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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
______________
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended December 31, 2002
Commission File No. 0-26728
TALK AMERICA HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 23-2827736
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
12020 SUNRISE VALLEY DRIVE, SUITE 250 20191
RESTON, VIRGINIA (zip code)
(Address of principal executive offices)
(703) 391-7500
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
None Not applicable
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
RIGHTS TO PURCHASE SERIES A JUNIOR PARTICIPATING PREFERRED STOCK
(Title of class)
----------------
Indicate by check mark whether the registrant (1) has filed all documents
and reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports) and (2) has been subject
to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment of this
Form 10-K. [ ]
Indicated by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
As of March 26, 2003, the aggregate market value of voting stock held by
non-affiliates of the registrant, based on the average of the high and low
prices of the Common Stock on March 26, 2003 of $7.24 per share as reported on
the Nasdaq National Market, was approximately $186,849,819 (calculated by
excluding solely for purposes of this form outstanding shares owned by directors
and executive officers).
As of March 26, 2003, the registrant had issued and outstanding 26,160,971
shares of its Common Stock, par value $.01 per share.
DOCUMENTS INCORPORATED BY REFERENCE
None.
TALK AMERICA HOLDINGS, INC.
INDEX TO FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002
ITEM NO. PAGE NO.
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PART I
1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . 14
4. Submission of Matters to a Vote of Security Holders . . . . 14
PART II
5. Market for Registrant's Common Equity and Related
Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . 15
6. Selected Consolidated Financial Data . . . . . . . . . . . . . . 16
7. Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . . . . . . . . . . . . . 17
7a. Quantitative and Qualitative Disclosure About Market Risk . . . . . .33
8. Financial Statements and Supplementary Data . . . . . . . . . . 34
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure . . . . . . . . . . . . . . . . 59
PART III
10. Directors and Executive Officers of the Registrant . . . . . . 60
11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . .62
12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters . . . . . . . . . . . . .67
13. Certain Relationships and Related Transactions . . . . . . . . . 68
PART IV
14. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . 67
15. Exhibits, Financial Statement Schedules and Reports on Form 8-K . . .67
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PART I
ITEM 1. BUSINESS
OVERVIEW
Talk America Holdings, Inc., through its subsidiaries, provides local and
long distance telecommunication services to residential and small business
customers in the United States. The Company has developed integrated order
processing, provisioning, billing, payment, collection, customer service and
information systems that enable the Company to offer and deliver high-quality
service, savings through competitively priced telecommunication products, and
simplicity through consolidated billing and responsive customer service.
The Company offers both local and long distance telecommunication services,
primarily the bundled service offering of local and long distance voice
services, which are billed to customers in one combined invoice. Local phone
services include local dial tone, various local calling plans that include free
member-to-member calling, and a variety of features such as caller
identification, call waiting and three-way calling. Long distance phone services
include traditional 1+ long distance, international and calling cards. The
Company uses the unbundled network element platform ("UNE-P") of the regional
bell operating companies ("RBOCs") network to provide local services and the
Company's nationwide network to provide long distance services. The Federal
Communications Commission ("FCC") has recently concluded its triennial review of
local phone competition. Although the text of the order is not yet available,
the decision appears to preserve the Company's ability to use UNE-P for the
provision of bundled telecommunications services pending further
market-by-market analyses by the respective state commissions.
By the end of 1999, the Company decided to expand beyond its historical
long distance business and utilize UNE-P to enter the large local
telecommunications market and diversify its product portfolio through the
bundling of local service with its core long distance service offerings. The
Company encountered a number of operational and business difficulties during the
rollout of the Company's bundled service offering in 2000 and worked to address
the operational issues that it encountered. The Company focused on improving the
overall efficiency of the bundled business model in 2001. During 2002, the
Company's top operating priorities were to lower bad debt expense, reduce
customer turnover, or "churn," and lower its customer acquisition costs. During
2003, the Company's primary focus will be to increase sales of its bundled
services within the targets established by management for acquisition costs,
customer turnover and bad debt expense.
The Company continues to manage its business to generate free cash flow
(defined as net cash provided by operating activities less net cash used in
investing activities) and has built a scaleable platform to provision, bill and
service bundled customers. The Company continues to focus on delivering better
service and value to customers. During 2002, the Company expanded its product
offerings to appeal to a broader customer base based upon calling patterns and
feature preferences. Although the Company is now operational with respect to its
local service offering in 26 states, the Company has limited the marketing of
its bundled services to those states, or certain areas of a state, where the
Company believes it can currently offer services to customers at competitive
prices. The Company will market to additional states (or certain areas of a
particular state) as the Company believes its pricing and cost structure permit
it to profitably offer services in those areas at competitive rates. While the
Company has actively marketed the bundled product in a number of states, at
present, a majority of the Company's bundled customers are in Michigan. The
Company continually reviews its product offerings, pricing and sales and
marketing programs in an effort to improve the efficiency of its sales and
marketing channels.
During 2002, the Company completed a significant restructuring of its debt
obligations, including (1) an exchange offer, that effectively extended the
final maturity on substantially all of the Company's public debt obligations to
2007; (2) the retirement of the Company's senior credit facility of $13.8
million prior to its scheduled maturity; (3) open market repurchases of $5.7
million principal amount of the Company's 12% Senior Subordinated Notes; (4) the
repurchase of $5.4 million principal amount of the Company's 8% Secured
Convertible Notes; and (5) the restructuring of the 8% Secured Convertible
Notes. In 2003, through March 28, the Company has (i) repurchased a further $9.4
million principal amount of its 12% Senior Subordinated Notes and $3.6 million
principal amount of its 8% Secured Convertible Notes, and (ii) purchased
approximately 1.3 million shares of its common stock for an aggregate purchase
price of $5 million.
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Talk America Inc. (formerly, Talk.com Holding Corp. and Tel-Save, Inc.),
the Company's predecessor and now its principal operating subsidiary, was
incorporated in Pennsylvania in May 1989. The Company was incorporated in June
1995. In connection with the Company's decision to enter the local
telecommunications market, the Company acquired Access One Communications Corp.
("Access One") in August 2000. Access One was a private, local
telecommunication services provider to nine states in the southeastern United
States. The address of the Company's current principal executive offices is
12020 Sunrise Valley Drive, Suite 250, Reston, Virginia 20190, and its telephone
number is (703) 391-7500. The Company's web address is www.talk.com. Unless
the context otherwise requires, references to the "Company" or to "Talk
America" refer to Talk America Holdings, Inc. and its subsidiaries.
The Company makes available free of charge on its website, www.talk.com,
the Company's annual report on Form 10-K, the Company's quarterly reports on
Form 10-Q, the Company's current reports on Form 8-K, and amendments to the
Company's reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934 as soon as reasonably practicable after the
Company files such material with, or furnishes it to, the Securities and
Exchange Commission.
LOCAL AND LONG DISTANCE TELECOMMUNICATION SERVICES
The Company offers both local and long distance telecommunication services
to residential and small business customers. The Company is focused on
providing high-quality service, savings through competitively priced
telecommunication products, and simplicity through consolidated billing and
responsive customer service.
LOCAL
The Company uses the unbundled network element platform, or UNE-P, from,
and, to a lesser extent, resale agreements with, the RBOCs to provide local
telephone services to residential and small business customers. The Company is
currently operational in 26 states. The Company ended 2002 with approximately
330,000 bundled lines (local and long distance services). The Company believes
that it offers and provides consumers value through competitive plans designed
to fit their particular calling patterns, broad feature selections and effective
customer service.
The Company's bundled service generally includes: unlimited local usage
dependent upon the service plan, free member-to-member calling, long distance
service and calling cards, one convenient invoice available both in paper and
electronically, and choices, where available, among the following features:
900 Call Blocking Calling Name Display
976 Call Restriction Custom Toll Restriction
Anonymous Call Reject Distinctive Ring
Auto Redial Priority Call
Automatic Callback Priority Ringing
Call Forwarding Privacy Features
Call Block Remote Call Forwarding
Call Block Denial Repeat Dialing
Call Hold Return Call ( *69 )
Call Return Return Call Block
Call Trace Speed Calling / Speed Dialing
Call Trace Denial Three Way Calling
Call Waiting Touch Tone Service
Caller ID Voice Mail
The provision of local telephone service through use of UNE-P generally
provides the Company with certain advantages, including: (i) offering local
telephone service to customers located virtually anywhere without deploying
costly local switching facilities; (ii) minimizing current capital expenditures
and at the same time maintaining network and service design flexibility for the
next generation of telecommunication technology; (iii) providing practically the
same services as the RBOCs; (iv) the potential for higher margins than
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comparable service offered through resale agreements; and (v) eliminating the
requirement to pay certain local network access fees while collecting local
network access fees for calls delivered to the Company's local telephone
customers. In some instances, however, such as customers having high usage
volumes, resale may provide the Company with a lower cost structure than the use
of UNE-P.
UNE-P became available to the Company and other carriers on November 5,
1999, when the FCC released an order reconfirming that RBOCs nationwide must
offer to competitors, in an individual or combined form, a series of unbundled
network elements, ("UNEs"), that comprise the most important facilities,
features, functions and capabilities of a RBOC's network. The price at which
such elements are offered must correspond to the forward-looking cost of
providing these elements. When offered in the combination known as UNE-P, these
components include the loop and switching elements needed to provide local
telephone service to a customer. Although RBOCs have a general obligation to
provide UNE-P, the obligation is limited in the central business districts of
the top 50 metropolitan statistical areas of the nation. In such markets, the
obligation to provide UNE-P currently is limited to carriers serving customers
with less than four telephone lines. Because the Company's current focus is on
residential and small business markets, the restriction on UNE-P availability in
the central business districts of the top 50 metropolitan statistical areas has
not been a major impediment to its operations to date. On December 12, 2001, the
FCC initiated its UNE Triennial Review rulemaking with respect to local
telecommunication competition in which it reviewed all UNEs and considered
whether RBOCs should continue to be required to provide them to competitors. The
FCC has recently concluded its Triennial Review of local phone competition.
Although the text of the order is not yet available, the decision appears to
preserve the Company's ability to use UNE-P for the provision of bundled
telecommunications services pending further market-by-market analyses by the
respective state commissions. Changes to the current rules and regulations and
adverse judicial and administrative interpretations and rulings relating thereto
that result in any curtailment in the availability of the local switching UNE
would materially impair the Company's ability to provide local
telecommunications services. Such changes could eliminate the Company's
capability to provide local telecommunications services entirely unless the
Company is able to utilize another technology, which may not be available or
available on economically feasible terms, or the Company purchases, builds and
implements its own local switching network, which would require significant
additional capital expenditures by the Company. See "Regulation."
In late 2002, the Company purchased two Lucent 5ESS-2000 switches and
related ancillary equipment. The Company currently intends that one of these
switches will be initially installed in Michigan, primarily for the provision of
long distance telecommunication services (see "Long Distance"). The Company is
also exploring and intends to use this switch to test providing local phone
service to determine the necessary operational processes and information systems
required to provide local switch-based service. The other switch has been
stored temporarily until such testing is complete. Following the testing of the
local switch, the Company will evaluate providing local telephone services to
customers using its own local switch.
The Company believes that UNE-P currently provides it with a cost-effective
means of offering local service bundled together with its long distance service.
The Company also believes that its operational systems are scalable and will
allow it to continue to expand its service offerings in the local
telecommunication market.
LONG DISTANCE
The Company provides 1+ long distance telecommunication services on a
stand-alone basis and bundled with the Company's local services. The Company's
long distance voice services include intrastate, interstate, international and
calling cards, at rates that are competitive within the industry. The Company
generally uses its own nationwide long distance network to provide services
directly to its customers. As of December 31, 2002, the Company provisioned
over its network approximately 90% of the lines using its long distance
services. The Company ended 2002 with approximately 460,000 stand-alone long
distance subscribers.
The Company's network is comprised of equipment and facilities that are
either owned or leased by the Company. The Company contracts for certain
telecommunication services with a variety of other carriers. The Company owns,
operates and maintains five Lucent 5ESS-2000 switches in its network. In late
2002, the Company purchased an additional Lucent 5ESS-2000 switch for use in its
long distance network. The Company plans to locate the switch in Michigan to
service the telecommunication requirements of its Michigan customers. These
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switches are generally considered extremely reliable and feature the Digital
Networking Unit--SONET technology. The Digital Networking Unit is a switching
interface that is designed to increase the reliability of the 5ESS-2000 and to
provide much greater capacity in a significantly smaller footprint.
The switches are connected to each other by connection lines and digital
cross-connect equipment that the Company owns or leases. See "Service
Agreements with Other Carriers." The Company also has installed lines to connect
its long distance switches to switches owned by various local telecommunication
service carriers. The Company is responsible for maintaining these lines and has
entered into a contract with GTE/Verizon with respect to the monitoring,
servicing and maintenance of this equipment.
Since the Company operates its own switches, it is subject to the risk of
significant interruption. Fires or natural disasters, for example, could cause
damage to the Company's switching equipment or to transmission facilities
connecting its switches. Any interruption in the Company's services over its
network caused by such damage could have a material adverse impact on the
Company's financial condition and results of operations. In such circumstances,
the Company could attempt to minimize the interruption of its service by
carrying traffic through its overflow and resale arrangements with other
carriers.
SERVICE AGREEMENTS WITH OTHER CARRIERS
The Company historically obtained services from AT&T through multiple
contract tariffs. With the deployment of its network, the Company requires fewer
such services from AT&T to sell its services. The Company has entered into
contracts with various other long distance and local carriers of
telecommunication services for the provision of both its network and reselling
operations, further reducing its reliance on AT&T. These services enable the
Company to connect the Company's switches to each other, connect the Company's
switches to the switches of local telecommunication service carriers, carry
overflow traffic during peak calling times, connect international calls and
provide directory assistance and other operator assisted services.
With respect to connections to local carriers, overflow, international and
operator assisted services, the Company maintains contracts with more than one
carrier for each of these services. In May 2001, the Company entered into a new
Master Carrier Agreement with AT&T. The agreement provides the Company with a
variety of services, including transmission facilities to connect the Company's
network switches as well as services for international calls, local traffic,
international calling cards, overflow traffic and operator assisted calls. The
Company believes that it is no longer dependent upon any single carrier for
these services. Currently, many price differences exist in the market for
purchasing these services in bulk. Under the terms of the Company's contracts
with its various carriers, the Company is able to choose which services and in
what volume the Company wishes to obtain the services from each carrier.
Several of the network service agreements contain certain minimum usage
commitments. The largest contract establishes pricing and provides for revenue
commitments based upon usage of $52 million for the 18 months ended February
2004 and $40 million for the 9 months ending December 2004. This contract
obligates the Company to pay 65 percent of the revenue shortfall, if any. A
separate contract with a different vendor establishes pricing and provides for
annual minimum payments as follows: 2003 - $6.0 million and 2004 - $3.0 million.
While the Company anticipates that it will not be required to make any shortfall
payments under these contracts as a result of (1) growth in network minutes, (2)
the management of traffic flows on its network, (3) the restructuring of these
obligations, and/or (4) the sale of additional minutes of usage on the wholesale
markets; there can be no assurances that the Company will be successful in its
efforts. In addition, these actions will likely cause the Company to experience
an increase in per minute network costs.
Many of the companies in the telecommunication sector have been adversely
affected by recent business trends and some have filed for bankruptcy
protection. To the extent that the credit quality of these carriers
deteriorates or they seek bankruptcy protection, the Company may have service
disruptions and the transition of the Company's customers to its network or
another carrier's network may cause potential disruptions for the affected
customers' services, although, to date, there has been no significant effect.
INTEGRATED INFORMATION SYSTEMS
The Company has developed and continues to improve and update its
integrated order processing, provisioning, billing, payment, collection,
customer service and information systems that enable the Company to offer and
4
deliver high-quality, competitively priced telecommunication services to
customers. Through dedicated electronic connections with its long distance
network and the RBOCs from which the Company purchases local services through
UNE-P, the Company has designed its systems to process information on a "real
time" basis. In addition, the Company processes millions of call records each
day.
The Company's core operational support systems include the following:
- The Company's leads database system is utilized in the marketing
of its telecommunication services. The leads database system
enables the Company to alter telemarketing campaigns to track
areas where mass advertisements are airing, manage the bundled
sales price by customer, zone and state, maintain customer credit
information, and comply with various regulatory requirements.
- The Company's proprietary automated order processing system
("OPS") enables the Company to shorten the customer provisioning
time cycle and reduce associated costs. Prior to submitting an
order to provision a customer to the Company's service, OPS
processes the customer's credit history, and, once the customer's
credit is approved, the customer's service record detailing the
customer's existing phone service is immediately verified. In
addition, OPS has enabled the Company to significantly increase
its customer provisioning rate for qualified and verified orders
while reducing the number of orders that are rejected by the
RBOC, reducing manual work requirements.
- The Company's automated service provisioning system enhances the
Company's ability to add customer lines to the Company's
telecommunication service and to change the features associated
with that particular customer's service, reducing manual work
requirements.
- The Company's billing system enables the Company to preview and
run a bill cycle each day of the month for the many different,
tailored service packages, increasing customer satisfaction while
minimizing revenue leakage in the provision of local
telecommunication service.
- The Company's proprietary automated collections management system
("CMS") is integrated with the Company's billing and customer
relationship management system. CMS increases the efficiency of
the Company's collection process, accelerates the recovery of
accounts receivable and assists in the retention of valuable
customers.
- The Company continues to develop and implement improvements to
its customer relationship manager system, which enables the
Company's customer service representatives to access data in a
real-time, organized manner, while the representative is speaking
with the customer, reducing the length of customer service calls
and improving the customer experience.
In addition, the Company maintains its own web site at www.talk.com to
provide for customer sign-up and to provide customers and potential customers
with information about the Company's products and services as well as billing
information and customer service. The Company provides these services and
features using the Company's web-enabled technologies that allow it to offer its
customers:
- Detailed rate schedules and product and service related
information.
- Online sign-up for the Company's telecommunication services.
- Credit card billing.
- Real-time and 24 x 7 billing services and online information,
providing customers with up to the hour billing information.
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The information functions of the Company's systems are designed to provide
easy access to all information about a customer, including volumes and patterns
of use. This information can be used to identify emerging customer trends and to
respond with services to meet customers' changing needs. This information also
allows the Company to identify unusual or declining use by an individual
customer, which may indicate fraud or that a customer is switching its service
to a competitor. FCC rules, however, may limit the Company's use of customer
proprietary network information. See "Regulation."
These systems are designed, where applicable, to support the Company's long
distance services and its local services utilizing UNE-P, as currently provided.
If the Company elects or is required to develop local switching capability,
these systems will need to be significantly modified.
SALES AND MARKETING
In 2002, the Company's sales and marketing efforts focused on marketing a
bundle of local and long distance telecommunication services directly to
customers under its own brand. The Company is now operational with respect to
its bundle of local and long distance telecommunication services in 26 states,
but has limited the marketing of its bundled services to those states, or
certain areas of a state, where the Company believes it can currently offer
services to customers at competitive prices to the general market. The Company
will market to additional states where the Company believes its pricing and cost
structure permit it to profitably offer services in those states at competitive
rates. While the Company has actively marketed the bundled product in a number
of states, at present, a majority of the Company's bundled customers are in
Michigan. The Company continually reviews its product offerings, pricing and
sales and marketing programs in an effort to improve the efficiency of its sales
and marketing channels. The Company increased personnel in 2002 to support the
expansion of its sales and marketing efforts from those of 2001.
The Company markets its bundled services within its targeted markets
through the following channels:
- Referrals - the Company solicits, through the use of referral
promotions and its member-to-member free long distance product,
the names of potential customers or referrals from the Company's
existing customers.
- Telemarketing - the Company purchases small business and
residential lead databases utilized for targeted, professional
and courteous outbound telesales campaigns. Telemarketing is an
important sales channel for the Company. Any changes in the
federal or state "do not call" regulations could adversely affect
the Company. See "Regulation."
- Direct Sales - the Company, utilizing both independent agents and
a recently developed internal sales force, acquires new customers
in targeted geographic areas.
- Broadcast Media - the Company receives inbound calls in direct
response to advertising on television, in print and via direct
mail.
- Online Marketing at www.talk.com - the Company has developed a
productive online marketing presence, through traditional media
and business relationships.
While the Company does not actively market its stand alone long distance
telecommunications service, it does promote the long distance telecommunications
service when contacted by persons located in those regions where local service
is unavailable. The Company also adds long distance customers when the customer
requests its local service provider to provide the customer with the Company's
long distance telecommunications service. The Company is focused upon providing
its customers savings, simplicity and service.
The Company continues to seek new marketing partners and arrangements to
expand both its opportunities to attract other customers to its services and the
products and services that it offers to its customer base.
COMPETITION
The telecommunication industry is highly competitive. Major
participants in the industry regularly introduce new services and marketing
activities. Competition in the telecommunication industry is based upon pricing,
customer service, billing services and perceived quality. The Company competes
6
against numerous telecommunication companies that offer essentially the same
services as those of the Company. Many of the Company's competitors, including
the RBOCs, are substantially larger and have greater financial, technical and
marketing resources than those of the Company. The Company's success will
depend upon its continued ability to provide high quality, high value services
at prices generally competitive with, or lower than, those charged by the
Company's competitors.
The major carriers, including AT&T, Sprint Corporation, MCI/Worldcom, Inc.,
and the RBOCs have targeted price plans at residential customers - the Company's
primary target market - with significantly simplified rate structures and with
bundles of local services with long distance, which may lower overall local and
long distance prices. Competition is also fierce for the small to medium-sized
businesses that the Company also serves. Additional pricing pressure may also
come from the introduction of new technologies, such as Internet telephony,
which seek to provide voice communications at a cost below that of traditional
circuit-switched long distance service. In addition, wireless carriers have
marketed their services as an alternative to traditional long distance service,
further increasing competition in the long distance sector. Reductions in
prices charged by competitors may have a material adverse effect on the Company.
Consolidation and alliances across geographic regions, in the local and
long distance market and across industry segments may also intensify competition
from significantly larger, well-capitalized carriers.
The entry of the RBOCs into the long distance market has further heightened
competition. Under the Telecommunications Act of 1996 (the "Telecommunications
Act"), the RBOCs were authorized to provide long distance service that
originates outside their traditional services areas, and may gain authority to
provide long distance service that originates within their region after
satisfying certain market opening conditions. The FCC has granted each of the
RBOCs the authority to provide long distance service in a quickly growing number
of states. Verizon has such authority in New York, Massachusetts, Pennsylvania,
Connecticut, Virginia, New Hampshire, Delaware, New Jersey, Maine, Vermont, and
Rhode Island. SBC Communications has such authority in Texas, Kansas, Oklahoma,
Arkansas, California and Missouri. BellSouth has such authority in Florida,
Georgia, Louisiana, Alabama, Kentucky, Mississippi, North Carolina, South
Carolina, and Tennessee. Qwest has such authority in Colorado, Idaho, Iowa,
Montana, Nebraska, North Dakota, Utah, Washington and Wyoming. In addition,
several more applications are currently pending at the FCC, including Verizon in
Maryland, West Virginia and the District of Columbia, SBC in Nevada and
Michigan, and Qwest in New Mexico, Oregon and South Dakota. We cannot predict
if any of these applications will be approved or when such approval is likely to
occur. The Company anticipates that the RBOCs will continue to seek to obtain
similar authority in other states. These actions are likely to increase long
distance competition within the affected states. RBOC entry into the long
distance market means new competition from well-capitalized, well-known
companies that have the capacity to "bundle" other services, such as local and
wireless telephone services and high speed Internet access, with long distance
telephone services. While the Telecommunications Act includes certain
safeguards against anti-competitive conduct by the RBOCs, it is impossible to
predict whether such safeguards will be adequate or what effect such conduct
would have on the Company. Because of the RBOCs' name recognition in their
existing markets, the established relationships that they have with their
existing local service customers, their ability to take advantage of those
relationships, and the possibility that interpretations of the
Telecommunications Act may be favorable to the RBOCs, it may be more difficult
for the Company to compete.
In addition, access to RBOC UNEs at rates competitive with the RBOC's
retail service offerings is critical to the Company's business. The RBOC UNE
rates are ordered by individual state commissions, which have only recently
begun lowering the RBOC UNE rates to a level that allows the Company to offer
rates competitive with the RBOC for similar services in those states. The RBOCs
have petitioned certain state commissions to raise the current RBOC UNE rates.
Failure of the remaining state commissions to lower RBOC UNE rates will have a
significant impact upon the Company's ability to offer services at rates
competitive with the RBOCs. See "Regulation."
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REGULATION
GENERAL
The Company's provision of telecommunication services is subject to
government regulation. Generally speaking, the FCC regulates interstate and
international telecommunications, while the state commissions regulate
telecommunications that originate and terminate within the same state.
The Telecommunications Act provided for a significant deregulation of the
domestic telecommunications industry, including the opening of the local markets
of incumbent local exchange carriers (ILECs) to competition and the ability,
pursuant to certain market-opening conditions, of the RBOCs to reenter the long
distance industry. See "Competition". The Telecommunications Act remains subject
to judicial review and additional FCC rulemaking, and thus it is difficult to
predict what effect the legislation and regulations will have on the Company and
its operations over time. There are currently a number of, and (as a result of
the FCC's recently announced decision concerning the Triennial Review, discussed
below) will soon be many additional, regulatory proceedings underway and being
contemplated by federal and state authorities regarding the availability of the
unbundled network element platform and other unbundled network elements,
interconnection, pricing and other issues that could result in significant
changes to the business conditions in the telecommunication industry and have a
material adverse effect on the Company. In addition, there has been discussion
in Congress of modifying the Telecommunications Act in ways that could prove
detrimental to the Company.
In January 1999, the U.S. Supreme Court confirmed the FCC's role in
establishing national telecommunications policy through implementation of the
Telecommunications Act, and thereby created greater certainty regarding the
rules governing local competition going forward. The FCC's rules which permit
the Company to purchase the UNE-P to provide local and long distance
telecommunications services to its customers are the primary rules governing
competition upon which the Company relies. On December 12, 2001, the FCC
initiated its UNE Triennial Review rulemaking with respect to local
telecommunication competition in which it reviewed all UNEs and considered
whether RBOCs should continue to be required to provide them to competitors.
The FCC has recently concluded its Triennial Review of local phone competition,
announcing a decision on February 20, 2003. Although the text of the order is
not yet available, the decision appears to preserve the Company's ability to use
UNE-P for the provision of bundled telecommunications services pending further
market-by-market analyses by the respective state commissions.
FEDERAL REGULATION OF THE COMPANY'S RATES, TERMS AND CONDITIONS
The FCC has imposed numerous reporting, accounting, record keeping and
other regulatory obligations on the Company. The Company must offer interstate
and international services under rates, terms and conditions that are just,
reasonable and not unreasonably discriminatory. The Company also must post
publicly the rates, terms and conditions of the Company's interstate and
international long distance service on the Company's web site or elsewhere, and
is authorized to file interstate tariffs on an ongoing basis for interstate
access services (rates charged among carriers for access to their networks).
Although the Company's interstate and international service rates, terms, and
conditions are subject to review, they are presumed to be lawful and have never
been formally contested by customers or other consumers. Other FCC rules govern
the procedures the Company uses to solicit customers, its handling of customer
information, its obligation to assist in funding the federal system of universal
service, its billing practices and the like. The Company may be subject to
forfeitures and other penalties if it violates the FCC's rules.
Long distance carriers pay local facilities-based carriers, including the
Company, interstate access charges for both originating and terminating the
interstate calls of long distance customers on the local carriers' networks and
facilities, including UNE-P. Historically, the RBOCs set access charges higher
than cost and justified this pricing to regulators as a subsidy to the cost of
providing local telephone service to higher cost customers. With the
establishment of an explicit and competitively neutral universal service subsidy
mechanism and, as a result of other access reform proceedings, the FCC is under
increasing pressure to revise the current access charge regime to bring the
charges closer to the cost of providing access. In response, the FCC issued a
decision in 2001 setting the rates that competitive local carriers charge to
long distance carriers at a level that will gradually decrease to the rates
8
charged by incumbent carriers. So long as the Company is in compliance with the
FCC's rate schedule, the FCC's order forbids long distance carriers from
challenging our interstate access rates. This FCC decision lowering access
charges may reduce our access charge revenues over time. The FCC is also
considering, in a declaratory ruling proceeding commenced in November 2002, the
question of whether voice over the Internet services or services utilizing an
Internet protocol should be made subject to interstate access charges in the
same manner as traditional telephony. The FCC has indicated on several
occasions that such services are exempt from interstate access charges, but
until the FCC issues its ruling in the current proceeding, it is unclear how
such traffic will be treated for intercarrier compensation purposes.
REGULATION OF ACCESS TO UNBUNDLED NETWORK ELEMENTS
Access to RBOC UNEs at cost-based rates is critical to the Company's
business. The Company's local telecommunications services are provided almost
exclusively through the use of combinations of RBOC UNEs, and it is the
availability of cost-based UNE rates that enables the Company to price its local
telecommunications services competitively. However, the obligation of RBOCs to
provide UNEs at such cost-based rates has been the subject of recent regulatory
and judicial actions which has affected their availability. Additional
proceedings are imminent which could result in them being substantially reduced,
at least in some markets.
Access to RBOC UNEs in a fashion in which they are combined by the RBOCs is
critical to the Company's business. The Company's local telecommunications
services are provided primarily through the use of UNE-P, in which UNEs
necessary to provide service to the Company's customers (unbundled loops,
transport, and local switching) are combined by the RBOCs and then leased to new
entrants. The FCC's yet-to-be-released Triennial Review decision, and
subsequent state proceedings called for by that decision, will determine the
extent to which RBOCs will continue to be required to provide such UNE
combinations to competitors.
The existing set of UNEs were largely established by the FCC in its Local
Interconnection Order in 1996, and updated in a proceeding on remand from the
Supreme Court's Iowa Utilities Board case in 1999. The Supreme Court held that
the FCC did not apply the correct standards when determining which network
elements must be unbundled and made available to competitive telephone companies
such as the Company. In November 1999, the FCC released its "UNE Remand Order"
addressing the deficiencies in the FCC's original ruling cited by the Supreme
Court. The order was generally viewed as favorable to the Company and other
competitive carriers because it ensured that incumbent carriers would be
required to make available those network elements, including UNE-P, that are
crucial to the Company's ability to provide local and other services. The
order was appealed by the incumbent carriers and in May, 2002, the United States
Court of Appeals for the D.C. Circuit released an opinion remanding the UNE
Remand Order to the FCC for further consideration. The Court remanded the UNE
Remand Order because (1) the FCC adopted, as to almost every unbundled element,
a uniform national rule mandating the element's unbundling in every geographic
market and customer class, without regard to the state of competition in any
particular market; and (2) the FCC's concept of the circumstances in which cost
disparities would under the Telecommunications Act's standards, "impair" a
competitor's ability to provide service without unbundled elements was
considered too broad.
As part of its regular periodic review of the list of unbundled elements,
the FCC initiated its so-called UNE Triennial Review rulemaking proceeding on
December 12, 2001. The FCC in its Triennial Review, and in response to the D.C.
Circuit Court's decision, reviewed all UNEs to determine whether RBOCs should
continue to be required to provide them to competitors.
At its Feb. 20, 2003, open meeting, the FCC adopted its Triennial Review
decision. The full text of the order is not yet available so at this time we
only have a broad outline of the FCC's announced actions without the detail
required to fully assess all of the potential ramifications of this important
decision. However, based on the FCC's press release and the FCC Commissioners'
comments at the meeting the decision appears to preserve the Company's ability
to use UNE-P for the provision of bundled telecommunications services and
appears to delegate to each state the overall responsibility for deciding, under
FCC guidelines, what unbundled elements should be available to competitors like
the Company in local markets
9
within the state's jurisdiction as well as the costs that the RBOCs may charge
for such elements. This creates the risk that some states may decide to limit
or eliminate unbundled elements that the Company currently has access to, that
the cost of such elements may increase and that the Company will be faced with
different sets of rules and costs if states issue inconsistent decisions. Among
the broad highlights of the Triennial Review decision that can be discerned at
this time are the following actions that have a significant impact on the
Company:
Unbundled Local Switching and UNE-P: The FCC's current rules generally require
incumbent carriers to offer local circuit switching as an unbundled network
element, and thus UNE-P, to competing carriers at cost-based prices. However,
an incumbent carrier need not make local circuit switching available where it
would be used to serve end users with four or more lines in zones with the
highest density of access lines and greatest traffic volume in the top 50
Metropolitan Statistical Areas, provided that the incumbent carrier provides
nondiscriminatory, cost-based access to the enhanced extended link, or EEL. The
EEL, which consists of an unbundled loop, multiplexing/concentrating equipment
and dedicated transport, allows a competing carrier to serve a customer by
extending the customer's loop from the end office serving that customer to a
different end office in which the competitor is already co-located with its own
network facilities.
During the FCC's Triennial Review proceeding, the incumbents launched a
fierce campaign, at both the FCC and in Congress, in an attempt to limit the
availability of circuit switching and, as a result, UNE-P. Comments made at the
Triennial Review FCC public meeting, during the FCC press conference, and in the
associated press release indicate that the FCC adopted a presumption that access
to unbundled switching for voice grade or DS-0 local circuit switching remains
impaired, which means that UNE-P would still be available to the Company for
residential and most small-business customers (provided unbundled loops and
transport also remain available in those geographic areas where the Company
intends to use UNE-P). Nonetheless, the FCC's presumption of impairment is
rebuttable, and the Company expects that incumbent carriers in all or virtually
all states will press for state commissions to conduct proceedings over the
nine-month period following the effectiveness of the FCC's Triennial Review
order, as contemplated by that decision, to rebut that presumption and to remove
local switching and UNE-P from the incumbent carriers' set of unbundling
obligations. The FCC's order appears to provide that, in that event, UNE-P would
remain available for the limited purpose of a customer acquisition vehicle for
an extended transition period of three years. (Again, the details of the FCC's
plan and the scope of the potential adverse effects on the Company's business
cannot be truly known until the text of the FCC's order is released.) In
addition, we anticipate that the incumbents will challenge the FCC's decisions
regarding unbundled local switching in court, and will also lobby the United
States Congress, in an effort to remove local circuit switching from the list of
UNEs on an even faster basis than could occur under the framework adopted by the
FCC based upon state commission proceedings. If the incumbents' campaign is
successful, this would disadvantage UNE-P providers such as the Company. Further
restrictions upon the availability of local circuit switching beyond those
currently in place would significantly restrict the Company's ability to provide
service on a UNE-P basis. Where circuit switching is not available, the Company
would be unable to offer service on a UNE-P basis and must instead serve
customers on its own facilities or rely on the switching facilities of other,
non-incumbent carriers, which may delay service roll-out in some markets,
increase costs, and negatively impact the Company's business, prospects,
operating margins, results of operations, cash flows and financial condition.
The FCC's anticipated order will adopt a rebuttable presumption that local
circuit switching has been eliminated as an unbundled network element for
high-capacity (DS-1 or T-1 and above) end users; state commissions will have 90
days after the effectiveness of the FCC's order to conduct proceedings to
determine whether to rebut the presumption of no impairment for this level of
unbundled local circuit switching, and UNE-P that relies on this level of
switching.
UNE Pricing: The current UNE pricing rules were established in 1996 in the
FCC's Local Competition Order, wherein the FCC concluded that the rates charged
to new entrants must be based on the forward-looking costs of providing the
interconnection or UNEs ordered. The FCC rejected the use of historical or
embedded costs in setting rates that new entrants pay. The FCC further required
a specific methodology, "total element long-run incremental cost" ("TELRIC"), to
calculate an RBOC's forward-looking costs. The FCC required that TELRIC be
measured based on the use of the most efficient telecommunications technology
currently available and the lowest cost network configuration, given the
location of existing RBOC wire centers. Under the Telecommunications Act, state
commissions set the actual UNE rates based on the federally-adopted methodology.
10
On remand from the U.S. Supreme Court in AT&T v. Iowa Utilities Board, the
Eighth Circuit Court of Appeals concluded in 2000 that the FCC's UNE pricing
rules violated the terms of the Telecommunications Act. The Eighth Circuit
determined that the FCC's TELRIC methodology incorrectly based costs on the most
efficient technology and configuration available, rather than the actual cost of
the particular facilities and equipment deployed by RBOCs. The Eighth Circuit
ruled that the FCC cannot require that UNE prices be calculated at the cost of a
hypothetical network, as opposed to the costs actually incurred, by the RBOCs.
The Eighth Circuit, however, did not vacate the FCC's decision to use a
forward-looking cost methodology. The Court determined that requiring that
forward-looking costs be used to establish UNE rates is a matter within the
FCC's discretion.
The FCC, RBOCs and CLECs (competitive local exchange carriers) all appealed
the Eighth Circuit decision to the U.S. Supreme Court. The Supreme Court
granted certiorari in these cases, styled Verizon Communications v. FCC, and in
May 2002, reversed the Eighth Circuit (except for its decision about the use of
a forward-looking methodology) and upheld the validity of the FCC's TELRIC
pricing methodology for UNEs.
Although the FCC's forward-looking cost model for establishing rates for
unbundled network elements has been upheld by the U.S. Supreme Court, it is
possible that either the FCC will review or revise the methodology in a manner
that raises the Company's costs or the states will review the UNE rates they
have established under a TELRIC methodology. The FCC's methodology and the
manner in which it is applied are under attack from the incumbent carriers and
the U.S. Telecom Association, their trade association, and intense lobbying
efforts by the incumbent carriers could lead the FCC to re-examine its pricing
rules further or even convince Congress to modify the pricing standard for
unbundled network elements in the Telecommunications Act, leading to higher
prices. In fact, the FCC has indicated that it may comprehensively review that
methodology in the near future. Further, as a possible foretaste, in its recent
Triennial Review decision, the FCC appears to have opened the door for
incumbents to utilize a higher cost of capital input and shorter depreciation
lives in establishing rates for unbundled elements. Incumbent carriers also
routinely file petitions with the state commissions seeking to increase the
rates they can charge competitors for unbundled elements. Such modifications to
the incumbents' UNE rates could raise our costs for leasing UNE-P and other UNEs
in the future.
As indicated above, the text of the Triennial Review decision has not yet
been released. It is anticipated that once the FCC's new unbundling rules
become effective, incumbent carriers will pursue review in courts, attempt to
institute proceedings with the FCC and state regulatory agencies, and lobby the
United States Congress in an effort to affect laws and regulations regarding the
availability of UNEs and UNE-P, and the prices competitors pay for them, in a
manner even more favorable to them and against the interests of competitive
carriers. Concomitantly, it is expected that competitive carriers will endeavor
to improve their positions and access to the incumbents' networks at cost-based
rates through similar means.
REGULATION OF MARKETING
The Company's current and past direct and partner marketing efforts all
require compliance with relevant federal and state regulations that govern the
sale of telecommunication services. The FCC and many states have rules that
prohibit switching a customer from one carrier to another without the customer's
express consent and specify how that consent must be obtained and verified.
Most states also have consumer protection laws that further define the framework
within which the Company's marketing activities must be conducted. While
directed at curbing abusive marketing practices, the design and enforcement of
these rules can have the incidental effect of entrenching incumbent carriers and
hindering the growth of new competitors, such as the Company.
The Company's marketing efforts are carried out through a variety of
marketing programs, including referrals from existing customers, outbound
telemarketing, direct sales through independent agents and the Company's own
direct sales force, broadcast media and online marketing initiatives.
Restrictions on the marketing of telecommunication services are becoming
stricter in the wake of widespread consumer complaints throughout the industry
about "slamming" (the unauthorized change of a customer's service from one
carrier to another carrier) and "cramming" (the unauthorized provision of
additional telecommunication services). The Telecommunications Act strengthened
penalties against slamming, and the FCC issued and updated rules tightening
federal requirements for the verification of orders for telecommunication
services and establishing additional financial penalties for slamming. In
11
addition, many states have been active in restricting marketing through new
legislation and regulation, as well as through enhanced enforcement activities.
The Federal Trade Commission and the FCC have proposed rules and regulations
governing the creation and enforcement of national "do not call" databases that
could affect the Company's ability to outbound telemarket. The Company's
marketing activities have subjected the Company to investigations or enforcement
actions by government authorities. The constraints of federal and state
regulation, as well as increased FCC, Federal Trade Commission and state
enforcement attention, could limit the scope and the success of the Company's
marketing efforts and subject them to enforcement actions, which may have an
adverse effect on the Company.
Statutes and regulations designed to protect consumer privacy also may have
the incidental effect of hindering the growth of newer telecommunication
carriers such as the Company. For example, the FCC rules that restrict the use
of "customer proprietary network information" (information that a carrier
obtains and uses about its customers through their use of the carrier's
services) may make it more difficult for the Company to market additional
telecommunication services (such as local and wireless), as well as other
services and products, to its existing customers.
UNIVERSAL SERVICE FUND REGULATION
Pursuant to Section 254 of the Telecommunications Act, the FCC requires the
Company and other providers of telecommunication services to contribute to a
federally administered universal service fund, which helps to subsidize the
provision of local telecommunication services and other services to low-income
consumers, schools, libraries, health care providers, and rural and insular
areas that are costly to serve. The Telecommunications Act requires every
telecommunication carrier that provides interstate telecommunication services to
contribute, on an equitable and nondiscriminatory basis, to the specific,
predictable, and sufficient mechanisms established by the FCC to preserve and
advance universal service. These regulations were recently amended and
contributions to the FCC's universal service funds are now assessed on
telecommunication providers' projected combined interstate and international end
user telecommunication revenues, and no longer permit telecommunication
providers to recover margin on this assessment. The Company's contribution of
revenues to universal service stands at 7.28% of end user telecommunications
revenues for the first quarter of 2003 and 9.0044% for the second quarter of
2003. In a December 2002 Notice of Proposed Rulemaking, the FCC has asked many
broad-ranging questions regarding universal service including, whether to change
its method of assessing contributions due from carriers by basing it on the
number and capacity of connections they provide, rather than on interstate and
international end user revenues they earn. The Company cannot be sure that
legislation or FCC rulemaking will not increase the size of its subsidy
payments, the scope of the subsidy program or the Company's costs of
calculating, collecting and remitting the payments. Some states have similar
universal fund programs, and in those instances the Company may be required to
remit a portion of its intrastate revenue to such funds.
STATE REGULATION
The vast majority of the states require the Company to apply for
certification to provide local and intrastate telecommunication services, or at
least to register or to be found exempt from regulation, before commencing
intrastate service. The majority of states also require the Company to file and
maintain detailed tariffs listing its rates for intrastate service. State law
typically requires charges and terms for the Company's services to meet certain
standards, such that its charges and practices be just, reasonable and not
unreasonably discriminatory. Many states also impose various reporting
requirements and/or require prior approval for transfers of control of certified
carriers, corporate reorganizations, acquisitions of telecommunication
operations, assignments of carrier assets, including subscriber bases, carrier
stock offerings and incurrence by carriers of significant debt obligations.
Certificates of authority can generally be conditioned, modified, canceled,
terminated or revoked by state regulatory authorities for failure to comply with
state law and the rules, regulations and policies of the state regulatory
authorities. Fines and other penalties, including the return of all monies
received for intrastate traffic from residents of a state, may be imposed for
such violations. State regulatory authorities may also place burdensome
requirements on telecommunication companies seeking transfers of control for
licenses and the like. Under the regulatory arrangement contemplated by the
Telecommunications Act, state authorities continue to regulate certain matters
related to universal service, public safety and welfare, quality of service and
12
consumer rights. All of these regulations, however, must be competitively
neutral and consistent with the Telecommunications Act, which generally
prohibits state regulation that has the effect of prohibiting us from providing
telecommunications services in any particular state. State commissions also
enforce some of the Telecommunications Act's local competition provisions,
including those governing the arbitration of interconnection disputes between
the incumbent carriers and competitive telephone companies and the setting of
rates for unbundled network elements.
FINANCIAL RESTRUCTURING
Beginning in the third quarter of 2001, the Company embarked upon a
comprehensive restructuring of its financial obligations with (i) America
Online, Inc. ("AOL"), (ii) its senior secured creditor, and (iii) the holders of
the Company's convertible subordinated notes. References in the following
discussion to numbers of shares of common stock and per share prices reflect
adjustment for the one-for-three reverse stock split as of October 15, 2002.
AOL RESTRUCTURING
In September, 2001, the Company restructured its financial obligations with
AOL that arose under the 1999 Investment Agreement between the Company and AOL
and, effective September 30, 2001, ended its marketing relationship with AOL.
The Company began marketing and providing telecommunication services to AOL
subscribers under the Company's and AOL's brand in 1997. In January, 1999, AOL
made a $55 million investment in the Company at $57 per share and the Company
provided AOL with the ability to protect the value of that investment for a
period of time, permitting AOL, at its election, to require the Company to make
certain "make whole" payments to AOL on or before September 30, 2001. As a
result of the September 2001 restructuring and the termination of the marketing
agreement, the Company issued to AOL $34 million of its 8% Secured Convertible
Notes due September 2011 ("8% Secured Convertible Notes") in exchange for a
release of the Company's reimbursement obligations under the 1999 Investment
Agreement. The Company also issued 1,026,209 additional shares of its common
stock in exchange for warrants to purchase the Company's common stock held by
AOL and the Company's related obligations under the 1999 Investment Agreement to
repurchase those warrants, bringing the total number of shares of the Company's
common stock held by AOL to 2,400,000. On December 23, 2002, the Company
restructured its 8% Secured Convertible Notes. The principal terms of the
restructuring were as follows: the new maturity date is September 19, 2006, a
pay-in-kind interest option was eliminated and interest is thereafter required
to be paid entirely in cash, and the Company was provided additional flexibility
to purchase subordinated debt and common stock through September 30, 2003. In
2002, the Company repurchased $5.4 million of its 8% Secured Convertible Notes.
Through March 28, 2003, the Company has repurchased $3.6 million of its 8%
Secured Convertible Notes, reducing the outstanding principal amount to $26.6
million as of March 28, 2003. In January 2003, the Company purchased 1,315,789
of its common shares from AOL for an aggregate purchase price of approximately
$5.0 million.
SECURED CREDIT FACILITY RESTRUCTURING
By amendments on February 12, 2002, and April 3, 2002, the Company
restructured certain portions, including financial covenants, of its Credit
Facility Agreement with MCG Finance Corporation ("MCG"), and the Consulting
Agreement, and other loan documents between the parties. In October 2002, the
Company retired the facility of $13.8 million prior to its originally scheduled
maturity in 2005.
CONVERTIBLE SUBORDINATED NOTES RESTRUCTURING
As of December 31, 2001, the Company had an aggregate amount of $61.8
million in 4 1/2% Convertible Subordinated Notes due in September 2002 ("4-1/2%
Convertible Subordinated Notes") and $18.1 million in 5% Convertible
Subordinated Notes due in 2004 ("5% Convertible Subordinated Notes"). The
Company decided to offer to exchange the 4-1/2% Convertible Subordinated Notes
and the 5% Convertible Subordinated Notes ("Existing Notes") for new notes,
principally to extend the time that the Company has to pay the Existing Notes,
as part of the Company's efforts to restructure its debt obligations, and
maintain sufficient cash to conduct its operations. On February 22, 2002, the
Company initiated Exchange Offers and Consent Solicitations ("the Exchange
Offers") for all of the Company's outstanding Existing Notes. On April 4, 2002,
the Company completed the exchange for $57.9 million principal amount, or 94% of
the total amount outstanding, of its 4-1/2% Convertible Subordinated Notes that
were
13
tendered for exchange in the Exchange Offers and approximately $17.4 million
principal amount, or 95% of the total amount outstanding, of its 5% Convertible
Subordinated Notes that were tendered for exchange in the Exchange Offers. The
Company issued $53.2 million in principal amount of its new 12% Senior
Subordinated PIK Notes due 2007 ("12% Senior Subordinated Notes") and $2.8
million in principal amount of its new 8% Convertible Senior Subordinated Notes
due 2007 ("8% Convertible Senior Subordinated Notes") (convertible into common
stock at $15.00 per share), and paid approximately $0.5 million in cash, in
exchange for the tendered 4-1/2% Convertible Subordinated Notes. Interest on the
new 12% Senior Subordinated Notes is payable in cash, except that the Company
may, at its election, pay up to one-third of the interest due on any interest
payment date through and including the August 15, 2004 interest payment in
additional 12% Senior Subordinated Notes. The Company also issued $17.4 million
in principal amount of its 12% Senior Subordinated Notes in exchange for the
tendered 5% Convertible Subordinated Notes. In addition, the holders of the
4-1/2% Convertible Subordinated Notes and 5% Convertible Subordinated Notes
consented to amend the respective indentures under which the Existing Notes were
issued to eliminate from the indentures the right to require the Company to
repurchase such notes should the Company's common stock cease to be approved for
trading on an established automated over-the-counter trading market in the
United States. After completion of the Exchange Offers, there were outstanding
approximately $70.7 million principal amount of the Company's 12% Senior
Subordinated Notes, approximately $2.8 million principal amount of the Company's
8% Convertible Senior Subordinated Notes, approximately $3.9 million principal
amount of the 4-1/2% Convertible Subordinated Notes and approximately $0.7
million principal amount of the 5% Convertible Subordinated Notes. In September
2002, the Company retired upon maturity the remaining $3.9 million principal
amount of the 4-1/2% Convertible Subordinated Notes. The Company repurchased
$5.7 million of its 12% Senior Subordinated Notes in 2002 and, in 2003, through
March 28, has repurchased an additional $9.4 million of its 12% Senior
Subordinated Notes, reducing the outstanding principal amount to $56.6 million
as of March 28, 2003.
EMPLOYEES
As of December 31, 2002 the Company employed approximately 1,000 persons.
The Company considers relations with its employees to be good.
ITEM 2. PROPERTIES
The Company leases an approximately 8,000 square foot facility in Reston,
Virginia, that serves as the Company's headquarters and is where a number of the
Company's executives, network and marketing personnel are located. The Company
owns an approximately 24,000 square foot facility in New Hope, Pennsylvania
where certain of the Company's executives and its finance, legal, information
technology development and marketing personnel are located. The Company also
leases properties in the cities in which switches for its network have been or
will be installed (New York, New York; San Francisco, California; Chicago,
Illinois; Dallas, Texas; Jacksonville, Florida; and Southfield, Michigan). The
Company leases an approximately 3,500 square foot facility in Chicago, Illinois
for additional information technology development personnel.
With respect to the Company's sales, provisioning and customer service
operations, the Company owns a 32,000 square foot facility located in Palm
Harbor, Florida. The Company also leases the following facilities for sales,
provisioning and customer service operations: an approximately 29,000 square
foot facility in Orlando, Florida, an approximately 13,000 square foot facility
in Greenville, South Carolina, and an approximately 12,000 square foot facility
in Fort Myers, Florida.
ITEM 3. LEGAL PROCEEDINGS
The Company is party to a number of legal actions and proceedings,
including purported class actions, arising from the Company's provision and
marketing of telecommunications services, as well as certain legal actions and
regulatory investigations and enforcement proceedings arising in the ordinary
course of business. The Company believes that the ultimate outcome of the
foregoing actions will not result in liability that would have a material
adverse effect on the Company's financial condition or results of operations.
However, it is possible that, because of fluctuations in the Company's cash
position, the timing of developments with respect to such matters that require
cash payments by the Company, while such payments are not expected to be
material to the Company's financial condition, could impair the Company's
ability in future interim or annual periods to continue to implement its
business plan, which could affect the Company's results of operations in future
interim or annual periods.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
14
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock, $.01 par value per share, is traded on the
Nasdaq National Market under the symbol "TALK". The Company's stockholders
approved a one-for-three reverse stock split of the Company's common stock,
effective October 15, 2002, decreasing the number of common shares authorized
from 300 million to 100 million. All applicable references to the number of
shares of common stock and per share information, stock option data and market
prices have been restated to reflect this reverse stock split. High and low
quotations listed below are actual closing sales prices as quoted on the Nasdaq
National Market:
COMMON STOCK PRICE RANGE OF COMMON STOCK
------------ ----------------------------
HIGH LOW
-------- --------
2001
First Quarter $ 7.59 $ 3.84
Second Quarter 7.53 2.73
Third Quarter 3.18 0.99
Fourth Quarter 1.56 1.02
2002
First Quarter $ 1.92 $ 1.11
Second Quarter 12.39 1.32
Third Quarter 11.91 6.15
Fourth Quarter 9.18 5.43
2003
First Quarter (through March 26, 2003) $ 7.34 $ 3.52
As of March 26, 2003, there were approximately 910 record holders of
Common Stock.
The Company has never declared or paid any cash dividends on its capital
stock. The Company currently intends generally to retain future earnings to
finance the growth and development of its business and, therefore, does not
anticipate paying cash dividends in the foreseeable future. In addition, the 8%
Secured Convertible Notes prohibit the Company from paying any dividends on its
capital stock.
COMPENSATION PLANS AND SECURITIES
The following table sets forth certain information as of December 31, 2002
with respect to compensation plans under which equity securities of the Company
are authorized for issuance:
NUMBER OF SECURITIES
NUMBER OF SECURITIES TO WEIGHTED-AVERAGE REMAINING AVAILABLE
BE ISSUED UPON EXERCISE EXERCISE PRICE OF FOR FUTURE ISSUANCE
OF OUTSTANDING OPTIONS, OUTSTANDING OPTIONS, UNDER EQUITY
PLAN CATEGORY WARRANTS AND RIGHTS WARRANTS AND RIGHTS COMPENSATION PLANS (1)
- ------------------------- ----------------------- ------------------- ----------------------
Equity compensation
plans approved by
security holders 2,141,758 $ 5.50 126,097
Equity compensation
plans not approved
by security holders (2) 2,043,942 $ 8.25 774,188(1)
----------------------- ------------------- ----------------------
Total 4,185,700 $ 6.84 900,285
(1) Under all plans, if any shares subject to a previous award are
forfeited, or if any award is terminated without issuance of shares or satisfied
with other consideration, the shares subject to such award shall again be
available for future grants.
(2) The shares are primarily under the Company's 2001 Non-Officer Long Term
Incentive Plan pursuant to which up to 1,666,666 shares of the Company's common
stock may be issued to employees of the Company in the form of options, rights,
restricted stock and incentive shares. The shares also include shares issuable
on exercise of certain options granted in connection with the initial employment
of executive officers and without shareholder approval as permitted by the rules
of Nasdaq. To the extent permitted by the rules of Nasdaq, there may be further
grants of securities by option or otherwise without shareholder approval, both
to non-executive employees and in connection with the initial employment of
executive officers.
15
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data should be read in conjunction
with, and are qualified in their entirety by, "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the Company's
Consolidated Financial Statements included elsewhere in this Form 10-K.
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT FOR PER SHARE AMOUNTS)
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Sales $ 317,507 $ 488,158 $ 525,712 $ 516,548 $ 448,600
Costs and expenses:
Network and line costs 155,567 235,153 292,931 289,029 321,215
General and administrative expenses 53,510 82,202 65,360 39,954 39,393
Provision for doubtful accounts 9,365 92,778 53,772 28,250 37,789
Sales and marketing expenses 27,148 73,973 152,028 96,264 210,552
Depreciation and amortization 17,318 34,390 19,257 6,214 5,499
Impairment and restructuring charges -- 170,571 -- -- --
Significant other charges (income) -- -- -- (2,718) 91,025
--------- --------- --------- --------- ---------
Total costs and expenses 262,908 689,067 583,348 456,993 705,473
--------- --------- --------- --------- ---------
Operating income (loss) 54,599 (200,909) (57,636) 59,555 (256,873)
Other income (expense):
Interest income 802 1,220 4,859 3,875 38,876
Interest expense (9,087) (6,091) (5,297) (4,616) (29,184)
Other, net (892) (2,698) (3,822) (1,115) (20,867)
--------- --------- --------- --------- ---------
Income (loss) before provision for income
taxes 45,422 (208,478) (61,896) 57,699 (268,048)
Provision (benefit) for income taxes (1) (22,300) -- -- -- 40,388
--------- --------- --------- --------- ---------
Income (loss) before extraordinary gains and
cumulative effect of an accounting change 67,722 (208,478) (61,896) 57,699 (308,436)
Extraordinary gains 29,340 20,648 -- 21,230 87,110
Cumulative effect of an accounting change -- (36,837) -- -- --
--------- --------- --------- --------- ---------
Net income (loss) $ 97,062 $(224,667) $ (61,896) $ 78,929 $(221,326)
========= ========= ========= ========= =========
Income (loss) per share - Basic:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per
share $ 2.48 $ (7.89) $ (2.63) $ 2.83 $ (15.61)
Extraordinary gains per share 1.08 0.78 -- 1.04 4.41
Cumulative effect of an accounting change per
share -- (1.40) -- -- --
--------- --------- --------- --------- ---------
Net income (loss) per share $ 3.56 $ (8.51) $ (2.63) $ 3.87 $ (11.20)
========= ========= ========= ========= =========
Weighted average common shares outstanding 27,253 26,414 23,509 20,395 19,761
========= ========= ========= ========= =========
Income (loss) per share - Diluted:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per
share $ 2.20 $ (7.89) $ (2.63) $ 2.69 $ (15.61)
Extraordinary gains per share 0.95 0.78 -- 0.99 4.41
Cumulative effect of an accounting change per
share -- (1.40) -- -- --
--------- --------- --------- --------- ---------
Net income (loss) per share $ 3.15 $ (8.51) $ (2.63) $ 3.68 $ (11.20)
========= ========= ========= ========= =========
Weighted average common and common
equivalent shares outstanding 30,798 26,414 23,509 21,471 19,761
========= ========= ========= ========= =========
16
AT DECEMBER 31,
--------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents $ 33,588 $ 22,100 $ 40,604 $ 78,937 $ 3,063
Total current assets 81,261 50,698 97,203 150,893 149,769
Goodwill and intangibles, net (4) 26,882 29,672 218,639 1,068 1,150
Total assets 187,511 165,221 407,749 215,008 272,560
Current portion of long-term debt (3) 61 14,454 2,822 -- 49,621
Total current liabilities 63,190 87,273 100,271 71,168 136,708
Contingent obligations -- -- 114,630 114,630 --
Long-term debt (2)(3) 100,855 152,370 103,695 84,985 242,387
Stockholders' equity (deficit) 23,466 (74,422) 82,700 (69,375) (136,785)
- -----------------------------------------
(1) The provision for income taxes in 1998 represents a valuation allowance for
deferred tax assets recorded in prior periods and current tax benefits that
may result from the 1998 loss. The Company provided the valuation
allowances in view of the loss incurred in 1998, the uncertainties
resulting from intense competition in the telecommunication industry and
the lack of any assurance that the Company would realize any tax benefits.
The Company has continued to provide a valuation allowance against its
deferred tax assets at December 31, 2001, 2000 and 1999. In 2002, as part
of the Company's 2003 budgeting process, management evaluated the deferred
tax valuation allowance and determined that a portion of this valuation
allowance should be reversed, resulting in a non-cash deferred income tax
benefit of $22.3 million.
(2) Long-term debt at December 31, 2001 included $31.0 million of future
accrued interest in connection with the 8% Secured Convertible Notes in
accordance with SFAS No. 15, "Accounting by Debtors and Creditors for
Troubled Debt Restructuring." In 2002, the 8% Secured Convertible Notes
were restructured, resulting in the elimination of the future accrued
interest in connection therewith. As a result of the 2002 restructuring of
the Company's 8% Secured Convertible Notes in 2002 and retirement of a
portion of such notes, the Company recorded an extraordinary gain of $28.9
million.
(3) The Company restructured substantially all of the 4-1/2% and 5% Convertible
Subordinated Notes in April 2002; accordingly, $57.9 million of the 4-1/2%
Convertible Subordinated Notes are classified as long-term debt as of
December 31, 2001.
(4) In 2001, the Company recorded an impairment charge of $168.7 million
primarily related to the write-down of goodwill associated with the
acquisition of Access One.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements included elsewhere in this Form 10-K. Certain
of the statements contained herein may be considered forward-looking statements.
Such statements are identified by the use of forward-looking words or phrases,
including, but not limited to, "estimates," "expects," "expected,"
"anticipates" and "anticipated." These forward-looking statements are based on
the Company's current expectations. Although the Company believes that the
expectations reflected in such forward-looking statements are reasonable, there
can be no assurance that such expectations will prove to have been correct.
Forward-looking statements involve risks and uncertainties and the
Company's actual results could differ materially from the Company's
expectations. In addition to those factors discussed in this Form 10-K and the
Company's other filings with the Securities and Exchange Commission, important
factors that could cause such actual results to differ materially include, among
others, dependence on the availability and functionality of RBOCs' networks as
they relate to the unbundled network element platform, increased price
competition for long distance and local services, failure of the marketing of
17
the bundle of local and long distance services and long distance services under
its agreements with its direct marketing channels and its various marketing
partners, failure to manage the nonpayment of amounts due the Company from its
customers from bundled and long distance services, attrition in the number of
end users, failure or difficulties in managing the Company's operations,
including attracting and retaining qualified personnel, failure of the Company
to be able to expand its active offering of local bundled services in a greater
number of states, failure to provide timely and accurate billing information to
customers, failure of the Company to manage its collection management systems
and credit controls for customers, interruption in the Company's network and
information systems, failure of the Company to provide adequate customer
service, and changes in government policy, regulation and enforcement and/or
adverse judicial or administrative interpretations and rulings relating to
regulations and enforcement, including, but not limited to, the continued
availability of unbundled network element platform of the local exchange
carriers network.
OVERVIEW
The Company provides local and long distance telecommunication services to
residential and small business customers in the United States. The Company has
developed integrated order processing, provisioning, billing, payment,
collection, customer service and information systems that enable the Company to
offer and deliver high-quality service, savings through competitively priced
telecommunication products, and simplicity through consolidated billing and
responsive customer service.
The Company offers both local and long distance telecommunication services,
primarily the bundled service offering of local and long distance voice
services, which are billed to customers in one combined invoice. Local phone
services include local dial tone, various local calling plans that include free
member-to-member calling, and a variety of features such as caller
identification, call waiting and three-way calling. Long distance phone
services include traditional 1+ long distance, international and calling cards.
The Company uses the unbundled network element platform ("UNE-P") of the
regional bell operating companies ("RBOCs") network to provide local services
and the Company's nationwide network to provide long distance services. The
Federal Communications Commission ("FCC") has recently concluded its triennial
review of local phone competition. Although the text of the order is not yet
available, the decision appears to preserve the Company's ability to use UNE-P
for the provision of bundled telecommunications services pending further
market-by-market analyses by the respective state commissions.
By the end of 1999, the Company decided to expand beyond its historical
long distance business and utilize UNE-P to enter the large local
telecommunications market and diversify its product portfolio through the
bundling of local service with its core long distance service offerings. In
connection therewith, the Company acquired Access One Communications Corp.
("Access One") in August 2000. Access One was a private, local telecommunication
services provider to nine states in the southeastern United States. The Company
encountered a number of operational and business difficulties during the rollout
of the Company's bundled service offering and worked to address the operational
issues that it encountered. The Company focused on improving the overall
efficiency of the bundled business model in 2001. During 2002, the Company's top
operating priorities were to lower bad debt expense, reduce customer turnover,
or "churn," and lower its customer acquisition costs. During 2003, the Company's
primary focus will be to increase sales of its local bundled service within the
targets established by management for acquisition costs, customer turnover and
bad debt expense.
The Company continues to manage its business to generate free cash flow
(defined as net cash provided by operating activities less net cash used in
investing activities) and has built a scaleable platform to provision, bill and
service bundled customers. The Company continues to focus on delivering better
service and value to customers. During 2002, the Company expanded its product
offerings to appeal to a broader customer base based upon calling patterns and
feature preferences. Although the Company is now operational with respect to
its local service offering in 26 states, the Company has limited the marketing
of its bundled services to those states, or certain areas of a state, where the
Company believes it can currently offer services to customers at competitive
prices. The Company will market to additional states (or certain areas of a
particular state) as the Company believes its pricing and cost structure permit
it to profitably offer services in those areas at competitive rates. While the
Company has actively marketed the bundled product in a number of states, at
present, a majority of the Company's bundled customers are inMichigan. The
Company continually reviews its product offerings, pricing and sales and
marketing programs in an effort to improve the efficiency of its sales and
marketing channels.
18
During 2002, the Company completed a significant restructuring of its debt
obligations, including (1) an exchange offer that effectively extended the final
maturity on substantially all of the Company's public debt obligations to 2007;
(2) the retirement of the Company's senior credit facility of $13.8 million
prior to its scheduled maturity; (3) open market repurchases of $5.7 million
principal amount of the Company's 12% Senior Subordinated Notes; (4) the
repurchase of $5.4 million principal amount of the Company's 8% Secured
Convertible Notes; and (5) the restructuring of the 8% Secured Convertible
Notes. In 2003, through March 28, the Company has (i) repurchased a further
$9.4 million principal amount of its 12% Senior Subordinated Notes and $3.6
million principal amount of its 8% Secured Convertible Notes, and (ii) purchased
approximately 1.3 million shares of its common stock for an aggregate purchase
price of $5 million.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain financial
data of the Company as a percentage of sales:
YEAR ENDED DECEMBER 31,
--------------------------------------
2002 2001 2000
-------- -------- --------
Sales 100.0% 100.0% 100.0%
Costs and expenses:
Network and line costs 49.0 48.2 55.7
General and administrative expenses 16.8 16.8 12.5
Provision for doubtful accounts 2.9 19.0 10.2
Sales and marketing expenses 8.6 15.2 28.9
Depreciation and amortization 5.5 7.0 3.7
Impairment and restructuring charges -- 35.0 --
-------- -------- --------
Total costs and expenses 82.8 141.2 111.0
-------- -------- --------
Operating income (loss) 17.2 (41.2) (11.0)
Other income (expense):
Interest income 0.3 0.3 0.9
Interest expense (2.9) (1.2) (1.0)
Other, net (0.3) (0.6) (0.7)
-------- -------- --------
Income (loss) before income taxes 14.3 (42.7) (11.8)
Provision (benefit) for income taxes (7.0) -- --
-------- -------- --------
Income (loss) before extraordinary gains and
cumulative effect of an accounting change 21.3 (42.7) (11.8)
Extraordinary gains 9.3 4.2 --
Cumulative effect of an accounting change -- (7.5) --
-------- -------- --------
Net income (loss) 30.6% (46.0)% (11.8)%
======== ======== ========
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001
Sales. Sales decreased by 35.0% to $317.5 million in 2002 from $488.2
million in 2001. The decrease in sales for 2002 compared to 2001 is due to (i)
lower long distance sales resulting from the Company's continued focus, begun in
2000, on its efforts in the local telecommunication services market by offering
local telecommunication services bundled with long distance services and
significantly reduced sales and marketing related to the long distance product,
and (ii) lower bundled sales resulting primarily from lower average revenues per
line in 2002 as the Company lowered product prices to provide more value to the
consumer.
19
The Company's bundled sales for the year ended December 31, 2002 were
$171.2 million as compared to $196.5 million for the year ended December 31,
2001. The decreases in sales was due to lower average revenue per bundled line
in 2002 as compared to 2001. Such decrease resulted from the Company's ongoing
strategy to market lower priced products to be more competitive with incumbent
and other competitive local exchange carriers. In 2002, bundled revenues
increased sequentially from $35.5 million in the first quarter to $51.8 million
in the fourth quarter. The 2002 quarterly sequential growth reflected both
growth in bundled lines and reductions in customer turnover. The Company had
approximately 333,000 bundled lines as of December 31, 2002 compared with
approximately 179,000 bundled lines at December 31, 2001. Approximately 203,000
of the bundled lines at December 31, 2002 were in Michigan. Bundled revenues for
the quarter ending March 31, 2003 and the year ended 2003 are expected to be
between $57 and $60 million and $270 and $280 million, respectively. Bundled
lines for the quarter ended March 31, 2003 and for the year ended December 31,
2003 are expected to be between 380,000 and 390,000 and 525,000 and 545,000,
respectively. Longer-term growth in revenues will depend upon continued
operating efficiencies, lower customer turnover and the Company's ability to
develop and scale various marketing programs in additional states or areas.
The Company's long distance sales decreased to $146.3 million in 2002 from
$291.7 million in 2001. In 2001, a significant percentage of the Company's
revenues from long distance telecommunication services derived from customers
who were obtained under the AOL marketing agreement. The Company's decision to
focus on the bundled product and the discontinuation of the AOL marketing
relationship effective September 30, 2001, together with customer turnover,
contributed to the decline in long distance customers and revenues. This decline
in long distance customers and revenues is expected to continue so long as the
Company continues to focus its marketing efforts on the bundled product. Long
distance revenues in 2002 and 2001 included non-cash amortization of deferred
revenue of $6.2 million and $7.4 million, respectively, related to a
telecommunications service agreement entered into in 1997. Deferred revenue
relating to this agreement has been amortized over a five-year period. The
agreement and related amortization terminated in October 2002. Long distance
revenues for the quarter ended March 31, 2003, and the year ended 2003 are
expected to be between $24 and $27 million and $80 and $90 million,
respectively.
Recently, the Company has selectively increased certain fees and rates
related to its long distance and bundled products and such changes in rates and
bill presentation may adversely impact customer turnover.
Network and Line Costs. Network and line costs decreased by 33.8% to $155.6
million for the year ended December 31, 2002 from $235.2 million for the year
ended December 31, 2001. The decrease in network and line costs was primarily
due to the lower numbers of local and long distance customers and a reduction in
access and usage rates. Network and line costs for the year ended December 31,
2002 benefited from a credit of $1.7 million in connection with a New York
Public Service Commission mandated refund from Verizon New York of certain UNE-P
switching costs. Network and line costs also benefited from favorable resolution
of certain disputes with vendors. The Company's policy is not to record credits
from such disputes until received.
As a percentage of sales, network and line costs increased to 49.0% for the
year ended December 31, 2002, as compared to 48.2% for the year ended December
31, 2001. The growth of local bundled service as a percentage of total revenue
and product mix has contributed to the increase in overall network and line cost
as a percentage of revenues. Bundled network and lines costs as a percentage of
bundled revenues were 56.1% in 2002 as compared to 54.8% in 2001. Excluding the
benefit of the Verizon New York credit and other dispute resolutions, the
network and line costs as a percentage of sales for the bundled product would
have been approximately 59% in 2002. Long distance network and line costs as a
percentage of long distance revenues were 40.6% in 2002 as compared to 43.7% in
2001. Excluding amortization of deferred revenue related to a telecommunications
service agreement, which expired in October 2002, and various dispute
resolutions, network and line costs as a percentage of long distance revenue
would have been approximately 44% in 2002.
There are several factors that could cause network and line costs as a
percentage of sales to increase in the future, including (i) adverse changes to
the current rules and regulations or adverse judicial and administrative
interpretations and rulings relating to the FCC's recently concluded triennial
review of local phone competition and the pending market-by-market analyses by
the respective state commissions, (ii) greater absorption of fixed network costs
as the Company's long distance customer base declines, and (iii) certain minimum
network service commitments relating to the Company's long distance network.
See "Liquidity and Capital Resources, Other Matters."
General and Administrative Expenses. General and administrative expenses
decreased by 34.9% to $53.5 million for the year ended December 31, 2002 from
$82.2 million for the year ended December 31, 2001. The overall decrease in
general and administrative expenses was due primarily to significant workforce
reductions and other cost cutting efforts by the Company as it pursued
improvements in operating efficiencies of the Company's bundled business model.
Included in general and administrative expenses for the year ended December 31,
20
2002 was a non-cash credit of $1.7 million related to a favorable legal
settlement of a dispute that had previously been reflected as a liability,
partially offset by an increase in legal reserves of $0.5 million. General and
administrative expenses as a percentage of sales were 16.8% for both 2002 and
2001. While the Company expects general and administrative expense as a
percentage of sales to decline as the customer base grows, realization of such
efficiencies will be dependent on the ability of management to continue to
control personnel costs in areas such as customer service and collections. There
can be no assurances that the Company will be able to realize these
efficiencies.
Provision for Doubtful Accounts. Provision for doubtful accounts decreased
by 89.9% to $9.4 million for the year ended December 31, 2002 from $92.8 million
for the year ended December 31, 2001 and, as a percentage of sales, decreased to
2.9% as compared to 19.0% for the year ended December 31, 2001. The Company had
taken several steps during the third and fourth quarters of 2001 to reduce bad
debt expense, improve the overall credit quality of its customer base and
improve its collections of past due amounts. The benefits of the Company's
actions to reduce bad debt expense and improve the overall credit quality of its
customer base are reflected in the lower bad debt expense for the year ended
December 31, 2002. Further, the provision for doubtful accounts for the year
ended December 31, 2002 reflects a benefit from a reversal of the reserve for
doubtful accounts of $1.9 million due to better than expected collections
experience on outstanding accounts receivable at year-end 2001. Adjusting for
the reversal, the provision for doubtful accounts as a percentage of sales would
have been 3.5% for 2002. In general, the Company believes that bad debt
expense as a percentage of sales of the Company's long distance customers is
lower than that of its bundled customers because of the relatively greater
maturity of the long distance customer base.
Sales and Marketing Expenses. During the year ended December 31, 2002, the
Company incurred $27.1 million of sales and marketing expenses as compared to
$74.0 million for the year ended December 31, 2001, a 63.3% decrease, and, as a
percentage of sales, a decrease to 8.6% as compared to 15.2% for the year ended
December 31, 2001. Included in sales and marketing expenses are advertising
expenses of $1.5 million for 2002 and $0.2 million for 2001, respectively. The
decrease in sales and marketing costs from 2002 as compared to 2001 is primarily
attributable to the reduction in marketing fees paid to AOL due to the
termination of the marketing relationship with AOL effective September 30, 2001.
Sales and marketing expenses declined further due to the Company's decision to
slow growth as it pursued its plan in 2002 to improve the efficiency of the
Company's bundled business model. Currently, substantially all of the sales and
marketing expenses relate to the bundled product. Sales and marketing expenses
are expected to increase in 2003 as the Company continues to target growth in
the bundled product and invest in the development of its marketing programs.
Depreciation and Amortization. Depreciation and amortization for the year
ended December 31, 2002 was $17.3 million, a decrease of $17.1 million as
compared to $34.4 million for the year ended December 31, 2001, and, as a
percentage of sales, decreased to 5.5% as compared to 7.0% for the year ended
December 31, 2001. The Company's amortization expense decreased significantly
for the year ended December 31, 2002 due to the write-down in the third quarter
of 2001 of goodwill associated with the acquisition of Access One. Additionally,
the Company adopted Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets," which established the impairment
approach rather than amortization for goodwill, resulting in reduced
amortization in 2002 (see Note 1 of the Notes to Consolidated Financial
Statements).
Impairment and Restructuring Charges. The Company incurred impairment and
restructuring charges of $170.6 million in 2001. Included in the amount for 2001
was an impairment charge of $168.7 million primarily related to the write-down
of goodwill associated with the acquisition of Access One. In September 2001,
the Company approved a plan to close one of its call center operations. The
Company incurred expenses of $1.9 million during 2001 to reflect the elimination
of approximately 225 positions and lease exit costs in connection with the call
center closure. There were no impairment or restructuring charges in 2002 (see
Note 4 of the Notes to Consolidated Financial Statements).
Interest Income. Interest income was $0.8 million in 2002 versus $1.2
million in 2001. Interest income in 2002 was lower due to lower interest rates
as compared to 2001.
Interest Expense. Interest expense was $9.1 million in 2002 as compared to
$6.1 million in 2001. The increase in interest expense is attributed to the
higher yielding debt instruments delivered in the exchange of the Company's
4-1/2% and 5% Convertible Subordinated Notes for 8% Convertible Senior
21
Subordinated Notes and 12% Senior Subordinated Notes and the restructuring of
the Company's senior credit facility (see Note 7 of the Notes to Consolidated
Financial Statements and "Liquidity and Capital Resources"). As described in
Note 2 of the Notes to Consolidated Financial Statements, the issuance in 2001
of the 8% Secured Convertible Notes was initially accounted for as a troubled
debt restructuring. As such, the aggregate interest expense for these notes was
recorded as a liability at such time and the subsequent interest expense
associated with these notes of $2.7 million and $0.8 million for 2002 and 2001,
respectively, were not reflected in the statement of operations. With the
restructuring of the Company's 8% Secured Convertible Notes in December 2002,
these notes will not be accounted for as a troubled debt restructuring and,
accordingly, interest expense will now be reflected on the statement of
operations. Interest expense is expected to increase in 2003 as compared to 2002
primarily due to interest expense on the 8% Secured Convertible Notes being
reflected in the statement of operations and a full year of interest expense on
the 8% Convertible Senior Subordinated Notes and 12% Senior Subordinated Notes,
partially offset by the early retirement of the Company's senior credit facility
and the Company's repurchase of 12% Senior Subordinated Notes and 8% Secured
Convertible Notes in 2002 and 2003.
Other, Net. Net other expenses were $0.8 million in 2002 as compared to
$2.7 million in 2001. The amount for the year ended December 31, 2001 primarily
consisted of a $2.4 million unrealized loss on the increase in fair value of the
AOL contingent redemptions in accordance with the fair value accounting
treatment under EITF Abstract No. 00-19. This amount did not recur, as the AOL
contingent redemptions had been restructured effective September 2001.
Provision for Income Taxes. In 2001, a full valuation allowance had been
provided against the Company's net operating loss carryforwards and other
deferred tax assets since the amounts and extent of the Company's future
earnings were not determinable with a sufficient degree of probability to
recognize the deferred tax assets in accordance with the requirements of
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes." The fourth quarter of 2002 represented the fifth consecutive quarter of
profitability for the Company. In the fourth quarter of 2002, as part of the
Company's 2003 budgeting process, management evaluated the deferred tax
valuation allowance and determined that a portion of this valuation allowance
should be reversed, resulting in a non-cash deferred income tax benefit in the
fourth quarter of $22.3 million. Beginning in 2003, the Company will record
income taxes at a rate equal to the Company's combined federal and state
effective rates. However, to the extent of available net operating loss
carryforwards, the Company will be shielded from paying cash income taxes for
several years, other than possibly alternative minimum taxes and some state
taxes. There can be no assurances that the Company will realize the full
benefit of the net operating loss carryforwards on future taxable income
generated by the Company due to the "change of ownership" provisions of the
Internal Revenue Code Section 382 (see "Liquidity and Capital Resources, Other
Matters").
Extraordinary Gains. The Company incurred extraordinary gains of $29.3
million in 2002 as compared to $20.6 million in 2001. The extraordinary gains in
2002 include $28.9 million attributed to the restructuring and repurchase of a
portion of the 8% Secured Convertible Notes and $1.6 million attributed to the
repurchase of a portion of the Company's 12% Senior Subordinated Notes,
partially offset by an extraordinary loss of $1.1 million related to the
retirement of the Company's senior credit facility. On December 23, 2002, the
Company restructured its 8% Secured Convertible Notes and, accordingly, these
notes will no longer be accounted for as a troubled debt restructuring. The
$28.9 million extraordinary gain from the restructuring and repurchase of these
notes was related to the decrease in future accrued interest, which was
reflected as a $28.9 million reduction in long-term debt. On October 4, 2002,
the Company retired its senior credit facility prior to its scheduled maturity.
As a result of this early retirement, the Company incurred an extraordinary loss
of approximately $1.1 million in the fourth quarter of 2002, reflecting the
acceleration of the amortization of certain deferred finance charges and fees.
In addition, the Company repurchased $5.7 million of its 12% Senior Subordinated
Notes at a $1.6 million discount from the face amount, which was reflected as an
extraordinary gain in the fourth quarter of 2002. The extraordinary gains in
2001 of $20.6 m