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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 January 31, 2005
Commission File Number 0-2180
[COVISTA COMMUNICATIONS LOGO]
COVISTA COMMUNICATIONS, INC.
(Exact name of Company as specified in its charter)
New Jersey 22-1656895
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
721 Broad Street, Suite 200
Chattanooga, TN 37402
(Address of principal executive offices)(Zip Code)
(423) 648-9500
Company's telephone number, including area code:
Securities registered pursuant to Section 12 (b) of the Act:
None
Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, $.05 par value per share
Indicate by check mark whether Covista Communications, Inc. ("Covista" or the
"Company")(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 Covista 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 Company'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 [_]
Aggregate market value (based upon a $1.79 closing price) of the voting stock
held by nonaffiliates of Covista as of April 1, 2005, was approximately
$9,865,000 (calculated by excluding solely for purposes of this form,
outstanding shares owned by Directors and Executive Officers).
Number of shares of Common Stock outstanding on April 1, 2005: 17,822,025
Documents Incorporated By Reference:
None
PART I
SPECIAL NOTE REGARDING 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, "believes," "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" "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
General
Covista Communications, Inc. ("Covista"), a New Jersey corporation, is
a telecommunications and data services provider that operates three distinct
business segments: retail, residential and wholesale. Retail has been the
largest segment and provides local, long distance and data services to small and
medium sized businesses, principally in the Northeast region of the United
States. Residential, formerly known as KISSLD, is the fastest growing segment
and offers bundled local and long distance services to residential users who are
located primarily in areas supported by our long distance network facilities.
The wholesale segment provides long distance telecommunication services to other
carriers for resale. Covista utilizes its own switching equipment and leased
fiber optic transmission cable. Our products and services include a broad range
of voice and data, including local, long distance and toll-free services,
calling cards, data, Internet access, virtual private network, directory
assistance and teleconferencing services. Covista currently operates three
switches in various locations. Covista processes approximately eighty five
percent of all its long distance call volume through its own switching
facilities.
In the retail segment, Covista has tailored its service offerings,
sales, marketing approach and network development to provide service in a
cost-effective manner. Covista recently sold a large portion of its retail
customer base to PAETEC Communications. Covista plans to retain and further grow
its remaining retail customer base in new geographic markets, primarily in the
Southeast. Covista sells to retail customers primarily through independent
marketing representatives.
The residential segment offers discount local and long distance
services to users through direct marketing campaigns, which include mail, space
advertising and web based efforts, in addition to a variety of affinity
relationships with marketing partners. The residential segment has experienced
considerable growth since its 2003 launch and the Company expects this segment
to remain the fastest growing of the three.
The Company also maintains a wholesale segment that provides primarily
domestic and international long distance services to other carriers. In recent
years, the Company has intentionally reduced its marketing and support efforts
for this wholesale segment in an effort to provide more support to the other two
segments. Both the retail and residential segments offer lower financial risk in
the form of un-collectible accounts and higher gross margins than those
generated from the wholesale segment.
For Fiscal 2005, Covista had gross revenues of approximately $60
million, derived approximately 57% from retail, 38% from residential, and 5%
from wholesale. This represents an approximately $24 million decrease when
compared to the approximately $84 million of gross revenue generated during the
previous fiscal year, principally due to the sale of selected retail customers
to PAETEC.
Covista maintains its corporate headquarters and call center facility
in Chattanooga, Tennessee. In addition, the Company operates a network
operations center in Chattanooga to monitor and control its network and to
coordinate its various services. Covista's principal executive offices are
located at 721 Broad Street, Suite 200, Chattanooga, TN, 37402, and its
telephone number is (423) 648-9500.
2
Business Strategy
Covista's strategy has been to develop a large geographic
concentration of revenue producing bundled phone service customers through the
sale of telecommunications services in areas where it has installed switching
platforms. In addition, Covista intends to use the wholesale operating platforms
of incumbent local exchange companies to provide local services. Our business
strategy may be materially impacted by regulatory changes, as discussed further
under Government Regulations.
Current Network
Currently, Covista operates an advanced telecommunications network,
which includes three Alcatel switches, located in Minneapolis, Minnesota,
Dallas, Texas and Chattanooga, Tennessee. In July 2001, Covista acquired
long-term access to nationwide network facilities comprising 2,822,400,000
channel miles of telecommunications capacity measured by length of voice-grade
circuits. During Fiscal 2005, Covista billed approximately 926,000,000 million
minutes, with approximately 85% of its minutes carried over its own switches.
Covista believes that increasing the traffic carried on its own network should
improve operating margins.
Covista is interconnected with a number of United States and foreign
wholesale international carriers. The purpose of connecting to a variety of
carriers is to provide state-of-the-art, lowest-cost routing and network
reliability. These interconnected international carriers have been a source of
wholesale international traffic and revenue. Covista is interconnected by SS7
out-of-band digital signaling throughout its network. The SS7 signaling system
reduces connect time delays, thereby enhancing overall network efficiencies.
Additionally, the SS7 technology is designed to permit the anticipated expansion
of Covista's Advanced Intelligent Network ("AIN") capabilities throughout its
network. Covista's advanced switching platform would enable it to (i) deploy
features and functions quickly throughout its entire network, (ii) expand switch
capacity in a cost-effective manner, and (iii) lower maintenance costs through
reduced training and spare parts requirements.
Covista has a Network Operating Center (NOC) in Chattanooga,
Tennessee, which monitors and controls Covista's network and coordinates its
various services from a central location, increasing the security, reliability
and efficiency of Covista's operations. Centralized electronic monitoring and
control of Covista's network allows Covista to avoid duplication of this
function in each switch site. The NOC also helps reduce Covista's per-customer
monitoring and customer service costs. In addition, Covista's network employs an
"authorized access" architecture. Unlike many telecommunications companies which
allow universal access to their network, Covista utilizes an automatic number
identification security screening architecture which ensures only the Automatic
Number Identification (ANIs) of those users who have subscribed to Covista's
services and have satisfied Covista's credit and provisioning criteria have
access to the network. Covista believes that this architecture provides Covista
the ability to better control bad debt and fraud in a manner, which is invisible
and nonintrusive to the customer. This architecture also allows Covista to
better manage network capacity, as unauthorized users cannot access the network.
3
PRINCIPAL PRODUCTS AND SERVICES
Product and Service Offerings
Retail Services. Covista provides telecommunications services to over
81,000 retail customers, primarily small and medium-sized businesses, located in
the Northeastern region of the United States. Covista sells retail services
through independent marketing representatives and web based marketing programs.
Retail services accounted for approximately $34 million or 57% of Covista's
Fiscal 2005 total revenue. This compares to approximately $62.4 million of
retail revenue in Fiscal 2004.
Residential, Covista targets residential customers via direct
marketing programs in locations supported by the existing company network. At
year-end, over 79,000 customers were being billed on a monthly basis.
Residential revenues accounted for approximately $23 million or 38% of Covista's
Fiscal 2005 total revenue. This compares to approximately $17 million of
residential revenue in Fiscal 2004. In previous years this segment was named
KISSLD.
Wholesale Services. Covista offers domestic and international
termination, switch ports, colocation facilities and transport services to a
broad spectrum of domestic and international carriers. Wholesale revenues were
approximately $3.2 million and $4.4 million during Fiscal 2005 and Fiscal 2004,
respectively.
Covista's services include the following:
o Long Distance: Covista offers a full range of switched and dedicated
domestic and international long distance services, including "1+"
outbound service in all 50 states along with global termination to
over 200 countries. Long distance services include intra-LATA (Local
Access Terminating Area), inter-LATA, and worldwide international
services. Long distance features include both verified and
non-verified accounting codes, station-to-station calling, third-party
calling, directory assistance and operator-assisted calling.
o Toll-free Services: Covista offers a full range of switched and
dedicated domestic toll-free services, including toll-free origination
in all 50 states, international toll-free origination from over 30
countries, and toll-free directory assistance. AIN enhanced toll-free
services include the following features: Command Routing, Dialed
Number Identification Service Area Code/Exchange Routing, Real Time
Automatic Number Identification Delivery, Day-of-Year Routing,
Day-of-Week Routing, Time-of-Day Routing, Percentage Allocation
Routing, PIN protected 800 services, integrated voice response
services and store locator services.
o Access Options: Covista offers its long distance and toll-free
customers multiple access options, including dedicated access at DS0,
DS1, and DS3 speed(s) and switched access.
o Calling Card and Services: Covista offers nationwide switched access,
customized calling card services. Customers have the option of calling
cards which are personalized, branded or generic.
o Data Services: Covista offers advanced data transmission services,
including private line and Frame Relay services. Data services have
multiple access options, including dedicated access at DS0, DS1, and
DS3 speed(s) and switched access.
o Customer Management Control Features: All of Covista's customers have
the option of customized management reporting features, including
interstate/intrastate area code summaries, international destination
matrix, daily usage summaries, state summaries, time of day summaries,
duration distribution matrix, exception reporting of long duration
calls, and incomplete and blocked call reporting.
o 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. Our cost of
purchasing unbundled network elements will most likely increase as the
result of recent regulatory changes, as discussed further under
Government Regulations.
Our bundled service generally includes: unlimited local usage
dependent upon the service plan, 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.
4
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 extensive framework for the introduction of new
products and services. Through dedicated electronic connections with our long
distance network and the incumbent local exchange companies, we have designed
our systems to process information on a "real time" basis.
In addition, we maintain our own web sites at www.covista.com,
www.kissld.com, and others 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:
o Detailed rate schedules and product and service related
information.
o Online sign-up for our telecommunication services.
o Credit card billing.
o 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 under our own brand and the brands of our agent
and affinity partners. We currently market our bundled services to customers in
five states where we can profitably offer services at competitive prices. We
intend to market in additional states (or certain areas of a particular state)
in which our pricing and cost structure permit us to profitably offer services
in those areas at competitive rates.
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 and free features. Customers can switch
to us online or through an authorized agent, each of which uses consultative
sales tools to assist the customer's selection of the right plan for its
telecommunications needs. 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. We market our bundled services within our targeted markets through the
following channels:
o 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.
o Referrals: We solicit, through the use of referral promotions, the
names of potential customers or referrals from our existing customers.
o Online Marketing: We have developed an online marketing presence
through traditional online media and business relationships.
o Direct Sales: Utilizing independent agents, we solicit new customers
in targeted geographic areas.
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.
5
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, which 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 and MCI Inc., have targeted
price plans at residential customers - one of our primary target markets - 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 serve. Additional
pricing pressure has also been introduced by new technologies, such as Voice
over Internet Protocol, or VoIP. VoIP providers seek to offer 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 and entertainment 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.
Seasonal Nature of Business
The Company's business is not seasonal.
Patents, Trademarks, Licenses, etc.
The Company does not hold any material patents, franchises or
concessions.
GOVERNMENT REGULATIONS
General
We are subject to federal, state, local and foreign laws, regulations,
and orders affecting the rates, billing, terms, and conditions of certain of our
service offerings, our costs and other aspects of our operations, including our
relations with other service providers. Regulation varies in each jurisdiction
and may change in response to judicial proceedings, legislative and
administrative proposals, government policies, competition and technological
developments. We cannot predict what impact, if any, such changes or proceedings
may have on our business or results of operations, and we cannot assure that
regulatory authorities will not raise material issues regarding our compliance
with applicable regulations.
The FCC has jurisdiction over our facilities and services to the
extent they are used in the provision of interstate or international
communications services or as otherwise required by federal law. State
regulatory commissions, commonly referred to as PUCs, generally have
jurisdiction over facilities and services to the extent they are used in the
provision of intrastate services. Local governments may assert authority to
regulate aspects of our business through zoning requirements, permit or
right-of-way procedures and franchise fees. Foreign laws and regulations apply
to communications that originate or terminate in a foreign country. Generally,
the FCC and State public utility commissions do not regulate Internet, video
conferencing and certain data services, although the underlying communications
components of such offerings may be regulated. Our operations also are subject
to various environmental, building, safety, health and other governmental laws
and regulations.
Federal law generally preempts state statutes and regulations that
restrict the provision of competitive local, long distance and enhanced
services; consequently, we generally are free to provide the full range of
local, long distance and data services in every state. While this federal
preemption greatly increases our potential for growth, it also increases the
amount of competition to which we may be subject.
6
Federal Regulation
The Communications Act of 1934, as amended, or the 1934 Act, grants
the FCC authority to regulate interstate and foreign communications by wire or
radio. We are regulated by the FCC as a non-dominant carrier and are subject to
less comprehensive regulation than dominant carriers. Nevertheless, we remain
subject to numerous requirements of the Communications Act, applicable to most
common carriers, which require us to offer service upon reasonable request and
pursuant to just and reasonable charges and terms that are not unjustly or
unreasonably discriminatory. The FCC has authority to impose additional
requirements on non-dominant carriers.
The Telecommunications Act of 1996, or the 1996 Act, amended the 1934
Act to eliminate many barriers to competition in the U.S. communications
industry, by setting standards for relationships between communications
providers, including between new entrants, such as our company, and the Regional
Bell Operating Companies and other incumbent local exchange companies. In
general, the 1996 Act requires incumbent local exchange companies to provide
competitors with nondiscriminatory access to, and interconnection with, the
incumbent local exchange company networks, and to provide unbundled network
elements at cost-based prices. The FCC and state public utility commissions have
adopted extensive rules to implement the 1996 Act, and revisit such regulations
on an ongoing basis in light of court decisions and as marketplaces evolve.
Several congressmen have recently suggested that Congress should
consider rewriting substantial portions of the 1996 Act. Any effort to reform
the 1996 Act could result in changes that would materially reduce the
obligations of the incumbent local exchange companies to interconnect with, or
provide unbundled network elements to, competitors. Any such legislative change
could have a material adverse impact on our business and operations.
The announced merger of AT&T with SBC and Verizon's and Qwest's
announced bids for MCI will, if they are completed, effectively eliminate the
two largest long distance and competitive local exchange carriers in the United
States, each of which was a strong voice in federal and state lobbying related
to telecommunications matters. These mergers will place an increased demand on
our resources and employees for lobbying and other regulatory matters and there
can be no assurances that our efforts will prove effective.
Long Distance Competition
Section 271 of the 1934 Act, enacted as part of the 1996 Act,
established a process by which a Regional Bell Operating Company could obtain
authority to provide long distance service in a state within its region. The
process required demonstrating to the FCC that the Regional Bell Operating
Company has adhered to a 14-point competitive checklist and that granting such
authority would be in the public interest. Each of the Regional Bell Operating
Companies already has received FCC approval to provide long distance services in
each state within its respective region, resulting in increased competition in
certain markets and services. The Regional Bell Operating Companies have a
continuing obligation to comply with the checklist. Section 272 of the 1934 Act
requires that, for a period of three years after receiving Section 271 approval
in any state (absent an FCC extension), a Regional Bell Operating Company must
comply with certain other structural and operational safeguards, including the
provision of in-region long distance service through a separate affiliate.
Local Service Regulation
The 1996 Act required the FCC to establish national rules implementing
the local competition provisions of the 1996 Act, which impose duties on all
local exchange carriers, including competitive local exchange companies such as
our company, to provide network interconnection, reciprocal compensation,
resale, number portability and access to rights-of-way.
The 1996 Act imposed additional duties on incumbent local exchange
companies, including the duty to provide access on an unbundled basis to
individual network elements on non-discriminatory terms and cost-based rates; to
allow competitors to interconnect with their networks in a nondiscriminatory
manner at any technically feasible point on their networks; to permit
collocation of competitors' equipment at the incumbent local exchange company
premises; and to offer retail services at wholesale rates to competitive local
exchange companies for resale.
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 to date have been provided through the use of
combinations of unbundled network elements, and it is the availability of
cost-based rates for these elements that has enabled us to price our local
telecommunications services competitively. However, the obligation of incumbent
local exchange companies to provide the unbundled network elements upon which we
have relied at such cost-based rates is the subject of recent regulatory action
that will result in the availability of these elements being substantially
reduced or otherwise subject to significantly higher, non-cost-based rates.
These recent actions may limit our ability to offer local services in certain
markets.
7
The 1996 Act required incumbent local exchange companies to provide
requesting telecommunications carriers with nondiscriminatory access to network
elements on an unbundled basis at any technically feasible point on rates, terms
and conditions that are just, reasonable and nondiscriminatory, in accordance
with the other requirements set forth in Sections 251 and 252 of the 1934 Act.
The 1996 Act gave the FCC authority to determine which network elements must be
made available to requesting carriers such as us. For network elements that are
not proprietary, the Commission is required to determine whether the failure to
provide access to such network elements would impair the ability of the carrier
seeking access to provide the services it seeks to offer. The FCC has determined
that most network elements are nonproprietary in nature and, thus, are subject
to the "impair" standard. The FCC's initial list of incumbent local exchange
company network elements that are required to be unbundled on a national basis
was first released in 1996 and has been subject to almost constant review and
revision since then.
When the FCC first adopted unbundled network element rules, it
indicated that it would reexamine the list of unbundled network elements every
three years. In December 2001, the FCC initiated its first so-called triennial
review of those rules. In August 2003, in the Triennial Review Order, or TRO,
the FCC substantially modified its rules governing access to unbundled network
elements. The FCC redefined the "impair" standard, concluding that a requesting
carrier is impaired when a lack of access to an unbundled network element poses
barriers to entry, including operational and economic barriers that are likely
to make entry into a market uneconomic. The FCC limited requesting carrier
access to certain aspects of the loop, transport, switching and signaling
databases unbundled network elements, but continued to require some unbundling
of these elements. In the TRO, the FCC also determined that certain broadband
elements, including fiber-to-the-home loops in greenfield situations, broadband
services over fiber-to-the-home loops in overbuild situations, packet switching
and the packetized portion of hybrid loops, are not subject to unbundling
obligations.
All of the FCC's decisions regarding unbundling have been the subject
of judicial review. Most recently, on March 2, 2004, the U.S. Court of Appeals
for the District of Columbia Circuit, or the D.C. Circuit, in United States
Telecom Ass'n v. FCC, or the USTA II decision, vacated certain portions of the
TRO and remanded to the FCC for further proceedings. Specifically, the D.C.
Circuit vacated the FCC's delegation of decision-making authority to State
commissions and several of the FCC's nationwide impairment determinations. The
D.C. Circuit found that the FCC used a flawed methodology when making certain
impairment determinations, including those relating to the mass market switching
and local transport network elements, and remanded those determinations to the
FCC for further analysis and justification. The D.C. Circuit affirmed the FCC's
decision to relieve the incumbent local exchange companies from unbundling
obligations with respect to broadband elements. The D.C. Circuit did not make a
formal pronouncement regarding the status of the FCC's findings regarding
enterprise market loops, batch hot cuts or preemption of inconsistent State
laws.
The FCC and the United States Solicitor General declined to seek
certiorari from the Supreme Court. The National Association of Regulatory
Utility Commissioners and a coalition of competitive local exchange companies
separately petitioned for certiorari. The Supreme Court has denied those
petitions.
In orders released in August 2004, the FCC extended relief from the unbundling
obligations to fiber-to-the-home loops serving predominantly residential
multiple dwelling units and granted the same relief to fiber-to-the-curb that it
has applied to fiber-to-the-home.
On October 27, 2004, the FCC issued an order granting requests by the
Regional Bell Operating Companies that the FCC forbear from enforcing the
independent unbundling requirements of Section 271 of the 1934 Act with regard
to the broadband elements that the FCC had determined in the TRO are not subject
to unbundling obligations (fiber-to-the-home loops, fiber-to-the-curb loops, the
packetized functionality of hybrid loops and packet switching). The FCC declined
to address broader forbearance requests by SBC and Qwest, which had asked the
FCC to forbear from applying applicable Section 271 requirements to any element
that the FCC determined no longer meets the impairment standard.
On December 15, 2004, the FCC adopted rules modifying the unbundling
obligations for incumbent local exchange companies under Section 251 of the 1934
Act, reducing the incumbent local exchange companies' obligation to provide
unbundled local switching as well as certain levels of unbundled loops and
transport. The FCC issued final rules on February 4, 2005. Those rules were
effective on March 11, 2005. In response to the USTA II decision, the FCC
clarified that it evaluated impairment with regard to the capabilities of a
reasonably efficient competitor. The FCC also modified the impairment standard
set forth in the TRO by: (1) setting aside the TRO's qualifying service
interpretation of Section 251(d)(2), but prohibiting the use of unbundled
network elements for the provision of exclusively long distance or exclusively
wireless services; (2) drawing inferences regarding the prospects for
competition in one geographic market based on the state of competition in
another, similar market; and (3) determining that in the context of local
exchange markets, a general rule prohibiting access to unbundled network
elements whenever a requesting carrier is able to compete using an incumbent
local exchange company's tariffed special access offering would be
inappropriate. As a result of these decisions, the availability of unbundled
network elements at cost-based rates has been substantially reduced and may have
a material effect on the way we conduct our business and operations. The Company
is presently evaluating alternative delivery methods, and retail price points
related to specific geographic markets.
The principal parts of the FCC's December 15, 2004 order regarding unbundled
switching and unbundled loops and transport are summarized below:
8
Local Switching: The FCC eliminated an incumbent local exchange company's
obligation to provide local switching (and the unbundled network element
platform, in particular, the one upon which we have historically relied) to
requesting carriers at Total Element Long Run Incremental Cost, or TELRIC,
rates. In doing so, the FCC found that competitive local exchange companies are
not impaired nationwide without access to unbundled local switching. The FCC
adopted a twelve-month transition plan for competitive local exchange companies
to transition away from the unbundled network element platform commencing on
March 11, 2005 and ending on March 10, 2006. The transition plan applies only to
our customer base as it exists on March 11, 2005 and we will continue to be
permitted to obtain local switching for our current customers at a rate per
customer equal to the greater of: (1) the rate at which we leased that
combination of elements on June 15, 2004, plus one dollar; and (2) the rate, if
any, the applicable state public utility commission establishes between June 16,
2004 and the effective date of the FCC's order, for the unbundled network
element platform, plus one dollar.
Local Loops and Transport: The FCC also made impairment findings and placed
certain limitations with respect to local loops and dedicated interoffice
transport. The FCC established 10 DS1s and 12 DS3s as the maximum transport a
carrier can purchase per route. Furthermore, for local loops, the FCC concluded
that competitive local exchange companies are impaired without access to (1)
DS1-capacity loops except in any building within the service area of a wire
center containing 60,000 or more business lines and four or more fiber-based
collocators; and (2) DS3-capacity loops except in any building within the
service area of a wire center containing 38,000 or more business lines and four
or more fiber-based collocations. The FCC determined that competitive local
exchange companies are not impaired without access to dark fiber loops in any
instance. For dedicated transport, the FCC found that competitive local exchange
companies are impaired without access to (1) DS1 transport except on routes
connecting a pair of wire centers where both wire centers contain at least four
fiber-based collocators or at least 38,000 business lines; and (2) DS3 or dark
fiber transport except on routes connecting a pair of wire centers where both
wire centers contain at least three fiber-based collocators or at least 24,000
business lines. The FCC concluded that competitive local exchange companies are
not impaired without access to entrance facilities connecting an incumbent local
exchange company's network with a competitive local exchange company's network
in any instance. The unavailability of these dedicated transport facilities;
dark fiber and entrance facilities under the FCC's rules at cost-based rates
could substantially impede any plans to deploy local network facilities. We
could be forced to use other means to effect this deployment, including the use
of facilities purchased from the incumbent local exchange carrier at higher
tariffed special access rates or transport services purchased from other
competitive access providers. In either event, our cost of service could rise
dramatically and our plans for a service rollout for use of our own network
facilities could be delayed substantially or derailed entirely.
Although the incumbent local exchange company's unbundling
requirements for local circuit switching arising under Section 251 of the 1996
Act have been eliminated by the FCC's December 15, 2004 order, competitive
carriers access to local circuit switching on an unbundled basis is preserved
under Section 271 of the 1996 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 1996 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.
As of March 11, 2005, local circuit switching effectively became
unavailable to us at then existing rates. Accordingly, for new customers and
possibly new lines for existing customers, we will be unable to offer our
telecommunications services as we have done in the past and will instead be
required to serve customers by other means, including total service resale
agreements with the incumbent local exchange companies, commercial agreements
with the incumbent local exchange companies, through the use of our own network
facilities, by migrating customers onto the networks of other facilities-based
competitive local telephone companies or by purchasing critical network elements
on an unbundled basis at "just and reasonable" rates pursuant to Section 271 of
the 1996 Act, which presumably will be higher than the rates currently available
to us. Since element purchases pursuant to Section 271will be on an unbundled
basis, we will need to pay additional charges to combine these elements. For
existing customers, as detailed earlier, the FCC announced a one-year transition
during which competitors will be obligated to pay an immediate $1 price increase
for existing customer's switching. With the transition period, we will have a
year to transition such customers to other network facilities, resale,
competitive substitutes or elements purchased through Section 271. Our
transition from providing telecommunications services on an unbundled network
element platform basis to providing services on another network or otherwise
will result in a significant reduction in the number of new customers that we
add in the periods after March 11, 2005 compared to prior periods, will prevent
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.
In anticipation of the recent developments regarding the FCC's
unbundling rules, we have started evaluating the deployment of local switches in
selected markets along with related collocation equipment. The use of our own
local switch could diminish our reliance on incumbent local exchange company-
provided local circuit switching, but could increase our reliance on incumbent
local exchange company unbundled loop and unbundled transport facilities over
time.
9
If we were to deploy local switching, the unavailability of dedicated
transport facilities, dark fiber and entrance facilities under the FCC's rules
on an unbundled basis at cost-based rates along certain routes may adversely
impact us. If many routes become effectively unavailable to us under the FCC's
newly adopted rules, our plans to deploy our own network facilities could be
substantially impeded, and we could be forced to use other means to effect this
deployment, including the use of facilities purchased at higher tariffed special
access rates or transport services purchased from other facilities-based
competitive local telephone carriers. In either event, our cost of service could
rise dramatically and our plans for a service rollout for use of our own network
facilities could be delayed substantially or derailed entirely. This would have
a material adverse effect on our business, prospects, operating margins, results
of operations, cash flows and financial condition.
We believe the loss of the availability of DS3 and DS1 loops at
cost-based rates will result in materially higher prices on loops that we must
purchase from either the incumbent local exchange company or a competitive
access provider. At this time, we cannot determine how many loops will become
unavailable at cost-based rates or the effect upon our network plans.
On January 18, 2005, the U.S. Court of Appeals for the D.C. Circuit
ordered the FCC to provide promptly a release date for the new rules and on
January 26, 2005, the FCC informed the Court of the FCC Chairman's plans to
release the rules on or before February 4, 2005. The FCC issued its final rules
on February 4, 2005. Appeals of the order have been filed in several U.S.
appellate courts and the appeals have been assigned to the U.S. Court of Appeals
for the Third Circuit, although it is expected that the Regional Bell Operating
Companies will move to transfer the cases to the U.S. Court of Appeals for the
D.C. Circuit. More appeals are expected.
The FCC has encouraged incumbent local exchange companies and
competitive local exchange companies to engage in commercial negotiations to
provide access to incumbent local exchange company facilities that may no longer
be available as unbundled network elements as a result of the withdrawal of
unbundling obligations, including the unbundled network element platform.
Although a few such agreements have been announced, a majority of competitive
local exchange companies have not negotiated new agreements as of this date.
While we have engaged in general discussions with some of the incumbent local
exchange companies, we have been unable to reach any agreements and there can be
no assurances that we will be able to reach agreement in the future. We have
signed an interim agreement with Verizon.
FCC rules implementing the local competition provisions of the 1996
Act currently permit competitive local exchange companies to lease unbundled
network elements at rates determined by state public utility commissions
employing the FCC's Total Element Long Run Incremental Cost, or TELRIC, forward
looking, cost-based pricing model. On September 15, 2003, the FCC opened a
proceeding reexamining the TELRIC methodology and wholesale pricing rules for
communications services made available for resale by incumbent local exchange
companies in accordance with the 1996 Act. This proceeding will comprehensively
re-examine whether the TELRIC pricing model produces unpredictable pricing
inconsistent with appropriate economic signals; fails to adequately reflect the
real-world attributes of the routing and topography of an incumbent local
exchange company's network; and creates disincentives to investment in
facilities by understating forward-looking costs in pricing Regional Bell
Operating Company network facilities and overstating efficiency assumptions. We
have participated in this proceeding as a member of a consortium of competitive
local exchange companies. To date, the FCC has not yet issued revised TELRIC
rules. The TELRIC methodology still governs our pricing for loops purchased from
the incumbent local exchange companies. We cannot predict if the FCC will order
new TELRIC pricing or if Congress will amend the 1996 Act, affecting such
pricing. The application and effect of a revised TELRIC pricing model on the
communications industry generally and on certain of our business activities
cannot be determined at this time, but it could have a material impact on our
business.
Interconnection Agreements
Pursuant to FCC rules implementing the 1996 Act, we negotiate
interconnection agreements with incumbent local exchange companies to obtain
access to unbundled network elements and other services, generally on a
state-by-state basis. These agreements typically have two- to three-year terms.
We currently have interconnection agreements, or their equivalent, in effect
with BellSouth and Verizon in the states where such companies act as the
incumbent local exchange company. Our agreements generally are subject to
amendment based upon a change of law. Following the adoption or vacating of
unbundling rules, the incumbent local exchange companies typically invoke the
change of law provisions in our interconnection agreements. These provisions
generally provide that when a party to the agreement believes that its
obligations under the agreement have changed as a result of a change in
applicable law, it may request that the other party enter into negotiations to
amend the agreement, and that in the event the parties are unable to agree upon
an amendment, the dispute is to be arbitrated either by a neutral arbitrator or
by the relevant state commission. Several of the incumbent local exchange
companies claim to have provided us with such change of law notification,
although we dispute the effectiveness of these notices. We do not know when any
such negotiations, where applicable, might begin or conclude or the impact on
our business of any amendments to our interconnection agreements resulting from
such negotiations. In an increasing number of cases, incumbent local exchange
companies are taking the position that changes of law, including reductions in
incumbent local exchange companies_ unbundling obligations, do not require
negotiations. Rather, incumbent local exchange companies are arguing with
respect to many interconnection agreements that the agreements are amended
automatically and immediately without a written amendment. Additionally,
incumbent local exchange companies are taking the position that they can reject
an order for elements on a route that they deem to be competitive under the
FCC's final rules. We have opposed these positions and cannot predict at this
time whether the incumbent local exchange companies will prevail in their
arguments regarding automatic amendment with respect to any particular
interconnection agreement we currently operate under or their ability to
unilaterally reject orders, nor can we precisely determine what the impact will
be of any such resolution. While we have engaged in discussions with incumbent
local exchange companies regarding our various interconnection agreements, we
have not been successful in entering into any new agreements or amendments
thereto.
10
Collocation
FCC rules generally require incumbent local exchange companies to
permit competitors to collocate equipment used for interconnection and/or access
to unbundled network elements. Changes to those rules, upheld in 2002 by the
D.C. Circuit, allow competitors to collocate multifunctional equipment and
require incumbent local exchange companies to provision cross-connects between
collocated carriers. We cannot determine the effect, if any, of future changes
in the FCC's collocation rules on our business or operations.
Access Charges
We pay access fees to local exchange carriers for the origination and
termination of our long distance communications traffic. Generally, intrastate
access charges are higher than interstate access charges. Therefore, to the
extent access charges increase or a greater percentage of our long distance
traffic is intrastate, our costs of providing long distance services will
increase.
As a local exchange provider, we bill long distance providers access
charges for the origination and termination of those providers' long distance
calls. Accordingly, in contrast with our long distance operations, our local
exchange business benefits from the receipt of intrastate and interstate long
distance traffic. As an entity that collects and remits access charges, we must
properly track and record the jurisdiction of our communications traffic and
remit or collect access charges accordingly. The result of any changes to the
existing regulatory scheme for access charges or a determination that we have
been improperly recording the jurisdiction of our communications traffic could
have a material adverse effect on our business.
The FCC has indicated that its existing carrier compensation rules
constitute transitional regimes that will conclude in mid-2005, when a new
interstate intercarrier compensation regime based on bill-and-keep or another
alternative should be in place. Because we both make payments to and receive
payments from other carriers for the exchange of local and long distance calls,
we will be affected by changes in the FCC's intercarrier compensation rules. We
cannot predict the impact that any such changes may have on our business.
Our costs of providing long distance services, and our revenues for
providing local services, also are affected by changes in access charge rates
imposed on competitive local exchange companies. Pursuant to the FCC's 2001 CLEC
Access Charge Order, which lowered the rates that competitive local exchange
companies may charge long distance carriers for the origination and termination
of calls over local facilities, access rates were reduced during 2003 and were
reduced again during 2004. AT&T and Sprint have appealed the CLEC Access Charge
Order to the D.C. Circuit, arguing that the FCC's benchmark rates are too high.
The FCC issued the first Access Charge Reform Report and Order in
1997. Although the FCC has since issued five further orders in that docket,
several petitions for reconsideration and clarification of the 1997 Order remain
pending. On December 15, 2003, the FCC issued a public notice requesting that
the parties to such petitions file supplemental notices identifying any issues
that were raised in the petitions and that have not been otherwise resolved. We
cannot predict whether the FCC will further modify its access charge rules as a
result of this proceeding, or the effect that any such changes would have on our
business.
Over the last several years, the FCC has granted incumbent local
exchange companies significant flexibility in pricing interstate special and
switched access services. In August 1999, the FCC granted immediate pricing
flexibility to many incumbent local exchange companies and established a
framework for granting greater flexibility in the pricing of all interstate
access services once an incumbent local exchange company market satisfies
certain prescribed competitive criteria. In February 2001, the D.C. Circuit
upheld the FCC's prescribed competitive criteria. To date, the FCC has granted
pricing flexibility in numerous specific markets to the Regional Bell Operating
Companies. This pricing flexibility may result in Regional Bell Operating
Companies lowering their prices in high traffic density areas, including areas
where we compete or plan to compete. We anticipate that the FCC will continue to
grant incumbent local exchange companies greater pricing flexibility for access
services if the number of actual and potential competitors increases in each of
these markets.
The FCC issued a Notice of Public Rulemaking on February 10, 2005 in
WCC Docket No. 05-25. This notice includes a broad examination of the regulatory
framework that is applied to local exchange carriers' interstate special access
services preventing them from exceeding certain prices after June 30, 2005. In
conducting this examination, the FCC announced that it seeks comment on the
special access regulatory regime that should follow the expiration of the
Coalition for Affordable Local and Long Distance Service plan, including whether
to maintain or modify the Commission's pricing flexibility rules for special
access services. We cannot predict whether the FCC will further modify its
access change rules as a result of this proceeding or the effect that any such
changes would have on our business.
On February 10, 2005, the FCC also adopted a Further Notice of
Proposed Rulemaking, and solicited comment on whether to adopt any of seven
different comprehensive proposals for reform of the FCC's existing rules
relating to intercarrier compensation. Further action in that proceeding could
lead to substantial changes to the way that reciprocal compensation, switched
access and universal charges are established and administered, and could lead to
material reductions in our intercarrier compensation revenues.
11
Detariffing
Consistent with other deregulatory measures, the FCC has largely
eliminated carriers' obligations to file tariffs with the FCC containing prices,
terms and conditions of service. All carriers, including us, were required to
complete this detariffing process for interstate domestic commercial, or
customer-specific, services by January 31, 2001, for consumer mass-market
services by July 31, 2001, and for international services by January 2002. In
lieu of federal tariffs, the FCC requires carriers to post information relating
to the rates, terms, and conditions of services on their corporate web sites.
Detariffing precludes our ability to rely on filed rates, terms and conditions
as a means of providing notice to customers of prices, terms and conditions
under which we offer services, and requires us instead to rely on individually
negotiated agreements with end users. We remain subject to the 1934 Act's
requirements that rates, terms and conditions of communications service be just,
reasonable and not discriminatory, and we are subject to the FCC's jurisdiction
over customer complaints regarding our communications services.
In 2002, a coalition of consumer-protection advocates and state public
utility commissions asked the FCC to require non-dominant interexchange carriers
to give at least 30 days' advance written notice to their presubscribed
customers of any material change to the rates, terms or conditions of a
carrier-customer agreement. The coalition argued that since detariffing took
effect, customer agreements generally offered by interexchange carriers reserve
for the carriers the right to unilaterally change rates, terms and conditions at
any time, thereby preventing consumers from making informed decisions regarding
the terms under which they acquire service from carriers. To date, the FCC has
not instituted such a proceeding. If adopted, such requirements could constrain
our ability to modify our rates, terms and conditions in response to competitive
market pressures.
Advanced Services
Section 706 of the 1996 Act requires the FCC to encourage the
deployment of advanced telecommunications capabilities to all Americans, and
Section 10 of the 1934 Act requires the FCC to forbear from applying regulation
where forbearance from regulation would be in the public interest. Several
incumbent local exchange companies have petitioned the FCC pursuant to these
provisions to modify or eliminate network unbundling obligations related to
these advanced services, or to forbear from imposing the FCC_s unbundling and
interconnection rules. In addition, incumbent local exchange companies have
filed similar petitions asking the FCC to bar competitive carriers like us from
billing and collecting interexchange carrier switched access charges when
providing service through the use of the local switching unbundled network
element. If any of these petitions for waiver or forbearance are approved by
action or inaction of the FCC, our access to critical unbundled network elements
could be thwarted, or our ability to collect switched access charges could be
forestalled, which could have a material adverse effect on our operations.
Universal Service
Section 254 of the 1934 Act and the FCC's implementing rules require
all communications carriers providing interstate or international communications
services to periodically contribute to the Universal Service Fund, or USF. The
USF supports four programs administered by the Universal Service Administrative
Company with oversight from the FCC: (i) communications and information services
for schools and libraries, (ii) communications and information services for
rural health care providers, (iii) basic telephone service in regions
characterized by high communications costs or low income levels, and (iv)
interstate common line support. Periodic USF contribution requirements currently
are measured and assessed based on the total subsidy funding needs and each
contributor's percentage of the total of certain interstate and international
end user communications revenues reported to the FCC by all communications
carriers. We measure and report our revenues in accordance with rules adopted by
the FCC. The contribution rate factors are calculated and revised quarterly and
we are billed for our contribution requirements each month based on projected
interstate and international end-user communications revenues, subject to
periodic true up.
USF contributions may be passed through to consumers on an equitable
and nondiscriminatory basis either as a component of the rate charged for
communications services or as a separately invoiced line item. Since April 1,
2003, communications carriers have been prohibited from using a separate line
item on invoices to identify, as a recovery of USF contributions, amounts that
exceed the rate of actual USF contributions.
A proceeding pending before the FCC has the potential to significantly
alter our USF contribution obligations. The FCC is considering changing the
basis upon which our USF contributions are determined from a revenue percentage
measurement to a connection or telephone number measurement. Adoption of this
proposal could have a material adverse affect on our costs, our ability to
separately list USF contributions on end-user bills and our ability to collect
these fees from our customers.
The application and effect of changes to the USF contribution
requirements and similar state requirements on the communications industry
generally and on certain of our business activities cannot be predicted. If our
collection procedures result in over-collection, we could be required to make
reimbursements of such over-collection and be subject to penalty, which could
have a material adverse affect on our business, financial condition and results
of operations. If a federal or state regulatory body determines that we have
incorrectly calculated or remitted any USF contribution, we could be subject to
the assessment and collection of past due remittances as well as interest and
penalties thereon. No such proceeding has been commenced at this time against
us.
12
Network Information
FCC rules protect the privacy of certain information about customers
that communications carriers, including us, acquire in the course of providing
communications services. Such protected information, known as Customer
Proprietary Network Information, or CPNI, includes information related to the
quantity, technological configuration, type, destination and the amount of use
of a communications service. The FCC's initial CPNI rules prevented a carrier
from using CPNI to market certain services without the express approval of the
affected customer, referred to as an opt-in approach. In July 2002, the FCC
revised its opt-in rules in a manner that limits our ability to use the CPNI of
our subscribers without first engaging in extensive customer service processes
and record keeping. Certain states have also adopted state-specific CPNI rules.
We use our subscribers' CPNI in accordance with applicable regulatory
requirements. However, if a federal or state regulatory body determines that we
have implemented those guidelines incorrectly, we could be subject to fines or
penalties. In addition, correcting our internal customer systems and CPNI
processes could generate significant administrative expenses.
Regulation of Internet Service Providers and VoIP
To date, the FCC has treated Internet service providers, or ISPs, as
enhanced service providers exempt from federal and state regulations governing
common carriers, including the obligation to pay access charges and contribute
to the USF. Nevertheless, regulations governing the disclosure of confidential
communications, copyright, excise tax and other requirements may apply to our
Internet access services. In addition, Congress has passed a number of laws that
concern the Internet and Internet users. Generally, these laws limit the
potential liability of ISPs and hosting companies that do not knowingly engage
in unlawful activity. Congress is actively considering a variety of Internet
regulation bills, some of which, if signed into law, could impose obligations on
us to monitor the Internet activities of our customers.
Where communications service providers have offered enhanced services
in addition to their communications services, the FCC and state public utility
commissions generally have exempted the enhanced service component and its
associated revenue from legacy communications regulations. Some of the services
we provide are enhanced services. Future and pending FCC and state proceedings
may significantly affect our future provision of enhanced services.
The use of the public Internet and private Internet protocol networks
to provide voice communications services, including voice-over-Internet
protocol, or VoIP, is a relatively recent market development. The provision of
such services is largely unregulated within the United States. In a 1998 Report
to Congress, the FCC declined to conclude that IP telephony services constitute
telecommunications services and stated that it would undertake a subsequent
examination of whether certain forms of phone-to-phone Internet telephony are
information services or telecommunications services. The FCC indicated that, in
the future, it would consider the extent to which phone-to-phone Internet
telephony providers could be considered telecommunications carriers such that
they could be subject to regulations governing traditional telephone companies.
The FCC also stated that, although it did not have a sufficient record upon
which to make a definitive ruling, the record suggested that, to the extent that
certain forms of phone-to-phone IP telephony appear to possess the same
characteristics as traditional communications services and to the extent the
providers of those services utilize circuit-switched access in the same manner
as interexchange carriers, the FCC may find it reasonable to require that IP
telephony providers pay charges similar to access charges. The FCC recognized,
however, that it should consider forbearing from imposing rules that would apply
to phone-to-phone Internet telephony providers if they were classified as
telecommunications carriers. To date, the FCC has not imposed regulatory
surcharges or traditional common carrier regulation upon providers of Internet
communications services.
Several pending FCC proceedings will affect the regulatory status of
Internet telephony. On February 12, 2004, the FCC adopted a notice of proposed
rulemaking to address, in a comprehensive manner, the future regulation of
services and applications making use of Internet protocol, including VoIP. In
the absence of federal legislation, we expect that through this IP-Enabled
Services proceeding the FCC will resolve certain regulatory issues relating to
VoIP services and develop a regulatory framework that is unique to IP telephony
providers or that subjects VoIP providers to minimal regulatory requirements. We
cannot predict when the FCC may take such actions. The FCC may determine that
certain types of Internet telephony should be regulated like basic interstate
communications services, rendering VoIP calls subject to the access charge
regime that permits local telephone companies to charge long distance carriers
for the use of the local telephone networks to originate and terminate
long-distance calls, generally on a per minute basis. The FCC also may conclude
that Internet telephony providers should contribute to the USF. The FCC's
pending review of intercarrier compensation policies (discussed above) also may
have an adverse impact on enhanced service providers.
13
In a series of decisions issued in 2004, the FCC clarified that the
FCC, not the state public utility commissions, has jurisdiction to decide the
regulatory status of certain IP-enabled services, including certain types of
VoIP. On November 12, 2004, in response to a request by Vonage Holdings Corp.
(Vonage), a VoIP services provider, the FCC issued an order preempting the
Minnesota PUC from imposing traditional telephone company regulation of VoIP
service, finding that the FCC alone could make such decisions because the
service cannot be separated into interstate and intrastate communications
without negating federal rules and policies. In September 2003, the Minnesota
PUC had issued an order requiring Vonage to comply with Minnesota laws that
regulate telephone companies. That order was appealed to the U.S. District Court
for the District of Minnesota, which issued a permanent injunction based on its
determination that federal communications law preempts the Minnesota PUC from
imposing state law common carrier telecommunications regulations on information
service providers such as Vonage. The Minnesota PUC appealed the judgment to the
U.S. Court of Appeals for the Eighth Circuit. While the appeal was pending, the
FCC issued its preemption order. In an order filed December 22, 2004, the Eighth
Circuit concluded that the intervening FCC preemption order was binding on the
court and could not be challenged in the litigation. On that basis, the Court of
Appeals affirmed the judgment of the district court, that the Minnesota PUC did
not have jurisdiction to regulate the provision of the Vonage services. Four
state commissions, including Minnesota, and the National Association of State
Utility Consumer Advocates (NASUCA) have asked federal appeals courts to
overturn the FCC's November 2004 order.
On October 18, 2002, AT&T filed a petition with the FCC seeking a
declaratory ruling that would prevent incumbent local exchange companies from
imposing traditional circuit-switched access charges on phone-to-phone IP
services. In April 2004, the FCC issued an order concluding that, under current
rules, AT&T's phone-to-phone IP telephony service is a telecommunications
service upon which interstate access charges may be assessed. AT&T's service
consists of an interexchange call initiated by an end user who dials 1 + the
called number from a regular telephone. When the call reaches AT&T's network,
AT&T converts it into an IP format and transports it over AT&T's Internet
backbone. AT&T then converts the call back from the IP format and delivers it to
the called party through local exchange carrier local business lines. This
decision is thus limited to interexchange service that: (1) uses ordinary
customer premises equipment with no enhanced functionality; (2) originates and
terminates on the public switched telephone network; and (3) undergoes no net
protocol conversion and provides no enhanced functionality to end users due to
the provider's use of IP technology. The FCC made no determination regarding
retroactive application of its ruling, and stated that the decision does not
preclude it from adopting a different approach when it resolves the IP-Enabled
Services or Intercarrier Compensation rulemaking proceedings.
On February 5, 2003, pulver.com filed a petition with the FCC seeking
a declaratory ruling that its Free World Dialup service, which facilitates
point-to-point broadband Internet protocol voice communications, is neither
telecommunications nor a telecommunications service as these terms are defined
in the 1934 Act. The FCC granted the pulver.com petition on February 12, 2004,
establishing that Free World Dialup is an information service, as defined in the
1934 Act. The FCC limited this finding to VoIP services that, like Free World
Dialup, exist solely as an Internet application, similar to electronic mail and
instant messaging, and which do not rely on the public switched telephone
network. Information services are subject to federal regulatory authority, but
may not be regulated by state authorities.
On February 23, 2005, the FCC denied a petition filed by AT&T
requesting that the FCC deem its enhanced prepaid calling card plan interstate
and informational in nature, and thus exempt from universal service and
intrastate access charge payments. The FCC ruled that the AT&T prepaid calling
cards at issue constituted "telecommunications service" that is subject to the
assessment of switched access charges and universal service fund assessments.
The FCC also requested further comment on whether other types of prepaid cards,
including those that provide callers the option to listen to information or are
transmitted using internet protocol technology, are also subject to switched
access charge and universal service fund assessment.
Other aspects of VoIP and Internet telephony services, such as
regulations relating to the confidentiality of data and communications,
copyright issues, taxation of services, licensing and 911 emergency access, may
be subject to federal or state regulation. For instance, in 2002 the FCC
undertook an examination of whether emergency 911 requirements should be
extended to packet-based networks and services. Similarly, changes in the legal
and regulatory environment relating to the Internet connectivity market,
including regulatory changes that affect communications costs or that may
increase the likelihood of competition from Regional Bell Operating Companies or
other communications companies could increase our costs of providing service.
Taxes and Regulatory Fees
We are subject to numerous local, state and federal taxes and
regulatory fees, including but not limited to a 3% Federal excise tax on
communications service, FCC regulatory fees and public utility commission
regulatory fees. We have procedures in place to ensure that we properly collect
taxes and fees from our customers and remit such taxes and fees to the
appropriate entity pursuant to applicable law and/or regulation. If our
collection procedures prove to be insufficient or if a taxing or regulatory
authority determines that our remittances were inadequate, we could be required
to make additional payments, which could have a material adverse effect on our
business.
On July 2, 2004, the Internal Revenue Service issued an advance notice
of proposed rulemaking asking for public comment on expanding the current 3%
excise tax to new communications services, such as VoIP and other IP-based
services, applications, and technologies, to reflect changes in technology. The
comment cycle ended September 30, 2004. We cannot predict the outcome of this
proceeding on our business.
14
State Regulation
The 1934 Act maintains the authority of individual states to impose
their own regulation of rates, terms and conditions of intrastate services, so
long as such regulation is not inconsistent with the requirements of federal
law. Because we provide communications services that originate and terminate
within individual states, including both local service and in-state long
distance toll calls, we are subject to the jurisdiction of the PUC and other
regulators in each state in which we provide such services. For instance, we
must obtain a Certificate of Public Convenience and Necessity or similar
authorization before we may commence the provision of communications services in
a state. We have obtained Certificates of Public Convenience and Necessity to
provide facilities-based or resold competitive local and interexchange service
in every state that we provide services. As our local service business expands,
we may offer additional intrastate services and may become subject to additional
state regulations.
In addition to requiring certification, state regulatory authorities
may impose tariff and filing requirements and obligations to contribute to state
universal service and other funds. State commissions also have jurisdiction to
approve negotiated rates, and to establish rates through arbitration for
interconnection, including rates for unbundled network elements.
We also are subject to state laws and regulations regarding slamming,
cramming and other consumer protection and disclosure regulations. These rules
could substantially increase the cost of doing business in any particular state.
State commissions have issued or proposed several substantial fines against
competitive local exchange companies for slamming or cramming. The risk of
financial damage from slamming, in the form of fines, penalties and legal fees
and costs, and to business reputation is significant. A slamming complaint
before a state commission could generate substantial litigation expenses. In
addition, state law enforcement authorities may use their consumer protection
authority against us if we fail to meet applicable state law requirements.
States also retain the right to sanction a service provider or to
revoke certification if a service provider violates relevant laws or
regulations. If any regulatory agency were to conclude that we are or were
providing intrastate services without the appropriate authority, the agency
could initiate enforcement actions, which could include the imposition of fines,
a requirement to disgorge revenues, or refusal to grant regulatory authority
necessary for the future provision of intrastate services.
We may be subject to requirements in some states to obtain prior
approval for, or notify the state commission of, any transfers of control, sales
of assets, corporate reorganizations, issuance of stock or debt instruments and
related transactions. Although we believe such authorizations could be obtained
in due course, there can be no assurance that state commissions would grant us
authority to complete any of these transactions, or that such authority would be
granted on a timely basis.
Rates for intrastate-switched access services, which we provide to
long-distance companies to originate and terminate in-state toll calls, are
subject to the jurisdiction of the state in which the call originated and /or
terminated. Such regulation by states could have a material adverse affect on
our revenues and business opportunities within that state. State public utility
commissions also regulate the rates incumbent local exchange companies charge
for interconnection of network elements with, and resale of services by,
competitors. In response to the USTA II decision and the FCC's ongoing TRO
proceedings, some state commissions have continued proceedings to address issues
affecting the rates, terms and conditions of intrastate services while other
states suspended or terminated their proceedings. Any such proceedings may
affect the rates, terms, and conditions contained in our interconnection
agreements. The pricing, terms and conditions under which the incumbent local
exchange company in each of the states in which we currently operate offers such
services may preclude our ability to offer a competitively viable and profitable
product within these and other states prospectively.
Some states are considering enactment of legislation that would
deregulate incumbent local exchange company broadband facilities and services.
If such legislation became law, it could prevent state regulators from requiring
that incumbent local exchange companies allow competitive carriers to
interconnect with critical facilities used to provide broadband services on
reasonable terms.
Federal and State Regulation of Marketing
Our current and past direct and partner marketing efforts all require
compliance with relevant federal and state regulations that govern the sale of
telecommunication services. The FCC and many states have rules that prohibit
switching a customer from one carrier to another without the customer's express
consent and specify how that consent must be obtained and verified. Most states
also have consumer protection laws that further define the framework within
which our marketing activities must be conducted. While directed at curbing
abusive marketing practices, the design and enforcement of these rules can have
the incidental effect of entrenching incumbent local exchange companies and
hindering the growth of new competitors, such as our business.
15
Our marketing efforts are carried out through a variety of marketing
programs, including referrals from existing customers, outbound telemarketing,
direct sales through independent agents, broadcast media, online marketing
initiatives and direct mail. Restrictions on the marketing of telecommunication
services are becoming stricter in the wake of widespread consumer complaints
throughout the industry about "slamming" (the unauthorized change of a
customer's service from one carrier to another carrier) and "cramming" (the
unauthorized provision of additional telecommunication services). The 1996 Act
strengthened penalties against slamming, and the FCC issued and updated rules
tightening federal requirements for the verification of orders for
telecommunication services and establishing additional financial penalties for
slamming. In addition, many states have been active in restricting marketing
through new legislation and regulation, as well as through enhanced enforcement
activities. On October 1, 2003, the FCC's rules and regulations governing the
creation and enforcement of national "do not call" databases became effective,
which has had the effect of reducing the total number of leads available to us
for outbound telemarketing (which is currently one of our important sales
channels) in a given market. On February 18, 2005, the FCC released new rules
that clarified certain aspects of the national "do not call" database.
Notwithstanding, we can still market to these leads through our other sales
channels, including direct mail. The constraints of federal and state
regulation, as well as increased FCC, Federal Trade Commission and state
enforcement attention, could limit the scope and the success of our marketing
efforts and subject them to enforcement actions, which may have an adverse
effect on us.
Statutes and regulations designed to protect consumer privacy also may
have the incidental effect of hindering the growth of newer telecommunication
carriers such as us. For example, the FCC rules that restrict the use of
"customer proprietary network information" (information that a carrier obtains
about its customers through their use of the carrier's services) may make it
more difficult for us to market additional telecommunication services (such as
local and wireless), as well as other services and products, to our existing
customers.
Other Domestic Regulation
We are subject to a variety of federal, state, and local
environmental, safety and health laws, and regulations governing matters such as
the generation, storage, handling, use, and transportation of hazardous
materials, the emission and discharge of hazardous materials into the
atmosphere, the emission of electromagnetic radiation, the protection of
wetlands, historic sites, and endangered species and the health and safety of
employees. We also may be subject to laws requiring the investigation and
cleanup of contamination at sites we own or operate or at third-party waste
disposal sites. Such laws often impose liability even if the owner or operator
did not know of, or was not responsible for, the contamination.
We operate several sites in connection with our operations. We are not
aware of any liability or alleged liability at any operated sites or third-party
waste disposal sites that would be expected to have a material adverse effect on
us. Although we monitor our compliance with environmental, safety and health
laws and regulations, we cannot give assurances that it has been or will be in
complete compliance with these laws and regulations. We may be subject to fines
or other sanctions by federal, state and local governmental authorities if we
fail to obtain required permits or violate applicable laws and regulations.
16
PERSONNEL
As of the April 1, 2005, Covista and its subsidiaries employed 162
full-time and part-time employees in its telecommunication business. Covista
also utilizes the services of approximately 1,000 independent sales agents.
Covista considers its relations with its employees and independent sales agents
to be satisfactory.
ITEM 2. Properties
On February 6, 1998, Covista entered into a lease for approximately
5,000 square feet of space at 28 W. Flagler Street, Miami, Florida, for use as a
switching facility. The term of the lease is 15 years, commencing February 1,
1998. The annual rental is approximately $116,160, with an annual adjustment
based on the Revised Urban Wage Earners and Clerical Workers Index, capped at a
maximum of 3% increase over the prior year's rental payment. In addition,
Covista is liable for its proportionate share of increases in real estate taxes
and operating expenses over the base year.
On September 1, 2001, Covista entered into a lease agreement for
approximately 28,000 square feet of office space in Chattanooga, Tennessee, with
Henry G. Luken III, Chairman of the Board, and a principal shareholder of
Covista. The original term of the lease was for five years and has been extended
for an additional five years. The lease provides for annual rent of $86,400 from
September 1, 2001 to August 30, 2002; $115,200 from September 1, 2002 to August
30, 2003; $144,000 from September 1, 2003 to August 30, 2004, with the last two
years to be $144,000 annually adjusted for the Consumer Price Index. Covista
believes that such premises are leased on terms not less favorable than an arm's
length transaction.
On December 1, 2001, Covista entered into a lease for property located
at 806 East Main Street, Chattanooga, Tennessee, for use as a switching
facility. The lessor is Henry G. Luken III, Chairman of the Board and a
principal shareholder of Covista. The lease expires on November 30, 2006. Annual
rent is payable as follows: $22,500 from December 1, 2001 to November 30, 2002,
$27,000 from December 1, 2002 to November 30, 2003, $31,500 from December 1,
2003 to November 30, 2004, and $36,000 from December 1, 2004 to November 30,
2005. Rental amounts for months beginning after October 1, 2005 will be adjusted
upward for the U.S. Consumer Price Index. The lease may be renewed for an
additional 5 years upon 90 days' written notice prior to the lease expiration
date. Covista believes that such premises are leased on terms not less favorable
than an arm's length transaction.
On December 15, 2001, Covista entered into a lease for Suite 1350,
1201 Main Street, Dallas, TX, for use as a switching facility and expires on
April 14, 2006. Annual rent is due as follows: $164,475 from April 15, 2000 to
April 14, 2002, $175,440 from April 15, 2002 to April 14, 2004, and $186,405
from April 15, 2004 to April 14, 2006. The lease has no provision for renewal.
On May 31, 2002, Covista entered into a lease for 2,900 useable (3,335
rentable) square feet at 511-11th Avenue South, Suite 312, Minneapolis,
Minnesota for use as a switching facility. The lease expires on May 31, 2009.
Annual rent is payable as follows: Year 1 = $86,376, Year 2 = $93,047, Year 3 =
$96,382, Year 4 = $99,717, Year 5 = $103,052, Year 6 = $106,387, and Year 7 =
$109,721. The lease may be renewed for an additional 5 years, upon 4 months'
written notice prior to the lease expiration date. Covista pays its
proportionate share of real estate taxes and utilities for the leased space.
On October 1, 2002, Covista entered into a lease for Suite 200 at 721
Broad Street, Chattanooga, Tennessee, for use as offices for Corporate
Headquarters. The lessor is Henry G. Luken III, Chairman of the Board and a
principal shareholder of Covista. The lease expires on November 30, 2007. Annual
rent is payable as follows: Year 1 = $101,674, Year 2 = $111,670, Year 3 =
$120,000, Year 4 = $120,000, Year 5 = $120,000. Rental amounts for months
beginning after October 1, 2005 will be adjusted upward for the U.S. Consumer
Price Index. The lease may be renewed for an additional 5 years upon 90 days'
written notice prior to the lease expiration date. Covista believes that such
premises are leased on terms not less favorable than an arm's length
transaction.
As a result of the PAETEC transaction, the Company assigned and
PAETEC assumed responsibility for certain property leases. These included
switching facilities located in New York and Philadelphia in addition to
office facilities in Paramus, NJ and Bensalem, PA.
ITEM 3. Pending Legal Proceedings
There are no pending legal proceedings, which could be expected to
have a material adverse effect on Covista.
ITEM 4. Submission of Matters to a Vote of Security Holders
A proxy statement dated September 24, 2004 and mailed to stockholders
on or about September 24, 2004 provided details on the election of six directors
to serve for a term of one year and until their successors were duly elected and
qualified; ratification of the selection of Deloitte & Touche LLP as independent
auditors of the Company for the fiscal year ending January 31, 2005; the
adoption of the Company's Audit Committee Charter; and the transaction of such
other business as properly came before the meeting or any adjournment or
postponement thereof. During the scheduled annual meeting of stockholders on
October 28, 2004, all of the foregoing matters were approved by the requisite
vote of stockholders of Covista.
17
PART II
ITEM 5. Market for Company's Common Stock and Related Security Holder Matters
Common Stock
Covista's authorized capital stock consists solely of 50,000,000
shares of Common Stock. Holders of Covista's Common Stock are entitled to
receive such dividends, if any, as may be declared from time to time by the
Board of Directors in its discretion from funds legally available therefore.
Each holder of Common Stock is entitled to one vote for each share held. There
is no right to cumulative voting. Upon liquidation, dissolution, or winding up
of Covista, the holders of Common Stock are entitled to receive a pro rata share
of all assets available for distribution to stockholders. The Common Stock has
no pre-emptive or other subscription rights, and there are no conversion or
redemption rights with respect to such shares.
As of the date of this report, there were 17,822,025 shares of Common
Stock issued and outstanding, held by approximately 860 persons.
Price Range of the Common Stock
Covista's Common Stock is traded on the NASDAQ National Market System
under the Symbol CVST. The following table sets forth, for the quarterly fiscal
periods indicated, the high and low closing sale prices for Covista's Common
Stock in such market, as reported by the National Association of Securities
Dealers, Inc.
FISCAL 2004 HIGH LOW
- ----------- ---- ----
February 1, 2003 thru April 30 $3.62 $1.75
May 1 thru July 31 $4.10 $1.82
August 1 thru October 31 $3.55 $2.60
November 1 thru January 31, 2004 $4.00 $2.21
FISCAL 2005 HIGH LOW
- ----------- ---- ----
February 1, 2004 thru April 30 $3.55 $2.80
May 1 thru July 31 $3.15 $2.26
August 1 thru October 31 $2.43 $1.62
November 1 thru January 31, 2005 $2.30 $1.55
Covista has not paid or declared any cash dividends during the past two fiscal
years and does not anticipate paying any in the foreseeable future.
18
Compensation Plans and Securities
The following table sets forth certain information as of January 31,
2005 with respect to compensation plans under which equity securities of the
Company are authorized for issuance:
Number of Securities
Number of Securities to Weighted-Average Remaining Available for
be Issued Upon Exercise Exercise Price of Future Issuance Under
of Outstanding Options, Outstanding Options, Equity Compensation
Plan Category Warrants and Rights Warrants and Rights Plans (1)
- -------------------------------------- ----------------------- -------------------- -----------------------
Equity compensation plans approved by
security holders 1,391,958 $2.90 1,257,100
Equity compensation plans not approved
by security holders -- -- --
--------- ----- ---------
Total 1,391,958 $2.90 1,257,100
(1) Under all plans, if any shares subject to a previous award are forfeited,
or if any award is terminated without issuance of shares or satisfied with
other consideration, the shares subject to such award shall again be
available for future grants.
19
ITEM 6. Selected Financial Data
The following selected consolidated statement of operations data,
balance sheet data, and cash flow data as of and for the years ended January 31,
2005, 2004, 2003, 2002, and 2001 have been derived from our audited consolidated
financial statements. The selected consolidated financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and our consolidated financial statements and the
notes hereto.
(In thousands except per share amounts)
Year ended January 31,
---------------------------------------------------
2005 2004 2003 2002 2001
------- ------- -------- -------- --------
RESULTS OF OPERATIONS:
Net Revenues $59,840 $84,056 $100,960 $ 95,313 $133,230
Net Loss $(5,333) $ (944) $ (9,407) $(11,970) $ (8,629)
Weighted average common shares outstanding:
Basic 17,822 17,796 13,283 10,204 7,324
Diluted 17,822 17,796 13,283 10,204 7,324
Loss per common and equivalent shares:
Basic loss per share $ (.30) $ (.05) $ (0.71) $ (1.17) $ (1.18)
Diluted loss per share $ (.30) $ (.05) $ (0.71) $ (1.17) $ (1.18)
Cash dividends per common share None None None None None
Additions to property and equipment $ 242 $ 277 $ 4,943(b) $ 5,465 $ 3,227
Depreciation and amortization $ 3,552 $ 5,932 $ 7,442 $ 4,569 $ 3,578
FINANCIAL POSITION:
Working Capital $ 4,538 $(6,088) $ (9,536) $(11,327) $ (7,734)
Property and equipment-net $ 6,082 $11,654 $ 15,150 $ 12,490 $ 13,021
Total assets $27,231 $40,887 $ 51,050 $ 31,257 $ 39,097
Long-term debt $ 0 $ 573 $ 1,811 $ 4,400(a) $ 382
Shareholders' Equity $13,514 $18,833 $ 19,693 $ 1,569 $ 5,777
Common shares outstanding 17,822 17,817 17,783 10,849 7,969
(a) $4,400,000 consists of a loan from Covista's Chairman of the Board, which
was converted to equity in Fiscal 2003 (see ITEM 13).
(b) Includes $3,400,000 of property contribution from Covista's Chairman of the
Board (see ITEM 13).
20
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion is presented to assist in assessing the
changes in financial condition and performance of Covista for the fiscal years
ended January 31, 2003 (Fiscal 2003), January 31, 2004 (Fiscal 2004) and January
31, 2005 (Fiscal 2005). The following information should be read in conjunction
with the financial statements and related notes and other detailed information
regarding Covista included elsewhere in this report.
Special Note Regarding 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, "believes," "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"
"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.
21
RESULTS OF OPERATIONS
FISCAL 2005 AS COMPARED TO FISCAL 2004
Revenues
The Company sells telecommunication services to three distinct
segments: a residential segment targeting residential users, a retail segment
consisting primarily of small to medium size businesses and a wholesale segment
with sales to other telecommunications carriers.
Net sales of telecommunications services for the fiscal year ended
January 31, 2005 were approximately $59,840,000, a decrease of approximately
$24,216,000 or 29% from the approximately $84,056,000 of net sales in Fiscal
2004. These revenues were comprised of retail sales of approximately
$33,639,000, residential revenue of approximately $23,017,000 and wholesale
revenue of approximately $3,184,000. Covista billed approximately 926 million
minutes in Fiscal 2005 as compared to approximately 1.27 billion minutes in
Fiscal 2004, a decrease of 345 million minutes or 27%. The overall decrease is
primarily related to the sale of certain retail customers to PAETEC as further
discussed below and intense competitive pressure in the retail segment.
Net retail sales for Fiscal 2005 were approximately $33,639,000, a
decrease of approximately $28,781,000, or 46% from the approximately $62,420,000
billed in Fiscal 2004. Current year retail sales includes approximately
$1,452,000 of local service revenue versus approximately $50,000 of local
service revenue in the prior year. Retail billed minutes were approximately 490
million, a decrease of approximately 426 million minutes or 46%, versus the
retail minutes of approximately 917 million billed in Fiscal 2004. The average
blended price per minute of $.067 decreased approximately 1.5% versus the prior
year blended average rate per minute of $.068 as the industry continues to
experience decreased price per minute of usage. Covista does not foresee that
this trend in pricing will abate in the near future. The current year sales
decrease in the retail segment is primarily attributed to the Company's sale of
a major portion of its retail customer base to PAETEC, in addition to the
intense competitive pressure from other providers, especially those which have
the ability to bundle local dial tone with traditional long distance offerings.
The Company does not foresee this intensely competitive climate relaxing in the
near future. The Company plans to continue to support its remaining retail
channel by expanding its competitive local and long distance product offering in
selected markets, primarily in the Southeast.
Net residential sales for Fiscal 2005 were approximately $23,017,000
for the year, an increase of approximately $5,756,000 or 33% from the
approximately $17,261,000 billed in fiscal 2004. The Company expanded its local
service revenue during the current fiscal year. Residential sales for Fiscal
2005 includes approximately $9,028,000 of local service revenue versus
approximately $477,000 of local service revenue in the prior fiscal year.
Residential billed minutes for Fiscal 2005 were approximately 295 million, a
decrease of approximately 1 million minutes or 0.3% from the approximately 296
million billed in the previous year. The average blended price per minute of
$0.047 decreased approximately 17.5% versus the prior year blended average rate
per minute of $0.057 as the industry continues to experience decreased prices
per minute of usage. Covista does not foresee that this trend in pricing will
abate in the near future. The current year sales increase in the residential
segment is primarily attributed the successful expansion of local service to
these residential users in selected markets, in addition to direct marketing via
mail and web based affinity marketing campaigns. While the Company has launched
local services to the residential segment in certain markets, the Company plans
to expand the number of markets in which it has the ability to offer its local
and long distance bundled product offering. Additionally, the Company plans to
expand its marketing resources to target new geographic market areas where the
Company has the ability to offer competitive bundled services to residential
users. These efforts will be accomplished in conjunction with maintaining the
support required for the retail segment.
Net wholesale (carrier) sales for Fiscal 2005 were approximately
$3,184,000, a decrease of approximately $1,192,000 or 27% from the approximately
$4,376,000 billed in Fiscal 2004. Fiscal 2005 wholesale revenue includes
approximately $607,000 of access charges billed to other long distance carriers,
which terminate calls to the Company's local customers. The Company did not
record access billing in the previous year since it had an insignificant number
of local customers in the prior year. Billed wholesale minutes amounted to
approximately 142 million, an increase of approximately 84 million minutes or
145% from the billed wholesale minutes of approximately 58 million billed in
Fiscal 2004 as the minute mix shifted to a greater share of domestic versus
international termination. The Company plans to maintain nominal wholesale
volume in the future, based on network capacity and gross margin opportunities
while balancing any possible financial exposure related to un-collectable
balances.
22
Cost of Revenue
Cost of revenue for Fiscal 2005 was approximately $32,833,000, a
decrease of approximately $14,506,000 or 31% from the approximately $47,339,000
recorded in Fiscal 2003. The decrease in cost of revenue was favorable in
relationship to the overall revenue decrease of 29% discussed previously.
In the normal course of business, billings for line costs are often
not received until after the period of service, Covista, therefore, uses certain
estimates to determine its monthly cost of revenue ("line cost") and
corresponding accounts payable to these service providers. These line costs
include fees for network transport, access, egress and facility charges. The
Company completes a detailed bill audit function, which includes a comparison of
invoices received to amounts accrued, contractual rates and applicable tariffs
and engineering data regarding usage. Accrued amounts are adjusted based on the
bill audit function and actual invoices received. These adjustments to actual
expense are typically identified within 90 days following the period of
estimate.
We structure and price our products in order to maintain network and
line costs as a percentage of revenue at certain targeted levels. There are
several factors that could cause our network and line costs as a percentage of
revenue to increase in the future, including without limitation:
Determinations by the FCC, courts or state commission(s) that make
unbundled local switching and/or combinations of unbundled network elements
effectively unavailable to us in some or all of our geographic service areas,
requiring us to provide services in these areas through other means, including
local service resale agreements with incumbent local telephone companies,
network elements purchased from the Regional Bell Operating Companies at "just
and reasonable" rates under Section 271 of the Act and the switching facilities
of other non-incumbent carriers, in any case, at significantly increased costs
or to provide services over our own switching facilities, if we were able to
deploy them.
Selling, General and Administrative
Selling, general and administrative (SG&A) expenses are comprised of
selling and marketing costs, and general and administrative costs. SG&A expenses
for Fiscal 2005 were approximately $27,049,000, a decrease of approximately
$4,354,000 or 14% versus approximately $31,403,000 in the previous year. The
overall decrease was primarily due to an overall decrease in payroll related
costs of approximately $1,840,000; a decrease in commission expense as a result
of lower retail revenue of approximately $3,956,000; increased marketing
expenses related to the residential segment for the launch of local services of
approximately $2,008,000; and general decreases in other categories of
approximately $566,000.
Loss on Disposal of Assets and Restructuring Expense
As a result of the PAETEC transaction, the Company recorded a pre-tax
charge of approximately $696,000. In addition, the Company recorded a pre-tax
restructuring charge of approximately $376,000 during the year related to
employee severance and other costs associated with the consolidation of back
office functions and other management initiatives.
Depreciation and Amortization
Depreciation and amortization was approximately $3,552,000 for Fiscal
2005. The decrease of approximately $2,379,000 is primarily due to the sale of
selected assets to PAETEC and the result of certain intangible assets becoming
fully amortized between years.
Other Income and Expense
Total other income (expense) for Fiscal 2005 was approximately
($487,000), representing an increase of approximately $159,000 versus
approximately ($328,000) of expense from previous fiscal year. The largest
component of other income (expense) is early retirement of debt. As a result of
the PAETEC transaction, the Company terminated and paid its revolving credit
facility with Capital Source Finance, LLC. The Company recorded an early
termination expense of approximately $307,000 related to this payoff.
Stock Compensation Expense
There was no stock compensation expense recorded for the Fiscal years
ended January 31, 2005 and 2004.
Income Tax
The Company recorded a tax provision of approximately $180,000 for the
year ended 2005. The provision results from the Alternative Minimum Tax due to
utilization of net operating loss carryforwards from the PAETEC transaction. No
income tax was realized for the year ended January 31, 2004. The Company
continues to provide a full valuation allowance against its net operating loss
carryforwards due to uncertainty of realization.
Net Loss
For the reasons set forth above, the net loss for Fiscal 2005 of
approximately $5,333,000 represents an increase in net loss of approximately
$4,389,000 over the net loss of approximately $944,000 reported in Fiscal 2004.
23
RESULTS OF OPERATIONS
FISCAL 2004 AS COMPARED TO FISCAL 2003
Revenues
Net sales of telecommunications services for the fiscal year ended
January 31, 2004 were approximately $84,056,000, a decrease of approximately
$16,904,000 or 17% from the approximately $100,960,000 of net sales in Fiscal
2003. These revenues were comprised of retail sales of approximately
$62,420,000, residential revenue of approximately $17,260,000 and wholesale
revenue of approximately $4,376,000. Covista billed approximately 1,270,875,338
minutes in Fiscal 2004 as compared to approximately 1,453,124,000 minutes in
Fiscal 2003, a decrease of 182,248,662 minutes or 13%. The overall decrease is
primarily related to intense competitive pressure in the retail segment combined
with planned reductions in wholesale revenue, as discussed in further details
below.
Net retail sales for Fiscal 2004 were approximately $62,420,000, a
decrease of approximately $13,035,000, or 17% from the approximately $75,455,000
billed in Fiscal 2003. Retail billed minutes were approximately 916,532,000, a
decrease of approximately 170,763,000 minutes or 16%, versus the retail minutes
of approximately 1,087,295,000 billed in Fiscal 2003. The average blended price
per minute of $.0681 decreased approximately 1.9% versus the prior year blended
average rate per minute of $.0694 as the industry continues to experience
decreased price per minute of usage. Covista does not foresee that this trend in
pricing will abate in the near future. The current year decrease in the retail
segment is primarily attributed to intense competitive pressure from other
providers, especially those which have the ability to bundle local dial tone
with traditional long distance offerings. While the Company has recently
launched local services to the retail segment in certain markets, the Company
has experienced significant loss of former retail customers that have taken
advantage of competitive providers bundled service offerings. The Company does
not foresee this intensely competitive climate relaxing in the near future. The
Company plans to continue to support the retail channel by expanding its
competitive local and long distance product offering across multiple markets as
well as launching a competitive "win back" program.
Net residential sales for Fiscal 2004 were approximately $17,261,000
for the year, an increase of approximately $4,271,000 or 33% from the
approximately $12,990,000 billed in fiscal 2003. The Company launched local
services, bundled together with long distance, into the residential segment
during the current fiscal year. Net residential sales for Fiscal 2004 includes
approximately $658,000 of bundled local service revenue. Residential billed
minutes for Fiscal 2004 were approximately 296,102,000, an increase of
approximately 100,070,000 minutes or 51% from the approximately 196,032,000
billed in the previous year. The average blended price per minute of $.0561
decreased approximately 15.4% versus the prior year blended average rate per
minute of $.0663 as the industry continues to experience decreased prices per
minute of usage. Covista does not foresee that this trend in pricing will abate
in the near future. The current year increase in the residential segment is
primarily attributed the successful launch of local service to these residential
users in selected markets in addition to direct marketing via mail and web based
affinity marketing campaigns. While the Company has launched local services to
the residential segment in certain markets, the Company plans to expand the
number of markets in which it has the ability to offer its local and long
distance bundled product offering. Additionally, the Company plans to expand its
marketing resources to target new geographic market areas where the Company has
the ability to offer competitive bundled services to residential users. These
efforts will be accomplished in conjunction with maintaining the support
required for the retail segment.
Net wholesale (carrier) sales for Fiscal 2004 were approximately
$4,376,000, a decrease of approximately $8,138,000 or 65% from the approximately
$12,514,000 billed in Fiscal 2003. Billed wholesale minutes amounted to
approximately 58,241,000, a decrease of approximately 111,556,000 minutes or 66%
from the billed wholesale minutes of approximately 169,797,000 billed in Fiscal
2003. As previously stated, the Company continues its planned efforts to reduce
volume in the wholesale segment. The Company plans to maintain nominal wholesale
volume in the future, based on network capacity and gross margin opportunities,
while balancing any possible financial exposure related to un-collectable
balances.
Cost of Revenue
Cost of revenue for Fiscal 2004 was approximately $47,339,000, a
decrease of approximately $15,131,000 or 24% from the approximately $62,470,000
recorded in Fiscal 2003. The decrease in cost of revenue was favorable in
relationship to the overall revenue decrease of 17% discussed previously. The
decrease in cost of revenue is primarily a result of the decrease in lower
margin wholesale volume of approximately $7,324,000 and the combined overall
decline in retail and residential volume of approximately $5,445,000. In
addition, the Company has improved its purchasing and line cost auditing
functions. These improvements have allowed the Company to generate an additional
savings of approximately $2,363,000 versus the prior year as a result of overall
rate reductions and improved auditing and dispute resolution capabilities.
In the normal course of business, billings for telco line costs are
often not received until after the period of service, Covista therefore uses
certain estimates to determine its monthly cost of revenue ("line cost") and
corresponding accounts payable to these service providers. These line costs
include fees for network transport, access, egress and facility charges. The
Company completes a detailed bill audit function, which includes a comparison of