on our own network
facilities.
8
BUSINESS SERVICES. End-user business customers can obtain local, long
distance and ancillary services, such as three-way calling and call
transfer, directly from us in each of the cities and towns in which we
offer communications services today.
We generally offer business customers our integrated local communications
services at prices that are similar to the published retail rates for
basic business service provided by the incumbent local exchange carrier.
We offer our business customers a flat rate or a negotiated rate for long
distance service consistent with their particular needs and within the
guidelines of our filed tariffs. These rates are not subject to increase
for the duration of the term selected by the customer.
Furthermore, in some states, including states outside of our target
markets, we offer business customers long distance service only, in order
to enhance our ability to attract business customers that have offices
outside of our target markets.
RESIDENTIAL SERVICES. We introduced our PrimeLine(R) service in 1996 and
now offer that service to residential customers in various cities and
towns in Iowa, Illinois, North Dakota, South Dakota, Wisconsin, Wyoming
and Colorado. Our basic PrimeLine(R) service includes local and long
distance telephone service, as well as enhanced features such as
three-way calling, call transfer and consultation hold. Voice mail,
Internet access and travel card services are also available at the
customer's option as part of our PrimeLine(R) service. We generally price
our basic PrimeLine(R) local service slightly higher than the rates for
basic local service offered by the incumbent local exchange carrier since
our basic PrimeLine(R) local service includes enhanced features that are
not typically provided as part of the incumbent local exchange carrier's
basic local service. Our customers can add voice mail and Internet access
services to their basic PrimeLine(R) service at incremental rates
designed to be no higher than separately purchasing these services from
other companies. We generally offer our PrimeLine(R) customers a choice
of either long distance rates that vary with the time of the call or
flat-rate long distance pricing applicable 24 hours a day, seven days a
week. In Michigan, we also offer residential services by leasing local
lines from the MegaBell and using our local switching.
DIRECTORY SERVICES. In 1999, we published 193 proprietary "white page"
and "yellow page" telephone directory titles and distributed
approximately 19.4 million copies of these directories to local telephone
subscribers in 22 states in the Midwestern and Rocky Mountain regions of
the United States, including most of our target markets. We also
published 280 "white page" and "yellow page" telephone directory titles
for other companies and distributed approximately 4.1 million copies of
these directories to local telephone subscribers in 37 states and the
U.S. Virgin Islands. Our telephone directory services generated 1999
revenues of approximately $211.3 million, primarily from the sale of
advertising space in the directories.
Our proprietary telephone directories serve as "direct mail" advertising
because they contain information on how to contact us and detailed
product descriptions and step-by-step instructions on the use of our
telecommunications products. In addition, we believe that our
directories' distinctive black-and-yellow motif combined with the trade
name McLeodUSA strengthens brand awareness in our markets. SEE "--SALES
AND MARKETING."
TRADITIONAL LOCAL TELEPHONE SERVICES. Through ICTC and Dakota
Telecommunications, we provide regulated incumbent local exchange
telephone service to subscribers in central Illinois and southeast South
Dakota.
ICTC operates in 37 exchanges, or service areas, the largest of which are
in Mattoon, Charleston, and Effingham, Illinois. As of December 31, 1999,
ICTC had 93,222 local access lines in its existing service areas. ICTC
offers a broad range of local exchange services, including long distance
carrier access service, intraLATA toll service, local telephone service,
9
local paging service, national directory assistance, and equipment
leasing. ICTC also offers most of its local telephone subscribers custom
calling features such as call waiting, call forwarding, conference
calling, speed dialing, caller identification, and call blocking. The
rates for these and other local exchange services are regulated by the
Illinois Commerce Commission and the FCC. To provide these services, ICTC
owns and operates three central office switches and 33 remote switches.
As of December 31, 1999, Dakota Telecommunications served approximately
6,700 local service access lines in 9 telephone exchanges in southeastern
South Dakota. Dakota Telecommunications provides a full range of
communications products and services, including local dial tone and
enhanced services, local private line and public telephone services,
dedicated and switched data transmission services, long distance
telephone services, operator assisted calling services, Internet access
and related services.
DEDICATED FACILITIES AND SERVICES. We provide, on a private carrier
basis, a wide range of special access, private line and data services to
long distance carriers, government agencies, wireless service providers
and cable television and other end-user customers. These services
include:
o POP-to-POP special access
o end user/long distance carrier special access
o private line services
POP-to-POP special access services provide telecommunications lines that
link the POPs of one long distance carrier or the POPs of different long
distance carriers in a market, allowing these POPs to exchange
telecommunications traffic for transport to final destinations.
End user/long distance carrier special access services provide
telecommunications lines that connect an end user such as a large
business to the local POP of its selected long distance carrier.
Long distance carrier special access services provide telecommunications
lines that link a long distance carrier POP to the local central office.
For example, we furnish long distance carrier special access services to
AT&T in 17 cities in Illinois, Iowa, North Dakota and South Dakota.
Private line services provide telecommunications lines that connect
various locations of a customer's operation to transmit internal voice,
video and/or data traffic. We provide private line services by using our
own communications network facilities, leasing communications network
facilities from other telecommunications carriers, or using some
combination of owned and leased communications network facilities.
NETWORK MAINTENANCE SERVICES. In 1990, the State of Iowa authorized
construction of the initial fiber optic links of the Iowa Communications
Network (the "Part I and II segments"). The Part I and II segments, which
are owned by the State of Iowa, provide 3,400 miles of fiber optic
communications network connections to approximately 139 sites in Iowa and
are used primarily for interactive distance learning, telemedicine and
the State's own long distance telephone traffic. Neither McLeodUSA nor
any other communications carrier may use capacity on the Part I and II
segments to provide communications services to customers because
commercial use of the Part I and II segments is forbidden.
10
We have entered into a fiber optic maintenance contract with the State of
Iowa to provide maintenance services for the Part I and II segments of
the Iowa Communications Network until 2004. Our maintenance activities
under this contract are performed on a 24-hour-per-day, 365-days-per-year
basis, and consist of alarm monitoring, repair services and cable
location services. We believe that the expertise in fiber optic
maintenance we have developed through the maintenance of the Iowa
Communications Network provides advantages in maintaining our own
communications network facilities.
TELEPHONE EQUIPMENT SERVICES. We sell, lease, install and service
telephone systems, primarily to small and medium sized businesses in
Iowa, Illinois and Minnesota. We believe these services provide valuable
expertise for and complement our communications services offerings,
giving us additional contact with the small and medium sized businesses
we target in marketing our communications services.
VIDEO SERVICES. We own 85% of Greene County Partners, Inc., a cable
television company that as of December 31, 1999 provides cable television
service to approximately 16,700 subscribers in Illinois and Michigan.
Through Dakota Telecommunications, we also own and operate 26 cable
television systems located in southeastern South Dakota, northwestern
Iowa and southwestern Minnesota. As of December 31, 1999, these systems
provided service to approximately 7,500 subscribers.
We provide cable television service in Cedar Rapids, Iowa pursuant to a
franchise from that city. We are using this franchise to explore the
possible synergies between cable television and our advanced
communications services offerings, such as Integrated Services Digital
Network ("ISDN"), low and high speed Internet, video and other advanced
services. Depending on the results of this preliminary initiative and on
other factors, including technological, regulatory or other developments
in our business, changes in the competitive climate in which we operate,
and the emergence of future opportunities, we may elect to offer cable
service on an expanded basis in the future.
TELEMARKETING SERVICES. We provide direct marketing and telemarketing
services for third parties, as well as a variety of fund-raising services
for colleges, universities and other non-profit organizations throughout
the United States. We believe that these services provide valuable
marketing opportunities and expertise for our communications services,
particularly with respect to potential residential customers. In addition
to providing telemarketing services for third parties, we also use our
telemarketing sales personnel to sell communications services to small
businesses and for sales of our PrimeLine(R) residential services. SEE
"--SALES AND MARKETING."
COMPUTER NETWORKING SERVICES. Through Dakota Telecommunications, we
provide customized, integrated solutions for computing networks in some
markets in South Dakota. Typical services include review of customer
system requirements; selection, design and planning of system components
and networks; and operating and network support services.
OTHER COMMUNICATIONS SERVICES. We provide pay telephone service, operator
services and paging services in some markets. In addition, we own a
minority interest in a partnership that provides cellular service in
central Illinois.
EXPANSION OF SERVICES USING OUR OWN COMMUNICATIONS NETWORK FACILITIES
We are also offering service to over 138,300 local lines, using our own
switches and fiber optic communications network facilities connected
directly to our customers' locations or combined with network elements
purchased from SBC/Ameritech and US West through interconnection
agreements. We are further enhancing our state-of-the-art fiber optic
communications network
11
either by extending our intra-city fiber optic communications network and
switching capacity or by combining with network elements from existing
telephone companies. Our communications network and switching capacity is
also designed to serve other wireline and wireless carriers on a
wholesale basis.
As of March 21, 2000, we have received state regulatory approval to offer
local switched services using our own communications network facilities
in Colorado, Idaho, Iowa, Illinois, Indiana, Kansas, Michigan, Minnesota,
Missouri, Montana, Nebraska, North Dakota, Ohio, Oregon, South Dakota,
Utah, Washington, Wisconsin and Wyoming. We intend to offer additional
local switched services using our own network facilities, either alone or
in combination with network elements purchased from existing telephone
companies, in selected markets in 21 states. We plan to expand these
facilities-based services as our communications network develops and our
market penetration increases.
Our plans to provide local switched services using our own communications
network facilities will depend upon obtaining favorable interconnection
agreements and terms for leasing network elements from existing telephone
companies. In August 1996, the FCC released a decision (the
"Interconnection Decision") implementing the interconnection portions of
the Telecommunications Act of 1996. The Interconnection Decision has been
the subject of significant legal dispute. In January 1999, the U.S.
Supreme Court rejected challenges to the Interconnection Decision and
affirmed the authority of the FCC to establish rules governing
interconnection. We believe that additional disputes regarding the
Interconnection Decision and other related FCC actions are likely. We
cannot assure you that we will succeed in obtaining interconnection
agreements on terms that would permit us to offer local services using
our own communications network facilities at profitable and competitive
rates. SEE "--REGULATION."
The foregoing statements are forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 and where
we actually provide such services will depend on factors such as:
o the outcome of the judicial proceedings regarding the
Interconnection Decision
o technological, regulatory or other developments in our business
o changes in the competitive climate in which we operate
o the emergence of future opportunities
For a detailed description of the expansion of our fiber optic
communications network, SEE "--NETWORK FACILITIES."
POTENTIAL WIRELESS SERVICES
We currently do not offer wireless services, although we do own a
minority interest in a cellular telephone partnership serving parts of
east central Illinois, and are conducting fixed wireless trials in two of
our markets. In April and June 1997, the FCC awarded us a total of 26 "D"
and "E" block frequency PCS licenses, each covering 10 MHz of radio
spectrum, and in September 1997 we acquired CCI and its "E" block
frequency PCS license, giving us a total of 27 PCS licenses in 25 markets
covering areas of Illinois, Iowa, Minnesota, Nebraska and South Dakota.
We paid approximately $32.8 million for the 26 PCS licenses awarded to us
by the FCC. CCI paid the FCC for its PCS license before we acquired CCI.
Our PCS licenses encompass approximately 110,000 square miles and a
population of approximately 6.6 million. We are evaluating whether to
offer PCS or other wireless services as part of our communications
services by building a wireless network, entering into strategic
acquisitions or alliances, or employing a combination of these methods.
12
We will need to spend significant time and money to develop wireless
services. To implement a wireless system, we will need to build or
otherwise acquire access to wireless infrastructure. The infrastructure
of a wireless system generally consists of switches, base station
transmitters and receivers, and related equipment. We may also incur
costs related to site acquisition and preparation, installation services,
zoning approval or other permits, frequency planning, construction and
equipment procurement, installation and testing. Furthermore, we believe
that our ability to successfully offer wireless services will depend on
our ability to offer roaming service to our customers so they can use
their handsets outside our service area. This will require us to
establish or acquire access to suitable roaming arrangements with other
wireless operators in other markets constructing systems compatible with
our own. We cannot predict when, or whether, we will be able to enter
into such roaming agreements with local providers.
We have entered into long-term agreements with Alliant Energy, an
electric utility which is one of our principal stockholders, and with
MidAmerican Energy, Wisconsin Electric Power Company, and Canadian
National Railroad (formerly Illinois Central Railroad), that will enable
us to install base stations and other equipment on such companies'
rights-of-way or towers. SEE "--NETWORK FACILITIES." We expect the use of
these existing towers and other facilities occupied by other
telecommunications service providers and utility companies to facilitate
our development of wireless services.
On July 21, 1997, the FCC also awarded us four WCS licenses covering
Milwaukee, Wisconsin, Minneapolis/St. Paul, Minnesota, Des Moines-Quad
Cities, Iowa/Illinois and Omaha, Nebraska. We expect to use the frequency
blocks covered by such licenses to provide fixed wireless services.
Additionally, the FCC awarded us 13 "A" and "B" block LMDS frequency
licenses in May 1999 covering 12 markets reaching approximately 2.8
million people.
As the wireline and wireless markets converge, we believe that we can
identify other opportunities to generate revenues from the wireless
industry on both a retail and a wholesale basis. On a retail basis, we
believe that we will be able to enter into strategic arrangements with
both cellular and PCS companies on favorable economic terms to allow us
to offer wireless services as part of our integrated communications
services offerings. On a wholesale basis, these opportunities may include
(1) leasing tower sites to wireless providers, (2) connecting or
transferring wireless traffic through our communications network
facilities and (3) transporting wireless traffic using our fiber optic
communications network to interconnect wireless providers' cell sites or
to connect such sites to either our communications network facilities or
to communications network facilities of other providers of wireline
services.
The statements in the foregoing paragraphs about our plans to offer
wireless services are forward-looking statements within the meaning of
the Private Securities Litigation Reform Act of 1995. These plans may be
revised, and our actual wireless services may differ materially from that
indicated by our current plans, in each case as a result of a variety of
factors, including:
o the availability of financing and regulatory approvals
o the number of potential customers in a target market
o the existence of strategic alliances or relationships
o technological, regulatory or other developments in our business
o changes in the competitive climate in which we operate
o the emergence of future opportunities
13
SEE "--RISK FACTORS--WE MAY NOT SUCCEED IN DEVELOPING OR MAKING A PROFIT
FROM WIRELESS SERVICE" AND "--RISK FACTORS--COMPETITION IN THE WIRELESS
TELECOMMUNICATIONS INDUSTRY COULD MAKE IT HARDER FOR US SUCCESSFULLY TO
OFFER WIRELESS SERVICES."
NETWORK FACILITIES
As the incumbent local exchange carriers are compelled, by regulatory
changes and competitive forces, to unbundle their network components and
to permit resale of their network elements and products, we expect to be
able to provide our customers with a full range of communications
services using a combination of our own communications network, the
networks of the incumbent local exchange carriers and the networks of
other competitive carriers.
As of December 31, 1999, we owned 10,036 route miles of fiber optic
communications network and expect to add approximately 1,000 additional
route miles of fiber optic network during 2000, primarily within the
cities we plan to serve. These route miles are in addition to the
acquisition of Splitrock and its fiber network. We will decide whether to
begin construction of fiber optic network in a market based on various
economic factors, including:
o the number of our customers in a market
o the anticipated operating cost savings associated with such
construction
o any strategic relationships with owners of existing infrastructure
(e.g., utilities and cable operators)
o strategic acquisitions of providers of wireless services or owners
of existing infrastructure
We are installing backbone communications network facilities that form a
series of fiber optic "self-healing rings" and intra-city communications
network facilities that provide access directly to customer locations.
These communications network facilities are intended to enable us to
provide local and long distance service using our own facilities in our
target market areas. Our communications networks are designed to support
a wide range of communications services, provide increased network
reliability and reduce costs. Our communications network consists of
fiber optic cables, which typically contain between 36 and 288 fiber
strands, each of which is capable of providing many telecommunications
circuits. A single pair of fibers on our network can transmit 32,256
simultaneous voice conversations, whereas a typical pair of copper wires
can carry a maximum of 24 digitized simultaneous voice conversations. We
expect that continuing developments in compression technology and
multiplexing equipment will increase the capacity of each fiber,
providing greater capacity at relatively low incremental cost.
In 1995, the Iowa General Assembly passed legislation to extend the Iowa
Communications Network to 543 more endpoints (which are usually located
in schools or public libraries) throughout the State of Iowa (the "Part
III segments"). The majority of these fiber optic links, unlike the Part
I and II segments of the Iowa Communications Network, will be leased to
the State of Iowa from a private entity, such as McLeodUSA. As of
December 31, 1999, we had contracts to build and then lease capacity to
the State of Iowa on 235 of such segments. Under our lease agreements
with the State of Iowa, we are constructing a "fiber-rich" broadband
communications network on which the State of Iowa has agreed to lease one
DS-3 circuit for a period of seven years for a total aggregate lease cost
of approximately $27.0 million. Upon completion of installation of each
segment, the leases provide that the State of Iowa will make a one-time
up-front lease payment to us for the capacity, with nominal monthly lease
payments thereafter. At the end of a seven-year period, the leases may be
extended, upon terms to be mutually agreed upon. During the term of the
leases, the State of Iowa may order additional DS-3 circuits at a
mutually agreed upon price.
14
We have reached agreements with Alliant Energy, an electric utility and
one of our principal stockholders, and with MidAmerican, Wisconsin
Electric Power Company, and Canadian National Railroad (formerly Illinois
Central Railroad) that allow us to make use of those companies'
rights-of-way, underground conduits, distribution poles, transmission
towers and building entrances in exchange for rights by such companies to
use capacity on our network. These agreements give us access to
rights-of-way in parts of Iowa, Illinois and Wisconsin for installation
of our wireline and wireless networks. We expect our access to these
rights-of-way to have a significant positive impact on our capital costs
for network construction and the speed with which we can construct our
networks. We believe that our strategic relationships with our electric
utility stockholders and other companies that own rights-of-way and
infrastructure give us a competitive advantage.
On January 7, 2000, we announced an agreement to acquire Splitrock
Services, Inc., a facilities-based provider of enhanced data services.
The acquisition of Splitrock is subject to approval of stockholders of
both companies. We expect that the transaction will be completed promptly
following the stockholders' meetings scheduled for March 30, 2000. SEE
"--RECENT TRANSACTIONS."
The Splitrock broadband access network includes over 320 operational
points of presence ("POPs") and, when completed, is expected to have
approximately 340 active broadband access POPs. The Splitrock network is
designed to provide coverage of roughly 90% of the population of the
United States. Splitrock has deployed asynchronous transfer mode (ATM)
switches at every core, hub and remote POP of its network. This network
architecture, called "ATM-to-the-EdgeTM," enables Splitrock to serve as a
broad-based provider of data communications services through the creation
of a platform that efficiently delivers multiple services, such as
Internet access, virtual private networks and web hosting, across
multiple protocols, including Internet Protocol, frame relay and ATM. The
flexibility inherent in the Splitrock network design allows it to expand
its service offerings to provide fully integrated data, video and voice
services.
To further expand and enhance its network and service offerings,
Splitrock has agreed to acquire the indefeasible rights to use four dark
fiber strands in a state-of-the-art fiber optic network currently under
construction by Level 3 Communications, LLC, with an option to acquire
indefeasible rights to use an additional 12 fibers. This nationwide fiber
network will cover approximately 15,000 route miles and will be delivered
in segments that are expected to become available from the first quarter
of 2000 through the first quarter of 2001. Combining this fiber optic
network with Splitrock's own broadband access network positions Splitrock
to:
o deliver, on its own facilities, a broad array of end-to-end data
communications services at the high level of quality and
reliability increasingly demanded by customers
o reduce significantly its network costs as a percentage of revenues
as it substitutes the acquired bandwidth for existing leased
circuit arrangements with various telecommunications carriers
o expand its service offerings by providing bandwidth leasing
services on a stand-alone basis or bundled with the other services
of Splitrock
o increase the reliability and redundancy of its network
o increase the variety of service options and speeds available to
customers
SALES AND MARKETING
We initially directed our communications sales efforts primarily toward
small and medium sized businesses. In June 1996, we began marketing our
PrimeLine(R) services to residential customers.
15
Marketing of our integrated communications services to business customers
is conducted by direct sales personnel, located in branch sales offices
in Iowa, Illinois, North Dakota, South Dakota, Idaho, Michigan,
Minnesota, Missouri, Wisconsin, Indiana, Colorado, Michigan, Utah,
Nebraska, Washington, Kansas and Wyoming. In addition, we use
telemarketers to market these services to smaller business customers and
those located in areas that are geographically remote. Sales activities
in our branch sales offices are organized and managed by region.
Marketing of our PrimeLine(R) integrated communications services to
residential customers is conducted by telemarketers. The telemarketers
emphasize the PrimeLine(R) integrated package of communications services
and its flat-rate per minute pricing structure for long distance service.
Our sales force is trained to emphasize our customer-focused sales and
service, including our 24-hours-per-day, 365-days-per-year customer
service center. Our employees answer customer service calls directly
rather than requiring customers to use an automated queried message
system. We believe that our emphasis on a single point of contact for
meeting our customer's communications needs is very appealing to our
current and prospective customers. In addition, we have deployed
skills-based routing software designed to match incoming calls with
customer service representatives best trained to respond to the
customer's needs.
We have also developed and installed customer-focused software for
providing integrated communications services. This software permits us to
provide our customers one fully integrated monthly billing statement for
local, long distance, 800, international, voice mail, paging, Internet
access and travel card services, and will permit us to include additional
services, such as wireless services, when available. We believe that our
customer-focused software platform is an important element in the
marketing of our communications services and gives us a competitive
advantage in the marketplace.
In addition, we believe our strategic acquisitions have enhanced our
sales and marketing efforts and increased our penetration of existing
markets and will also help accelerate our entry into new markets. For
example, we began publishing and distributing telephone directories as a
result of acquisitions. We can use our proprietary telephone directories
as direct mail advertising simply by including detailed product
descriptions and information about our communications products in them.
We believe that these telephone directories provide us with a long-term
marketing presence in the millions of households and businesses that
receive them. We also believe that combining our directories' distinctive
black-and-yellow motif with the trade name McLeodUSA strengthens brand
awareness in all of our markets.
In 1999, we expanded our communications sales and marketing efforts by
adding 10 states to our target market area. We continue our efforts to
expand sales and marketing in all states where we are located. For
example, at the end of 1999 we had sales offices in 110 cities, compared
to 68 sales offices at the end of 1998.
The foregoing statements are forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 and the
results of our actual expansion efforts may be materially different,
depending on a variety of other factors, including:
o the availability of financing and regulatory approvals
o the number of potential customers in a target market
o the existence of strategic alliances or relationships
o technological, regulatory or other developments in our business
o changes in the competitive climate in which we operate
o the emergence of future opportunities
16
COMPETITION
WIRELINE COMPETITION. The communications services industry is highly
competitive. We face intense competition from local exchange carriers,
including the MegaBells (primarily U S WEST and SBC/Ameritech ) and GTE,
which currently dominate their respective local telecommunications
markets. Our long distance services also compete with the services of
hundreds of other companies in the long distance marketplace. AT&T, MCI
WorldCom and Sprint currently dominate the long distance market. Our
local and long distance services also compete with the services of other
competitive local exchange carriers in some markets. Other competitors
may include cable television companies, competitive access providers,
microwave and satellite carriers, wireless telecommunications providers,
and private networks owned by large end-users. In addition, we compete
with the MegaBells and other local exchange carriers, numerous direct
marketers and telemarketers, equipment vendors and installers, and
telecommunications management companies with respect to portions of our
business. Many of our existing and potential competitors have financial
and other resources far greater than our own.
We believe that the distinction between the local and long distance
markets is eroding, and other competitors will begin to offer integrated
communications services similar to our own. For example, each of AT&T,
MCI WorldCom and Sprint has begun to offer local telecommunications
services using their own network facilities, network elements obtained
from incumbent local exchange carriers, or the facilities of other
parties. AT&T has announced its plan to enter into exclusive arrangements
with cable operators to use their local network facilities for
telecommunications services. These and other companies currently hold
state regulatory certificates to offer local and long distance service in
Iowa, Illinois and other states within our target markets. We cannot
assure you that these firms, and others, will not enter the markets or
target the small and medium sized businesses where we focus our sales
efforts.
A continuing trend toward business combinations and strategic alliances
in the telecommunications industry may strengthen our competitors. For
example, Southwestern Bell acquired Ameritech in October 1999, WorldCom
acquired MCI in September 1998 and AT&T acquired Teleport Communications
Group Inc. in July 1998 and Tele-Communications, Inc. in March 1999. In
addition, merger plans have been announced by U S West and Qwest
Communications, by Bell Atlantic and GTE and by MCI WorldCom and Sprint.
Southwestern Bell and Williams Communications, Inc., a long distance
company, have announced a strategic alliance to supply services to each
other. These or other alliances or combinations between our competitors
could put us at a significant competitive disadvantage.
We depend on incumbent local exchange carriers, primarily the MegaBells,
to provide access service for the origination and termination of most of
our toll long distance traffic and interexchange private lines.
Historically, charges for such access service made up a significant
percentage of the overall cost of providing long distance service. The
FCC and various states are considering changes to access charge rate
levels and related issues involving support for universal service and
other public policy objectives. The impact of these changes on us and our
competitors is not yet clear. We could be adversely affected if we do not
experience access cost reductions proportionally equivalent to those of
our competitors, if our competitors receive a disproportionate share of
universal service revenues, or if regulation of incumbent local exchange
carriers' access services is reduced. As long as new Internet-based
competitors continue to be exempt from these charges, they could enjoy a
significant cost advantage in this area.
17
The Telecommunications Act of 1996 requires payments by each carrier that
terminates local traffic to another carrier. This system of payments is
referred to as reciprocal compensation. Because a number of our customers
typically receive more calls than they make, we expect to receive more
reciprocal compensation than we pay for calls which originate on our
network. As a result of developments in the regulatory environment and
trends in the industry, we expect that the revenue we receive from
reciprocal compensation (net of reciprocal compensation payments we make)
will decline in the future.
Some MegaBells have disputed payments for reciprocal compensation that
they believe are the result of their customers' calls to internet service
providers (ISPs), contending that this traffic is outside the scope of
existing interconnection agreements. On February 26, 1999, the FCC issued
a declaratory ruling and Notice of Proposed Rulemaking holding that
ISP-bound traffic is largely interstate in nature, and that the FCC
therefore has jurisidiction over compensation for that traffic. Pursuant
to the Notice of Proposed Rulemaking, the FCC will consider what rules it
should adopt to govern compensation for this traffic. Comments have been
filed in that proceeding, but no decision has been made by the FCC. The
FCC also determined in its February 26, 1999 declaratory ruling that no
federal rule governed such compensation and that, in the absence of a
federal rule, states were free to determine that this traffic should be
treated as local traffic for purposes of existing interconnection
agreements. Of the 28 state commissions that have considered the issue
since the FCC's order, all but 4 have required carriers to compensate
each other for terminating ISP-bound traffic. Court appeals on these
issues remain pending in some states.
The FCC's order was appealed to the United States Court of Appeals for
the District of Columbia Circuit, which issued a decision on March 24,
2000 vacating the order. The Court stated that the FCC had not adequately
explained its conclusion that calls to ISPs should not be treated as
"local" traffic. We view this decision as favorable but the court's
direction to the FCC to re-examine the issue will likely result in
further delay in the resolution of pending compensation disputes, and
there can be no assurance about the ultimate outcome of these
proceedings. We cannot predict the effect of the FCC's pending
rulemaking, or an order on remand from the District of Columbia Circuit,
or any future appeals, on existing state decisions or future compensation
levels. In light of these orders, state commissions may, in the context
of existing agreements, reconsider or modify their+ decisions about what
compensation is applicable. Such decisions could include repayment of
past reciprocal compensation for ISP-bound traffic.
Upon expiration of existing interconnection agreements, new agreements
must be negotiated. Those agreements may address compensation for
ISP-bound traffic, or such compensation may be addressed in other ways.
It is possible that rates of compensation for ISP-bound traffic will be
lower in these new agreements than under our existing agreements.
Recently, a U.S. District Court in Wisconsin dismissed several appeals of
state commission decisions involving, among other issues, the obligation
to pay reciprocal compensation. The Court dismissed the appeals in light
of recent U.S. Supreme Court decisions which sought to clarify when
states may be sued in the U.S. courts. Based on a reading of those
decisions, the U.S. District Court determined the Wisconsin Public
Service Commission may not be sued in federal court in connection with
the Commission's enforcement of interconnection agreements. The decisions
have been appealed to the U.S. Court of Appeals for the Seventh Circuit.
If the ruling of the U.S. District Court in Wisconsin is upheld, it would
raise serious questions concerning how state commission action approving
and enforcing interconnection agreements may be reviewed.
We also depend on incumbent local exchange carriers, primarily the
MegaBells, to provide our local telephone service through access to local
communications network elements, termination
18
service or local central office switching, or through wholesale purchase
of the local telephone services of such carriers that we then resell to
end users. Any successful effort by the incumbent local exchange carriers
to deny or substantially limit our access to their network elements or
wholesale services would have a material adverse effect on our ability to
provide local telephone services. Although the Telecommunications Act of
1996 imposes interconnection obligations on incumbent local exchange
carriers, we cannot assure you that we will be able to obtain access to
their communications network elements or services at rates, and on terms
and conditions, that will permit us to offer local services at rates that
are both profitable and competitive.
The Telecommunications Act also contains provisions that affect various
"universal service" programs designed to promote the availability of
telecommunications services in various areas and for various market
segments. These programs provide assistance to schools, libraries, rural
health care providers, low-income subscribers, and subscribers living in
high-cost areas, for their purchase of various telecommunications related
services. These programs are funded through charges on providers of
interstate telecommunications services, although the amounts contributed
may be recovered through charges to our end users. The current
contribution rate is 5.877% of international and interstate end-user
telecommunications revenue.
We are unable to specify the amount of universal service contributions we
will be required to make in future years, or the extent of universal
service programs that will be in existence for areas served by rural and
non-rural telephone companies. Changes to universal service programs may
increase or decrease the level of support provided to various programs,
and may change the level of contribution which telecommunications
providers such as McLeodUSA are required to make.
The Telecommunications Act of 1996 also provides the incumbent local
exchange carriers with new competitive opportunities. For example, under
the Telecommunications Act of 1996, the MegaBells will, upon the
satisfaction of various conditions, be able to offer interLATA long
distance services to local telephone service customers in their regions.
The MegaBells are actively engaged in proceedings and other activities by
which they are seeking to satisfy those conditions. We believe that we
have advantages over the incumbent local exchange carriers in providing
our telecommunications services, including our management's prior
experience in the competitive telecommunications industry and our
emphasis on marketing (primarily using a direct sales force for sales to
business customers and telemarketing for sales to residential customers)
and on responsive customer service. However, the MegaBells may be allowed
to offer interLATA long distance services before their local exchange
markets are completely open to competition. Under such circumstances in
particular, additional competition from the incumbent local exchange
carriers could have a material adverse effect on our business, results of
operations and financial condition.
Competition for local and special access telecommunications services is
based principally on price, quality, network reliability, customer
service and service features. We believe that our management expertise
and emphasis on customer service allows us to compete effectively with
the incumbent local exchange carriers in providing these services. In
addition, our fiber optic communications networks provide both diverse
access routing and redundant electronics, which design features are not
widely deployed by the local exchange carriers' networks. However, if the
incumbent local exchange carriers, particularly the MegaBells, charge
alternative providers such as McLeodUSA unreasonably high fees for
interconnection to their networks, significantly lower their rates for
access and private line services, or offer significant volume and term
discount pricing options to their customers, we could be at a significant
competitive disadvantage.
19
In the future, an important element of providing competitive services may
be the ability to offer customers high-speed broadband local connections.
The FCC is considering a proposal that would allow incumbent local
exchange carriers to offer these and other services through separate
affiliates, in which case their network elements for providing these
services would not need to be made available to us or other competitors.
AT&T has announced that it is entering into arrangements with cable
companies for the exclusive use of their local networks for broadband
telecommunications and several cable companies are offering broadband
Internet access over their network facilities. As of March 17, 2000, we
offer such broadband local access to our customers only in limited areas
in Cedar Rapids, Iowa, southwest Minnesota and southeast South Dakota. If
we are unable to meet future demands of our customers for broadband local
access or other services on a timely basis at competitive rates, we may
be at a significant competitive disadvantage.
For more information about the regulatory environment in which we
operate, SEE "--REGULATION."
WIRELESS COMPETITION. The wireless telecommunications industry is
experiencing significant technological change, as evidenced by the
increasing pace of improvements in the capacity and quality of digital
technology, the growth of wireless data, shorter cycles for new products
and enhancements, and changes in consumer preferences and expectations.
We believe the market for wireless telecommunications services is likely
to expand significantly as equipment costs and service rates continue to
decline, equipment becomes more convenient and functional, wireless
services become more diverse, technology improves and new competitors
enter the market. We also believe providers of wireless services
increasingly will offer, in addition to products that supplement a
customer's wireline communications like cellular telephone services in
use today, wireline replacement products that may result in wireless
services becoming the customer's primary mode of communication.
Accordingly, we expect competition in the wireless telecommunications
business to be dynamic and intense as a result of the entrance of new
competitors and the development of new technologies, products and
services. We anticipate that in the future there could potentially be
eight wireless competitors in each of our proposed PCS markets: two
existing cellular providers, five other PCS providers and Nextel
Communications Inc., an ESMR provider. There are over ten principal
cellular providers and over 20 principal PCS licensees in our proposed
PCS markets. In addition, we could face competition from mobile satellite
services which are under development.
Competition with these or other providers of wireless telecommunications
services may be intense. Many of our potential wireless competitors have
substantially greater financial, technical, marketing, sales,
manufacturing and distribution resources than our own and have
significantly greater experience than us in testing new or improved
wireless telecommunications products and services. Some competitors,
particularly LMDS carriers, are expected to market other services, such
as cable television access, with their wireless telecommunications
service offerings. We do not currently offer wireless cable television
access. In addition, several of our potential wireless competitors are
operating or planning to operate, through joint ventures and affiliation
arrangements, wireless telecommunications systems that encompass most of
the United States. We cannot assure you that we will be able to compete
successfully in this environment or that new technologies and products
that are more commercially effective than our technologies and products
will not be developed. SEE "--WIRELESS SERVICES."
REGULATION
OVERVIEW. Our services are subject to federal, state and local
regulation. The FCC has jurisdiction over our facilities and services to
the extent they are used to provide, originate or terminate interstate or
international common carrier communications. State regulatory
20
commissions retain jurisdiction over the same facilities and services to
the extent they are used to originate or terminate intrastate common
carrier communications. Local governments may require us to obtain
licenses, permits or franchises regulating use of public rights-of-way
necessary to install and operate our networks. In addition, the
licensing, construction, operation, sale and interconnection arrangements
of wireless telecommunications systems are regulated to varying degrees
by the FCC. The construction and operation of wireless systems also may
be subject to state and local regulation.
Through our subsidiaries, we hold various federal and state regulatory
authorizations. We often join other industry members in seeking
regulatory reform at the federal and state levels to open additional
telecommunications markets to competition.
Through our wholly owned subsidiary McLeodUSA Network Services, we
provide competitive access services as a private carrier on a
non-regulated basis. In general, a private carrier is one that provides
service to customers on an individually negotiated contractual basis, as
opposed to a common carrier that provides service to the public on the
basis of generally available rates, terms and conditions. We believe that
McLeodUSA Network Services' private carrier status is consistent with
applicable federal and state laws, as well as regulatory decisions
interpreting and implementing those laws. Should such laws and/or
regulatory interpretations change in the future to reclassify McLeodUSA
Network Services' regulatory status, we believe that compliance with such
reclassification would not have a material adverse effect on us.
Through our wholly owned subsidiaries, we are also subject to federal and
state regulatory requirements, including, in some states, bonding
requirements, due to our direct marketing, telemarketing, fund-raising
activities and sale of prepaid calling cards.
FEDERAL REGULATION. The FCC classifies us as a non-dominant carrier. As a
non-dominant carrier, our interstate and international services are not
subject to material federal regulation, although we file tariffs with the
FCC for our common carrier services. The FCC also imposes prior approval
requirements on transfers of control and assignments of radio licenses
and operating authorizations. The FCC has the authority to condition,
modify, cancel, terminate or revoke such licenses and authorizations for
failure to comply with federal laws or the rules, regulations and
policies of the FCC. The FCC may also impose fines or other penalties for
such violations. While we believe we are in compliance with applicable
laws and regulations, we cannot assure you that the FCC or third parties
will not raise issues with regard to our compliance.
The FCC's role with respect to local telephone competition arises
principally from the Telecommunications Act of 1996, which became
effective February 8, 1996. The Telecommunications Act of 1996 preempts
state and local laws to the extent that they prevent competitive entry
into the provision of any telecommunications service and gives the FCC
jurisdiction over important issues related to local competition. However,
state and local governments retain authority over significant aspects of
the provision of local telecommunications. The Telecommunications Act of
1996 imposes a variety of new duties on local exchange carriers,
including non-incumbent local exchange carriers like McLeodUSA, in order
to promote competition in local exchange and access services. These
duties include requirements to:
o complete calls originated by competing carriers on a reciprocal
basis
o permit resale of services
o permit users to retain their telephone numbers when
changing carriers
o provide competing carriers access to poles, ducts, conduits
and
o rights-of-way at regulated prices
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Incumbent local exchange carriers are also subject to additional
requirements. These duties include obligations of the incumbent local
exchange carriers to:
o interconnect their networks with competitors
o offer collocation of competitors' equipment at their premises
o make available elements of their networks (including network
facilities, features and capabilities) on non-discriminatory,
cost-based terms
o offer wholesale versions of their retail services for resale at
discounted rates
Collectively, these requirements recognize that local exchange
competition is dependent upon cost-based and non-discriminatory
interconnection with and use of incumbent local exchange carrier
networks. Failure to achieve such interconnection arrangements could have
an adverse impact on the ability of McLeodUSA or other entities to
provide competitive local exchange services. Under the Telecommunications
Act of 1996, incumbent local exchange carriers are required to negotiate
in good faith with carriers requesting any or all of the above
arrangements. In addition, in the Interconnection Decision and related
actions the FCC has adopted more specific rules to implement these
requirements. The Interconnection Decision has been the subject of
significant legal dispute. In January 1999, the U.S. Supreme Court
rejected challenges to the Interconnection Decision and affirmed the
authority of the FCC to establish rules governing interconnection. Other
challenges to the Interconnection Decision and related rules remain
pending in various courts. We believe that additional disputes regarding
the Interconnection Decision and other related FCC actions are likely.
The Telecommunications Act of 1996 also eliminates previous prohibitions
on the provision of interLATA long distance services by the MegaBells and
the general telephone operating companies. The MegaBells are permitted to
provide interLATA long distance service outside those states in which
they provide local exchange service ("out-of- region long distance
service") upon receipt of any necessary state and/or federal regulatory
approvals that are otherwise applicable to the provision of intrastate
and/or interstate long distance service. Under the Telecommunications Act
of 1996, the MegaBells will be allowed to provide long distance service
within the regions in which they also provide local exchange service
("in-region service") on a state-by-state basis upon specific approval of
the FCC and satisfaction of other conditions, including a checklist of
interconnection requirements intended to open local telephone markets to
competition. The FCC has found that only Bell Atlantic's operations in
the state of New York have met these interconnection requirements. The
FCC is currently considering the application of Southwestern Bell for its
Texas operations, which application has been endorsed by the Texas Public
Utility Commission. If the FCC does permit U S WEST or SBC/Ameritech to
provide long distance service in their local service regions before they
meet our local interconnection needs, they would be able to offer
integrated local and long distance services and could have a significant
competitive advantage in marketing those services to their existing local
customers.
The Telecommunications Act of 1996 imposes restrictions on the MegaBells
in connection with their entry into the interLATA long distance services
market. Among other things, for the first three years (unless extended by
the FCC) the MegaBells must pursue such activities only through separate
subsidiaries with separate books and records, financing, management and
employees. In addition, affiliate transactions with these subsidiaries
must be conducted on a non-discriminatory basis.
In the future, an important element of providing competitive services may
be the ability to offer customers high-speed broadband local connections.
The FCC is considering a proposal that would allow incumbent local
exchange carriers to offer these and other services through separate
affiliates, in which case their network elements for providing these
services would not
22
need to be made available to us or other competitors. AT&T has announced
that it is entering into arrangements with cable companies for the
exclusive use of their local networks for broadband telecommunications
and several cable companies are offering broadband Internet access over
their network facilities. As of March 17, 2000, we offer such broadband
local access to our customers only in limited areas in Cedar Rapids,
Iowa, southwest Minnesota and southeast South Dakota. If we are unable to
meet future demands of our customers for broadband local access or other
services on a timely basis at competitive rates, we may be at a
significant competitive disadvantage.
The FCC also regulates the interstate access rates charged by incumbent
local exchange carriers for the origination and termination of interstate
long distance traffic. Those access rates make up a significant portion
of the cost of providing long distance service. The FCC has implemented
changes to its interstate access rules that result in restructuring of
the access charge system and changes in access charge rate levels. These
and related actions may reduce access rates, and hence the cost of
providing long distance service, especially to business customers. The
impact of these new changes will not be known until they are fully
implemented over the next several years. In a related proceeding, the FCC
has adopted changes to the methodology by which access has been used in
part to subsidize universal telephone service and other public policy
goals. Telecommunications providers like McLeodUSA pay a fee calculated
as a percentage of their revenues to support these goals. The full
implications of these charges also remain uncertain and subject to
change.
In addition, the FCC and the states are considering related questions
regarding the applicability of access charge and universal service fees
to Internet service providers. Currently, Internet service providers are
not subject to these expenses. Many incumbent local exchange carriers and
other parties have argued that this exemption unfairly advantages
Internet service providers, particularly when they provide data, voice or
other services in direct competition with conventional telecommunications
providers.
In connection with its interconnection decisions, the FCC has granted
local exchange carriers additional flexibility in pricing their
interstate, special and switched access services on a central office
specific basis. Under this pricing scheme, local exchange carriers may
establish pricing zones based on access traffic density and charge
different prices for central offices in each zone. We anticipate that the
FCC will grant local exchange carriers increasing pricing flexibility as
the number of interconnection agreements and competitors increases. The
potential impact of such pricing flexibility on McLeodUSA and other
competitors is unclear at this time.
With the exception of an alpha fixed wireless trial in Illinois, we do
not currently offer PCS services. However, we do own a minority interest
in a cellular telephone partnership serving parts of east central
Illinois. We own 27 "D" and "E" block frequency PCS licenses in 25
markets covering areas of Iowa, Illinois, Minnesota, Nebraska and South
Dakota. Our PCS licenses encompass approximately 110,000 square miles and
a population of approximately 6.9 million. We own four WCS licenses in
the Major Economic Areas of Milwaukee, Wisconsin, Minneapolis/St. Paul,
Minnesota, Des Moines-Quad Cities, Iowa/Illinois and Omaha, Nebraska. We
also own 13 "A" and "B" block LMDS licenses. We are evaluating proposed
wireless systems and expect to utilize our PCS licenses as part of a
network or a strategic combination to add PCS or other wireless services
to our integrated communications services. We intend to use the frequency
blocks covered by our WCS licenses to provide fixed wireless services.
All wireless licenses are subject to FCC regulation.
23
All PCS licenses are awarded for a ten-year period, at the end of which,
absent prior revocation or a violation of the FCC's rules by the
licensee, they will be renewed. As a PCS licensee, we are subject to
"build-out" requirements which require that specified levels of service
be available by specified times. If we fail to meet these coverage
requirements, we may be subject to forfeiture of our PCS licenses.
PCS licenses permit use of radio spectrum that may be currently occupied
by fixed microwave systems. The existing licensees of such systems retain
the right to continue to operate their systems until 2005. To secure a
sufficient amount of unencumbered spectrum to operate a PCS system
efficiently, we may need to relocate many of these existing licensees. In
an effort to balance the competing interests of existing microwave users
and newly authorized PCS licensees, the FCC has adopted a transition plan
to relocate such microwave operators to other spectrum blocks. This
transition plan allows most microwave users to operate in the PCS
spectrum for a one-year voluntary negotiation period and an additional
one-year mandatory negotiation period. For public safety entities
dedicating a majority of their system communications for police, fire or
emergency medical services operations, the voluntary negotiation period
is three years. Parties unable to reach agreement within these time
periods may refer the matter to the FCC for resolution, but the existing
microwave user is permitted to continue its operations until final FCC
resolution of the matter. We estimate that we would be required to pay to
relocate approximately 50 microwave links operated by 19 different
microwave licensees in order to develop a PCS system in our target
wireless markets. In addition, the FCC has imposed new universal service
requirements on wireless carriers, as well as new number portability and
enhanced "911" obligations on commercial mobile radio service providers
including PCS carriers, which may require us to invest in advanced
technology over the next few years.
Wireless systems are also subject to Federal Aviation Administration
regulations respecting the location, lighting and construction of
transmitter towers and antennas and may be subject to regulation under
the National Environmental Policy Act and the environmental regulations
of the FCC. Wireless providers also must satisfy a variety of FCC
requirements relating to technical and reporting matters. One such
requirement is the coordination of proposed frequency usage between
adjacent systems. In addition, the height and power of base station
transmitting facilities and the type of signals they emit must fall
within specified parameters.
The Communications Act of 1934 requires the FCC's prior approval of the
assignment or transfer of control of a PCS or other radio license. In
addition, the FCC has established transfer disclosure requirements that
require licensees who transfer control of or assign a PCS license within
the first three years to file associated contracts for sale, option
agreements, management agreements or other documents disclosing the total
consideration that the applicant would receive in return for the transfer
or assignment of its license. Non- controlling interests in an entity
that holds a PCS license or PCS system generally may be bought or sold by
U.S. companies or individuals without prior FCC approval, but subsequent
notice must be provided to the FCC.
The Telecommunications Act of 1996 imposes restrictions on investment in
McLeodUSA by foreign persons or corporations arising from our ownership
of common carrier radio licenses. However, these restrictions generally
do not apply to investment by nationals of member countries of the World
Trade Organization. We have no knowledge of any ownership by or
affiliation with foreign persons or telecommunications carriers in
violation of the Communications Act or the FCC's rules.
24
Through our wholly owned subsidiaries, we are also subject to rules
governing telemarketing that have been promulgated by both the FCC and
the Federal Trade Commission. The FCC and FTC telemarketing rules
prohibit telemarketers from engaging in deceptive telemarketing practices
and require that telemarketers make specified disclosures. For example,
these telemarketing rules:
o prohibit the use of autodialers that employ prerecorded voice
messages without the prior express consent of the dialed party
o require telemarketers to disclose clear and conspicuous
information concerning quality, cost and refunds to a customer
before a customer makes a purchase
o require telemarketers to compile lists of individuals who desire
not to be contacted
o limit telemarketers to calling residences between the hours of
8:00 a.m. and 9:00 p.m.
o require telemarketers to explicitly identify the seller and state
the purpose of the call
o prohibit product misrepresentations
STATE REGULATION. We provide intrastate common carrier services and are
subject to various state laws and regulations. Most public utility
commissions subject providers such as McLeodUSA to some form of
certification requirement, which requires providers to obtain authority
from the state public utility commission before initiating service. In
most states, we are also required to file tariffs setting forth the
terms, conditions and prices for services that are classified as
intrastate. We are required to update or amend these tariffs when we
adjust our rates or add new products, and are subject to various
reporting and record-keeping requirements in these states.
Many states also require prior approval for transfers of control of
certified carriers, corporate reorganizations, acquisitions of
telecommunications operations, assignment of carrier assets, carrier
stock offerings and incurrence by carriers of significant debt
obligations. Certificates of authority can generally be conditioned,
modified, canceled, terminated or revoked by state regulatory authorities
for failure to comply with state law or the rules, regulations and
policies of state regulatory authorities. Fines or other penalties also
may be imposed for such violations. State utility commissions or third
parties could raise issues with regard to our compliance with applicable
laws or regulations which could have a material adverse effect on our
business, results of operations and financial condition.
We hold certificates of authority to offer local services using our own
communications network facilities in Iowa, Illinois, Wisconsin,
Minnesota, North Dakota, South Dakota, Wyoming, Idaho, Indiana, Missouri,
Nebraska, Michigan, Colorado, Washington, Oregon, Kansas, Ohio, Montana
and Utah and to resell the local services of the MegaBells in most of the
markets they serve in those states. Applications are pending in New
Mexico and Arizona. In addition, we are certificated to resell the local
services of the incumbent and to offer local services using our own
network facilities in states in which our target markets are served by
major independent local exchanges companies, including GTE and Sprint.
SEE "-- EXPANSION OF SERVICES USING OUR OWN COMMUNICATIONS NETWORK
FACILITIES."
25
We are also authorized to offer long distance service in all 48 states in
the continental United States. We have obtained authority to offer long
distance service in such states, including states outside our target
markets, because we believe this capability will enhance our ability to
attract business customers that have offices outside of our target
markets. We may also apply for authority to provide services in all
MegaBell exchanges in our target market states and, in the future, in
other states. While we expect and intend to obtain the necessary
regulatory authority in each jurisdiction where we plan to operate, we
cannot assure you that each respective agency will grant our request for
authority.
The Telecommunications Act of 1996 preserves the ability of states to
impose reasonable terms and conditions on the provision of intrastate
service and other related regulatory requirements. In the last several
years, many states have enacted broad changes in their telecommunications
laws that authorize the entry of competitive local exchange carriers and
provide for new regulations to promote competition in local and other
intrastate telecommunications services. The MegaBells have consistently
promoted sweeping legislation that would if enacted severely limit or
altogether eliminate state regulatory oversight of the MegaBells. As a
general matter, we believe the states will play a key role in the
development of local exchange competition. Consequently, we could face
regulatory decisions that adversely affect our ability to compete in
particular states.
States also regulate the intrastate carrier access services of the
incumbent local exchange carriers. We are required to pay access charges
to originate and connect our intrastate long distance traffic. We could
be adversely affected by high access charges, particularly to the extent
that the incumbent local exchange carriers do not incur the same level of
costs with respect to their own intrastate long distance services. In a
related development, states also will be developing intrastate universal
service charges parallel to the interstate universal service charges
created by the FCC. For example, some incumbent local exchange carriers
are proposing that states create funds that would be supported by
potentially large payments by firms such as McLeodUSA based on their
total intrastate revenues. Another state regulatory issue that could
adversely affect our business is the approval by some state regulatory
agencies of extended local area calling for incumbent local exchange
carriers, converting otherwise competitive intrastate toll service to
local service. Our business could be adversely affected by these or other
developments.
We believe that, as the degree of intrastate competition increases,
states will offer the local exchange carriers increasing pricing
flexibility. This flexibility may present the local exchange carriers
with an opportunity to subsidize services that compete with our services
with revenues generated from non-competitive services, allowing incumbent
local exchange carriers to offer competitive services at prices below the
cost of providing the service. We cannot predict the extent to which this
may occur or its impact on our business.
ICTC is subject to rate of return regulation by the Illinois Commerce
Commission. Under such regulation, ICTC is allowed to earn up to a fixed
rate of return on its equity. In the event that the Illinois Commerce
Commission finds that ICTC has exceeded its authorized rate of return on
equity, ICTC could be required to lower its customer rates or make
refunds. While we believe ICTC will earn less than its authorized rate of
return during the current monitoring period, we cannot assure you that
the Illinois Commerce Commission will not, at some future date, find that
ICTC has earned more than its authorized rate of return or that such a
finding would not have a material adverse effect on us.
26
In addition, a substantial proportion of ICTC's and Dakota
Telecommunications' revenues are derived from access charges imposed on
long distance carriers. Access charge rate structures and rate levels
have been modified by recent regulatory changes, and further changes are
possible. If such revisions result in a reduction of ICTC's and Dakota
Telecommunications' revenues and gross margins, it could have a material
adverse effect on us.
Several of our subsidiaries also hold state and federal certificates and
FCC licenses in connection with the operation of wireless
telecommunications services and paging services.
Through our wholly owned subsidiaries, we engage in various direct
marketing, telemarketing and fund-raising activities. Most states have
laws that govern these activities. In states that regulate such
activities, several types of restriction have been imposed, either singly
or in combination, including requirements to:
o register with state authorities
o post professional bonds
o file operational contracts with state authorities
o respect statutory waiting periods
o register employees with state authorities
o prohibit control over funds collected from such activities
LOCAL GOVERNMENT AUTHORIZATIONS. We are required to obtain construction
permits and licenses or franchises to install and expand our fiber optic
communications networks using rights-of-way. Some local governments where
we have installed or anticipate constructing networks are proposing and
enacting ordinances regulating use of rights-of-way and imposing various
fees in connection with such use. In some instances we have negotiated
interim agreements to authorize installation of facilities pending
resolution of the fee issue. In many markets, the local exchange carriers
do not pay rights-of-way fees or pay fees that are substantially less
than the fees we are required to pay. To the extent that competitors do
not pay the same level of fees as us, we could be at a competitive
disadvantage. We must also negotiate and enter into franchise agreements
with local governments in order to operate our video services networks.
We have franchises for our existing services, but will need additional
franchises in order to expand into additional markets. If we fail to
receive necessary permits or franchise agreements on commercially
reasonable terms or are unable to obtain or maintain right-of-way
authorization or license agreements, we could be materially adversely
affected. If we lose a right-of-way, we could be required to remove our
facilities from the right-of-way or abandon our network in place.
RISK FACTORS
In connection with the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995, set forth below are cautionary statements
identifying important factors that could cause our actual results to
differ materially from those projected in any forward-looking statements
made by or on behalf of us, whether oral or written. We wish to ensure
that any forward- looking statements are accompanied by meaningful
cautionary statements in order to maximize to the fullest extent possible
the protections of the safe harbor established in the Private Securities
Litigation Reform Act of 1995. Accordingly, any such statements are
qualified in their entirety by reference to, and are accompanied by, the
following important factors that could cause our actual results to differ
materially from those projected in our forward-looking statements.
FLUCTUATIONS IN THE MARKET PRICE OF OUR CLASS A COMMON STOCK MAY MAKE IT
MORE DIFFICULT FOR US TO RAISE CAPITAL.
27
The market price of our Class A common stock is extremely volatile and
has fluctuated over a wide range. These fluctuations may impair our
ability to raise capital by offering equity securities. The market price
may continue to fluctuate significantly in response to various factors,
including:
o market conditions in the industry
o announcements and actions by competitors
o low trading volume
o quarterly variations in operating results or growth rates
o changes in estimates by securities analys