UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
Commission File No. 000-26728
TALK AMERICA HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
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Delaware |
23-2827736 |
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(State or other jurisdiction of |
(I.R.S. Employer |
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incorporation or organization) |
Identification Number) |
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12020 Sunrise Valley Drive, Suite 250 |
20191 |
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Reston, Virginia |
(zip code) |
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(Address of principal executive offices) |
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(703) 391-7500
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
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Title of each class |
Name of each exchange on which registered |
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None |
Not applicable |
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, Par Value $.01 Per Share
Rights to Purchase Series A Junior Participating Preferred Stock
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X] No [ ]
As of June 30, 2003, the aggregate market value of the voting stock held by non-affiliates of the registrant, based on the average of the high and low prices of the common stock on June 30, 2003 of $10.79 per share as reported on the Nasdaq National Market, was approximately $280,519,337.15 (calculated by excluding solely for purposes of this form outstanding shares owned by directors and executive officers).
As of March 9, 2004, the registrant had issued and outstanding 26,670,050 shares of common stock, par value $.01 per share.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the 2004 Annual Meeting of Stockholders. Part III
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TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
INDEX TO FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2003
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ITEM
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PAGE
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PART I |
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1. Business |
1 |
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2. Properties |
14 |
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3. Legal Proceedings |
14 |
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4. Submission of Matters to a Vote of Security Holders |
14 |
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PART II |
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5. Market for Registrant's Common Equity and Related Stockholder Matters |
17 |
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6. Selected Consolidated Financial Data |
18 |
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7. Management's Discussion and Analysis of Financial Condition and Results of Operations |
19 |
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7a. Quantitative and Qualitative Disclosure About Market Risk |
30 |
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8. Financial Statements and Supplementary Data |
30 |
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9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
52 |
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9a. Controls and Procedures |
52 |
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PART III |
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10. Directors and Executive Officers of the Registrant |
53 |
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11. Executive Compensation |
53 |
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12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
53 |
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13. Certain Relationships and Related Transactions |
53 |
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14. Principal Accountant Fees and Services |
53 |
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PART IV |
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15. Exhibits, Financial Statement Schedules and Reports on Form 8-K |
54 |
Unless the context otherwise requires, references to "us," "we," and "our" or to "Talk America" refer to Talk America Holdings, Inc. and its subsidiaries.
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PART I
Cautionary Note Concerning Forward-Looking Statements
Certain of the statements contained in this Form 10-K Report may be considered "forward-looking statements" for purposes of the securities laws. From time to time, oral or written forward-looking statements may also be included in other materials released to the public. These forward-looking statements are intended to provide our management’s current expectations or plans for our future operating and financial performance, based on our current expectations and assumptions currently believed to be valid. For these statements, we claim protection of the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified by the use of forward-looking words or phrases, including, but not limited to, "b
elieves," "estimates," "expects," "expected," "anticipates," "anticipated," "plans," "strategy," "target," "prospects" and other words of similar meaning in connection with a discussion of future operating or financial performance. Although we believe that the expectations reflected in such forward-looking statements are reasonable, there can be no assurance that such expectations will prove to have been correct.
All forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from those expressed or implied in the forward-looking statements. This Form 10-K Report includes important information as to risk factors in the "Business" section under the headings "Business Operations," "Competition" and "Regulation" and in "Management’s Discussion and Analysis of Financial Condition and Results of Operations." In addition to those factors discussed in this Form 10-K Report, you should see our other reports on Forms 10-K, 10-Q and 8-K filed with the Securities and Exchange Commission from time to time for information identifying factors that may cause actual results to differ materially from those expressed
or implied in the forward-looking statements.
ITEM 1. BUSINESS
OVERVIEW
Talk America Holdings, Inc., through its subsidiaries, offers a bundle of local and long distance phone services to residential and small business customers in the United States. We operate our own nationwide long distance network and deliver local services through wholesale operating agreements with the incumbent local exchange companies. We have developed integrated order processing, provisioning, billing, payment, collection, customer service and information systems that enable us to provide high-quality service to our customers. We deliver to our customers savings through competitively priced telecommunication products, simplicity through consolidated billing and award winning customer service. We operate our own sales and customer service cent
ers.
BUSINESS STRATEGY
Our business strategy is to build a large, profitable base of bundled phone service customers using the wholesale operating platforms of the incumbent local exchange companies and then to migrate customers to our own networking platform and further increase our revenues and profitability by offering new products and services to these customers. We refer to this strategy as our "customer first" strategy.
We offer diverse calling and service plans tailored to fit our customer's needs and use consultative sales tools to assist their selection of the right service plan for their telecommunications needs. Since entering the local services market in 2000, we have captured significant market share in the Michigan market. In 2003, we demonstrated our ability to market our local product into other markets and ended the year with 557,000 billed bundled lines.
To date, we have provided bundled local and long distance services to residential and small business customers using the unbundled network element platform from, and, to a lesser extent, resale agreements with, the incumbent local exchange companies to provide local telephone services and generally using our own nationwide long distance network to provide the long distance services component.
An integral element of our business strategy is our development of our own local networking capacity. This development, if successful, will enhance our operating flexibility and provide us with an alternative to the wholesale operating platforms of the incumbent local exchange companies. As the first step in enabling us to implement this stage of our business strategy, during 2003, we deployed networking assets in Michigan and have begun to carry test calls over our own switching platform. We also began
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developing the integrated information systems required to provide our own local network-based services and are in the process of developing plans for a broader roll-out of networking equipment. In addition, we plan to continue to add new services and enhance our existing offerings, as available, to increase our revenue and profitability from our customers.
BUSINESS OPERATIONS
Local Services
The unbundled network element platform of the incumbent local exchange companies offer to us, in an individual or combined form, a series of unbundled network elements, or UNEs, that comprise the most important facilities, features, functions and capabilities of an incumbent local exchange company's network. When offered in the combination known as the unbundled network element platform, these components include the loop and switching elements needed to provide local telephone service to a customer. We are currently operational in 28 states. We focus on providing consumers value through competitive plans designed to fit their particular calling patterns, broad feature selections and effective customer service.
Our bundled service generally includes: unlimited local usage dependent upon the service plan, free member-to-member calling, long distance service and calling cards, one convenient invoice available both in paper and electronically, and choices of various features such as caller ID, call waiting, voice mail and three-way calling.
The unbundled network element operating platform of the incumbent local exchange companies generally provides us with certain advantages, including: (i) offering local telephone service to customers located virtually anywhere without having to deploy local switching facilities; (ii) providing the same services as the incumbent local exchange companies; (iii) delivering higher margins than comparable service offered through resale agreements; and (iv) eliminating the requirement to pay certain local network access fees while collecting local network access fees for calls delivered to our local telephone customers. In some instances, however, such as customers having high usage volumes, resale may provide us with a lower cost structure than the use o
f the unbundled network element platform. The provision of local telephone service through use of the unbundled network element platform of the incumbent local exchange companies also allows us to pursue and execute our "customer first" strategy by enabling us currently to continue to build a base of bundled service customers that could be migrated to our own networking platform when implemented.
In 2003, we deployed and began testing a local switch and end office colocation in Michigan to offer local facilities-based phone service using our own network. In addition, we began developing the necessary operational processes and information systems required to provide our own local switch-based service. In 2004, we plan to add two more colocations in Michigan, begin provisioning local bundled customers over to our own network and develop plans for the deployment of our own networking assets in the Chicago and Atlanta metropolitan areas. We expect to have provisioned approximately 1,000 bundled local customers to our own local network by the end of the first quarter of 2004. In addition to providing us with alternatives to our reliance on the unbundled network element operating platforms o
f the incumbent local exchange companies, our own local networking should provide us with certain strategic benefits such as increased operating flexibility with respect to capability to enhance and expand our service and product offerings for our customers and the opportunity to increase our operating margins. In addition, we expect that newly available technology and networking architecture will provide us with the flexibility to utilize the switches that comprise our long distance network (located in New York, Chicago, San Francisco, Dallas and Jacksonville) as host switches to remote switching technology located as far as 2,000 miles from the host switch, expediting the potential deployment of our own local network with reduced capital expenditures.
As we continue to pursue our "customer first" strategy and the development and deployment of our own networking platform, we expect that our capital expenditures will increase significantly from what they have been in previous years. In addition to the difficulties and uncertainties of operating a service that we have not previously operated, operating our own local switches will, as it does with our long distance switches, subject us to the risk of significant interruption. Fires or natural disasters, for example, could cause damage to our switching equipment or to transmission facilities connecting our switches. Any interruption in our services over our network caused by such damage could have a material adverse impact on our financial condition
and results of operations. In such circumstances, we could attempt to minimize the interruption of our service by carrying traffic through one of our other local switches or obtaining a portable disaster recovery switch from Lucent.
As discussed under "Regulation", below, effective October 2, 2003, the Federal Communications Commission's Unbundled Network Element Triennial Review Order eliminated certain incumbent local exchange carrier unbundling obligations and, for other unbundled network elements, delegated to the state commissions the ultimate authority,
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subject to the FCC's established guidelines, to determine whether such unbundled network elements should be available to competitors like us in local markets within the state's jurisdiction, including local circuit switching. The Order was subject to numerous federal judicial appeals, which were consolidated in the U.S. Court of Appeals for the District of Columbia Circuit. The Court of Appeals, on March 2, 2004, issued an order that reversed the FCC’s Order in part and remanded to the FCC with instructions to revise the Order in material ways. The Court stayed its decision until the denial of any petitions for rehearing or for a 60 day period (i.e., until May 1, 2004), whichever is later. The U.S. Court of Appeals for the District of Columbia did, however, reaffirm the obligation of the i
ncumbent local exchange companies to make switching available to competitors at "just and reasonable" rates pursuant to Section 271 of the Telecommunications Act of 1996. "Just and reasonable" rates under Section 271 of the Act have not been established at this time. Should local circuit switching not be available to us due to this adverse decision or otherwise, we would be unable to offer services on an unbundled network element platform basis and would instead have to serve customers through total service resale agreements with the incumbent local telephone companies, through network elements purchased from the Regional Bell Operating Companies at "just and reasonable" rates under Section 271 of the Act or through our own facilities or the switching facilities of other non-incumbent carriers, any of which could delay our service roll-out in some markets, increase our costs and negatively impact our business, prospects, operating margins, results of operations, cash flows and financial condition.
See "Regulation."
Long Distance Services
We provide 1+ long distance telecommunication services both on a stand-alone basis and bundled with our local services. Our long distance voice services include intrastate, interstate, international and calling cards, at rates that are competitive within the industry. We generally use our own nationwide long distance network to provide services directly to our customers. We ended 2003 with approximately 251,000 billed stand-alone long distance subscribers.
Our long distance network is comprised of equipment and facilities that are either owned or leased by us. We contract for certain telecommunication services with a variety of other carriers. We own, operate and maintain five Lucent 5ESS-2000 switches in our long distance network. Our switches are generally considered extremely reliable and feature the Digital Networking Unit-SONET technology. The Digital Networking Unit is a switching interface that is designed to increase the reliability of the 5ESS-2000 and to provide much greater capacity in a significantly smaller footprint. The switches are connected to each other by connection lines and digital cross-connect equipment that we own or lease. We also have installed lines to connect our long dist
ance switches to switches owned by various local telecommunication service carriers. We are responsible for maintaining these lines and have entered into a contract with a third party vendor with respect to the monitoring, servicing and maintenance of this equipment.
Since we operate our own switches, we are subject to the risk of significant interruption, as discussed with respect to our operation of our own local switches, above. In such circumstances, we could attempt to minimize the interruption of our long distance service by carrying traffic through our resale arrangements with other carriers.
With respect to connections to local carriers, international and operator assisted services, we had previously maintained contracts with more than one carrier for most of these services. In December 2003, we entered into a new four-year master carrier agreement with AT&T. The agreement provides us with a variety of services, including transmission facilities to connect our network switches as well as services for international calls, local traffic, international calling cards, overflow traffic and operator assisted calls. The agreement also provides that, subject to certain terms and conditions, we will purchase these services exclusively from AT&T during the term of the agreement, provided, however, that we are not obligated to purchase ex
clusively in certain cases, including if such purchases would result in a breach of any contract with another carrier that was in place when we entered into the AT&T agreement, or if vendor diversity is required. Certain of our network service agreements, including the AT&T agreement, contain certain minimum usage commitments. Our contract with AT&T establishes pricing and provides for annual minimum revenue commitments based upon usage as follows: 2004 - $25 million, 2005 - $32 million, 2006 - $32 million and 2007 - $32 million and obligates us to pay 65 percent of the revenue shortfall, if any. A separate contract with a different vendor establishes pricing and provides for annual minimum payments for 2004 of $3.0 million. While we believe we will meet these annual minimum revenue commitments, and that we will not have to pay the shortfalls, there can be no assurances of this, and, if we are required to pay any of the shortfall amounts under one of these agreements, our costs of purchasing the
services under the agreement will correspondingly increase.
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Additional Services
As part of our "customer first" strategy, we seek to add new services and enhance our existing offerings, as part of our efforts to increase our revenues and profitability from our customers and reduce our customer turnover, or "churn."
· We developed and installed a new voicemail platform, during 2003, that allows us to provide previously unavailable features such as ‘stutter tone’ and ‘message indicator’, to our customers located in the Detroit area under the unbundled network element platform that we utilize in Michigan. In addition to providing the expanded features, our new voicemail platform is less expensive than the platforms available to us from either the incumbent local exchange carrier providing the platform or third party vendors.
· We currently offer dial-up internet services to our bundled customers. We plan to launch a new product in 2004 that will offer higher connection speeds than our current dial-up product.
· We plan to begin developing and installing digital subscriber line, or DSL, internet services, using our own local networking assets. DSL is a broadband connection to the internet that provides people with a higher connection speed than standard dial-up connections. We are currently developing plans to offer DSL to customers in the Detroit market that are on our local network in 2004.
· In 2004, we plan to begin developing voice over internet protocol services, or VoIP. VoIP is a service that manages the delivery of voice information over data networks, using Internet Protocol. Rather than send voice information across traditional circuits through the public switched telephone network, VoIP sends voice information in digital form using discrete packets that are routed in the same manner as data packets. This will allow customers to make phone calls using their broadband (DSL or cable modem) connection to the internet. We plan on offering VoIP second line phone service to our bundled residential customers.
INTEGRATED INFORMATION SYSTEMS
We have integrated order processing, provisioning, billing, payment, collection, customer service and information systems that enable us to offer and deliver high-quality, competitively priced telecommunication services to our customers and process millions of call records each day. These operational support systems were developed by our employees and customized for our business and operational requirements and, due to the system's component-based architecture, provide an extensible framework for the introduction of new products and services. We use "state-of-the-art" software and hardware applications and products to support our systems and development efforts. Through dedicated electronic connections with our long distance network and the incumbe
nt local exchange companies, we have designed our systems to process information on a "real time" basis. We are in the process of automating the business processes required to provide local switch-based service and to support the proposed deployment of our own local network.
Our core operational support systems include the following:
· Our leads database system is utilized in the marketing of our telecommunication services. The leads database system enables us to alter telemarketing campaigns to track areas where mass advertisements are airing, manage the bundled sales price by customer, zone and state, maintain customer credit information, and comply with various regulatory requirements.
· Our proprietary automated order processing system enables us to shorten the customer provisioning time cycle and reduce associated costs. Prior to submitting an order to provision a customer to our service, our system processes the customer's credit history, and, once the customer's credit is approved, the customer's service record detailing the customer's existing phone service is immediately verified. In addition, our system has enabled us to significantly increase our customer provisioning rate for qualified and verified orders while reducing the number of orders that
are rejected by the incumbent local exchange carrier, reducing manual work requirements.
· Our automated service provisioning system enhances our ability to add customer lines to our telecommunication service and to change the features associated with that particular customer's service, reducing manual work requirements.
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· Our billing system enables us to preview and run a bill cycle each day of the month for the many different, tailored service packages, increasing customer satisfaction while minimizing revenue leakage in the provision of local telecommunication service.
· Our proprietary automated payment and collections management system is integrated with our billing and customer relationship management system. This system increases the efficiency of our collection process, accelerates the recovery of accounts receivable and assists in the retention of valuable customers.
· We are developing and implementing a new customer relationship manager system, which will enable our customer service representatives to access data in a real-time, organized manner, while the representative is speaking with the customer, thereby reducing the length of customer service calls and improving the customer experience.
In addition, we maintain our own web site at www.talkamerica.com and www.talk.com to provide for customer sign-up and to provide customers and potential customers with information about our products and services as well as billing information and customer service. We provide these services and features using our web-enabled technologies that allow us to offer our customers:
· Detailed rate schedules and product and service related information.
· Online sign-up for our telecommunication services.
· Credit card billing.
· Real-time and 24 x 7 billing services and online information, providing customers with up to the hour billing information.
The information functions of our systems are designed to provide easy access to all information about a customer, including volumes and patterns of use. This information can be used to identify emerging customer trends and to respond with services to meet customers' changing needs. This information also allows us to identify unusual usage by an individual customer, which may indicate fraud. FCC rules, however, may limit our use of customer proprietary network information. See "Regulation."
SALES AND MARKETING
We use diverse sales and marketing channels to reach the residential and small business markets with our service offerings. Our sales and marketing efforts focus on marketing a bundle of local and long distance telephone services directly to customers exclusively under our own brand. We currently market our bundled services to customers in those states, or certain areas of a state, where we can profitably offer services at competitive prices. We will market in additional states (or certain areas of a particular state) as our pricing and cost structure permit us to profitably offer services in those areas at competitive rates. During 2003, we expanded our marketing efforts outside of Michigan, to include Georgia, Illinois, New York, New Jersey, Indi
ana, Wisconsin, Ohio and Maryland. During the fourth quarter 2003 and reflecting our expansion of the states into which we actively market, approximately 67% of our new bundled customers were from states other than Michigan, as compared to approximately 26% for the same period in 2002. We regularly review our product offerings, pricing and sales and marketing programs in an effort to improve the efficiency of our sales and marketing channels.
We employ a targeted approach to customer acquisition and use database-marketing tools to identify and prioritize target customers. We offer diverse calling and service plans tailored to fit the needs of the broader residential market with low base prices, free features, extended local calling areas and free member-to-member calling. Customers can switch to us online, through a telesales representative, or through an authorized agent, each of which uses consultative sales tools to assist the customer's selection of the right plan for their telecommunications needs. At the point of sale, we provide each customer with an estimate of their first month’s invoice, including all fees and taxes. Customers are able to keep their same phone lines and number, can easily add features, and, generally
within days of the sale, are switched to our service and receive a personalized welcome kit explaining their service.
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We market our bundled services within our targeted markets through the following channels:
· Telemarketing - We operate our own call centers and purchase residential and small business lead databases utilized for targeted, professional and courteous outbound telesales campaigns. Telemarketing is an important sales channel for us. Any changes in the federal or state "do not call" regulations could adversely affect us. See "Regulation."
· Direct Mail - We purchase small business and residential lead databases utilized for demographically targeted direct mail campaigns designed to direct inbound calls to our telemarketing centers.
· Referrals - We solicit, through the use of referral promotions and our member-to-member free long distance product, the names of potential customers or referrals from our existing customers.
· Online Marketing - We have developed a productive online marketing presence, through traditional online media and business relationships.
· Direct Sales - Utilizing independent agents, we solicit new customers in targeted geographic areas.
· Broadcast Media - We solicit inbound subscriber calls through advertising on television, radio and in print.
While we do not actively market our stand-alone long distance telecommunications service, we offer the long distance telecommunications service when contacted by persons located in those regions where local service is unavailable. We also add long distance customers when the customer requests its local service provider to provide the customer with our long distance telecommunications service.
We focus on targeting, acquiring and retaining profitable customers by providing savings, simplicity and service. We continue to seek new marketing partners and arrangements to expand both our opportunities to attract other customers to our services and the products and services that we offer to our customer base.
COMPETITION
The telecommunication industry is highly competitive. Major participants in the industry regularly introduce new services and marketing activities. Competition in the telecommunication industry is based upon pricing, customer service, billing services and perceived quality. We compete against numerous telecommunication companies that offer essentially the same services as we do. Many of our competitors, including the incumbent local exchange companies, are substantially larger and have greater financial, technical and marketing resources. Our success will depend upon our continued ability to provide high quality, high value services at prices generally competitive with, or lower than, those charged by our competitors.
The incumbent local exchange companies and the major carriers, including SBC, Verizon, BellSouth, AT&T, Sprint Corporation and MCI/Worldcom, Inc., have targeted price plans at residential customers - our primary target market - with significantly simplified rate structures and with bundles of local services with long distance, which may lower overall local and long distance prices. Competition is also fierce for the small businesses that we also serve. Additional pricing pressure may also come from the introduction of new technologies, such as Voice over Internet Protocol, or VoIP, which seek to provide voice communications at a cost below that of traditional circuit-switched service. In addition, wireless carriers have marketed their services
as an alternative to traditional long distance and local services, further increasing competition. Reductions in prices charged by competitors may have a material adverse effect on us.
The incumbent local exchange companies are well-capitalized, well-known companies that have the capacity to "bundle" other services, such as local and wireless telephone services and high speed Internet access, with long distance telephone services. The incumbent local exchange companies' name recognition in their existing markets, the established relationships that they have with their existing local service customers, their ability to take advantage of those relationships, and the possibility that interpretations of the Telecommunications Act may be favorable to the incumbent local exchange companies, also make it more difficult for us to compete with them.
REGULATION
General
Our provision of telecommunication services is subject to government regulation. Generally speaking, the FCC regulates interstate and international telecommunications, while the state commissions regulate telecommunications that originate and terminate within the same state.
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The Telecommunications Act of 1996 provides for a significant deregulation of the domestic telecommunications industry, including the opening of the local markets of the incumbent local exchange companies to competition and the ability, pursuant to certain market-opening conditions, of the Regional Bell Operating Companies, which are incumbent local exchange companies, to reenter the long distance industry. The Telecommunications Act remains subject to judicial review and additional FCC rulemaking, and thus it is difficult to predict what effect the legislation and regulations will have on us and our operations over time. As we discuss below, there are currently a number of regulatory proceedings underway, and being contemplated by federal and stat
e authorities regarding the availability of the unbundled network element platform and other unbundled network elements, interconnection, pricing and other issues that could result in significant changes to the business conditions in the telecommunication industry, and have a material adverse effect on our operations and us. In addition, there has been discussion in Congress of modifying the Telecommunications Act in ways that could prove detrimental to us.
In January 1999, the U.S. Supreme Court confirmed the FCC’s role in establishing national telecommunications policy through implementation of the Telecommunications Act, and thereby created greater certainty regarding the rules governing local competition going forward. The FCC’s rules that permit us to purchase the unbundled network element platform to provide local and long distance telecommunications services to our customers are the primary rules governing competition upon which we rely. Although the rights established in the Telecommunications Act are a necessary prerequisite to the introduction of full local competition, they must be properly implemented and enforced to permit competitive telephone companies like us to compete effectively with the incumbent carriers.
Regulation of Access to Unbundled Network Elements
Access to incumbent local exchange companies' unbundled network elements at cost-based rates is critical to our business. Our local telecommunications services are provided almost exclusively through the use of combinations of unbundled network elements, and it is the availability of cost-based rates for these elements that enables us to price our local telecommunications services competitively. However, the obligation of incumbent local exchange companies to provide unbundled network elements at such cost-based rates currently is the subject of regulatory and judicial actions that may affect their availability. Such proceedings could result in the availability of these elements being substantially reduced or otherwise subject to significantly high
er, non-cost-based rates.
Access to incumbent local exchange companies' unbundled network elements in a fashion in which they are combined by the incumbent local exchange company is critical to our business. Our local telecommunications services are provided primarily through the use of the unbundled network element platform, in which unbundled network elements necessary to provide service to our customers (unbundled loops, transport, and local switching) are combined by the incumbent local exchange company and then leased to us. The existing set of unbundled network elements were largely established by the FCC in its 1996 Local Interconnection Order , and updated in a proceeding on remand from the Supreme Court’s Iowa Utilities Board decision in 1999. The Supreme Court held that the FCC did not apply the correct standards when determining which network elements must be unbundled and made available to competitive telephone companies such as us. In November 1999, the FCC released its "UNE Remand Order", addressing the deficiencies in the FCC’s original ruling cited by the Supreme Court. The UNE Remand Order was generally viewed as favorable to us
and other competitive carriers because it ensured that incumbent local exchange companies would be required to make available those network elements, including the unbundled network element platform, that are crucial to our ability to provide local and other telecommunications services. The UNE Remand Order was appealed by the incumbent local exchange companies and, in May 2002, the United States Court of Appeals for the District of Columbia Circuit released an opinion reversing and remanding the UNE Remand Order to the FCC for further consideration. The Court remanded the UNE Remand Order because (1) the FCC adopted, as to almost every unbundled element, a uniform national rule mandating the element’s unbundling in every geographic market and customer class, without regard to the state of competition in any particular market; and (2) the FCC’s concept of the circumstances in which cost disparities would, under the Telecommunications Act’s standards, "impair" a competitor’s ability to provide service without unbundled elements was considered too broad.
As part of its regular periodic review of the list of unbundled elements available to competitive carriers under the Telecommunications Act and in response to the remand of the UNE Remand Order , the FCC initiated its so-called Unbundled Network Element Triennial Review rulemaking proceeding on December 12, 2001. The FCC, in its Triennial Review and in response to the D.C. Circuit Court’s decision, reviewed all unbundled network elements to determine whether incumbent local exchange companies should continue to be required to provide them to competitors.
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In the FCC’s Unbundled Network Element Triennial Review Order, released August 21, 2003 and effective as of October 2, 2003, the FCC determined that certain network elements will no longer be subject to unbundling requirements, while other network elements must continue to be offered subject to further, more detailed review by the state commissions. The FCC established guidelines for these state determinations, which are currently underway, and ordered state commissions to complete their reviews by July 2, 2004. Among the network elements subject to further state review is local circuit switching, which is a critical component of the unbundled network element platform. Also subject to further review are certain types of unbundled loops and interoffice transport.
The FCC's UNE Triennial Review Order was appealed by numerous parties. The federal judicial appeals were consolidated in the U.S. Court of Appeals for the District of Columbia. On March 2, 2004, the Court released a decision that reversed, vacated and remanded the FCC's UNE Triennial Review Order in material respects. Of most importance to us, the Court determined that the FCC erred in delegating decision-making authority to state commissions, and in making national findings of impairment with respect to the switching and dedicated interoffice transport unbundled network elements. The Court stayed its decision until the denial of any petitions for rehearing or for a 60 day period (i.e., until May 1, 2004), whichever is later. Unless the Court's decision is itself stayed by the Court
or the U.S. Supreme Court, or the FCC promulgates effective replacement rules, the result of the Court's decision will be that the FCC's rules requiring incumbent local telephone companies to make available the mass market switching and dedicated interoffice transport unbundled network elements to competitors at cost based rates pursuant to Section 251 of the Telecommunications Act will no longer be effective. However, the Court affirmed FCC rules that require former Regional Bell Operating Companies to make available similar unbundled network elements pursuant to Section 271 of the Telecommunications Act, albeit at rates that are "just and reasonable" rather than strictly cost based. Although prices for Section 271 unbundled network elements have not yet been established, it is probable that they will generally be higher than those charged for Section 251 unbundled network elements. Notably, in response to the Court's ruling, some state public utility commissions, but not all, have suspended their state imp
airment proceedings.
Should local circuit switching not be available to us due to this adverse decision or otherwise, we would be unable to offer services on an unbundled network element platform basis and would instead have to serve customers through total service resale agreements with the incumbent local telephone companies, through network elements purchased from the Regional Bell Operating Companies at "just and reasonable" rates under Section 271 of the Act or through our own facilities or the switching facilities of other non-incumbent carriers, any of which which could delay our service roll-out in some markets, increase our cost, and negatively impact our business, prospects, operating margins, results of operations, cash flows and financial condition.
A brief summary of the FCC’s actions under its UNE Triennial Review Order that would likely have a significant impact on us is provided below:
Unbundled Local Switching and the Unbundled Network Element Platform: Our telecommunications services are provided primarily through the combination of unbundled network elements, including unbundled local circuit switching, loop and shared transport elements, commonly referred to as the unbundled network element platform. The FCC’s rules previously required that the incumbent local exchange companies provide to competitors the unbundled network element platform, including all network elements required by the competitor to provide retail telecommunications services, in most geographic areas. Through the use of the unbundled network element platform, we are able to provide
retail local services entirely through the use of the incumbent local exchange companies’ facilities at lower prices than those available for local resale through total resale service agreements with the incumbent local exchange companies.
Among the network elements made subject to further state review under the FCC's UNE Triennial Review Order is the local circuit switching unbundled network element, which is a critical component of the unbundled network element platform. With respect to the local circuit switching element, the FCC adopted a national finding that competitive carriers providing telecommunications services to "mass market" customers are impaired without access to unbundled local circuit switching. Accordingly, under the FCC's UNE Triennial Review Order, incumbent local exchange companies were required to provide to competitive carriers serving the mass market access to the local circuit switching element, except where a state commission has determined in a nine-month proceeding, pursuant to the guidelines establi
shed by the FCC, that competitive carriers are not impaired without access to the local circuit switching element in a particular market, or otherwise that impairment in a particular market would be cured by implementation of a transitional local circuit switching regime. The state commissions could eliminate incumbent local exchange company unbundling requirements for local circuit switching in a
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particular market where one of the two "triggers" established by the FCC is satisfied: (1) three or more competing providers (providers not affiliated with each other or the incumbent local exchange company) serve mass market customers with the use of their own local circuit switches; or (2) two or more competing providers (providers not affiliated with each other or the incumbent local exchange company) offer wholesale local circuit switching service to carriers serving mass market customers using their own switches. In addition, where neither of the so-called "triggers" are satisfied for a particular market, the state commissions could nonetheless eliminate existing unbundling requirements for local circuit switching where market conditions would permit competitive entry through the deploymen
t of new local circuits, or otherwise relax existing unbundling requirements where impairment in a particular market would be cured by implementation of a transitional local circuit switching regime. If the state commission determined that any of these tests is satisfied, then competitors could be foreclosed from submitting new orders for use of the local switching network element after five months, and they would be required to submit orders to migrate their embedded based of customers over a 13-27 month timeline.
However, as discussed above, the Court recently reversed, vacated and remanded both the FCC rules that delegated decision-making with respect to unbundled network elements to state commissions and the FCC’s national findings that competitive carriers are impaired absent the availability of the mass market switching and dedicated interoffice transport unbundled network elements. Thus, current FCC rules requiring incumbent telephone companies to make the mass market switching and dedicated interoffice transport unbundled network elements available to competitors at call-based rates could expire as soon as May 1, 2004. Although the incumbent local exchange company unbundling requirements for local circuit switching arising under Section 251 of th
e Telecommunications Act may be eliminated or limited by state commissions acting under the FCC's UNE Triennial Review Order, or due to the Court's decision to reverse and vacate these rules, competitive carriers’ access to local circuit switching on unbundled basis is preserved under Section 271 of the Telecommunications Act as a condition to the Regional Bell Operating Company's ability to provide in-region long distance services. However, the local circuit switching element, if accessible to competitive carriers only pursuant to Section 271 of the Telecommunications Act, may be offered at significantly higher rates, and subject to less favorable terms and conditions imposed by the incumbent local exchange companies, including the possibility that the incumbent local exchange companies will not be required to combine unbundled local circuit switching provided pursuant to Section 271 with other non-unbundled network elements or tariffed services. Should the local circuit switching element becomes
effectively unavailable to serve a particular market, we would be unable to provide services on an unbundled network element platform basis and would instead have to serve customers through total service resale agreements with the incumbent local exchange companies, through network elements purchased from the Regional Bell Operating Companies at "just and reasonable" rates under Section 271 of the Act or through our own facilities or the switching facilities of other non-incumbent carriers. Our transition from providing telecommunications services on an unbundled network element platform basis may delay our service roll-out in some markets, increase our costs and negatively impact our business, prospects, operating margins, results of operations, cash flows and financial condition.
Unbundled Transport Facilities : We have installed a local switch in Michigan along with related colocation equipment and have begun to carry test calls over its circuits, using a combination of our own switching capacity and unbundled loop and dedicated interoffice transport facilities purchased from the incumbent local exchange companies. In addition, we are in the process of developing plans for a broader roll-out of networking equipment. The use of our own local switch will diminish our reliance on incumbent local exchange company-provided local circuit switching and increase our reliance on incumbent local exchange company unbundled loop and unbundled transport facilities
over time.
Under the FCC's UNE Triennial Review Order, "dedicated transport" is narrowly defined to include only those transmission facilities connecting incumbent local exchange company switches and wire centers within a local access and transportation area, or LATA. In general, with the exception of the optical carrier dedicated transport element, the FCC adopted a national finding that competitive carriers providing telecommunications services are impaired without access to incumbent local exchange company dedicated transport facilities on an unbundled basis. Accordingly, under the order, incumbent local exchange companies are required to provide to competitive carriers dedicated transport facilities on an unbundled basis along most requested routes. Howev
er, under the terms of the FCC’s UNE Triennial Review Order, the continued availability of dedicated transport elements, including DS1, DS3 and dark fiber facilities, was made subject to further review by the state commissions, and incumbent local exchange company unbundling requirements could be eliminated where a state commission has determined in a nine-month proceeding, pursuant to the guidelines established by the FCC, that competitive carriers are not impaired without access to incumbent local exchange company dedicated transport facilities on an unbundled basis along certain requested routes. Specifically, the state commissions may eliminate unbundling requirements for incumbent local exchange company dedicated transport facilities for a requested route where one of
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the two "triggers" established by the FCC is satisfied: (1) where three or more competing providers (providers not affiliated with each other or the incumbent local exchange company ) have self-provisioned DS3 or dark fiber facilities along the requested route, the state commission may eliminate incumbent local exchange company unbundling requirements for such facilities along the requested route; or (2) where two or more competing providers (providers not affiliated with each other or the incumbent local exchange company ) currently offer wholesale dedicated transport facilities to carriers along the requested route, the state commission shall eliminate incumbent local exchange company unbundling requirements for such facilities along the requested route. In addition, even where the first of t
he so-called triggers is not satisfied, the sta