Back to GetFilings.com
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-K
(Mark
One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2000
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Transition period from to
Commission File No. 333-49397
----------------
FOCAL COMMUNICATIONS CORPORATION
(Exact name of registrant as specified in its charter)
----------------
Delaware 36-4167094
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
200 North LaSalle Street,
Suite 1100, Chicago, Illinois 60601
(Address of principal executive (Zip Code)
offices)
Registrant's telephone number, including area code: (312) 895-8400
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference on Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
Based on the closing sales price on the Nasdaq National Market on February
28, 2001 of $12.8125, the aggregate market value of our voting stock held by
non-affiliates on such date was approximately $382,153,082. Shares of common
stock held by each director and executive officer and by each person who owns
or may be deemed to own 10% or more of our outstanding common stock have been
excluded, since such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive
determination for other purposes. As of that date, Focal Communications
Corporation had 61,537,117 shares of common stock issued and outstanding.
Documents Incorporated by Reference: None.
Index of Exhibits is located on page 50.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
We make statements in this Annual Report on Form 10-K that are not
historical facts. These "forward-looking statements" can be identified by the
use of terminology such as "believes," "expects," "may," "will," "should" or
"anticipates" or comparable terminology. These forward-looking statements
include, among others, statements concerning:
. Our business strategy and competitive advantages
. Our anticipation of potential revenues from designated markets or
customers
. Statements regarding the growth of the telecommunications industry and
our business
. The markets for our services and products
. Forecasts of when we will enter particular markets or begin offering
particular services
. Our anticipated capital expenditures and funding requirements
. Anticipated regulatory developments
These statements are only predictions. You should be aware that these
forward-looking statements are subject to risks and uncertainties, including
financial and regulatory developments and industry growth and trend
projections, that could cause actual events or results to differ materially
from those expressed or implied by the statements. The most important factors
that could prevent us from achieving our stated goals include, but are not
limited to, our failure to:
. Successfully expand our operations into new geographic markets on a
timely and cost-effective basis
. Successfully introduce and expand our data and voice service offerings on
a timely and cost-effective basis
. Design and install our Internet services infrastructure
. Respond to competitors in our existing and planned markets
. Execute and renew interconnection agreements with incumbent carriers on
terms satisfactory to us
. Enter into and maintain our agreements for transport facilities and
services, including Internet transit services
. Maintain acceptance of our services by new and existing customers
. Receive full and timely payments from customers
. Attract and retain talented employees
. Prevail in legal and regulatory proceedings regarding reciprocal
compensation for Internet-related calls or changes to laws and
regulations that govern reciprocal compensation
. Obtain and maintain any required governmental authorizations, franchises
and permits, all in a timely manner, at reasonable costs and on
satisfactory terms and conditions
. Respond effectively to regulatory, legislative and judicial developments,
including developments relating to reciprocal compensation
. Manage administrative, technical and operational issues presented by our
expansion plans
. Raise sufficient capital on acceptable terms and on a timely basis
. Successfully provision digital subscriber line, or DSL services
2
PART I
ITEM 1. BUSINESS
Except as otherwise required by the context, references in this report to
the "Company," "Focal," "we," "us," or "our" refer to the combined business of
Focal Communications Corporation and all of its subsidiaries. Unless otherwise
indicated, the information in this Annual Report on Form 10-K gives effect to
a recapitalization pursuant to which our Class A common stock, Class B common
stock and Class C common stock were converted into a single class of common
stock and a 500-for-1 stock split. Both the recapitalization and the stock
split were effected on July 30, 1999.
This report contains trademarks of Focal, and may contain trademarks,
tradenames and service marks of other parties.
Introduction
We are a national broadband communications provider that offers voice,
data, and Internet infrastructure services to large communications-intensive
users in major cities. We began operations in 1996, initiated service first in
May 1997 and as of December 31, 2000 offered services in the following 20
markets:
Atlanta Houston Orange County, California
Boston Los Angeles Philadelphia
Chicago Minneapolis San Francisco
Cleveland New York San Jose
Dallas Northern New Jersey Seattle
Detroit Northern Virginia Washington, D.C.
Fort Worth Oakland
As part of our expansion, we plan to offer services in four additional
markets in 2001.
When we complete our expansion, the 24 markets in service will encompass a
total of 56 metropolitan statistical areas. As of December 31, 2000, we had
435,272 lines installed and in service. This compares to 181,103 lines
installed and in service as of December 31, 1999.
Our primary objective is to become the provider of choice to
communications-intensive customers in our target markets for voice, data and
Internet infrastructure services. Our sales and marketing efforts principally
target Fortune 1000 companies and we had successfully penetrated approximately
40% of the Fortune 100 as of December 31, 2000. We also provide services to
many of the leading network service providers in the nation.
We compete primarily on diversity, reliability, service, and price. Our
primary competition is the Incumbent Local Exchange Carrier ("ILEC").
Our customers tend to be the largest, most sophisticated communications
users in the country. We meet their demanding needs through our unique network
architecture, the experience of our operations team, and our award winning
back office systems. The superior performance of our network stems, in part,
to our extensive interconnections with the ILEC in each of our markets. As of
December 31, 2000, we had approximately 2,000 interconnections points. Our
customers recognize the advantages of this design in assuring them the high
throughput they need.
Most of our revenue is derived from the provision of switched voice and
data services. Our customers have also asked for Internet access services that
are as reliable as our local dial tone. To meet this demand, we launched a
suite of services in 2000 based on a high speed Internet switching platform
called the Focal Internet eXchange. These services take advantage of our
current infrastructure and customer base to provide dedicated Internet access,
colocation and private peering. These services are primarily targeted to both
corporate accounts and network service providers.
We believe we were the first communications provider to employ the "smart-
build" approach to network design. As such, we own and operate our switches,
and initially lease, rather than own, transport capacity. As our customer
traffic increases, it becomes economically attractive to own transport
capacity in select markets. Accordingly, we signed agreements to acquire 9,730
local fiber transport miles in nine cities as of December 31, 2000. To support
our service offerings, we have also leased approximately 23,000 DS-3 miles of
long haul fiber transport capacity connecting each of our markets. Using these
facilities, we are developing a nationwide ATM network to carry voice and data
traffic.
3
Market Potential
We believe communications-intensive users in large metropolitan markets are
not adequately supplied with highly reliable, local voice and data services. We
also believe that these types of users will increasingly demand diversity in
communications providers. As a result, we have chosen to initially do business
only in large metropolitan markets with a high concentration of communications-
intensive customers. We select our target geographical markets using several
criteria:
. Sufficient market size
. Supportive state regulatory environment
. The existence of multiple fiber transport providers with extensive
networks
We currently offer circuit-switched voice and data services, packet-switched
data services, and high-speed Internet services. We believe the market
potential in our target markets for these services is substantial.
The table below summarizes estimates from our market study regarding our
current and planned markets. You should be aware that, with the exception of
the "Operational Markets," the launch period shown in the second column is our
current estimate of when we will begin providing services in our planned
markets. These estimates are subject to change based upon numerous factors,
including timely performance by third party suppliers and receipt of required
regulatory approvals. You should also be aware that the markets targeted for
launch in 2001 are preliminary and each may be replaced by other markets.
Estimated Addressable
2000 Market Data(1)
---------------------
Number of Business
and Residential
Launch Period Switched Access Lines
------------------- ---------------------
(in thousands)
Operational Markets:
Chicago, IL........................... May 1997 5,762
New York, NY.......................... January 1998 8,063
Philadelphia, PA...................... September 1998 2,795
San Francisco, CA..................... September 1998 1,631
San Jose, CA.......................... September 1998 1,359
Oakland, CA........................... September 1998 1,880
Washington, D.C....................... December 1998 4,257(2)
Northern Virginia, VA................. December 1998 --
Los Angeles, CA....................... December 1998 6,281
Orange County, CA..................... December 1998 4,131
Northern New Jersey................... January 1999 4,804
Boston, MA............................ January 1999 4,300
Detroit, MI........................... June 1999 3,553
Seattle, WA........................... September 1999 2,272
Dallas, TX............................ December 1999 2,238
Fort Worth, TX........................ December 1999 998
Atlanta, GA........................... First Quarter 2000 2,513
Houston, TX........................... First Quarter 2000 2,927
Cleveland, OH......................... Second Quarter 2000 1,808
Minneapolis, MN....................... Third Quarter 2000 1,700
------
Planned Markets:
Baltimore, MD......................... First Quarter 2001 1,733
San Diego, CA......................... Second Quarter 2001 1,861
Miami, FL............................. Second Quarter 2001 3,048
St. Louis, MO......................... Third Quarter 2001 1,745
------
Total:.............................. 71,659
======
- --------
(1) This addressable market data does not include information for non-switched
data and voice services.
(2) Data for Northern Virginia are included in the data for Washington, D.C.
4
Strategy
Our objective is to become the provider of choice for broadband voice and
data services to communication intensive users in our target markets. Our
customer base already includes many leading companies such as:
Akamai Genuity Motorola Sony
Compuserve IBM Nortel Networks United
Earthlink Kraft Sears Stationers
Wyeth
In total, Focal served approximately 40% of the Fortune 100 as of December
31, 2000.
We believe that our success is based on our superior network reliability,
customer service, and sales force among other factors. The majority of our
sales people bring significant industry experience and long standing customer
relationships to the Company. Our back office support systems have won
numerous awards including CIO Magazine's Top 100, which recognizes the
companies with the leading information systems in the country.
Perhaps the best measure of customer satisfaction is our exceptional
customer loyalty. We have had virtually zero customer related churn during the
past several years. In fact, sales to the "same customer" grew by over 50% on
a year over year basis. We also added a significant number of new customers
during 2000 with the number of Telecom customers growing from 495 at the
beginning of 2000 to 1,225 at the end of the year.
Our primary source of competition is the ILEC usually a Regional Bell
Operating Company ("RBOC"). In addition to the above strengths, we also
differentiate Focal from the competition by offering customers the ability to
manage their local service on a national basis much like they do their long
distance services. Despite our success, we still have a very low share of the
local telecommunications market in the cities we serve, providing us with
significant growth opportunities for the future.
Develop New Markets, Expand Geographic Coverage
Our six most established markets, accounted for 68% of our installed lines
and 75% of our revenue for the three months ended December 31, 2000. This
means that the remaining 14 markets, 70% of our current markets, have
tremendous growth potential as they develop and perform more like our older
markets. In addition to developing these more recent markets, Focal plans to
expand into four new Tier 1 markets in 2001. This will bring our total markets
served to 24 and our metropolitan statistical areas served to 56. Our first
customers in a new market are usually existing customers that we serve in
other locations.
Expand Service Offerings
We have responded to our customers' requests for additional services by
offering new services that build on and leverage our existing infrastructure.
This strategy reduces our start-up costs and required capital investment. The
best example of this strategy is our high speed Internet access services based
on the Focal Internet eXchange which was launched in September of 2000. This
suite of services includes dedicated Internet access, colocation, private
peering, and managed modems. As a result of our network architecture, our
Internet access service provides measurably better performance than
competitive offerings. We believe our strong presence in both the corporate
and network services markets makes us a natural aggregation point for content
providers, aggregators, and end-users.
Design a Capital-Efficient Network
By utilizing the "smart-build" approach to network design we believe we
have optimized our return on invested capital. We do this by initially
leasing, rather than owning, fiber capacity, concentrating our capital
expenditures on switching facilities and information systems and acquiring
fiber transport capacity as the volume and demands of our customer traffic
warrants. Because of increased customer traffic volume in some of our
5
markets, we began acquiring our own fiber transport capacity in 1999. By
continuing to use the "smart-build" approach to network and service
deployment, we expect to reduce the time and money required to launch new
markets and services, minimize the financial risk associated with
underutilized networks and generate revenue and cash flow more quickly. We
employ this same strategy for our suite of data services.
Maximize Network Utilization
We supplement our direct sales efforts with indirect sales to maximize the
utilization of our network assets and systems infrastructure. To achieve this
goal we actively utilize our VAR distribution channel. We provide services to
VARs, such as managers of multi-dwelling units and companies that market
bundled communications services to small- and medium-sized businesses. This
enables us to increase the number of access lines served by our networks,
driving network utilization. We also intend to pursue ways to maximize
utilization rates for our Internet backbone. For example, we plan to sell
unused upstream capacity to network service providers, content providers and
application service providers as a way to maximize the utilization and
efficiency of our network.
Networks
We utilize Nortel DMS-500 SuperNode digital central office switches for our
existing markets, and currently plan to deploy similar switches in our
additional markets. As we add customers in a market, it has generally been
most cost-effective for us to use leased fiber transport capacity to connect
our customers to our network. We have initially leased local network trunking
facilities from the ILECs and metropolitan network providers in each of our
markets in order to connect our switches to major ILEC central offices serving
the central business district and outlying areas of business concentrations.
Given the large volume of traffic that we generally carry, we are able to
negotiate favorable transport rates and still offer our customers redundancy
and diversity. In addition, we have designed our networks to maximize call
completion and significantly reduce the likelihood of blocked calls, which
helps us satisfy the needs of our high-volume customers. This "smart-build"
approach is possible because there are multiple vendors of local fiber
transport facilities in each of our large metropolitan markets, both current
and planned. Our switch-based, leased transport network architecture has
allowed us to:
. Reduce the time and money required to launch a new market
. Minimize financial risk associated with under-utilized networks
. Generate revenue and cash flow more quickly
We believe that the quantity of existing and planned fiber transport
facilities available from numerous carriers will be sufficient to satisfy our
need for local leased transport facilities and permit us to obtain these
facilities at competitive prices for the foreseeable future. The fiber
transport providers in our current and planned markets compete with each other
for our business in order to maximize the return on their fixed-asset
networks, which enables us to obtain competitive pricing. In addition, because
each of our fiber transport capacity providers is a common carrier, they are
required to make their transport services available to us on terms no less
favorable than those provided to similar customers.
We own a portion of our local transport capacity because of increased
volumes of customer traffic between our switches and specific ILEC central
offices in some of our markets. We are a party to agreements for the
acquisition of local fiber transport capacity covering a combined minimum of
10,800 fiber miles. As of December 31, 2000, we had activated our transport
network in nine cities, comprising 9,730 fiber miles.
We have also employed a "smart-build" approach in developing our inter-city
strategy. Initially, we resold long distance transmission service by buying
minutes on a wholesale basis. We currently lease fiber optic transport
capacity connecting our switches between each of our existing and planned
markets that transports our calls from market to market over our own network
and terminates the calls either directly at our customer's location or at the
ILEC switch. For international calls, we have negotiated agreements with
various international carriers for termination of our international calls
throughout the world.
6
To implement our inter-city network, we have signed agreements with a
number of carriers under which we have leased approximately 23,000 DS-3 miles
of transport capacity connecting each of our existing and planned markets.
This inter-city, DS-3 backbone network will initially be based on time
division multiplexing technology and then we will transition the inter-city
backbone to ATM technology. We believe the use of ATM switches will provide
greater flexibility in creating and managing both data and voice services over
the same physical network. We are currently able to price inter-city calls
that remain on our network as if they were local calls--a service we call
FocaLINC.
We are a party to a three year private line service agreement with MCI
WorldCom providing for the lease of fiber transport capacity that will be used
to connect our existing and planned markets. Under this agreement, we have
agreed to pay total charges of at least $70 million for private line services,
including existing private lines used within our markets to provide local
service.
In order to support high-speed access to corporate LANs, we began in 1999
to deploy DSL technology in our key markets. We have obtained colocation space
from the ILECs and we are installing DSL access multiplexers, or DSLAMs, in
colocation cages in ILEC central offices located in densely populated regions.
We had 292 ILEC central office colocations in service or under development as
of December 31, 2000. Once installed, the DSLAMs terminate into an ATM switch,
which transports high-speed data from end-users to Focal's corporate
customers. These customers then manage the flow of this traffic onto their
corporate LANs.
In connection with our data services, which include managed high-speed
Internet access, colocation and peering services, we:
. Built a new Internet platform, called a Focal Internet eXchange. Each
Focal Internet eXchange consists of a state-of-the art, fully-redundant,
powerful Internet routing and switching infrastructure that enables us
to provide high quality Internet access services to our customers. The
local facilities are monitored by a centralized data network operations
center, staffed 24 hours a day, seven days a week, and supported by
trained technical resources in the field.
. Purchased transit services from multiple Tier-1 backbone providers in
each of our markets. The transit services terminate in routers in our
Focal Internet eXchanges, giving our customers direct access to multiple
Internet backbones and allowing them to bypass congested, public
interconnection points.
Products and Services
Voice Services
Inbound Services. Our basic, inbound service allows for the completion of
calls to a new phone number we supply to our customer. Alternatively, local
number portability, or LNP, allows us to provide inbound services using a
customer's existing phone number. While LNP is occasionally unavailable and
cumbersome to implement, it permits us to serve customers without altering
their existing phone numbers. Consequently, we expect LNP to become
increasingly useful to us in taking existing business from our primary
competitors, the ILECs.
Direct inward dial service allows inbound calls to reach a particular
station on a customer's phone system without operator intervention. We market
direct inward dial service to our corporate customers as both a primary and
backup service. As a primary service, the customer uses Focal numbers where a
new line and number are needed, as when a customer hires a new employee. As a
backup service, we can implement an alternative numbering plan for the
customer in case the customer's primary service from the ILEC or another CLEC
is interrupted.
Outbound Services. Our basic outbound services allow local and toll calls
to be completed within a metropolitan region and long distance calls to be
completed worldwide. This direct outward dial service is utilized by end-users
in several ways. As a primary service, a customer uses Focal as a replacement
for the ILEC
7
in placing calls to destinations within the region. In our least cost routing
application, a customer can utilize our service in conjunction with its
existing ILEC service to route calls using whichever carrier is least
expensive for that particular type of call or time of day.
Other outbound applications include long distance overflow service in which
we act as a backup to the customer's existing long distance carrier in order
to optimize the number of direct, special access lines installed from the
customer's premises to the long distance carrier's network.
Our FocaLINC service is designed to price inter-city calls that remain on
our network as if they were local calls. This product provides a cost-
effective way for our customers in one market to make calls to their offices
in other Focal markets.
All of the services described above are commonly provisioned over a high-
speed digital communications circuit called a T-1 facility and interface
directly with our customers' private branch exchange or other customer-owned
equipment. Direct interfacing averts our need to provide multiplexing
equipment, which combines a number of communications paths onto one path, at
the customer's location. This is possible due to the high call volume
generated by the large communications-intensive customers we target. Our
ability to directly interface with existing customer equipment further
minimizes our capital investment and maximizes our overall return on capital.
Data Services
Access Services. Focal Virtual Office is designed to allow a corporate
customer's employees to dial-in to the corporate customer's local area network
using a telephone number in the employee's local calling area. This allows the
employee to access the local area network for the price of a local call and
enables our corporate customer to avoid the higher cost of maintaining region-
wide 800 service for local area network access. In addition, our Virtual
Office customers are able to use the Focal FinderTM service, an interactive
tool placed on the customer's web site that automatically provides a
telecommuting employee with the local calling number to be used for server
access.
Focal Multi-Exchange Service, a variant of the Focal Virtual Office service
marketed to network service providers, allows an network service provider's
customers to cost-effectively access the network service provider's remote
access servers. The combination of the multi-exchange service capacity and our
high level of customer care has resulted in strong demand for our Multi-
Exchange Service.
We are currently deploying DSL access services to provide high-speed,
dedicated access to corporate LANs and the Internet. This service is being
marketed to each of our targeted customer segments--large corporations, ISPs
and VARs. DSL service is or will be available in a variety of speeds ranging
from 144 kilobits per second to up to seven megabits per second. We believe
DSL access service is a natural extension of the switched data services that
we have provided since inception.
We offer our customers the ability to colocate equipment in our switching
centers. Equipment colocation benefits the customer by allowing it to
inexpensively house its data equipment without having to maintain secure,
environmentally controlled space. We also offer them equipment maintenance
services. These services are particularly well-suited to our network service
provider customers, who frequently operate remote access servers and routers
in conjunction with our switched services. As of December 31, 2000, we had
over 138,000 square feet of customer colocation space available or under
development.
Internet Services. As overall Internet usage has grown, it has placed
tremendous demands on public networks and peering points. As traffic moves
from one Internet backbone to another, it passes through a variety of
interconnection points. Users frequently complain about delays, lost packets
and other deterioration in service at these congested exchange points. At the
same time, access speeds available to consumers and businesses continue to
increase. New technology and faster modems are accelerating the speed at which
users can access the Internet.
8
With these greater access speeds and as more and more companies begin to
distribute content and applications over the Internet, demand for larger-sized
files and more complex applications has increased. As a result, reliable
Internet network performance has become essential to businesses and consumers.
Erratic performance and lengthy delays, once an acceptable norm, have become
unacceptable. For most, this means that fast, reliable and stable delivery of
content and applications will become the new standard.
Our data services respond to the increased demand for high-speed Internet
access and improved Internet content and services delivery. These services
include managed high-speed Internet access, colocation and peering services.
By building on our reputation as a premier provider of local access services
data, we intend to expand the value proposition to our customers while
satisfying their demand for additional data services.
Our managed high-speed Internet access services are principally targeted to
our corporate and network service provider customer segments. These services
provide high-quality access optimally routed over multiple Tier-1 Internet
backbone networks. We buy Internet transit services from multiple Tier-1
backbone providers, terminating those connections on our routers in our
switching centers. We believe that our aggregation of different providers and
control over these routers allows us to provide a higher quality of service
than our customers could otherwise afford. The service allows direct access to
the leading global backbones with private peering connections to reach most of
the Internet's top destinations, with availability of other backbones in case
of a network failure or outage. We expect that this solution will continue to
reduce many of the problems, namely packet loss and latency, that slow
Internet services today, and continue to provide faster download speeds and
increased reliability.
Our colocation services are targeted to customers who need to reach a high
concentration of end-users. Following the installation of a Focal Internet
eXchange, we will be able to offer an enhanced colocation environment to our
customers. By colocating in a Focal facility, our colocation customers have
the ability to improve the performance of content and application delivery by
situating as close to the edge of the network as possible and reach customers
of multiple network service providers from one location. Potential customers
for this service include content replication and distribution services,
streaming media hosting services, application service providers, unified
messaging providers and companies providing downloads of software and other
large files.
We believe that our private peering points facilitate a more reliable
exchange of traffic than is currently available. The current peering option
for most of our network service provider customers is to exchange traffic at
the public exchange points. These public exchange points are major bottlenecks
in the transfer of data as congestion causes lost packets and delays. By
managing a private peering environment for the exclusive use of our customers,
we will be able to facilitate smoother exchanges of Internet traffic.
While we expect that each of our Internet services will stand on its own,
the services are highly complementary. We believe that we will attract
colocation customers because we offer convenient access to end-users of
multiple network service providers. We believe we will attract network service
provider and corporate customers not only because of our more reliable
connectivity services, but also because of the ready access to content and
applications that our customers may host in our facilities.
Advanced Services
CDR Express provides our VAR customers with automated delivery of daily
call detail records, or CDRs, via the Internet. This system enables these
customers to accurately bill their customers in a secure environment. CDR
Express, as well as some other Focal products, are located in Your Domain--a
section of our web site specifically dedicated to each customer. Your Domain
enables our customers to access their most recent invoices, call detail
records and the customer order entry forms. Your Domain is protected by a
customer's user name and password. Your Domain can also inform customers of
new product offerings being developed by us. Our Form View product, located in
Your Domain, allows our customers to download order forms and other important
documents through the Internet at their convenience.
9
Focal FLOW is an outbound service marketed to VARs that need to be able to
switch outbound traffic among multiple long distance or international
carriers. We partition our central office switch so VARs can utilize the core
switching capability of our equipment at reasonable per minute or per port
cost.
Sales and Marketing
Our primary objective is to satisfy the need for highly reliable
communications services for communications-intensive users in the large
metropolitan markets in which we operate by providing diverse, reliable and
sophisticated services. We believe that we have a competitive advantage in
satisfying this need since we are focused on delivering a specific set of
innovative services to our target customers.
Diversity. Focal provides diversity to communications-intensive users by
delivering highly reliable, local communications services as an alternative to
the ILEC. This type of diversity already exists in other areas of
communications services, such as long distance. Communications-intensive
customers clearly embrace the benefits of diversity, particularly because
redundancy minimizes the effects of facilities failures and maximizes
competitive pricing. As a result, most of our target customers typically have
multiple long distance providers, multiple equipment vendors and multiple
local private-line providers. Because of our focused strategy, we believe that
we are uniquely positioned to become the provider of choice for data and voice
communications services for large, communications-intensive corporate users,
VARs and network service providers. Our focused strategy is based on our
ability to deliver the superior level of diverse, reliable and sophisticated
services that our customers require.
Reliability. We provide reliable service to communications-intensive users,
who are highly sensitive to the potential effects of facilities failures, by
designing our networks around the same theme of diversity that we advocate for
our customers. Although local services are perceived as simple, basic
services, the delivery of highly reliable, local services requires
sophisticated systems. We have engineered our switching and transport networks
to meet the demanding traffic and reliability requirements of our target
customers. Our network strategy is based on developing and operating a robust,
reliable, high-throughput local network relative to the ILECs and other CLECs.
Because we are a relatively new entrant to the markets we serve, we must meet
or exceed the performance quality of the existing local networks in order to
attract communications-intensive users to our networks. Unlike smaller users
that tend to pre-qualify vendors based on price, we believe that
communications-intensive users choose vendors based on the performance of
their networks, and specifically, their reliability. As a result, the design
and operation of our network are key success factors in our business
development process.
We conducted extensive research to identify the best hardware for the high-
volume users that we serve. As a result of this research, we selected Nortel
DMS-500 SuperNode central office switches, which we have engineered to reduce
significantly the likelihood of blocked calls and to maximize call completion.
As such, our customers are unlikely to find themselves unable to complete or
receive calls due to limitations inherent in our switches. We typically
connect to a large number of switches in the ILEC's network. As of December
31, 2000, we had connected to a total of 1,975 ILEC switches. We believe this
is a competitive advantage because it increases call completion even if a
portion of the ILEC's trunking network becomes blocked. We optimize the
configuration of our network by implementing overflow routing between the
ILEC's network and ours, where available. Because the customer base of the
ILECs and other CLECs is not typically as communications-intensive as ours, we
specifically engineered our network to accommodate traffic volumes per
customer far in excess of that which the ILECs or other CLECs typically
experience. We believe that our design is unique among ILECs and CLECs and is
attractive to our target customer base of communications-intensive users. In
addition, we enhance our reliability by delivering service from our switches
to customers over multiple fiber transport systems.
We have also implemented safeguards in our network design to maximize
reliability. The DMS-500 SuperNode switch allows us to distribute customer
traffic across multiple bays of equipment, thus minimizing the effects of any
customer outage. In addition, these switches were engineered by Nortel
Networks with fully redundant processors and memory in the event of a
temporary failure. Similarly, we design our Focal Internet
10
eXchanges to achieve high levels of reliability by connecting each Focal
Internet eXchange to at least three Internet backbone providers and by
building two levels of redundancy into our switching and routing
infrastructure at each Focal Internet eXchange. Our disaster prevention
strategy includes service from multiple power sources where available, on-site
battery backup and diesel generator power at each switching facility to
protect against failures of our electrical service.
Sophistication. Our target customers are knowledgeable, sophisticated
buyers of communications services that demand a high level of professionalism
throughout a vendor's organization. We believe that the technical
sophistication of our management and operations team has been a critical
factor in our initial success and will continue to differentiate us from our
competitors. Execution of our strategy of penetrating communications-intensive
accounts requires a well-experienced team of sales professionals. As a result,
attracting and retaining experienced sales professionals is important to our
overall success. Our sales professionals' compensation is structured to retain
these valuable employees through the grant of stock options and cash
compensation incentives.
We divide our direct sales force into four groups:
. The corporate services group
. The data services group
. The network solutions group
. The government services group
The corporate services group is responsible for selling to large corporate
users. Our sales strategy for these corporate customers is to initially
complement the customer's service from the ILEC. After we build the service
relationship, we anticipate increasing our overall penetration of the
customer's local service. Over a period of time, we hope to dominate a
corporate customer's local switched traffic. We emphasize the diversity,
reliability and sophistication of our services in order to earn our place as
the local provider of choice for our corporate customers.
The data services group is responsible for selling to network services
providers, DSL providers and other data carriers, including ISPs. We are able
to offer several innovative services such as environmentally conditioned
colocation space, virtually non-blocking switching, transport facilities, firm
installation times and high speed Internet access services based on our Focal
Internet eXchange.
The network solutions group markets directly to VARs and other carriers by
positioning us as a highly-reliable, responsive and cost-effective source of
wholesale local communications services. We believe a wide array of
communications service providers, including long distance companies, will seek
to provide bundled communications services in the large metropolitan markets
we target. We are well-positioned to be the provider of choice for re-bundled
local service. Because we do not intend to directly distribute our services to
residential or small- and medium-sized business customers, we believe that
VARs and other carriers looking to purchase the local service portion of their
bundled service offerings are more likely to purchase service from us rather
than from other ILECs or CLECs that compete with them.
The government services group is a dedicated group of telecommunications
professionals focused solely on meeting the demanding needs of telecom-
intensive government customers. Our teams are highly experienced in the
communications industry and understand the special requirements of the
government sector.
Information Systems
Superior customer service is critical to achieving our goal of capturing
market share. We are continually enhancing our service approach, which
utilizes a trained team of customer sales and service representatives to
coordinate customer installation, billing and service. Comprehensive support
systems are also a critical
11
component of our service delivery. We have installed systems designed to
address all aspects of our business, including service order, network
provisioning, end-user and carrier billing, and trouble reporting. The
efficiency of our operating processes contributes to our ability to rapidly
initiate service to new accounts. Our installation desk follows a customer's
order, ensuring the installation date is met. Additionally, our customer sales
representatives respond to all other customer service inquiries, including
billing questions and repair calls.
We are enhancing our systems and procedures for operations support, order
provisioning and other back office systems in order to facilitate and
streamline the processing of large order volumes and customer service. These
systems are required to enter, schedule, provision and track a customer's
order from the point of sale to the installation and testing of service. The
existing systems currently employed by most ILECs, CLECs and long distance
carriers generally require multiple entries of customer information to
accomplish order management, provisioning, switch administration and billing.
This process is not only labor intensive, but it creates numerous
opportunities for errors in provisioning service and billing, delays in
installing orders, service interruptions, poor customer service, increased
customer turnover and significant added expenses due to duplicated efforts and
decreased customer satisfaction.
We are currently using order management software to develop processes that
allow us not only to enter customer orders onsite, via computer and/or over
the Internet, but also to monitor the status of an order as it progresses
through the service initiation process. This software supports the process by
which we convert a customer to our network from the local exchange network of
an ILEC or other carrier, including circuit design and work flow management.
Electronic Bonding with ILECs. In an effort to make the initiation of
service for a customer more efficient, we have electronically bonded with
several ILECs and third party service providers. Electronic bonding has
improved our productivity by decreasing the period between the time of sale
and the time a customer's line is installed. Electronic bonding allows us to
access data from the ILEC, submit service requests electronically, and more
quickly attend to errors in the local service request form because an order is
bounced back if the ILEC determines that there is a mistake. As a result, we
expect to be able to eventually substantially reduce the time required to
switch service to us. Electronic bonding should also enable us to improve our
ability to provide better customer care since we will more readily be able to
pinpoint problems with a customer's order.
Electronic Bonding with Customers. We are also working toward the
electronic bonding of that portion of the billing process in which we gather
customer specific information, including their current service options, and
the process of identifying and resolving customer service problems.
We believe automation of internal processes contributes to the overall
success of a service provider and that billing is a critical element of any
telephone company's operation. We deliver billing information in a number of
media besides paper, including electronic files and Internet inquiry. Our
Invoice Domain service allows customers to securely access and view their
monthly invoices over the Internet. In addition, this service allows customers
to download call detail records. Similarly, our VAR customers can download
call records on a daily basis through our secure web site. This allows them to
efficiently process invoices for their end-user customers.
Significant Relationships
We have no customers that accounted for more than 10% of our revenues
during the three years ended December 31, 2000.
Competition
Portions of our industry are highly competitive. We face a variety of
existing and potential competitors, including:
. The ILECs in our current and target markets
. Other voice and data CLECs
12
. Long distance carriers
. Potential market entrants, including cable television companies, VARs,
electric utilities, microwave carriers, wireless telephone system
operators and private networks built by large end-users
. Foreign carriers
. Internet infrastructure companies
Our primary competitor in each of our existing and planned markets is the
ILEC. Examples include BellSouth, Verizon, Qwest, and SBC. These ILECs are
generally required to file their prices with the state regulatory agencies in
their service areas. Any price changes must be reflected in these filings. The
ILECs have also generally been given the flexibility to respond to competition
with lower pricing. In most cases, proposals for lower pricing must also be
filed with the state utility commissions and the pricing must be made
available to similarly situated customers. We believe this provides a
disincentive for the ILECs to significantly vary or discount prices even in
competitive situations. However, as a CLEC, similar obligations apply to us.
See "--Regulation--State Regulation."
The ILECs offer a wider variety of services in a broader geographic area
than ours and have much greater resources than we do. This may encourage an
ILEC to subsidize the pricing for services with which we compete with the
profits of other services in which the ILEC remains the dominant provider. We
believe competition has limited the number of services dominated by ILECs. In
addition, state regulators have exercised their enforcement powers in a way
that makes it unlikely the ILECs would be able to successfully pursue this
type of protective pricing strategy for an extended period.
In addition to competition from ILECs, we also face competition from a
growing number of other CLECs. Although CLECs overall have only captured
approximately 5% of total revenue of the U.S. local telecommunications market,
we nevertheless compete to some extent with other CLECs in our customer
segments. There are typically several other CLECs competing in each
metropolitan market we serve or plan to enter. Examples of data and voice
CLECs in our markets include Allegiance Telecom, Covad Communications Group,
MCI WorldCom, XO Communications (formerly NEXTLINK Communications), Rhythms
NetConnections and Teleport Communications Group, now a part of AT&T. In some
instances, these CLECs have resources greater than ours and offer a wider
range of services. Many of the CLECs in our markets target small- and medium-
sized business customers, which differs from our target customer base of
large, communications-intensive users.
The data services market is also extremely competitive. Our principal
competitors in this market include Internet connectivity providers such as
UUNET Technologies and Verio, private peering companies, such as InterNAP
Network Services and Equinix, RBOCs that offer Internet access, global,
national and local ISPs and companies that offer colocation services, such as
Exodus Communications and AboveNet Communications. We also believe that new
competitors will enter the data services market.
Some of the ILECs recently requested, among other things, that the FCC
relax regulation of their provision of advanced data networks, which may also
be used for voice traffic. While the FCC has denied those requests, it has
initiated a rule-making that is intended to establish the procedures and
safeguards necessary before these ILECs could, through separate subsidiary
companies, provide these services on a largely deregulated basis. If adopted,
these rules may provide additional opportunities for competition from these
ILECs. SBC and Ameritech received authority from the FCC to create such a
subsidiary in the FCC's approval of their merger. Bell Atlantic New York also
received similar authority with the recent grant of its application to provide
long-distance service in New York. The FCC recently released an order
addressing, among other things, colocation rights of carriers offering
advanced data services, but deferred action on the separate subsidiary issue.
Bills have been introduced in Congress that would grant RBOCs permission to
provide data services in areas where they are currently restricted from doing
so. Although we cannot predict the outcome of any proposed or pending
legislation, the
13
ability of RBOCs to provide data services on a broader basis could have a
material adverse effect on us. In addition, the FCC recently acted to enable
ISPs to buy DSL services in bulk from ILECs, which could result in additional
competition for ISP business.
In addition to ILECs and other CLECs, we are competing with long distance
carriers. A number of long distance carriers have introduced local
telecommunications services to compete with us and the ILECs. These services
include toll calling and other local calling services, which are often
packaged with the carrier's long distance service. While we do not believe the
packaging aspect of the service is particularly attractive to the
communications-intensive customers we target, large long distance carriers
enjoy certain competitive advantages due to their vast financial resources and
brand name recognition. In addition, we believe there is a risk the long
distance carriers may subsidize the pricing of their local services with
profits from long distance services. We anticipate that the entry of some of
the ILECs into the long distance market will reduce the risk of this type of
activity by reducing the profitability of the long distance carrier's long
distance minutes. Further, to the extent the long distance carrier purchases
our service on a wholesale basis and rebundles it at a subsidized rate, we may
benefit as the subsidized, wholesale service could result in higher market
penetration than we would otherwise have achieved. In addition, we have
displaced long distance carriers where the customer was dissatisfied with the
quality of the long distance carrier's local service. We expect our reputation
for exceptional service quality and customer care will continue to result in
us displacing the long distance carrier as the primary alternative to the ILEC
in competitive situations. In addition, we expect that some of our recent and
proposed service offerings, which enable long distance calls to be priced like
local calls, will increase our competitiveness.
We compete principally on the basis of the quality, sophistication and
reliability of our service. See "--Sales and Marketing." We believe that the
principal competitive factors in our markets are speed and reliability of
service, quality of facilities, level of customer care and technical support,
and the timing and market acceptance of new services and enhancements to
existing services.
Regulation
The following summary of regulatory developments and legislation is not
complete. It does not describe all present and proposed federal, state and
local regulation and legislation affecting the telecommunications industry.
Existing federal and state regulations are currently subject to judicial
proceedings, legislative hearings and administrative proposals that could
change, in varying degrees, the manner in which our industry operates. We
cannot predict the outcome of these proceedings or their impact on the
telecommunications industry or us.
Overview. Our services are subject to varying degrees of federal, state and
local regulation. The decisions of regulatory bodies such as the FCC and state
agencies are often subject to judicial review, which makes it difficult for us
to predict outcomes in this area.
Federal Regulation. We must comply with the requirements of common carriage
under the Communications Act of 1934. Comprehensive amendments to the
Communications Act of 1934 were made by the Telecommunications Act of 1996,
referred to as the Telecom Act, which substantially altered both federal and
state regulation of the telecommunications industry. The purpose of this
legislation was to foster increased competition in the telecommunications
industry. Because implementation of the Telecom Act is subject to numerous
federal and state policy rule-making and judicial review, we cannot predict
with certainty what its ultimate effect on us will be.
Under the Telecom Act, any entity may enter a telecommunications market,
subject to reasonable state safety, quality and consumer protection
regulations. The Telecom Act makes local markets accessible by requiring the
ILEC to permit interconnection to its network and establishing ILEC
obligations with respect to:
. Colocation of equipment. This allows companies like us to install and
maintain our own network equipment, including DSLAMs, ATM switches, and
fiber optic equipment, in ILEC central offices.
14
. Interconnection. This requires the ILECs to permit their competitors to
interconnect with ILEC facilities at any technically feasible point in
the ILECs' networks.
. Reciprocal compensation. This requires the ILECs and CLECs to compensate
each other for telecommunications traffic that originates on the network
of one carrier and is sent to the network of the other.
. Resale of service offerings. This requires the ILEC to establish
wholesale rates for services it provides to end-users at retail rates to
promote resale by CLECs.
. Access to unbundled network elements. This requires the ILECs to
unbundle and provide access to some components of their local service
network to other local service providers. Unbundled network elements are
portions of an ILEC's network, such as copper lines or "loops," that
CLECs can lease in order to create their own facilities networks.
. Number portability. This requires the ILECs and CLECs to allow a
customer to retain an existing phone number within the same local area
even if the customer changes telecommunications services providers. All
telecommunications carriers are required to contribute to the shared
industry costs of number portability.
. Dialing parity. This requires the ILECs and CLECs to establish dialing
parity so that all customers must dial the same number of digits to
place the same type of call.
. Access to rights-of-way. This requires the ILECs and CLECs to establish
non-discriminatory access to telephone poles, ducts, conduits and
rights-of-way.
ILECs are required to negotiate in good faith with other carriers that
request any or all of the arrangements discussed above. If a requesting
carrier is unable to reach agreement with the ILEC within a prescribed time,
either carrier may request arbitration by the applicable state commission. If
an agreement still cannot be reached, carriers are forced to abide by the
obligations established by the FCC and the applicable state commission.
We have entered into a number of interconnection agreements with the ILECs
in our markets. We have existing interconnection agreements in each of our
existing markets and in several of our planned markets. Several of the
original interconnection agreements covering our existing markets, including
the agreements covering Chicago and New York, have already expired. The
expiration of these agreements has required us either to negotiate and
arbitrate new interconnection terms with the ILECs, or to opt-in to other
agreements. Pending conclusion of these negotiations and arbitrations, several
existing interconnection agreements should continue to govern the payment of
reciprocal compensation and other interconnection terms, while other
renegotiated or arbitrated agreements may be given retroactive effect from the
expiration date of the superceded agreement following the conclusion of
negotiations and arbitrations.
The FCC is charged with establishing guidelines to implement the Telecom
Act. In August 1996, the FCC released a decision, known as the Interconnection
Decision, that established rules for the interconnection requirements outlined
above and provided guidelines for interconnection agreements by state
commissions. The U.S. Court of Appeals for the Eighth Circuit vacated portions
of the Interconnection Decision. On January 25, 1999, the U.S. Supreme Court
reversed the Eighth Circuit and upheld the FCC's authority to issue
regulations governing pricing of unbundled network elements provided by the
ILECs in interconnection agreements, including regulations governing
reciprocal compensation, which are discussed in more detail below. In
addition, the Supreme Court affirmed an FCC rule that allows requesting
carriers to "pick and choose" the most attractive portions of existing
interconnection agreements with other carriers. The Supreme Court did not,
however, address other challenges raised about the FCC's rules at the Eighth
Circuit because those challenges had not first been decided by the Eighth
Circuit. In addition, the Supreme Court disagreed with the standard applied by
the FCC for determining whether an ILEC should be required to provide a
competitor with particular unbundled network elements.
15
The FCC adopted a new standard in November 1999 for analyzing unbundled
network elements as required by the Supreme Court's order. Applying this
standard to the existing network elements, the FCC concluded that ILECs would
no longer be required to provide directory assistance and operator services as
network elements, though they will continue to be available pursuant to tariff
at different prices. The FCC also removed unbundled switching as an element in
urban areas where the incumbents are also providing certain other combinations
of elements in a non-discriminatory fashion. However the FCC declined, except
in limited circumstances, to require ILECs to unbundle certain facilities used
to provide high speed Internet access and other data services.
On July 18, 2000, the Eighth Circuit issued its order concerning the issues
left unresolved by the Supreme Court. It vacated the FCC's rules regarding the
discount on retail services that ILECs must provide to CLECs, the costing
rules that must be applied in determining the price of unbundled network
elements from ILECs, and the requirement that ILECs must provision
combinations of UNEs that are not already combined. The Supreme Court will
hear the latter two issues in its coming term. It is not possible to predict
the outcome of that decision.
The Supreme Court's 1999 decision and the FCC's order on remand do not
remove all uncertainty concerning the pricing terms and conditions of
interconnection agreements. In particular, the Supreme Court's further review
and ILEC appeals of the FCC's order on remand create contingencies. The
resulting uncertainty makes it difficult to predict whether we will be able to
continue to rely on our existing interconnection agreements or have the
ability to negotiate acceptable interconnection agreements in the future.
In addition to requiring the ILECs to open their networks to competitors
and reducing the level of regulation applicable to CLECs, the Telecom Act also
reduces the level of regulation that applies to the ILECs, thereby increasing
their ability to respond quickly in a competitive market. For example, the FCC
has applied "streamlined" tariff regulation of the ILECs, which shortens the
requisite waiting period before which tariff changes may take effect. These
developments enable the ILECs to change rates more quickly in response to
competitive pressures. The FCC has also adopted heightened price flexibility
for the ILECs, subject to specified caps. If exercised by the ILECs, this
flexibility may decrease our ability to effectively compete with the ILECs in
our markets.
The Telecom Act also gives the FCC authority to determine not to regulate
carriers if it believes regulation would not serve the public interest. The
FCC is charged with reviewing its regulations for continued relevance on a
regular basis. As a result of this mandate, a number of regulations that apply
to CLECs have been and may in the future continue to be eliminated. We cannot,
however, guarantee that any regulations that are now or will in the future be
applicable to us will be eliminated.
In March 1999, the FCC issued an order requiring ILECs to provide unbundled
loops and colocation on more favorable terms than had previously been
available. The order permits colocation of equipment that could be used to
more efficiently provide advanced data services such as high-speed DSL
service, and requires less expensive "cageless" colocation. In the March
order, the FCC deferred action on its previous proposal to permit ILECs to
offer advanced data services through separate affiliates, free from some of
the obligations of the Telecom Act. The D.C. Circuit vacated the FCC's rules
regarding the colocation of equipment providing functionalities in addition to
interconnection and access to UNEs, connections between colocating CLECs, and
selection of colocation space. The FCC has not yet issued its order on remand
from this decision.
In an August 1999 order, the FCC determined that advanced services are
telecommunication services subject to regulation under Sections 251 and 252 of
the Telecom Act. In the same order the FCC issued a notice of proposed rule
making on terms for the provision of such services on a separate subsidiary
basis. Permitting ILECs to provision data services through separate affiliates
with fewer regulatory requirements could have a material adverse impact on our
ability to compete in the data services sector. The FCC imposed conditions on
the merger of SBC with Ameritech in October 1999 that permit the provisioning
of advanced data services via separate subsidiaries pursuant to various
requirements, some of which expire in the near term. The D.C. Circuit vacated
the separate subsidiary requirement on January 29, 2001. We cannot predict
whether these requirements will ultimately prove enforceable, nor whether they
will deter anticompetitive behavior if they are enforceable.
16
Bell Atlantic's application for long distance service in New York has been
approved subject to similar separate subsidiary provisions. These areas of
regulation are subject to change through additional proceedings at the FCC or
judicial challenge.
On December 9, 1999, the FCC released its line sharing order that requires
ILECs to offer line sharing as an unbundled network element by June 6, 2000.
Line sharing permits CLECs to use a customer's existing line to provide DSL
services while the ILEC continues to use the same line to provide voice
service. Prices for line sharing will be set by the states.
Reciprocal Compensation. Reciprocal compensation is the compensation paid
by one carrier to complete particular calls on another local exchange
carrier's network. Because a significant portion of our customers typically
receive more calls than they make, we expect to receive more reciprocal
compensation than we pay for calls that originate on our networks. As a result
of the current regulatory environment and several trends in our business,
which are discussed below, we expect our revenues from reciprocal compensation
to decline significantly.
Some ILECs have refused to pay reciprocal compensation charges that they
estimate are the result of inbound ISP traffic because they believe that this
type of traffic is outside the scope of existing interconnection agreements.
For example, Ameritech disputed a portion of the reciprocal compensation
charges billed to it by us, which it believed were related to Internet
charges. In March of 1998, the Illinois Commerce Commission ruled in favor of
Focal and other CLECs regarding this dispute. In October 1998, Ameritech
complied with the ruling and we received payment for past reciprocal
compensation charges that represents substantially all of the disputed
amounts. On June 18, 1999, the Seventh Circuit affirmed the Illinois Commerce
Commission's order requiring the payment of reciprocal compensation for ISP-
bound traffic. On August 19, 1999, the Seventh Circuit modified its prior
order by providing that Ameritech is free to raise in state courts any state
claims concerning reciprocal compensation, and by deferring any ruling on the
petitions for rehearing pending the Court's resolution in other cases of
procedural issues concerning the participation of state commissioners.
Ameritech had previously filed such a state complaint which at its request had
been held in abeyance pending the outcome of the federal case. On March 5,
2001, the Supreme Court granted certiorari to hear the issues pertaining to
the participation of the state commissioners, and whether interconnection
agreement enforcement actions may be appealed in federal court. We cannot
predict the Supreme Court's ultimate order.
Some states in which our current and planned markets are located have
ordered the ILECs to pay reciprocal compensation for Internet-related calls.
The majority of states that have addressed the question have ruled that
compensation is owed for this traffic. However, these states and other states
that have not considered the issue to date may yet determine that no
compensation is owed. A finding that reciprocal compensation is not payable
for ISP traffic in California, Illinois, New York or Pennsylvania would have a
material adverse effect on us.
In addition, on February 26, 1999, the FCC issued a declaratory ruling and
Notice of Proposed Rulemaking concerning inbound ISP traffic. The FCC
concluded in its ruling that ISP traffic is jurisdictionally mixed and largely
interstate in nature, and also concluded that this traffic is not subject to
the reciprocal compensation provisions of the Telecom Act. The FCC has
requested comment as to what reciprocal compensation rules should govern this
traffic upon expiration of existing interconnection agreements. The FCC also
determined that no federal rule existed that governed reciprocal compensation
for ISP traffic at the time existing interconnection agreements were
negotiated and concluded that it would permit states to determine whether
reciprocal compensation should be paid for calls to ISPs under existing
interconnection agreements. On March 24, 2000, the D.C. Circuit vacated the
FCC's finding that this traffic is not subject to reciprocal compensation
provisions of the Telecom Act, and remanded this issue to the FCC for further
examination. The Court did not address the jurisdictional issue, nor the
authority of the states.
In light of the FCC's order and the court decision, state commissions,
which previously addressed this issue and required reciprocal compensation to
be paid for ISP traffic, may reconsider and may modify their prior
17
rulings. Several ILECs, including Ameritech, are seeking to overturn prior
orders that they claim are inconsistent with the FCC's February 26, 1999
order. Relief sought could include repayment of reciprocal compensation
amounts previously paid by the ILECs. Of the 32 state commissions that have
considered the issue since the FCC's February 26, 1999 order, 25 of these
states have upheld the requirement to pay reciprocal compensation for ISP-
bound traffic. Only Massachusetts, New Jersey, South Carolina, Louisiana,
Arizona, Colorado, and Iowa are not requiring reciprocal compensation for this
traffic, at least pending negotiations and a further FCC decision. Missouri
and Ohio are not requiring current payment, but are requiring a true-up based
on the FCC's future decision. In addition, of the seven Federal District
Courts and the three Courts of Appeals that have reviewed this issue on the
merits to date, all have upheld state decisions requiring that reciprocal
compensation be paid for ISP-bound traffic.
The New York Public Service Commission (the "NYPSC") determined that in
certain circumstances, Verizon can pay a lower reciprocal compensation for
calls terminated by a CLEC in excess of a ratio of three terminating minutes
to each originating minute. The NYPSC also provided an opportunity to a CLEC
having a ratio in excess of three-to-one, such as Focal, to demonstrate that
its network is such that the higher rate should be applied. The NYPSC also
permitted Verizon to file a tariff seeking to reduce the end office rate by
thirty percent from its current level of $0.0034/MOU. Focal and other CLECs
have protested this filing. Verizon has unilaterally reduced the reciprocal
compensation rate in the New York market from July 1, 1999 on a going forward
basis, which we have vigorously challenged in connection with the NYPSC
proceeding described above. Verizon has also informed us that it intends to
unilaterally escrow these payments in two smaller markets, New Jersey and
Delaware.
Upon expiration of our existing interconnection agreements, we must
negotiate new rates for reciprocal compensation with each carrier. Pending
conclusion of these negotiations, the existing interconnection agreements are
expected to continue to govern the payment of reciprocal compensation. We
expect rates for reciprocal compensation will be lower under new
interconnection agreements than under our existing agreements. A reduction in
rates payable for reciprocal compensation could have a material adverse effect
on us, as could any requirement to refund reciprocal compensation paid to
date.
In addition to charging other carriers reciprocal compensation for
terminating local traffic, Focal also collects access charges from carriers
for originating and terminating interexchange traffic. Two interexchange
carriers, AT&T and WorldCom, have stated that they will not pay the portion of
Focal's traffic-sensitive access charges that exceed ILEC traffic-sensitive
access charges. The Company is currently suing AT&T to recover these amounts.
In May 1997, the FCC released an order establishing a significantly
expanded universal service regime to subsidize the cost of telecommunications
service to high cost areas, as well as to low-income customers and qualifying
schools, libraries, and rural health care providers. Providers of interstate
telecommunications services, like us, as well as certain other entities, must
pay for these programs. We are also eligible to receive funding from these
programs if we meet certain requirements, but we are not currently planning to
do so. Our share of the payments into these subsidy funds will be based on our
share of certain defined telecommunications end-user revenues. Currently, the
FCC is assessing such payments on the basis of a provider's revenue for the
previous year. Various states are also in the process of implementing their
own universal service programs. We are currently unable to quantify the amount
of subsidy payments that we will be required to make and the effect that these
required payments will have on our financial condition. Moreover, some of the
FCC's universal service rules remain subject to judicial appeal and further
FCC review including the FCC's 8% rule. The FCC's 8% rule provides that a
carrier's international revenue is exempt from universal service assessment
when its total interstate revenue represents 8% or less of its combined
interstate and international revenue. Any court decision that has the effect
of reducing the entities subject to universal service contributions could
increase the contributions of the remaining entities that are subject to the
rules. The FCC currently assesses universal service contributions based on
prior year revenues; however, the FCC has initiated a rulemaking to reconsider
this approach. Additional changes to the universal service program could
increase our costs.
18
The FCC has made and is continuing to consider various reforms to the
existing rate structure for charges assessed on long distance carriers for
allowing them to connect to local networks. These reforms are designed to move
these "access charges," over time, to lower, cost-based rate levels and
structures. These changes will reduce access charges and will shift charges,
which had historically been based on minutes-of-use, to flat-rate, monthly per
line charges on end-user customers rather than long distance carriers. On
August 5, 1999, the FCC adopted an order granting price cap local exchange
carriers additional pricing flexibility, implementing certain access charge
reforms, and seeking comment on others. The order provides certain immediate
regulatory relief to price cap carriers and sets a framework of "triggers" to
provide these companies with greater flexibility to set interstate access
rates as competition increases. The order also initiated rulemaking to
determine whether the FCC should regulate competitive local exchange carriers
access charges. On February 2, 2001, the D.C. Circuit upheld the FCC rules
regarding pricing flexibility. The FCC has recently granted pricing
flexibility applications for switched access services provided by BellSouth in
a number of cities in its service territory. The FCC also granted flexible
pricing authority for dedicated transport and special access services provided
by SBC entities in certain cities, and for dedicated transport and special
access services provided by Verizon entities in certain cities. The manner in
which the FCC continues to implement its approach to lowering access charge
levels and a decision to regulate competitive local exchange carrier access
rates could have a material effect on our ability to compete in providing
interstate access services.
On May 31, 2000 the FCC adopted the proposal of the Coalition for
Affordable Long Distance Service ("CALLS") that significantly restructures
and, reduces in some respects, the interstate access charges of the RBOCs,
AT&T, and Sprint. Among the more significant regulatory changes established by
the CALLS Order, the RBOCs are required to reduce switched access charges to
an average of $0.0055/minute. Price cap ILECs are additionally required to
eliminate the presubscribed interexchange carrier charge ("PICC") as a
separate charge and fold it into an increased subscriber line charge. AT&T and
Sprint have committed in this proceeding to pass on access charge reductions
to consumers, and to eliminate minimum monthly usage charges. Although the
CALLS Order will not apply directly to CLECs, ILEC reductions in switched
access charges may place some downward pressure on CLEC's to reduce their own
switched access charges. In addition, IXCs other than AT&T and Sprint are not
subject to the CALLS Order, but may seek to alter their offerings to conform
to AT&T's and Sprint's commitments in this proceeding. A Petition for
Reconsideration of the CALLS Order is currently before the FCC.
Tariff and Filing Requirements. Non-dominant carriers, including Focal,
must file tariffs with the FCC listing the rates, terms and conditions of
interstate and international services provided by the carrier. On October 29,
1996, the FCC adopted an order in which it eliminated the requirement that
non-dominant interstate carriers maintain tariffs on file with the FCC for
domestic interstate services. Accordingly, non-dominant interstate carriers,
including Focal, no longer file interstate tariffs with the FCC for these
services.
In addition, periodic reports concerning carriers' interstate circuits and
deployment of network facilities also are required to be filed with the FCC.
The FCC generally does not exercise direct oversight over cost justification
and the level of charges for services of non-dominant carriers, although it
has the power to do so. The FCC may also impose prior approval requirements on
transfers of control and assignments of operating authorizations.
Fines or other penalties also may be imposed for violations of FCC rules or
regulations. The FCC also requires that certified carriers like Focal notify
the FCC of foreign carrier affiliations and secure a determination that such
affiliations, if in excess of a specified amount, are in the public interest.
State Regulation. Most states regulate entry into the markets for local
exchange and other intrastate services, and states' regulation of CLECs vary
in their regulatory intensity. The majority of states require that companies
seeking to provide local exchange and other intrastate services to apply for
and obtain the requisite authorization from a state regulatory body, such as a
state commission. This authorization process generally requires the carrier to
demonstrate that it has sufficient financial, technical and managerial
capabilities and that granting the
19
authorization will serve the public interest. As of December 31, 2000, we had
obtained local exchange certification or were otherwise authorized to provide
local exchange service in:
California Illinois Minnesota Pennsylvania
Delaware Indiana Missouri Texas
District of Maryland New Jersey Virginia
Columbia Massachusetts New York Washington
Florida Michigan Ohio
Georgia
To the extent that an area within a state in which we provide service is
served by a small or rural exchange carrier not currently subject to
competition, we may not currently have authority to provide service in those
areas at this time.
As a CLEC, we are and will continue to be subject to the regulatory
directives of each state in which we are and will be certified. Most states
require that CLECs charge just and reasonable rates and not discriminate among
similarly situated customers. Some other state requirements include:
. The filing of periodic reports
. The payment of various regulatory fees and surcharges
. Compliance with service standards and consumer protection rules
States also often require prior approvals or notifications for certain
transfers of assets, customers, or ownership of a CLEC and for issuances by
certified carriers of equity securities, notes or indebtedness, although the
terms of this offering do not require any prior approval. States generally
retain the right to sanction a carrier or to revoke certifications if a
carrier violates relevant laws and/or regulations. Delays in receiving
required regulatory approvals could also have a material adverse effect on us.
We cannot assure you that regulators or third parties will not raise material
issues with regard to our compliance or non-compliance with applicable laws or
regulations.
In most states, certificated carriers like us are required to file tariffs
setting forth the terms, conditions, and prices for services which are
classified as intrastate. In some states, the required tariff may list a range
of prices for particular services, and in others, such prices can be set on an
individual customer basis. We may, however, be required to file tariff addenda
of the contract terms.
Under the Telecom Act, implementation of our plans to compete in local
markets is and will continue to be, to a certain extent, controlled by the
individual states. The states in which we operate or intend to operate have
taken regulatory and legislative action to open local communications markets
to various degrees of local exchange competition.
Local Regulation. We are also subject to numerous local regulations, such
as building code requirements, franchise and local public rights of way. These
regulations may vary greatly from state to state and from city to city.
Employees
As of December 31, 2000, we employed 1,130 full-time employees, none of
whom were covered by a collective bargaining agreement. We believe that our
future success will depend on our continued ability to attract and retain
highly skilled and qualified employees. We believe that our relations with our
employees are good.
ITEM 2. DESCRIPTION OF PROPERTY
We are headquartered in Chicago, Illinois and lease office space in a
number of locations, primarily for network equipment installations and sales
and administrative offices and cover approximately 796,000 square feet of
leased space. These leases expire in years ranging from 2002 to 2015 and have
varying renewal options. We also own approximately 13 acres of real property
in Arlington Heights, Illinois. This property, which includes a 52,000 square
foot building, houses our second Chicago-area switching center, national data
center and national network operations center.
20
ITEM 3. LEGAL PROCEEDINGS
With the exception of the matters discussed below, we are not aware of any
material litigation against us. In the ordinary course of our business, we are
involved in a number of regulatory proceedings before various state
commissions and the FCC.
On September 16, 1997, we filed a complaint and request for temporary
injunction against Ameritech Illinois with the Illinois Commerce Commission.
The complaint claimed breach of the terms of the interconnection agreement
between us and Ameritech Illinois because Ameritech Illinois refused to pay
reciprocal compensation for our transport and termination of calls to our end-
users that Ameritech Illinois believed were ISPs. In the interests of
obtaining a more timely judgment, we withdrew our complaint without prejudice
on October 17, 1997 and filed to intervene in a consolidated suit that
included similar complaints against Ameritech Illinois by several other CLECs.
On March 11, 1998, the Illinois Commerce Commission issued an order that
required Ameritech Illinois to pay reciprocal compensation for calls made to
ISPs. On March 15, 1998, Ameritech Illinois filed a motion with the Illinois
Commerce Commission to stay the order pending an appeal, which was denied on
March 23, 1998. On March 27, 1998, Ameritech Illinois filed suit in the United
States District Court for the Northern District of Illinois seeking reversal
of the Illinois Commerce Commission order. Ameritech Illinois also sought a
stay of this order from the District Court, which was granted while the case
was decided. On July 21, 1998, the District Court upheld the Illinois Commerce
Commission's order, finding that calls to ISPs are local calls and therefore
subject to the reciprocal compensation rules contained in the Telecom Act. The
District Court stayed the decision to permit any party to appeal. Ameritech
Illinois then appealed the decision to the U.S. Court of Appeals for the
Seventh Circuit on August 25, 1998, and was denied a stay while the appeal is
pending. In October 1998, Ameritech Illinois complied with the order and we
received payment for past reciprocal compensation charges that represent
substantially all of the disputed amounts. On June 18, 1999, the Seventh
Circuit affirmed the Illinois Commerce Commission's order requiring the
payment of reciprocal compensation for ISP-bound traffic. On August 19, 1999,
the Seventh Circuit modified its prior order to permit Ameritech to raise in
state courts any state claims concerning reciprocal compensation. On March 5,
2001, the Supreme Court agreed to hear the appeal pertaining to the
participation of the state commissioners, and whether interconnection
agreement enforcement actions may be appealed in federal court. We cannot
predict the Supreme Court's ultimate order or its effect on our business or
financial condition. See "Business--Regulation" for a description of federal
rule-making and other developments affecting reciprocal compensation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Focal did not submit any matter to a vote of its stockholders during the
fourth quarter of 2000.
21
PART II
ITEM 5. MARKET FOR FOCAL'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS AND
MARKET INFORMATION
Focal's common stock is traded on the Nasdaq National Market. Focal's
ticker symbol is "FCOM." Focal completed the initial public offering of its
common stock in August 1999. Prior to August 1, 1999, no established public
trading market for the common stock existed.
The following table sets forth on a per share basis, the high and low bid
information per share for our common stock as reported on the Nasdaq National
Market for the periods indicated:
High Low
------ ------
Year ended December 31, 1999:
Third quarter (from July 28, 1999)....................... $29.75 $15.50
Fourth quarter........................................... $26.88 $18.50
Year ended December 31, 2000:
First quarter............................................ $77.75 $26.00
Second quarter........................................... $46.00 $20.00
Third quarter............................................ $43.63 $13.88
Fourth quarter........................................... $20.75 $ 6.94
There were approximately 161 owners of record of Focal common stock as of
February 28, 2001. This number excludes stockholders whose stock is held in
nominee or street name by brokers and Focal believes that it has a
significantly larger number of beneficial holders of common stock. A recently
reported sale price of our common stock on the Nasdaq National Market is set
forth on the front cover of this report.
Dividends
We have not paid any cash dividends on our common stock in the past and do
not anticipate paying any cash dividends on our common stock in the
foreseeable future. Any future determination to pay dividends will be at the
discretion of our board of directors and will be dependent upon then existing
conditions, including our financial condition, results of operations,
contractual restrictions, capital requirements, business prospects, and other
factors our board of directors deems relevant. In addition, our current
financing arrangements effectively prohibit us from paying cash dividends for
the foreseeable future.
Recent Sales of Unregistered Securities
Focal did not sell any equity securities during the period covered by this
report that were not registered under the Securities Act of 1933 and that were
not previously reported on Form 10-Q.
22
ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
The selected consolidated financial data presented below for the three
years ended December 31, 2000, have been derived from our Consolidated
Financial Statements and the accompanying notes related thereto. Our
Consolidated Financial Statements for the three years ended December 31, 2000
have been audited by Arthur Andersen LLP, our independent public accountants.
The balance sheet data as of December 31, 1996, 1997 and 1998 has been derived
from our audited consolidated financial statements not included in this
report. You should read the information in this table in conjunction with Item
7A, "Quantitative and Qualitative Disclosures About Market Risk", Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," and our Consolidated Financial Statements and the accompanying
notes related thereto appearing elsewhere in this report.
Period from
Commencement
of Operations
Years Ended December 31, (May 31, 1996)
---------------------------------------------- to December 31,
2000 1999 1998 1997 1996
---------- ---------- ---------- ---------- ---------------
(Dollars in thousands, except share data)
Statement of Operations
Data:
Data services........... $ 158,968 $ 96,856 $ -- $ -- $ --
Telecom services........ 75,152 30,005 -- -- --
---------- ---------- ---------- ---------- ---------
Total revenues...... $ 234,120 $ 126,861 $ 43,532 $ 4,024 $ --
Expenses:
Network expenses...... 89,741 29,941 5,098 2,155 --
Selling, general and
administrative....... 155,498 73,455 22,396 2,887 422
Depreciation and
amortization......... 56,985 23,763 6,671 616 1
Non-cash compensation
expense.............. 6,360 7,186 3,070 1,300 108
---------- ---------- ---------- ---------- ---------
Operating income (loss). (74,464) (7,484) 6,297 (2,934) (531)
Other income (expense),
net.................... (35,598) (14,302) (9,606) 68 17
Income tax benefit
(expense).............. 4,205 (600) (4,660) -- --
Accretion to redemption
value of Class A common
Stock -- -- -- (104) --
---------- ---------- ---------- ---------- ---------
Net loss applicable to
common stockholders.... $ (105,857) $ (22,386) $ (7,969) $ (2,970) $ (514)
========== ========== ========== ========== =========
Basic and diluted net
loss per share......... $ (1.75) $ (0.45) $ (0.18) $ (0.07) $ (0.06)
========== ========== ========== ========== =========
Basic weighted average
common stock
outstanding............ 60,456,245 50,066,315 43,763,000 42,186,500 8,498,000
========== ========== ========== ========== =========
Other Financial Data:
EBITDA.................. $ (11,119) $ 23,465 $ 16,038 $ (1,018) $ (422)
Capital expenditures.... 309,617 128,550 64,229 11,655 82
Summary Cash Flow Data:
Net cash provided by
(used in) operating
activities............. $ 52,196 $ 18,549 $ 22,507 $ (1,634) $ (153)
Net cash used in
investing activities... (309,937) (130,590) (72,189) (11,655) (82)
Net cash provided by
financing activities... 251,016 164,142 173,466 11,756 4,025
Operating Data:
Access lines in service. 435,272 181,103 52,011 7,394 --
Minutes of use
(millions)............. 27,569 13,362 3,568 282 --
23
As of December 31,
-----------------------------------------
2000 1999 1998 1997 1996
-------- -------- -------- ------ ------
Balance Sheet Data:
Cash, cash equivalents and short-
term investments................... $181,737 $188,142 $134,001 $2,257 $3,790
Current assets...................... 249,629 219,932 144,637 4,738 3,807
Property, plant and equipment, net.. 451,272 196,301 69,973 11,177 81
Total assets........................ 723,685 420,986 219,574 15,915 3,888
Long-term debt, including current
portion............................ 544,750 253,786 185,296 3,537 --
Total stockholders' equity
(deficit).......................... 44,789 142,487 19,328 (2,075) (405)
You should not assume that the results of operations above are indicative
of the financial results we can achieve in the future. You should also keep
the following matters in mind when you read this information:
. Non-cash compensation expense consists of:
-- charges totaling $0.1 million for 1996, $1.3 million for each of 1997
and 1998 and $2.5 million for 1999, which resulted from the vesting
over time of shares of common stock issued to some of our executive
officers in November 1996
-- charges of $1.8 million, $0.3 million, and $0.3 million for 1998,
1999 and 2000, respectively, which resulted from the vesting and
cancellation of shares of common stock in connection with the
September 30, 1998 amendment of vesting agreements with some of our
executive officers
-- charges of $4.4 million in 1999 and $6.1 million in 2000, which
resulted from our 1999 stock option grants to employees, directors
and an outside consultant, and common stock issued to a director
. EBITDA represents earnings before interest, income taxes, depreciation
and amortization and other non-cash charges, including non-cash
compensation expense. EBITDA is not a measurement of financial
performance under generally accepted accounting principles, is not
intended to represent cash flow from operations, and should not be
considered as an alternative to net loss applicable to common
stockholders as an indicator of our operating performance or to cash
flows as a measure of liquidity. We believe that EBITDA is widely used
by analysts, investors and other interested parties in the
telecommunications industry. EBITDA is not necessarily comparable to
similarly titled measures for other companies.
. We count access lines as of the end of the period indicated and on a
one-for-one basis using DS-0 equivalents.
. Data and Telecom services revenue information is not available for 1996,
1997 and 1998.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Overview
General. We provide voice, data and Internet infrastructure services to
large, communications-intensive users in major cities. We began operations in
1996 and initiated service first in Chicago in May 1997. As of December 31,
2000 we offered service in a total of 20 markets, which encompass a total of
49 metropolitan statistical areas, or MSAs, and plan to serve 24 markets, or
56 MSAs, by the end of 2001. We believe our market expansion will allow us to
reach a critical mass of geographic coverage and service capability for our
target customer base of communications-intensive users. As of December 31,
2000, we had 435,272 lines in service.
In September 2000, we announced the launch of our first Focal Internet
eXchange platform in our Chicago market. Our state-of-the-art Internet
eXchange platforms provide high-speed, managed Internet access, colocation,
and private peering services to large corporations, value-added resellers,
network service providers, and content and application service providers.
During the fourth quarter of 2000, we deployed Focal Internet
24
eXchanges in seven additional markets: New York; Northern New Jersey;
Philadelphia; Washington D.C.; San Francisco; Oakland and San Jose. At the end
of 2000, our Focal Internet eXchanges served eight markets. We intend to
deploy a total of 36 Focal Internet eXchanges across our 24 planned markets.
Revenue. Data services revenue includes revenues from circuit switched
lines sold to network service providers, DSL, colocation, and Internet
infrastructure services. Telecom services revenue includes circuit switched
lines sold to corporate and VAR customers. Our data and telecom services
revenue is composed of monthly recurring charges, usage charges, and initial
non-recurring charges. Monthly recurring charges include the fees paid by our
customers for lines in service, additional features on those lines, and
colocation space. Monthly recurring charges are derived only from end user
customers. Usage charges consist of fees paid by end-users for each call made,
fees paid by the ILEC and other CLECs as reciprocal compensation, and access
charges paid by the IXCs for long distance traffic that we originate and
terminate. Non-recurring revenues are typically derived from fees charged to
install new customer lines and are deferred and amortized over estimated
customer lives.
We earn reciprocal compensation revenue for calls made by customers of
another local exchange carrier to our customers. Conversely, we incur
reciprocal compensation expense to other local exchange carriers for calls by
our customers to their customers. We expect the proportion of revenues
represented by reciprocal compensation to decrease in the future as a result
of the expiration and subsequent renegotiation of our existing interconnection
agreements with the ILECs and the impact of recent and future regulatory
developments.
Expenses. Our expenses are categorized as network expenses; selling,
general and administrative; depreciation and amortization; and non-cash
compensation expense. Network expenses are composed of leased transport
charges, the cost of leasing space in ILEC central offices for colocating our
transmission equipment, the costs of leasing our nationwide Internet network,
reciprocal compensation payments and the cost of completing local and long
distance calls. Leased transport charges are the lease payments we make for
the use of fiber transport facilities connecting our customers to our switches
and for our connection to the ILECs' and other CLECs' networks. Generally, we
have been successful in negotiating lease agreements that match the duration
of our customer contracts, thereby allowing us to avoid the risk of incurring
expenses associated with transport facilities that are not being used by
revenue generating customers.
Our strategy of initially leasing rather than building our own fiber
transport facilities has resulted in our cost of service being a significant
component of total cost. Accordingly, our network expenses may be higher on a
relative basis compared to CLECs who own a higher percentage of their
transport network. However, compared to these same companies, our capital
expenditures will be significantly lower.
A key aspect of our "smart-build" strategy is that we only operate in Tier
1 markets which are served by multiple fiber providers. When traffic volumes
grow sufficiently to justify investing in our own network, we have purchased
our own fiber. As of December 31, 2000 we were operating our own fiber
networks in nine of our markets with approximately 9,730 fiber miles in
operation.
Selling, general and administrative expense ("SG&A") consists of network
and customer care personnel costs, sales force compensation and promotional
expenses as well as the cost of corporate activities related to regulatory,
finance, human resources, legal, executive, and other administrative
activities. We expect our sales expense to be lower as a percentage of revenue
than that of our competitors because we have relatively high sales
productivity associated with our strategy of serving communications-intensive
customers. These customers generally utilize a large number of switched access
lines relative to the average business customer, resulting in more revenue per
sale. Further, fewer sales representatives are required to service the
relatively smaller number of communications-intensive customers in a given
region.
We record monthly non-cash compensation expense related to shares issued to
some of our executive officers in November 1996, in connection with the
September 30, 1998 amendments to vesting agreements with some of our executive
officers, in connection with stock options granted to employees, an outside
consultant,
25
and directors during 1999 and shares issued to a director during the first
quarter of 1999. We will continue to record non-cash compensation expense in
future periods relating to these events through the third quarter of 2003. See
the notes to our Consolidated Financial Statements.
Quarterly Operating Results
The following table sets forth unaudited financial, operating and
statistical data for each of the specified quarters of 2000 and 1999. The
unaudited quarterly financial information has been prepared on the same basis
as our Consolidated Financial Statements and, in our opinion, contains all
normal recurring adjustments necessary to fairly state this information. The
operating results for any quarter are not necessarily indicative of results
for any future period.
2000
---------------------------------- 1999
Fourth Third Second First Fourth
Quarter Quarter Quarter Quarter Quarter
------- ------- ------- ------- -------
Data Services Revenue ($ mil)..... $43,567 $40,573 $42,638 $32,190 $26,306
Telecom Services Revenue ($ mil).. $23,784 $20,179 $18,050 $13,139 $ 9,740
Switched Lines Sold to Date....... 526,356 427,641 356,918 291,443 237,167
Switched Lines Installed to Date.. 435,272 365,016 298,983 238,697 181,103
Estimated Data Lines (% of
Installed Lines)................. 61% 65% 68% 71% 72%
Lines on Switch (%)............... 100% 100% 100% 100% 100%
ILEC Switches Interconnected...... 1,975 1,823 1,677 1,447 1,209
ILEC Central Office DSL
Colocations in Service or Under
Development...................... 292 275 270 223 221
ILEC Central Office DSL
Colocations Market Ready......... 178 127 -- -- --
Quarterly Minutes of Use (mil).... 7,396 7,112 6,640 6,421 5,158
Markets in Operation.............. 20 20 19 18 16
Markets Under Development......... 4 4 5 6 4
MSAs Served....................... 49 49 48 47 40
MSAs Under Development............ 7 7 8 9 10
Circuit Switches Operational...... 20 19 16 14 12
Circuit Switches Under
Development...................... 5 6 8 7 7
ATM Switches Deployed............. 28 22 16 6 2
Fiber Miles Operational........... 9,730 7,914 4,488 864 --
Focal Customer Colocation Space in
Service (Sq. Ft.) 107,201 107,201 80,096 73,840 70,105
Focal Customer Colocation Space
Under Development (Sq. Ft.)...... 31,503 27,830 54,802 36,549 24,654
Capital Expenditures ($ mil)...... $ 82 $ 99 $ 77 $ 52 $ 34
Employees......................... 1,130 1,089 935 747 592
Sales Force(1).................... 184 180 166 124 116
- --------
(1) Quota bearing sales professionals. Does not include sales engineers or
customers support personnel.
Year Ended December 31, 2000 Compared to Year Ended December 31, 1999
Our data services revenue increased 64% for the year ended December 31,
2000 to $159.0 million. Telecom services revenue increased 150% to $75.2
million for the year ended December 31, 2000. The increase in our data and
telecom services revenue is primarily due to the generation of revenues from
new markets that went into operation during 2000 and from a sequential
increase in revenue from our more mature markets. In addition, we installed
254,169 lines during 2000, which exceeded the lines installed during the
comparable period of 1999 by approximately 97% or 125,077 lines.
26
Network expenses totaled $89.7 million for the year ended December 31, 2000
compared to $29.9 million for the year ended December 31, 1999. This $59.8
million increase resulted from our expansion into new markets during 2000 and
related costs for leased transport facilities, usage settlements, colocation
and Internet network costs related to our Focal Internet eXchange platforms.
Our gross margin was approximately 62% and 76% for the years ended December
31, 2000 and 1999, respectively. This decrease in our gross margin is a direct
result of our market expansion, our effective reciprocal compensation per
minute of use rate having declined between periods and due to initial network
costs related to our Focal Internet eXchange platforms. SG&A expenses
increased by $82.0 million to $155.5 million for the year ended December 31,
2000. This increase is the result of our expansion into new markets, the
rollout of our Focal Internet eXchange platforms, and due to a corresponding
increase in our employee base by 538 employees.
Depreciation and amortization increased from $23.8 million to $57.0 million
in the comparative year to year periods. This $33.2 million increase is a
result of our expansion into new markets, an increase in our fixed asset base
for our existing markets, and due to the build-out of our nationwide network
and Focal Internet eXchange platforms. Interest income was $20.3 million and
$7.9 million for the years ended December 31, 2000 and 1999, respectively.
This $12.4 million increase is primarily due to the receipt of $265.7 million
in net proceeds from our 11 7/8% senior notes ("2000 Notes") offering
completed in January 2000. Our net interest expense increased from $21.6
million during 1999 to $56.2 million for 2000. This net increase of $34.6
million is primarily due to an additional $31.8 million of interest expense
charged relating to our outstanding 2000 notes which was partially offset by
interest capitalized during the year ended December 31, 2000 totaling $9.4
million.
We incurred U.S. income tax expense of $0.6 million for 1999 compared to a
tax benefit of $4.2 million in 2000. The tax benefit recorded for 2000 is the
result of a net operating loss carryback for a refund of federal and state
taxes paid.
Our six most established markets had $186.8 million in revenue, EBITDA of
$94.0 million, and an EBITDA margin of 50% during 2000. We provide market
specific information to provide insight into the life cycle performance of our
older markets which are comprised of Chicago, New York, San Francisco, San
Jose, Oakland, and Philadelphia.
Year Ended December 31, 1999 Compared to Year Ended December 31, 1998
Our total revenue for the year ended 1999 was $126.9 million compared to
$43.5 million for the year ended 1998. This increase of 192% is primarily due
to the generation of revenue from numerous markets during 1999 compared to
revenues from primarily two markets, Chicago and New York, in the comparable
period of 1998. We installed approximately 129,000 access lines during 1999,
which exceeded the lines installed in the comparable period of 1998 by
approximately 187% or 84,000 lines.
Network expenses totaled $29.9 million for the year ended December 31, 1999
compared to $5.1 million for the year ended December 31, 1998. This $24.8
million increase resulted from our rapid expansion into six new markets and
related costs for leased transport facilities and usage settlements. Our gross
margin was approximately 76% and 88% for the years ended December 31, 1999 and
1998, respectively. This decrease in our gross margin is a direct result of
our effective reciprocal compensation per minute of use rate having declined
between periods. SG&A expenses increased by $51.1 million to $73.5 million
during the year ended December 31, 1999. This increase is the result of our
planned expansion and due to a corresponding increase in our employee base by
359 employees.
Depreciation and amortization increased from $6.7 million to $23.8 million
in the comparative year to year periods. This increase of $17.1 million is a
result of our 1999 expansion into six new markets and due to our fixed asset
base increase for our existing markets. Our 1999 capital expenditures of
approximately $128.5 million (excluding $21.0 million of assets acquired under
capital lease) were $64.3 million greater than that of the comparable period
of 1998. Non-cash compensation expense was $7.2 million for the year ended
December 31,
27
1999 compared to $3.1 million for comparable period in 1998. This $4.1 million
increase in non-cash compensation expense is the result of September 30, 1998
amendments of vesting agreements with some of our executive officers, stock
options granted to employees, an outside consultant, and directors during
1999, and stock issued to a director during the first quarter of 1999.
Interest income was $7.9 million and $6.5 million for the years ended 1999
and 1998, respectively. This increase of $1.4 million is primarily due to our
cash, cash equivalents, and short-term investments increasing from $134.0
million at the end of 1998 to $188.1 million at the end of 1999. This increase
is the result of our net proceeds of approximately $137 million raised in our
August 1999 initial public offering. Interest expense increased from $16.1
million during 1998 to $21.6 million for 1999. This net increase of $5.5
million is due to an additional $4.6 million of amortization of our
outstanding senior discount notes, $3.4 million of interest expense on our
secured equipment term loan, and $1.1 million of non-cash interest expense
relating to our capital lease obligation for dark fiber transport capacity.
This increase of $9.1 million was partially offset by approximately $3.6
million of interest capitalized during 1999 in connection with the
construction of our major facilities and networks.
We incurred U.S. income tax expense of $0.6 million for the year ended 1999
compared to $4.7 million in the same period of 1998. This decrease of $4.1
million in our tax expense between years is primarily due to the $18.5 million
of additional pre-tax losses incurred during 1999 and the realization of a net
operating loss at the end of 1999. We are obligated to pay federal and state
income taxes due to the application of the alternative minimum tax.
Liquidity and Capital Resources
Our current business plan anticipates that we expand our existing networks
and services, expand into four new markets in 2001, deploy our own fiber
capacity in a majority of our markets, construct 36 Focal Internet eXchange
platforms across our 24 planned markets, construct expanded colocation
centers, and fund operating losses. We will require significant capital to
fund this plan including the purchase and installation of voice and data
switches, routers, equipment, infrastructure and fiber facilities and/or long-
term rights to use fiber transport capacity. The implementation of this plan
requires significant capital expenditures, a substantial portion of which will
be incurred before significant related revenues from our new markets are
expected to be realized. These expenditures, together with associated
operating expenses, may result in our having substantial negative operating
cash flow and substantial net operating losses for the foreseeable future,
including 2001. Our current plan indicates we will turn EBITDA positive during
2001. In addition, our cash on hand and funds available under our Credit
Facility (see below) provides over $300 million in liquidity as of December
31, 2000. Although we believe that our current plan, cost estimates and the
scope and timing of our planned network build-out are reasonable, we cannot
assure that actual costs or the timing of the expenditures, or that the scope
and timing of our build-out, will be consistent with current estimates.
Our capital expenditures were approximately $309.6 million in 2000 compared
to $128.5 million in 1999 (excluding $21.0 million of assets acquired under
capital lease). This increase of $181.1 million primarily reflects capital
spending for the build-out of our new and existing markets and for the
construction of our nationwide network and Focal Internet eXchange platforms.
We estimate that our capital expenditures in connection with our current
business plan will be approximately $175 million to $200 million during 2001.
The 2001 capital expenditures are expected to be made primarily for the build-
out of four additional markets, the construction of Focal Internet eXchange
platforms, the expansion of our existing markets and the activation of local
dark fiber transport capacity in a number of our markets.
Our expectations of future capital requirements and cash flows from
operations are based on current estimates. If our plans or assumptions change
or prove to be inaccurate, we may be required to seek additional sources of
capital or seek additional capital sooner than currently anticipated.
28
Net cash provided by operating activities for 2000 was $52.2 million, an
increase of $33.6 million from the same period in 1999. This increase is
primarily the result of a $33.2 million increase in depreciation and
amortization, a $97.2 million increase in accounts payable and accrued
liabilities, and an additio