Back to GetFilings.com
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ___________ TO ___________
COMMISSION FILE NUMBER: 000-28467
Z-TEL TECHNOLOGIES, INC.
------------------------------------------------------
(Exact name of Registrant as specified in its charter)
DELAWARE 59-3501119
------------------------------ ----------------------
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
601 SOUTH HARBOUR ISLAND BOULEVARD, SUITE 220
TAMPA, FLORIDA 33602
(813) 273-6261
-----------------------------------------------------------------
(Address, including zip code, and telephone number
including area code, of Registrant's principal executive offices)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common
Stock, par value $.01 per share
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. 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 to this Form 10 K. [ ]
The aggregate market value of the Registrant's Common Stock held by
non-affiliates of the Registrant on March 23, 2000 (assuming solely for these
purposes that all directors, executive officers and 10% or greater stockholders
are affiliates), based on the closing price of the Common Stock on the Nasdaq
National Market as of such date, was approximately $777,720,354.
The number of shares of the Registrant's Common Stock outstanding as of
March 23, 2000 was approximately 32,006,661.
================================================================================
TABLE OF CONTENTS
PART I.
Item 1. Business 3
Item 2. Properties 23
Item 3. Legal Proceedings 23
Item 4. Submission of Matters to a Vote of Security Holders 23
PART II.
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters 25
Item 6. Selected Consolidated Financial Data 27
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations 29
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 44
Item 8. Financial Statements and Supplementary Data 45
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 64
PART III.
Item 10. Directors and Executive Officers of the Registrant 65
Item 11. Executive Compensation 69
Item 12. Security Ownership of Certain Beneficial Owners and
Management 73
Item 13. Certain Relationships and Related Transactions 76
PART IV.
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form
8-K 78
Signatures
2
PART I
ITEM 1. BUSINESS
GENERAL
Z-Tel Technologies, Inc. was incorporated under the laws of Delaware in
1998. We are a provider of advanced, integrated communications services
primarily to residential customers. We offer local and long distance telephone
services in combination with enhanced communications features accessible through
the telephone or the Internet. Through our uniquely designed web interface, our
subscribers are able to manage their communications through the power of the
Internet and the visual, "point and click" functionality of the personal
computer. Our services are designed to make communications easier and more
efficient.
Our business strategy takes advantage of recent statutory and
regulatory changes that enable us to gain access to the individual components of
the traditional local telephone service provider's (incumbent local exchange
carrier or ILEC) networks, referred to as the unbundled network element
platform. The Federal Communications Commission (the FCC) has recently mandated
that the incumbent local exchange carriers provide competing local telephone
companies such as us with the unbundled network element platform components at
prices based on a forward-looking, long-run incremental cost methodology. Access
to these components, in combination with our proprietary technology and advanced
communications network, enables us to provide cost-effective local and long
distance telephone services with enhanced features.
We currently offer our Z-Line Home Edition(TM) service in areas of New
York and, on an initial marketing basis, in areas of Massachusetts served by
Bell Atlantic Corporation (Bell Atlantic), and in areas of Texas served by
Southwestern Bell Telephone Company (Southwestern Bell). Within these markets,
we believe that we are one of few competitive local exchange carriers
specifically targeting the needs of residential customers. It is our intent to
expand service into additional areas as they become available. In particular, we
intend to begin initial marketing of Z-Line Home Edition in Pennsylvania in the
second quarter of 2000.
We currently offer three services to individual customers, Z-Line Home
Edition, Z-Line Anywhere(TM) and Z-Line Messenger(TM), each centered around Your
Personal Communications Center(TM) (the PCC). The PCC includes multiple features
that combine the convenience of the telephone with the power of the Internet.
Accessible by telephone or the Internet, located at www.myzline.com or
www.z-tel.com, the PCC enables our customers to direct, retrieve, deliver,
compile and otherwise manage their voice communications. One of the features
offered through the PCC is the Z-Line Community(TM) feature, which allows us to
provide group messaging features to individual consumers as well as sponsored
communities such as colleges, civic organizations and businesses. We intend to
begin offering soon an additional service to individual customers, Z-Line Long
Distance(TM).
ACQUISITION OF TOUCH 1 COMMUNICATIONS, INC.
On January 24, 2000, we reached an agreement in principle with Touch 1
Communications, Inc. (Touch 1) for the acquisition of Touch 1, a transaction
which will bring together our bundled
3
consumer telecommunications services with Touch 1's extensive telemarketing,
customer service and provisioning infrastructure. Touch 1 is a leading consumer
telecommunications company with approximately 400,000 customers in 48 states.
Touch 1 produced revenues for 1999 of approximately $65 million. The
transaction, which is subject to, among other things, the signing of a
definitive agreement, other regulatory approvals, and customary closing
conditions, is expected to close before the end of May 2000.
INDUSTRY BACKGROUND
The Telecommunications Act of 1996 (the Telecommunications Act) was
passed principally to foster competition in the telecommunications markets. The
Telecommunications Act imposes a variety of duties upon the incumbent local
exchange carriers, including the duty to provide other communications companies
with access to their network elements on an unbundled basis at any feasible
point. Such access must be at rates and on terms and conditions that are just,
reasonable and nondiscriminatory. A network element is a facility or piece of
equipment of the local telephone company's network or the features, functions or
capabilities such facility or equipment provides. The Telecommunications Act
also establishes procedures under which the Regional Bell Operating Companies
(Bell operating companies) will be allowed to handle long distance calls
originating from within their telephone service area and terminating outside
their area. The Bell operating companies were divested by AT&T in 1984 pursuant
to court order under which they were prohibited from providing "in-region" long
distance telephone service. With the passage of the Telecommunications Act, a
Bell operating company can provide such in-region service if it complies with a
14-point regulatory checklist, including offering interconnection to other
communications companies and providing access to its unbundled network elements
on terms approved by a state public service commission.
On September 10, 1999, in an effort to comply with the 14-point
regulatory checklist in order to be able to offer "in-region" long distance
telephone service, Bell Atlantic filed a tariff which establishes favorable
rates, terms and conditions under which competitors may purchase unbundled
network elements in New York. In its New York tariff, Bell Atlantic committed to
provide unbundled network elements, both individually and on a combined basis,
for provision of residential telephone service and small business telephone
service, with the exclusion of business service from end offices with two or
more competitive local telephone service providers (CLECs) collocated in that
end office.
On November 5, 1999, the FCC released an order establishing the list of
unbundled network elements that incumbent local exchange carriers nationwide
must provide. Taken together, these unbundled network elements comprise the most
important facilities, features, functions and capabilities of an incumbent local
exchange carrier's network. Under the FCC's order, the incumbent local exchange
carriers must allow competing local telephone companies such as us to use the
unbundled network elements, in an individual or combined fashion, to provide
basic local telephone service and must price the elements using a
forward-looking, long-run incremental cost methodology. We expect both
individual network components and components in combined component service
packages to be available at attractive prices nationwide as state regulatory
authorities and incumbent local exchange carriers conform to the recent FCC
mandates. Pricing and implementation rules for unbundled network elements in
4
combined service packages or platform offerings that are at least acceptable for
market entry have been adopted in New York, Pennsylvania, Texas and
Massachusetts. The prices for the use of individual network components and
combined component service packages will nevertheless vary from state to state,
as will an individual state's oversight of unbundled network element platform
implementation and operation.
BUSINESS OVERVIEW
By integrating the simplicity of standard telephone service with the
robust features that our Internet applications deliver, we have created an
environment for managing communications that is accessible by the telephone or
personal computer. That environment includes the following elements:
COST-EFFECTIVE BUNDLED LOCAL AND LONG DISTANCE TELEPHONE SERVICE. We
provide a cost-effective bundled package of local and long distance telephone
services, which includes all the enhanced features of the PCC as well as
enhanced telephone services such as call waiting and caller identification, in
markets that have favorable regulatory environments to residential customers in
those markets. We lease facilities of the existing incumbent local exchange
carrier at a forward-looking, long-term incremental cost basis, which enables us
to avoid the need to invest significant capital into switching equipment at the
incumbent local exchange carrier's central office. As a result, we are able to
provide a competitively priced, bundled package that includes local and long
distance telephone services and enhanced services.
SEAMLESS INTEGRATION OF PERSONAL ORGANIZATIONAL TOOLS. The PCC has been
designed to allow users to download their personal directories from a variety of
software packages, including Microsoft Outlook. In addition, other personal
contact managers, such as Palm Pilot, can be downloaded into Outlook and then
downloaded into the PCC. Once this information has been downloaded, customers
can use their database of contacts to create easily sub-directories for special
group messaging. By utilizing the PCC, customers can, with the click of a mouse,
initiate calls or forward messages to contacts that have been stored in their
personal directories. We believe the ability to manage personal directories on
our network creates a more loyal customer over time because of the difficulty of
transferring personal directories to other services.
SCALABLE PLATFORM FOR NEW MARKETS. The unbundling of network elements
allows us to access the incumbent local exchange carriers' facilities to
provision our service to our customers. As a result, we have the ability to
enter new markets quickly, and without a significant investment in equipment, as
regulatory authorities in those markets adopt favorable pricing. In addition, we
have a centralized sales staff that receives incoming calls for new service and
electronically provides service to new customers. Using the PCC, customers can
manage and configure their own service requirements, thus minimizing our need
for an expanded customer service infrastructure.
ADVANCED PROPRIETARY TECHNOLOGY. We have created an integrated and
proprietary software and advanced network architecture that enables the enhanced
features of our service. We have created software applications that can control
the basic functions of initiating and completing a telephone call regardless of
the access device, such as a telephone or personal
5
computer. These applications allow our customers to control simultaneously all
the basic functions of a telephone call from either the telephone or personal
computer. In addition, we, in collaboration with a third party, have created our
own proprietary billing system. We are also in the process of developing and
enhancing our customer care, billing and provisioning software into one
seamlessly integrated package.
Our network is designed to route traffic to our main enterprise
management center in Tampa for call management. This reduces our need to
collocate network equipment in the central offices of the incumbent local
exchange carrier in our target markets and enhances our ability to enter new
markets quickly and cost effectively. Our network architecture also is designed
to accommodate a number of developing technologies, such as telephone calls over
Internet protocol, digital subscriber line, asynchronous transfer mode, or
coaxial cable systems.
ENHANCED COMMUNICATION SERVICES FOR GROUPS AND INDIVIDUAL USERS
NATIONWIDE. We offer our Z-Line Community features to consumers, organizations
and business users nationwide through the PCC. Those features may be accessed
from any of our services. The PCC capabilities, including specialized features
for directories and group messaging, provide value to users within sponsored
communities by facilitating communication among dispersed community members.
We intend to pursue Z-Line Home Edition marketing and distribution in
new states as state regulatory authorities impose favorable pricing,
implementation rules and acceptable operations support systems performance for
the unbundled network element platform components. Favorable implementation
requirements for providing the unbundled network element platform components
were a feature of the SBC Communications, Inc./Ameritech Corporation merger
order conditions recently approved by the FCC. Accordingly, as acceptable
pricing and operations support systems become available, we intend to evaluate
the entry into each state in the combined SBC/Ameritech regions. Similar
requirements are currently being discussed by the FCC with regard to conditions
likely to be required in association with the approval of the pending Bell
Atlantic/GTE merger. Furthermore, U S WEST Corporation and BellSouth Corporation
recently announced the general availability of the unbundled network element
platform components as part of a general effort to meet FCC requirements.
SERVICES
Z-LINE HOME EDITION
Z-Line Home Edition is our principal service offering and is currently
being offered in New York, Texas and, on an initial marketing basis, in
Massachusetts, in areas serviced by the Bell operating company operating in
those states. Z-Line Home Edition includes low-priced local and long distance
(1+) residential telephone services using a customer's existing telephone
number, bundled with enhanced features, including caller identification, call
forwarding, three-way calling, call waiting and speed calling, dial-up remote
access through our Z-Line Anywhere access card service, the full functionality
of the PCC and, for an additional fee, Internet access.
6
We intend to pursue offering Z-Line Home Edition in additional states
as soon as favorable pricing and implementation rules are imposed in those
states, and to start marketing Z-Line Home Edition in Pennsylvania before the
end of the second quarter of 2000.
Z-LINE ANYWHERE
Z-Line Anywhere is our access card service that allows a customer to
make long-distance calls using Z-Tel's network from any phone simply by dialing
a toll-free 800 number or local access number. No change in phone service is
required. Customers of Z-Line Anywhere also receive the full functionality of
the PCC and, for an additional fee, Internet access. Z-Line Anywhere is being
offered nationwide.
Z-LINE MESSENGER
Z-Line Messenger is a trial service we offer to consumers and members
of sponsored communities free of charge that provides certain limited features
of the PCC. Z-Line Messenger customers are limited to sixty minutes of voice
mail per month and are not authorized to use certain enhanced services provided
by the PCC, such as the ability to complete a call using the web, the "Find-Me"
functionality and the ability to create and manage "Communities." Customers may
upgrade their service to Z-Line Anywhere or Z-Line Home Edition, provided that
that latter service is offered in their markets. Z-Line Messenger is being
offered nationwide.
Z-LINE LONG DISTANCE
Z-Line Long Distance is a usage-based service currently in development
that will allow customers to use us as their primary long-distance calling
provider to complete their residential long distance (1+) calls. Z-Line Long
Distance will also provide our customers with dial-up remote access through our
Z-Line Anywhere access card product, the full functionality of the PCC and, for
an additional fee, Internet access. We intend to offer Z-Line Long Distance
nationwide in the near future.
KEY FEATURES OF OUR SERVICES
THE PCC
The PCC is the core feature set of all of our service offerings,
although only limited functionality is provided to Z-Line Messenger customers.
It is a suite of features subscribers can access via any telephone or at our web
site. Subscribers can retrieve, forward, deliver, store, compile and otherwise
manage their voice mail and other communication needs. Using the "Find-Me"
feature, subscribers can have the PCC attempt to locate them at up to three
numbers when they receive incoming calls, and notify them via e-mail, pager or
ICQ Internet Chat (instant messaging) when a new voice mail message arrives. At
our website, subscribers can view a list of their voice mail messages and listen
to them through their computer speakers, create an on-line Address Book by
inputting information directly or importing it from other services, place calls
with the click of a mouse, deliver voice messages to groups of other
subscribers, forward voicemails and view historical billing statements on-line.
7
We expect to provide additional functionality to the PCC in the future,
including the ability to use the PCC in conjunction with personal digital
assistants (PDAs), voice recognition capability, the ability to use the PCC for
conference calling, the ability to manipulate voicemail and Z-Line settings from
the user's desktop, and dedicated e-mail accounts and fax receiving capability.
Z-LINE COMMUNITY
Z-Line Community is a set of features embedded within the PCC that
allows users or group sponsors to search for, create or join "Communities,"
which are pre-defined groups of our users usually based on professional or
personal affinities. Users can also invite other of our subscribers to join
Communities and administrate the user access options of a Community. Once the
Communities are created, users can send group messages to specific members of
the communities or the entire group.
Z-Line Community enables us to offer sponsored communities such as
colleges, civic organizations and businesses with a robust communication
solution. Each community member automatically receives our Z-Line Messenger
trial product and can thereby gain access to limited features of the PCC,
including Z-Line Community, and can upgrade to any of our other service
offerings. Community members can then interact with one another, even when the
individual community members have subscribed to different services.
Z-Line Community features benefit both the sponsor and members of a
community. Sponsors can use group messaging features to deliver voice mail
messages to their widely-dispersed members. Colleges, for instance, can use our
services to deliver simultaneously voice mail messages, including personalized
information such as financial aid and class schedule updates, to their widely
dispersed students. Students, faculty and administrators can take advantage of
low long distance rates by upgrading their Z-Line Messenger service, or set up
their own sub-communities based on student groups or other affiliations, and can
use our network to disseminate information to community members.
MARKETING AND DISTRIBUTION
We market our services to our customers through telemarketing, agent
programs, strategic business partnerships, direct mail and marketing and
traditional advertising campaigns promoting recognition and awareness of our "Z"
brand. We also have entered into joint marketing or co-branding arrangements
with organizations that have large, well-established relationships or customer
bases in our target markets, such as Hofstra University, the Fraternal Order of
Police, the Fire Fighters' Association of Texas and Kinkos.com. We intend to
explore the formation of alliances or ventures with other companies, including
Internet service providers, paging operators, cable television companies,
utilities, newspapers, banks, credit card companies and department stores, which
we believe will allow us to penetrate efficiently large customer bases with a
relatively small capital outlay.
8
BILLING AND COLLECTION
We have three primary methods for billing and collecting from our
customers. For our Z-Line Home Edition customers, we can either (1) charge their
credit card account; (2) mail a bill to their address for payment by check; or
(3) set up an automatic withdrawal from the customer's checking account. For our
Z-Line Anywhere customers, we currently require all new customers to pay by
credit card or automatic withdrawal; however, we had, in the past, allowed them
to pay bills using all three methods. Our billing software can be customized to
handle new and different billing programs.
OPERATIONS SUPPORT SYSTEMS AND CUSTOMER SUPPORT
We have invested substantially in our software platform, which includes
integrated customer ordering and provisioning, customer service and billing
functionality for our services. For our Z-Line Anywhere service, a new
subscriber can enroll via the Internet or our toll free number with service
immediately activated. The PCC allows our Z-Line Home Edition and Z-Line
Anywhere customers to change billing options and service feature configurations.
A subscriber may also update service configurations on the telephone.
Z-Line Home Edition orders require us to interact with the applicable
local exchange carrier. Currently, after receiving a signed letter of
authorization or a verified verbal request for service, we enter orders using an
electronic web-based interface provided by Bell Atlantic for our New York and
Massachusetts customers and Southwestern Bell for our Texas customers. Our
provisioning agents also enter the order in the Z-Tel system.
We expect to invest over the next year to expand our operations support
systems to include electronic gateways to the major incumbent local exchange
carriers, network element management software, and a standard internal
provisioning interface that can handle multiple incumbent local exchange carrier
ordering systems. This investment will include outside integration and
consulting assistance.
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
We have developed proprietary software that manages the integrated
features of our service offerings. Our software allows our network to interface
and interconnect with the systems of the incumbent local exchange carriers and
long-distance carriers. In addition, our software allows our remote network
communication facilities, which we call "Z-Nodes," located throughout the United
States, to communicate with each other and with our enterprise management center
in Tampa, Florida.
Our intellectual property reflects the know-how, work product and
inventions of over eighty engineers in our research and development team, based
at our technology center in Atlanta, Georgia, who have substantial experience in
computer technology, telecommunications, web-based services, database management
and integration, and network development, architecture, operation and
management.
9
For the fiscal years ended December 31, 1999 and 1998, we invested
approximately $8,356,000 and $4,728,000, respectively, in company-sponsored
research and development activities.
We have entered into, and will continue to enter into, nondisclosure
agreements with our employees, independent contractors, business customers and
others. We believe these agreements will protect our confidential and
proprietary information, whether or not such information is copyrighted or
subject to trademark or patent protection. We intend to take all appropriate
legal action to protect our ownership and the confidentiality of all our
proprietary software, including, as appropriate, the filing of copyrights in the
U.S. Copyright Office.
We have filed trademark applications for federal registration of more than
fifty trademarks with the United States Patent and Trademark Office including
Z-TEL, Z-TEL TECHNOLOGIES, INC., Z-TEL COMMUNICATIONS, INC. AND DESIGN, Z-LINE
HOME EDITION, Z-LINE ANYWHERE, Z-NODE, Z-LINE, Z-NOTIFY, Z-SITE, Z-MAILBOX,
Z-DIRECTORY, Z-NOW!, Z-NUMBER, Z-BILL PAYMENT SERVICES, Z-NET, GENERATION Z,
MYZLINE, YOUR PERSONAL TELECOMMUNICATIONS PORTAL and YOUR PERSONAL
COMMUNICATIONS CENTER.
COMPETITION
OVERVIEW
The telecommunications industry is highly competitive in many market
segments. However, at present, we believe few telecommunications carriers
provide the type of bundled packages that include the range of services and
features we offer, but various competitors offer one or more of the services
that make up our service offering. Competition in the local telephone services
market is still emerging, but already has attracted many strong competitors.
Competition in the long distance and information services markets, which have
fewer entry barriers, is already intense and is expected to remain so.
We believe the principal competitive factors affecting our business will
be the quality and reliability of our services, innovation, customer service and
price. Our ability to compete effectively will depend upon our continued ability
to offer innovative, high-quality, market-driven services at prices generally
equal to or below those charged by our competitors. Many of our current and
potential competitors have greater financial, marketing, personnel and other
resources than we do, as well as other competitive advantages.
10
LOCAL TELEPHONE SERVICE
INCUMBENT LOCAL EXCHANGE CARRIERS. In each of our target markets, we will
compete with the incumbent local exchange carrier serving that area, which may
be one of the Bell operating companies. As a recent entrant in the
telecommunications services industry, we have not achieved and do not expect to
achieve a significant market share for any of our services in our markets in the
foreseeable future. In particular, the incumbent local exchange carriers have
long-standing relationships with their customers, have financial, technical and
marketing resources substantially greater than ours, have the potential to
subsidize services that compete with our services with revenue from a variety of
other unregulated businesses, and currently benefit from certain existing
regulations that favor the incumbent local exchange carriers over us in certain
respects.
Recent regulatory initiatives that allow competitive local exchange
carriers, such as us, to interconnect with incumbent local exchange carrier
facilities and acquire and combine the unbundled network elements of an
incumbent local exchange carrier provide increased business opportunities for
us. However, such interconnection opportunities have been, and likely will
continue to be, accompanied by increased pricing flexibility and relaxation of
regulatory oversight for the incumbent local exchange carriers.
COMPETITIVE LOCAL EXCHANGE CARRIERS. The Telecommunications Act radically
altered the market opportunity for competitive local exchange carriers.
Competitive access providers who entered the market prior to passage of the
Telecommunications Act built their own infrastructure to offer exchange access
services to large end-users. Since the passage of the Telecommunications Act,
many competitive access providers have added switches to become competitive
local exchange carriers in order to take advantage of the opening of the local
market. With the Telecommunications Act requiring unbundling of the incumbent
local exchange carrier's networks, competitive local exchange carriers will now
be able to enter the market more rapidly by leasing switches, trunks and loop
capacity until traffic volume justifies building facilities. Newer competitive
local exchange carriers, like us, will not have to replicate existing facilities
and can be more opportunistic in designing and implementing networks, which
could have the effect of increasing competition for local exchange services.
INTEREXCHANGE CARRIERS. We also expect to face competition from other
current and potential market entrants, including interexchange (long distance)
carriers such as AT&T, MCI WorldCom, and Sprint, seeking to enter, reenter or
expand entry into the local exchange market. A continuing trend toward
consolidation of telecommunications companies and the formation of strategic
alliances within the telecommunications industry, as well as the development of
new technologies, could give rise to significant new competitors. For example,
in September 1998, WorldCom merged with MCI Communications Corp. and, in October
1999, MCI WorldCom and Sprint Communications Company, L.P. announced merger
plans. In March 1999, AT&T acquired Tele-Communications, Inc., the largest
provider of cable television services in the United States. These types of
consolidations and strategic alliances could put us at a competitive
disadvantage.
11
LONG DISTANCE TELEPHONE SERVICE
The long distance telecommunications industry has numerous entities
competing for the same customers and a high average churn rate because customers
frequently change long distance providers in response to the offering of lower
rates or promotional incentives by competitors. Our primary competitors in the
long distance market include major interexchange carriers such as AT&T, MCI
WorldCom, Sprint and Qwest Communications International Inc., certain incumbent
local exchange carriers and resellers of long distance services. We believe that
pricing levels are a principal competitive factor in providing long distance
telephone service. We hope to avoid direct price competition by bundling long
distance telephone service with a wide array of value-added services.
Incumbent local exchange carriers that offer a package of local, long
distance telephone and information services will be particularly strong
competitors. Incumbent local exchange carriers, including Bell Atlantic, are
currently providing both long distance and local services as well as certain
enhanced telephone services we offer. We believe that the Bell operating
companies will attempt to offset market share losses in their local markets by
attempting to capture a significant percentage of the long distance market.
ENHANCED SERVICES
We compete with a variety of enhanced service companies. Enhanced services
markets are highly competitive, and we expect that competition will continue to
intensify. Our competitors in these markets will include Internet service
providers, web-based communications service providers and other
telecommunications companies, including the major interexchange carriers,
incumbent local exchange carriers, competitive local exchange carriers and
wireless carriers.
OTHER MARKET ENTRANTS
We may face competition in local, long distance and information services
from other market entrants such as electric utilities, cable television
companies, fixed and mobile wireless system operators, and operators of private
networks built for large end-users. All of these companies are free to offer
bundled services similar to those that we offer. Electric utilities have
existing assets and low cost access to capital that could allow them to enter a
market rapidly and accelerate network development. Cable television companies
are also entering the telecommunications market by upgrading their networks with
fiber optics and installing facilities to provide fully interactive transmission
of broadband voice, video and data communications. Wireless companies have
developed, and are deploying in the United States, wireless technology as a
substitute for traditional wireline local telephones. The recent World Trade
Organization agreement on basic telecommunications services could increase the
level of competition we face. Under this agreement, the United States and 68
other member states of the World Trade Organization committed to open their
respective telecommunications markets, including permitting foreign companies to
enter into basic telecommunications services markets. This development may
increase the number of established foreign-based telecommunications carriers
entering the U.S. markets.
12
The Telecommunications Act includes provisions that impose certain
regulatory requirements on all local exchange carriers, including competitive
local exchange carriers. At the same time, the Telecommunications Act expands
the FCC's authority to reduce the level of regulation applicable to any or all
telecommunications carriers, including incumbent local exchange carriers. The
manner in which these provisions are implemented and enforced could have a
material adverse effect on our ability to compete successfully against incumbent
local exchange carriers and other telecommunications service providers.
GOVERNMENT REGULATION
OVERVIEW
Some of our services are regulated and some are not. In providing our
non-common carrier services such as voice mail, "Find-Me," notification and
directory services offered through the PCC, we operate as an unregulated
provider of information services, as that term is defined in the Communications
Act of 1934, as amended by the Telecommunications Act of 1996, and as an
enhanced service provider, as that term is defined in the FCC rules. These
operations currently are not regulated by the FCC or the states where we
operate. In providing Z-Line Home Edition and our long distance services, we are
regulated as a common carrier at the state and federal level and are subject to
additional rules and policies not applicable to providers of information
services alone. We are certificated as a facilities-based competitive local
exchange carrier in a number of states, including New York, Texas,
Massachusetts, Pennsylvania, Georgia, Illinois, New Jersey, Florida, Kentucky,
Missouri, Oregon, Virginia and Washington. We are currently seeking this
certification in additional states, including California and Michigan.
The local and long distance telecommunications services we provide are
regulated by federal, state, and, to some extent, local government authorities.
The FCC has jurisdiction over all telecommunications common carriers to the
extent they provide interstate or international communications services. Each
state regulatory commission has jurisdiction over the same carriers with respect
to the provision of intrastate communications services within that state. Local
governments sometimes seek to impose franchise requirements on
telecommunications carriers and regulate construction activities involving
public rights-of-way. Changes to the regulations imposed by any of these
regulators could have a material adverse effect on our business, operating
results and financial condition.
In recent years, the regulation of the telecommunications industry has
been in a state of flux as the United States Congress and various state
legislatures have passed laws seeking to foster greater competition in
telecommunications markets. The FCC and state utility commissions have adopted
many new rules to implement this legislation and encourage competition. These
changes, which are still incomplete, have created new opportunities and
challenges for us and our competitors. The following summary of regulatory
developments and legislation is intended to describe the most important, but not
all, present and proposed federal, state and local regulations and legislation
affecting the telecommunications industry. Some of these and other existing
federal and state regulations are the subject of judicial proceedings and
legislative and administrative proposals which could change, in varying degrees,
the manner in
13
which this industry operates. We cannot predict the outcome of any of these
proceedings or their impact on the telecommunications industry at this time.
Some of these future legislative, regulatory or judicial changes may have a
material adverse impact on our business.
Specifically, as states re-evaluate pricing of network elements, it is
possible that some states could increase rates over existing levels. Currently,
Bell Atlantic and Southwestern Bell have rate cases pending before state
regulatory commissions in New York and Illinois that could significantly raise
the existing rates for some network elements and network element combinations.
Our intent is to be an active participant in these rate cases and any others
that might be critical to our operations. We anticipate joining other
competitive service providers in arguing that existing rates are overstated and
do not reflect the true total element long run incremental costing principles
required by the FCC and the Telecommunications Act. While the prevailing trends
within the industry would predict the adoption of lower rates in association
with the provision of unbundled network elements and network element
combinations, we cannot predict the outcome of any pending or potential rate
case. Increases or decreases in rate levels charged by incumbent local exchange
carriers as a result of regulatory review through rate case or arbitration
proceedings could significantly impact our business plans.
FEDERAL REGULATION
FCC POLICY ON ENHANCED AND INFORMATION SERVICES
In 1980, the FCC created a distinction between basic telecommunications
services, which it regulates as common carrier services, and enhanced services,
which remain unregulated. The FCC exempted enhanced service providers from
federal regulations governing common carriers, including the obligation to pay
access charges for the origination or termination of calls on carrier networks
and the obligation to contribute to universal service. The Telecommunications
Act of 1996 established a similar distinction between telecommunications
services and information services. Changing technology and changing market
conditions, however, sometimes make it difficult to discern the boundary between
unregulated and regulated services.
In general, information services are value-added services that use
regulated transmission facilities only as part of a services package that also
includes network or computer software to change or enhance the information
transmitted. We believe that most of the services we provide, including voice
mail, "Find-Me" notification, and directory services offered through the PCC are
information services under the FCC's definition. Because the regulatory
boundaries in this area are somewhat unclear and subject to dispute, however,
the FCC could seek to characterize some of our information services as
"telecommunications services." If that happens, those services would become
subject to FCC regulation, although the impact of that reclassification is
difficult to predict.
In general, the FCC does not regulate the rates, services, and market
entry and exit of non-dominant telecommunications carriers, but does require
them to contribute to universal service and comply with other regulatory
requirements. We are currently regulated as non-dominant with respect to both
our local and long distance telephone services.
14
FCC REGULATION OF COMMON CARRIER SERVICES
We currently are not subject to price cap or rate of return regulation
at the federal level and are not currently required to obtain FCC authorization
for the installation, acquisition or operation of our domestic exchange or
interexchange network facilities. However, we must comply with the requirements
of common carriage under the Communications Act of 1934. We are subject to the
general requirement that our charges and terms for our telecommunications
services be "just and reasonable" and that we not make any "unjust or
unreasonable discrimination" in our charges or terms. The FCC has jurisdiction
to act upon complaints against any common carrier for failure to comply with its
statutory obligations.
Comprehensive amendments to the Communications Act of 1934 were made by
the Telecommunications Act of 1996, which was signed into law on February 8,
1996. The Telecommunications Act effected changes in regulation at both the
federal and state levels that affect virtually every segment of the
telecommunications industry. The stated purpose of the Telecommunications Act is
to promote competition in all areas of telecommunications. While it may take
years for the industry to feel the full impact of the Telecommunications Act, it
is already clear that the legislation provides us with new opportunities and
challenges.
INTERCONNECTION. The Telecommunications Act greatly expands the
interconnection requirements applicable to the incumbent local exchange
carriers, i.e., generally, those existing local exchange carriers that, in the
past, enjoyed virtual or legal monopoly status. The Telecommunications Act
requires the incumbent local exchange carriers to
o provide physical collocation, which allows companies such as us
and other competitive local exchange carriers to install and
maintain our own network termination equipment in incumbent local
exchange carrier central offices or, if requested or if physical
collocation is demonstrated to be technically infeasible, virtual
collocation;
o offer components of their local service networks on an unbundled
basis so that other providers of local service can use these
elements in their networks to provide a wide range of local
services to customers; and
o establish "wholesale" rates for their services to promote resale
by competitive local exchange carriers. We currently do not have
plans to enter any markets by reselling incumbent local exchange
carrier service.
In addition, all local exchange carriers must
o interconnect with the facilities of other carriers;
o establish number portability, which will allow customers to
retain their existing phone numbers if they switch from the local
exchange carrier to a competitive local service provider;
15
o provide nondiscriminatory access to telephone poles, ducts,
conduits and rights-of-way; and
o compensate other local exchange carriers on a reciprocal basis
for traffic originated by one local exchange carrier and
terminated by another local exchange carrier.
The FCC is charged with establishing national guidelines to implement
certain portions of the Telecommunications Act. The FCC issued its
interconnection order on August 8, 1996. Among other rules, the FCC established
a list of seven network elements, comprising most of the significant facilities,
features, functionalities, or capabilities of the network, that the incumbent
local exchange carriers must unbundle. It is possible for competitors to provide
competitive local exchange service using only these unbundled network elements.
In addition, the FCC mandated a particular forward looking pricing methodology
for these network elements that produces relatively low element prices that are
favorable to competitors.
On July 18, 1997, however, the United States Court of Appeals for the
Eighth Circuit issued a decision vacating the FCC's pricing rules, as well as
certain other portions of the FCC's interconnection rules, on the grounds that
the FCC had improperly intruded into matters reserved for state jurisdiction. On
January 25, 1999, the Supreme Court largely reversed the Eighth Circuit's order,
holding that the FCC has general jurisdiction to implement the local competition
provisions of the Telecommunications Act. In so doing, the Supreme Court stated
that the FCC has authority to set pricing guidelines for unbundled network
elements, to prevent incumbent local exchange carriers from disaggregating
existing combinations of network elements, and to establish "pick and choose"
rules regarding interconnection agreements. "Pick and choose" rules would permit
a carrier seeking interconnection to pick and choose among the terms of service
from other interconnection agreements between the incumbent local exchange
carriers and other competitive local exchange carriers. This action
reestablishes the validity of many of the FCC rules vacated by the Eighth
Circuit.
Although the Supreme Court affirmed the FCC's authority to develop
pricing guidelines, the Supreme Court did not evaluate the specific
forward-looking pricing methodology mandated by the FCC and has remanded the
case to the Eighth Circuit for further consideration. Some incumbent local
exchange carriers have argued that this pricing methodology does not allow
adequate compensation for the provision of unbundled network elements. The
Eighth Circuit heard oral arguments on this pricing issue on September 16, 1999,
but has not yet issued a ruling.
The Supreme Court also remanded the list of unbundled network elements
to the FCC for further consideration of the necessity of each one under the
statutory standard. On November 5, 1999, the FCC released an order largely
retaining its list of unbundled network elements, but eliminating the
requirement that incumbent local exchange carriers provide unbundled access to
local switching for customers with four or more lines in the densest parts of
the top 50 Metropolitan Statistical Areas, and to operator services and
directory assistance. The FCC concluded that the market has developed since 1996
such that competitors can and do self-provision these services, or acquire them
from alternative sources. The FCC also noted that incumbent local exchange
carriers remain obligated under the non-discrimination requirements of the
Communications Act of 1934 to comply with the reasonable request of a carrier
that
16
purchases these services from the incumbent local exchange carriers to rebrand
or unbrand those services, and to provide directory assistance listings and
updates in daily electronic batch files. In addition, the competitive checklist
contained in Section 271 of the Communications Act of 1934 requires Bell
operating companies to provide nondiscriminatory access to these services.
These new FCC rules are likely to be the subject of further appeals.
Thus, while the Supreme Court resolved many issues, including the FCC's
jurisdictional authority, other issues remain subject to further consideration
by the courts and the FCC. We cannot predict the ultimate disposition of those
matters. If the Eighth Circuit fails to affirm the FCC's pricing
methodology--which is favorable to competitors such as us because it is based on
forward-looking costs--then unbundled network element prices, including prices
for unbundled network element combinations, may rise. Such increases could have
a materially adverse effect on our business.
INTERCONNECTION AGREEMENTS. The Telecommunications Act obligates
incumbent local exchange carriers to negotiate with us in good faith to enter
into interconnection agreements. Competitive local exchange carriers like us can
purchase unbundled network elements under such an agreement or under a tariff or
a Statement of Generally Available Terms filed with the state regulators.
Although we purchase the unbundled network element platform in New York under
Bell Atlantic's tariff, we will need interconnection agreements in some states,
and have entered into interconnection agreements in Texas, Massachusetts and
Pennsylvania, to provide enhanced connectivity to our network and to provide
local exchange services, including Z-Line Home Edition. If we cannot reach
agreement, either side may petition the applicable state commission to arbitrate
remaining disagreements. These arbitration proceedings can last for a
substantial period of time. Moreover, state commission approval of any
interconnection agreement resulting from negotiation or arbitration is required,
and any party may appeal an adverse decision by the state commission to federal
district court, although some federal district courts have refused to exercise
jurisdiction over such cases. The potential cost in resources and delay from
this process could harm our ability to compete in certain markets, and there is
no guarantee that a state commission would resolve disputes, including pricing
disputes, in our favor.
COLLOCATION AND LINE SHARING. The FCC recently adopted new rules
designed to make it easier and less expensive for competitive local exchange
carriers to obtain collocation at incumbent local exchange carriers' central
offices by, among other things, restricting the incumbent local exchange
carriers' ability to prevent certain types of equipment from being collocated
and requiring incumbent local exchange carriers to offer alternative collocation
arrangements. On November 18, 1999, the FCC also adopted a new order requiring
incumbent local exchange carriers to provide line sharing, which will allow
competitive local exchange carriers to offer data services over the same line
that a consumer uses for voice services without the competitive local exchange
carriers' having to provide the voice service. While we expect that the FCC's
new rules will be beneficial to competitive local exchange carriers, we cannot
be certain that these new rules will be implemented by the incumbent local
exchange carrier in a timely or favorable manner. Moreover, incumbent local
exchange carriers and other parties have asked the FCC to reconsider portions of
these rules. In addition, on March 17, 2000, the United States Court of Appeals
for the District of Columbia Circuit vacated portions of the FCC's new
collocation rules. Specifically, the court found that the FCC's interpretation
of the statutory terms "necessary" and "physical collocation" are impermissibly
broad, and remanded those portions of the order to the FCC for reconsideration.
We cannot predict the outcome of these actions or the effect they may have on
our business.
17
BELL OPERATING COMPANY ENTRY INTO THE LONG DISTANCE MARKET. The
Telecommunications Act permitted the Bell operating companies to provide long
distance services outside their local service regions immediately, and will
permit them to provide in-region long distance service upon demonstrating to the
FCC and state regulatory agencies that they have adhered to the
Telecommunication Act's Section 271 14-point competitive checklist. Some Bell
operating companies have filed applications with various state public utility
commissions and the FCC seeking approval to offer in-region interLATA service.
Some states have denied these applications while others have approved them.
Prior to December 1999, the FCC had denied each of the Bell operating company
applications brought before it because it found that the particular Bell
operating company had not sufficiently made its local network available to
competitors. On September 29, 1999, Bell Atlantic filed with the FCC an
application to provide in-region long distance service originating in New York.
The FCC issued an order allowing Bell Atlantic to enter the in-region long
distance market in New York in late-December 1999. Bell Atlantic began offering
long distance service in New York on a commercial basis in January 2000. On
January 10, 2000, Southwestern Bell filed an application with the FCC seeking
approval to offer in-region interLATA services in Texas. By statute, the FCC
must act on that application by April 10, 2000. While we cannot predict the
outcome of any Section 271 applications before the FCC, it is generally expected
that long distance competition will increase as the Bell operating companies
enter the market. We also expect other Bell operating companies to file similar
applications in 2000 and 2001.
UNIVERSAL SERVICE. In May 1997, the FCC released an order establishing
a significantly expanded universal service regime to subsidize the cost of
telecommunications service to high cost areas, as well as to low-income
customers and qualifying schools, libraries and rural health care providers.
Providers of interstate telecommunications services, like us, as well as certain
other entities, must pay for these programs. We are also eligible to receive
funding from these programs if we meet certain requirements, but we do not
currently have plans to do so. Our share of the payments into these subsidy
funds will be based on our share of certain defined telecommunications end-user
revenues. Currently, the FCC is assessing such payments on the basis of a
provider's revenue for the previous year. Various states are also in the process
of implementing their own universal service programs. We are currently unable to
quantify the amount of subsidy payments that we will be required to make to
individual states. On July 30, 1999, the United States Court of Appeals for the
Fifth Circuit overturned certain of the FCC's rules governing the basis on which
the FCC collects subsidy payments from telecommunications carriers and recovery
of those payments by incumbent local exchange carriers. In October 1999, on
remand, the FCC issued new universal service rules. These or other changes to
the universal service program could affect our costs. One or more parties may
seek review of the new FCC rules by the Fifth Circuit and subsequently by the
Supreme Court. The Fifth Circuit also remanded other rules to the FCC for
further consideration.
TARIFFS AND RATES. In 1996, the FCC issued an order that required
nondominant interexchange carriers, like us, to cease filing tariffs for our
domestic interexchange services. The order required mandatory detariffing and
gave carriers nine months to withdraw federal tariffs and move to contractual
relationships with their customers. This order subsequently was stayed by a
federal appeals court, and it is unclear at this time whether the detariffing
order will be
18
implemented. In June 1997, the FCC issued another order stating that nondominant
local exchange carriers, like us, could withdraw their tariffs for interstate
access services provided to long distance carriers. If the FCC's orders become
effective, nondominant interstate services providers will no longer be able to
rely on the filing of tariffs with the FCC as a means of providing notice to
customers of prices, terms and conditions under which they offer their
interstate services. If we cancel our FCC tariffs as a result of the FCC's
orders, we may need to implement customer contracts, which could result in
substantial administrative expenses.
In March 1999, the FCC adopted further rules that, while still
maintaining mandatory detariffing, nonetheless require interexchange carriers to
make specific public disclosures on their web sites of their rates, terms and
conditions for domestic interstate services. The effective date for these rules
is also delayed until a court decision on the appeal of the FCC's detariffing
order.
JURISDICTIONAL NATURE OF INTERNET TRAFFIC. Recently, the FCC has
determined that both continuous access and dial-up calls from a customer to an
Internet service provider are interstate, not local, calls, and, therefore, are
subject to the FCC's jurisdiction. The FCC has initiated a proceeding to
determine the effect that this regulatory classification will have on the
obligation of local exchange carriers to pay reciprocal compensation for dial-up
calls to Internet service providers that originate on one local exchange carrier
network and terminate on another local exchange carrier network. Moreover,
several states are considering this issue, and several states have held that
local exchange carriers do not need to pay reciprocal compensation for calls
terminating at Internet service providers. On March 24, 2000, the Court of
Appeals for the District of Columbia remanded for reconsideration the FCC's
determination that calls to Internet service providers are interstate rather
than local. Specifically, the Court indicated that the FCC has not provided a
satisfactory explanation why calls to Internet service providers are not local
telecommunications traffic and why such traffic is exchange access rather than
telephone exchange service. We cannot predict the effect that the FCC's
resolution of these issues will have on our business.
NUMBERING AND NUMBER PORTABILITY. In August 1997, the FCC issued rules
transferring responsibility for administering and assigning local telephone
numbers from the Bell operating companies and other incumbent local exchange
carriers to a neutral entity in each geographic region in the United States. In
August 1996, the FCC issued new numbering regulations that prohibit states from
creating new area codes that could unfairly hinder competitive local exchange
carriers by requiring their customers to use 10 digit dialing while existing
incumbent local exchange carrier customers use seven digit dialing. In addition,
each carrier is required to contribute to the cost of numbering administration
through a formula based on net telecommunications revenues. Beginning in March
2000, contributions for this purpose will be based on end user
telecommunications revenues and will be submitted in association with FCC
Lifeline, Universal Service and the Schools and Libraries Funds.
In July 1996, the FCC released rules requiring all local exchange
carriers to have the capability to permit both residential and business
consumers to retain their telephone numbers when switching from one local
service provider to another, known as "number portability." Number portability
has been implemented in most of the areas in which we provide service, but has
not been implemented everywhere in the United States. Some carriers have
obtained waivers of the requirement to provide number portability, and others
have delayed implementation by obtaining extensions of time before compliance is
required. Lack of number portability in a given market could adversely affect
our ability to attract customers for our competitive local
19
exchange service offerings, particularly business customers, should we seek to
provide services to such customers.
In May 1999, the FCC also initiated a proceeding to address the problem
of the declining availability of area codes and phone numbers. Many of these
numbering-related issues are subject to further change by the FCC and the
courts, and could produce added administrative expenses for us.
RESTRICTIONS ON BUNDLING. Current FCC rules prohibit dominant carriers
from bundling their non-competitive, regulated telecommunications services with
their unregulated enhanced or information services. The Commission has never
enforced this rule with respect to competitive local exchange carriers and has
proposed eliminating the rule for all carriers.
SLAMMING. A customer's choice of local or long distance
telecommunications company is encoded in a customer record, which is used to
route the customer's calls so that the customer is served and billed by the
desired company. A user may change service providers at any time, but the FCC
and some states regulate this process and require that specific procedures be
followed. When these procedures are not followed, particularly if the change is
unauthorized or fraudulent, the process is known as "slamming." Slamming is such
a significant problem that it has been addressed in detail by Congress in the
Telecommunications Act, by some state legislatures, and by the FCC in recent
orders. The FCC has levied substantial fines for slamming. The risk of financial
damage and to business reputation from slamming is significant. Even one
slamming complaint could cause extensive litigation expenses for us. The FCC
recently decided to apply its slamming rules (which originally covered only long
distance) to local service as well.
NETWORK INFORMATION. The Communications Act of 1934 and FCC rules
protect the privacy of certain information about telecommunications customers
that a telecommunications carrier such as us acquires by providing
telecommunications services to such customers. Such protected information, known
as Customer Proprietary Network Information (CPNI), includes information related
to the quantity, technological configuration, type, destination and the amount
of use of a telecommunications service. Under the FCC's rules, a carrier may not
use the Customer Proprietary Network Information acquired through one of its
offerings of telecommunications services to market certain other services
without the approval of the affected customers. The United States Court of
Appeals for the Tenth Circuit recently overturned the FCC's rules regarding the
use and protection of Customer Proprietary Network Information. The FCC recently
relaxed its customer proprietary network information rules somewhat, but it also
has sought reconsideration of the Tenth Circuit decision. Further, FCC rules
regarding handling of CPNI could result in significant administrative expense in
modifying internal customer systems to meet such requirements.
OTHER ISSUES. There are a number of other issues and proceedings that
could have an effect on our business in the future, including the fact that
o The FCC has adopted rules to require telecommunications service
providers to make their services accessible to individuals with
disabilities, if readily achievable.
20
o The FCC has also ordered telecommunications service providers to
provide law enforcement personnel with a sufficient number of
ports and technical assistance in connection with wiretaps. We
cannot predict the cost to us of complying with this order.
o The FCC has adopted new rules designed to make it easier for
customers to understand the bills of telecommunications carriers.
These new rules establish certain requirements regarding the
formatting of bills and the information that must be included on
bills. These rules have been appealed in Federal court.
o We are subject to annual regulatory fees assessed by the FCC, and
must file an annual employment report to comply with the FCC's
Equal Employment Opportunity policies.
o The FCC has adopted an order granting limited pricing flexibility
to large incumbent local exchange carriers, and is considering
granting additional pricing flexibility and price deregulation
options. These actions could increase competition for some of our
services.
The foregoing is not an exhaustive list of proceedings or issues that
could materially affect our business. We cannot predict the outcome of these or
any other proceedings before the courts, the FCC, or state or local governments.
STATE REGULATION
To the extent that we provide telecommunications services which
originate and terminate in the same state, we are subject to the jurisdiction of
that state's public service commission. As our local service business and
product lines expand, we will offer more intrastate service and may become
increasingly subject to state regulation. The Telecommunications Act maintains
the authority of individual state utility commissions to preside over rate and
other proceedings, and to impose their own regulation on local exchange and
intrastate interexchange services, so long as such regulation is not
inconsistent with the requirements of federal law. For instance, states may
require us to obtain a Certificate of Public Convenience and Necessity before
commencing service in the state, and may impose tariff and filing requirements,
consumer protection measures, and obligations to contribute to universal service
and other funds. State commissions also have jurisdiction to approve negotiated
rates, or establish rates through arbitration, for interconnection, including
rates for unbundled network elements.
We are subject to requirements in some states to obtain prior approval
for, or notify the state commission of, any transfers of control, sales of
assets, corporate reorganizations, issuances of stock or debt instruments and
related transactions. Although we believe such authorizations could be obtained
in due course, there can be no assurance that state commissions would grant us
authority to complete any of these transactions.
The Telecommunications Act generally preempts state statutes and
regulations that restrict the provision of competitive services. As a result of
this broad preemption, we will be generally free to provide the full range of
local, long distance, and data services in any state. While this action greatly
increases our potential for growth, it also increases the amount of
21
competition to which we may be subject. States, however, may still restrict
competition in some rural areas.
In particular, we expect to expand our Z-Line Home Edition service by
starting to market this service in Pennsylvania by the end of the second quarter
of 2000. We are currently offering service in New York via Bell Atlantic's
tariffed offerings and in Massachusetts via a local interconnection agreement,
dated December 30, 1999, between us and Bell Atlantic. Our service in Texas is
provided via an interconnection agreement effective between us and Southwestern
Bell Telephone Company, dated November 5, 1999. To effectuate service in
Pennsylvania, we entered into a local interconnection agreement with Bell
Atlantic on December 30, 1999. Under the terms of the agreements entered into
with Bell Atlantic with respect to Massachusetts and Pennsylvania, Bell Atlantic
will provide the unbundled network element platform components in a manner
similar to that provided by Bell Atlantic in New York.
In order to enter new market areas, we may be required to negotiate
interconnection contracts with incumbent local exchange carriers on an
individual state basis. While current FCC rules and regulations require the
incumbent provider to provide the network elements on an individual and combined
basis necessary for us to provision end-user services, no assurance can be made
that the individual local exchange providers will provide these components in a
manner and at a price that will support competitive operations. If the incumbent
providers do not readily provide network functionality in the manner required,
we have regulatory and legal alternatives, including arbitration before state
public service commissions, to force provision of services in a manner required
to support our service offerings. However, if we are forced to litigate in order
to obtain the combinations of network elements required to support our service,
we are likely to incur significant incremental costs and delays in entering such
markets.
LOCAL GOVERNMENT REGULATION
In some of the areas where we provide service, we may be subject to
municipal franchise requirements requiring us to pay license or franchise fees
either on a percentage of gross revenue, flat fee or other basis. We may be
required to obtain street opening and construction permits from municipal
authorities to install our facilities in some cities. The Telecommunications Act
prohibits municipalities from discriminating among telecommunications service
providers in imposing fees or franchise requirements. In some localities, the
FCC has preempted fees and other requirements determined to be discriminatory or
to effectively preclude entry by competitors, but such proceedings have been
lengthy and the outcome of any request for FCC preemption would be uncertain.
EMPLOYEES
As of March 21, 2000, we had approximately 450 full-time employees,
excluding approximately 31 individuals employed by a temporary employment
service, some of whom we expect to offer full-time employment. None of our
employees are covered under collective bargaining agreements, and we believe
that our relationships with our employees are good.
22
In connection with the deployment of our network architecture and the
execution of our business plan, as well as the addition of Touch 1's personnel,
if the acquisition is consummated, we believe that the number of our customer
service, information systems installation and sales and marketing personnel will
increase significantly.
ITEM 2. PROPERTIES
We currently lease our principal executive offices in Tampa, Florida
and our principal engineering offices in Atlanta, Georgia.
ITEM 3. LEGAL PROCEEDINGS
We are a party to various routine administrative proceedings. For more
information, please refer to the section entitled "Item 1. Business--Government
Regulation."
In addition, in May 1998 we received a letter from Premiere
Technologies, Inc. (Premiere), threatening legal action based on the allegation
that our chief executive officer, Mr. Smith, a founder and a former director and
executive vice president of Premiere, had, among other things, improperly used
trade secrets belonging to Premiere in connection with the development of our
technology. Although the parties have subsequently had some discussions and
exchanged correspondence, including letters sent by Premiere to us in December
1999 reiterating prior claims and further discussions during which Premiere
alleged the existence of additional intellectual property claims arising from
the conduct of Mr. Smith, another one of our directors, one of our other
officers and us, Premiere has never commenced any legal proceedings against us
or Mr. Smith. While we believe that Premiere's alleged claims are without merit,
we cannot assure you that Premiere will not try to pursue its claims through
litigation or what the outcome of such litigation would be.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
On or about October 8, 1999, a majority of our Series A and Series B
preferred stockholders, respectively, approved, by written consent, an amendment
to the Stockholders' Agreement by and among us, certain management personnel,
and the Series A and Series B preferred stockholders that had the effect of
adding the Series C preferred stockholder to the Stockholders' Agreement and
altering certain rights of the Series B preferred stockholders. Series A
preferred stockholders representing 1,078,318 shares of our Series A preferred
stock and Series B preferred stockholders representing 2,140,477 shares of our
Series B preferred stock approved the amendment pursuant to such written
consent.
On or about October 30, 1999, a majority of our Series A preferred
stockholders, Series B preferred stockholders and common stockholders,
respectively, approved, by written consent, our 1998 Equity Participation Plan,
adopted October 30, 1998, as amended (the Plan). Common stockholders
representing 10,338,000 shares of our common stock, Series A preferred
stockholders representing 1,078,318 shares of our Series A preferred stock and
343,588 shares of the Company's Series B preferred stock approved the Plan
pursuant to such written consent.
23
On November 23, 1999, we held a special meeting of our stockholders, at
which our stockholders were requested to (1) approve an amendment to our
articles of incorporation increasing the authorized shares to 200,000,000
shares, consisting of 150,000,000 shares of common stock, par value $0.01 per
share, and 50,000,000 shares of preferred stock, par value $0.01 per share; and
(2) approve an amendment to increase the number of shares subject to the Plan to
7,500,000. 14,657,017 votes were cast in favor of each proposal, with no votes
cast against either of the proposals and no abstentions.
24
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the Nasdaq National Market
under the symbol "ZTEL."
The following table sets forth, for the periods indicated, the range of
high and low closing sale prices for the Common Stock, as reported on the Nasdaq
National Market since trading began on December 15, 1999, in connection with the
Company's initial public offering, under the symbol ZTEL:
HIGH LOW
------- -------
CALENDAR YEAR 1999:
Fourth Quarter (from December 15, 1999) $42.375 $33.125
FISCAL YEAR 2000: $47.25 $25.8125
First Quarter (through March 23, 2000)
On March 23, 2000, the last reported sales price of the Common Stock on
the Nasdaq National Market was $42.25 per share. As of March 23, 2000, there
were approximately 218 holders of record of the Common Stock.
We have not paid dividends on our common stock since our inception and
do not intend to pay any cash dividends for the foreseeable future but instead
intend to retain earnings, if any, for the future operation and expansion of our
business. Any determination to pay dividends in the future will be at the
discretion of our Board of Directors and will be dependent upon our results of
operations, financial condition, restrictions imposed by applicable law and
other factors deemed relevant by the Board of Directors.
USE OF PROCEEDS FROM INITIAL PUBLIC OFFERING
We filed a registration statement (Commission file no. 333-89063),
which became effective on December 14, 1999, with respect to the initial public
offering of 6,900,000 shares of our common stock (including the underwriters'
over-allotment option). All 6,900,000 shares were sold, for an aggregate
offering price of $117,300,000. The offering was co-lead by joint-book running
managers Thomas Weisel Partners LLC and Credit Suisse First Boston, and
co-managed by J.C. Bradford & Co. and Stephens Inc.
From December 14, 1999 through December 31, 1999, the expenses incurred
in connection with the offering were as follows: $8,211,000 in underwriting
discounts and commissions, $1,693,000 in other expenses and $9,904,000 in total
expenses. The net offering proceeds after deduction of expenses were
$107,396,000. No expenses were paid, directly or indirectly, to our directors,
officers, 10% shareholders or affiliates. Through December 31, 1999,
approximately $5,823,000
25
of the net offering proceeds were used in the following estimated amounts and
for the following purposes: $1,398,000 for the purchase and installation of
network equipment, $1,041,000 for the purchase of software and support and
software development, $1,985,000 for marketing expenses, $1,157,000 for
operational expenses, and $242,000 for construction of plant, building and
facilities. The remaining $99,234,000 has been placed in temporary investments
in cash and cash equivalents. None of the net offering proceeds have been paid,
directly or indirectly, to our directors, officers, 10% shareholders or
affiliates.
RECENT SALES OF UNREGISTERED SECURITIES
During the period covered by this report, Z-Tel sold shares of its
common stock in the amounts, at the times, and for the aggregate amounts of
consideration listed below without registration under the Securities Act of
1933. Exemption from registration under the Securities Act for each of the
following sales is claimed under Section 4(2) of the Securities Act because such
transactions were by an issuer and did not involve a public offering:
On March 15, 1999, Z-Tel issued a warrant to purchase 521,832 shares of
Common Stock to CMB Capital, LLC in connection with a $35.2 million revolving
sale-leaseback credit facility.
On September 22, 1999, Z-Tel issued, in the aggregate, 2,695,795 shares
of Series B Preferred Stock to 53 persons for an aggregate consideration of $10
million.
On October 8, 1999, Z-Tel issued 2,794,800 shares of Series C Preferred
Stock to Gramercy Z-Tel, LLC for an aggregate consideration of $15 million.
On October 13, 1999, Z-Tel issued 11,000 shares of common stock to
Telebot Corporation in exchange for substantially all of its assets.
On October 13, 1999, Z-Tel issued 55,000 shares of common stock to
Telutions LLC in connection with our purchase of software and support services.
On October 13, 1999, Z-Tel granted a warrant to purchase 115,500 shares
of common stock to CMB Capital LLC in connection with an amendment to the
existing facility, in which CMB Capital LLC agreed to, among other things, a
provision for prepayment of the facility.
26
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected historical consolidated financial data should be
read in conjunction with the financial statements, related notes and other
financial information contained in this document. You should also read
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," contained later in this document. The Consolidated Statements of
Operations Data for the year ended December 31, 1999 and the period from January
15, 1998 (Inception) through December 31, 1998, and the consolidated balance
sheet data and other financial data as of December 31, 1999 and December 31,
1998, are derived from our financial statements that have been audited by our
independent auditors.
PERIOD
JANUARY 15, 1998
YEAR ENDED (INCEPTION)
DECEMBER 31, THROUGH DECEMBER 31,
1999 1998
------------ --------------------
Revenues $ 6,615,000 $ 140,000
------------ ------------
Operating expenses:
Network operations 7,942,000 382,000
Sales and marketing 8,588,000 2,201,000
Research and development 3,562,000 4,728,000
General and administrative 15,379,000 4,718,000
Depreciation and amortization 4,372,000 1,283,000
------------ ------------
Total operating expenses 39,843,000 13,312,000
------------ ------------
Operating loss (33,228,000) (13,172,000)
------------ ------------
Nonoperating income (expense):
Interest income 608,000 228,000
Interest expense (3,351,000) (178,000)
------------ ------------
Total nonoperating income (expense) (2,743,000) 50,000
------------ ------------
Net loss (35,971,000) (13,122,000)
Less mandatorily convertible redeemable
preferred stock dividends (1,654,000) (190,000)
------------ ------------
Net loss attributable to common stockholders $(37,625,000) $(13,312,000)
============ ============
Weighted average common shares outstanding 15,099,359 6,554,499
============ ============
Basic and diluted net loss per share $ (2.49) $ (2.03)
============ ============
27
CONSOLIDATED BALANCE SHEET DATA
Cash and cash equivalents 101,657,000 7,973,000
Working capital 95,315,000 3,328,000
Total assets 137,677,000 20,274,000
Total debt 14,134,000 724,000
Mandatorily convertible redeemable preferred stock -- 15,154,000
Total stockholder's equity (deficit) 114,378,000 (6,000)
OTHER FINANCIAL DATA
EBITDA (1) (28,856,000) (11,889,000)
Net cash used in operating activities (32,681,000) (7,769,000)
Net cash used in investing activities (5,182,000) (11,393,000)
Net cash provided by financing activities 131,547,000 27,135,000
(1) EBITDA consists of earnings before interest, income taxes, depreciation and
amortization. While not a measure under generally accepted accounting
principles, EBITDA is a measure commonly used in the telecommunications
industry and is presented to assist in understanding our operating results.
Although EBITDA should not be construed as a substitute for operating income
(loss) determined in accordance with generally accepted accounting
principles, it is included herein to provide additional information with
respect to our ability to meet future debt service, capital expenditures
and working capital requirements. The calculation of EBITDA does not
include our commitments for capital expenditures and payment of debt and
should not be deemed to represent our available funds. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
for a discussion of our financial operations and liquidity as determined
in accordance with generally accepted accounting principles.
28
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
You should read the following discussion together with the "Selected
Consolidated Financial Data," financial statements and related notes included in
this document. This discussion contains forward-looking statements that involve
risks and uncertainties. Our actual results may differ materially from those
projected in the forward-looking statements as a result of certain factors,
including, but not limited to, those discussed in "Item 1. Business," as well as
"Cautionary Statements Regarding Forward-Looking Statements," "Risks Related to
our Financial Condition and our Business" and "Risks Related to our Industries,"
below, and other factors relating to our business and us that are not historical
facts. Factors that may affect our results of operations include, but are not
limited to, our limited operating history and cumulative losses, uncertainty of
customer demand, rapid expansion, potential software failures and errors,
potential network and interconnection failure, dependence on local exchange
carriers, dependence on third party vendors, dependence on key personnel,
uncertainty of government regulation, legal uncertainties, and competition. We
disclaim any obligation to update information contained in any forward-looking
statement.
OVERVIEW
We are an emerging provider of advanced, integrated telecommunications
services targeted primarily to residential subscribers. For management purposes,
we are organized into one reportable operating segment. We offer local and long
distance telephone services in combination with enhanced communication features
accessible through the telephone or the Internet. The nature of our business is
rapidly evolving and we have a limited operating history. As a result, we
believe that period-to-period comparisons of our revenues and operating results,
including our network operations and other operating expenses as a percentage of
total revenue, are not meaningful and should not be relied upon as indicators of
future performance. We do not believe that our historical growth rates are
indicative of future results.
REVENUES
We began offering Z-Line Home Edition service in New York in June 1999,
Texas in December of 1999, and Massachusetts in March 2000. Z-Line Home Edition
is our principal service offering. Z-Line Home Edition includes low-priced local
and long-distance (1+) residential telephone services using a customer's
existing telephone number, bundled with enhanced features, including caller
identification, call forwarding, three-way calling, speed dialing, and dial-up
remote access through our Z-Line Anywhere access card product, the full
functionality of the Personal Communication Center (PCC) and, for an additional
fee, Internet access. We expect sales and marketing expenses to increase
substantially as we introduce our Z-Line Home Edition service into new markets.
We intend to expand into Pennsylvania before the end of the second quarter of
2000. Our strategy will require us to hire additional sales and marketing
personnel to build awareness of our services. We will also need to hire
technical personnel to continue to expand our network architecture and enhance
our service offerings. In addition to our internal technical staff, we expect to
continue our relationship with third-party vendors and system integration
consultants to integrate and enhance our customer care and
29
billing software applications. We will continue to expand our network through
leased facilities, strategic alliances, and acquisitions.
We began offering an access card service, similar to our current Z-Line
Anywhere service, in the quarter ended December 31, 1998. Z-Line Anywhere is our
access card product that allows a customer to make long-distance calls using
Z-Tel's network from any phone simply by dialing a local access or toll-free
1-800 number. No change in phone service is required. Subscribers of Z-Line
Anywhere also receive the full functionality of our PCC. Z-Line Anywhere is
offered nationwide. Z-Line Anywhere customers are billed monthly in arrears, and
the associated revenue is recognized in the month of service.
We began offering Z-Line Home Edition in June 1999. During 1999, we
derived most of our revenue from service fees charged to Home Edition customers
located in areas of New York served by Bell Atlantic. In addition to New York,
we have begun to offer Z-Line Home Edition in Texas and Massachusetts and expect
to offer this service in Pennsylvania before the end of the second quarter of
2000. We intend to offer the Z-Line Home Edition product throughout the United
States, subject to the establishment, implementation, operation, and favorable
pricing of the unbundled network elements by each state in accordance with the
Telecommunications Act of 1996 and the more recent November 5, 1999 FCC order.
Charges for our Z-Line Home Edition basic services are billed in
advance on a monthly basis. Long distance services in excess of a subscriber's
basic package are billed in arrears. Revenue from Z-Line Home Edition is
recognized as earned. Our Z-Line Home Edition customer agreements may be
canceled on 30 days notice.
OPERATING EXPENSES
Operating expenses are comprised of:
o network operations, which consists primarily of fixed and variable
transmission expenditures, and rent expense for space in data centers;
o sales and marketing, which consists primarily of telemarketing,
advertising, sales compensation and related expenses;
o research and development, which consists primarily of compensation and
consulting fees related to the development of our proprietary
technologies;
o general and administrative, which consists primarily of compensation
and related expenses, bad debt expense, occupancy costs and various
administrative expenses; and
o depreciation and amortization, which consists primarily of the
non-cash reduction in carrying value of our long-lived assets.
We expect to expand our operations and workforce, including our network
operations, technical support, sales, marketing and administrative resources. In
particular, we intend to
30
expand our existing sales force and create a locally based sales force in
selected metropolitan areas where we intend to initiate service and determine a
need for a physical sales presence. As a result, we expect to continue to incur
substantial losses for the foreseeable future.
RESULTS OF OPERATIONS
Comparison of the year ended December 31, 1999 and the period January 15, 1998
(Inception) through December 31, 1998:
REVENUE. Revenue increased by $6.5 million to $6.6 million for the year
ended December 31, 1999, compared to $0.1 million for the period January 15,
1998 (Inception) through December 31, 1998. The following tables outline the
approximate number of subscribers for Z-Line Home Edition and Z-Line Anywhere:
TYPE OF SERVICE DECEMBER 31, 1999 DECEMBER 31, 1998
- ------------------------------------------------------------------------
Z-LINE HOME EDITION SUBSCRIBERS 40,100 0
Z-LINE ANYWHERE SUBSCRIBERS 26,000 5,800
NETWORK OPERATIONS. Network operations expense increased by $7.5
million to $7.9 million for the year ended December 31, 1999, compared to $0.4
million for the period January 15, 1998 (Inception) through December 31, 1998.
The network operations expense primarily consists of transmission expenses for
interconnection agreements with incumbent local exchange carriers (ILECs),
service level agreements with inter-exchange carriers (IXCs), transmission
services based on tariff arrangements, and employee salaries and benefits
associated with the maintenance and operations of our networks. These various
agreements include both fixed and variable line charges.
The increase in network operations expense was due primarily to growth
in the number of subscribers resulting from the introduction of our Z-Line Home
Edition services. We expect our network operations expense to increase
significantly in future periods due to increases in subscribers.
SALES AND MARKETING. Sales and marketing expense increased $6.4 million
to $8.6 million for the year ended December 31, 1999, compared to $2.2 million
for the period January 15, 1998 (Inception) to December 31, 1998. The sales and
marketing expense primarily consists of telemarketing, development of our brand
awareness through promotional and advertising materials, and employee salaries
and benefits.
The increase in sales and marketing expense is attributable to our
expanded sales and marketing efforts to increase our subscribers. We increased
our telemarketing and advertising expenses in 1999 in connection with the
introduction of our Z-Line Home Edition service. To
31
meet the demands of our growth we increased our personnel in this department
from approximately 10 at December 31, 1998 to approximately 20 at December 31,
1999. This increase is also attributable to the fact that marketing of our
services did not begin in earnest until the fourth quarter of 1998. We intend to
significantly increase our sales and marketing expenditures during the year
2000.
RESEARCH AND DEVELOPMENT. Research and development expenditures
decreased $1.1 million to $3.6 million for the year ended December 31, 1999,
compared to $4.7 million, for the period January 15, 1998 (Inception) to
December 31, 1998. Our research and development expenses consist primarily of
software development costs and employee salaries and benefits. We adopted the
provisions of Statement of Position (SOP) 98-1 "Accounting for the Cost of
Computer Software Developed or Obtained for Internal Use," at the beginning of
1999. As a result, $4.8 million of our research and development costs relating
to development of internal use software were capitalized for the year ended
December 31, 1999, compared to $0 for the period January 15, 1998 (Inception)
through December 31, 1998.
In 1998, we expensed internal software development costs, as we were
developing our Z-Line Anywhere and Z-Line Home Edition services and had not
fulfilled the requirements for capitalization. The development of our Z-Line
Home Edition, and the integration of our customer care and billing software
required significant expenditures from employee compensation and outside
consulting fees. These efforts were spent adding functionality and making
significant enhancements to our technology. A portion of these services and
purchases of software were capitalized in 1999 compared to 1998, as a result of
the adoption of SOP 98-1 discussed in the prior paragraph, causing research and
development expenses to decrease in 1999. We expect research and development
costs to increase in the future as we improve and enhance our services.
GENERAL AND ADMINISTRATIVE. General and administrative expense
increased $10.7 million to $15.4 million for the year ended December 31, 1999,
compared to $4.7 million for the period January 15, 1998 (Inception) to December
31, 1998. The increase in general and administrative expense was primarily due
to increases in its primary components of employee salaries, temporary services,
bad debt expense, and occupancy costs.
We increased the number of employees in general and administrative
functions to 83 employees at December 31, 1999, from 22 employees at December
31, 1998. We increased our provision for bad debts during 1999, primarily
because of our increase in subscribers for the year. We have implemented revised
credit policies and are closely monitoring collection procedures to help
minimize these expenses in the future. We have increased our leased facilities
utilized to meet our increased personnel and growing need for infrastructure to
support our current and future needs. We anticipate general and administrative
expenditures will continue to increase in the future as we increase our services
and enter new states to meet the demands of our anticipated growth.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased $3.1 million to $4.4 million for the year ended December 31, 1999,
compared to $1.3 million for the period January 15, 1998 (Inception) through
December 31, 1998. The increase was due to
32
purchases of equipment, facilities, and the capitalized costs associated with
internal software development totaling $21.2 million for the year-ended December
31, 1999, compared to $11.4 million for the period January 15, 1998 (Inception)
through December 31, 1998. We expect depreciation and amortization to continue
to increase significantly as we increase our capital expenditures.
INTEREST INCOME. Interest income increased $0.4 million to $0.6 million
for the year ended December 31, 1999, compared to $0.2 million for the period
January 15, 1998 (Inception) through December 31, 1998. Interest income consists
of income on our cash balances invested in short-term liquid investments. This
increase was due primarily to the closing of two private securities offerings in
1999 and our initial public offering on December 15, 1999, which offering
provided net proceeds of $109.1 million after underwriting discount and
commissions. These transactions in 1999 provided for larger cash balances
compared to 1998. We anticipate that our interest income will continue to
increase, as we will benefit from the interest earned from our initial public
offering proceeds.
INTEREST EXPENSE. Interest expense increased $3.2 million to $3.4
million for the year ended December 31, 1999, compared to $0.2 million for the
period January 15, 1998 (Inception) through December 31, 1998. Our interest
expense is a result of the interest charge on our capital lease obligations. The
increase in our interest expense is primarily a result of our payments on the
CMB Capital, LLC sale-leaseback agreement. We anticipate a reduction in the
amount of interest expense in the future due to the extinguishment of our CMB
Capital, LLC $35.2 million revolving sale-leaseback credit facility on February
14, 2000.
INCOME TAX EXPENSE. No provision for federal or state income taxes has
been recorded due to the full valuation allowance recorded against the deferred
tax asset for the year ended December 31, 1999 and the period January 15, 1998
(Inception) through December 31, 1998.
NET LOSS. Our net loss increased $22.9 million to $36.0 million for the
year ended December 31, 1999, compared to $13.1 million for the period January
15, 1998 (Inception) through December 31, 1998. This increase was due primarily
to the increases in expenses described above.
EBITDA. Many securities analysts use the measure of earnings before
deducting interest, taxes, depreciation and amortization, also commonly referred
to as "EBITDA," as a way of evaluating a company's financial performance. While
EBITDA is not a measure under generally accepted accounting principles, EBITDA
is a measure commonly used in the telecommunications industry and is presented
to assist in understanding our operating results. Our negative EBITDA increased
$17.0 million to $28.9 million for the year ended December 31, 1999, compared to
$11.9 million for the period January 15, 1998 (Inception) through December 31,
1998. We expect to experience increasing operating losses and negative EBITDA as
result of our network development and the expansion of our markets and growth
and expansion of operations.
33
LIQUIDITY AND CAPITAL RESOURCES
The competitive local telecommunications service business is
traditionally considered to be a capital intensive business owing to the
significant investments required in fiber optic communication networks and the
collocation of switches and transmission equipment in incumbent local exchange
carriers' central offices. Our network architecture is designed with remotely
located points of presence, or Z-Nodes, that can be interconnected through local
and long distance communications networks to the Z-Tel enterprise management
center. We do not expect that the growth of our business will require
the levels of capital investment in fiber optics and switches that existed in
historical models. Instead, we will devote significant amounts of our capital
resources to continued software development and to marketing efforts that we
have designed to achieve rapid penetration of our target markets.
We have incurred significant accumulated losses since our inception as
a result of developing our business, research and development, building and
maintaining network infrastructure and technology, sales and promotion of our
services, and administrative expenditures. As of December 31, 1999, we had an
accumulated deficit of $49.1 million and net operating loss carryforwards of
$49.3 million for tax purposes. We have funded these expenditures primarily
through operating revenues, private securities offerings, a sale-leaseback
credit facility and an initial public offering of 6.9 million shares of common
stock (including the underwriters' over-allotment option) that raised net
proceeds of $109.1 million after underwriter discount and commissions. We intend
to continue building our organization in anticipation of future growth and
believe that our operating expenditures will also continue to increase. As of
December 31, 1999, we had $101.7 million in cash and cash equivalents.
NET CASH USED IN OPERATING ACTIVITIES. Net cash used in operating
activities increased by $24.9 million to $32.7 million for the year ended
December 31, 1999, compared to $7.8 million for the period January 15, 1998
(Inception) through December 31, 1998. This net change in cash used in operating
activities from year to year primarily was affected by increasing net losses,
and was offset partially by non-cash charges associated with bad debt expense,
depreciation, and expenses from the granting of stock options.
NET CASH USED IN INVESTING ACTIVITIES. Net cash used in investing
activities decreased by $6.2 million to $5.2 million for the year ended December
31, 1999, compared to $11.4 million for the period January 15, 1998 (Inception)
through December 31, 1998. For the year ended December 31, 1999, we invested
$21.2 million in capital expenditures as compared to $11.4 million in the period
January 15, 1998 (Inception) through December 31, 1998. These purchases were
primarily for the following items:
o continued enhancement and improvement of our network;
o employee compensation and outside consulting fees associated with the
internal development and integration of our customer care and billing
software; and
o the build-out of our headquarters in Tampa, Florida.
34
The significant increase in capital expenditures is a direct result of our rapid
growth in subscribers and the need to build and purchase infrastructure to
support our current and future needs. In 1998, we focused on product development
and the establishment of our infrastructure, the operation of our technology and
a network that primarily involved the purchases of equipment for our Z-Nodes. As
noted in the discussion regarding research and development, pursuant to our
adoption of Statement of Position 98-1 as of January 1, 1999, we capitalized
$4.8 million of software development costs for the year ended December 31, 1999,
compared to $0 during the period January 15, 1998 (Inception) through December
31, 1998. Capitalized software development costs, in conjunction with capital
outlays, contributed to the increased capital expenditures. On March 15, 1999,
we entered into a $35.2 million sale-leaseback facility agreement with CMB
Capital, LLC to sell and lease back certain equipment, which provided $16.0
million in cash from investment activities for the year ended December 31, 1999.
On February 14, 2000, we made a payment of $14.4 million to extinguish
the outstanding CMB Capital, LLC debt. This was the repayment of transactions
involving the sale and leaseback of various furniture and equipment payable over
four years from the date of the transactions. This transaction resulted in $1.6
million of extraordinary loss, to be recorded in the first quarter of 2000,
associated with the loss for the early extinguishment of debt and the expense
relating to 115,500 stock warrants associated with the debt that was being
expensed over the life of the lease. We expect cash used in investing activities
to increase as we maintain and develop our network.
NET CASH PROVIDED BY FINANCING ACTIVITIES. Net cash provided by
financing activities increased $104.4 million to $131.5 million for the year
ended December 31, 1999, compared to $27.1 million for the period January 15,
1998 (Inception) through December 31, 1999. The overall increase is primarily
attributable to our initial public offering on December 15, 1999 of 6.9 million
shares of common stock (including the underwriters' over-allotment options) for
net proceeds of $109.1 million after underwriter discount and commissions. Prior
to our initial public offering, we raised $10.0 million and $15.0 million,
respectively, through the offerings of our Series B and Series C preferred
shares, compared with $15.0 million raised through a Series A preferred stock
offering in 1998. The net increase of cash provided by financing activities was
reduced by the payments of our long-term debt and payments on our capital lease
obligations, in the amounts of $0.6 million and $2.0 million, respectively, in
1999, compared to $0.9 million and $24,000, respectively, in 1998.
Our ongoing capital requirements will depend on several factors,
including market acceptance of our services, the amount of resources we devote
to investments in our networks, facilities, build-out of additional enterprise
management centers, services development and brand promotions, the resources we
devote to sales and marketing of our services, and other factors. We have
experienced a substantial increase in our capital expenditures and operating
losses since our inception consistent with the growth in our operations and
staffing, and we anticipate that this will continue for the foreseeable future.
Additionally, we expect to make additional investments in technologies and our
network architecture, and plan to expand our sales and marketing programs and
conduct more aggressive brand promotions. Although operating activities may
provide cash in certain periods, to the extent we experience growth in the
future, we anticipate that our operating and investing activities will use cash.
Consequently, any such
35
future growth will require us to obtain additional equity or debt financing
which may not be available on attractive terms, or at all, or may be dilutive.
See "Item 1. Business--Acquisition of Touch 1 Communications, Inc." for
a discussion of our planned acquisition of Touch 1 Communications, Inc.
IMPACT OF THE YEAR 2000
We did not experience any significant disruptions in its operations
during the transition into the Year 2000. We believe we have completed necessary
assessments, modifications or replacement and testing of systems critical for
the delivery of our services. We believe our Year 2000 readiness objectives have
been met. Because of these preparations, we did not experience any significant
disruptions in our operations. We also prepared a contingency plan to mitigate
potential adverse effects that might have arisen from non-compliant systems or
third parties that had not adequately addressed the Year 2000 issue. While we
did not experience any significant Year 2000 disruptions during the transition
into the Year 2000, we will continue to monitor our operations and systems and
address any date-related problems that may arise as the year progresses.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The forward-looking statements in this document are based on the belief
of our management, as well as assumptions made by and information currently
available to our management. Forward-looking statements also may be included in
other written and oral statements made or released by us. You can identify
forward-looking statements by the fact that they do not relate strictly to
historical or current facts. The words "believe," "anticipate," "intend,"
"expect," "estimate," "project" and similar expressions are intended to identify
forward-looking statements. Forward-looking statements describe our expectations
today of what we believe is most likely to occur or may be reasonably achievable
in the future, but they do not predict or assure any future occurrence and may
turn out to be wrong. Forward-looking statements are subject to both known and
unknown risks and uncertainties and can be affected by inaccurate assumptions we
might make. Consequently, no forward-looking statement can be guaranteed. Actual
future results may vary materially. We do not undertake any obligation to
publicly update any forward-looking statements to reflect new information or
future events or occurrences. These statements reflect our current views with
respect to future events and are subject to risks and uncertainties about us,
including, among other things:
o our ability to market our services successfully to new
subscribers;
o our ability to access markets and finance network developments;
o our enhancement and expansion;
o additions or departures of key personnel;
36
o competition, including the introduction of new products or
services by our competitors;
o existing and future regulations affecting our business and our
ability to comply with these regulations;
o technological innovations;
o general economic and business conditions, both nationally and in
the regions in which we operate; and
o other factors described in this document, including those
described in more detail below.
We caution you not to place undue reliance on these forward-looking
statements, which speak only as of the date of this document.
RISKS RELATED TO OUR FINANCIAL CONDITION AND OUR BUSINESS
LIMITED OPERATING HISTORY. We were formed in January 1998 and began
offering telecommunications services to the public in September 1998. In
addition, in June 1999, we began marketing our Z-Line Home Edition service in
New York City and Long Island. We have had fewer than 17 months of actual
marketing, sales and operational results. Our limited operating history and
results make it very difficult to evaluate or predict our ability to, among
other things, retain customers, generate and sustain a revenue base sufficient
to cover our operating expenses, and to achieve profitability. As a result, we
believe that our historical financial information is of little or no value in
projecting our future results, making it even more difficult to evaluate our
business and prospects.
UNCERTAIN DEMAND. We initially began to market our products and
services in September 1998. In June 1999, we focused our product offering on
sales of our Z-Line Home Edition service. Our products and services represent an
emerging sector of the telecommunications industry, and the demand for our
services and our ability to retain customers over time are highly uncertain.
Consumer acceptance of our products and services could be limited by:
o the willingness of customers to accept Z-Tel as an alternative
provider of local and long distance telephone services and of
other enhanced, integrated services;
o the presence and attractiveness of other enhanced
telecommunications service offerings in our target markets;
o the perception of complexity in using our services;
o the reliability of our technology and network infrastructure;
37
o the quality of our customer service; and
o the prices of our services.
We have determined that substantial marketing effort, time and expense
are required to stimulate initial demand for our products and services. In
addition, we have incurred and will continue to incur substantial operating
expenses, have made, and will continue to make, significant capital investments
and have entered or plan to enter into real property leases, equipment supply
contracts and service arrangements, in each case based upon our expectations as
to the market acceptance of our products and services. We cannot be certain that
substantial markets will develop for our products and services, or, if such
markets develop, that we will be able to attract and maintain a sufficient
revenue-generating customer base to cover our operating expenses. Lack of
acceptance of our services in our target markets would materially and adversely
affect the commercial viability of our business, and as a consequence, the value
of your investment.
In addition, to maintain our competitive posture, we must be in a
position to reduce the prices for our services in order to meet reductions in
local and long distance rates, if any, offered by others. We cannot be sure that
we will be able to match the reductions made by our competitors and, if we do,
such reductions could have an adverse effect on our business, operating results
and financial condition.
EXPECTATION OF FUTURE LOSSES. Our product and service offerings are at
an early stage, and we cannot be sure that sales of our products or services
will generate revenues sufficient to cover our operating expenses. Even if our
products and services prove to be commercially successful, our operations may
not become profitable. Starting up our company and developing our communications
technology required substantial capital and other expenditures and further
development of our business will require significant additional expenditures.
Since our inception in January 1998 through December 31, 1999, we have
incurred accumulated losses of $49.1 million. We expect to continue to have
significant operating losses and retained losses and will record significant
negative net cash flow before financing for the foreseeable future.
AVAILABILITY AND FAVORABLE PRICING OF UNBUNDLED NETWORK COMPONENTS. Our
business strategy depends on a continued availability of unbundled network
components and on existing and additional states maintaining and adopting
favorable pricing rules for unbundled network components.
The public utilities commissions of certain states have adopted pricing
rules for unbundled network components. As a result of these regulatory
initiatives, the Bell operating companies operating in those states are required
to offer to competitive local exchange carriers such as us, at forward-looking,
long-run incremental cost-based prices, the facilities and equipment and the
features, functions and capabilities of their local exchange network on an
unbundled basis. We have recently commenced operations in New York, Texas and
Massachusetts using