Back to GetFilings.com
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 1996
OR
[ ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the transition period from ______ to ______
Commission File Number: 0-20763
McLEOD, INC.
---------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 58-421407240
- ----------------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
221 Third Avenue SE, Suite 500
Cedar Rapids, IA 52401
- ----------------------------------------- -------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (319) 364-0000
Securities registered pursuant to Section 12(b) of the Act:
Not Applicable
Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, par value $.01 per share
------------------------------------------------
Title of Class
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months 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 19, 1997 is $328,114,167. */
-
The number of shares outstanding of each of the registrant's classes of common
stock, as of the latest practicable date is:
Class A Common Stock, par value $.01 per share, outstanding as of March 19,
1997: 36,989,242
Class B Common Stock, par value $.01 per share, outstanding as of March 19,
1997: 15,625,929
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:
(1) Portions of the definitive proxy statement for the Annual Meeting of
Stockholders to be held on May 29, 1997, 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.
- ----------
*/ 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 are considered to be affiliates.
TABLE OF CONTENTS
Page
PART I Item 1. Business............................................... 1
Item 2. Properties............................................. 36
Item 3. Legal Proceedings...................................... 36
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.................................... 39
Item 6. Selected Financial Data................................ 41
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................... 42
Item 8. Financial Statements and Supplementary Data............ 49
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................... 50
PART III Item 10. Directors and Executive Officers of the Registrant..... 50
Item 11. Executive Compensation................................. 50
Item 12. Security Ownership of Certain Beneficial Owners and
Management............................................. 50
Item 13. Certain Relationships and Related Transactions......... 51
PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on
Form 8-K............................................... 51
GLOSSARY.................................................................. 61
SIGNATURES................................................................ 64
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS................................ F-1
INDEPENDENT AUDITOR'S REPORT ON THE FINANCIAL STATEMENT SCHEDULES......... S-1
This Form 10-K contains certain forward-looking statements that
involve risks and uncertainties. The Company's actual results could differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including those set forth under the caption
"Business--Risk Factors" and elsewhere in this Form 10-K. Unless the context
suggests otherwise, references in this Form 10-K to the "Company" mean McLeod,
Inc. and its subsidiaries and predecessors. Unless otherwise indicated, the
information in this Form 10-K reflects the recapitalization, effective May 2,
1996, in which shares of the Company's Class A Common Stock, $.01 par value
per share (the "Class A Common Stock"), and Class B Common Stock, $.01 par
value per share (the "Class B Common Stock"), were split on the basis of 3.75
for one. Unless otherwise indicated, 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. See the "Glossary" appearing elsewhere herein
for definitions of certain terms used in this Form 10-K.
PART I
Item 1. Business.
Overview
The Company is a provider of integrated telecommunications services to
small and medium-sized businesses and, since June 1996, residential customers,
primarily in Iowa and Illinois. The Company derives its telecommunications
revenue from (i) the sale of "bundled" local, long distance and other
telecommunications services to end users, (ii) telecommunications network
maintenance services, (iii) competitive access services, including special
access and private line services, and (iv) ancillary services, including
direct marketing and telemarketing services, the sale of advertising space in
telephone directories and the sale of business telephone systems. As of
December 31, 1996, the Company served over 17,800 telecommunications customers
in 92 cities and towns.
The Company offers "one-stop" integrated telecommunications services,
including local, long distance, voice mail, paging and Internet access
services, tailored to the customer's specific needs. For business customers,
this approach simplifies telecommunications procurement and management and
makes available customized services, such as "least-cost" long distance
pricing and enhanced calling features, that might not otherwise be directly
available to such customers on a cost-effective basis. For residential
customers, this approach provides integrated local, long distance and other
telecommunications services, flat-rate long distance pricing and enhanced
calling features as part of the Company's basic PrimeLine(R) residential
services. The Company also offers a variety of special access and private line
services to large businesses, institutional customers and interexchange
carriers, primarily in Des Moines, Iowa. In addition, the Company provides
network maintenance services for the State of Iowa's fiber optic network.
The Company was formed on June 6, 1991 as McLeod Telecommunications, Inc.
It began operations in November of 1992, providing fiber optic maintenance
services for the Iowa Communications Network. The Iowa Communications Network
is a fiber optic network that links certain of the State of Iowa's schools,
libraries and other public buildings. On August 1, 1993, the Company was
reincorporated in the State of Delaware. McLeodUSA Telecommunications
Services, Inc., a wholly owned subsidiary of the Company ("McLeodUSA
Telecommunications"), received regulatory approvals in Iowa and Illinois to
offer local and long distance services in December 1993 and began providing
such services in January 1994. In April 1995, July 1996, September 1996 and
January 1997, respectively, the Company acquired MWR Telecom, Inc. ("MWR")
(now part of McLeodUSA Network Services, Inc. ("McLeodUSA Network Services")),
a competitive access provider in Des Moines, Iowa, Ruffalo, Cody & Associates,
Inc. ("Ruffalo, Cody"), a telemarketing company, Telecom*USA Publishing Group,
Inc. (now known as McLeodUSA Media Group, Inc. ("McLeodUSA Publishing")), a
publisher of telephone directories, and Digital Communications of Iowa, Inc.
("Digital Communications"), a telephone equipment company.
The Company is organized as a holding company and operates primarily
through wholly owned subsidiaries. Since September 1996, the Company's
business has been organized into four operational groups: (i) Business
Services, which develops, markets and sells the Company's telecommunications
services to business customers; (ii) Consumer Services, which markets and
sells the Company's PrimeLine(R) service to residential customers and engages
in various direct marketing and telemarketing activities; (iii) Network
Services, which designs, constructs, and operates the Company's fiber optic
network and engages in the Company's network maintenance activities; and (iv)
Publishing Services, which publishes and distributes telephone directories.
As of the date hereof, the Company is offering integrated
telecommunications services to business and residential customers located
primarily in Iowa and Illinois. The Company has recently begun sales of
integrated telecommunications services in a number of markets in Minnesota and
Wisconsin. The Company plans to begin offering integrated telecommunications
services in markets in South Dakota, North Dakota, Colorado and Wyoming in
1997. Over the next several years, depending on competitive and other factors,
the Company also intends to offer integrated telecommunications services in
Montana, Idaho, Utah and Nebraska. The Company also offers long distance
service in Alabama, Arizona, Arkansas, California, Colorado, Delaware,
Georgia, Idaho, Indiana, Kansas, Kentucky, Maine, Maryland, Massachusetts,
Mississippi, Michigan, Missouri, Montana, Nebraska, Nevada, New Hampshire, New
Jersey, Ohio, Oregon, Pennsylvania, Rhode Island, Texas, Utah, Virginia,
Washington and Wyoming.
On January 15, 1997, the Federal Communications Commission ("FCC")
notified the Company that it was the successful bidder for 26 "D" and "E"
block frequency personal communications services ("PCS") licenses in 24
markets covering areas of Iowa, Illinois, Minnesota, Nebraska and South
Dakota. The Company bid an aggregate of approximately $32.8 million for these
PCS licenses, which the Company will be required to pay to the FCC following
grant of the licenses, anticipated to occur during the second or third quarter
of 1997. The PCS licenses encompass approximately 110,000 square miles and a
population of approximately 6.5 million. The Company is assessing its
technological options and beginning to design and engineer its proposed PCS
system. The Company expects to begin constructing its PCS network by the end
of 1997 and offering PCS services as part of its integrated telecommunications
services in 1998. See "--Risk Factors--PCS System Implementation Risks."
The statements in the foregoing paragraphs about the Company's expansion
plans and proposed PCS 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 the Company's actual
geographic expansion and wireless services may differ materially from that
indicated by its current plans, in each case as a result of a variety of
factors, including: (i) the availability of financing and regulatory
approvals; (ii) the number of potential customers in a target market; (iii)
the existence of strategic alliances or relationships; (iv) technological,
regulatory or other developments in the Company's business; (v) changes in the
competitive climate in which the Company operates; and (vi) the emergence of
future opportunities.
As of the date hereof, the Company believes it is the first
telecommunications provider in most of its markets to offer "bundled" local,
long distance and other telecommunications services. As a result, the Company
believes that it is well-positioned to take advantage of fundamental changes
occurring in the telecommunications industry resulting from the
Telecommunications Act of 1996 (the "Telecommunications Act") and to challenge
incumbent local carriers. The Company provides local service using existing
telephone lines obtained from incumbent local exchange carriers, which allows
customers to switch to local service provided by the Company without changing
existing telephone numbers. The Company provides long distance services by
purchasing bulk capacity from a long distance carrier. Using the Company's
sophisticated proprietary software, known as Raterizer(R), each business
customer subscribing to the Company's integrated telecommunications services
receives the lowest long distance rate available each month from among the
pricing plans of AT&T Corp. ("AT&T"), MCI Communications Corporation ("MCI")
and Sprint Corporation ("Sprint") that generally are most popular with the
Company's business customers, and, in certain cases, rates specifically
identified by a
2
business customer and agreed to by the Company. The Company also provides
paging and Internet access services.
The Company's principal executive offices are located at 221 Third Avenue
SE, Suite 500, Cedar Rapids, Iowa 52401, and its phone number is (319)
364-0000.
Recent Transactions
On July 15, 1996, the Company acquired Ruffalo, Cody by means of a merger
of Ruffalo, Cody with and into a newly formed wholly owned subsidiary of the
Company. As consideration for the acquisition, the Company paid approximately
$4.8 million in cash and issued an aggregate of 361,420 shares of Class A
Common Stock to the shareholders of Ruffalo, Cody, and granted options to
purchase an aggregate of 158,009 shares of Class A Common Stock to the holders
of options to purchase shares of Ruffalo, Cody common stock. An additional
$50,782 in cash and 113,387 shares of Class A Common Stock were placed into
escrow to be delivered to certain of the shareholders of Ruffalo, Cody over a
period of 18 months, contingent upon the fulfillment of certain conditions
relating to Ruffalo, Cody's ongoing revenues from a material agreement with a
major long distance carrier to provide telemarketing services. The major long
distance carrier terminated this agreement, effective December 31, 1996. A
total of $50,782 and 37,107 shares of Class A Common Stock were distributed
pursuant to the escrow agreement in January 1997 and the Company expects one
additional distribution of 19,070 shares of Class A Common Stock to occur in
April 1997.
Ruffalo, Cody specializes in direct marketing and telemarketing services,
including telecommunications sales, as well as a variety of fund-raising
services for colleges, universities and other non-profit organizations
throughout the United States.
On September 20, 1996, the Company acquired McLeodUSA Publishing by means
of a merger of a newly formed wholly owned subsidiary of the Company with and
into McLeodUSA Publishing. As consideration for the acquisition, the Company
paid approximately $74.1 million in cash and an additional amount estimated as
of the date hereof to be approximately $1.6 million to be paid to certain
employees of McLeodUSA Publishing as part of an incentive plan. At the time of
the acquisition, McLeodUSA Publishing had outstanding debt of approximately
$6.6 million.
McLeodUSA Publishing publishes and distributes "white page" and "yellow
page" telephone directories in nineteen states in the midwestern and Rocky
Mountain regions of the United States, including most of the Company's target
markets. McLeodUSA Publishing derives its revenues primarily from the sale of
advertising space in its telephone directories.
On December 9, 1996, the Company, through McLeodUSA Telecommunications,
acquired the customer base of Total Communication Systems, Inc. ("TCSI") for
an aggregate cash purchase price of approximately $534,000. TCSI is an Iowa
corporation that offered local and long distance service in Iowa by
partitioning central office switches of U S WEST Communications, Inc. ("U S
WEST"). TCSI managed approximately 1,600 local and long distance lines in Iowa
prior to the acquisition.
McLeodUSA Publishing entered into an option agreement with Fronteer
Directory Company, Inc. ("Fronteer") on April 27, 1995 pursuant to which
Fronteer granted to McLeodUSA Publishing the right and option to acquire nine
telephone directories published by Fronteer (the "Fronteer Option"). On
January 27, 1997, McLeodUSA Publishing exercised the Fronteer Option to
acquire six of the telephone directories at a price to be determined based on
the sum of the revenues derived from the last Fronteer editions of the
directories. The purchase price is estimated as of the date hereof to be
approximately $4 million. The transaction was consummated on February 25,
1997.
On January 30, 1997, the Company acquired Digital Communications by means
of a merger of a newly formed wholly owned subsidiary of the Company with and
into Digital Communications. As consideration for the acquisition, the Company
issued an aggregate of 84,430 shares of Class A
3
Common Stock to the shareholders of Digital Communications. Digital
Communications sells, installs and services telephone systems primarily to
small businesses in eastern Iowa.
On February 27, 1997, McLeodUSA Publishing entered into an agreement with
Indiana Directories, Inc. to acquire 26 telephone directories published by
Indiana Directories, Inc. at a price to be determined based on the sum of the
revenues derived from the last Indiana Directories, Inc. editions of the
directories. The purchase price is estimated as of the date hereof to be
approximately $10.5 million. Closing of the transaction is expected to occur on
March 31, 1997.
On March 4, 1997, the Company completed a private offering of $500
million aggregate principal amount at maturity of 10 1/2% senior discount
notes due March 1, 2007 (the "Notes"). The Notes were priced at a discount and
the Company received net proceeds of approximately $289.5 million.
Business Strategy
The Company's objective is to become a leading provider of integrated
wireline and wireless telecommunications services in Iowa, Illinois,
Minnesota, Wisconsin, South Dakota, North Dakota, Colorado, Wyoming, Montana,
Utah, Idaho and Nebraska. The Company intends to increase its penetration of
its current markets and expand into new markets by: (i) aggressively capturing
market share and generating revenues using leased network capacity and (ii)
concurrently constructing additional network infrastructure to more cost-
effectively serve its customers.
The principal elements of the Company's business strategy include:
. Provide Integrated Telecommunications Services. The Company believes
that there is substantial demand among business and residential
customers in its target markets for an integrated package of wireline
and wireless telecommunications services that meets all of the
customer's telecommunications needs. The Company believes that, by
bundling a variety of telecommunications services, it will position
itself to become an industry leader in offering "one-stop" integrated
telecommunications services, to penetrate rapidly its target markets
and to build customer loyalty. The Company intends to add PCS services
to its current array of integrated telecommunications services
beginning in 1998.
. Build Market Share Through Branding and Customer Service. The
Company believes that, by branding its telecommunications services
with the trade name *McLeodUSA in combination with the distinctive
black-and-yellow motif of the McLeodUSA Publishing directories, it
will create and strengthen brand awareness in all of the Company's
markets. The Company also believes that the key to revenue growth in
its target markets is capturing and retaining customers through an
emphasis on marketing, sales and customer service. The Company's
customer-focused software and network architecture allow immediate
access to the Company's customer data by Company personnel, enabling a
quick and effective response to customer requests and needs at any
time. This software permits the Company to present its customers with
one fully integrated monthly billing statement for local, long
distance, 800, international, voice mail, paging, Internet access and
travel card services, and will permit the Company to include
additional services, such as PCS, when available. The Company believes
that its customer-focused software platform is an important element in
the marketing of its telecommunications services and gives it a
competitive advantage in the marketplace. The Company has been
successful in obtaining long-term commitments from its business
customers and responding rapidly and creatively to customer needs.
. Focus on Small and Mid-sized Markets. The Company principally
targets small and mid-sized markets (cities and towns with a
population between 8,000 and 350,000) in its service areas. The
Company estimates that its current and planned target markets have a
combined population of approximately 9.5 million. The Company strives
to be the first to market integrated telecommunications services in
its principal markets and expects that intense
4
competition in bundled telecommunications services will be slower to
develop in these markets than in larger markets.
. Expand its Fiber Optic Network. The Company is constructing a state-
of-the-art digital fiber optic telecommunications network designed to
serve markets in Iowa. In the future, the Company expects to expand
its fiber optic network to include additional markets. The Company's
decision to expand its fiber optic network will be based on various
economic factors, including: (i) the number of its customers in a
market; (ii) the anticipated operating cost savings associated with
such construction; and (iii) any strategic relationships with owners
of existing infrastructure (e.g., utilities and cable operators). As
of March 21, 1997, the Company owned approximately 2,500 route miles
of fiber optic network and, subject to the foregoing factors, expects
to construct approximately 5,000 additional route miles of fiber optic
network during the next three years. Through its strategic
relationships with its electric utility stockholders and its contracts
to build the final links of the Iowa Communications Network and lease
a portion of the capacity on those links to the State of Iowa, the
Company believes that it will be able to achieve capital efficiencies
in constructing its fiber optic network in a rapid and cost-effective
manner. The Company also believes that its fiber optic network in
combination with its proprietary software will create an attractive
customer-focused platform for the provision of local, long distance,
wireless and enhanced services.
. Transition into Local Switched Services Business. When certain
judicial and regulatory proceedings are resolved, and assuming the
economics are favorable to the Company, the Company intends to begin
offering facilities-based switched services by using its existing high
capacity digital AT&T switch and installing additional switches. In
August 1996, the FCC released a decision implementing the
interconnection portions of the Telecommunications Act (the
"Interconnection Decision"). Certain provisions of the Interconnection
Decision have been stayed by an October 1996 court decision, and will
be subject to further judicial and regulatory proceedings. The Company
believes that these proceedings should be substantially resolved, and
that the Company could begin offering local facilities-based switched
services, during the next three years. In March 1995 and April 1996,
respectively, the Company received state regulatory approval in Iowa
and Illinois to offer local switched services in Cedar Rapids, Iowa
and in Illinois cities other than Chicago. The Company intends to seek
regulatory approval to provide such services in other cities and towns
in Iowa and other states targeted by the Company when the economic
terms of interconnection with the incumbent local exchange carrier
make the provision of local switched services cost-effective.
. Explore Potential Acquisitions and Strategic Alliances. The Company
believes that its strategic alliances with two utilities in its Iowa
markets provide it with access to rights-of-way and other resources on
favorable terms. The Company believes that its acquisitions of
Ruffalo, Cody and McLeodUSA Publishing during 1996 will increase the
Company's penetration of its current markets and accelerate its entry
into new markets. As part of its expansion strategy, the Company
contemplates additional acquisitions, joint ventures and strategic
alliances with businesses that are related or complementary to its
current operations. The Company believes that the addition of such
related or complementary businesses will help it to expand its
operations into its target markets. As a result, the Company plans to
consider acquisitions, joint ventures and strategic alliances in areas
such as wireline and wireless services, directory publishing, network
construction and infrastructure and Internet access.
. Leverage Proven Management Team. The Company has recruited a team of
veteran competitive telecommunications managers, led by entrepreneur
Clark McLeod, who have together in the past successfully implemented a
similar customer-focused telecommunications strategy in the same
regions. Seven of the nine executive officers of the Company served as
officers of Teleconnect Company ("Teleconnect") or its successor,
Telecom*USA, Inc. ("Telecom*USA"). Teleconnect began providing long
distance services
5
in Iowa in 1982 and rapidly expanded into dozens of cities and towns
in the Midwest. Telecom*USA was the fourth-largest U.S. long distance
provider when MCI purchased it in 1990 for $1.25 billion.
Market Potential
The telecommunications industry is undergoing substantial changes due to
statutory, regulatory and technological developments. The Company believes
that it is well-positioned to take advantage of these fundamental changes.
Wireline Services. The market for local exchange services consists of a
number of distinct service components. These service components are defined by
specific regulatory tariff classifications including: (i) local network
services, which generally include basic dial tone, local area charges,
enhanced calling features and private line services (dedicated point-to-point
intraLATA service); (ii) network access services, which consist of access
provided by local exchange carriers to long distance network carriers; (iii)
long distance network services, which include intraLATA long distance calls;
and (iv) other varied services, including the publication of "white page" and
"yellow page" telephone directories and the sale of business telephone
equipment. Industry sources have estimated that the 1995 aggregate revenues of
all local exchange carriers approximated $95 billion. Until recently, there
was virtually no competition in the local exchange markets.
Until 1984, AT&T largely monopolized local and long distance telephone
services in the United States. Technological developments gradually enabled
others to compete with AT&T in the long distance market. In 1984, largely as
the result of a court decree, AT&T was required to divest its local telephone
systems (the "Divestiture"), which created the present structure of the
telecommunications industry. 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
Regional Bell Operating Companies were given the right to provide local
telephone service, local access service and intraLATA long distance service,
but were prohibited from providing interLATA service. AT&T retained its long
distance services operations. The separation of the Regional Bell Operating
Companies from AT&T's long distance business created two distinct
telecommunications market segments: local exchange and long distance. The
Divestiture decreed direct, open competition in the long distance segment, but
continued the regulated monopoly environment in local exchange services.
In 1984, a separate court decree (the "GTE Decree") required the local
exchange operations of the General Telephone Operating Companies to be
structurally separated from the competitive operations of GTE Corp., their
parent company. As a result, the GTE Decree also prohibited the General
Telephone Operating Companies from providing interLATA services.
On February 8, 1996, the Telecommunications Act was enacted. The
Telecommunications Act removed the restrictions in the Divestiture and the GTE
Decree concerning the provision of interLATA service by the Regional Bell
Operating Companies and the General Telephone Operating Companies. These
decree restrictions have been replaced, with respect to the Regional Bell
Operating Companies, by provisions of the Telecommunications Act setting forth
the conditions under which the Regional Bell Operating Companies may enter
formerly prohibited markets. The Telecommunications Act requires all local
exchange carriers to "unbundle" their local network offerings and allow other
providers of telecommunications services to interconnect with their facilities
and equipment. Most significantly, the incumbent local exchange carriers will
be required to complete local calls originated by the Company's customers and
switched by the Company and to deliver inbound local calls to the Company for
termination to its customers, assuring customers of unimpaired local calling
ability. Although there can be no assurance, the Company believes that it
should also be able to obtain access to incumbent carrier "loop" facilities
(the transmission lines connecting customers' premises to the public telephone
network) on an unbundled basis at reasonable and non-discriminatory rates. 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
6
competitors non-discriminatory access to local exchange carrier poles, conduit
space and other rights-of-way. Moreover, states may not erect "barriers to
entry" of local competition, although they may regulate such competition.
The Company believes that each of these requirements is likely, when
fully implemented, to increase competition among providers of local
telecommunications services and simplify the process of switching from local
exchange carrier services to those offered by competitive access
provider/competitive local exchange carriers. However, the Telecommunications
Act also offers important benefits to the incumbent local exchange carriers.
The incumbent local exchange carriers have been granted substantial new
pricing flexibility. Regional Bell Operating Companies and General Telephone
Operating Companies have regained the ability to provide long distance
services under specified conditions and have new rights to provide certain
cable TV services. The Telecommunications Act, however, also provides for
certain safeguards to attempt to protect against anticompetitive abuses by the
Regional Bell Operating Companies. Among other protections, the ability of the
Regional Bell Operating Companies to market jointly interLATA and local
services is limited under certain circumstances.
Prior to the enactment of the Telecommunications Act, several factors
served to promote competition in the local exchange market, including: (i)
rapidly growing customer demand for an alternative to the local exchange
carrier monopoly, spurred partly by the development of competitive activities
in the long distance market; (ii) advances in the technology for transmission
of data and video, which require greater capacity and reliability levels than
many local exchange carrier networks (which principally are copper-based) can
accommodate; (iii) the development of fiber optic and digital electronic
technology, which reduced network construction costs while increasing
transmission speeds, capacity and reliability as compared to the local
exchange carriers' copper-based network; (iv) the significant access charges
interexchange carriers are required to pay to local exchange carriers to
access the local exchange carriers' networks; and (v) a willingness on the
part of legislators to enact and regulators to enforce legislation and
regulations permitting and promoting competition in the local exchange market.
Competitors in the local exchange market, designated as competitive
access providers by the FCC, were first established in the mid-1980s.
Initially, competitive access providers were allowed to compete for only the
non-switched special access/private line service of the local exchange market.
In New York City, Chicago and Washington, D.C., newly formed companies
provided dedicated non-switched services by installing fiber optic facilities
capable of connecting points of presence of interexchange carriers within a
metropolitan area, connecting two or more customer locations with private line
service and, in some cases, connecting business and government users with
interexchange carriers. Competitive access providers used the substantial
capacity and economies of scale inherent in fiber optic cable to offer
customers service that was generally less expensive and of higher quality than
could be obtained from the local exchange carriers due, in part, to copper-
based facilities used in many local exchange carrier networks. In addition,
competitive access providers offered shorter installation and repair intervals
and improved reliability in comparison to the local exchange carriers.
Most of the early competitive access providers were entrepreneurial
enterprises that operated limited networks in the central business districts
of major cities in the United States where the highest concentration of voice
and data traffic, including interexchange carrier to interexchange carrier
traffic, was located. The provision of competitive access services, however,
need not be confined to large metropolitan areas. The Company believes that,
through proper design and installation of its network in its targeted markets,
it can effectively provide integrated local and long distance services not
only to interexchange carriers and large users, but also to residential and
small to medium-sized business customers.
As a result of regulatory changes and competitive trends, competitive
local telecommunications companies and access providers appear to be
positioned for dramatic growth. Effective in early 1994, FCC decisions
announced in September 1992 and August 1993, as modified by subsequent FCC and
court decisions (the "Initial Interconnection Decisions"), opened additional
segments of the market by permitting competitive access providers expanded
authority to interconnect with and use facilities owned by local exchange
companies for interstate traffic. The Company believes that the Initial
Interconnection
7
Decisions, together with other statutory and regulatory initiatives in the
telecommunications industry (including the Telecommunications Act), recently
introduced to foster competition in the local exchange markets, have
stimulated demand for competitive local services. In August 1996 the FCC
released the Interconnection Decision implementing the interconnection
portions of the Telecommunications Act. The Interconnection Decision
establishes rules for negotiating interconnection agreements and guidelines
for review of such agreements by state public utilities commissions. Certain
provisions of the Interconnection Decision have been stayed by an October 1996
court decision, and will be subject to further judicial and regulatory
proceedings. Although this judicial stay does not prevent the Company from
negotiating interconnection agreements, it does create uncertainty about the
rules governing pricing, terms and conditions of interconnection agreements
and will likely delay the execution of these agreements. If the Company can
negotiate favorable interconnection agreements, and subject to the resolution
of judicial and regulatory proceedings necessary to implement such agreements,
the Company believes that it could begin offering local facilities-based
switched services within three years.
As of December 31, 1996, a number of states, including Iowa, Illinois,
Minnesota, Wisconsin and North Dakota, have taken regulatory and legislative
action to open local telecommunications markets to various degrees of
competition. State regulatory agencies in other states within the Company's
target market area, including South Dakota, Nebraska, Colorado, Montana, Idaho
and Wyoming, are conducting administrative proceedings to investigate opening
local telecommunications markets to competition. The Telecommunications Act
preempts any remaining state prohibitions of local competition and also
forbids unreasonable restrictions on resale of local services. The Company
expects 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 networks and
address a larger customer base.
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 38.2 million as
of June 30, 1996, with a compound annual growth rate in excess of 45% from
1990 through 1995. Wireless communication revenues for the 12-month period
ended June 30, 1996 are estimated by CTIA to have totaled over $21 billion, a
31% increase over the prior 12-month period. The Company believes 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. The Company also believes the rapid growth of
notebook computers and personal digital assistants, combined with emerging
software applications for wireless delivery of electronic mail, fax and
database searching, will further stimulate demand for wireless service. BIA
Consulting, Inc. estimates that the number of wireless service subscriptions
will reach 90.5 million by the year 2000, with PCS accounting for
approximately 23.1 million of such subscriptions.
Current Products and Services
The Company has historically derived revenue from: (i) the sale of local
and long distance telecommunications services, (ii) special access and private
line services and (iii) telecommunications network maintenance services. As a
result of the acquisition by the Company of Ruffalo, Cody, McLeodUSA
Publishing and Digital Communications in July 1996, September 1996 and January
1997, respectively, the Company also derives revenue from ancillary services,
including direct marketing and telemarketing services, the sale of advertising
space in telephone directories and the sale of business telephone systems. For
the year ended December 31, 1996, these services represented 51%, 13%, 7% and
29%, respectively, of the Company's total revenues.
Integrated Telecommunications Services. As of December 31, 1996, the
Company was providing service, on a retail basis, to approximately 65,000
lines in its Iowa and Illinois markets, primarily to small and medium-sized
business customers. Since beginning sales activities in January 1994, the
Company has increased its revenue approximately 800% from the sale of local
and long distance telecommunications services from $4.6 million for the year
ended December 31, 1994 to $41.4 million for
8
the year ended December 31, 1996. In order to provide integrated
telecommunications services to its business and residential customers, the
Company, pursuant to agreements with U S WEST for its Iowa and Minnesota
customers and Ameritech Corporation ("Ameritech") for its Illinois and
Wisconsin customers, partitions part of the central office switches serving
the communities in which the Company provides such services ("Centrex"
services). The Company's customers' telephone lines and numbers are assigned
to the Company's portion of the switch. U S WEST or Ameritech, as the case may
be, bills the Company for all the lines that the Company has assigned to the
Company's customers and provides the Company with call detail reports, which
enable the Company to verify its customers' bills for both local and long
distance service.
The Company believes that these services are superior to a standard
business or residential telephone line, since the Company can offer features,
such as three-way calling, consultation hold and call transfer, at no extra
charge to the end user. Certain other custom calling features are also
available at additional cost to the end user. Because the Company has also
purchased the "Centrex Management System" and the "Centrex Mate Service" from
U S WEST and Ameritech, respectively, Company personnel have on-line access to
U S WEST and Ameritech facilities and may make changes to the customers'
services electronically and quickly.
In March 1996, the Company entered into a settlement agreement with U S
WEST in connection with a complaint brought against U S WEST by the Company
before the Iowa Utilities Board. The settlement agreement permits the Company
to obtain access to the partitioned portion of U S WEST central office
switches in Iowa until March 18, 2001 and contains rates that may not be
increased by U S WEST unless the rates are renegotiated by the parties based
on U S WEST's rates for access to unbundled elements of its network. See
"Legal Proceedings." As of the date hereof, the Company is purchasing Centrex
service in Minnesota from U S WEST on a month-to-month basis while negotiating
a term agreement. The Company has seven-year Centrex agreements with Ameritech
that extend through 2001 or 2002 in Illinois and 2003 in Wisconsin. These
agreements provide for stabilized rates that may not be unilaterally increased
by Ameritech.
The Company provides long distance service by purchasing capacity, in
bulk, from WorldCom Network Services, Inc., d/b/a Wiltel ("WilTel"), a wholly
owned subsidiary of WorldCom, Inc. ("WorldCom"), and routing its customers'
long distance traffic over this capacity. The Company is subject to certain
minimum monthly purchase requirements under its agreement with WilTel. If the
Company fails to meet the minimum purchase requirement in any month, it is
obligated to pay WilTel the difference between its actual purchases and the
minimum commitment. The Company has consistently met the minimum purchase
requirements under its agreement with WilTel. The Company believes that it
will be able to continue to meet such requirements in the future. Because of
the many potential suppliers of wholesale long distance services in the
marketplace, the Company expects, as of the date hereof, that it will be able
to continue to obtain favorable wholesale long distance pricing.
The Company has also developed and installed state-of-the-art, "customer-
focused" software for providing integrated telecommunications services. This
software permits the Company to present its customers with one fully
integrated monthly billing statement for local, long distance, 800,
international, voice mail, paging, Internet access and travel card services,
and will permit the Company to include additional services, such as PCS, when
available. The Company believes that its customer-focused software platform is
an important element in the marketing of its telecommunications services and
gives it a competitive advantage in the marketplace.
Business Services. End-user business customers in each of the 91 cities
and towns in which the Company offers its integrated telecommunications
services as of the date hereof can obtain local, long distance and ancillary
(such as three-way calling and call transfer) services directly from the
Company. By using Centrex service instead of a private branch exchange ("PBX")
to direct their telecommunications traffic, business customers can also avoid
the large investment in equipment required and the fixed costs associated with
maintaining a PBX network infrastructure. The Company's telemanagement
services allow small to medium-sized business customers, which may lack the
9
resources to support their own PBX, to benefit from a sophisticated
telecommunications system managed by industry experts.
Business customers subscribing to the Company's integrated
telecommunications services generally receive local service at prices that are
substantially similar to the published retail local exchange carrier rates for
basic business service provided by the incumbent local exchange carrier. Long
distance rates for such business customers generally are calculated by
totaling each business customer's monthly calls and comparing the total
charges that would be applicable to that customer's calls under each of the
pricing plans of the major long distance carriers that generally are most
popular with the Company's business customers. The Company then bills the
customer the lowest long distance charges identified in this comparison.
Specifically, the Company's billing software, known as Raterizer(R), enables
the Company to calculate the monthly charges that each customer would be
billed based on the customer's actual calls under each of several long
distance plans offered by AT&T, MCI and Sprint and, in certain instances,
other rates specifically identified by a customer and agreed to by the
Company. The customer is then billed an amount equal to such "lowest cost"
monthly charges calculated using this software, minus any discount to which
the customer may be entitled as a result of having made a long-term commitment
to use the Company's services. As of the date hereof, the Company compares the
monthly calls of business customers subscribing to the Company's integrated
telecommunications services to the following plans offered by other long
distance carriers:
Outbound Products. AT&T Commercial Long Distance; AT&T CustomNet;
AT&T ProWATS/Plan Q; AT&T Megacom; AT&T Uniplan; MCI Commercial Dial 1;
MCI Prism Plus; MCI Preferred; MCI Vision (Switched Access); MCI Vision
(Dedicated Access); MCI Prism I; Sprint Business Sense; Sprint Business
Sense ($200 minimum usage required); Sprint Clarity "Most for Business";
Sprint Clarity (Dedicated Access); and Sprint UltraWATS.
800 Service Products. AT&T Readyline; AT&T Starterline (Plan K);
AT&T Megacom 800; AT&T Uniplan 800; MCI Business Line 800; MCI Preferred
800; MCI Vision 800; MCI 800; Sprint FONline 800; Sprint Business Sense
($0 commitment); Sprint Business Sense ($200 minimum usage required);
Sprint Clarity 800; and Sprint Ultra 800.
The Company has developed the software that performs its long distance
rating analysis. Like other Company software, it is designed around the
customer rather than around a given product. The Company believes that its
method of computing long distance service rates is an important factor in
attracting and retaining business customers. As of March 21, 1997, the
Company's average integrated telecommunications service contract for business
customers had an approximately 40-month term.
The Company also offers other long distance rates to certain business
customers, based on the customer's particular needs. Furthermore, in certain
states, including states outside of its target markets, the Company offers
business customers long distance service only, in order to enhance the
Company's ability to attract business customers that have offices outside of
the Company's target markets. In the markets in which the Company offers long
distance service only, business customers generally receive flat-rate long
distance pricing at rates ranging from $.115 to $.185 per minute as of the
date hereof.
Residential Services. In June 1996, the Company introduced its
PrimeLine(R) service to residential and certain small business customers in
the Cedar Rapids and Iowa City, Iowa markets. The Company expanded its
PrimeLine(R) service to Cedar Falls and Waterloo, Iowa in January 1997, Des
Moines, Iowa in February 1997, and Ames, Davenport and Bettendorf, Iowa in
March 1997. The Company intends to begin offering PrimeLine(R) service in all
of its Iowa markets and in Illinois, Minnesota and Wisconsin in the near
future. PrimeLine(R) service includes local and long distance telephone
service, paging, voice mail, Internet access and travel card services, as well
as enhanced features such as three-way calling, call transfer and consultation
hold. As of the date hereof, PrimeLine(R) customers may choose from five
integrated telecommunications service packages generally ranging in price from
$16.95 to $39.95 per month. Per minute long distance rates for PrimeLine(R)
customers range from $.12 to $.15, depending on monthly calling volumes. These
rates are applied 24 hours a day, seven days a week for all
10
calls within the continental United States. The Company's standard
PrimeLine/(R)/ service contract has either a month-to-month or a 12-month
term.
Special Access and Private Line Services. The Company provides, on a
private carrier basis, a wide range of special access and private line
services to its interexchange carrier and end-user (including two cable
television company) customers. These services include POP-to-POP special
access, end user/interexchange carrier special access and private line
services. POP-to-POP special access services provide telecommunications lines
that link the POPs of one interexchange carrier, or the POPs of different
interexchange carriers, in a market, allowing these POPs to exchange
telecommunications traffic for transport to final destinations. End
user/interexchange carrier special access services provide telecommunications
lines that connect an end user (such as a large business) to the local POP of
its selected interexchange carrier. Private line services provide
telecommunications lines that connect various locations of a customer's
operation to transmit internal voice, video and/or data traffic.
To provide these services, the Company offers various types of highly
reliable fiber optic lines that operate at different speeds and handle varying
amounts of traffic to provide tailor-made solutions to meet its customers'
needs. These lines include:
DS-0. A dedicated line that meets the requirements of everyday
business communications, with transmission capacity of up to 64 kilobits
of bandwidth per second (one voice-grade equivalent circuit). This
service offers a basic low-capacity dedicated digital channel for
connecting telephones, fax machines, personal computers and other
telecommunications equipment.
DS-1. A high-speed channel typically linking high volume customer
locations to interexchange carriers or other customer locations. Used for
voice transmissions as well as the interconnection of local area
networks, DS-1 service accommodates transmission speeds of up to 1.544
megabits per second, the equivalent of 24 voice-grade equivalent
circuits. The Company offers this high-capacity service for customers who
need a larger communications pipeline.
DS-3. A very high-capacity digital channel with transmission
capacity of 45 megabits per second, which is equivalent to 28 DS-1
circuits or 672 voice-grade circuits. This is a digital service used by
interexchange carriers for central office connections and by some large
commercial users to link multiple sites.
The Company's networks are designed to support this wide range of
communications services, provide increased network reliability and reduce
costs for its customers. The Company's network consists of fiber optic cables,
which typically contain between 24 and 144 fiber strands, each of which is
capable of providing many telecommunications circuits. As of the date hereof,
a single pair of fibers on the Company's 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. The Company
expects that continuing developments in compression technology and
multiplexing equipment will increase the capacity of each fiber, thereby
providing more capacity at relatively low incremental cost.
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 were
completed in 1993 and are owned by the State of Iowa, provide fiber optic
connections to over 100 classrooms or other meeting facilities in Iowa, and
are used primarily for interactive distance learning, telemedicine and the
State's own long distance telephone traffic. The Company maintains the Part I
and II segments of the 2,900 miles of the Iowa Communications Network pursuant
to a fiber optic maintenance contract (the "Iowa Communications Network
Maintenance Contract"). The Company's maintenance activities under the Iowa
Communications Network Maintenance Contract are available on a 24-hour-per-
day, 365-days-per-year basis, and consist of alarm monitoring, repair services
(include splicing, digital circuit card replacement, cable relocation and
circuit installation
11
testing) and cable location services. The Iowa Communications Network
Maintenance Contract expires in 2004.
For its services under the Iowa Communications Network Maintenance
Contract, the Company receives approximately $3.2 million per year, plus an
additional amount based on an hourly rate for certain overtime, equipment and
repair supervision activities. The Company believes that the expertise in
fiber optic maintenance developed through the maintenance of the Iowa
Communications Network will provide significant advantages in maintenance of
the Company's own network facilities. Because commercial telecommunications
use of the Part I and II segments is forbidden, however, neither the Company
nor any other telecommunications carrier may use capacity on the Part I and II
segments to provide telecommunications services to customers.
Ancillary Services. Through McLeodUSA Publishing, the Company publishes
and distributes annual "white page" and "yellow page" telephone directories to
local telephone subscribers in nineteen states in the midwestern and Rocky
Mountain regions of the United States, including most of the Company's target
markets. In its fiscal year 1996, McLeodUSA Publishing published and
distributed an aggregate of over 7 million copies of 80 telephone directories
and had revenues of $52.1 million, primarily from the sale of advertising
space in its telephone directories to approximately 85,000 advertisers.
In addition, the Company provides direct marketing and telemarketing
services through Ruffalo, Cody. Such services include telecommunications
sales, as well as a variety of fund-raising services for colleges,
universities and other non-profit organizations throughout the United States.
Ruffalo, Cody derived approximately 40% of its revenues in 1996 from an
agreement with a major long distance carrier to provide telemarketing
services. The major long distance carrier terminated this agreement, effective
December 31, 1996. As a result, the Company is redirecting telemarketing
resources towards selling the Company's local, long distance and other
telecommunications services.
The Company believes that its telephone directories and its direct
marketing and telemarketing services will provide valuable marketing
opportunities and expertise for its telecommunications services, particularly
with respect to potential residential customers. The Company intends to
utilize McLeodUSA Publishing's sales force of 260 direct sales personnel and
telemarketers to sell both advertising space in the Company's telephone
directories and, where available, the Company's telecommunications services.
Furthermore, by December 31, 1996, 52 of the Company's 206 full-time
telemarketing sales personnel at its Ruffalo, Cody subsidiary were engaged in
sales of the Company's PrimeLine(R) residential services. See "--Sales and
Marketing."
The Company also sells, installs and services telephone systems,
primarily to small businesses in eastern Iowa, through Digital Communications,
which the Company acquired in January 1997. The Company believes that these
services will provide valuable expertise for and complement its
telecommunications services offerings.
Expansion of Certain Facilities-based Services
The Company is constructing a fiber optic network that will enable it,
upon receipt of all necessary regulatory approvals, to serve its end-user
customers on a local switched basis as well as to serve other wireline and
wireless carriers on a wholesale basis.
The Company has leased and is testing a state-of-the-art high-capacity
digital AT&T switch and plans to acquire additional switches in the future.
Although, as of the date hereof, the Company is not engaged in negotiations to
acquire additional switches, such products are readily available from several
suppliers, and the Company does not believe it will experience any
difficulties or delays when it determines to acquire additional switches. It
is anticipated that these switches will provide the switching platform for the
local exchange switched telephone and long distance services to be offered by
the Company. Given the size and regional concentration of the Company's
markets, available technology and current cost structures, the Company plans
ultimately to deploy a hubbed switching strategy, whereby one or more central
switches would serve multiple markets via remote switching modules.
12
In March 1995, the Iowa Utilities Board approved the Company's
application for authorization to provide competitive switched local telephone
service to business and residential customers in Cedar Rapids, Iowa. In April
1996, the Company received similar approval from the Illinois Commerce
Commission to offer such service in Illinois cities other than in Chicago
(which was not included in the Company's application). The Company intends to
seek authorizations from the appropriate public utilities commissions to
provide similar services in other markets served by the Company.
The Company's plans to provide local switched services are dependent upon
obtaining favorable interconnection agreements with local exchange carriers.
In August 1996, the FCC released the Interconnection Decision implementing the
interconnection portions of the Telecommunications Act. Certain provisions of
the Interconnection Decision have been appealed in proceedings before the U.S.
Eighth Circuit Court of Appeals. In October 1996, the U.S. Eighth Circuit
Court of Appeals temporarily stayed the effectiveness of portions of the
Interconnection Decision, including provisions establishing a pricing
methodology and a procedure permitting new entrants to "pick and choose" among
various provisions of existing interconnection agreements, pending a decision
on the merits. Although the judicial stay of the Interconnection Decision does
not prevent the Company from negotiating interconnection agreements with local
exchange carriers, it does create uncertainty about the rules governing
pricing, terms and conditions of interconnection agreements, and could make
negotiating such agreements more difficult and protracted. The FCC applied to
the U.S. Supreme Court to vacate the judicial stay, but the U.S. Supreme
Court, on November 12, 1996, refused to do so. The U.S. Eighth Circuit Court
of Appeals heard oral arguments on the merits of the challenges to the
Interconnection Decision on January 17, 1997, but as of the date hereof had
not ruled in the case. Further appeals are possible. There can be no assurance
that the Company will be able to obtain interconnection agreements on terms
acceptable to the Company.
Although the Company has made no final determinations as to its target
markets for facilities-based switched services, the Company intends initially
to provide facilities-based switched services in Cedar Rapids, Des Moines,
Waterloo, Cedar Falls, Dubuque, Sioux City, Council Bluffs, and Iowa City,
Iowa and the Quad Cities of Iowa/Illinois (Davenport, Bettendorf, Rock Island
and Moline), among other places. The Company plans to expand its facilities-
based services to other cities as its network develops and its market
penetration increases. The foregoing statements are "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995 and where the Company actually provides such services will depend on
factors such as the outcome of the judicial proceedings regarding the
Interconnection Decision. See "--Regulation."
For a detailed description of the expansion of the Company's fiber optic
network, see "--Network Facilities."
Wireless Services
The Company believes that 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
and wireless services become more diverse. The Company also believes that
wireline and wireless markets are converging, and that providers of wireless
services increasingly will offer, in addition to products that supplement a
customer's wireline communications (similar to cellular telephone services in
use today), wireline replacement products that may result in wireless services
becoming the customer's primary mode of communication. The Company anticipates
that in the future there could potentially be eight wireless competitors in
each of its proposed PCS markets: two existing cellular providers, five other
PCS providers and one enhanced specialized mobile radio ("ESMR") provider.
Wireless telecommunications networks use a variety of radio frequencies
to transmit voice and data in place of, or in addition to, standard wireline
telephone networks. Wireless telecommunications technologies include one-way
radio applications, such as paging or beeper services, and two-way radio
applications, such as cellular and PCS telephone networks. In 1993, the FCC
allocated 140 MHz of the radio spectrum (and subsequently allocated an
additional 10 MHz of spectrum) for the provision of a new
13
wireless communications service, commonly known as PCS. PCS differs from
traditional cellular telephone service principally in that PCS systems will
operate at a higher frequency band and employ advanced digital technology.
Relative to existing cellular service, these features are expected to enable
PCS system operators to offer customers lower cost service options, lighter
handsets with longer battery lives, and new and enhanced service offerings.
To accommodate a wide range of services and technologies with different
spectrum requirements and to facilitate the entry of small business and rural
telephone companies, the FCC divided the 150 MHz of PCS spectrum into three 10
MHz blocks, three 30 MHz blocks and 30 MHz of unlicensed spectrum. The FCC
adopted the following frequency plan.
Block A: 30 MHz (1850-1865/1930-1945 MHz)
Block B: 30 MHz (1870-1885/1950-1965 MHz)
Block C: 30 MHz (1895-1910/1975-1990 MHz)
Block D: 10 MHz (1865-1870/1945-1950 MHz)
Block E: 10 MHz (1885-1890/1965-1970 MHz)
Block F: 10 MHz (1890-1895/1970-1975 MHz)
The FCC divided service areas based upon the 51 Major Trading Areas
("MTA") and the 493 Basic Trading Areas ("BTA"), as defined by Rand McNally
Commercial Atlas and Marketing Guide. Two 30 MHz frequency blocks were
designated for MTA operation, and one 30 MHz frequency block was designated
for BTA operation. The FCC determined that providing two frequency blocks on
an MTA basis will provide economies of scale and scope necessary for the
development of low-cost PCS equipment. The remaining three 10 MHz frequency
blocks are designated for BTA operation. The FCC concluded that a combination
of these frequency blocks and BTA service areas will minimize the start-up
costs likely to result from competitive bidding, and therefore provide greater
opportunity for participation by small businesses, rural telephone companies
and others.
On January 15, 1997, the FCC notified the Company that it was the
successful bidder for 26 "D" and "E" block frequency PCS licenses in 24 BTAs
covering all of Iowa, seven cities in Illinois, three cities in southern
Minnesota, Omaha, Nebraska and Sioux Falls, South Dakota. The Company bid an
aggregate of approximately $32.8 million for these PCS licenses, which the
Company will be required to pay to the FCC following grant of the licenses,
anticipated to occur during the second or third quarter of 1997. The Company
is assessing its technological options and beginning to design and engineer
its proposed PCS system. The Company expects to begin constructing its PCS
network by the end of 1997 and offering PCS services as part of its integrated
telecommunications services in 1998.
The infrastructure of a PCS system generally consists of digital
switches, base station transmitters and receivers, and related equipment.
Additional costs are attributable to site acquisition and preparation, and
installation services. The Company expects to begin selecting and acquiring
sites for transmitters by the end of 1997. Sites will be selected on the basis
of their coverage of targeted customers and on frequency propagation
characteristics. In many cases, the Company may be required to obtain zoning
approval or other permits. The use of existing towers and other facilities
occupied by other telecommunications service providers and utility companies
is also expected to facilitate this process. The Company has entered into
long-term agreements with its electric utility stockholders (MidAmerican
Energy Holdings Company (collectively with its predecessors and subsidiaries,
"MidAmerican") and IES Industries Inc. (collectively with its subsidiaries,
"IES")), and may negotiate similar agreements with other companies, that will
enable the Company to install PCS base stations and other equipment on such
companies towers. See "--Network Facilities." For new sites, the Company
estimates that the site acquisition process may take three to twelve months.
Once sites are acquired and the requisite governmental approvals are obtained,
preparation of each site, including grounding, ventilation and air
conditioning, equipment installation, testing and optimization, generally will
require an additional two to four months. In addition to system design and
site acquisitions, the implementation of the proposed PCS system will require
frequency planning, construction and equipment procurement, installation and
testing. The Company will be required to make significant expenditures to
develop, construct and operate a PCS system.
14
In order to build and operate a PCS system, the Company will be required
to select from among competing and potentially incompatible technologies.
Digital signal transmission is accomplished through the use of frequency
management technologies, or "protocols." These protocols "manage" the radio
channel either by dividing it into distinct time slots (a method known as Time
Division Multiple Access, or "TDMA") or by assigning specific coding
instructions to each packet of digitized data that comprises a signal (a
method known as Code Division Multiple Access, or "CDMA"). While the FCC has
established compatible analog signaling protocols for licensed cellular
systems in the U.S., there is no required universal digital signaling
protocol. As of the date hereof, two principal competing, incompatible
signaling protocols have been proposed by various vendors for use in PCS
systems: Global System for Mobile Communications ("GSM") (a TDMA-based
protocol) and CDMA. Because these protocols are incompatible, a subscriber of
a system that relies on GSM technology, for example, will be unable to use a
GSM handset when traveling in an area served only by CDMA-based wireless
operators, unless it is a dual-mode handset that permits the subscriber to use
the cellular system in that area. For this reason, the success of each
protocol will depend both on its ability to offer enhanced wireless service
and on the extent to which its users will be able to use their handsets when
roaming outside their service area. Each of the two principal PCS signaling
protocols have been adopted by at least one PCS licensee, and each offers
certain advantages and disadvantages.
The Company has not yet selected one of the digital signaling protocols
for its planned PCS network. The Company anticipates that its decision will be
based primarily on an assessment of the signaling protocols selected by PCS
licensees in the markets in which the Company wishes to offer roaming services
as well as the technical advantages and disadvantages of each protocol.
The Company intends to provide roaming service in its proposed PCS
markets by establishing suitable roaming arrangements with other PCS operators
in other markets constructing systems compatible with the digital protocol
technology to be selected by the Company. The Company cannot predict when, or
whether, it will be able to enter into such roaming agreements with local
providers. Future subscribers to the Company's proposed PCS services will not
be able to roam in markets without at least one PCS licensee using the
protocol selected by the Company unless the subscriber uses a dual-mode
telephone that would permit the subscriber to use the existing cellular
wireless system in such other market. Such dual-mode phones are heavier and
more expensive than single-mode phones.
The Company plans to operate a fully digital PCS system. As of the date
hereof, most cellular services transmit voice and data signals over analog-
based systems, which use one continuous electronic signal that varies in
amplitude or frequency over a single radio channel. Digital systems, on the
other hand, convert voice or data signals into a stream of digits that is
compressed before transmission, enabling a single radio channel to carry
multiple simultaneous signal transmissions. The Company believes that this
enhanced capacity, along with improvements in digital protocols, will allow
the Company's proposed PCS system to offer new and enhanced services,
including:
. Secure Communications. Sophisticated encryption algorithms
provide increased call security, encouraging users to make private
professional and personal calls that they might otherwise have made
only on wireline telephones.
. Sophisticated Call Management. The Company expects that it will
be able to offer call screening, routing and forwarding, caller I.D.,
message waiting, call hold, call transfer, voice activated dialing and
selective call screening, rejection and forwarding through a digital
PCS system.
. Enhanced Battery Performance. While analog handsets transmit
continuous electronic signals, digital handsets transmit messages in
segments, turning the handset off between transmissions. (Because the
handset is turned on and off hundreds of times each second, this
switching is not noticed by the user.) As a result, the handset is
effectively turned off for almost 90 percent of each call, thereby
extending the amount of time a battery can be used
15
without having to be recharged. Digital handsets are also capable of
entering into "sleep" and "hibernation" modes when not in use, which
will significantly extend the handset's battery life.
. Single Number Service. This service provides subscribers with a
convenient way to transfer all incoming calls between primary wireline
and wireless locations automatically. When a subscriber's handset is
activated, the network will route all incoming calls to the
subscriber's wireless number. When the handset is deactivated, all
calls will be directed to the subscriber's primary wireline location.
Such service will enable subscribers to direct their incoming calls to
one of several alternative locations (wireline telephone, paging
system handset, mailbox, etc.) on an ongoing basis.
. Enhanced Wireless Data Transmission. Digital networks will offer
simultaneous voice and data communications. The Company believes that,
as data transmission technologies develop, a number of potential uses
for such services will merge, including short message service, "mobile
office" applications (e.g., facsimile, electronic mail and connecting
notebook computers with computer/data networks), access to stock quote
services, transmission of text such as maps and manuals, transmission
of photographs, connections of wireless point-of-sale terminals to
host computers, monitoring of alarm systems, automation of meter
reading and monitoring of status and inventory levels of vending
machines.
. SIM Card. Credit card-sized Subscriber Identity Module ("SIM")
cards, programmed with the user's billing information and a specified
service package, will allow subscribers to open accounts and obtain
PCS connectivity automatically, simply by inserting their SIM cards
into compatible PCS handsets. With roaming agreements between the
local providers and the Company, SIM cards could also enable
subscribers to roam wherever the digital protocol technology selected
by the Company is deployed by using their SIM cards with handsets
compatible with the local system as they travel.
The Company intends to offer a variety of wireless telecommunications
services, ranging from wireline enhancement services that supplement the
customer's wireline telephone (much like cellular) to wireline replacement
services that will serve as the customer's primary mode of communication. An
example of the latter service is "enhanced cordless" handsets, which operate
as cordless wireline telephones when used in or near the customer's home and
operate as wireless PCS handsets when used elsewhere.
As the wireline and wireless markets converge, the Company believes that
it can also identify other opportunities to generate revenues from the
wireless industry on both a retail and a wholesale basis. On a retail basis,
the Company believes that it will be able to enter into "bundling/branding"
arrangements with both cellular and PCS companies on favorable economic terms.
On a wholesale basis, these opportunities may include (i) leasing tower sites
to wireless providers, (ii) switching wireless traffic through the Company's
switching platform and (iii) transporting wireless traffic using the Company's
fiber optic network to interconnect wireless providers' cell sites or to
connect such sites to either the Company's switches or to switches of other
providers of wireline services. In May 1996, the Company entered into an
agreement with a paging company to provide access to several of the towers
controlled by the Company.
The statements in the foregoing paragraphs about the Company's plans to
own, develop, construct and operate a PCS system are "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. These plans may be revised, and the Company's actual wireless
services may differ materially from that indicated by its current plans, in
each case as a result of a variety of factors, including: (i) the availability
of financing and regulatory approvals; (ii) the number of potential customers
in a target market; (iii) the existence of strategic alliances or
relationships; (iv) technological, regulatory or other developments in the
Company's business; (v) changes in the competitive climate in which the
Company operates; and (vi) the emergence of future opportunities. See "--Risk
Factors--PCS System Implementation Risks."
16
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 products, the Company expects to be able to provide its
customers with a full range of telecommunications services using a combination
of its own network, the networks of the incumbent local exchange carriers and
the networks of other competitive carriers.
In April 1995, as part of its overall business strategy, the Company
acquired MWR from MidAmerican. MWR, which is now part of McLeodUSA Network
Services, is a competitive access provider which owns and operates a fiber
optic network and offers special access and private line services to large
businesses, institutional customers and interexchange carriers, primarily in
Des Moines, Iowa. As a result of this strategic acquisition, the Company
believes that it is the only competitive access provider in the Des Moines
market. The Company believes the already-installed MWR network is an important
aspect of its efforts to become the first state-wide integrated
telecommunications provider.
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 (the "Part III segments").
The majority of these fiber optic links, unlike the Part I and II segments of
the Iowa Communications Network, are not to be owned by the State of Iowa, but
are to be leased from a private entity, such as the Company. As a result of
public bidding, the Company has the right to build and then lease capacity to
the State of Iowa on 265 of such segments. Under its lease agreements with the
State of Iowa, the Company is constructing a "fiber-rich" broadband 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 $30.5
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 the
Company 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 may order
additional DS-3 circuits at a mutually agreed upon price.
The Company has reached agreements with its electric utility stockholders
(MidAmerican and IES) that allow the Company to make use of those utilities'
underground conduits, distribution poles, transmission towers and building
entrances in exchange for rights by such stockholders to use certain capacity
on the Company's network. These agreements give the Company access to rights-
of-way in Iowa and in certain portions of Illinois for installation of the
Company's wireline and wireless networks. The Company's access to these
rights-of-way are expected to have a significant positive impact on the
Company's capital costs for network construction and the speed with which the
Company can construct its networks. The Company believes that its strategic
relationships with its electric utility stockholders give it a significant
competitive advantage.
Concurrently with construction of the Part III segments, the Company is
also installing low-cost network facilities that are expected to form a series
of fiber optic "self-healing rings" intended to enable the Company to provide
facilities-based local and long distance service to most significant cities
and towns in Iowa. Thus, the Company believes it is well positioned to become
the first facilities-based state-wide integrated provider of competitive
telecommunications services in the Midwest.
As of March 21, 1997, the Company owned approximately 2,500 route miles
of fiber optic network and expects to construct approximately 5,000 additional
route miles of fiber optic network during the next three years. The Company
expects that approximately half of this fiber capacity will be in the State of
Iowa, with the balance built throughout the Company's other target markets.
The Company will decide whether to begin construction of fiber optic network
in a market based on various economic factors, including: (i) the number of
its customers in a market, (ii) the anticipated operating cost savings
associated with such construction and (iii) any strategic relationships with
owners of existing infrastructure (e.g., utilities and cable operators).
17
Sales and Marketing
Until June 1996, the Company directed its telecommunications sales
efforts primarily toward small and medium-sized businesses. In June 1996, the
Company began marketing its PrimeLine(R) services to residential customers.
Marketing of the Company's integrated telecommunications services is
handled by a sales and marketing group composed of direct sales personnel and
telemarketers. The Company's sales force is trained to emphasize the Company's
customer-focused sales and customer service efforts, including its 24-hours-
per-day, 365-days-per-year customer service center, which a customer may call
with any question or problem regarding the Company's services. The Company's
employees answer customer service calls directly rather than requiring
customers to use an automated queried message system. The Company believes
that its emphasis on a "single point of contact" for meeting the customer's
telecommunications needs, as well as its ability to provide one fully
integrated monthly billing statement for local, long distance, 800,
international, voice mail, paging, Internet access and travel card service, is
very appealing to its prospective customers.
As of March 21, 1997, marketing of the Company's integrated
telecommunications services to business customers was conducted by 210 direct
sales personnel, located at the Company's headquarters in Cedar Rapids, Iowa
and in 43 branch sales offices in Iowa, Illinois, Minnesota, Wisconsin, South
Dakota, North Dakota and Colorado. The sales personnel make direct calls to
prospective and existing business customers, conduct analyses of business
customers' call usage histories, and demonstrate that the Company's software
systems will rate the customers' calls by comparison to the lowest cost plan
of the most popular business calling plans offered by AT&T, MCI and Sprint.
Marketing of the Company's integrated telecommunications services to
residential customers was conducted as of March 21, 1997 by 168 telemarketers
from the Company's Ruffalo, Cody subsidiary. The Company plans to increase
this number in the future. The telemarketers emphasize the PrimeLine(R)
integrated package of telecommunications services and its flat-rated per
minute pricing structure for long distance service. The Company uses Ruffalo,
Cody's information database to identify attractive sales opportunities and
pursues those opportunities through a variety of methods, including calls from
Ruffalo, Cody's telemarketing personnel.
The Company believes that its acquisition of McLeodUSA Publishing in
September 1996 will further the Company's sales and marketing efforts of its
residential services in several ways. First, it gives the Company an immediate
presence in states where it is initiating service (Minnesota and Wisconsin)
and also in states where it does not yet provide integrated telecommunications
service but expects to do so in the future (such as South Dakota, North
Dakota, Colorado, Wyoming, Montana, Utah and Idaho). Second, the Company
believes that the acquisition will increase the Company's penetration of
current markets and accelerate its entry into new markets. The telephone
directories published and distributed by McLeodUSA Publishing will serve as
"direct mail" advertising for the Company's telecommunications products. The
directories will contain detailed product descriptions and step-by-step
instructions on the use of the Company's telecommunications products. The
Company believes that telephone directories are commonly used sources of
information that potentially provide the Company with a long-term marketing
presence in millions of households and businesses that receive a McLeodUSA
Publishing directory. By using the directories to market its products, the
Company can reach more customers than would be possible if the acquisition had
not occurred. Third, the Company believes that combining the directories'
distinctive black-and-yellow motif with the trade name McLeodUSA will create
and strengthen brand awareness in all of the Company's markets.
In 1997, the Company expects to expand its telecommunications sales and
marketing efforts primarily by opening new branch sales offices in Minnesota,
Wisconsin, South Dakota, North Dakota and Colorado, by continuing its
expansion in Iowa and Illinois and by increasing its sales of long distance
service in Omaha, Nebraska. The Company also expects to begin sales and
marketing efforts in 1997 in Wyoming. Over the next several years, depending
on competitive and other factors, the Company also
18
intends to begin sales and marketing efforts in Montana, Idaho, Utah and
Nebraska. See "Legal Proceedings." In addition, the Company expects to expand
its long distance sales and marketing efforts in 1997 to the remaining states
in the continental United States. The foregoing statements are "forward-
looking statements" within the meaning of the Private Securities Litigation
Reform Act of 1995 and the results of the Company's actual expansion efforts
may be materially different, depending on a variety of other factors,
including: (i) the availability of financing and regulatory approvals; (ii)
the number of potential customers in a target market; (iii) the existence of
strategic alliances or relationships; (iv) technological, regulatory or other
developments in the Company's business; (v) changes in the competitive climate
in which the Company operates; and (vi) the emergence of future opportunities.
Sales and marketing of the Company's competitive access services are
handled as of the date hereof by a small sales staff located in Des Moines,
Iowa. These sales people work closely with the Company's network engineers to
design and market special access and private line services.
Competition
Wireline Competition. The telecommunications industry is highly
competitive. The Company faces intense competition from local exchange
carriers, including the Regional Bell Operating Companies (primarily U S WEST
and Ameritech) and the General Telephone Operating Companies, which, as of the
date hereof, dominate their local telecommunications markets. The Company also
competes with long distance carriers in the provision of long distance
services. The long distance market is dominated by three major competitors,
AT&T, MCI and Sprint. Hundreds of other companies also compete in the long
distance marketplace. Other competitors of the Company may include cable
television companies, competitive access providers, microwave and satellite
carriers, wireless telecommunications providers, teleports and private
networks owned by large end-users. In addition, the Company competes with the
Regional Bell Operating Companies and other local exchange carriers, numerous
direct marketers and telemarketers, equipment vendors and installers, and
telecommunications management companies with respect to certain portions of
its business. Many of the Company's existing and potential competitors have
financial and other resources far greater than those of the Company.
The local and access telephone services offered by the Company compete
principally with the services offered by the incumbent local exchange carrier
serving each of the Company's markets. Incumbent local exchange carriers have
long-standing relationships with their customers and have the potential to
subsidize competitive services from less competitive service revenues.
In addition, a continuing trend toward business combinations and
strategic alliances in the telecommunications industry may create significant
new competitors. For example, the national long distance carrier WorldCom
acquired MFS Communications Company, Inc., a competitive access provider, in
December 1996. Moreover, in November 1996, British Telecommunications plc, an
international telecommunications company, announced its agreement to acquire
the national long distance carrier MCI. The ability of these or other
competitors of the Company to enter into strategic alliances could put the
Company at a significant disadvantage.
The Company may, in the future, face competition in the markets in which
it operates from one or more competitive access providers operating fiber
optic networks, in many cases in conjunction with the local cable television
operator. Each of AT&T, MCI and Sprint has indicated its intention to offer
local telecommunications services, either directly or in conjunction with
other competitive access providers or cable television operators. Like the
Company, MCI holds a certificate of public convenience and necessity to offer
local and long distance service in Iowa through partitioning of U S WEST's
central office switch. One other small telecommunications company also holds
such a certificate in Iowa. On July 26, 1996, the Iowa Utilities Board
approved AT&T's application to offer local service in Iowa on both a resale
and facilities-based basis, subject to certain additional filing requirements.
During the past twelve months, AT&T has received certification to provide
local service in all of the Company's current and target markets. There can be
no assurance that these firms, and others, will not enter the small and mid-
sized markets where the Company focuses its sales efforts.
19
The Company believes that the Telecommunications Act and state
legislative and regulatory initiatives and developments in Illinois, Iowa and
other states within the Company's target markets, as well as a recent series
of transactions and proposed transactions between telephone companies, long
distance carriers and cable companies, increase the likelihood that barriers
to local exchange competition will be substantially reduced or removed. These
initiatives include requirements that the Regional Bell Operating Companies
negotiate with entities such as the Company to provide interconnection to the
existing local telephone network, to allow the purchase, at cost-based rates,
of access to unbundled network elements, to establish dialing parity, to
obtain access to rights-of-way and to resell services offered by the incumbent
local exchange carriers.
The Company's plans to provide local switched services are dependent upon
obtaining favorable interconnection agreements with local exchange carriers.
In August 1996, the FCC released the Interconnection Decision implementing the
interconnection portions of the Telecommunications Act. Certain provisions of
the Interconnection Decision implementing the interconnection portions of the
Telecommunications Act have been stayed by the U.S. Eighth Circuit Court of
Appeals, which may limit or delay the development of competition in the local
exchange switched services market. There can be no assurance that the Company
will be able to obtain interconnection agreements on terms acceptable to the
Company.
The Telecommunications Act provides the incumbent local exchange carriers
with new competitive opportunities. The Telecommunications Act removes
previous restrictions concerning the provision of long distance service by the
Regional Bell Operating Companies and also provides them with increased
pricing flexibility. Under the Telecommunications Act, the Regional Bell
Operating Companies will, upon the satisfaction of certain conditions, be able
to offer long distance services that would enable them to duplicate the "one-
stop" integrated telecommunications approach used by the Company. The Company
believes that it has certain advantages over these companies in providing its
telecommunications services, including management's prior experience in the
competitive telecommunications industry and the Company's 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, there can be no assurance that the
anticipated increased competition will not have a material adverse effect on
the Company. The Telecommunications Act provides that rates charged by
incumbent local exchange carriers for interconnection to the incumbent
carrier's network are to be nondiscriminatory and based upon the cost of
providing such interconnection, and may include a "reasonable profit," which
terms are subject to interpretation by regulatory authorities. If the
incumbent local exchange carriers, particularly the Regional Bell Operating
Companies, charge alternative providers such as the Company unreasonably high
fees for interconnection to the local exchange carriers' networks,
significantly lower their rates for access and private line services or offer
significant volume and term discount pricing options to their customers, the
Company could be at a significant competitive disadvantage. See
"--Regulation."
Competition for local and access telecommunications services is based
principally on price, quality, network reliability, customer service and
service features. The Company believes that its management expertise allows it
to compete effectively with the incumbent local exchange carriers. The Company
generally offers its business customers local exchange services at prices that
are substantially similar to the established retail local exchange carrier
rates for basic business service, while generally providing enhanced calling
features and a higher level of customer service. Using the Company's
sophisticated proprietary software, each business customer subscribing to the
Company's integrated telecommunications services receives the lowest long
distance rate available each month from among the pricing plans of AT&T, MCI
and Sprint that generally are most popular with the Company's business
customers, and, in certain cases, rates specifically identified by a business
customer and agreed to by the Company. Residential customers receive flat-rate
long distance pricing. The Company's fiber optic networks will provide both
diverse access routing and redundant electronics, which design features are
not widely deployed by the local exchange carriers' networks.
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
20
digital technology, shorter cycles for new products and enhancements, and
changes in consumer preferences and expectations. The Company believes that
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, and wireless services become
more diverse. The Company also believes that providers of wireless services
increasingly will offer, in addition to products that supplement a customer's
wireline communications (similar to cellular telephone services in use today),
wireline replacement products that may result in wireless services becoming
the customer's primary mode of communication. Accordingly, the Company expects
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. The Company anticipates that in the
future there could potentially be eight wireless competitors in each of its
proposed PCS markets: two existing cellular providers, five other PCS
providers and Nextel Communications Inc., an ESMR provider. Principal cellular
providers in the Company's proposed PCS markets include Ameritech Mobile
Communications, Inc., AT&T Wireless Services, Inc., Southwestern Bell Mobile
Systems, Inc., Western Wireless Corporation, CommNet Cellular Incorporated,
GTE Mobilnet Service Corporation, 360 Communications Company, Airtouch
Cellular, United States Cellular Corporation and BellSouth Corporation.
Principal PCS licensees in the Company's proposed PCS markets include AT&T
Wireless PCS, Inc., PRIMECO Personal Communications, L.P., WirelessCo, d/b/a
Sprint PCS, American Portable Telecommunications, Inc., d/b/a Aerial
Communications, Inc., Western PCS Corp., Cox Communications, Inc., DCR PCS,
Inc., d/b/a Pocket Communication Corp., Wireless PCS, Inc., d/b/a Airadigm
Communications, Inc., SprintCom, Inc., BRK Wireless Co. Inc., Western PCS BTA
I Corp., OPCSE-Galloway Consortium, Northcoast Operating Co. Inc., Minnesota
PCS Limited Partnership, Northeast Nebraska Telephone Company, Triad Cellular
Corp., Iowa L.P. 136, Redwood Wireless Corp., Polycell Communications Inc.,
CM-PCS Partners, and U S WEST.
Competition with these or other providers of wireless telecommunications
services may be intense. Many of the Company's potential wireless competitors
have substantially greater financial, technical, marketing, sales,
manufacturing and distribution resources than those of the Company and have
significantly greater experience than the Company in testing new or improved
wireless telecommunications products and services. Some competitors are
expected to market other services, such as cable television access, with their
wireless telecommunications service offerings. The Company does not offer
cable television access. In addition, several of the Company's 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. There can be no assurance that the
Company will be able to compete successfully in this environment or that new
technologies and products that are more commercially effective than the
Company's technologies and products will not be developed. See "--Wireless
Services."
Regulation
Overview. The Company's services are subject to federal, state and
local regulation. The FCC exercises jurisdiction over all facilities of, and
services offered by, telecommunications common carriers to the extent those
facilities are used to provide, originate or terminate interstate or
international communications. State regulatory commissions retain some
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 the Company to obtain licenses, permits or franchises
regulating use of public rights-of-way necessary to install and operate its
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.
The Company, through its wholly owned subsidiary McLeodUSA
Telecommunications, holds various federal and state regulatory authorizations
and often joins other industry members in seeking regulatory reform at the
federal and state levels to open additional telecommunications markets to
competition.
21
The Company, through its wholly owned subsidiary McLeodUSA Network
Services, provides certain 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. The Company believes 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 as of the date of this Offering
Memorandum. Should such laws and/or regulatory interpretations change in the
future to reclassify McLeodUSA Network Services' regulatory status, the
Company believes that compliance with such reclassification would not have a
material adverse effect on the Company.
The Company, through its wholly owned subsidiary Ruffalo, Cody, is
subject to certain federal and state regulatory requirements, including, in
certain states, bonding requirements, due to its direct marketing,
telemarketing and fund-raising activities.
Federal Regulation. The Telecommunications Act became effective
February 8, 1996. The Telecommunications Act preempts state and local laws to
the extent that they prevent competitive entry into the provision of any
telecommunications service. Subject to this limitation, however, the state and
local governments retain most of their existing regulatory authority. The
Telecommunications Act imposes a variety of new duties on incumbent local
exchange carriers in order to promote competition in local exchange and access
services. Some smaller telephone companies may seek suspension or modification
of these duties, and some companies serving rural areas are exempt from these
duties. Some duties are also imposed on non-incumbent local exchange carriers,
such as the Company. The duties created by the Telecommunications Act include
the following:
Reciprocal Compensation Requires all local exchange carriers to complete
calls originated by competing carriers under
reciprocal arrangements at prices based on a
reasonable approximation of incremental cost or
through mutual exchange of traffic without
explicit payment.
Resale Requires all local exchange carriers to permit
resale of their telecommunications services
without unreasonable restrictions or conditions.
In addition, incumbent local exchange carriers are
required to offer wholesale versions of all retail
services to other telecommunications carriers for
resale at discounted rates, based on the costs
avoided by the incumbent local carrier in the
wholesale offering.
Interconnection Requires incumbent local exchange carriers to
permit their competitors to interconnect with
their facilities at any technically feasible point
within their networks, on nondiscriminatory terms,
at prices based on cost (which may include a
reasonable profit). At the option of the carrier
seeking interconnection, physical collocation of
the requesting carrier's equipment in the
incumbent local exchange carrier's premises must
be offered, except where the incumbent local
exchange carrier can demonstrate space limitations
or other technical impediments to collocation.
Unbundled Access Requires incumbent local exchange carriers to
provide nondiscriminatory access to unbundled
network elements (including network facilities,
equipment, features, functions, and capabilities)
at any technically feasible point within their
networks, on nondiscriminatory terms, at prices
based on cost (which may include a reasonable
profit).
22
Number Portability Requires all local exchange carriers to permit
users of telecommunications services to retain
existing telephone numbers without impairment of
quality, reliability or convenience when switching
from one telecommunications carrier to another.
Dialing Parity Requires all local exchange carriers to provide
"1+" equal access to competing providers of
telephone exchange service and toll service, and
to provide nondiscriminatory access to telephone
numbers, operator services, directory assistance,
and directory listing, with no unreasonable
dialing delays.
Access to Rights-of-Way Requires all local exchange carriers to permit
competing carriers access to poles, ducts,
conduits and rights-of-way at regulated prices.
Incumbent local exchange carriers are required to negotiate in good faith
with carriers requesting any or all of the above arrangements. Certain FCC
rules regarding negotiation and pricing of interconnection agreements have
been stayed by the U.S. Eighth Circuit Court of Appeals. However, carriers
still may negotiate agreements, and if the negotiating carriers cannot reach
agreement within a prescribed time, either carrier may request binding
arbitration of the disputed issues by the state regulatory commission.
The Telecommunications Act also eliminates previous prohibitions on the
provision of interLATA long distance services by the Regional Bell Operating
Companies and the General Telephone Operating Companies. The Regional Bell
Operating Companies are now 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, the Regional Bell Operating Companies will be allowed
to provide long distance service within the regions in which they also provide
local exchange service ("in-region service") upon specific approval of the FCC
and satisfaction of other conditions, including a checklist of interconnection
requirements. The General Telephone Operating Companies are permitted to enter
the long distance market without regard to limitations by region, although
regulatory approvals otherwise applicable to the provision of long distance
service will need to be obtained. The General Telephone Operating Companies
are also subject to the provisions of the Telecommunications Act that impose
interconnection and other requirements on local exchange carriers.
The Telecommunications Act imposes certain restrictions on the Regional
Bell Operating Companies in connection with the Regional Bell Operating
Companies' entry into long distance services. Among other things, the Regional
Bell Operating Companies must pursue such activities only through separate
subsidiaries with separate books and records, financing, management and
employees, and all affiliate transactions must be conducted on an arm's length
and nondiscriminatory basis. The Regional Bell Operating Companies are also
prohibited from jointly marketing local and long distance services, equipment
and certain information services unless competitors are permitted to offer
similar packages of local and long distance services in their market. Further,
the Regional Bell Operating Company must obtain in-region long distance
authority before jointly marketing local and long distance services in a
particular state. Additionally, AT&T and other major carriers serving more
than 5% of the nation's presubscribed long distance access lines are also
restricted, under certain conditions, from packaging their long distance
services and local services provided over Regional Bell Operating Company
facilities. These restrictions do not, however, apply to the Company because
it does not serve more than 5% of the nation's presubscribed access lines.
Prior to passage of the Telecommunications Act, the FCC had already
established different levels of regulations for dominant and non-dominant
carriers. For domestic common carrier telecommunications regulation, incumbent
local exchange carriers, including the Regional Bell Operating Companies, are,
as of the date hereof, considered dominant carriers for the provision of
interstate access and interexchange
23
services, while other interstate service providers, such as the Company, are
considered non-dominant carriers. The FCC has recently proposed that the
Regional Bell Operating Companies offering out-of-region interstate long
distance services be regulated as non-dominant carriers, as long as such
services are offered by an affiliate of the Regional Bell Operating Company
that complies with certain structural separation requirements. The FCC
regulates many of the rates, charges and services of dominant carriers to a
greater degree than non-dominant carriers.
As a non-dominant carrier, the Company may install and operate facilities
for the transmission of domestic interstate communications without prior FCC
authorization, although FCC authorization is required for the provision of
international telecommunications by non-dominant carriers. McLeodUSA
Telecommunications has obtained FCC authority to provide international
services. Services of non-dominant carriers are subject to relatively limited
regulation by the FCC. As of the date hereof, non-dominant carriers are
required to file tariffs listing the rates, terms and conditions of interstate
access and international services provided by the carrier. Periodic reports
concerning the carrier's interstate circuits and deployment of network
facilities also are required to be filed. The FCC generally does not exercise
direct oversight over cost justification and the level of charges for services
of non-dominant carriers, although it has the power to do so. The Company must
offer its interstate services on a nondiscriminatory basis, at just and
reasonable rates, and remains subject to FCC complaint procedures. Pursuant to
these FCC requirements, the Company's subsidiary, McLeodUSA
Telecommunications, has filed and maintains with the FCC a tariff for its
interstate and international services. All of the interstate and international
retail "basic" services (as defined by the FCC) provided by the Company
(through such subsidiary) and the rates charged for those services are
described therein.
On October 29, 1996, the FCC adopted an order in which it eliminated the
requirement that non-dominant interstate carriers such as the Company maintain
tariffs on file with the FCC for domestic interstate interexchange services.
The FCC's order was issued pursuant to authority granted to the FCC in the
Telecommunications Act to "forebear" from regulating any telecommunications
service provider if the FCC determines that the public interest will be
served. Following a nine-month transition period, relationships between
carriers and their customers will be set by contract. Long distance companies
are no longer required to file with the FCC tariffs for interstate
interexchange services and may immediately cease filing such tariffs. However,
several parties formally requested the FCC to reconsider its order, and MCI,
Sprint and The American Carriers Telephone Association have separately
appealed the FCC's order to the United States Court of Appeals for the
District of Columbia Circuit. On February 13, 1997, the United States Court of
Appeals for the District of Columbia Circuit stayed the FCC's order pending
judicial review of the appeals. If the appeals are unsuccessful and the FCC's
order becomes effective, the Company believes that the elimination of the
FCC's tariff requirement will permit the Company more rapidly to respond to
changes in the marketplace. In the absence of tariffs, however, the Company
will be required to obtain agreements with its