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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 2000
Commission File Number: 0-24061
US LEC CORP.
(Exact name of registrant as specified in its charter)
DELAWARE 56-2065535
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
Morrocroft III, 6801 Morrison Boulevard
CHARLOTTE, NORTH CAROLINA 28211
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (704) 319-1000
Securities registered pursuant to Section 12(b) of Act: None.
Securities registered pursuant to Section 12(g) of Act: Class A Common
Stock, par value $.01 per share.
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. X Yes 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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of voting stock of the registrant held by
non-affiliates of the registrant was $79,046,345 as of March 20, 2001 based on
the closing sales price on The Nasdaq National Market as of that date. For
purposes of this calculation only, affiliates are deemed to be directors and
executive officers of the registrant.
As of March 20, 2001, there were 11,008,885 shares of Class A Common
Stock and 16,759,270 shares of Class B Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement ("the Proxy Statement") for
its Annual Meeting of Stockholders to be held on May 3, 2001 are incorporated by
reference into Part III of this report.
US LEC CORP.
2000 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
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PART I
Item 1: Business 3
Item 2: Properties 24
Item 3: Legal Proceedings 24
Item 4. Submission of Matters to a Vote of Security Holders 24
PART II
Item 5: Market for the Registrant's Common Stock and Related Stockholder Matters 25
Item 6: Selected Consolidated Financial Data 26
Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations 27
Item 7A: Quantitative and Qualitative Disclosures about Market Risk 38
Item 8: Financial Statements and Supplementary Data 40
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 68
PART III
Item 10: Directors and Executive Officers of the Registrant 69
Item 11: Executive Compensation 69
Item 12: Security Ownership of Certain Beneficial Owners and Management 70
Item 13: Certain Relationships and Related Transactions 70
PART IV
Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K 71
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PART I
ITEM 1. BUSINESS
THE COMPANY
US LEC Corp. ("US LEC" or the "Company") is a provider of integrated
telecommunications services, including: local, long distance, data, Internet and
enhanced services to customers in selected markets in Alabama, Florida, Georgia,
Kentucky, Louisiana, Maryland, Mississippi, North Carolina, Pennsylvania, South
Carolina, Tennessee, Virginia and Washington D.C. US LEC is also currently
certified to provide telecommunications services in Connecticut, Delaware,
Indiana, Massachusetts, New Jersey, New York, Ohio and Texas. The predecessor to
US LEC was incorporated in June 1996 after passage of the Telecommunications Act
of 1996 ("Telecom Act"), which enhanced the competitive environment for local
telephone exchange services. On December 31, 1996, the original corporation was
merged into US LEC L.L.C., a limited liability company. On December 31, 1997, in
anticipation of an initial public offering, US LEC L.L.C. was merged into US
LEC. US LEC initiated service in North Carolina in March 1997, becoming one of
the first competitive local exchange carriers ("CLEC") in North Carolina to
provide switched local exchange services. As of December 31, 2000, US LEC's
network was comprised of 23 Lucent 5ESS(R) AnyMedia(TM) digital switches and 17
Lucent CBX500 ATM data switches that are located throughout the Southeast and
mid-Atlantic states, in addition to an Alcatel MegaHub(R) 600ES switch in
Charlotte, North Carolina. The Company primarily serves
telecommunications-intensive customers including businesses, universities,
financial institutions, professional service firms and practices, hospitals,
enhanced service providers, Internet service providers, hotels, automobile
dealerships and government agencies.
BUSINESS STRATEGY
US LEC's objective is to become a leading provider of integrated
telecommunications, Internet and data services to its existing and target
customers and to increase its market share by its expanding product portfolio
and by providing exceptional customer service. The principal elements of US
LEC's business strategy include:
Deploy a Capital-Efficient Network. US LEC utilizes a "smart-build"
strategy of purchasing and deploying switching equipment and leasing the
required fiber optic transmission capacity from competitive access providers
("CAPs"), other CLECs and incumbent local exchange carriers ("ILECs").
Management believes the Company's switch-based, leased-transport strategy
enables it to enter markets and generate revenue and positive cash flow more
rapidly than if the Company first constructed its own transmission facilities.
By leasing fiber transport, this smart-build strategy also reduces the up-front
capital expenditures required to build a network and enter new markets and
avoids the risk of "stranded" investment in under-utilized fiber networks.
Focus of Operations. The Company focuses its network build out and
marketing presence in target markets composed of Tier I cities (major
metropolitan areas such as Atlanta, Miami, Washington D.C. and Philadelphia) and
Tier II cities (mid-size metropolitan areas such as Greensboro, Tampa and
Nashville). The Company has selected its target markets based on a number of
considerations, including the number of potential customers and other
competitors in such markets and the presence of multiple transmission facility
suppliers. The Company currently focuses on markets in the Southeast and
Mid-Atlantic United States. Management believes that the Company's clustered
network will enable it to take advantage of calling patterns and capture an
increasing portion of customer traffic on its network.
Target Telecommunications-Intensive Customers. The Company focuses its
sales efforts on telecommunications-intensive customers including businesses,
universities, financial institutions, professional service firms and practices,
hospitals, enhanced service providers, ISPs, hotels, and
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government agencies. The volume of usage generated by the Company's target
customers allows the Company to efficiently concentrate the telecommunications
traffic of its customers. In addition, the Company frequently is able to sell
enhanced, long distance and data services to complement its local services. This
further enhances network utilization and thereby improves margins, as fixed
network costs are spread over a larger base of services. Unlike some other
CLECs, the Company does not resell ILEC services.
Install a Robust Technology Platform. The Company has chosen the 5ESS(R)
Any Media(TM) digital switch and the Lucent CBX 500 Asynchronous Transfer Mode
("ATM") data switches, both of which are manufactured by Lucent Technologies,
Inc. ("Lucent") to provide a consistent technology platform throughout its
network. As of December 31, 2000, US LEC had 23 Lucent voice switches and 17
Lucent ATM data switches active throughout its network. To enhance its service
offerings, the Company deployed an Alcatel MegaHub(R) 600ES ("Alcatel") tandem
switch in Charlotte. The Alcatel switch complements the Lucent switches and
improves US LEC's ability to provide enhanced services. The Company has also
deployed an Advanced Intelligent Network ("AIN") platform. This AIN platform
positions US LEC for enhanced services as well as allows the Company Signaling
System No. 7 ("SS#7") connectivity independent of the ILECs.
Employ an Experienced Sales Force. Management believes that the
Company's success in a particular market is enhanced by employing a direct sales
force with extensive local market and telecommunications sales experience. The
Company employs this strategy in building its sales force. Salespeople with
experience in a particular market provide the Company with extensive knowledge
of the Company's target customer base and in many cases have existing
relationships with target customers.
Implement Efficient Provisioning Processes with State-of-the-Art Back
Office Support. Management believes that a critical aspect of the success of a
CLEC is timely and effective provisioning systems, which includes the process of
transitioning ILEC or other CLEC customers to the Company's network. The Company
focuses on implementing effective and timely provisioning practices to
efficiently transition customers from the ILEC or other CLECs to the Company
with minimal disruption of the customer's operations. Among other things, US LEC
is approved by Lockheed Martin as a provider of Local Number Portability ("LNP")
for its customers. In addition, the US LEC Network Operations Center ("NOC")
houses the tools to monitor its network. The NOC provides network surveillance,
real-time alarm notification, dispatch services, and 24 hours a day, 7 days a
week availability and notification. In 2000, the Company began a project to
update and upgrade its back office systems through a strategy of deploying "best
of breed" systems for various back office functions including software from
Siebel, MetaSolv, Vitria, and Kenan. Management believes that the project will
be implemented in 2001 and that it will enhance the electronic exchange of
information within US LEC by providing a centralized view of customer and order
tracking data. In addition, the new systems will increase the integrity and
consistency of customer data by reducing paper forms, eliminating data input
redundancies and fully integrating US LEC's front and back office systems.
Offer a Broad Range of Products and Services. US LEC offers customers a
broad range of telecommunication services, which can be bundled. Management
believes a broad product range, competitive pricing, and an opportunity to
bundle services gives US LEC customers an exceptional value. US LEC offers its
customers local access, calling card, enhanced toll-free, digital private line,
dedicated high-speed Internet access, frame relay, web hosting, digital
subscriber line (DSL) and competitively priced long distance service, including
intrastate, interstate, international and toll-free. To further the Company's
product strategy, US LEC has deployed its Asynchronous Transfer Mode ("ATM") and
AIN platforms. These systems provide the Company the ability to provide advanced
voice and data communications products and services.
Provide Outstanding Customer Service. Management believes that a key
element of the success of a CLEC is the ability to satisfy the service needs of
its customers. Among other things, the Company must be able to resolve troubles,
promptly implement change requests, resolve billing issues and promptly add
additional service and capacity. Management believes that providing customers
with outstanding customer care enhances the ability of the Company to retain its
customers, as well as attract new customers.
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Customer care is provided locally by the market-based sales, sales support and
operations team and centrally by US LEC's NOC and customer service center.
US LEC'S NETWORK
During 2000, the Company installed seven new Lucent 5ESS(R) Any Media(TM)
digital switches and 13 new Lucent CBX500 ATM data switches, to bring the
network to 23 voice switches and 17 data switches. The Company has announced
plans to activate additional Lucent switches in, Mobile, Alabama, Ft. Myers,
Florida and a second switch in Atlanta, Georgia. The Company has also announced
that each switching center site will also house a data switch for a total of 26
digital and 25 data switches in addition to its Alcatel MegaHub(R) 600ES switch
in Charlotte. Four of the sites will also be long distance platforms which will
provide additional capability to route and concentrate the Company's long
distance traffic.
US LEC utilizes a "smart build" strategy of purchasing and deploying
switching equipment and leasing fiber optic transmission capacity from CAPs,
other CLECs and ILECs.
Calls originating with a US LEC customer are transported over leased lines
to the US LEC switch and can either be terminated directly on the Company's
network or routed to a long distance carrier, an ILEC or another CLEC, depending
on the location of the call recipient. Similarly, calls originating from the
public switched telephone network and destined for a US LEC customer are routed
through the US LEC switch and delivered to call recipients via leased
transmission facilities.
In order to interconnect its switches to the network of the local
incumbent phone company and to exchange traffic with it, the Company executes
interconnection agreements with the incumbent carriers. The terms and conditions
of the interconnection agreements are effected by the Telecom Act, decisions of
state and federal regulatory bodies and negotiation with the carriers involved.
The Company may voluntarily enter into such an agreement, petition a state
regulatory commission to arbitrate issues that can not be resolved by
negotiation or by opting into agreement executed by the incumbent and other
competitive carriers. The Company has signed or opted into interconnection
agreements with all of the incumbent local carriers where it offers services
requiring such agreements, including BellSouth Telecommunications, Inc.
("BellSouth"), Verizon Communications Inc. ("Verizon"), Sprint Communications
Company L.P. ("Sprint") (See "Business -- Forward Looking Statements and Risk
Factors - Existing BellSouth Interconnection Agreements" and "Business --
Forward Looking Statements and Risk Factors -Interconnection Agreements").
PRODUCTS AND SERVICES
The Company provides local dial-tone services to customers. Local access
is available in many different forms including PRI, T1 Access and Channel
Access. The Company's network is designed to allow a customer to easily increase
or decrease capacity and utilize enhanced services as the telecommunications
requirements of the customer change. The Company also provides directory
assistance and operator services.
US LEC provides long distance services for completing intrastate,
interstate and international calls. The Company also provides toll-free
services, calling cards and typical enhanced services such as voice mail.
The Company has also added data products to its portfolio of products.
The Company offers US LECnet (a direct, dedicated, high-speed connection to the
Internet), frame relay, digital private line and a number of other services such
as email, news feeds and web hosting.
The Company's ability to bundle local, long distance and data services
on the same facility allows it to offer its customers more efficient use of
transport facilities and allows it to aggregate customers' monthly recurring and
usage charges on a single consolidated invoice.
In the third quarter of 2000, the Company introduced the ADVANTAGE T, a
single-rate, bundled
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product offering which allows customers to put local, long distance, dedicated
high-speed Internet access, digital private line and toll-free services all on a
single T-1. Not only can customers choose between multiple products to be
carried, but they can also allocate bandwidth dedicated to each product on the
T-1. Management believes that the development of this product allows US LEC to
expand the total market to which the Company has access.
SALES AND MARKETING
Sales. US LEC employs a highly motivated and experienced direct sales
force. The Company recruits salespeople with strong sales backgrounds in its
markets, including salespeople from long distance companies, telecommunications
equipment manufacturers, network systems integrators, CLECs and ILECs. The
Company expanded its quota-bearing sales force from 127 salespeople at December
31, 1999 to 234 salespeople at December 31, 2000. Management expects to further
increase the Company's sales force to approximately 300 salespeople by the end
of 2001. The Company plans to continue to attract and retain highly qualified
salespeople by offering them an opportunity to work with an experienced
management team in an entrepreneurial environment and to participate in the
potential economic rewards made available through a results-oriented
compensation program. In 2000, US LEC implemented the Customer Account Manager
("CAM") program in an effort to gain additional sales from current customers and
to enhance the Company's relationships with its customer base. The Company also
utilizes independent sales agents to identify and maintain customers.
Marketing. In its existing markets, US LEC seeks to position itself as a
high quality alternative to ILECs and other CLECs for local telecommunication
services by offering network reliability, bundled products and superior customer
support at competitive prices. The Company builds its reputation and brand
identity by working closely with its customers to develop services tailored to
their particular needs and by implementing targeted product offerings and
promotional efforts.
The Company primarily uses three trademarks and service marks: US LEC, a
logo that includes US LEC, and THE COMPETITIVE TELEPHONE COMPANY. These marks
have been registered either on the Principal or the Supplemental Register of the
United States Patent and Trademark Office for uses related to telecommunications
products and services.
Customer Service. Management believes that the Company's ability to
provide superior customer service is a key factor in acquiring new customers and
retaining existing customers. The Company has developed a customer service
strategy that is designed to effectively meet the service requirements of its
target customers. Customer support is provided in a two-tiered structure: the
local operations, sales and account support personnel, and to support these
locally-based teams, a centrally based customer service center and NOC.
Billing. In 2000, the Company migrated its billing function in-house,
allowing the Company to realize cost savings and provide additional services to
customers. Customer bills are available in a variety of formats to meet a
customer's specific needs. US LEC offers customers simplicity and convenience by
sending one bill for all services.
SIGNIFICANT CUSTOMER
In fiscal 1998, 1999, and 2000, BellSouth, operating in the majority of
the Company's markets, accounted for approximately 80%, 70%, and 15%,
respectively, of the Company's net revenue (before reduction for the $12,000,
$27,823 and $0 allowance in 1998, 1999, and 2000, respectively, described above
and in Note 7 to the Company's Consolidated Financial Statements). The majority
of this revenue was generated from reciprocal compensation. Although reciprocal
compensation owed to the Company by BellSouth is not a customer relationship in
the traditional sense, BellSouth is shown here due to the significant
contribution to revenue. At December 31, 1998, 1999, and 2000, BellSouth
accounted for 94%,
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92%, and 70% of the Company's total accounts receivable before allowance,
respectively. The majority of such receivables and revenues in 1998 and 1999,
resulted from traffic associated with Metacomm, LLC ("Metacomm"), a customer of
the Company and BellSouth, which became a related party to the Company during
1998. During 2000, Metacomm ceased to be a customer of BellSouth and the Company
and no revenue was recorded in 2000 related to Metacomm traffic. As a result of
the March 31, 2000 order issued by the North Carolina Utilities Commission
("NCUC") denying reciprocal compensation to the Company from traffic associated
with the Metacomm network, the Company recorded a pre-tax, non-recurring,
non-cash charge of approximately $55,000 (See "Business -- Forward Looking
Statements and Risk Factors -- Disputed Revenue).
EMPLOYEES
As of December 31, 2000, the Company employed 816 people. The Company
expects to employ approximately
REGULATION
The following summary of regulatory developments and legislation does
not purport to describe all present and proposed federal, state and local
regulations and legislation affecting the telecommunications industry. Other
existing federal and state legislation and regulations are currently the subject
of judicial proceedings and legislation, legislative hearings and administrative
proposals which could change, in varying degrees, the manner in which this
industry operates. Neither the outcome of these proceedings and legislation, nor
their impact upon the telecommunications industry or the Company, can be
predicted at this time. This section also includes a brief description of
regulatory and tariff issues pertaining to the operation of the Company.
Overview. The Company's services are subject to varying degrees of
federal, state and local regulation. The Federal Communications Commission (the
"FCC") generally exercises jurisdiction over the facilities of, and services
offered by, telecommunications common carriers that provide interstate or
international communications. The state regulatory commissions (herein "PUCs")
retain jurisdiction over the same facilities and services to the extent they are
used to provide intrastate communications.
Federal Legislation. The Company must comply with the requirements of
common carriage under the Communications Act of 1934, as amended (the
"Communications Act"). The Telecom Act, enacted on February 8, 1996,
substantially revised the Communications Act. The Telecom Act establishes a
regulatory framework for the introduction of local competition throughout the
United States and was intended to reduce unnecessary regulation to the greatest
extent possible. Among other things, the Telecom Act preempts, after notice and
an opportunity for comment, any state or local government from prohibiting any
entity from providing telecommunications service.
The Telecom Act also establishes a dual federal-state regulatory scheme
for eliminating other barriers to competition faced by competitors to the
incumbent local exchange carriers and other new entrants into the local
telephone market. Specifically, the Telecom Act imposes on ILECs certain
interconnection obligations, some of which are implemented by FCC regulations.
The Telecom Act contemplates that states will apply the federal regulations and
oversee the implementation of all aspects of interconnection not subject to FCC
jurisdiction as they oversee interconnection negotiations between ILECs and
their new competitors.
The FCC has significant responsibility in the manner in which the
Telecom Act will be implemented especially in the areas of pricing, universal
service, access charges and price caps. The details of the rules adopted by the
FCC will have a significant effect in determining the extent to which barriers
to competition in local services are removed, as well as the time frame within
which such barriers are eliminated.
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The PUCs also have significant responsibility in implementing the
Telecom Act. Specifically, the states have authority to establish
interconnection pricing, including unbundled loop charges, reciprocal
compensation and wholesale pricing consistent with the FCC regulations. The
states are also charged under the Telecom Act with overseeing the arbitration
process for resolving interconnection negotiation disputes between CLECs and the
ILECs and must approve interconnection agreements, and resolve contract
compliance disputes arising from interconnection agreements. (See "Business --
Forward Looking Statements and Risk Factors -- Disputed Revenues" for a
discussion of the actions before PUCs related to the Company's interconnection
agreement with BellSouth).
The Company has historically earned a significant portion of its revenue
from the ILEC in the form of reciprocal compensation payments due to the
Company. Several ILECs in the Company's territory (principally BellSouth) have
challenged the applicability of the reciprocal compensation related to enhanced
service providers and ISP customers receiving more calls than they make. With
increasing frequency the ILECs with whom US LEC interconnects (principally
BellSouth) have been raising additional objections to their obligations to pay
reciprocal compensation, including challenges to the rates at which such
payments are calculated and the types of traffic to with the obligations apply
(See "Business -- Forward Looking Statements and Risk Factors -- Disputed
Revenues").
The obligations imposed on ILECs by the Telecom Act to promote
competition, such as local number portability, dialing parity, reciprocal
compensation arrangements and non-discriminatory access to telephone poles,
ducts, conduits and rights-of-way also apply to CLECs, including the Company. As
a result of the Telecom Act's applicability to other telecommunications
carriers, it may provide the Company with the ability to reduce its own
interconnection costs by interconnecting directly with non-ILECs, but may also
cause the Company to incur additional administrative and regulatory expenses in
responding to interconnection requests. At the same time, the Telecom Act also
makes competitive entry into other service or geographic markets more attractive
to Regional Bell Operating Companies ("RBOC"), other ILECs, long distance
carriers and other companies and has increased and likely will continue to
increase the level of competition the Company faces. (See "Business --
Competition").
In addition, the Telecom Act provided that ILECs that are subsidiaries
of RBOCs could not offer in-region, long distance services across LATAs until
they had demonstrated that (i) they have entered into an approved
interconnection agreement with a facilities-based CLEC or that no such CLEC has
requested interconnection as of a statutorily determined deadline, (ii) they
have satisfied a 14-element checklist designed to ensure that the ILEC is
offering access and interconnection to all local exchange carriers on
competitive terms and (iii) the FCC has determined that in-region, inter-LATA
approval is consistent with the public interest, convenience and necessity. The
FCC approved Verizon's right to provide interLATA service in New York and SBC's
in Texas, Kansas and Oklahoma, which to the Company's knowledge are the only
interLATA applications by an RBOC that have been approved to date (See "Business
- -- Forward Looking Statements and Risk Factors--Regulation" and "Business --
Forward Looking Statements and Risk Factors--Competition").
Federal Regulation And Related Proceedings. The Telecom Act and the
FCC's efforts to initiate reform have resulted in numerous legal challenges. As
a result, the regulatory framework in which the Company operates is subject to a
great deal of uncertainty. Any changes that result from this uncertainty could
have a material adverse effect on the Company. The FCC has adopted orders
eliminating tariff filing requirements for non-dominant carriers providing
interstate access and domestic interstate long distance services. Although the
FCC order was stayed by the United States Court of Appeals for the District of
Columbia Circuit, that stay has now been lifted. Accordingly, non-dominant
interstate services providers will no longer be able to rely on the filing of
tariffs with the FCC as a means of providing notice to customers of prices,
terms, and conditions under which they offer their domestic interstate
inter-exchange services. During 2001, the Company is required to cancel such
federal tariffs as a result of the FCC's orders. Tariff filing requirements
remain in place for international traffic.
The FCC also has proposed reducing the level of regulation that applies
to the ILECs, and increasing their ability to respond quickly to competition
from the Company and others. For example, in
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accordance with the Telecom Act, the FCC has applied "streamlined" tariff
regulation to the ILECs, which greatly accelerates the time prior to which
changes to tariffed service rates may take effect, and has eliminated the
requirement that ILECs obtain FCC authorization before constructing new domestic
facilities. These actions will allow ILECs to change service rates more quickly
in response to competition. Similarly, the FCC has afforded significant new
pricing flexibility to ILECs subject to price cap regulation. On August 5, 1999,
the FCC adopted an order granting price cap ILECs additional pricing
flexibility. The order provides certain immediate regulatory relief regarding
price cap ILECs and sets forth a framework of "triggers" to provide those
companies with greater flexibility to set rates for interstate access services.
The order also initiated a rulemaking to determine whether the FCC should
regulate the access charges of CLECs, such as the Company. On February 2, 2001,
the D.C. Circuit upheld the FCC rules regarding pricing flexibility. To the
extent such increased pricing flexibility is utilized for ILECs or such
additional regulation is implemented, the Company's ability to compete with
ILECs for certain service could be adversely affected. The FCC has recently
granted pricing flexibility applications for switched access services provided
by BellSouth in a number of cities in its service territory, including in
several of the Company's markets. 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 FCC has taken several actions related to the assignment of telephone
numbers, first in July 1995 mandating the responsibility for administering and
assigning local telephone numbers be transferred from the RBOCs and a few other
ILECs to a neutral entity, and second in July 1996 adopting a regulatory
structure under which a wide range of number portability issues would be
resolved. In March 1997, the FCC affirmed its number portability rules, but it
extended slightly certain deadlines for the implementation of true number
portability. The FCC has established cost recovery rules for long-term number
portability.
On August 8, 1996, the FCC issued an order containing rules providing
guidance to the ILECs, CLECs, long distance companies and PUCs regarding several
provisions of the Telecom Act. The rules include, among other things, FCC
guidance on: (i) discounts for end-to-end resale of ILEC retail local exchange
services (which the FCC suggested should be in the range of 17%-25%); (ii)
availability of unbundled local loops and other unbundled ILEC network elements;
(iii) the use of Total Element Long Run Incremental Costs in the pricing of
these unbundled network elements; (iv) average default proxy prices for
unbundled local loops in each state; (v) mutual compensation proxy rates for
termination of ILEC/CLEC local calls; and (vi) the ability of CLECs and other
service providers to opt into portions of previously-approved interconnection
agreements negotiated by the ILECs with other parties on a most favored nation
(or a "pick and choose") basis. (See "Regulation -- Eighth Circuit Court of
Appeals Decision and Supreme Court Reversal" for a discussion of the Eighth
Circuit Court of Appeals decision related to this order).
On May 8, 1997, the FCC released an order establishing a significantly
expanded federal universal service program which subsidized certain eligible
services. For example, the FCC established new subsidies for services provided
to qualifying schools and libraries with an annual cap of $2.25 billion and for
services provided to rural health care providers with an annual cap of $400
million. The FCC also expanded the federal subsidies to low-income consumers and
consumers in high-cost areas. Providers of interstate telecommunications
service, such as the Company, as well as certain other entities, must pay for
these programs. The Company's share of the schools, libraries and rural health
care funds is based on its share of the total industry telecommunications
service and certain defined telecommunications end user revenues. The Company's
share of all other federal subsidy funds is based on its share of the total
interstate telecommunications service and certain defined telecommunications end
user revenues. Although the Company has made its required contributions to the
fund, the amount of the Company's contribution changes each quarter. As a
result, the Company cannot predict the effect these regulations will have on the
Company in the future. In the May 8 order, the FCC also announced that it will
revise its rules for subsidizing service provided to consumers in high cost
areas. The United States Court of Appeals for the Fifth Circuit upheld those
rules.
In a combined Report and Order and Notice of Proposed Rulemaking
released on December 24, 1996, the FCC made changes and proposed further changes
in the interstate access charge structure. In the
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Report and Order, the FCC removed restrictions on an ILEC's ability to lower
access prices and relaxed the regulation of new switched access services in
those markets where there are other providers of access services. If this
increased pricing flexibility is not effectively monitored by federal
regulators, it could have a material adverse effect on the Company's ability to
compete in providing interstate access services. On May 16, 1997, the FCC
released an order revising its access charge rate structure. The new rules
substantially increase the costs that ILECs subject to the FCC's price cap rules
("price cap LECs") recover through monthly, non-traffic sensitive access charges
and substantially decrease the costs that price cap ILECs recover through
traffic sensitive access charges. In the May 16 order, the FCC also announced
its plan to bring interstate access rate levels more in line with cost. The plan
will include rules to be established that grant price cap LECs increased pricing
flexibility upon demonstrations of increased competition (or potential
competition) in relevant markets. The manner in which the FCC implements this
approach to lowering access charge levels could have a material effect on the
Company's ability to compete in providing interstate access services. Several
parties have appealed the May 16 order. Those appeals were consolidated and
transferred to the United States Court of Appeals for the Eighth Circuit which
upheld the Commission's rules.
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 May
31, 2000 the FCC adopted the proposal of the Coalition for Affordable Long
Distance Service ("CALLS Order") that significantly restructures and, reduces in
some respects, the interstate access charges of the RBOCs, Verizon, AT&T, and
Sprint. Among the more significant regulatory changes established by the CALLS
Order, the RBOCs and Verizon are required to reduce switched access charges to
an average of $0.0055/minute. Price cap ILECs are additionally required to
eliminate the pre-subscribed inter-exchange carrier charge ("PICC") as a
separate charge and fold it into an increased subscriber line charge ("SLC").
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 will likely place downward pressure on CLECs, including
the Company, to reduce their own switched access charges either in the form of
regulatory pressure or commercial pressure from the IXCs. 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.
On February 26, 1999, the FCC issued a declaratory ruling and notice of
proposed rulemaking concerning ISP traffic. The FCC concluded in its ruling that
ISP traffic is jurisdictionally mixed, but largely interstate in nature. 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 should permit states to determine whether
reciprocal compensation should be paid for calls to ISPs under existing
interconnection agreements. In light of the FCC order, state commissions which
previously addressed this issue and required reciprocal compensation to be paid
for ISP traffic may reconsider and may modify their prior rulings. To date,
seven PUCs in states where the Company has earned reciprocal compensation have
affirmed their prior position on this issue. The FCC order has been appealed by
several parties. On March 24, 2000, the United States Court of Appeals for the
D.C. Circuit vacated the FCC's February 26, 1999 declaratory ruling and remanded
it to the FCC. The D.C. Circuit Court of Appeals found that the FCC failed to
clearly explain and support why ISP traffic should be regulated as long distance
traffic rather than as local traffic. This ruling means the FCC will have to
reexamine its rules covering reciprocal compensation as they apply to ISP-bound
traffic. The Company cannot predict the results of such reexamination.
The Company also anticipates that the FCC will initiate a number of
additional proceedings, of its own volition and as a result of requests from
CLECs and others, as a result of the Telecom Act.
10
The FCC also requires carriers to file periodic reports concerning
carriers interstate circuits and deployment of network facilities. 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 also imposes prior approval requirements on transfers of
control and assignments of operating authorizations. The FCC has the authority
to generally condition, modify, cancel, terminate, or revoke operating authority
for failure to comply with federal laws or rules, regulations and policies of
the FCC. Fines or other penalties also may be imposed for such violations.
Although the Company believes it is in compliance with all applicable laws and
regulations, there can be no assurance that the FCC or third parties will not
raise issues with regard to the Company's compliance with such laws and
regulations.
Eighth Circuit Court Of Appeals Decisions And The Supreme Court
Reversal. Various parties, including ILECs and state PUCs, requested that the
FCC reconsider its own rules and/or filed appeals of the FCC's August 8, 1996
order.
The U.S Court of Appeals for the Eighth Circuit ("8th Circuit") held
that, in general, the FCC does not have jurisdiction over prices for
interconnection, resale, leased unbundled network elements ("UNEs") and traffic
termination. The 8th Circuit also overturned the FCC's "pick and choose" rules
as well as certain other FCC rules implementing the Telecom Act's local
competition provisions. In addition, the 8th Circuit decisions substantially
limited the FCC's authority to enforce the local competition provisions of the
Telecom Act. On January 25, 1999, U.S. Supreme Court reversed the 8th 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). In addition, the
Supreme Court affirmed the "pick and choose" rules which allows carriers to
choose individual portions of existing interconnection agreements with other
carriers and to opt-in only to those portions of the interconnection agreement
that they find most attractive. The Supreme Court did not, however, address
other challenges raised about the FCC's rules at the 8th Circuit because the 8th
Circuit did not decide those challenges. 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. On remand, the FCC largely retained its list of unbundled elements,
but eliminated the requirement that ILECs provide unbundled access to local
switching for customers with four or more lines in the top 50 MSAs, and the
requirement to provide unbundled operator service and directory assistance.
On July 18, 2000, the 8th 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
Company does not currently purchase or provision UNEs, and does not anticipate
any adverse effects as a result of the regulation of these two services.
The 8th Circuit decisions and the reversal by the Supreme Court continue
to create uncertainty about the rules governing pricing terms and conditions of
interconnection agreements. This uncertainty makes it difficult to predict
whether the Company will have the ability to negotiate acceptable
interconnection agreements in the future should the Company decide to resale
ILEC services or purchase or provision UNEs.
In August 1998, the FCC determined that high-speed wire-line data
services are telecommunications services subject to regulation under Sections
251 and 252 of the Telecom Act. In the same order, the FCC issued a notice of
proposed rulemaking 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 the Company's 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 high-speed wire-line data services via separate
subsidiaries pursuant to various requirements. The D.C. Circuit vacated the
separate subsidiary requirement on January 9, 2001. The
11
Company cannot predict whether these requirements will ultimately prove
enforceable, nor whether they will deter anti-competitive conduct if they are
enforceable.
Slamming. The FCC and many state PUCs have implemented rules to prevent
unauthorized changes in a customer's pre-subscribed local and long distance
carrier (a practice commonly known as "slamming.") Pursuant to the FCC's
slamming rules, a carrier found to have slammed a customer is subject to
substantial fines. In addition, the FCC's slamming rules were revised effective
November 2000 to include new provisions governing liability for slamming, and
provisions allowing state PUCs to elect to administer and enforce the FCC's
slamming rules. These new slamming liability rules substantially increase a
carrier's possible liability for unauthorized carrier changes, and may
substantially increase a carrier's administrative costs in connection with
alleged unauthorized carrier changes (even if the carrier can provide valid
proof that such changes were authorized). Under the new rules, carriers must
immediately remove from the customer's bill all charges incurred within 30 days
following an alleged slam. If the FCC (or the relevant state PUC) determines
that the carrier has slammed the customer, and the customer has not yet paid the
bill, the customer will be absolved from any charges for the first 30 days
following the slam (whereas if the carrier provides clear and convincing proof
that the consumer authorized the change, the carrier may re-bill the customer.)
If the FCC (or relevant state PUC) determines that a carrier has slammed a
customer and the customer has already paid the unauthorized carrier, the
unauthorized carrier must remit to the authorized carrier 150% of all payments
received from a slammed customer. The authorized carrier must in turn remit 50%
of the amount received from the unauthorized carrier back to the slammed
customer. The new slamming liability rules have been appealed to the United
States Court of Appeals for the District of Columbia Circuit. Although the
Company cannot predict the effect that these new liability rules will have on
its business, because virtually all of the Company's customers are connected on
a dedicated basis to US LEC's network, it is unlikely that the Company will
incur any significant liability under these new rules. The FCC also issued
revised rules in August 2000 that are expected to become effective in April 2001
or shortly thereafter, regarding the procedures for changing a subscriber's
pre-subscribed carrier, and establishing new carrier reporting and registration
requirements. Implementation of these new rules may increase the Company's costs
of administering long distance service accounts.
State Regulation. The Company has all of the certifications necessary to
offer its current services in the states of:
State
-----
North Carolina
Georgia
Virginia
Tennessee
South Carolina
Florida
Alabama
Washington, D.C.
Pennsylvania
Maryland
Delaware
New Jersey
New York
Massachusetts
Kentucky
Mississippi
Ohio
Texas
Connecticut
Louisiana
Indiana
12
There are no applications for certification currently pending before any
PUC or the FCC.
To the extent that an area within a state in which the Company operates
is served by a small (in line counts) or rural ILEC not currently subject to
competition, the Company generally does not have authority to service those
areas at this time. Most states regulate entry into local exchange and other
intrastate service markets, and states' regulation of CLECs vary in their
regulatory intensity. The majority of states mandate that companies seeking to
provide local exchange and other intrastate services apply for and obtain the
requisite authorization from the PUC. This authorization process generally
requires the carrier to demonstrate that it has sufficient financial, technical,
and managerial capabilities and that granting the authorization will serve the
public interest.
As a CLEC, the Company is subject to the regulatory directives of each
state in which the Company is certified. In addition to tariff filing
requirements, most states require that CLECs charge just and reasonable rates
and not discriminate among similarly situated customers. Some states also
require the filing of periodic reports, the payment of various regulatory fees
and surcharges, and 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. States generally retain
the right to sanction a carrier or to revoke certifications if a carrier
violates relevant laws and/or regulations.
In all of the states where US LEC is certified, the Company is required
to file tariffs or price lists setting forth the terms, conditions and/or prices
for services which are classified as intrastate. In some states, the Company's
tariff may list a range of prices or a ceiling price for particular services,
and in others, such prices can be set on an individual customer basis, although
the Company may be required to file tariff addenda of the contract terms. The
Company is not subject to price cap or to rate of return regulation in any state
in which it currently provides services. Some states where the Company operates
have adopted de-tarriffing rules
As noted above, the states have the primary regulatory role over
intrastate services under the Telecom Act. The Telecom Act allows state
regulatory authorities to continue to impose competitively neutral and
nondiscriminatory requirements designed to promote universal service, protect
the public safety and welfare, maintain the quality of service and safeguard the
rights of consumers. PUCs will implement and enforce most of the Telecom Act's
local competition provisions, including those governing the specific charges for
local network interconnection. In some states, those charges are being
determined by generic cost proceedings and in other states they are being
established through arbitration proceedings. Depending on how such charges are
ultimately determined, such charges could become a material expense to the
Company.
COMPETITION
As noted above, the regulatory environment in which the Company operates
is changing rapidly. The passage of the Telecom Act combined with other actions
by the FCC and state regulatory authorities continues to promote competition in
the provision of telecommunications services.
ILECs. In each market served by its networks, the Company faces, and
expects to continue to face, significant competition from the ILECs, which
currently dominate their local telecommunications markets as a result of their
historic monopoly position.
The Company competes with the ILECs in its markets for local exchange
services on the basis of product offerings, bundling, reliability,
state-of-the-art technology, price, network design, ease of ordering and
customer service. However, the ILECs have long-standing relationships with their
customers and provide those customers with various transmission and switching
services, a number of which the Company does not currently offer. In addition,
ILECs enjoy a competitive advantage due to their vast financial resources. The
Company has sought, and will continue to seek, to achieve parity with the ILECs
in order to become able to provide a full range of local telecommunications
services. (See "Business -- Regulation" for additional information concerning
the regulatory environment in which the Company operates.) Because US LEC leases
fiber optic transmission capacity to link its customers with its networks, and
uses state-of-
13
the-art technology in its switch platforms, the Company has demonstrated cost
and service quality advantages over some currently available ILEC networks.
Other CLECs. In every market where US LEC has a switching center, one or
more other CLECs are also operating. In some cases, the Company competes
head-to-head with other CLECs and in some cases the other CLECs seek to serve a
different customer base. The Company competes with other CLECs in its markets on
the basis of product offerings, bundling, reliability, state-of-the-art
technology, price, network design, ease of ordering and customer service.
Other Competitors. The Company also faces, and expects to continue to
face, competition from other potential competitors in certain of the markets in
which the Company offers its services. In addition to the ILECs and other CLECs,
potential competitors capable of offering switched local and long distance
services include long distance carriers, cable television companies, electric
utilities, microwave carriers, wireless telephone system operators and private
networks built by large end-users. Many of these potential competitors enjoy
competitive advantages based upon existing relationships with subscribers, brand
name recognition and vast financial resources. A continuing trend toward
business combinations and alliances in the telecommunications industry may
create significant new competitors to the Company.
The Company believes that the Telecom Act, as well as a recent series of
completed and proposed transactions between ILECs and long distance companies
and cable companies, increase the likelihood that barriers to local exchange
competition will be removed. The Telecom Act, as passed, conditioned the
provision of in-region interLATA services by RBOCs upon a demonstration that the
market in which an RBOC seeks to provide such services has been opened to
competition. When ILECs that are RBOC subsidiaries are permitted to provide such
services they will be in a position to offer single source service which will
represent a significant competitive challenge for the Company. ILECs that are
not RBOC subsidiaries may offer single source service presently. The Telecom
Act's limitations on provision of in-region interLATA services have been
challenged by the RBOCs. (See "Business - Regulation").
The Company also competes with long distance carriers in the provision
of long distance services. Although the long distance market is dominated by a
few major competitors, hundreds of other companies also compete in the long
distance marketplace.
FORWARD LOOKING STATEMENTS AND RISK FACTORS
Except for historical statements and discussions, statements contained
in this report constitute "forward looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. In addition, the Company's Annual
Report to Stockholders for the year ended December 31, 2000, Quarterly Reports
on Form 10-Q, Current Reports on Form 8-K and subsequently filed Annual Reports
on Form 10-K, may include forward looking statements. Other written or oral
statements which constitute forward looking statements have been made and may in
the future be made by or on behalf of US LEC, including statements regarding
future operating performance, share of new and existing markets, short-term and
long-term revenue, earnings and cash flow amounts, judicial, statutory and
regulatory developments and general industry growth rates and US LEC's
performance in relation thereto. These statements are identified by the use of
forward-looking terminology such as "believes," "expects," "may," "will,"
"should," "estimates" or "anticipates" or the negative thereof or other
variations thereon or comparable terminology, or by discussions of strategy that
involve risks and uncertainties. These forward looking statements are based on a
number of assumptions concerning future events, including the outcome of
judicial and regulatory proceedings, the adoption of balanced and effective
rules and regulations by the FCC and PUCs, and US LEC's ability to successfully
execute its strategy. These forward looking statements are also subject to a
number of uncertainties and risks, many of which are outside of US LEC's
control, that could cause actual results to differ materially from such
statements. These risks include, but are not limited to, the following:
Disputed Revenues. The deregulation of the telecommunications industry
and the implementation of the Telecommunications Act of 1996 have embroiled the
industry and the Company in numerous
14
proceedings in arbitration, state regulatory commissions, and the courts over
issues including reciprocal compensation and access rates, the characterization
of traffic for compensation purposes, and the interpretation of interconnection
agreements, among other issues. Rulings adverse to the Company on any of the
issues, which are material to it, could have an adverse impact on the Company's
financial results or its operations.
The Company is involved in several legal and regulatory proceedings
regarding revenues and receivables from ILECs, IXCs and other carriers. As of
December 31, 2000, the Company's gross accounts receivable was approximately
$115 million, of which approximately $77 million was attributed to BellSouth and
approximately $13 million was attributed to Sprint.
In the case of BellSouth, the majority of the receivables are being
disputed primarily due to issues regarding reciprocal compensation for ISPs and
certain rate issues. In the case of Sprint, a significant portion of the
receivable is being disputed based on access rates. The following paragraphs
discuss in detail each of the material disputes and associated regulatory or
legal proceeding.
The Metacomm Decision - As the Company has previously reported,
BellSouth Telecommunications, Inc. ("BellSouth") began a proceeding in September
1998 before the North Carolina Utilities Commission ("NCUC") seeking to be
relieved of any obligation under its interconnection agreements with the Company
to pay reciprocal compensation for traffic related to the network operated by
Metacomm, LLC ("Metacomm"), a customer of both the Company and BellSouth. On
March 31, 2000, the NCUC issued an order in this proceeding (the "March 31
Order") that relieved BellSouth from paying reciprocal compensation to the
Company for any minutes of use attributable to Metacomm network traffic and
required the Company to cease billing BellSouth reciprocal compensation for
minutes of use attributable to the Metacomm or any similar network as such
networks are identified in the March 31 Order. The March 31 Order does not
affect in any way the NCUC's order of February 1998 requiring BellSouth to pay
reciprocal compensation to the Company for Internet service provider ("ISP")
traffic in North Carolina (the "NCUC ISP Order"). It relates solely to traffic
on Metacomm's network in North Carolina (the only state in which Metacomm
operated). The Company did not appeal the March 31 Order, although Metacomm is
prosecuting an appeal.
As a result of the March 31 Order, the Company recorded a pre-tax,
non-recurring, non-cash charge of approximately $55 million in the first quarter
of 2000. The charge was composed of the write-off of approximately $153 million
in receivables related to reciprocal compensation revenue offset by previously
established reserves of $39 million and a reduction of $59 million in
commissions payable to Metacomm.
On March 21, 2000, the NCUC issued an interim order (the "March 21
Order") to BellSouth to pay to the Company all reciprocal compensation owing to
the Company for traffic terminated in North Carolina, other than traffic related
to Metacomm and like networks. This order was issued in connection with the
on-going proceeding before the NCUC filed in September 1998 by the Company in
which it seeks payment of reciprocal compensation not related to Metacomm or to
traffic terminated to ISPs, and of other amounts owing to the Company. The
Company's action before the NCUC to recover reciprocal compensation and other
charges for non-Metacomm/non-ISP traffic has been stayed by the NCUC while the
Company and BellSouth conduct NCUC-ordered negotiations to resolve the matter.
The amount due to the Company as a result of this proceeding will be determined
by the negotiations or subsequent ruling by the NCUC regarding the
non-Metacomm/non-ISP charges BellSouth is obligated to pay. The Company is
currently working with BellSouth to determine the amount BellSouth will pay
under the March 21, 2000 Order. Once this is determined by negotiation or NCUC
ruling, the Company will adjust the non-recurring charge relating to the March
31 Order. Management believes that this adjustment will not be material to the
Company's operating results or financial position. If the negotiations are
unsuccessful, the Company will seek a lifting of the stay and seek a hearing and
ruling from the NCUC on its claims against BellSouth.
In 2000, additional paid-in capital has been reduced by $36 million
representing amounts due from Metacomm, which is indirectly controlled by
Richard T. Aab, a majority stockholder of the Company. Due to Mr. Aab's
controlling position in both Metacomm and the Company, this amount is being
treated for financial reporting purposes as a deemed distribution to the
stockholder. At the time such amounts are paid to the Company, the payment will
increase additional paid-in capital as a capital contribution to the Company.
(See Note 14 to the Company's Consolidated Financial Statements)
Other Disputed Reciprocal Compensation Revenue - The Company is also a
party to the following material proceedings in which it seeks collection of
outstanding amounts owed by incumbent local telephone companies, primarily
BellSouth, for non-Metacomm related reciprocal compensation,
15
including reciprocal compensation related to traffic terminating to ISPs and
other customers:
North Carolina -- On February 26, 1998, following a petition by the
Company, the NCUC ordered BellSouth to bill and pay for all ISP-related traffic
(defined above, the "NCUC ISP Order"). Following motions filed by BellSouth, the
NCUC stayed enforcement of its order until June 1, 1998. On April 27, 1998,
BellSouth filed a petition for judicial review of the NCUC ISP Order and an
action for declaratory judgment and other relief (including a request for an
additional stay) with the United States District Court for the Western District
of North Carolina ("U.S. District Court-NC") pending determination of certain
related issues by the Federal Communications Commission ("FCC"). This action was
filed against the Company and the NCUC. In June 1999, the U.S. District Court-NC
dismissed BellSouth's petition without prejudice and remanded it back to the
NCUC for further review. Following the U.S District Court-NC's remand, on June
22, 1999, the NCUC denied BellSouth's request for a further stay of the NCUC ISP
Order.
In addition to denying BellSouth's request for a further stay, the NCUC
filed an appeal with the U.S. Fourth Circuit Court of Appeals (the "4th
Circuit") of the U.S. District Court-NC's order that rejected the NCUC's
defenses, including its defense that the 11th Amendment to the United States
Constitution bars BellSouth from making the NCUC a party to a proceeding in the
federal courts. The Company also appealed and the United States Justice
Department intervened in the appeal. On February 14, 2001 the 4th Circuit issued
a ruling in favor of the Company and the NCUC, ruling that the U.S. District
Court - NC did not have subject matter jurisdiction over the appeal of an
enforcement proceeding and ruling the NCUC was immune from suit under the
Eleventh Amendment of the United States Constitution. On March 5, 2001, the
United States Supreme Court granted a petition for certiorari in which it agreed
to consider these issues in a case originating in the U.S. Circuit Court of
Appeals for the Seventh Circuit. The Company anticipates that BellSouth will
seek review of the Fourth Circuit Court's ruling by the Supreme Court as well.
On July 16, 1999, the Company received a payment of $11.2 million from
BellSouth representing a portion of the amounts due the Company for ISP
reciprocal compensation in North Carolina. In making the payment, BellSouth
stated that it was for ISP traffic the NCUC had ordered it to pay for in the
NCUC ISP Order, including late fees, and that it was reserving all of its appeal
rights with respect to the payment. BellSouth also stated that this payment did
not include any amounts at issue in its September 1998 NCUC proceeding regarding
Metacomm. This partial payment did not cover all outstanding non-Metacomm
related amounts the Company claims are due from BellSouth in North Carolina. In
addition, BellSouth has from time to time made payments to US LEC for reciprocal
compensation related to traffic terminated in North Carolina, but BellSouth has
not paid the entire amount due to the Company for non-Metacomm reciprocal
compensation.
Georgia -- On June 30, 1999, the Company filed a complaint against
BellSouth before the Georgia Public Service Commission ("GAPSC") concerning the
Company's first and second interconnection agreements with BellSouth in Georgia.
These interconnection agreements cover the period through June 1999. On May 17,
2000, the hearing officer reviewing the Company's first and second
interconnection agreements with BellSouth issued a recommended decision to the
GAPSC stating that BellSouth should be ordered to pay US LEC the disputed
reciprocal compensation at the end office rate, pending submission of evidence
by the Company showing that it is entitled to be compensated at the higher
tandem rate. On June 15, 2000, the GAPSC affirmed this recommended decision, and
issued an order requiring BellSouth to pay US LEC reciprocal compensation for
traffic to ISPs and other customers in Georgia at the end office rate (the
"GAPSC Order"). On July 12, 2000, US LEC filed evidence with the GAPSC regarding
its right to be compensated at the tandem rate. On July 14, 2000, BellSouth
filed an appeal of the GAPSC Order with the U.S. District Court for the Northern
District of Georgia ("U.S. District Court-GA") and with the Georgia Superior
Court in and for Fulton County, Georgia. BellSouth asked the Georgia state court
to cede the appeal to the U.S. District Court - GA and asked the latter court
for permission to pay amounts due into court to avoid paying US LEC pending
appeal. On July 18, 2000, the U.S. District Court- GA granted BellSouth's motion
to pay amounts due into court prior to receipt by the Company of any papers
related to that appeal. On October 2, 2000, the U.S. District Court - GA denied
the Company's request for reconsideration of the order allowing BellSouth to pay
amounts due into court. The Georgia State and Federal Courts are setting a
briefing schedule for the proceeding, and the Company and expects a decision
16
sometime in 2001. The GAPSC held a hearing on the tandem/end office rate issue
on March 8, 2001, but has not yet rendered a decision.
Florida -- On July 2, 1999, the Company filed a complaint against
BellSouth before the Florida Public Service Commission ("FLPSC") seeking
recovery of reciprocal compensation for ISP and other traffic in that state. The
FLPSC will also be called upon to decide issues in dispute between the Company
and BellSouth regarding the rate at which reciprocal compensation should be paid
for some of the traffic at issue. The hearing is scheduled to take place later
in 2001.
Tennessee -- On August 6, 1999, the Company filed a complaint against
BellSouth before the Tennessee Regulatory Authority ("TRA") seeking recovery of
reciprocal compensation for ISP and other traffic in that state. The TRA will
also be called upon to decide issues in dispute between the Company and
BellSouth regarding the rate at which reciprocal compensation should be paid for
some of the traffic at issue. There is no hearing scheduled for this matter at
this time.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the FLPSC and the TRA
and in the pending appeal of the NCUC ISP Order and the GAPSC Order with respect
to the eligibility of ISP traffic for reciprocal compensation. Management's
belief is supported by the determinations of state regulatory bodies and by
courts hearing appeals of the state regulatory decisions, which are discussed
below, notwithstanding the jurisdictional position on ISP traffic taken by the
FCC in February 1999, which has now been vacated, also discussed below. However,
BellSouth may elect to initiate additional proceedings (by way of appeal or
otherwise) or attempt to expand the pending proceedings challenging amounts owed
to the Company. In this regard, BellSouth has asserted a variety of other
objections to paying portions of the reciprocal compensation billed by the
Company. They include assertions that US LEC has miscalculated late payment fees
due from BellSouth and that the Company has billed reciprocal compensation using
the wrong rates. The Company believes BellSouth has asserted these issues and
will attempt to raise further issues, in order to avoid or delay payment. In
September 2000, the FLPSC issued a ruling regarding one of these rate issues
favorable to BellSouth in a proceeding bought by Intermedia Communications, Inc
("Intermedia"). The impact of this ruling has not yet been determined, and the
Company has been informed that Intermedia intends to appeal the decision.
Proceedings on the same issue are pending decision in Georgia and North
Carolina.
FCC's ISP Ruling and Related Proceedings -- In February, 1999, the FCC
issued a declaratory ruling (the "ISP Ruling") which concluded that for
jurisdictional purposes most calls delivered to ISPs should be deemed to
continue to Internet web sites, which are often located in other states. Thus,
the FCC ruled that such calls are jurisdictionally "interstate" in nature.
However, the FCC further declared that, in light of its long-standing policy of
treating calls to ISPs as though they were local, where parties have previously
agreed in interconnection agreements that reciprocal compensation must be paid
for traffic bound for ISPs, the parties should be bound by those agreements, as
interpreted and enforced by state regulatory bodies. The FCC also recognized
that some commissions might reconsider their decisions in light of its ruling.
On March 24, 2000, the U.S. Circuit Court for the District of Columbia
(the "D.C. Circuit") vacated the FCC's ISP Ruling. The D.C. Circuit ruled that
the FCC did not give adequate consideration to a number of facts when it found
that ISP calls were jurisdictionally interstate, including the FCC's own past
analyses of how to determine whether calls dialed to telephone numbers within
the local exchange are interstate or intrastate. The D.C. Circuit also concluded
that the FCC had failed to explain why its jurisdictional analysis had any
relevance to the issue of whether calls to ISPs should be eligible for
reciprocal compensation. The D.C. Circuit sent the case back to the FCC to give
the FCC opportunity to reconsider those questions in light of the D.C. Circuit's
ruling. On June 23, 2000, the FCC requested comments on the issues raised by the
D.C. Circuit in its remand of the ISP Ruling. Initial comments were filed on
July 21, 2000. Reply comments were filed on August 4, 2000. The Company cannot
predict when the FCC will issue its decision on remand.
To date, state regulatory bodies in at least thirty states have
considered the effect of the FCC's ISP
17
Ruling and have overwhelmingly reaffirmed their earlier decisions requiring
payment of reciprocal compensation for this type of traffic or for the first
time determined that such compensation is due. Included among these states are
Alabama, Florida, Georgia and Tennessee, which together with North Carolina (see
discussion above) represent the only states in BellSouth's operating territory
where the Company has significant reciprocal compensation disputes at December
31, 2000. In this regard, the Alabama Public Service Commission (the "APSC")
concluded that the treatment of ISP traffic as local was so prevalent in the
industry at the time BellSouth entered into interconnection agreements with
CLECs that, if it had so intended, BellSouth had an obligation to negate such
local treatment in the agreements by specifically delineating that ISP traffic
was not local traffic subject to the payment of reciprocal compensation. The
APSC decision was affirmed by the United States District Court for the Middle
District of Alabama, and the GAPSC decision was affirmed by the United States
District Court of the Northern District of Georgia. The FLPSC and the TRA have
also reaffirmed decisions that reciprocal compensation is owed for calls to
ISPs. Two BellSouth states - South Carolina and Louisiana - have ruled that
reciprocal compensation is not due for traffic to ISPs. These decisions, which
came before the FCC's ISP Ruling was vacated by the D.C. Circuit, represent a
view adopted by very few other states (The Company did not have ISP reciprocal
compensation recorded in 2000 for traffic in South Carolina or Louisiana.)
State and federal courts considering the issue on appeal have also
universally supported the position that reciprocal compensation is due for
traffic terminated to ISPs. Included among these are decisions of the U.S.
Circuit Courts of Appeal for the Fifth, Seventh, Ninth and Tenth Circuits, all
of which considered the issue in light of the FCC's ISP Ruling and affirmed the
underlying decisions of the state regulatory agencies that reciprocal
compensation is due for traffic terminated to ISPs.
If a decision adverse to the Company is issued in any of these
proceedings by any of the state commissions, or in any federal or state appeal
or review of a favorable decision, or if either the FCC or any of the applicable
state commissions was to alter its view of reciprocal compensation or if
Congress or any state legislature enacted legislation that ended reciprocal
compensation for ISP traffic or all local traffic, such an event could have a
material adverse effect on the Company's operating results and financial
condition. Management estimates the Company's gross trade accounts receivable as
of December 31, 2000 included approximately $54 million of earned, but
uncollected, disputed reciprocal compensation related to non-Metacomm related
ISP traffic.
Potential Future Proceedings. The proceedings described above relate to
certain of the Company's interconnection agreements. As the Company executes new
interconnection agreements or as ILECs raise additional disputes, the Company
may be required to initiate additional proceedings seeking payment of amounts it
believes it is owed.
Legislation - At the end of the last session of Congress, legislation
was introduced in the United States House of Representatives and the United
States Senate that would eliminate all reciprocal compensation for calls to ISPs
and, under some proposals, for all local calls. A House subcommittee approved a
version of this legislation. No action was taken in the Senate. If this or
similar legislation were to become law, it would have a material adverse effect
on the Company.
GTE Reciprocal Compensation Dispute in North Carolina - In addition to
the proceedings involving BellSouth which are discussed above, in February 2000,
the Company received payment from GTE South Incorporated ("GTE") (now Verizon
South Incorporated) for reciprocal compensation for traffic in North Carolina,
including ISP traffic. This payment was pursuant to a commercial arbitration
award rendered January 4, 2000 resulting from a proceeding before the American
Arbitration Association. GTE was ordered to pay US LEC for all reciprocal
compensation for the period ending September 1999 (approximately $650 thousand).
GTE challenged the decision of the arbitrator in the U.S. District Court for the
Eastern District of North Carolina. This challenge was denied by the U.S.
District Court for the Eastern District of North Carolina and judgement was
entered in the Company's favor on January 11, 2001. The judgement was not
appealed so it is a final judgement.
In addition, the Company has filed for arbitration to resolve its
reciprocal compensation dispute with GTE in North Carolina for periods after
September 1999. The hearing in this arbitration took place on
18
February 26-27, 2001, and all post-hearing briefs are scheduled to be filed by
April 23, 2001. Although the Company cannot predict when this arbitrator will
issue a decision, management knows of no reason why the second arbitration
should have an outcome different from the first, favorable arbitration ruling.
The Company anticipates that GTE will appeal any ruling adverse to it.
Existing BellSouth Interconnection Agreements -- In October 2000, the
Company agreed to adopt existing local interconnection agreements with BellSouth
in South Carolina, Kentucky, Louisiana and Mississippi. The Agreements are for a
term of two years and relate back to the expiration date of the prior agreements
in each state, and therefore will expire at varying dates in 2002. The
Agreements provide for reciprocal compensation at rates significantly lower than
in the Company's prior interconnection agreements. These agreements do not
provide for any reciprocal compensation payments for ISP traffic; rather, the
agreements include a true up provision whereby the parties will track that
traffic pending an order from the FCC on the issue. The Company does not have
significant amounts of reciprocal compensation in these states. The Company has
adopted new interconnection agreements in North Carolina, Florida and Tennessee,
all of which relate back to January 1, 2000 and which expire April 2002, October
2002 and November 2002, respectively. These agreements provide for reciprocal
compensation for all local traffic, including ISP traffic, at rates
significantly lower than in the Company's prior interconnection agreements.
However, the agreement for North Carolina provides for a true-up of payments
made for ISP traffic should the FCC determine that reciprocal compensation is
not owing for ISP traffic and that determination is given retroactive effect.
The Company continues to seek interconnection agreements with BellSouth in
Alabama and Georgia. The Company's existing agreements with BellSouth in these
states have expired, but continue in force until new interconnection agreements
are signed. BellSouth filed petitions for arbitration in these states seeking to
obtain state-ordered interconnection agreements, but the Company anticipates
that it will be able to avoid or shorten the arbitration process in these states
by adopting interconnection agreements that will result from recently concluded
arbitrations involving other CLECs. These new agreements will be effective as of
the expiration date of the prior agreements. The Company anticipates that new
interconnection agreements in these states will also provide for significantly
lower rates, but, unlike the agreements in South Carolina, Kentucky, Louisiana
and Mississippi, the Company does not anticipate that payment of reciprocal
compensation for ISP traffic would be affected by a true up provision.
Disputed Access Revenues - A number of IXCs have refused to pay access
charges to CLECs, including those of the Company, on the allegation that the
access charges exceed those of the ILEC serving that territory in an apparent
effort to induce the CLECs, including the Company, to reduce access charges.
Currently there are a number of court cases, regulatory proceedings at the FCC,
and legislative efforts involving such challenges. The Company cannot predict
the outcome of these cases, regulatory proceedings, and legislative efforts or
their impact on access rates. In February 2000, the Company filed suit in U.S.
District Court for the Western District of North Carolina against Sprint
Communications Company L.P. ("Sprint"). This action seeks to collect amounts
owed to the Company for access charges for intrastate and interstate traffic
which was either handed off to Sprint by the Company or terminated to the
Company by Sprint. As of December 31, 2000, Sprint owed the Company
approximately $13 million in access charges. Sprint has refused to pay the
amounts invoiced by the Company on the basis that the rates are higher than the
amounts that Sprint believes are just and reasonable. Sprint claims it is not
obligated to pay more than an undefined incumbent local exchange carrier
("ILEC") rate. The Company's invoices to Sprint are at the rates specified in
the Company's state and federal tariffs. The FCC recently determined that a long
distance company may not withhold interstate access charges on the basis that it
believes the charges to be too high while also continuing to accept the benefits
of interconnection with the local carrier without taking formal action to
challenge the rates. The FCC has ruled that AT&T was obligated to pay such
access charges due to its failure to commence a proceeding or terminate
interconnection. (MGC Communications, Inc. v. AT&T Corp., FCC Release 99-408).
This decision is now final, as AT&T did not appeal the FCC's ruling. In
addition, the FCC ruled recently in an action brought by Sprint against MGC
Communications, Inc. ("MGC") that the fact that a CLEC's filed interstate rates
exceeded those of the competing ILECs was insufficient to establish that the
CLEC's rates were excessive. The FCC dismissed Sprint's challenge to MGC's
rates. Sprint has appealed the FCC's decision to the United States Court of
Appeals for the District of Columbia Circuit, and oral argument is
19
scheduled for April 20, 2001. As a result of these rulings, management
Santicipates a favorable resolution of the Company's dispute with Sprint (See
Business - Forward Looking Statement and Risk Factors - "Legal Proceedings").
Risks Associated with Strategy. The operation, construction, expansion
and development of US LEC's operations depend on, among other things, the
Company's ability to continue to (i) accurately assess potential new markets and
products, (ii) identify, hire and retain qualified personnel, (iii) lease access
to suitable fiber optic transmission facilities, (iv) install and operate
switches and related equipment and (v) obtain any required government
authorizations, all in a timely manner, at reasonable costs and on satisfactory
terms and conditions. In addition, US LEC has experienced rapid growth since its
inception, and management believes that sustained growth will place a strain on
operational, human and financial resources. The Company's ability to manage its
operations and expansion effectively depends on the continued development of
plans, systems and controls for its operational, financial and management needs.
There can be no assurance that the Company will be able to satisfy these
requirements or otherwise manage its operations and growth effectively. The
failure of US LEC to satisfy these requirements could have a material adverse
effect on the Company's financial condition and its ability to fully implement
its operating plans.
The Company's growth strategy also involves the following risks:
Qualified Personnel. A critical component for US LEC's success is hiring
and retaining additional qualified managerial, sales and technical personnel.
Since its inception, the Company has experienced significant competition in
hiring and retaining personnel possessing necessary skills and
telecommunications experience. Although management believes the Company has been
successful in hiring and retaining qualified personnel, there can be no
assurance that US LEC will be able to do so in the future.
Switches and Related Equipment. An essential element of the Company's
current strategy is the provision of switched local service. There can be no
assurance that installation of the switches and associated equipment necessary
to implement the Company's business plan will be completed on a timely basis or
that the Company will not experience technological or operational problems that
cannot be resolved in a satisfactory or timely matter. The failure of the
Company to install and operate successfully switches and other network equipment
could have a material adverse effect on the Company's financial condition and
its ability to attract and retain customers or to enter additional markets.
Interconnection Agreements. The Company has agreements for the
interconnection of its networks with the networks of the ILECs covering each
market in which US LEC either has or is currently installing a switching
platform. US LEC may be required to negotiate new interconnection agreements as
it enters new markets in the future. In addition, as its existing
interconnection agreements expire, it will be required to negotiate extension or
replacement agreements. There can be no assurance that the Company will
successfully negotiate such additional agreements for interconnection with the
ILECs or renewals of existing interconnection agreements on terms and conditions
acceptable to the Company. The Company has signed interconnection agreements
with various ILECs, including BellSouth Telecommunications, Inc. ("BellSouth"),
Sprint Communications Company L.P. ("Sprint"), Verizon Communications
("Verizon") and other carriers. These agreements provide the framework for the
Company to serve its customers when other local carriers are involved. The
Company has signed multiple agreements with BellSouth which govern relationships
in all nine states (See Existing BellSouth Interconnection Agreements above).
Agreements with GTE are in force in states where GTE and the Company
operate. The agreement for Virginia expired in July 2000, and remains in force
and effect until a new agreement is executed. All other agreements expire during
2001 or 2002. The Company continued to seek new interconnection agreements in
these states.
The Company also has interconnection agreements with Verizon in the
states of Virginia, Pennsylvania, Maryland, Delaware, New Jersey and the
District of Columbia. Each of these agreements expired in 2000, and remains in
force and effect until a new agreement is entered into by Verizon and the
Company.
Agreements with Sprint are in force and effect in Florida, Virginia,
North Carolina and Tennessee.
20
Ordering, Provisioning And Billing. The Company has developed processes
and procedures and is working with external vendors, including the ILECs, in the
implementation of customer orders for services, the provisioning, installation
and delivery of such services and monthly billing for those services. The
failure to manage effectively processes and systems for these service elements
or the failure of the Company's current vendors or the ILECs to deliver
ordering, provisioning and billing services on a timely and accurate basis could
have a material adverse effect upon the Company's ability to fully execute its
strategy.
Products and Services. The Company currently offers local, long
distance, data, Internet and enhanced services. In order to address the needs of
its target customers, the Company will be required to emphasize and develop
additional products and services. No assurance can be given that the Company
will be able to provide the range of telecommunication services that its target
customers need or desire.
Acquisitions. US LEC may acquire other businesses as a means of
expanding into new markets or developing new services. The Company is unable to
predict whether or when any prospective acquisitions will occur or the
likelihood of a material transaction being completed on favorable terms and
conditions. Such transactions would involve certain risks including, but not
limited to, (i) difficulties assimilating acquired operations and personnel;
(ii) potential disruptions of the Company's ongoing business; (iii) the
diversion of resources and management time; (iv) the possibility that uniform
standards, controls, procedures and policies may not be maintained; (v) risks
associated with entering new markets in which the Company has little or no
experience; and (vi) the potential impairment of relationships with employees or
customers as a result of changes in management. If an acquisition were to be
made, there can be no assurance that the Company would be able to obtain the
financing to consummate any such acquisition on terms satisfactory to it or that
the acquired business would perform as expected.
Dependence on Key Personnel. The Company's business is managed by a
small number of executive officers, most notably Richard T. Aab, Chairman,
Tansukh V. Ganatra, Vice Chairman and Chief Executive Officer, Aaron D. Cowell,
Jr., President and Michael K. Robinson, Executive Vice President and Chief
Financial Officer. The loss of the services of one or more of these key people
could materially and adversely affect US LEC's business and its prospects. None
of the Company's executive officers have employment agreements and the Company
does not maintain key man life insurance on any of its officers. The competition
for qualified managers in the telecommunications industry is intense.
Accordingly, there can be no assurance that US LEC will be able to hire and
retain necessary personnel in the future to replace any of its key executive
officers, if any of them were to leave US LEC or be otherwise unable to provide
services to US LEC.
Reliance on Leased Capacity. A key element of US LEC's business and
growth strategy is leasing fiber optic transmission capacity instead of
constructing its own transport facilities. In implementing this strategy, the
Company relies upon its ability to lease capacity from CAPs, other CLECs and
LECs operating in its markets. In order for this strategy to be successful, the
Company must be able to negotiate and renew satisfactory agreements with its
fiber optic network providers, and the providers must process provisioning
requests on a timely basis, maintain their networks in good working order and
provide adequate capacity at competitive prices. Although US LEC enters into
agreements with its network providers that are intended to ensure access to
adequate capacity and timely processing of provisioning requests and although US
LEC's interconnection agreements with ILECs generally provide that the Company's
connection and maintenance orders will receive attention at parity with the
ILECs and other CLECs and that adequate capacity will be provided, there can be
no assurance that the ILECs and other network providers will comply with their
contractual (and, in the case of the ILECs, legally required) network
provisioning obligations, or that the provisioning process will be completed for
the Company's customers on a timely and otherwise satisfactory basis.
Furthermore, there can be no assurance that the rates to be charged to US LEC
under future interconnection agreements or lease agreements with other providers
will allow the Company to offer usage rates low enough to attract a sufficient
number of customers and operate its networks at satisfactory margins.
Competition. The telecommunications industry is highly competitive. In
each of the Company's existing and target markets, the Company competes and will
continue to compete principally with the
21
ILECs serving that area. ILECs are established providers of local telephone and
exchange access services to all or virtually all telephone subscribers within
their respective service areas. ILECs also have greater financial and personnel
resources, brand name recognition and long-standing relationships with customers
and with regulatory authorities at the federal and state levels and with most
long distance carriers.
The Company also faces, and expects to continue to face, competition
from other current and potential market entrants, including long distance
carriers seeking to enter, reenter or expand entry into the local exchange
marketplace, and from other CLECs, CAPs, cable television companies, electric
utilities, microwave carriers, wireless telephone system operators and private
networks built by large end-users. In addition, a continuing trend toward
combinations and strategic alliances in the telecommunications industry could
give rise to significant new competitors. Many of these current and potential
competitors have financial, personnel and other resources, including brand name
recognition, substantially greater than those of the Company, as well as other
competitive advantages over the Company.
The Company also competes with long distance carriers in the
provisioning of long distance services. Although the long distance market is
dominated by few major competitors, hundreds of other companies also compete in
the long distance marketplace.
In addition, the regulatory environment in which the Company operates is
undergoing significant change. As this regulatory environment evolves, changes
may occur which could create greater or unique competitive advantages for all or
some of the Company's current or potential competitors, or could make it easier
for additional parties to provide services. (See "Business -- Competition").
At December 31, 2000, the Company served over 3,900 customers. A key
element of the Company's future success will depend on its ability to retain
these customers and minimize loss of revenue associated with customer or
product churn. While the Company has historically achieved significant success
in retaining customers, competition in the Company's marketplace is intense and
the Company anticipates that other carriers will seek to persuade the Company's
customers to switch service provided for some or all of their products.
Regulation. Although passage of the Telecom Act has resulted in
increased opportunities for companies that are competing with the ILECs, no
assurance can be given that changes in current or future regulations adopted by
the FCC or state regulators or other legislative or judicial initiatives
relating to the telecommunications industry would not have a material adverse
effect on the Company. In addition, although the Telecom Act, as passed,
conditions RBOCs' provisioning of in-region long distance service on a showing
that the local market has been opened to competition, in the event a RBOC has
satisfied these conditions, it could (i) remove the incentive RBOCs presently
have to cooperate with companies like US LEC to foster competition within their
service areas so that they can qualify to offer in-region long distance by
allowing RBOCs to offer such services immediately and (ii) give the RBOCs the
ability to offer "one-stop shopping" for both long distance and local service.
In addition to the specific concerns regarding the RBOC's ability to
provide in-region long distance, the regulatory environment facing the Company
is subject to numerous uncertainties. The FCC and PUC orders that were designed
to implement the Telecom Act have been challenged in numerous proceedings. As a
result, the Company must attempt to execute its business strategy without
knowing the rules that will govern its operations and its dealings with other
telecommunications companies including the rates and terms under which it may
charge other carriers for reciprocal compensation and other access charges. Even
though a number of the past regulatory efforts by the FCC and PUCs are or have
been challenged, the Company expects further rule making from the FCC and PUCs.
The outcome of these challenges and the nature and scope of future rule making
are unknown. In particular, the Company anticipates further efforts by other
carriers, primarily ILECs and IXCs, at the FCC, PUC and in legislative
initiatives to seek to cap, reduce and/or eliminate reciprocal compensation and
to cap or significantly reduce other access charges. The Company cannot predict
the degree to which the ILECs and IXCs will be successful in such efforts, or,
if they are, when such changes will take effect. If such changes result in a
significant decrease in the rates which the Company may charge other carriers
for reciprocal compensation and access or if such charges are retroactive, such
changes could have a material adverse effect on the Company.
22
As the regulatory environment changes, it is possible that the Company's
strategy and its execution of the strategy may not be the optimal choice. Any
such changes could also result in additional, unanticipated expenses. There can
be no assurances that regulatory change will not have a material and adverse
effect on the Company. (See "Business -- Regulation").
Legal Proceedings. The Company is currently involved in arbitral,
administrative and judicial proceedings and appeals thereof to collect amounts
owed to the Company by other carriers, primarily BellSouth, Verizon and Sprint.
The Company cannot predict when these matters will be formally resolved and,
although Management anticipates that these pending actions and appeals will be
resolved favorably, no assurance can be given that the Company will be
ultimately successful in these actions or the appeals thereof or that the
Company will collect all amounts that it believes to be due it from these other
carriers, or that if it does collect some or all of the award due to it, when
payment of the awards will be received (See Disputed Revenues.)
Future Capital and Operating Requirements. Implementation of the
Company's business strategy will require significant capital and operating
expenditures during 2001 and future years. In December 1999, the Company amended
its senior secured credit facility increasing the amount available under the
facility to $150 million (the "Credit Facility"). In addition, in February 2000,
the Company announced it had executed a letter of intent with affiliates of Bain
Capital, Inc. and Thomas H. Lee Partners, L.P. to invest up to $300 million in
convertible preferred stock of US LEC (the "Preferred Stock Investment"). The
first tranche of $200 million closed on April 11, 2000. The option for an
additional $100 million will expire on April 11, 2001 and is not expected to be
exercised. (See "Item 7: Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources"). The
Company's principal capital expenditures relate to the purchase and installation
of its switching platform, related infrastructure and facilities. Management
expects to satisfy its capital and operating requirements primarily with current
cash balances, borrowings under the Credit Facility and cash flow from
operations, although there can be no assurance that the actual expenditures
required to implement the Company's business strategy will not exceed amounts
available from these sources. In addition, the actual amount and timing of the
Company's future expenditures may differ materially from the Company's estimates
as a result of, among other things, the ability of the Company to meet its
planned expansion schedule, the number of its customers and the services for
which they subscribe and regulatory, technological and competitive developments
in the Company's industry. Due to the uncertainty of these factors, actual
revenues and costs may vary from expected amounts, possibly to a material
degree, and such variations are likely to affect the implementation of the
Company's business strategy.
The Company also will continue to evaluate revenue opportunities in
planned and other markets as well as potential acquisitions. The Company expects
to obtain the capital required to pursue additional opportunities from the
Credit Facility and other borrowings, the sale of additional equity or debt
securities or cash generated from operations. In light of the risk factors
discussed herein, there can be no assurance, however, that the Company will be
successful in raising sufficient additional capital on acceptable terms or that
the Company's operations will produce sufficient positive cash flow to pursue
such opportunities should they arise. Failure to raise and generate sufficient
funds, or unanticipated increases in capital requirements may require the
Company to delay or curtail its expansion plans, which could have a material
adverse effect on the Company's growth and its ability to compete in the
telecommunications services industry.
Variability of Quarterly Operating Results. As a result of the
significant expenses associated with the Company's expansion into new markets
and the anticipated decline in reciprocal compensation and access revenue, the
Company's operating results may vary significantly from period to period.
Control By Single Stockholder. As of March 20, 2001, Richard T. Aab
beneficially owned or otherwise controlled 100% of the outstanding shares of
Class B Common Stock representing approximately 91% of the Company's total
voting power. In addition, holders of Class B Common Stock are entitled to vote
as a separate class to elect two members of the Board of Directors and to vote
with the holders of Class A Common Stock for the election of other members of
the Board of Directors. As a result, Mr. Aab,
23
subject to the rights of the holders of the Company's Series A Mandatorily
Redeemable Convertible Preferred Stock, will be able to control the board and
all stockholder decisions and, in general, to determine (without the consent of
the Company's other stockholders) the outcome of any corporate transaction or
other matter submitted to the stockholders for approval, including mergers,
consolidations and the sale of all or substantially all of the Company's assets.
Mr. Aab also has the power to prevent or cause a change in control of the
Company. (See "Item 12: Security Ownership of Certain Beneficial Owners and
Management"). For information on a recent significant development effecting Mr.
Aab's voting control, see Management's Discussion and Analysis of Financial
Condition and Results of Operations and Footnote 14 to the Company's
Consolidated Financial Statements.
ITEM 2. PROPERTIES
The Company's corporate headquarters are located at its principal office
at Morrocroft III, 6801 Morrison Blvd., Charlotte, NC 28211. The Company leases
all of its administrative and sales offices and its switch sites. The various
leases expire in years ranging from 2001 to 2010. Most of these leases have
renewal options. Additional office space and switch sites will be leased or
otherwise acquired as the Company's operations and networks are expanded and as
new networks are constructed.
ITEM 3. LEGAL PROCEEDINGS
US LEC is not currently a party to any material legal proceedings, other
than the GPSC, TRA, FPSC, NCUC and U.S. District Court proceedings, the
arbitrations, and any appeals thereof, related to reciprocal compensation and
other amounts due from BellSouth and other ILECs and the U.S. District Court
proceeding related to access fees due from Sprint Communications (See
"Business--Regulation" and "Forward Looking Statements and Risk Factors" above
and Note 7 of the Company's consolidated financial statements for a detailed
description of these proceedings).
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
No matters were submitted to a vote of security holders during the quarter
ending December 31, 2000.
24
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
The Company's common stock trades on The Nasdaq National Market under the
symbol CLEC. As of March 20, 2001, US LEC Corp. had approximately 6,200
beneficial holders of its common stock. Of that total, 129 were stockholders of
record. To date, the Company has not paid cash dividends on its common stock.
The Company currently intends to retain earnings to support operations and
finance expansion and therefore does not anticipate paying cash dividends in the
foreseeable future.
The following table sets forth the high and low closing price information as
reported by Nasdaq during the period indicated since the Company's Class A
Common Stock began trading publicly on April 24, 1998.
Stock Price*
------------
1998 High Low
---- ---- ---
First Quarter N/A N/A
Second Quarter $27.00 $15.00
Third Quarter $25.88 $ 7.31
Fourth Quarter $14.81 $ 9.50
1999 High Low
---- ---- ---
First Quarter $19.50 $13.38
Second Quarter $24.62 $16.50
Third Quarter $33.13 $22.75
Fourth Quarter $32.25 $23.50
2000 High Low
---- ---- ---
First Quarter $46.31 $28.88
Second Quarter $33.64 $15.94
Third Quarter $17.00 $ 7.56
Fourth Quarter $11.22 $ 3.50
*No public market for the stock prior to April 24, 1998
25
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
SELECTED FINANCIAL DATA
For the years ended December 31, 1996, 1997, 1998, 1999 and 2000
(In Thousands, Except Per Share Data and Operating Data, as noted below)
**1996 1997 1998 1999 2000
------ ---- ---- ---- ----
Statement of Operations:
Revenue, Net $ - $ 6,458 $ 84,716 $ 175,180 $ 114,964
Cost of Services - 4,201 33,646 73,613 52,684
Gross Margin - 2,257 51,070 101,567 62,280
Selling, General and Administrative 942 6,117 25,020 48,375 80,684
Depreciation and Amortization 4 443 4,941 11,720 24,365
Loss on Resolution of Disputed Revenue* - - - - 55,345
Provision for Disputed Receivables* - - - - 40,000
Earnings (Loss) from Operations (946) (4,303) 21,109 41,472 (138,114)
Interest Income (Expense), Net (17) (355) 1,623 (2,046) (3,005)
Earnings (Loss) before Income Taxes (963) (4,658) 22,732 39,426 (141,119)
Income Taxes Provision (Benefit) - - 9,305 15,617 (23,727)
Net Earnings (Loss) (963) (4,658) 13,427 23,809 (117,392)
Less: Dividends on Preferred Stock - - - - 8,758
Less: Accretion of Preferred Stock Issuance Cost - - - - 336
Net Earnings (Loss) Attributable to Common Shareholders $ (963) $ (4,658) $ 13,427 $ 23,809 $(126,486)
Net Earnings (Loss) Per Share-Basic $ (0.06) $ (0.25) $ 0.53 $ 0.87 $ (4.58)
Net Earnings (Loss) Per Share-Diluted $ (0.06) $ (0.25) $ 0.52 $ 0.84 $ (4.58)
Weighted Average Shares Outstanding-Basic 17,310 18,653 25,295 27,431 27,618
Weighted Average Shares Outstanding-Diluted 17,310 18,653 25,804 28,411 27,618
Other Financial Data:
Capital Expenditures $ 280 $ 13,055 $ 47,292 $ 57,396 $ 109,740
Net Cash Flow Used in Operating Activities (1,079) (5,594) (19,143) (25,935) (49,319)
Net Cash Flow Used in Investing Activities (466) (5,951) (48,538) (49,696) (111,743)
Net Cash Flow Provided in Financing Activities 2,271 14,008 106,457 48,840 251,709
Operating Data:
Number of States Served - 1 4 7 12
Number of Local Switches - 3 11 16 23
Number of Customers - 142 558 1,946 3,929
Number of Employees 15 78 253 460 816
Number of Sales Employees 3 24 98 180 330
Balance Sheet Data:
Working Capital (Deficit) $ 937 $ (2,269) $ 76,215 $ 113,109 $ 112,402
Accounts Receivable, Net - 6,006 66,214 193,943 61,164
Current Assets 1,068 9,656 112,184 213,269 160,782
Property and Equipment, Net 276 12,889 56,219 102,002 188,052
Total Assets 1,467 22,681 170,203 320,100 373,158
Long-Term Debt 1,671 5,000 20,000 72,000 130,000
Series A Redeemable Convertible Preferred Stock - - - - 202,854
Total Stockholders' Equity (Deficiency) (355) 5,757 112,975 138,870 (22,250)
* See Note 7 of the Company's Consolidated Financial Statements for the
period ended December 31, 2000.
** The Company was a development stage enterprise in 1996. See Note 1 of
the Company's Consolidated Financial Statements for the period ended
December 31, 2000
26
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
Except for the historical information contained herein, this report
contains forward-looking statements, subject to uncertainties and risks,
including the demand for US LEC's services, the ability of the Company to
introduce additional products, the ability of the Company to successfully
attract and retain personnel, competition in existing and potential additional
markets, uncertainties regarding its dealings with ILECs and other
telecommunications carriers and facilities providers, regulatory uncertainties,
the possibility of adverse decisions related to reciprocal compensation and
access charges owing to the Company by BellSouth, Sprint and other carriers, as
well as the Company's ability to begin operations in additional markets. These
and other applicable risks are summarized in the "Forward-Looking Statements and
Risk Factors" section and elsewhere in the Company's Annual Report on Form 10-K
for the period ended December 31, 2000, and in other reports which are on file
with the Securities and Exchange Commission.
The following discussion and analysis should be read in conjunction with
the "Selected Consolidated Financial Data" on page 26 of this report and the
Company's consolidated financial statements and related notes thereto appearing
elsewhere in this report.
Company Overview
US LEC is a rapidly growing switch-based competitive local exchange
carrier ("CLEC") that provides integrated telecommunications services to its
customers. The Company primarily serves telecommunication-intensive customers
including businesses, universities, financial institutions, professional service
firms, hospitals, enhanced service providers ("ESPs"), Internet service
providers ("ISPs"), and hotels. US LEC was founded in June 1996 after passage of
the Telecommunications Act of 1996 (the "Telecom Act"), which enhanced the
competitive environment for local exchange services. US LEC initiated service in
North Carolina in March 1997, becoming one of the first CLECs in North Carolina
to provide switched local exchange services. US LEC currently offers local,
long-distance, data and enhanced services to customers in selected markets in
North Carolina, Florida, Georgia, Tennessee, Virginia, Alabama, Washington D.C.,
Pennsylvania, Mississippi, Maryland, South Carolina, Louisiana and Kentucky. In
addition, US LEC is currently certified to provide telecommunication services in
Indiana, Delaware, New Jersey, New York, Ohio, Texas, Connecticut and
Massachusetts. As of December 31, 2000, US LEC's network was comprised of 23
Lucent 5ESS(R) AnyMedia(TM) digital switches and 17 Lucent CBX500 ATM data
switches that are located throughout the Southeast and mid-Atlantic states, in
addition to an Alcatel MegaHub(R) 600ES switch in Charlotte, North Carolina.
Revenue and Cost of Services
US LEC's revenue is comprised of two primary components: (1) fees paid
by customers for local, long distance, data, Internet and enhanced services, and
(2) access charges, including reciprocal compensation, which is discussed below.
Local, long distance, data, Internet and enhanced service revenue is comprised
of monthly recurring charges, usage charges, and initial non-recurring charges.
Monthly recurring charges include the fees paid by customers for facilities
(lines and trunks) in service and additional features on those facilities. Usage
charges consist of usage-sensitive fees paid for calls made. Initial
non-recurring charges consist primarily of installation charges. Access charges
are comprised of charges paid primarily by inter-exchange carriers ("IXCs") for
the origination and termination of inter-exchange toll and toll-free calls and
reciprocal compensation, which is discussed below. US LEC's "core business"
revenue is comprised of local, long distance, data, Internet, and enhanced
service fees and toll and toll-free access charges other than reciprocal
compensation. The Company does not resell any ILEC services.
Reciprocal compensation arises when a local exchange carrier completes a
call that originated on another local exchange carrier's network. Reciprocal
compensation rates are fixed by an interconnection agreement executed between
those carriers. The majority of the Company's 1998 and 1999 revenue and 11% of
its 2000 revenue was earned from reciprocal compensation and is currently being
disputed by the
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incumbent local exchange carriers, primarily BellSouth. This dispute primarily
arises from reciprocal compensation charges related to traffic that is
terminated to enhanced service providers, including internet service providers.
(See Disputed Reciprocal Compensation Revenue appearing below for a description
of these proceedings and uncertainties associated with their outcome.)
Although the Company has generated a majority of its revenue from
reciprocal compensation prior to 2000, US LEC was founded to establish a company
that would provide a wide array of telecommunications services to its customers
and reciprocal compensation is not currently considered to be a part of the
Company's core revenue. US LEC has deployed a significant