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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, 2001
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 $46,159,955 as of March 21, 2002 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 21, 2002 there were 26,388,672 shares of Class A 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 7, 2002 are incorporated by
reference into Part III of this report.
US LEC CORP.
2001 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
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PART I
Item 1: Business 3
Item 2: Properties 20
Item 3: Legal Proceedings 20
Item 4. Submission of Matters to a Vote of Security Holders 20
PART II
Item 5: Market for the Registrant's Common Stock and Related Stockholder Matters 21
Item 6: Selected Consolidated Financial Data 22
Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations 23
Item 7A: Quantitative and Qualitative Disclosures about Market Risk 32
Item 8: Financial Statements and Supplementary Data 33
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 56
PART III
Item 10: Directors and Executive Officers of the Registrant 57
Item 11: Executive Compensation 58
Item 12: Security Ownership of Certain Beneficial Owners and Management 58
Item 13: Certain Relationships and Related Transactions 58
PART IV
Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K 59
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PART I
ITEM 1. BUSINESS
THE COMPANY
US LEC Corp. ("US LEC" or the "Company) is a Charlotte, NC-based
telecommunications carrier providing voice, data and Internet services to over
6,800 mid-to-large-sized business customers throughout the southeastern and
mid-Atlantic United States. As of December 31, 2001, US LEC's network consisted
of 26 Lucent 5ESS(R) AnyMedia(TM) digital switches, 25 Lucent CBX500
Asynchronous Transfer Mode ("ATM") data switches, 4 Juniper Networks(R) M20(TM)
Internet Gateway routers and an Alcatel MegaHub(R) 600ES tandem switch. The US
LEC service area includes Alabama, Florida, Georgia, Kentucky, Louisiana,
Maryland, Mississippi, New Jersey, North Carolina, Pennsylvania, South Carolina,
Tennessee, Virginia and the District of Columbia. The Company primarily serves
telecommunications-intensive business customers such as hotels, universities,
financial institutions, professional service firms and practices, hospitals,
enhanced service providers, Internet service providers, automobile dealerships
and government agencies. 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.
BUSINESS STRATEGY
US LEC's objective is to be the leading provider of voice, data and
Internet services to its existing and target customers, and to increase its
market share by expanding its customer base and 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 owning and deploying switching equipment and leasing the required
fiber optic transmission capacity from competitive access providers ("CAPs"),
other CLECs or incumbent local exchange carriers ("ILECs"). Management believes
the Company's switch-based, leased-transport strategy enables it to enter and
penetrate 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 customer 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 business customers including among
others, hotels, universities, financial institutions, professional service
firms and practices, hospitals, enhanced service providers, Internet service
providers, automobile dealerships and government agencies. By focusing
on such customers, the Company is able to more efficiently concentrate the
telecommunications traffic. In addition, the Company
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frequently is able to bundle 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 dial tone.
Install a Robust Technology Platform. The Company has chosen the 5ESS(R)
Any Media(TM) digital switch and the CBX500 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, 2001, US LEC had
26 Lucent voice switches and 25 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. In addition, the
Company has also deployed 4 Juniper Networks (R) M20 (TM) Internet Gateway
routers to provide reliable, scalable, and high-speed network elements to
significantly enhance the performance of US LEC's Internet access service. The
Company has also deployed an Advanced Intelligent Network ("AIN") platform that
positions US LEC for enhanced services.
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. 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 2001, the Company continued its project of
upgrading its back office systems by deploying "best of breed" systems for
various back office functions. Management believes that the implementation of
these or similar systems will enhance the electronic exchange of information
within US LEC by providing a centralized view of customer and order tracking
data.
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, ATM service and
long distance service, including intrastate, interstate, international and
toll-free. To further the Company's product strategy, US LEC has deployed its
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 customer
issues, 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. 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 2001, the Company activated additional Lucent switches in
Pittsburgh, Pennsylvania, New Orleans, Louisiana, and a second switch in
Atlanta, Georgia to bring the network to 26 switching centers.
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Four of the sites are also long distance platforms that provide additional
capability to route and concentrate the Company's long distance traffic.
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 maintains
interconnection agreements with the incumbent carriers. The Telecom Act,
decisions of state and federal regulatory bodies and negotiation affect the
terms and conditions of the interconnection agreements with the carriers
involved. The Company may voluntarily enter into such an agreement, petition a
state regulatory commission to arbitrate issues that cannot be resolved by
negotiation or by opting into agreements 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") and 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, T-1 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 offers 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 certain enhanced services such as voice mail.
The Company also provides data products including US LECnet (a direct,
dedicated, high-speed connection to the Internet), frame relay, ATM service and
a number of other services such as email, news feeds and web hosting.
The Company's ability to bundle local, long distance, data and Internet
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.
During 2000, the Company introduced the ADVANTAGE T, a single-rate,
bundled 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 this product allows US LEC to
expand the total market to which the Company has access.
Most recently, US LEC expanded its data portfolio with the launch of ATM
service. This new service allows US LEC's customers to dynamically allocate
bandwidth, making the transfer of data communications more efficient and
cost-effective. ATM is currently the core technology in the Internet backbone
and is widely supported by mainstream CPE (Customer Premise Equipment)
manufacturers. US
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LEC provides the new ATM service from its existing ATM-core data network, and
offers customers better control of service costs by allowing them to tailor
their traffic speeds and traffic priorities to fit their actual usage patterns.
ATM is most suited for companies with larger telecommunication needs, and it
allows them to migrate to faster services without significant changes to their
equipment.
SALES AND MARKETING
Sales. US LEC employs a well-trained 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 234 salespeople at December 31, 2000
to 256 salespeople at December 31, 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. During 2001, the Company continued to enhance its sales
force by hiring additional quota bearing and sales support staff, continuing
education regarding the Company's voice and data products and forming a central
group to focus on large sales and data sales.
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 two trademarks and service marks: US LEC, and a
logo that includes US LEC. 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.
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. The Company believes this is an important
aspect of customer acquisition and retention.
EMPLOYEES
As of December 31, 2001, the Company employed 892 people. The Company does
not expect significant changes in its staffing level in 2002. The Company
considers its employee relations to be very good.
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.
6
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.
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. The Supreme Court is considering cases
in which the issue of the PUC's ability to enforce interconnection agreements
has been challenged.
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 "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- 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").
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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 Connecticut, New York,
Massachusetts, and Pennsylvania and SBC's in Arkansas, Texas, Kansas, Missouri,
and Oklahoma. (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
prohibiting the use of tariffs for non-dominant carriers providing international
and domestic interstate long distance services. Accordingly, non-dominant
interstate services providers and international service 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 international and domestic interstate inter-exchange services. The order
does not apply to the switched and special access services of the BOCs and other
local exchange service providers. The FCC allows permissive detariffing of these
services.
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 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. 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 granted pricing flexibility applications for various
interstate access services provided by BOCs in a number of cities, including
cities in BellSouth's service territory, including in several of the Company's
markets.
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
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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. The FCC
has recently initiated rulemaking proceedings to examine various issues on
unusual services, including from whom contributions are required and how the
contribution is calculated.
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 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. The Order was appealed to the U.S. Court of Appeals for the
District of Columbia. The Court remanded the case to the FCC.
On May 21, 2001, the FCC's new rules governing CLEC interstate access
charges became effective. The rules establish an initial maximum rate of 2.5
cents per minute for interstate access charges for the first year. In the second
year, the rate is reduced to 1.8 cents per minute. In the third year, the rate
is further
9
reduced to 1.2 cents per minute. At the end of the third year, the benchmark
rate is reduced to the level of the ILEC. A CLEC may not file tariffs for above
benchmark rates unless the ILEC in whose territory it operates charges a higher
rate, in which case the CLEC may charge the higher ILEC rate or the rate it had
tariffed in the previous six months, if lower than the ILEC's rate. A CLEC may
charge a rate higher than the benchmark if the IXC, through negotiations, agrees
to such higher rate.
In addition, the FCC only allowed a CLEC to charge the benchmark rates in
those areas in which the CLEC was actually serving customers on May 21, 2001. In
new service areas, the CLEC may only tariff rates as high as the ILEC. Several
petitions for reconsideration of the FCC's order were filed with the FCC, as
well as appeals to the U.S. Court of Appeals for the District of Columbia
Circuit. The Court recently granted the FCC's request to hold the appeals in
abeyance until the FCC decides the motions for reconsideration.
In the same order, the FCC determined that a IXC's refusal to serve
customers of a CLEC that tariffs the FCC's benchmark rates would generally
violate the IXC's duty as a common carrier to provide service was a reasonable
decision.
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. The FCC order had 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.
On April 27, 2001, the FCC released its Order on Remand regarding
intercarrier compensation for ISP-bound traffic. The FCC asserted exclusive
jurisdiction over ISP-bound traffic and established a new interim intercarrier
compensation regime for ISP-bound traffic with capped rates above a fixed
traffic exchange ratio. Traffic in excess of a ratio of 3:1 (terminating minutes
to originating minutes) is presumed to be ISP-bound traffic, and is to be
compensated at rates that decrease from $.0015 to $.0007, or the applicable
state-approved rate if lower, over three years. Traffic below the 3:1 threshold
is to be compensated at the rates in existing and future interconnection
agreements. Traffic above the 3:1 ratio is also subject to a growth ceiling
using First Quarter 2001 traffic data as the baseline. Traffic in excess of the
growth ceiling is subject to "bill and keep," an arrangement in which the
originating carrier pays no compensation to the terminating carrier to complete
calls. In addition, when a competitive carrier begins to provide service in a
state it has not previously served, all traffic in excess of the 3:1 ratio is
subject to bill-and-keep arrangements. In exchange for this reduction in
reciprocal compensation obligations to CLECs, the ILECs must offer to exchange
all traffic subject to Section 251 (b) (5) of the Telecommunications Act of
1996, as well as ISP-bound traffic, at the federal capped rates. It is not
possible to estimate the full impact of the FCC Order at this time because the
federal regime does not alter existing contracts except to the extent that they
incorporate changes of federal law, and because adoption of the federal regime
is within the discretion of the ILEC exchanging traffic with CLECs on a
state-by-state basis. In addition, the rules are the subject of petitions for
reconsideration before the FCC and appeals to the U.S. Court of Appeals for the
District of Columbia Circuit. In the event an ILEC determines not to adopt the
federal regime, the ILEC must pay the same rate for ISP bound traffic as for
calls subject to reciprocal compensation. We cannot predict the impact of the
FCC's and the Court's ruling on existing state decisions, the outcome of pending
appeals or future litigation on this issue.
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
10
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 is expected to rule on these cases
by June 2002. 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 resell
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 Company cannot predict whether
these requirements will ultimately prove enforceable, nor whether they will
deter anti-competitive conduct if they are enforceable. The FCC has initiated
rulemaking proceedings to consider whether advanced services offered by ILECs
should be regulated as services offered by a dominant or nondominant carrier. If
the service offerings are deemed nondominant, the ILEC will be subject to
licensed regulation. In a related proceeding, the FCC is seeking to determine
whether advanced services are information services and what regulations should
apply, if that is the case. A finding that
11
advanced services are information services, and not telephone services, could
result in significantly lower levels of regulation. The Company cannot predict
the outcome of these proceedings.
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 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). 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.
The Communications Assistance for Law Enforcement Act ("CALEA") provides
rules to ensure that law enforcement agencies would be able to conduct properly
authorized electronic surveillance of digital and wireless telecommunication
services. CALEA requires telecommunications carriers to modify their equipment,
facilities, and services used to provide telecommunications services to ensure
that they are able to comply with authorized electronic surveillance
requirements. For circuit-switched facilities, carriers were required to
complete these modifications by June 30, 2001. Carriers providing
packet-switched services were required to comply by November 19, 2001. The
deadline for carrier compliance with certain additional requirements has been
extended by the FCC until June 30, 2002. US LEC's network is CALEA compliant.
State Regulation. The Company has all of the certifications necessary to
offer its current services in the states of:
State
-----
North Carolina
Alabama
Mississippi
Kentucky
Maryland
Pennsylvania
Delaware
District of Columbia
New Jersey
Louisiana
Georgia
Virginia
Indiana
New York
Ohio
Connecticut
Massachusetts
12
Tennessee
South Carolina
Florida
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
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
13
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-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, 2001, 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. 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
14
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, the
implementation of the Telecom Act, and the distress of many carriers in the wake
of the downturn in the telecommunications industry have embroiled numerous
industry participants, including the Company, in lawsuits, proceedings and
arbitrations before state regulatory commissions, private arbitration
organizations such as the American Arbitration Association, and courts over many
issues important to the financial and operational success of the Company. These
issues include the interpretation and enforcement of interconnection agreements,
the terms of interconnection agreements the Company may adopt, operating
performance obligations, reciprocal compensation, access rates, rates applicable
to different categories of traffic, and the characterization of traffic for
compensation purposes. The Company anticipates that it will continue to be
involved in various lawsuits, arbitrations, and proceedings (see "Management's
Discussion and Analysis of Financial Condition and Results of Operations
Disputed Revenues") over these and other material issues. The Company
anticipates also that further legislative and regulatory rulemaking will
occur--on the federal and state level--as the industry deregulates and as the
Company enters new markets or offers new products. Rulings adverse to the
Company, adverse legislation, or changes in governmental policy on issues
material to the Company could have a material adverse effect on the Company's
financial condition or results of operations.
15
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 the switches and associated equipment necessary to operate the
Company's network will not experience technological or operational problems that
cannot be resolved in a satisfactory or timely matter. The failure of the
Company to 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 has 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, the Company 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, Sprint, 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).
16
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 effectively manage 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, Francis J. Jules, Chief Executive
Officer, Aaron D. Cowell, Jr., President and Chief Operating Officer 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. 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 ILECs 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
17
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 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, 2001, the Company was providing services to over 6,800
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,
18
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 changes are retroactive, such changes could
have a material adverse effect on the Company.
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 "Management's Discussion and
Analysis of Financial Condition and Results of Operations-- Disputed Revenues.")
Future Capital and Operating Requirements. Implementation of the Company's
business strategy will require significant capital and operating expenditures
during 2002 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"). At December 31, 2001, all $150 million was
borrowed. In April 2000, the Company completed a transaction with
affiliates of Bain Capital, Inc. and Thomas H. Lee Partners, L.P. to invest $200
million in convertible preferred stock of US LEC (the "Preferred Stock
Investment"). (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 expansion of its
switching platform, related infrastructure and facilities. Management expects to
satisfy its capital and operating requirements primarily with current cash
balances, 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 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
existing and other markets as well as potential acquisitions. The Company
expects to obtain the capital required to pursue additional opportunities from
current cash balances, additional 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.
19
Executive Officers of the Registrant
The following table sets forth certain information regarding the executive
officers of US LEC Corp:
Name Age Position
- ---- --- --------
Richard T. Aab 53 Chairman of the Board and Director
Tansukh V. Ganatra 58 Director, Former Vice Chairman and Chief Executive
Officer until his retirement in December 2001
Francis J. Jules 45 Chief Executive Office as of December 2001
Aaron D. Cowell, Jr. 39 President, Chief Operating Officer and General Counsel
Michael K. Robinson 45 Chief Financial Officer and Executive Vice President
Richard T. Aab co-founded US LEC in June 1996 and has served as Chairman
of the Board of Directors since that time. He also served as Chief Executive
Officer from June 1996 until July 1999. Between 1982 and 1997, Mr. Aab held
various positions with ACC Corp., an international telecommunications company in
Rochester, NY, including Chairman and Chief Executive Officer, and served as a
director.
Tansukh V. Ganatra co-founded US LEC in June 1996 and has served as a
director since that time. He served as Chief Executive Officer and Vice Chairman
of the Board of Directors from July 1999 until his retirement in December 2001.
He also served as President and Chief Operating Officer from June 1996 until
July 1999. From 1987 to 1997, Mr. Ganatra held various positions with ACC Corp.,
including serving as its President and Chief Operating Officer. Prior to joining
ACC Corp., Mr. Ganatra held various positions during a 19-year career with
Rochester Telephone Corp., culminating with the position of Director of Network
Engineering. Mr. Ganatra currently serves as a consultant to US LEC Corp.
Francis J. Jules joined US LEC as Chief Executive Officer and as a
Director in December 2001 with more than 20 years of data, communications and
Internet industry experience. He served as president of Winstar Communications,
Inc.("Winstar") from August 2000 to December 2001 at which time he was named
Chief Executive Officer. Mr. Jules served as president of SBC/Ameritech Business
Communications Services ("SBC/Ameritech") from October 1997 to August 2000.
Prior to joining SBC/Ameritech, he held senior management positions with
Northern Telecom (now Nortel), IBM and New York Telephone.
Aaron D. Cowell, Jr. has been involved in numerous operating areas of the
Company's business and legal affairs since 1996, including its IPO in April
1998. Mr. Cowell joined US LEC in June 1998 as executive vice president and
general counsel. Later that year, he assumed responsibility for US LEC's sales
and field sales support functions. In 1999, his executive management duties were
expanded to include US LEC's engineering, operations, regulatory, customer care
services and marketing departments. Mr. Cowell was appointed as president and
chief operating officer of US LEC in 2000. He also holds a position on the
Executive Committee for ALTS (The Association for Local Telecommunications
Services), through which he helps promote regulations and decisions that will
facilitate fair competition in the telecommunications industry. Before joining
US LEC in 1998, Mr. Cowell spent 11 years with Moore & Van Allen PLLC, a large
Southeastern law firm, where he represented, among others, US LEC and Alcatel,
primarily in corporate finance and merger and acquisition matters. Mr. Cowell is
a graduate of Harvard Law School and Duke University.
Michael K. Robinson has been US LEC's executive vice president of finance
and chief financial officer since July 1998. Prior to joining US LEC, Mr.
Robinson held positions with the telecommunications division of Alcatel, an
international telecommunications equipment company headquartered in Paris,
France. From 1996 to July 1998, Mr. Robinson was executive vice president and
chief financial officer of Alcatel Data Networks, a developer and manufacturer
of wide area network data switching equipment for carrier and enterprise
solutions. He was responsible for financial controls, treasury, contracts
management, information systems, and facilities. In addition to his duties at
Alcatel Data Networks, Mr. Robinson was responsible for the worldwide financial
operations of the enterprise and data networking division of Alcatel. From 1989
to 1995, Mr. Robinson was vice president and chief financial officer of Alcatel
Network Systems, which developed, manufactured, and marketed transmission
equipment for telecommunications systems. Prior to joining Alcatel, Mr. Robinson
held various management positions with Windward International and Siecor Corp.
Mr. Robinson holds a masters degree in business administration from Wake Forrest
University.
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 during years through 2016. 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 proceedings, arbitrations, and any appeals thereof, related to reciprocal
compensation, intercarrier access and other amounts due from other carriers. The
Company believes it will be largely successful in these proceedings, and that
any adverse ruling in any pending proceeding or arbitration will not have a
material adverse effect on the Company. (See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Disputed Revenues")
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDER MATTERS
No matters were submitted to a vote of security holders during the quarter
ending December 31, 2001.
20
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED
STOCKHOLDERS
The Company's common stock trades on The Nasdaq National Market under the
symbol CLEC. As of March 21, 2002, US LEC Corp. had approximately 5,895
beneficial holders of its common stock, and approximately 145 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. In addition, both the credit facility and preferred stock
agreements contain certain limitations on the payment of dividends.
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
2001 High Low
---- ---- ---
First Quarter $9.06 $4.69
Second Quarter $6.50 $2.28
Third Quarter $4.01 $2.32
Fourth Quarter $6.75 $2.73
*No public market for the stock prior to April 24, 1998
21
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
SELECTED FINANCIAL DATA
For the years ended December 31, 1997, 1998, 1999, 2000 and 2001
(In Thousands, Except Per Share Data and Operating Data, as noted below)
1997 1998 1999 2000 2001
---- ---- ---- ---- ----
Statement of Operations:
Revenue, Net $ 6,458 $ 84,716 $175,180 $ 114,964 $178,602
Cost of Services 4,201 33,646 73,613 52,684 90,298
Gross Margin 2,257 51,070 101,567 62,280 88,304
Selling, General and Administrative 6,117 25,020 48,375 80,684 114,898
Depreciation and Amortization 443 4,941 11,720 24,365 35,103
Loss on Resolution of Disputed Revenue* -- -- -- 55,345 --
Provision (Recovery) for Disputed Receivables* -- -- -- 40,000 (7,042)
Earnings (Loss) from Operations (4,303) 21,109 41,472 (138,114) (54,655)
Interest Income (Expense), Net (355) 1,623 (2,046) (3,005) (8,699)
Earnings (Loss) before Income Taxes (4,658) 22,732 39,426 (141,119) (63,354)
Income Taxes Provision (Benefit) -- 9,305 15,617 (23,727) --
Net Earnings (Loss) (4,658) 13,427 23,809 (117,392) (63,354)
Less: Dividends on Preferred Stock -- -- -- 8,758 12,810
Less: Accretion of Preferred Stock Issuance Cost -- -- -- 336 491
Net Earnings (Loss) Attributable to Common Shareholders $(4,658) $ 13,427 $ 23,809 $(126,486) $(76,655)
Net Earnings (Loss) Per Share-Basic $ (0.25) $ 0.53 $ 0.87 $ (4.58) $ (2.83)
Net Earnings (Loss) Per Share-Diluted $ (0.25) $ 0.52 $ 0.84 $ (4.58) $ (2.83)
Weighted Average Shares Outstanding-Basic 18,653 25,295 27,431 27,618 27,108
Weighted Average Shares Outstanding-Diluted 18,653 25,804 28,411 27,618 27,108
Other Financial Data:
Capital Expenditures $13,055 $ 47,292 $ 57,396 $ 109,740 $ 40,425
Net Cash Flow Used in Operating Activities (5,594) (19,143) (25,935) (49,319) (5,971)
Net Cash Flow Used in Investing Activities (5,951) (48,538) (49,696) (111,743) (40,425)
Net Cash Flow Provided in Financing Activities 14,008 106,457 48,840 251,709 21,077
Operating Data:
Number of States Served 1 4 7 12 13
Number of Local Switches 3 11 16 23 26
Number of Customers 142 558 1,946 3,929 6,823
Number of Employees 78 253 460 816 892
Number of Sales and Sales Related Employees 24 98 180 330 365
Balance Sheet Data:
Working Capital (Deficit) $(2,269) $ 76,215 $113,109 $ 112,402 $ 59,972
Accounts Receivable, Net 6,006 66,214 193,943 61,165 42,972
Current Assets 9,656 112,184 213,269 160,782 135,644
Property and Equipment, Net 12,889 56,219 102,002 188,052 188,436
Total Assets 22,681 170,203 320,100 373,159 333,313
Long-Term Debt (including current portion) 5,000 20,000 72,000 130,000 150,000
Series A Redeemable Convertible Preferred Stock -- -- -- 202,854 216,155
Total Stockholders' Equity (Deficiency) 5,757 112,975 138,870 (22,250) (97,325)
*See Note 6 of the Company's Consolidated Financial Statements for the
period ended December 31, 2001.
22
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,
and the possibility of adverse decisions related to reciprocal compensation and
access charges owing to the Company by other carriers. 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, 2001, 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 23 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, including local and long distance voice services, toll free services,
frame relay, high speed internet, ATM and web hosting. The Company primarily
serves telecommunication-intensive business customers including hotels,
universities, financial institutions, professional service firms, hospitals, and
Internet service providers ("ISPs"). 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 service to customers in selected markets in North Carolina,
Florida, Georgia, Tennessee, Virginia, Alabama, Washington D.C., Pennsylvania,
New Jersey, Mississippi, Maryland, South Carolina, Louisiana and Kentucky. In
addition, US LEC is currently certified to provide telecommunication services in
Indiana, Delaware, New York, Ohio, Texas, Connecticut and Massachusetts. As of
December 31, 2001, US LEC's network was comprised of 26 Lucent 5ESS(R)
AnyMedia(TM) digital switches, 25 Lucent CBX500 ATM data switches and 4 Juniper
M20(TM) Internet Gateway routers 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
end customers for local, long distance, data, Internet and enhanced services,
and (2) carrier 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. The Company does not resell any ILEC dial tone
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. In 2001, 2000 and 1999, 8%, 11% and 80% of the Company's revenue
was recognized from reciprocal compensation and was being disputed by the
incumbent local exchange carriers, primarily BellSouth. The dispute primarily
arose from reciprocal compensation charges related to traffic that was
terminated to enhanced service providers, including internet service providers.
23
On October 3, 2001, the Company and BellSouth entered into a settlement
agreement by which they resolved outstanding reciprocal receivables owed the
Company by BellSouth. (See Disputed Revenue appearing below.)
Although the Company 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. US LEC has
deployed a significant regional network, and as of December 2001 has active
switches in 26 sites, serving over 6,800 medium to large size business
customers. Management believes this customer base, achieved in less than five
years, is indicative of the market's acceptance of US LEC's strategy and service
offerings. Management expects the Company's end customer revenue to continue to
increase and carrier access revenue to continue to decrease as percentages of
total revenue in future periods as US LEC continues to deploy its network and
expand its customer base, and as carrier access rates decline due primarily from
rate reductions in new agreements entered into by the Company with ILECs and to
regulatory and legislative actions. During 2001, access charges represented
approximately 39% of the Company's revenue.
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 (See "Business -- Forward Looking Statements and Risk
Factors - Interconnection Agreements, and -Disputed Revenues").
In 2000, the Company began deferring installation revenue from end
customers and from other carriers. The Company is amortizing this revenue over
the average life of these contracts. As of December 31, 2001 and 2000, the
Company had $3.8 and $2.1 million, respectively, recorded as deferred
installation revenue, including $1.4 and $0.6 million, respectively, recorded as
current liabilities.
In 2000, the Company began deferring installation charges from ILECs
related to network and end customer facilities. The Company is amortizing these
costs over the average life of these contracts. During the years ended December
31, 2001 and 2000, the Company amortized $2.0 and $0.6 million, respectively, of
deferred installation charges into cost of services. As of December 31, 2001
and 2000, the Company had $3.0 million and $1.7 million, respectively, recorded
in other assets on its consolidated balance sheets.
The Company's cost of services is comprised primarily of two types of
charges: leased transport charges which comprise approximately three-fourths of
the Company's cost of services and usage sensitive charges (primarily usage
charges associated with the Company's off-net toll and toll-free services and
access and reciprocal compensation charges owing to other carriers) which
comprise approximately one-fourth of the Company's cost of services. The
Company's leased transport charges are the lease payments incurred by US LEC for
the transmission facilities used to connect the Company's customers to its
switch and to connect to the ILEC and other carrier networks. US LEC, as part of
its "smart-build" strategy, does not currently own any fiber or copper transport
facilities. These facilities are leased from various providers including, in
many cases, the ILEC. The Company's strategy of leasing rather than building its
own fiber transport facilities results in the Company's cost of services being a
significant component of total costs. Management believes that this strategy has
several benefits, including faster time-to-market, more efficient asset
utilization, and diverse interconnection opportunities. The Company has to date
been successful in negotiating lease agreements which generally match in the
aggregate the duration of its customer contracts, thereby allowing the Company
to mitigate the risk of incurring charges associated with transmission
facilities that are not being utilized by customers.
24
Selling, General and Administrative Expenses; Depreciation and Amortization
In addition to the costs of services described above, the Company incurs
certain other expenses. The largest component of selling, general and
administrative expense ("SG&A") relates to employee salaries, related taxes and
benefits, and other incentive-based compensation. During 2001 these categories
represented 63% of total SG&A expense. Other major categories of SG&A include
expenses associated with leasing real estate for the Company's offices and
switching centers, insurance, travel, supplies, legal and accounting.
Depreciation and amortization expense is primarily due to capital
expenditures made by the Company. Gross property, plant and equipment increased
from $118.5 million in 1999, to $228.0 million in 2000 and to $262.2 million in
2001. Depreciation and amortization expense increased from $11.7 million in 1999
to $24.4 million in 2000 and to $35.1 million in 2001.
As the Company continues to expand its network and grow its customer base,
SG&A and depreciation and amortization expense is expected to continue to grow,
but decline as a percentage of revenue.
Stockholders' Deficiency
In 2000, additional paid-in-capital was reduced by approximately $36.0
million representing amounts due from Metacomm, which is indirectly controlled
by Richard T. Aab, the Company's Chairman and largest stockholder. Due to
Mr. Aab's controlling position in both Metacomm and the Company, this amount was
treated for financial reporting purposes as a deemed
distribution to the stockholder.
On March 31, 2001, the Company, Richard T. Aab, and Tansukh V. Ganatra,
the Company's former Vice Chairman and former Chief Executive Officer, reached
an agreement in principle to effect a recapitalization of the Company and to
resolve Mr. Aab's commitment that Metacomm would fully satisfy its obligations
to the Company for facilities, advances and interest. This transaction was
closed on August 6, 2001. Under the agreement, the following events occurred:
(1) Mr. Aab made a contribution to the capital of the Company by delivering to
the Company for cancellation 2 million shares of Class B Common Stock,
(2) Mr. Aab and Mr. Ganatra converted all of the then remaining and outstanding
shares of Class B Common Stock - a total of approximately 14 million such shares
were outstanding after the 2 million shares were cancelled - into the same
number of shares of Class A Common Stock, (3) the Company agreed to indemnify
Mr. Aab for certain adverse tax effects, if any, relating to the Company's
treatment in its balance sheet of the amount of the Metacomm obligation as a
distribution to shareholder and (4) the Company agreed to indemnify Mr. Ganatra
for certain adverse tax effects, if any, from the conversion of his Class B
shares to Class A shares.
As required by the agreement, the Company obtained a valuation by a
qualified valuation firm approved by the Company's audit committee that the
delivery of the 2 million shares of Class B Common Stock and the conversion of
the approximately 14 million shares of Class B Common Stock into the same number
of shares of Class A Common Stock resulted in the realization by the Companyand
its Class A shareholders of value approximately equal to the outstanding
Metacomm obligation, received a favorable tax opinion, and received certain
consents.
As a result of this transaction, the number of issued and outstanding
shares of Common Stock (Class A and Class B together) decreased by 2 million
and, as a result of the elimination of the 10-vote-per-share Class B Common
Stock, Mr. Aab no longer holds shares representing a majority of the voting
power of the Company's outstanding common stock.
25
Results of Operations
Comparison of Year Ended December 31, 2001 to Year Ended December 31, 2000
Net revenue increased to $178.6 million for the year ended December 31,
2001, from $115.0 million in 2000. The significant increase in revenue resulted
from an increase in the total number of customers in existing markets and an
increase in telecommunications traffic on its network. In 2001, the Company's
end customer revenue increased to $93.8 million or 53% of total revenue from
$54.2 million or 47% of total revenue in 2000.
The loss on the resolution of disputed revenue in 2000 was a result of an
order issued by the North Carolina Utilities Commission on March 31, 2000 (the
"March 31, 2000 NCUC Order") that relieved BellSouth from paying reciprocal
compensation to US LEC for any minutes of use attributable to the network
operated by Metacomm, a customer of BellSouth and US LEC, or any similar
network. As a result of this order, the Company recorded a pre-tax, non-
recurring,non-cash charge of $55.3 million in the first quarter of 2000. This
charge was composed of the write-off of approximately $153.0 million in
receivables related to reciprocal compensation revenue offset by a previously
established allowance of $39.0 million, and a reduction of approximately $59.0
million in reciprocal compensation commissions payable to Metacomm.
The Company recorded a significant charge relating to disputed receivables
in the fourth quarter of 2000. The $52.0 million provision is netted on the
Company's consolidated statement of operations against a $12.0 million reduction
in commissions payable on those receivables, resulting in the $40.0 million
provision on the company's consolidated statement of operations. Management
believed that this charge was necessary due to the uncertainty related to
current regulatory proceedings related to reciprocal compensation and other
access charges and the continued refusal by ILECs, principally BellSouth, to pay
amounts believed by the Company to be owed to it under applicable
interconnection agreements and due to Sprint's failure to pay US LEC's access
charges. The Company resolved its disputes with both BellSouth and Sprint during
2001. Included in the 2001 consolidated statement of operations is an amount
approximating $7.0 million, representing a net recovery of amounts previously
recorded as reserves for disputed receivables and certain other related
accruals.(See Disputed Revenue below)
Cost of services is comprised primarily of leased transport, facility
installation, and usage charges. Cost of services increased to $90.3 million, or
50% of revenue for 2001 from $52.7 million, or 45% of revenue, for 2000. This
increase in cost of services was primarily a result of the increase in the size
of US LEC's network, an increase in customers and usage by customers, as well
as a shift to lower margin end customer revenue.
Selling, general and administrative expenses for the year ended December
31, 2001 increased to $107.9 million, or 60% of revenue, compared to $80.7
million, or 70% of revenue, for the year ended December 31, 2000. This increase
was primarily a result of costs associated with developing and expanding the
infrastructure of the Company as it expands into new markets and adds products,
such as expenses associated with personnel, sales and marketing, occupancy,
administration and billing, as well as legal expenses associated with
litigation. The decrease in selling, general and administrative expenses as a
percentage of revenue in 2001 was primarily due to expense control, an
improvement in back office efficiencies and growth in end customer revenue.
Depreciation and amortization for 2001 increased to $35.1 million from
$24.4 million in 2000 primarily due to the increase in depreciable assets in
service related to US LEC's network expansion.
Interest income for 2001 decreased to $3.2 million from $4.8 million in
2000. The decrease in interest income in 2001 was primarily due to a decline in
cash available for investing and declining rates of return on invested funds.
Interest expense for 2001 increased to $11.9 million from $7.8 million in
2000. This increase in interest expense was primarily due to increased
borrowings under the Company's credit facility partially offset by declining
interest rates.
26
For the year ended December 31, 2001, the Company did not record an income
tax expense or benefit, compared to a $23.7 million income tax benefit in 2000.
In 2001, the income tax benefit, primarily created from operating losses, was
offset by increases in the tax valuation allowance. The $23.7 million benefit
for the year ended December 31, 2000 is net of an increase of $35.7 million in
the valuation allowance against deferred tax assets relating to the anticipated
use of federal and state net operating losses.
Net loss for 2001 amounted to $63.4 million, compared to a net loss of
$117.4 million for 2000. Dividends paid in kind and accrued on Series A
Mandatorily Redeemable Convertible Preferred Stock for the year ended
December 31, 2001 and 2000 amounted to $12.8 million and $8.8 million,
respectively (See Note 5 of the Company's consolidated financial statements).
The accretion of preferred stock issuance cost was $0.5 million and $0.3 million
for the years ended December 31, 2001 and 2000, respectively.
As a result of the foregoing, net loss attributable to common shareholders
for the year ended December 31, 2001 amounted to $ 76.7 million or ($2.83) per
diluted share as compared to $126.5 million, or ($4.58) per diluted share for
2000. The decrease in net loss and net loss per share is attributed to the
factors discussed above.
Comparison of Year Ended December 31, 2000 to Year Ended December 31, 1999
Net revenue decreased to $115.0 million for the year ended December 31,
2000, from $175.2 million in 1999. The significant decrease in revenue resulted
from the elimination of reciprocal compensation revenue related to Metacomm and
a reduction of local interconnect rates, partially offset by the Company's
expansion into new markets, an increase in the total number of customers in
existing markets and an increase in telecommunications traffic on its network.
The Company recorded a $27.8 million reduction against reciprocal compensation
revenue and related receivables for the year ended December 31, 1999 due to the
judicial and regulatory proceedings related to this disputed revenue and
management's assessment that the collectibility of such revenue was not assured.
As of December 31, 1999, the total allowance offsetting the disputed receivables
totaled $39.8 million. Unless otherwise specified, the results of operations
reflected in this report are net of these and other normal operating adjustments
(See Disputed Revenue below).
The loss on the resolution of disputed revenue was a result of the March
31, 2000 NCUC Order that relieved BellSouth from paying reciprocal compensation
to US LEC for any minutes of use attributable to the network operated by
Metacomm, a customer of BellSouth and US LEC, or any similar network. As a
result of this order, the Company recorded a pre-tax non-recurring non-cash
charge of $55 million in the first quarter of 2000. This charge is composed of
the write-off of approximately $153 million in receivables related to reciprocal
compensation revenue offset by a previously established allowance of $39
million, and a reduction of approximately $59 million in reciprocal compensation
commissions payable to Metacomm.
The Company recorded a significant charge relating to disputed receivables
in the fourth quarter of 2000. The $52 million provision is netted on the
Company's consolidated statement of operations against a $12 million reduction
in commissions payable on those receivables, resulting in the $40 million
provision on the Company's consolidated statement of operations. Management
believes this charge was necessary due to the uncertainty related to current
regulatory proceedings related to reciprocal compensation and other access
charges and the continued refusal by ILECs, principally BellSouth, to pay
amounts believed by the Company to be owed to it under applicable
interconnection agreements and due to Sprint's failure to pay US LEC's access
charges (See Disputed Revenue below).
Cost of services is comprised primarily of leased transport, facility
installation, and usage charges. In 1999, cost of services also included
commissions payable to Metacomm on reciprocal compensation revenue. Cost of
services decreased from $73.6 million, or 42% of revenue, for 1999 to $52.7
million, or 45% of revenue, for 2000. This decrease in cost of services was
primarily a result of the decrease in local interconnect rates and the
elimination of commissions payable to Metacomm on reciprocal compensation
revenue, partially offset by the increase in the size of US LEC's network, and
increase usage by its
27
customers other than Metacomm. The increase in cost of services as a percentage
of revenue was due to the increase of core revenue as a percentage of total
revenue and the one-time costs associated with entering several new markets.
Selling, general and administrative expenses for the year ended December
31, 2000 increased to $80.7 million, or 70% of revenue, compared to $48.4
million, or 28% of revenue, for the year ended December 31, 1999. This increase
was primarily a result of costs associated with developing and expanding the
infrastructure of the Company as it expanded into new markets and added
products, such as expenses associated with personnel, sales and marketing,
occupancy, administration and billing, as well as legal expenses associated with
litigation. The increase in selling, general and administrative expenses as a
percentage of revenue in 2000 was primarily due to the reduction in reciprocal
compensation revenue.
Depreciation and amortization for 2000 increased to $24.4 million from
$11.7 million in 1999 primarily due to the increase in depreciable assets in
service related to US LEC's network expansion.
Interest income for 2000 increased to $4.8 million from $1.1 million in
1999. The increase in interest income in 2000 was primarily due to the investing
of a portion of the proceeds from the issuance of Series A Mandatorily
Redeemable Convertible Preferred Stock on April 11, 2000.
Interest expense for 2000 increased to $7.8 million from $3.1 million in
1999. This increase in interest expense was primarily due to increased
borrowings under the Company's credit facility and an increase in interest
rates.
For the year ended December 31, 2000, the Company recorded a $23.7 million
income tax benefit, compared to $15.6 million in expense in 1999. The $23.7
million benefit for the year ended December 31, 2000 is a net amount which
includes a $35.7 million valuation allowance against deferred tax assets
relating to the anticipated use of federal and state net operating losses.
Net loss for 2000 amounted to $117.4 million, compared to net earnings of
$23.8 million for 1999. Dividends paid in kind and accrued on Series A
Mandatorily Redeemable Convertible Preferred Stock for the year ended
December 31, 2000 amounted to $8.8 million (See Note 5 of the Company's
Consolidated Financial Statements). The accretion of preferred stock issuance
cost was $0.3 million for the year ended December 31, 2000.
As a result of the foregoing, net loss attributable to common shareholders
for the year ended December 31, 2000 amounted to $126.5 million, or ($4.58) per
share (diluted), compared to net earnings of $23.8 million, or $0.84 per share
(diluted) for 1999. The increase in net loss and net loss per share is
attributed to the factors discussed above.
Liquidity and Capital Resources
US LEC's business is capital intensive and its operations require
substantial capital expenditures for the expansion of its network
switches, related electronic equipment, information systems, and facilities. The
Company's cash capital expenditures were $40.4 and $111.6 million for the years
ended December 31, 2001 and 2000, respectively. As of December 31, 2001, the
outstanding amount under the Company's senior secured credit facility was $150.0
million. While management believes the $80.5 million in cash at December 31,
2001 will fund the Company's capital requirements until it becomes EBITDA
positive, funding to free cash flow may require additional financing.
On April 11, 2000, the Company issued $200 million of its Series A
Mandatorily Redeemable Convertible Preferred Stock to affiliates of Bain
Capital, Inc. ("Bain") and Thomas H. Lee Partners, L.P. ("THL"). See Note 5 to
the Company's Consolidated Financial Statements for a description of this
28
transaction and the terms of the Preferred Stock. Proceeds to the Company, net
of commissions and other transaction costs, were approximately $193.7 million.
Cash used in operating activities was approximately $5.9 million in 2001
compared to $49.3 million in 2000. The decrease in cash used in operating
activities was primarily due to the collection of amounts due from BellSouth for
reciprocal compensation, facility charges, and other charges and amounts due
from Sprint for access charges. The Company received payment of approximately
$50.0 million from BellSouth and Sprint during 2001 as a result of its
settlements with both companies over disputed revenues (See Disputed Revenue
appearing below).
Cash used in investing activities decreased to $40.5 million in 2001 from
$111.7 million in 2000. The investing activities are related to purchases of
switching and related telecommunications equipment, office equipment and
leasehold improvements associated with the Company's expansion into additional
locations and markets primarily during 2000. This decrease is evidence that the
network build-out is substantially complete and capital spending is success
based, as well as continued control of new expenditures.
Cash provided by financing activities decreased to $21.1 million in 2001
from $251.7 million for 2000 due to increased borrowings under the credit
facility and the issuance of preferred stock in 2000. In 2000, the Company
issued $200.0 million in Series A Mandatorily Redeemable Convertible Preferred
Stock (see above). Proceeds from borrowings, net of repayments, under the
Company's credit facility decreased during 2001.
The Company's credit facility is subject to certain financial covenants,
measured quarterly, the most significant of which relates to the achievement of
increasing levels of revenue and earnings, and debt ratios. The Company was in
compliance with these covenants as of the quarter ended December 31, 2001.
Company management believes it will be in compliance with all quarterly
financial covenants during 2002 based upon projected operating results. These
projected operating results are dependent upon the Company meeting quarterly
2002 targets of new customers, existing customer retention, customer usage and
billing rates, and as a result involve some degree of uncertainty. Should any of
these assumptions not be achieved for a particular quarter, it is possible that
a financial covenant will not be met during 2002. Although there can be no
assurances, Company management believes if this were to occur, it would be able
to obtain the nece