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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, 1998
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
McLEODUSA INCORPORATED
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(Exact name of registrant as specified in its charter)
Delaware 42-1407240
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
McLeodUSA Technology Park
6400 C Street SW, P.O. Box 3177
Cedar Rapids, IA 52406-3177
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(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 22, 1999 is $1,102,713,924. */
-
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 22,
1999: 68,630,796
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:
None
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*/ 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
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PART I Item 1. Business............................................. 1
Item 2. Properties........................................... 30
Item 3. Legal Proceedings.................................... 30
Item 4. Submission of Matters to a Vote of Security Holders.. 31
PART II Item 5. Market for Registrant's Common Equity and
Related Stockholder Matters.......................... 32
Item 6. Selected Financial Data.............................. 34
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................. 36
Item 7A. Quantitative and Qualitative Disclosures
About Market Risk.................................... 48
Item 8. Financial Statements and Supplementary Data.......... 48
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................. 48
PART III Item 10. Directors and Executive Officers of the Registrant... 50
Item 11. Executive Compensation............................... 55
Item 12. Security Ownership of Certain Beneficial Owners
and Management....................................... 58
Item 13. Certain Relationships and Related Transactions....... 63
PART IV Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K.................................. 65
GLOSSARY.................................................................... 74
SIGNATURES.................................................................. 77
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS.................................. F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
ON THE FINANCIAL STATEMENT SCHEDULES........................................ S-1
(i)
Unless the context suggests otherwise, references in this Form 10-K to
"we," "us," "our" and "McLeodUSA" mean McLeodUSA incorporated and its
subsidiaries and predecessors. 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. Some of the statements
contained in this Form 10-K discuss future expectations, contain projections of
results of operations or financial condition or state other forward-looking
information. These statements are subject to known and unknown risks,
uncertainties and other factors that could cause the actual results to differ
materially from those contemplated by the statements. The forward-looking
information is based on various factors and was derived using numerous
assumptions. In some cases, you can identify these so-called "forward-looking
statements" by words like "may," "will," "should," "expects," "plans,"
"anticipates," "believes," "estimates," "predicts," "potential," or "continue"
or the negative of those words and other comparable words. You should be aware
that those statements only reflect our predictions. Actual events or results
may differ substantially. Important factors that could cause our actual results
to be materially different from the forward-looking statements are disclosed
under the heading "Business--Risk Factors" and throughout this Form 10-K. See
the "Glossary" appearing at page 74 for definitions of some of the terms used in
this Form 10-K.
PART I
Item 1. Business.
Overview
We provide communications services to business and residential customers in
the Midwestern and Rocky Mountain regions of the United States. Our
communications services include local, long distance, Internet access, data,
voice mail and paging, all from a single company on a single bill. We believe
we are the first communications provider in most of our markets to offer one-
stop shopping for communications services tailored to customers' specific needs.
Our approach makes it easier for both our business and our residential
customers to satisfy their communications needs. It also allows businesses to
receive customized services, such as competitive long distance pricing and
enhanced calling features, that might not otherwise be directly available on a
cost-effective basis. As of December 31, 1998, we served over 397,600 local
lines in 269 cities and towns.
In addition to our core business of providing competitive local, long
distance and related communications services, we also derive revenue from:
. sale of advertising space in telephone directories
. traditional local telephone company services in east central Illinois and
southeast South Dakota
. special access, private line and data services
. communications network maintenance services
. telephone equipment sales, leasing, service and installation
. video services
. telemarketing services
. computer networking services
. other communications services, including cellular, operator, payphone,
mobile radio and paging services
In most of our markets, we compete with the incumbent local phone company
by leasing its lines and switches. In other markets, primarily in east central
Illinois and southeast South Dakota, we operate our own lines and switches. We
provide long distance services by using our own communications network
facilities and leasing capacity from long distance and local communications
providers. We are constructing fiber optic communications networks in Iowa,
Illinois, Wisconsin, Indiana, Missouri, Minnesota, South Dakota, North Dakota,
Colorado and Wyoming to carry additional communications traffic on our own
network.
The following chronology highlights some of the important events in the
development of our business:
Date Event
- --------------------------- ---------------------------------------------------
June 1991 McLeodUSA was incorporated in Iowa as "McLeod
Telecommunications, Inc."
November 1992 McLeodUSA began operations, providing fiber optic
maintenance services for the Iowa Communications
Network. The Iowa Communications Network is a
fiber optic communications network that links many
of the State of Iowa's schools, libraries and
other public buildings.
August 1993 McLeodUSA was reincorporated in the State of
Delaware.
December 1993 One of our wholly owned subsidiaries, McLeodUSA
Telecommunications Services, Inc., received
regulatory approvals in Iowa and Illinois to offer
local and long distance services.
January 1994 McLeodUSA began providing local and long distance
services in Iowa and Illinois.
April 1995 McLeodUSA acquired MWR Telecom, Inc., a
competitive access provider in Des Moines, Iowa.
June 1996 McLeodUSA completed its initial public offering of
Class A common stock.
July 1996 McLeodUSA acquired Ruffalo, Cody & Associates,
Inc., a telemarketing company.
September 1996 McLeodUSA acquired TelecomUSA Publishing Group,
Inc. (now known as McLeodUSA Media Group, Inc.), a
telephone directory company.
April and June 1997 The Federal Communications Commission awarded
McLeodUSA a total of 26 "D" and "E" block
frequency personal communications services ("PCS")
licenses for approximately $32.8 million.
May 1997 McLeodUSA changed its name from "McLeod, Inc." to
"McLeodUSA Incorporated."
July 1997 The FCC awarded McLeodUSA four wireless
communications services ("WCS") licenses.
September 1997 McLeodUSA acquired Consolidated Communications
Inc. ("CCI"), a diversified telecommunications
holding company offering a variety of
communications products and services, including
local exchange and long distance services and
telephone directory publishing. As part of the
acquisition of CCI, McLeodUSA acquired one
additional "E" block frequency PCS license.
As of the date hereof, we offer communications services to business and
residential customers in Iowa, Illinois, North Dakota, South Dakota, Wisconsin
and Colorado. We also offer communications services to business customers in a
number of markets in Minnesota, Missouri, Indiana, and Wyoming. Over the next
several years, depending on competitive and other factors, we intend to offer
communications services in Idaho, Montana, Nebraska and Utah. We offer long
distance service in 48 states in the continental United States.
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Our 27 PCS licenses cover areas of Iowa, Illinois, Minnesota, Nebraska and
South Dakota, encompassing approximately 110,000 square miles and a population
of approximately 6.9 million. We plan to offer PCS or other wireless services
as part of our communications services by building a wireless network, entering
into strategic acquisitions or alliances, or employing a combination of these
methods. Our four WCS licenses cover the Major Economic Areas of Milwaukee,
Wisconsin, Minneapolis/St. Paul, Minnesota, Des Moines-Quad Cities,
Iowa/Illinois and Omaha, Nebraska. We intend to use the frequency blocks
covered by these licenses to provide fixed services, such as wireless local
loop, Internet access or meter reading. See "--Proposed Wireless Services," "--
Regulation" and "--Risk Factors--We May Not Succeed in Developing or Making a
Profit from Wireless Services."
The statements in the foregoing paragraphs about our expansion plans and
proposed wireless services are forward-looking statements within the meaning of
the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. These plans may be revised, and our actual geographic expansion and
services may differ materially from that indicated by our current plans, in each
case as a result of a variety of factors, including:
. the availability of financing and regulatory approvals
. the number of potential customers in a target market
. the existence of strategic alliances or relationships
. technological, regulatory or other developments in our business
. changes in the competitive climate in which we operate
. the emergence of future opportunities.
Our principal executive offices are located at McLeodUSA Technology Park,
6400 C Street SW, P.O. Box 3177, Cedar Rapids, Iowa 52406-3177, and our main
phone number is (319) 364-0000.
Recent Transactions
Acquisition of Talking Directories and Info America. On February 10, 1999,
we acquired Talking Directories, Inc., a Michigan corporation, for an aggregate
of 2,556,390 shares of our Class A common stock. In a related and concurrent
transaction, on February 10, 1999, we also acquired Info America Phone Books,
Inc., a Michigan corporation, for an aggregate of 1,203,007 shares of our Class
A common stock. We also paid approximately $27 million of the outstanding
obligations of Talking Directories and Info America at the time of these
transactions.
Talking Directories and Info America are related companies, headquartered
in Grand Rapids, Michigan, that together publish and distribute proprietary
"white page" and "yellow page" telephone directories primarily in Michigan and
northwestern Ohio. In 1998, Talking Directories and Info America collectively
published and distributed approximately 2.6 million copies of 19 telephone
directories. As of December 31, 1998, Talking Directories had 257 employees and
Info America had no employees.
The Ovation Merger Agreement. On January 7, 1999, we entered into an
Agreement and Plan of Merger with Ovation Communications, Inc., a Delaware
corporation, and several stockholders of Ovation by which Ovation will be merged
with and into a newly formed wholly owned subsidiary of McLeodUSA. As a result
of the Ovation merger, (1) each share of Ovation's preferred stock will be
converted into the right to receive cash, and (2) each share of Ovation's common
stock will be converted, at the election of the stockholder, into the right to
receive cash or shares of our Class A common stock. The amount of cash into
which each share of Ovation's preferred stock will be converted and the amount
of cash or number of shares of Class A common stock into which each share of
Ovation's common stock will be converted will be determined immediately before
completion of the Ovation merger based on formulas specified in the Ovation
merger agreement. We estimate that we will be required to issue approximately
5.1 million shares of our Class A common stock and to pay approximately $141
million cash to effect the Ovation merger. We will also assume approximately
$95 million in Ovation debt. In addition, under the terms of the Ovation merger
agreement, each option to purchase Ovation common stock issued under Ovation's
stock option plan will become or be replaced by an option to purchase a number
of shares of our Class A common stock equal to the number of shares of Ovation
common stock that could have been
3
purchased (assuming full vesting) under the Ovation stock option multiplied by
the exchange ratio used to convert Ovation common stock into Class A common
stock.
Consummation of the Ovation merger is subject to the satisfaction of
several conditions. Stockholders of Ovation holding in the aggregate
approximately 94% of the voting power attributable to Ovation's common stock and
preferred stock have agreed to vote all of their shares in favor of the Ovation
merger at a meeting of the stockholders of Ovation.
In connection with the execution of the Ovation merger agreement, we
entered into a revolving credit agreement with Ovation by which we agreed to
lend Ovation up to $20 million on a senior subordinated unsecured basis. In
addition, several Ovation stockholders agreed through December 31, 2001 to
restrictions on their ability to transfer the shares of Class A common stock
they will receive in the Ovation merger. See "Security Ownership of Certain
Beneficial Owners and Management--Investor Agreement and Stockholders'
Agreements."
Ovation is a diversified communications services company serving business
customers primarily in larger metropolitan areas in Minnesota, Illinois and
Wisconsin (such as Minneapolis/St. Paul, Chicago and Milwaukee) and in small to
mid-sized cites in Michigan. Ovation provides the following services:
. local and network access
. competitive local exchange
. incumbent local exchange
. long distance
. voice mail, teleconferencing and calling card
. Internet access
As of December 31, 1998, Ovation served approximately 32,650 business local
lines and 12,900 residential local lines to approximately 2,900 business
customers and 11,750 residential customers in 135 cities and towns. Ovation had
1998 revenues of $21.5 million, including revenues received between October 1,
1998 and December 31, 1998 as a result of Ovation's acquisition of BRE
Communications, L.L.C. d/b/a Phone Michigan on October 1, 1998. As of December
31, 1998, Ovation had four switches, approximately 564 miles of fiber optic
communications network and 384 employees.
___________
We have obtained information regarding Talking Directories, Info America
and Ovation from each of these companies, respectively. Although we believe
this information is reliable, it has not been independently verified. The
financial information about each of these companies is unaudited.
Recent Financings. On February 22, 1999, we completed a private offering of
$500 million aggregate principal amount of our 8 1/8% senior notes due February
15, 2009, yielding net proceeds of approximately $487.8 million. The 8 1/8%
senior notes accrue interest at a rate of 8 1/8% per annum payable in cash semi-
annually in arrears on February 15 and August 15 of each year, starting August
15, 1999.
As of December 31, 1998, we estimated, based on our business plan, capital
requirements and growth projections as of that date, our aggregate capital
requirements through 2001 would be $1.4 billion. Our estimated aggregate
capital requirements include the projected cost of:
. building our fiber optic communications network, including intra-city
fiber optic communications networks
. expanding operations in existing and new markets
. developing wireless services
. funding general corporate purposes
. completing recent and pending acquisitions
. constructing, acquiring, developing or improving telecommunications
assets
4
The estimated costs and incremental capital needs associated with the
acquisitions of Talking Directories, Info America and Ovation are included in
our estimated aggregate capital requirements.
We expect to use the following to address our capital needs:
. approximately $487.8 million in net proceeds from our offering of 8 1/8%
senior notes
. approximately $591.7 million of cash and investments on hand at December
31, 1998
. additional issuances of debt or equity securities
. projected operating cash flow
The actual amount and timing of our future capital requirements is subject
to risks and uncertainties and may differ materially from our estimates.
Accordingly, we may need additional capital to continue to expand our markets,
operations, facilities, network and services. See "Risk Factors Failure to Raise
Necessary Capital Could Restrict Our Ability to Develop Our Network and Services
and Engage in Strategic Acquisitions."
Business Strategy
We want to be the leading and most admired provider of communications
services in our markets. To achieve this goal, we are:
. aggressively capturing customer share and generating revenue using
leased communications network capacity
. concurrently building our own communications network
. migrating customers to our communications network to provide enhanced
services and reduce operating costs
The principal elements of our business strategy are to:
Provide integrated communications services. We believe we can rapidly
penetrate our target markets and build customer loyalty by providing an
integrated product offering to business and residential customers.
Build customer share through branding. We believe we will create and
strengthen brand awareness in our target markets by branding our
communications services with the trade name McLeodUSA in combination with
the distinctive black-and-yellow motif of our telephone directories.
Provide outstanding customer service. Our customer service representatives
are available 24 hours a day, seven days a week, to answer customer calls.
Our customer-focused software and systems allow our representatives
immediate access to our customer and network data, enabling a rapid and
effective response to customer requests.
Emphasize small and medium sized businesses. We primarily target small and
medium sized businesses because we believe we can rapidly capture customer
share by providing face-to-face business sales and strong service support
to these customers.
Expand our fiber optic communications network. We are building a state-of-
the-art fiber optic communications network to deliver multiple services and
reduce operating costs.
Expand our intra-city fiber optic communications network. Within selected
cities, we plan to extend our network directly to our customers' locations.
This will allow us to provide expanded services and reduce the expense of
leasing communications facilities from the local exchange carrier.
Explore acquisitions and strategic alliances. We plan to pursue
acquisitions, joint ventures
5
and strategic alliances to expand or complement our business.
Leverage proven management team. Our executive management team consists of
veteran telecommunications managers who successfully implemented similar
customer-focused telecommunications strategies in the past.
Market Potential
The telecommunications industry is undergoing substantial changes due to
statutory, regulatory and technological developments. We believe that we are
well-positioned to take advantage of these fundamental changes.
Wireline Services. The market for local exchange services consists of a
number of distinct service components, including:
. local network services, which generally include basic dial tone, local
area charges, enhanced calling features and private line services
(dedicated for a customer's use between locations)
. network access services, which consist of access provided by local
exchange carriers to long distance communications network carriers
. short-haul long distance communications network services, which
include intraLATA long distance calls and private lines
. other varied services, including operator services, Internet access,
calling cards, publication of "white page" and "yellow page" telephone
directories and the sale of business telephone equipment.
Industry sources have estimated that the 1999 aggregate revenues of all
local exchange carriers will approximate $102 billion. Until recently, there
was little competition in the local exchange markets, particularly for local
network and network access services.
Before 1984, AT&T largely monopolized local and long distance telephone
services in the United States. In 1984, as the result of a court decree, AT&T
was required to divest its local telephone systems (the "Divestiture"), which
created the present structure of the telecommunications industry in the U.S.
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 (now five, as a result
of industry consolidation) independent regional Bell operating companies.
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.
Subsequently, several factors began to promote competition with respect to
local exchange services, including:
. 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
. advances in the technology for transmission of voice, data and video
requiring greater capacity and reliability levels than many local
exchange carrier networks, which principally are copper-based, can
accommodate
. the development of fiber optic and digital electronic technology,
which reduced communications network construction costs while
increasing transmission speeds, capacity
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and reliability compared to the older copper-based network typically
employed by the existing local exchange carriers
. the significant access charges long distance carriers are required to
pay to local exchange carriers to access the local exchange carriers'
networks
. statutory and regulatory initiatives in the telecommunications
industry permitting and promoting competition in the local exchange
market.
Opportunities to compete in the local exchange market expanded
substantially on February 8, 1996, when the Telecommunications Act of 1996 was
enacted. The Telecommunications Act of 1996 eliminated state legal prohibitions
against local exchange competition and requires incumbent local exchange
carriers to allow other providers of telecommunications services to purchase
elements of their local communications network offerings and to interconnect
with their communications facilities and equipment. Most significantly, it
requires the incumbent local exchange carriers to complete local calls
originated by our customers and transferred or connected by us using our own
communications network facilities, and to deliver inbound local calls to us for
connection to our customers, assuring our customers of unimpaired local calling
ability. In addition, local exchange carriers are obligated to provide local
number portability and dialing parity upon request and make their local services
available for resale by competitors. Local exchange carriers also are required
to allow competitors non-discriminatory access to local exchange carrier poles,
conduit space and other rights-of-way.
We believe that these requirements are likely, when fully implemented, to
increase competition among providers of local communications services and
simplify the process of switching from incumbent local exchange carrier services
to those offered by competitive local exchange carriers. The Telecommunications
Act of 1996 also offers important benefits to the regional Bell operating
companies, however, such as the ability to provide interLATA long distance
services under specified conditions. The process of implementing the
Telecommunications Act of 1996 is still incomplete, and important questions
remain unresolved. See "--Regulation".
A number of states have also taken regulatory and legislative action to
open local communications markets to various degrees of competition. We expect
that continuing pro-competitive regulatory changes, together with increasing
customer demand, will create more opportunities for competitive service
providers to introduce additional services, expand their networks and address a
larger customer base. However, we cannot assure you that government actions to
implement local telephone competition will be as complete or as timely as we
require to implement our business plans.
Wireless Services. Demand for wireless communications has grown rapidly
over the past decade. According to the Cellular Telecommunications Industry
Association ("CTIA"), the number of wireless telephone subscribers nationwide
has grown from approximately 680,000 in 1986 to an estimated 61 million as of
June 30, 1998, with a compound annual growth rate of approximately 40% from
1990 through 1997. Wireless communication revenues for the 12-month period ended
June 30, 1998 are estimated by CTIA to have totaled over $29.6 billion, a 16%
increase over the prior 12-month period. We believe that the demand for wireless
communications will continue to grow dramatically, and that PCS will capture a
significant share of the wireless market, due to anticipated declines in costs
of service, increased function versatility, and increased awareness of the
productivity, convenience and safety benefits associated with such services. We
also believe the rapid growth of notebook computers and personal digital
assistants, combined with emerging software applications for wireless delivery
of electronic mail, fax and database searching, will further stimulate demand
for wireless service. In addition, we expect future competition between wireline
local exchange carriers and wireless service providers as "wireless local loop"
technology and reduced wireless rates facilitate migration of wireline minutes
to wireless carriers.
7
Current Products and Services
We derive our revenue from:
. our core business of providing local, long distance and related
communications services to end users, typically in a bundled package
. the sale of advertising space in telephone directories
. traditional local telephone company services through the operation of
Illinois Consolidated Telephone Company ("ICTC") in east central
Illinois and Dakota Telecommunications Group, Inc. in southeast South
Dakota
. special access, private line and data services
. communications network maintenance services
. telephone equipment sales, leasing, service and installation
. video services
. telemarketing services
. computer networking services
. other communications services, including cellular, operator, payphone
and paging services
For the year ended December 31, 1998, we derived 44% of our total revenues
from our core business of providing local, long distance and related
communications services, 24% from the sale of advertising space in telephone
directories, and 11% from traditional local telephone company services. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Overview."
Integrated Communications Services.
Overview. As of December 31, 1998, we provided service, on a retail basis,
to over 397,000 local lines in our markets, primarily to small and medium sized
business customers and to residential customers. Since beginning sales
activities in January 1994, we have increased our revenue from the sale of local
and long distance telecommunications services from $4.6 million for the year
ended December 31, 1994 to $267.4 million for the year ended December 31, 1998.
In order to provide local communications services to most of our business
and residential customers in Iowa, Minnesota, North Dakota, South Dakota,
Colorado, Wisconsin, and Illinois, we purchase "Centrex" services through
various resale, interconnection and retail rate stability agreements with U S
WEST Communications, Inc. for our customers located in U S WEST's service
territories and Ameritech Corporation for most of our customers located in
Ameritech's service territories. These "Centrex" agreements allow us to
partition part of the central office switching equipment serving the communities
in which we provide local services, which allows us to aggregate lines, have
control over several characteristics of those lines and provide a set of
standard features on them. Our customers' telephone lines and numbers are
assigned to our portion of the switch. U S WEST or Ameritech, as the case may
be, bills us for all the lines assigned to our customers and provides us with
call detail reports, which enable us to verify our customers' bills for both
local and long distance service. These Centrex agreements protect us from
unilateral rate increases until 2002 or 2003, depending on the state. We
believe that our Centrex-based local services are superior to a standard
business or residential telephone line, since we can offer features, such as
three-way calling, consultation hold and call transfer, at no extra charge.
Other custom calling features are available at additional cost. Because we also
purchase the "Centrex Management System" and the "Centrex Mate Service" from U S
WEST and Ameritech, respectively, our personnel have on-line access to U S WEST
and Ameritech facilities and may make changes to the customers' services
electronically and quickly.
In Missouri, we have an interconnection agreement with Southwestern Bell
Telephone Company that allows us to provide local service by leasing individual
lines and switches from Southwestern Bell for
8
resale to our customers. This interconnection agreement provides for a wholesale
discount from the prevailing Southwestern Bell retail price, but does not allow
us to partition a portion of Southwestern Bell's switching equipment as with
Centrex services. As of the date hereof, we are renegotiating the terms of this
interconnection agreement with Southwestern Bell.
In addition, in order to provide integrated communications services to many
of our business and residential customers in central Illinois and in the
Indianapolis, Indiana metropolitan area, we use our own switching equipment and
communications network facilities together with unbundled local "loop" elements
of Ameritech's telecommunications network that we purchase through
interconnection agreements. In Cedar Rapids, Iowa and southeast South Dakota,
we also provide communications services to some of our business and residential
customers using only our own lines and communications network facilities.
We provide most of our long distance service by purchasing communications
network capacity, in bulk, from national long distance carriers, and routing our
customers' long distance traffic over this capacity. In some service areas, we
also carry long distance traffic on our own network facilities.
Business Services. End-user business customers can obtain local, long
distance and ancillary services, such as three-way calling and call transfer,
directly from us in each of the cities and towns in which we offer
communications services today.
We generally offer business customers our integrated local communications
services at prices that are similar to the published retail rates for basic
business service provided by the incumbent local exchange carrier. We offer our
business customers a flat rate or a negotiated rate for long distance service
consistent with their particular needs and within the guidelines of our filed
tariffs. These rates are not subject to increase for the duration of the term
selected by the customer. We also offer some of our business customers long
distance rates calculated by totaling their monthly calls and comparing the
total charges that would be applicable to such calls under different pricing
plans of the major long distance carriers. The customer is then billed an
amount equal to the approximate lowest monthly charges among these plans, minus
any discount to which the customer may be entitled as a result of having made a
long-term commitment to use our services.
Business customers previously served by CCI were on different long distance
rate plans. We are transitioning these customers to our most appropriate rate
plan consistent with their needs. Furthermore, in some states, including states
outside of our target markets, we offer business customers long distance service
only, in order to enhance our ability to attract business customers that have
offices outside of our target markets.
Residential Services. We introduced our PrimeLine(R) service in 1996 and
now offer that service to residential and small business customers in various
cities and towns in Iowa, Illinois, North Dakota, South Dakota, Wisconsin,
Wyoming and Colorado. Our basic PrimeLine(R) service includes local and long
distance telephone service, as well as enhanced features such as three-way
calling, call transfer and consultation hold. Paging, voice mail, Internet
access and travel card services are also available at the customer's option as
part of our PrimeLine(R) service. We generally price our basic PrimeLine(R)
local service slightly higher than the rates for basic local service offered by
the incumbent local exchange carrier since our basic PrimeLine(R) local service
includes enhanced features that are not typically provided as part of the
incumbent local exchange carrier's basic local service. Our customers can add
paging, voice mail and Internet access services to their basic PrimeLine(R)
service at incremental rates designed to be no higher than separately purchasing
these services from other companies. We generally offer our PrimeLine(R)
customers a choice of either long distance rates that vary with the time of the
call or flat-rate long distance pricing applicable 24 hours a day, seven days a
week.
Directory Services. In 1998, we published 156 proprietary "white page" and
"yellow page" telephone directory titles and distributed approximately 14.2
million copies of these directories to local telephone subscribers in 21 states
in the Midwestern and Rocky Mountain regions of the United States, including
most of our target markets. We also published 287 "white page" and "yellow
page" telephone directory titles for other companies and distributed
approximately 4 million copies of these directories to local telephone
subscribers in 38 states and the U.S. Virgin Islands. Our telephone directory
services generated 1998 revenues of approximately $144.9 million, primarily from
the sale of advertising space in the directories.
9
Many of our telephone directories serve as "direct mail" advertising
because they contain information on how to contact us and detailed product
descriptions and step-by-step instructions on the use of our telecommunications
products. In addition, we believe that our directories' distinctive black-and-
yellow motif combined with the trade name McLeodUSA strengthens brand awareness
in our markets. See "--Sales and Marketing."
Traditional Local Telephone Services. Through ICTC and Dakota
Telecommunications, we provide regulated incumbent local exchange telephone
service to subscribers in central Illinois and southeast South Dakota.
ICTC operates in 37 exchanges, or service areas, the largest of which are
in Mattoon, Charleston, and Effingham, Illinois. As of December 31, 1998, ICTC
had over 91,000 local access lines in its existing service areas. ICTC offers a
broad range of local exchange services, including long distance carrier access
service, intraLATA toll service, local telephone service, local paging service,
national directory assistance, and equipment leasing. Local telephone service
consists of furnishing a dial tone to local subscribers, at which time
subscribers can make a local call or a long distance call. ICTC also offers
most of its local telephone subscribers custom calling features such as call
waiting, call forwarding, conference calling, speed dialing, caller
identification, and call blocking. The rates for these and other local exchange
services are regulated by the Illinois Commerce Commission and the FCC. To
provide these services, ICTC owns and operates three central office switches and
33 remote switches.
As of December 31, 1998, Dakota Telecommunications served approximately
7,350 local service access lines in 13 telephone exchanges in southeastern South
Dakota. Dakota Telecommunications provides a full range of communications
products and services, including local dial tone and enhanced services, local
private line and public telephone services, dedicated and switched data
transmission services, long distance telephone services, operator assisted
calling services, Internet access and related services.
Special Access, Private Line and Data Services. We provide, on a private
carrier basis, a wide range of special access, private line and data services to
our long distance carrier, wireless, cable television and other end-user
customers. These services include:
. POP-to-POP special access
. end user/long distance carrier special access
. private line services
POP-to-POP special access services provide telecommunications lines that
link the POPs of one long distance carrier or the POPs of different long
distance carriers in a market, allowing these POPs to exchange
telecommunications traffic for transport to final destinations.
End user/long distance carrier special access services provide
telecommunications lines that connect an end user such as a large business to
the local POP of its selected long distance carrier.
Long distance carrier special access services provide telecommunications
lines that link a long distance carrier POP to the local central office. For
example, we have agreed to furnish long distance carrier special access services
to AT&T in up to 30 Midwestern cities in Illinois, Iowa, Minnesota, North Dakota
and South Dakota, providing a catalyst for the expansion of our intra-city
networks.
Private line services provide telecommunications lines that connect various
locations of a customer's operation to transmit internal voice, video and/or
data traffic. We provide private line services by using our own communications
network facilities, leasing communications network facilities from other
telecommunications carriers, or using some combination of owned and leased
communications network facilities
Network Maintenance Services. In 1990, the State of Iowa authorized
construction of the initial fiber optic links of the Iowa Communications Network
(the "Part I and II segments"). The Part I and II segments, which are owned by
the State of Iowa, provide 3,400 miles of fiber optic communications network
connections to approximately 139 sites in Iowa and are used primarily for
interactive distance
10
learning, telemedicine and the State's own long distance telephone traffic. We
have entered into a fiber optic maintenance contract with the State of Iowa to
provide maintenance services for the Part I and II segments of the Iowa
Communications Network until 2004. Our maintenance activities under this
contract are performed on a 24-hour-per-day, 365-days-per-year basis, and
consist of alarm monitoring, repair services and cable location services.
We believe that the expertise in fiber optic maintenance we have developed
through the maintenance of the Iowa Communications Network provides advantages
in maintaining our own communications network facilities. Because commercial
use of the Part I and II segments is forbidden, however, neither McLeodUSA nor
any other communications carrier may use capacity on the Part I and II segments
to provide communications services to customers.
Telephone Equipment Services. We sell, lease, install and service
telephone systems, primarily to small and medium sized businesses in Iowa,
Illinois and Minnesota. We believe these services provide valuable expertise
for and complement our communications services offerings, giving us additional
contact with the small and medium sized businesses we target in marketing our
communications services.
Video Services. We own 85% of Greene County Partners, Inc., a cable
television company that as of the date hereof provides cable television service
to approximately 16,800 subscribers in Illinois and Michigan. Through Dakota
Telecommunications, we also own and operate 26 cable television systems located
in southeastern South Dakota, northwestern Iowa and southwestern Minnesota. As
of December 31, 1998, these systems provided service to approximately 5,930
subscribers.
We have also received a franchise from the city of Cedar Rapids, Iowa to
provide cable television service. We are using this franchise to explore the
possible synergies between cable television and our advanced communications
services offerings, such as Integrated Services Digital Network ("ISDN"), low
and high speed Internet, video and other advanced services. Depending on the
results of this preliminary initiative and on other factors, including
technological, regulatory or other developments in our business, changes in the
competitive climate in which we operate, and the emergence of future
opportunities, we may elect to offer cable service on an expanded basis in the
future.
Telemarketing Services. We provide direct marketing and telemarketing
services for third parties, as well as a variety of fund-raising services for
colleges, universities and other non-profit organizations throughout the United
States. We believe that these services provide valuable marketing opportunities
and expertise for our communications services, particularly with respect to
potential residential customers. In addition to providing telemarketing
services for third parties, we also use our telemarketing sales personnel for
sales of our PrimeLine(R) residential services. See "--Sales and Marketing."
Computer Networking Services. Through Dakota Telecommunications, we
provide customized, integrated solutions for computing networks in some markets
in South Dakota. Typical services include review of customer system
requirements; selection, design and planning of system components and networks;
and operating and network support services.
Other Communications Services. We provide pay telephone service, operator
services and paging services in some markets. In addition, we own a minority
interest in a partnership that provides cellular service in central Illinois.
Expansion of Services Using Our Own Communications Network Facilities
As of the date hereof, we are providing service to over 2,300 local lines
in Cedar Rapids, Iowa and southeast South Dakota using only our own switching
and fiber optic communications network facilities connected directly to our
customers' locations. We are extending our intra-city fiber optic
communications network and switching capacity to enable us to provide expanded
services directly to our customers and reduce the expense of leasing
communications facilities from the existing telephone company.
As of the date hereof, we are also offering service to over 7,000 local
lines located in central
11
Illinois and in Indianapolis, Indiana using our own switches and fiber optic
communications network facilities combined with network elements purchased from
Ameritech through interconnection agreements. We are building a state-of-the-art
fiber optic communications network to enable us to serve additional end-user
customers in this manner, using our communications network facilities in
combination with network elements of existing telephone companies. Our
communications network and switching capacity is also designed to serve other
wireline and wireless carriers on a wholesale basis.
We have received state regulatory approval to offer local switched services
using our own communications network facilities in Colorado, Idaho, Iowa,
Illinois, Indiana, Minnesota, Missouri, Nebraska, North Dakota, South Dakota,
Utah, Wisconsin and Wyoming. We intend to offer additional local switched
services using our own network facilities, either alone or in combination with
network elements purchased from existing telephone companies, in 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. We then plan to expand these facilities-based
services to other cities as our communications network develops and our market
penetration increases.
Our plans to provide local switched services using our own communications
network facilities will depend upon obtaining favorable interconnection
agreements and terms for leasing network elements from existing telephone
companies. In August 1996, the FCC released a decision (the "Interconnection
Decision") implementing the interconnection portions of the Telecommunications
Act of 1996. The Interconnection Decision has been the subject of significant
legal dispute. In January 1999, the U.S. Supreme Court rejected challenges to
the Interconnection Decision and affirmed the authority of the FCC to establish
rules governing interconnection. We believe that additional disputes regarding
the Interconnection Decision and other related FCC actions are likely. We cannot
assure you that we will succeed in obtaining interconnection agreements on terms
that would permit us to offer local services using our own communications
network facilities at profitable and competitive rates. See "--Regulation."
The foregoing statements are forward-looking statements within the meaning
of the Private Securities Litigation Reform Act of 1995 and where we actually
provide such services will depend on factors such as:
. the outcome of the judicial proceedings regarding the Interconnection
Decision
. technological, regulatory or other developments in our business
. changes in the competitive climate in which we operate
. the emergence of future opportunities
For a detailed description of the expansion of our fiber optic
communications network, see "--Network Facilities."
Proposed Wireless Services
As of the date hereof, we do not offer wireless services, although we do
own a minority interest in a cellular telephone partnership serving parts of
east central Illinois. In April and June 1997, the FCC awarded us a total of 26
"D" and "E" block frequency PCS licenses, each covering 10 MHz of radio
spectrum, and in September 1997 we acquired CCI and its "E" block frequency PCS
license, giving us a total of 27 PCS licenses in 25 markets covering areas of
Illinois, Iowa, Minnesota, Nebraska and South Dakota. We paid approximately
$32.8 million for the 26 PCS licenses awarded to us by the FCC. CCI paid the
FCC for its PCS license before we acquired CCI. Our PCS licenses encompass
approximately 110,000 square miles and a population of approximately 6.9
million. We plan to offer PCS or other wireless services as part of our
communications services by building a wireless network, entering into strategic
acquisitions or alliances, or employing a combination of these methods.
PCS differs from traditional cellular telephone service principally in that
PCS systems operate at a higher frequency band and employ advanced digital
technology. Compared 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.
12
We will need to spend significant time and money to develop wireless
services. To implement a wireless system, we will need to build or otherwise
acquire access to wireless infrastructure. The infrastructure of a wireless
system generally consists of switches, base station transmitters and receivers,
and related equipment. We may also incur costs related to site acquisition and
preparation, installation services, zoning approval or other permits, frequency
planning, construction and equipment procurement, installation and testing.
Furthermore, we believe that our ability to successfully offer wireless services
will depend on our ability to offer roaming service to our customers so they can
use their handsets outside our service area. This will require us to establish
suitable roaming arrangements with other wireless operators in other markets
constructing systems compatible with our own. We cannot predict when, or
whether, we will be able to enter into such roaming agreements with local
providers.
We have entered into long-term agreements with our electric utility
stockholders (Alliant Energy Investments Inc. (collectively with its
predecessors and affiliates, "Alliant Energy"), and MHC Investment Company
(collectively with its predecessors and affiliates, "MidAmerican")) and with
Wisconsin Power and Light Company, Illinois Power Company and Illinois Central
Railroad Corporation, that will enable us to install base stations and other
equipment on such companies' towers. See "--Network Facilities." We expect the
use of these existing towers and other facilities occupied by other
telecommunications service providers and utility companies to facilitate our
development of wireless services.
On July 21, 1997, the FCC also awarded us four WCS licenses covering
Milwaukee, Wisconsin, Minneapolis/St. Paul, Minnesota, Des Moines-Quad Cities,
Iowa/Illinois and Omaha, Nebraska. We expect to use the frequency blocks
covered by such licenses to provide fixed services, such as wireless local loop,
Internet access or meter reading.
As the wireline and wireless markets converge, we believe that we can
identify other opportunities to generate revenues from the wireless industry on
both a retail and a wholesale basis. On a retail basis, we believe that we will
be able to enter into strategic arrangements with both cellular and PCS
companies on favorable economic terms to allow us to offer wireless services as
part of our integrated communications services offerings. On a wholesale basis,
these opportunities may include (1) leasing tower sites to wireless providers,
(2) connecting or transferring wireless traffic through our communications
network facilities and (3) transporting wireless traffic using our fiber optic
communications network to interconnect wireless providers' cell sites or to
connect such sites to either our communications network facilities or to
communications network facilities of other providers of wireline services. For
example, we have entered into agreements with five wireless companies to provide
access to several of the towers we control.
The statements in the foregoing paragraphs about our plans to offer
wireless services are forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. These plans may be revised,
and our actual wireless services may differ materially from that indicated by
our current plans, in each case as a result of a variety of factors, including:
. the availability of financing and regulatory approvals
. the number of potential customers in a target market
. the existence of strategic alliances or relationships
. technological, regulatory or other developments in our business
. changes in the competitive climate in which we operate
. the emergence of future opportunities
See "--Risk Factors--We May Not Succeed in Developing or Making a Profit from
Wireless Service" and "--Risk Factors--Competition in the Wireless
Telecommunications Industry Could Make it Harder for Us Successfully to Offer
Wireless Services."
Network Facilities
As the incumbent local exchange carriers are compelled, by regulatory
changes and competitive forces, to unbundle their network components and to
permit resale of their network elements and products, we expect to be able to
provide our customers with a full range of communications services
13
using a combination of our own communications network, the networks of the
incumbent local exchange carriers and the networks of other competitive
carriers.
As of December 31, 1998, we owned approximately 7,100 route miles of fiber
optic communications network and expect to add approximately 2,000
additional route miles of fiber optic network during 1999. We will decide
whether to begin construction of fiber optic network in a market based on
various economic factors, including:
. the number of our customers in a market
. the anticipated operating cost savings associated with such
construction
. any strategic relationships with owners of existing infrastructure
(e.g., utilities and cable operators)
. strategic acquisitions of providers of wireless services or owners of
existing infrastructure
We are installing backbone communications network facilities that form a
series of fiber optic "self-healing rings" and intra-city communications network
facilities that provide access directly to customer locations. These
communications network facilities are intended to enable us to provide local and
long distance service using our own facilities in selected cities and towns in
Iowa, Illinois, Indiana, Wisconsin and Minnesota, and in Sioux Falls, South
Dakota. Our communications networks are designed to support a wide range of
communications services, provide increased network reliability and reduce costs.
Our communications network consists of fiber optic cables, which typically
contain between 24 and 144 fiber strands, each of which is capable of providing
many telecommunications circuits. A single pair of fibers on our network can
transmit 32,256 simultaneous voice conversations, whereas a typical pair of
copper wires can carry a maximum of 24 digitized simultaneous voice
conversations. We expect that continuing developments in compression technology
and multiplexing equipment will increase the capacity of each fiber, providing
greater capacity at relatively low incremental cost.
In 1995, the Iowa General Assembly passed legislation to extend the Iowa
Communications Network to 543 more endpoints (which are usually located in
schools or public libraries) throughout the State of Iowa (the "Part III
segments"). The majority of these fiber optic links, unlike the Part I and II
segments of the Iowa Communications Network, will be leased to the State of
Iowa, from a private entity, such as McLeodUSA. As of December 31, 1998, we had
contracts to build and then lease capacity to the State of Iowa on 235 of such
segments. Under our lease agreements with the State of Iowa, we are
constructing a "fiber-rich" broadband communications network on which the State
of Iowa has agreed to lease one DS-3 circuit for a period of seven years for a
total aggregate lease cost of approximately $27.0 million. Upon completion of
installation of each segment, the leases provide that the State of Iowa will
make a one-time up-front lease payment to us for the capacity, with nominal
monthly lease payments thereafter. At the end of a seven-year period, the
leases may be extended, upon terms to be mutually agreed upon. During the term
of the leases, the State of Iowa may order additional DS-3 circuits at a
mutually agreed upon price.
In September 1997, as a result of our acquisition of CCI, we acquired
approximately 900 route miles of fiber optic network facilities, parts of which
are currently connected to Ameritech unbundled network elements through an
interconnection agreement. We believe that CCI's experience in serving end user
local lines under the interconnection agreement will substantially assist our
technical abilities in interconnection to the unbundled network elements of
incumbent local exchange carriers.
In March 1999, as a result of our acquisition of Dakota Telecommunications,
we acquired approximately 290 additional route miles of fiber optic
communications network facilities.
We have reached agreements with our electric utility stockholders
(MidAmerican and Alliant Energy) and with Wisconsin Power and Light Company,
Illinois Power and Illinois Central Railroad that allow us to make use of those
companies' rights-of-way, underground conduits, distribution poles, transmission
towers and building entrances in exchange for rights by such companies to use
capacity on our network. These agreements give us access to rights-of-way in
parts of Iowa, Illinois and Wisconsin for installation of our wireline and
wireless networks. We expect our access to these rights-of-way to have a
significant positive impact on our capital costs for network construction and
the speed with which we can
14
construct our networks. We believe that our strategic relationships with our
electric utility stockholders and other companies that own rights-of-way and
infrastructure give us a competitive advantage.
Sales and Marketing
Until June 1996, we directed our communications sales efforts primarily
toward small and medium sized businesses. In June 1996, we began marketing our
PrimeLine(R) services to residential customers.
Marketing of our integrated communications services to business customers
is conducted by direct sales personnel, located at our headquarters in Cedar
Rapids, Iowa and in branch sales offices in Iowa, Illinois, North Dakota, South
Dakota, Minnesota, Missouri, Wisconsin, Indiana, Colorado, Nebraska and Wyoming.
Sales activities in our branch sales offices are organized and managed by
region.
Marketing of our integrated communications services to residential
customers is conducted by telemarketers. The telemarketers emphasize the
PrimeLine(R) integrated package of communications services and its flat-rated
per minute pricing structure for long distance service. We also use Ruffalo
Cody's information database to identify attractive sales opportunities and
pursue those opportunities through a variety of methods, including calls from
our telemarketing personnel.
Our sales force is trained to emphasize our customer-focused sales and
service efforts, including our 24-hours-per-day, 365-days-per-year customer
service center. Our employees answer customer service calls directly rather
than requiring customers to use an automated queried message system. We believe
that our emphasis on a single point of contact for meeting our customer's
communications needs is very appealing to our current and prospective customers.
We have also developed and installed customer-focused software for providing
integrated communications services. This software permits us to present our
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 us to include additional services, such as
wireless services, when available. We believe that our customer-focused
software platform is an important element in the marketing of our communications
services and gives us a competitive advantage in the marketplace.
We believe our strategic acquisitions have enhanced our sales and marketing
efforts and increased our penetration of existing markets. We believe these
acquisitions will also help accelerate our entry into new markets. For example,
we began publishing and distributing telephone directories as a result of
acquisitions. We can use our proprietary telephone directories as direct mail
advertising simply by including detailed product descriptions and information
about our communications products in them. We believe that these telephone
directories provide us with a long-term marketing presence in the millions of
households and businesses that receive them. We also believe that combining our
directories' distinctive black-and-yellow motif with the trade name McLeodUSA
strengthens brand awareness in all of our markets.
In 1998, we expanded our communications sales and marketing efforts
primarily by opening new branch sales offices in North Dakota, South Dakota,
Minnesota, Colorado, Missouri, Wisconsin and Wyoming and continuing to expand
our sales and marketing efforts in Iowa and Illinois. Over the next several
years, depending on competitive and other factors, we also intend to begin sales
and marketing efforts in Montana, Idaho and Utah. The foregoing statements are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 and the results of our actual expansion efforts
may be materially different, depending on a variety of other factors, including:
. the availability of financing and regulatory approvals
. the number of potential customers in a target market
. the existence of strategic alliances or relationships
. technological, regulatory or other developments in our business
. changes in the competitive climate in which we operate
. the emergence of future opportunities
15
Competition
Wireline Competition. The communications services industry is highly
competitive. We face intense competition from local exchange carriers, including
the regional Bell operating companies (primarily U S WEST, Ameritech and
Southwestern Bell) and GTE, which currently dominate their respective local
telecommunications markets. Our long distance services also compete with the
services of hundreds of other companies in the long distance marketplace. AT&T,
MCI WorldCom and Sprint currently dominate the long distance market. Our local
and long distance services also compete with the services of other competitive
local exchange carriers in some markets. Other competitors may include cable
television companies, competitive access providers, microwave and satellite
carriers, wireless telecommunications providers, and private networks owned by
large end-users. In addition, we compete with the 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 portions of our business. Many of our
existing and potential competitors have financial and other resources far
greater than our own.
We believe that the distinction between the local and long distance markets
is eroding, and other competitors will begin to offer integrated communications
services similar to our own. For example, each of AT&T, MCI WorldCom and Sprint
has begun to offer local telecommunications services using their own network
facilities, network elements obtained from incumbent local exchange carriers, or
the facilities of other parties. AT&T has announced its plan to enter into
exclusive arrangements with cable operators to use their local network
facilities for telecommunications services. These and other companies currently
hold state regulatory certificates to offer local and long distance service in
Iowa, Illinois and other states within our target markets. We cannot assure you
that these firms, and others, will not enter the markets or target the small and
medium sized businesses where we focus our sales efforts.
A continuing trend toward business combinations and strategic alliances in
the telecommunications industry may strengthen our competitors. For example,
WorldCom acquired MCI in September 1998 and AT&T acquired Teleport
Communications Group Inc. in July 1998 and Tele-Communications, Inc. in March
1999. In addition, merger plans have been announced by Southwestern Bell and
Ameritech and by Bell Atlantic and GTE. U S WEST and Ameritech also announced
in May 1998 that each had entered into a marketing arrangement with Qwest
Communications, a long distance company. The FCC ruled that these marketing
arrangements violate the Telecommunications Act of 1996, but both U S WEST and
Ameritech have appealed this ruling. In addition, Southwestern Bell and
Williams Communications, Inc., a long distance company, have announced a
strategic alliance to supply services to each other. These or other alliances
or combinations between our competitors could put us at a significant
competitive disadvantage.
We depend on incumbent local exchange carriers to provide access service
for the origination and termination of most of our toll long distance traffic
and interexchange private lines. Historically, charges for such access service
made up a significant percentage of the overall cost of providing long distance
service. The FCC and various states are considering changes to access charge
rate levels and related issues involving support for universal service and other
public policy objectives. The impact of these changes on us and our competitors
is not yet clear. We could be adversely affected if we do not experience access
cost reductions proportionally equivalent to those of our competitors, if our
competitors receive a disproportionate share of universal service revenues, or
if regulation of incumbent local exchange carriers' access services is reduced.
As long as new Internet-based competitors continue to be exempt from these
charges, they could enjoy a significant cost advantage in this area.
We also depend on incumbent local exchange carriers to provide our local
telephone service through access to local communications network elements,
termination service or local central office switching, or through wholesale
purchase of the local telephone services of such carriers that we then resell to
end users. Any successful effort by the incumbent local exchange carriers to
deny or substantially limit our access to their network elements or wholesale
services would have a material adverse effect on our ability to provide local
telephone services. Although the Telecommunications Act of 1996 imposes
interconnection obligations on incumbent local exchange carriers, we cannot
assure you that we will be able to obtain access to their communications network
elements or services at rates, and on terms and conditions, that will permit us
to offer local services at rates that are both profitable and competitive.
16
The Telecommunications Act of 1996 also provides the incumbent local
exchange carriers with new competitive opportunities. For example, under the
Telecommunications Act of 1996, the regional Bell operating companies will, upon
the satisfaction of various conditions, be able to offer interLATA long distance
services to local telephone service customers in their regions. The regional
Bell operating companies are actively engaged in proceedings and other
activities by which they are seeking to satisfy those conditions. We believe
that we have advantages over the incumbent local exchange carriers in providing
our telecommunications services, including our management's prior experience in
the competitive telecommunications industry and our emphasis on marketing
(primarily using a direct sales force for sales to business customers and
telemarketing for sales to residential customers) and on responsive customer
service. However, the regional Bell operating companies may be allowed to offer
interLATA long distance services before their local exchange markets are
completely open to competition. Under such circumstances in particular,
additional competition from the incumbent local exchange carriers could have a
material adverse effect on our business, results of operations and financial
condition.
Competition for local and special access telecommunications services is
based principally on price, quality, network reliability, customer service and
service features. We believe that our management expertise and emphasis on
customer service allows us to compete effectively with the incumbent local
exchange carriers in providing these services. In addition, our fiber optic
communications networks provide both diverse access routing and redundant
electronics, which design features are not widely deployed by the local exchange
carriers' networks. However, if the incumbent local exchange carriers,
particularly the regional Bell operating companies, charge alternative providers
such as McLeodUSA unreasonably high fees for interconnection to their networks,
significantly lower their rates for access and private line services, or offer
significant volume and term discount pricing options to their customers, we
could be at a significant competitive disadvantage.
In the future, an important element of providing competitive services may
be the ability to offer customers high-speed broadband local connections. The
FCC is considering a proposal that would allow incumbent local exchange carriers
to offer these and other services through separate affiliates, in which case
their network elements for providing these services would not need to be made
available to us or other competitors. AT&T has announced that it is entering
into arrangements with cable companies for the exclusive use of their local
networks for broadband telecommunications and several cable companies are
offering broadband Internet access over their network facilities. As of the
date hereof, we offer such broadband local access to our customers only in
limited areas in Cedar Rapids, Iowa and southeast South Dakota. If we are
unable to meet future demands of our customers for broadband local access or
other services on a timely basis at competitive rates, we may be at a
significant competitive disadvantage.
For more information about the regulatory environment in which we operate,
see "--Regulation."
Wireless Competition. The wireless telecommunications industry is
experiencing significant technological change, as evidenced by the increasing
pace of improvements in the capacity and quality of digital technology, shorter
cycles for new products and enhancements, and changes in consumer preferences
and expectations. We believe the market for wireless telecommunications
services is likely to expand significantly as equipment costs and service rates
continue to decline, equipment becomes more convenient and functional, wireless
services become more diverse, technology improves and new competitors enter the
market. We also believe providers of wireless services increasingly will offer,
in addition to products that supplement a customer's wireline communications
like cellular telephone services in use today, wireline replacement products
that may result in wireless services becoming the customer's primary mode of
communication. Accordingly, we expect competition in the wireless
telecommunications business to be dynamic and intense as a result of the
entrance of new competitors and the development of new technologies, products
and services. We anticipate that in the future there could potentially be eight
wireless competitors in each of our proposed PCS markets: two existing cellular
providers, five other PCS providers and Nextel Communications Inc., an ESMR
provider. There are over ten principal cellular providers and over 20 principal
PCS licensees in our proposed PCS markets. In addition, we could face
competition from mobile satellite services which are under development.
Competition with these or other providers of wireless telecommunications
services may be intense. Many of our potential wireless competitors have
substantially greater financial, technical, marketing, sales, manufacturing and
distribution resources than our own and have significantly greater experience
than us in testing new or improved wireless telecommunications products and
services. Some
17
competitors, particularly WCS carriers, are expected to market other services,
such as cable television access, with their wireless telecommunications service
offerings. We do not currently offer wireless cable television access. In
addition, several of our potential wireless competitors are operating or
planning to operate, through joint ventures and affiliation arrangements,
wireless telecommunications systems that encompass most of the United States. We
cannot assure you that we will be able to compete successfully in this
environment or that new technologies and products that are more commercially
effective than our technologies and products will not be developed. See
"--Wireless Services."
Regulation
Overview. Our services are subject to federal, state and local
regulation. The FCC exercises jurisdiction over our facilities and services to
the extent they are used to provide, originate or terminate interstate or
international common carrier communications. State regulatory commissions
retain jurisdiction over the same facilities and services to the extent they are
used to originate or terminate intrastate common carrier communications. Local
governments may require us to obtain licenses, permits or franchises regulating
use of public rights-of-way necessary to install and operate our networks. In
addition, the licensing, construction, operation, sale and interconnection
arrangements of wireless telecommunications systems are regulated to varying
degrees by the FCC. The construction and operation of wireless systems also may
be subject to state and local regulation.
Through our subsidiaries, we hold various federal and state regulatory
authorizations. We often join other industry members in seeking regulatory
reform at the federal and state levels to open additional telecommunications
markets to competition.
Through our wholly owned subsidiary McLeodUSA Network Services, we provide
competitive access services as a private carrier on a non-regulated basis. In
general, a private carrier is one that provides service to customers on an
individually negotiated contractual basis, as opposed to a common carrier that
provides service to the public on the basis of generally available rates, terms
and conditions. We believe that McLeodUSA Network Services' private carrier
status is consistent with applicable federal and state laws, as well as
regulatory decisions interpreting and implementing those laws as of the date
hereof. Should such laws and/or regulatory interpretations change in the future
to reclassify McLeodUSA Network Services' regulatory status, we believe that
compliance with such reclassification would not have a material adverse effect
on us.
Through our wholly owned subsidiaries, we are also subject to federal and
state regulatory requirements, including, in some states, bonding requirements,
due to our direct marketing, telemarketing and fund-raising activities.
Federal Regulation. The FCC classifies us as a non-dominant carrier. As
a non-dominant carrier, our interstate and international services are not
subject to material federal regulation, although we are required to file tariffs
with the FCC for our common carrier services. The FCC also imposes prior
approval requirements on transfers of control and assignments of radio licenses
and operating authorizations. The FCC has the authority to condition, modify,
cancel, terminate or revoke such licenses and authorizations for failure to
comply with federal laws or the rules, regulations and policies of the FCC. The
FCC may also impose fines or other penalties for such violations. While we
believe we are in compliance with applicable laws and regulations, we cannot
assure you that the FCC or third parties will not raise issues with regard to
our compliance.
The FCC's role with respect to local telephone competition arises
principally from the Telecommunications Act of 1996, which became effective
February 8, 1996. The Telecommunications Act of 1996 preempts state and local
laws to the extent that they prevent competitive entry into the provision of any
telecommunications service and gives the FCC jurisdiction over important issues
related to local competition. However, state and local governments retain
authority over significant aspects of the provision of local telecommunications.
The Telecommunications Act of 1996 imposes a variety of new duties on local
exchange carriers, including non-incumbent local exchange carriers like
McLeodUSA, in order to promote competition in local exchange and access
services. These duties include requirements to:
18
. complete calls originated by competing carriers on a reciprocal basis
. permit resale of services
. permit users to retain their telephone numbers when changing carriers
. provide competing carriers access to poles, ducts, conduits and
rights-of- way at regulated prices
Incumbent local exchange carriers are also subject to additional
requirements. These duties include obligations of the incumbent local exchange
carriers to:
. interconnect their networks with competitors
. offer collocation of competitors' equipment at their premises
. make available elements of their networks (including network
facilities, features and capabilities) on non-discriminatory,
cost-based terms
. offer wholesale versions of their retail services for resale at
discounted rates
Collectively, these requirements recognize that local exchange competition
is dependent upon cost-based and non-discriminatory interconnection with and use
of incumbent local exchange carrier networks. Failure to achieve such
interconnection arrangements could have an adverse impact on the ability of
McLeodUSA or other entities to provide competitive local exchange services.
Under the Telecommunications Act of 1996, incumbent local exchange carriers are
required to negotiate in good faith with carriers requesting any or all of the
above arrangements. In addition, in the Interconnection Decision and related
actions the FCC has adopted more specific rules to implement these requirements.
The Interconnection Decision has been the subject of significant legal dispute.
In January 1999, the U.S. Supreme Court rejected challenges to the
Interconnection Decision and affirmed the authority of the FCC to establish
rules governing interconnection. We believe that additional disputes regarding
the Interconnection Decision and other related FCC actions are likely.
The Telecommunications Act of 1996 also eliminates previous prohibitions on
the provision of interLATA long distance services by the regional Bell operating
companies and the general telephone operating companies. The regional Bell
operating companies are permitted to provide interLATA long distance service
outside those states in which they provide local exchange service ("out-of-
region long distance service") upon receipt of any necessary state and/or
federal regulatory approvals that are otherwise applicable to the provision of
intrastate and/or interstate long distance service. Under the
Telecommunications Act of 1996, the 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") on a state-by-state basis
upon specific approval of the FCC and satisfaction of other conditions,
including a checklist of interconnection requirements intended to open local
telephone markets to competition. As of the date hereof, the FCC has not found
that any regional Bell operating company has met these interconnection
requirements. If the FCC does permit U S WEST, Ameritech or Southwestern Bell
to provide long distance service in their local service regions before they meet
our local interconnection needs, they would be able to offer integrated local
and long distance services and could have a significant competitive advantage in
marketing those services to their existing local customers.
The Telecommunications Act of 1996 imposes restrictions on the regional
Bell operating companies in connection with their entry into the interLATA long
distance services market. Among other things, for the first three years (unless
extended by the FCC) the regional Bell operating companies must pursue such
activities only through separate subsidiaries with separate books and records,
financing, management and employees. In addition, affiliate transactions with
these subsidiaries must be conducted on a non-discriminatory basis.
In the future, an important element of providing competitive services may
be the ability to offer customers high-speed broadband local connections. The
FCC is considering a proposal that would allow incumbent local exchange carriers
to offer these and other services through separate affiliates, in which case
their network elements for providing these services would not need to be made
available to us or other competitors. AT&T has announced that it is entering
into arrangements with cable companies for the exclusive use of their local
networks for broadband telecommunications and several cable companies are
offering broadband Internet access over their network facilities. As of the
date hereof, we offer such broadband local access to our customers only in
limited areas in Cedar Rapids, Iowa and southeast South
19
Dakota. If we are unable to meet future demands of our customers for broadband
local access or other services on a timely basis at competitive rates, we may be
at a significant competitive disadvantage.
The FCC also regulates the interstate access rates charged by incumbent
local exchange carriers for the origination and termination of interstate long
distance traffic. Those access rates make up a significant portion of the cost
of providing long distance service. The FCC has implemented changes to its
interstate access rules that result in restructuring of the access charge system
and changes in access charge rate levels. These and related actions may reduce
access rates, and hence the cost of providing long distance service, especially
to business customers. The impact of these new changes will not be known until
they are fully implemented over the next several years. In a related
proceeding, the FCC has adopted changes to the methodology by which access has
been used in part to subsidize universal telephone service and other public
policy goals. Telecommunications providers like McLeodUSA will pay a fee
calculated as a percentage of their revenues to support these goals. The full
implications of these changes also remain uncertain and subject to change.
In addition, the FCC and the states are considering related questions
regarding the applicability of access charge and universal service fees to
Internet service providers. Currently, Internet service providers are not
subject to these expenses. Many incumbent local exchange carriers and other
parties have argued that this exemption unfairly advantages Internet service
providers, particularly when they provide data, voice or other services in
direct competition with conventional telecommunications.
In connection with its interconnection decisions, the FCC has granted local
exchange carriers additional flexibility in pricing their interstate special and
switched access services on a central office specific basis. Under this pricing
scheme, local exchange carriers may establish pricing zones based on access
traffic density and charge different prices for central offices in each zone.
We anticipate that the FCC will grant local exchange carriers increasing pricing
flexibility as the number of interconnection agreements and competitors
increases. The potential impact of such pricing flexibility on McLeodUSA and
other competitors is unclear at this time.
As of the date hereof, we do not offer PCS services, although we do own a
minority interest in a cellular telephone partnership serving parts of east
central Illinois. In April and June 1997, the FCC awarded us a total of 26 "D"
and "E" block frequency PCS licenses and in September 1997 we acquired CCI and
its "E" block frequency PCS license, giving us a total of 27 PCS licenses in 25
markets covering areas of Iowa, Illinois, Minnesota, Nebraska and South Dakota.
We paid approximately $32.8 million for the 26 PCS licenses awarded to us by the
FCC. Our PCS licenses encompass approximately 110,000 square miles and a
population of approximately 6.9 million. In July 1997, the FCC also awarded us
four WCS licenses in the Major Economic Areas of Milwaukee, Wisconsin,
Minneapolis/St. Paul, Minnesota, Des Moines-Quad Cities, Iowa/Illinois and
Omaha, Nebraska. We are evaluating proposed wireless systems and expect to
utilize our PCS licenses as part of a network or a strategic combination to add
PCS or other wireless services to our integrated communications services. We
intend to use the frequency blocks covered by our WCS licenses to provide fixed
services such as wireless local loop, Internet access or meter reading.
All PCS licenses are awarded for a ten-year period, at the end of which,
absent prior revocation or a violation of the FCC's rules by the licensee, they
will be renewed. As a PCS licensee, we are subject to "build-out" requirements
which require that specified levels of service be available by specified times.
If we fail to meet these coverage requirements, we may be subject to forfeiture
of our PCS licenses.
PCS licenses permit use of radio spectrum that may be currently occupied by
fixed microwave systems. The existing licensees of such systems retain the
right to continue to operate their systems until 2005. To secure a sufficient
amount of unencumbered spectrum to operate a PCS system efficiently, we may need
to relocate many of these existing licensees. In an effort to balance the
competing interests of existing microwave users and newly authorized PCS
licensees, the FCC has adopted a transition plan to relocate such microwave
operators to other spectrum blocks. This transition plan allows most microwave
users to operate in the PCS spectrum for a one-year voluntary negotiation period
and an additional one-year mandatory negotiation period. For public safety
entities dedicating a majority of their system communications for police, fire
or emergency medical services operations, the voluntary negotiation period is
three years. Parties unable to reach agreement within these time periods may
refer the matter to the FCC for resolution, but the existing microwave user is
permitted to continue its operations until final FCC
20
resolution of the matter. We estimate that we would be required to pay to
relocate approximately 50 microwave links operated by 19 different microwave
licensees in order to develop a PCS system in our target wireless markets. In
addition, the FCC has imposed new universal service requirements on wireless
carriers, as well as new number portability and enhanced "911" obligations on
commercial mobile radio service providers including PCS carriers, which may
require us to invest in advanced technology over the next few years.
Wireless systems are also subject to Federal Aviation Administration
regulations respecting the location, lighting and construction of transmitter
towers and antennas and may be subject to regulation under the National
Environmental Policy Act and the environmental regulations of the FCC. Wireless
providers also must satisfy a variety of FCC requirements relating to technical
and reporting matters. One such requirement is the coordination of proposed
frequency usage between adjacent systems. In addition, the height and power of
base station transmitting facilities and the type of signals they emit must fall
within specified parameters.
The Communications Act of 1934 requires the FCC's prior approval of the
assignment or transfer of control of a PCS or other radio license. In addition,
the FCC has established transfer disclosure requirements that require licensees
who transfer control of or assign a PCS license within the first three years to
file associated contracts for sale, option agreements, management agreements or
other documents disclosing the total consideration that the applicant would
receive in return for the transfer or assignment of its license. Non-
controlling interests in an entity that holds a PCS license or PCS system
generally may be bought or sold by U.S. companies or individuals without prior
FCC approval, but subsequent notice must be provided to the FCC.
The Telecommunications Act of 1996 imposes restrictions on investment in
McLeodUSA by foreign persons or corporations arising from our ownership of
common carrier radio licenses. However, these restrictions generally do not
apply to investment by nationals of member countries of the World Trade
Organization. As of the date hereof, we have no knowledge of any ownership by
or affiliation with foreign persons or telecommunications carriers in violation
of the Communications Act or the FCC's rules.
Through our wholly owned subsidiaries, we are also subject to rules
governing telemarketing that have been promulgated by both the FCC and the
Federal Trade Commission. The FCC and FTC telemarketing rules prohibit
telemarketers from engaging in deceptive telemarketing practices and require
that telemarketers make specified disclosures. For example, these telemarketing
rules:
. prohibit the use of autodialers that employ prerecorded voice messages
without the prior express consent of the dialed party
. proscribe the facsimile transmission of unsolicited advertisements
. require telemarketers to disclose clear and conspicuous information
concerning quality, cost and refunds to a customer before a customer
makes a purchase
. require telemarketers to compile lists of individuals who desire not
to be contacted
. limit telemarketers to calling residences between the hours of 8:00
a.m. and 9:00 p.m.
. require telemarketers to explicitly identify the seller and state the
purpose of the call
. prohibit product misrepresentations
State Regulation. We provide intrastate common carrier services and are
subject to various state laws and regulations. Most public utility commissions
subject providers such as McLeodUSA to some form of certification requirement,
which requires providers to obtain authority from the state public utility
commission before initiating service. In most states, including Iowa and
Illinois, we are also required to file tariffs setting forth the terms,
conditions and prices for services that are classified as intrastate. We are
required to update or amend these tariffs when we adjust our rates or add new
products, and are subject to various reporting and record-keeping requirements
in these states.
Many states also require prior approval for transfers of control of
certified carriers, corporate reorganizations, acquisitions of
telecommunications operations, assignment of carrier assets, carrier stock
21
offerings and incurrence by carriers of significant debt obligations.
Certificates of authority can generally be conditioned, modified, canceled,
terminated or revoked by state regulatory authorities for failure to comply with
state law or the rules, regulations and policies of state regulatory
authorities. Fines or other penalties also may be imposed for such violations.
State utility commissions or third parties could raise issues with regard to our
compliance with applicable laws or regulations which could have a material
adverse effect on our business, results of operations and financial condition.
We hold certificates of authority to resell the local services of the
regional Bell operating companies and to offer local services using our own
communications network facilities in incumbent regional Bell operating company
exchanges in Iowa, Illinois, Wisconsin, Minnesota, North Dakota, South Dakota,
Wyoming, Idaho, Indiana, Missouri, Nebraska and Utah. We also hold certificates
of authority to resell the local services of the regional Bell operating
companies in Colorado and Montana. We intend to seek regulatory approval to
provide resale and facilities-based services in all states within our target
markets when the economic terms of interconnection with the incumbent local
exchange company make the provision of local services using our own
communications network facilities cost-effective. See "-- Expansion of Services
Using Our Own Communications Network Facilities." We are also authorized to
offer long distance service in all 48 states in the continental United States.
We have obtained authority to offer long distance service in such states,
including states outside our target markets, because we believe this capability
will enhance our ability to attract business customers that have offices outside
of our target markets. We may also apply for authority to provide services in
non-regional Bell operating company exchanges in our target market states and
other states in the futures. While we expect and intend to obtain the necessary
regulatory authority in each jurisdiction where we plan to operate, we cannot
assure you that each respective agency will grant our request for authority.
The Telecommunications Act of 1996 preserves the ability of states to
impose reasonable terms and conditions on the provision of intrastate service
and other related regulatory requirements. In the last several years, Iowa,
Illinois, Minnesota, Wisconsin, Wyoming and North Dakota have enacted broad
changes in their telecommunications laws that authorize the entry of competitive
local exchange carriers and provide for new regulations to promote competition
in local and other intrastate telecommunications services. As a general matter,
we believe the states will play a key role in the development of local exchange
competition. Consequently, we could face regulatory decisions that adversely
affect our ability to compete in particular states.
States also regulate the intrastate carrier access services of the
incumbent local exchange carriers. We are required to pay access charges to
originate and connect our intrastate long distance traffic. We could be
adversely affected by high access charges, particularly to the extent that the
incumbent local exchange carriers do not incur the same level of costs with
respect to their own intrastate long distance services. In a related
development, states also will be developing intrastate universal service charges
parallel to the interstate charges created by the FCC. For example, some
incumbent local exchange carriers are proposing that states create funds that
would be supported by potentially large payments by firms such as McLeodUSA
based on their total intrastate revenues. Another state regulatory issue that
could adversely affect our business is the approval by some state regulatory
agencies of extended local area calling for incumbent local exchange carriers,
converting otherwise competitive intrastate toll service to local service.
States also are or will be addressing various intraLATA dialing parity issues
that may affect competition. Our business could be adversely affected by these
or other developments.
We believe that, as the degree of intrastate competition increases, states
will offer the local exchange carriers increasing pricing flexibility. This
flexibility may present the local exchange carriers with an opportunity to
subsidize services that compete with our services with revenues generated from
non-competitive services, allowing incumbent local exchange carriers to offer
competitive services at prices below the cost of providing the service. We
cannot predict the extent to which this may occur or its impact on our business.
ICTC is subject to rate of return regulation by the Illinois Commerce
Commission. Under such regulation, ICTC is allowed to earn up to a fixed rate
of return on its equity. In the event that the Illinois Commerce Commission
finds that ICTC has exceeded its authorized rate of return on equity, ICTC could
be required to lower its customer rates or make refunds. While we believe ICTC
is earning less than its authorized rate of return, we cannot assure you that
the Illinois Commerce Commission will not, at some
22
future date, find that ICTC has earned more than its authorized rate of return
or that such a finding would not have a material adverse effect on us.
In addition, a substantial proportion of ICTC's and Dakota
Telecommunications' revenues are derived from access charges imposed on long
distance carriers. Access charge rate structures and rate levels have been
modified by recent regulatory changes, and further changes are possible. If
such revisions result in a reduction of ICTC's and Dakota Telecommunications'
revenues and gross margins, it could have a material adverse effect on us.
Several of our subsidiaries also hold state and federal certificates and
FCC licenses in connection with the operation of wireless telecommunications
services and paging services.
Through our wholly owned subsidiaries, we engage in various direct
marketing, telemarketing and fund-raising activities. Most states have laws
that govern these activities. In states that regulate such activities, several
types of restriction have been imposed, either singly or in combination,
including requirements to:
. register with state authorities
. post professional bonds
. file operational contracts with state authorities
. respect statutory waiting periods
. register employees with state authorities
. prohibit control over funds collected from such activities
Local Government Authorizations. We are required to obtain construction
permits and licenses or franchises to install and expand our fiber optic
communications networks using municipal rights-of-way. Some municipalities
where we have installed or anticipate constructing networks are proposing and
enacting ordinances regulating use of rights-of-way and imposing various fees in
connection with such use. In some instances we have negotiated interim
agreements to authorize installation of facilities pending resolution of the fee
issue. In many markets, the local exchange carriers do not pay rights-of-way
fees or pay fees that are substantially less than the fees we are required to
pay. To the extent that competitors do not pay the same level of fees as us, we
could be at a competitive disadvantage. We must also negotiate and enter into
franchise agreements with local governments in order to operate our video
services networks. We have franchises for our existing services, but will need
additional franchises in order to expand into additional markets. If we fail to
receive necessary permits or franchise agreements on commercially reasonable
terms or are unable to obtain or maintain right-of-way authorization or license
agreements, we could be materially adversely affected. If we lose a right-of-
way, we could be required to remove our facilities from the right-of-way or
abandon our network in place.
Risk Factors
In connection with the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995, set forth below are cautionary statements
identifying important factors that could cause our actual results to differ
materially from those projected in any forward-looking statements made by or on
behalf of us, whether oral or written. We wish to ensure that any forward-
looking statements are accompanied by meaningful cautionary statements in order
to maximize to the fullest extent possible the protections of the safe harbor
established in the Private Securities Litigation Reform Act of 1995.
Accordingly, any such statements are qualified in their entirety by reference
to, and are accompanied by, the following important factors that could cause our
actual results to differ materially from those projected in our forward-looking
statements.
Fluctuations in the Market Price of Our Class A Common Stock May Make it More
Difficult for Us to Raise Capital.
The market price of our Class A common stock is extremely volatile and has
fluctuated over a wide range. These fluctuations may impair our ability to
raise capital by offering equity securities. The market price may continue to
fluctuate significantly in response to various factors, including:
23
. market conditions in the industry
. announcements and actions by competitors
. low trading volume
. quarterly variations in operating results or growth rates
. changes in estimates by securities analysts
. regulatory and judicial actions
. general economic conditions
See "Market for Registrants' Common Equity and Related Stockholder Matters
- --Price Range of Class A Common Stock."
We May Not Be Able to Successfully Integrate Acquired Companies into Our
Operations, Which Could Slow Our Growth.
The integration of acquired companies into our operations involves a number
of risks, including:
. difficulty integrating new operations and personnel
. diversion of management attention
. potential disruption of ongoing business
. inability to retain key personnel
. inability successfully to incorporate new assets and rights into our
service offerings
. inability to maintain uniform standards, controls, procedures and
policies
. impairment of relationships with employees, customers or vendors
Failure to overcome these risks or any other problems encountered in
connection with acquisition transactions could slow our growth or lower the
quality of our services, which could reduce customer demand.
Continued Rapid Growth of Our Network, Services and Subscribers Could Be Slowed
if We Cannot Manage this Growth
We have rapidly expanded and developed our network, services and
subscribers. This has placed and will continue to place significant demands on
our management, operational and financial systems and procedures and controls.
We may not be able to manage our anticipated growth effectively, which would
harm our business, results of operations and financial condition. Further
expansion and development will depend on a number of factors, including:
. cooperation of the existing local telephone companies
. regulatory and governmental developments
. changes in the competitive climate in which we operate
. development of customer billing, order processing and network
management systems
. availability of financing
. technological developments
. availability of rights-of-way, building access and antenna sites
. existence of strategic alliances or relationships
. emergence of future opportunities
We will need to continue to improve our operational and financial systems
and our procedures and controls as we grow. We must also develop, train and
manage our employees.
We Expect to Incur Significant Losses Over the Next Several Years.
If we do not become profitable in the future, the value of our shares may
fall and we could have difficulty obtaining funds to continue our operations.
We have incurred net losses every year since we began operations. Since January
1, 1995, our net losses have been as follows:
24
Net Losses
----------
Period Amount
------ ------
1995 $ 11.3 million
1996 $ 22.3 million
1997 $ 79.9 million
1998 $ 124.9 million
We expect to incur significant operating losses during the next several years
while we develop our businesses, expand our fiber optic communications network
and develop wireless services.
Failure to Raise Necessary Capital Could Restrict Our Ability to Develop Our
Network and Services and Engage in Strategic Acquisitions.
We need significant capital to continue to expand our operations,
facilities, network and services. We cannot assure you that our capital
resources will permit us to fund our planned network deployment and operations
or achieve operating profitability. Failure to generate or raise sufficient
funds may require us to delay or abandon some of our expansion plans or
expenditures, which could harm our business and competitive position.
As of December 31, 1998, based on our business plan, capital requirements
and growth projections as of that date, we estimated that we would require
approximately $1.4 billion through 2001 to fund our planned capital expenditures
and operating expenses. Our estimated aggregate capital requirements include the
projected costs of:
. building our fiber optic communications network, including intra-city
fiber optic networks
. expanding operations in existing and new markets
. developing wireless services
. funding general corporate expenses
. completing recent and pending acquisitions
. constructing, acquiring, developing or improving telecommunications
assets
Our estimate of future capital requirements is a forward-looking statement
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. The actual amount and timing of our future
capital requirements may differ substantially from our estimate due to factors
such as:
. strategic acquisition costs and effects of acquisitions on our
business plan, capital requirements and growth projections
. unforeseen delays
. cost overruns
. engineering design changes
. changes in demand for our services
. regulatory, technological or competitive developments
. new opportunities
We also expect to evaluate potential acquisitions, joint ventures and
strategic alliances on an ongoing basis. We may require additional financing if
we pursue any of these opportunities. We may meet any additional capital needs
by issuing additional debt or equity securities or borrowing funds from one or
more lenders. We cannot assure you that we will have timely access to
additional financing sources on acceptable terms. If we do not, we may not be
able to expand our markets, operations, facilities, network and services through
acquisitions as we intend. See "Managements' Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital Resources."
25
Our High Level of Debt Could Limit Our Flexibility in Responding to Business
Developments and Put Us at a Competitive Disadvantage.
We have substantial debt, which could adversely affect us in a number of
ways, including:
. limiting our ability to obtain necessary financing in the future
. limiting our flexibility to plan for, or react to, changes in our
business
. requiring us to use a substantial portion of our cash flow from
operations to pay debt rather than for other purposes, such as working
capital or capital expenditures
. making us more highly leveraged than some of our competitors, which
may place us at a competitive disadvantage
. making us more vulnerable to a downturn in our business
As of December 31, 1998, we had $1.2 billion of long-term debt and $462.8
million of stockholders' equity. We incurred an additional $500 million of
long-term debt on February 22, 1999. As a result, we expect our fixed charges
to exceed our earnings for the foreseeable future. See "Managements' Discussion
and Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources."
Covenants in Debt Instruments Restrict Our Capacity to Borrow and Invest, Which
Could Impair Our Ability to Expand or Finance Our Operations.
The indentures governing the terms of our long-term debt impose operating
and financial restrictions that limit our discretion on some business matters,
which could make it more difficult for us to expand, finance our operations or
engage in other business activities that may be in our interest. These
restrictions limit or prohibit our ability to:
. incur additional debt
. pay dividends or make other distributions
. make investments or other restricted payments
. enter into sale and leaseback transactions
. pledge or mortgage assets
. enter into transactions with related persons
. sell assets
. consolidate, merge or sell all or substantially all of our assets
If we fail to comply with these restrictions, all of our long-term debt could
become immediately due and payable. See "Managements' Discussion and Analysis
of Financial Condition and Results of Operations--Liquidity and Capital
Resources."
We Are Prohibited from Paying Dividends.
We do not anticipate paying any dividends for the foreseeable future. The
indentures governing our debt prohibit us from paying cash dividends. You
should therefore not expect to receive dividends on shares of our Class A common
stock.
Our Dependence on Regional Bell Operating Companies to Provide Most of Our
Communications Services Could Make it Harder for Us to Offer Our Services at a
Profit.
We depend on the regional Bell operating companies to provide most of our
core local and some of our long distance services. Today, without using the
communications facilities of these companies, we could not provide bundled local
and long distance services to most of our customers. Because of this
dependence, our communications services are highly susceptible to changes in the
conditions for access to these facilities and we may therefore have difficulty
offering our services at profitable and competitive rates.
26
U S WEST, Ameritech and Southwestern Bell are our primary suppliers of
local lines to our customers and communications services that allow us to
transfer and connect calls. Their communications facilities allow us to provide
(1) local service, (2) long distance service and (3) private lines dedicated to
our customers' use. If these or other companies deny or limit our access to
their communications network elements or wholesale services, we may not be able
to offer profitable communications services.
Our plans to provide local service using our own communications network
equipment also depend on the regional Bell operating companies. In order to
interconnect our network equipment and other communications facilities to
network elements controlled by the regional Bell operating companies, we must
first negotiate and enter into interconnection agreements with them.
Interconnection obligations imposed on the regional Bell operating companies by
the Telecommunications Act of 1996 have been and continue to be subject to a
variety of legal proceedings, which could affect our ability to obtain
interconnection agreements on acceptable