UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 2004
Commission File Number: 0-24061
US LEC CORP.
(Exact name of registrant as specified in its charter)
| DELAWARE | 56-2065535 | |
| (State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) |
Morrocroft III, 6801 Morrison Boulevard
CHARLOTTE, NORTH CAROLINA 28211
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code: (704) 319-1000
Securities registered pursuant to Section 12(b) of the Act: None.
Securities registered pursuant to Section 12(g) of the Act: Class A Common Stock, par value $.01 per share.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 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 the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Rule 12b-2). Yes ¨ No x
The aggregate market value of voting stock of the registrant held by non-affiliates of the registrant was $69,620,774 as of June 30, 2004 based on the closing sales price on The Nasdaq National Market as of that date. For purposes of this calculation only, affiliates are deemed to be directors and executive officers of the registrant.
As of March 4, 2005 there were 30,292,862 shares of Class A common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s Proxy Statement for its Annual Meeting of Stockholders to be held in May of 2005 are incorporated by reference into Part III of this report.
2004 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
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CAUTION REGARDING FORWARD-LOOKING STATEMENTS
This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding, among other items, our expected financial position, business, risk factors and financing plans. These statements are identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “estimates” or “anticipates” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. These forward-looking statements are based on a number of assumptions concerning future events, including the outcome of judicial and regulatory proceedings, the adoption of balanced and effective rules and regulations by the Federal Communications Commission (“FCC”) and state public utility commissions (“PUCs”), and US LEC’s ability to successfully execute its business plan. These forward-looking statements are also subject to a number of uncertainties and risks, many of which are outside of US LEC’s control, that could cause actual results to differ materially from such statements. Important factors that could cause actual results to differ materially from the expectations described in this report are set forth in this report under the headings “Business—Regulation,” “Business—Risk Factors,” in Note 7 to the consolidated financial statements, and elsewhere in this report. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date they are made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as of a result of new information, future events or otherwise.
As used in the report, the words “we,” “our,” “US LEC,” and the “Company” refer to US LEC Corp. and its subsidiaries.
OVERVIEW
Based in Charlotte, North Carolina, US LEC is a super-regional telecommunications carrier providing integrated voice, data and Internet services to more than 22,000 mid-to-large-sized business customers and enterprise organizations throughout the eastern United States. The Company also provides shared Web hosting and dial-up Internet services to approximately 16,000 additional residential and small business customers.
US LEC was founded in 1996 and first initiated service in North Carolina in March 1997, becoming one of the first competitive local exchange carriers in North Carolina to provide switched local exchange services. Since 1997, US LEC’s business has evolved substantially as our product offerings have grown to include a full suite of voice, data and Internet services and our geographic area of service has expanded significantly to encompass nearly all of the major business centers in the eastern United States.
US LEC’s principal offices are located at 6801 Morrison Boulevard, Charlotte, North Carolina 28211, and the telephone number is (704) 319-1000. The Company’s Internet address is www.uslec.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this report. We make available free of charge (other than an investor’s own Internet access charges) through our website this report, quarterly reports on Form 10-Q, and current reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission (“SEC”).
The US LEC product line includes local calling services, long distance, long distance plans featuring toll free, calling card, audio conference and Web-enabled audio conferencing services, dedicated and dial-up Internet services, including our MegaPOP® Internet access product, frame relay, multi-link frame relay, Asynchronous Transfer Mode (“ATM”), Digital Private Line (“DPL”) services, Voice over Internet Protocol (“VoIP”)-enabled
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services, managed data solutions, data center services, co-location and Web hosting. The US LEC network consists of 80 Points of Presence (“POPs”) and encompasses 27 digital voice and data switching centers, two carrier-grade data centers, 12 additional data POPs and 39 dial-up POPs throughout the country. Also, within the above-described US LEC network, there are nine VoIP POPs currently operational. US LEC utilizes only best in class equipment that includes Lucent 5ESS® AnyMedia™, Lucent CBX500 ATM, and Tekelec SanteraOne™ digital switches and Internet routers from Juniper and Cisco®.
US LEC provides its full suite of voice, data and Internet services in the following 15 states plus the District of Columbia: Alabama, Delaware, Florida, Georgia, Kentucky, Louisiana, Maryland, Mississippi, New Jersey, New York, North Carolina, Pennsylvania, South Carolina, Tennessee and Virginia. US LEC also offers nationwide data services, as well as selected voice services such as long distance calling, calling card, audio conferencing, Web-enhanced audio conferencing and toll free service, in a total of 42 states that, in addition to those referenced above, include Arkansas, Arizona, California, Colorado, Connecticut, Illinois, Indiana, Iowa, Kansas, Massachusetts, Michigan, Minnesota, Missouri, Montana, Nebraska, Nevada, New Hampshire, North Dakota, Ohio, Oregon, South Dakota, Texas, Utah, Washington, West Virginia, Wisconsin and Wyoming.
In November 2004, as part of the Company’s strategy of expanding its range of services, US LEC acquired the majority of the assets of StarNet, Inc. (“StarNet”), a nationwide provider of dial-up Internet access and telephony services to Internet service providers (“ISPs”). US LEC now also owns and operates a nationwide, seamless network providing local dial-up Internet access for more than 400 ISPs. The StarNet assets that the Company acquired also include StarNet’s full suite of services, featuring the MegaPOP® Internet access product, VoiceEclipse (VoIP product), 61 StarNet POPs and StarNet’s Network Operations Center (“NOC”) in Palatine, Illinois.
BUSINESS STRATEGY
US LEC’s mission is to be the premier communications partner for businesses by delivering quality voice, data and Internet services and exceeding expectations for customer care.
The principal elements of US LEC’s business strategy include:
Provide Outstanding Customer Service. Management believes that a key element of the success of a competitive carrier is the ability to satisfy the service needs of its customers, and that providing customers with outstanding customer care enhances the ability of the Company to retain its customers, as well as attract new customers. The Company must be able to provide a quality and timely activation, resolve service issues, quickly implement change requests, produce accurate bills, resolve billing issues, provide reliable services, and promptly add additional service and capacity required by our customers. Customer service is provided locally by our market-based sales, sales support and operations team and centrally by US LEC’s four NOCs. The Company also provides a Web-enabled customer self-care portal that allows customers to obtain detailed billing and trending account information, as well as manage, provision and monitor selected US LEC services such as US LEC Conferencing, US LEC Web Hosting, US LECnet Dial and selected US LEC Toll Free services.
Offer a Broad Range of Services. US LEC offers customers a broad range of voice, data and Internet services that can be bundled on a single customer network connection. US LEC offers its customers local calling services, long distance, long distance plans featuring toll free, audio conferencing and Web-enhanced audio conferencing services, dedicated and dial-up Internet services, including the MegaPOP® Internet access product, frame relay, multi-link frame relay, ATM, DPL services, VoIP-enabled services, managed data solutions, data center services, co-location and Web hosting. Management believes a broad range of services, competitive pricing and an opportunity to bundle services gives US LEC customers an exceptional value, and enables the Company to build a stream of quality recurring revenue.
Target Telecommunications-Intensive Customers. The Company focuses its sales efforts on telecommunications-intensive business customers that include the automotive, construction, education, financial,
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government, healthcare, hospitality, ISPs, professional/legal, real estate, retail, transportation sectors and other telecommunications providers. By focusing on such customers, the Company is able to more efficiently concentrate their telecommunications traffic. In addition, the Company frequently is able to bundle its voice, data and Internet services. This further enhances network utilization and thereby improves margins, as fixed network costs are spread over a larger base of services.
Deploy a Capital-Efficient Network. Unlike some other competitive carriers, US LEC does not resell ILEC dial tone services or provide service via Unbundled Network Element Platforms (“UNE-P”). US LEC owns and operates the switching and routing equipment while leasing the required fiber optic transmission capacity from competitive access providers (“CAPs”), CLECs, inter-exchange carriers (“IXCs”) or incumbent local exchange carriers (“ILECs”). Management believes this switch-based, leased-transport strategy enables it to continually take advantage of changes in the transport market. By employing this “smart-build” strategy, US LEC reduces the up-front capital expenditures required to build a network and enter new markets and avoids the risk of “stranded” investment in under-utilized networks.
Maintain a Robust Technology Platform. US LEC currently operates 26 Lucent voice switches, 27 Lucent ATM data switches, one Tekelec SanteraOne™ digital switch, and over 150 Juniper and Cisco® Internet routers throughout its network. The Company also employs a redundant and diverse advanced intelligent network (“AIN”) platform and SS7 signaling network, which includes Telcordia integrated services control points (“ISCPs”) and Tekelec Eagle signal transfer points (“STPs”). In addition, the Company has also deployed Juniper and Cisco® routers to provide reliable, scalable and high-speed network elements that enhance the performance of US LEC’s Internet access service. The Company’s data centers are equipped with Intel ISP platforms as well as a variety of other server platforms, based on customer needs.
Focus of Operations. The Company focuses its network and marketing presence in target markets composed of certain Tier I cities (defined as major metropolitan areas such as Atlanta, Miami, New York, Philadelphia and Washington D.C.) and certain Tier II cities (defined as mid-size metropolitan areas such as Charlotte, Nashville and Tampa) located in the eastern United States. Management believes that the Company’s strategically designed network will enable it to take advantage of customer relationships, calling patterns, capture an increasing portion of customer traffic on its network and improve brand identification.
THE US LEC NETWORK
The US LEC network consists of 80 POPs, supported by 26 Lucent 5ESS® AnyMedia™ digital switches, 27 Lucent CBX500 ATM data switches and one Tekelec SanteraOne™ digital switch. In selected markets, the digital switching centers include Juniper and Cisco M Internet routers that provide advanced IP services to customers. The network also includes two carrier-grade data centers, 12 additional data POPs and 39 dial-up POPs throughout the country. Also, within the above-described US LEC network, there are nine VoIP POPs currently operational. The digital switching centers are connected to each other across the network on SONET OC-12, SONET OC-3 and DS-3 lines leased from various other carriers. The Company connects its customers to its digital switching centers through leased lines, including SONET OC-48, SONET OC-12, SONET OC-3, DS-3 and T-1. The SONET lines are generally deployed in a ring configuration.
In order to interconnect its switches to the network of the local incumbent phone companies and to exchange traffic with them, the Company maintains interconnection agreements with the incumbent carriers. The Telecommunications Act of 1996 (the “Telecom Act”), decisions of state and federal regulatory bodies and commercial negotiation affect the terms and conditions of the interconnection agreements with the carriers involved. The Company may voluntarily enter into such agreements, petition a state regulatory commission to arbitrate issues that cannot be resolved by negotiation or adopt agreements executed by the incumbents and other competitive carriers. The Company has signed interconnection agreements with all of the incumbent local carriers where it offers services requiring such agreements, including BellSouth Telecommunications, Inc. (“BellSouth”), Verizon Communications Inc. (“Verizon”) and Sprint Communications Company L.P. (“Sprint”).
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Voice calls originating with a US LEC customer are transported over leased lines to a US LEC switch and can either be terminated directly on the Company’s network or routed to a long distance carrier, an ILEC or another CLEC, depending on the location of the call recipient. Similarly, voice calls originating from the public switched telephone network and destined for a US LEC customer are routed through a US LEC switch and delivered to call recipients via leased transmission facilities.
Data transmissions from a US LEC customer are transported over leased lines to a US LEC switch and then transmitted directly on the Company’s network or transmitted to another carrier for termination. Data transmissions to a US LEC customer work in reverse.
Internet access for US LEC customers is provided by transport over leased lines to a US LEC switch, transmitted over leased lines to one of US LEC’s Internet Gateways, and then, if necessary, to the Internet via Internet transit leased from other carriers.
SERVICES
The Company’s ability to bundle voice, data and Internet services on the same transport facility allows us to offer customers more efficient use of such facilities, and also allows us to aggregate customers’ charges on a single consolidated invoice.
The Company provides voice services, most significantly local dial-tone services, to customers in most of the major business markets in 15 states plus the District of Columbia. Local access is available in many different forms including Primary Rate Interface (“PRI”), T-1 and channels. The Company’s network is designed to allow a customer to increase or decrease capacity easily and to utilize enhanced services as the telecommunications requirements of the customer change. The Company offers a variety of long distance services and calling plans, as well as directory assistance and operator services, long distance services for completing intrastate, interstate and international calls, toll-free services, calling cards, audio conferencing, Web-enhanced audio conferencing and certain enhanced features such as voice mail. Additionally, US LEC began the roll-out of VoIP-enabled services in 2004.
The Company provides data services including frame relay, multi-link frame relay, Multi-Link FAST PipeSM, ATM and DPL (digital private line) services for the efficient transfer of data communications. US LEC also operates two carrier-grade data centers.
US LEC’s Internet services include dedicated and dial-up Internet access, burstable Internet products, dedicated server hosting, managed router service and data solutions, data center services, co-location, managed firewalls and IP-VPN, Web hosting, e-mail, news feeds and other services.
During 2004, the Company introduced seven new products, continuing to expand its voice, data and Internet product offerings while minimizing the capital requirements associated with product expansions:
| • | Managed Router Service is designed to help customers better manage their IT infrastructure by outsourcing the technical complexities of their network to US LEC, including router selection, configuration, installation and management, as well as perform the ongoing support functions in the form of network monitoring, troubleshooting, upgrades, off-site configuration back-ups and outage notifications. |
| • | Burstable Dedicated Internet product provides significant flexibility by accommodating a customer’s Internet bandwidth needs at peak times when Internet traffic “bursts,” while only requiring the purchase of a smaller, committed bandwidth amount for normal Internet usage. |
| • | Multi-Link FAST PipeSM applies the same technology to Internet service that is utilized by Multi-Link Frame Relay, which US LEC announced in 2003. By incrementally linking multiple DS1 lines, customers eliminate the need to purchase larger costly DS3 facilities to increase capacity. |
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| • | Dedicated Server Hosting provides a range of management options that simplify the process of starting and expanding Web-enabled services for customers by handling many of the technology aspects for them. |
| • | Dynamic TSM is the VoIP-enabled product that utilizes VoIP technology solely between US LEC switching facilities and the US LEC customer, and dynamically allocates bandwidth between high-speed Internet access and high-quality voice service as required to readily meet business customers’ fluctuating demands. |
| • | Data Center Colocation allows customers to locate their servers in one of two carrier-grade data centers in Pennsylvania to accommodate the increasing bandwidth and high-availability demands of customers. |
| • | MegaPOP® Internet access provides Internet service provider customers with local dial-up Internet access nationwide, so customers can market and provide service across the country using over 80,000 local access numbers, without the responsibility of operating a nationwide network. |
SALES AND MARKETING
Sales. US LEC employs a well trained and experienced direct sales force to attract new customers and dedicate its efforts to retaining customers. The Company recruits sales professionals with strong sales backgrounds in its markets, many of whom have had experience with other telecommunications carriers, including long distance companies, CLECs, ILECs, ISPs, telecommunications equipment manufacturers and network systems integrators. The Company plans to continue to attract and retain highly qualified salespeople by offering them an opportunity to participate in the potential economic rewards made available through a results-oriented compensation program. The Company also leverages its sales force by employing highly skilled data and solutions engineers, who are specialists in designing customer networks. The Company also utilizes independent sales agents to identify and service customers.
Marketing and Branding. US LEC seeks to be the premier communications partner for businesses by delivering quality voice, data and Internet services and exceeding expectations for customer care. The Company builds its reputation and brand identity by delivering on a ‘customer comes first’ philosophy, working closely with its customers to develop services customized to their particular needs and by implementing targeted product offerings and promotional efforts. With marketing focus and expertise in a number of vertical industries, US LEC is able to distinctly define its competitive advantages, value propositions and service provider differentiators to its customers.
The Company primarily uses two trademarks and service marks: US LEC, and a logo that includes US LEC and VOICE/DATA/INTERNET. The US LEC mark has been registered on the Supplemental Register of the United States Patent and Trademark Office since 1997 for use with telecommunications services and is now registered on the Principal Register with those services pursuant to a claim of acquired distinctiveness. The US LEC word mark has also been preliminarily approved for registration on the Principal Register for use with related services in multiple classes and the logo mark has similarly been preliminarily approved for registration on the Principal Register for use with all services. In addition, the Company has continued to use the marks acquired upon the acquisition of the assets of Fastnet as we have integrated Fastnet’s services into the Company’s existing suite of telecommunications services.
The Company has recently acquired the federal service mark registration MEGAPOP and pending federal application STARNET, each for use with providing multi-user access to the Internet. The Company’s use of these marks will be evaluated as these services are integrated into the Company’s existing suite of telecommunications services.
Billing. The Company believes that accurate billing is an important aspect of customer acquisition and retention, and operates its billing function in-house, allowing the Company to realize cost savings and provide
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additional services to customers. The Company conducts an internal review of the initial customer bills before they are made available to the customer, and the process concludes with a US LEC representative reviewing the initial invoice with the customer to ensure it is as expected. Customer bills are available in a variety of formats to meet a customer’s specific needs. US LEC offers customers simplicity and convenience by sending one invoice for all services. The Company offers electronic bill presentment and tools, such as Web access to billing data and supporting information such as call detail information, call trend analysis and busy hour reports.
EMPLOYEES
As of December 31, 2004, the Company employed 1,065 people. The Company does not expect significant changes in its staffing level in 2005. The Company considers its employee relations to be very good.
REGULATION
The following summary of regulatory developments and legislation does not purport to describe all current and proposed federal, state and local regulations, rule-making and legislation affecting the telecommunications industry. Other federal and state legislation and regulations are currently the subject of judicial proceedings, rule-making and legislative hearings and there are administrative proposals which could change, in varying degrees, the manner in which this industry operates. Neither the outcome of these proceedings, rule-making and legislation, nor their impact upon the telecommunications industry or the Company, can be predicted at this time. This section also includes a brief description of regulatory issues pertaining to the operation of the Company.
Overview. The Company’s services are subject to varying degrees of federal, state and local regulation. The FCC generally exercises jurisdiction over the facilities of, and services offered by, telecommunications common carriers that provide interstate or international communications. The PUCs retain jurisdiction over the same facilities and services to the extent they are used to provide intrastate communications.
Federal Legislation. The Company must comply with the requirements of common carriage under the Communications Act of 1934, as amended (the “Communications Act”). The Telecom Act, enacted on February 8, 1996, substantially revised the Communications Act. The Telecom Act established a regulatory framework for the introduction of local competition throughout the United States and was intended to reduce unnecessary regulation to the greatest extent possible. Among other things, the Telecom Act preempts, after notice and an opportunity for comment, any state or local government from prohibiting any entity from providing telecommunications service.
The Telecom Act also establishes a dual federal-state regulatory scheme for eliminating other barriers to competition faced by competitors to the ILECs and other new entrants into the local telephone market. Specifically, the Telecom Act imposes on ILECs certain interconnection obligations, some of which are implemented by FCC regulations. The Telecom Act contemplates that state PUCs will apply the federal regulations and oversee the implementation of all aspects of interconnection not subject to FCC jurisdiction as they oversee interconnection negotiations and, to the extent necessary, enforcement actions between ILECs and their new competitors.
The FCC has significant responsibility for the manner in which the Telecom Act will continue to be implemented, especially in the areas of pricing, universal service, terms of access to ILECs’ networks, interstate access charges and price caps. The details of the interpretation and continued adoption of the rules adopted by the FCC will continue to have a significant impact in determining the extent to which barriers to competition in local services are removed, as well as the time frame within which such barriers are eliminated.
The PUCs also have significant responsibility for implementing the Telecom Act. Specifically, the states have authority to establish interconnection pricing, including unbundled loop charges, reciprocal compensation, intrastate access charges and wholesale pricing consistent with FCC regulations. The PUCs are also charged
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under the Telecom Act with overseeing the arbitration process for resolving interconnection negotiation disputes between CLECs and the ILECs, must approve negotiated, arbitrated or adopted interconnection agreements, and may resolve contract compliance disputes arising from interconnection agreements.
The obligations imposed on ILECs by the Telecom Act to promote competition, such as local number portability, dialing parity, reciprocal compensation arrangements and non-discriminatory access to telephone poles, ducts, conduits and rights-of-way, also apply to CLECs, including the Company. As a result of the Telecom Act’s applicability to other telecommunications carriers, it may provide the Company with the ability to reduce its own interconnection costs by interconnecting directly with non-ILECs, but may also cause the Company to incur additional administrative and regulatory expenses in responding to interconnection requests. At the same time, the Telecom Act also has increased, and likely will continue to increase, the level of competition the Company faces.
Federal Regulation and Related Proceedings. The Telecom Act and the FCC’s efforts to initiate reform have resulted in numerous legal challenges. As a result, the regulatory framework in which the Company operates is subject to a great deal of uncertainty. Any changes to the current regulatory framework resulting from this uncertainty could have a material adverse effect on the Company. The FCC has adopted orders prohibiting the use of tariffs for non-dominant carriers providing international and domestic interstate long distance services. Accordingly, non-dominant interstate service providers and international service providers can no longer rely on the filing of end user tariffs with the FCC as a means of providing notice to customers of prices, terms, and conditions under which they offer their international and domestic interstate inter-exchange services. Those FCC orders do not apply to the switched and special access services of the regional bell operating companies (“RBOCs”) and other local exchange service providers. The FCC allows permissive detariffing of CLEC access services.
The FCC also has proposed reducing the level of regulation that applies to the ILECs, and increasing their ability to respond quickly to competition from the Company and others. For example, in accordance with the Telecom Act, the FCC has applied “streamlined” tariff regulation to the ILECs, which greatly accelerates the time prior to which changes to tariffed service rates may take effect, and has eliminated the requirement that ILECs obtain FCC authorization before constructing new domestic facilities. These actions allow ILECs to change service rates more quickly in response to competition. Similarly, the FCC has afforded significant new pricing flexibility to ILECs subject to price cap regulation. On August 5, 1999, the FCC adopted an order granting price cap ILECs additional pricing flexibility. The order provided certain immediate regulatory relief regarding price cap ILECs and set forth a framework of “triggers” to provide those companies with greater flexibility to set rates for interstate access services. On February 2, 2001, the D.C. Circuit upheld the FCC’s rules regarding pricing flexibility. To the extent such increased pricing flexibility is utilized for ILECs or such additional regulation is implemented, the Company’s ability to compete with ILECs for certain service could be adversely affected. The FCC has granted pricing flexibility applications for various interstate access services provided by RBOCs in a number of cities, including cities where US LEC competes against BellSouth and Verizon. The FCC has initiated a proceeding to examine its pricing flexibility policy for special access.
On March 2, 2004, the United States Court of Appeals for the D.C. Circuit (“D.C. Circuit”) issued an order (the “TRO Court Order”) reversing a substantial portion of the Triennial Review Order (“TRO”) previously issued by the FCC. The Court vacated the FCC’s decision to order unbundling of mass market switches, DS3 and DS1 loops and dark fiber. The Court affirmed the FCC’s decision not to require unbundling of hybrid loops, fiber-to-the-home loops, and line sharing. The Court also found reasonable the specific eligibility standards for enhanced extended links (“EEL”) (loop transport UNE combinations, which are the same elements that comprise special access facilities purchased by long distance carriers) pursuant to which CLECs may obtain high capacity EELs; however, given the availability of special access, the Court expressed skepticism that carriers providing long distance services or otherwise using special access circuits to provide competitive local exchange services were impaired without access to EELs, and remanded the conversion requirement to the FCC for further
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consideration. The FCC chose not to appeal the TRO Court Order to the U.S. Supreme Court. A number of parties did file an appeal, but the Court declined to accept the appeal. The Order became effective on June 16, 2004.
On August 20, 2004, the FCC released an Order adopting interim rules and issued a Notice of Proposed Rulemaking (“NPRM”) for final UNE rules. On August 24, 2004, Verizon, Qwest and the United States Telecom Association filed a petition for a writ of mandamus with the D.C. Circuit asking the Court to vacate the FCC’s interim rules and to direct the FCC to implement new rules that comply with the mandate of the TRO Court Order. The D.C. Circuit has not issued a final ruling on the mandamus petition.
On October 14, 2004, the FCC adopted an Order in which it granted a petition filed by BellSouth and SureWest seeking reconsideration of the TRO in connection with the ILEC’s unbundling requirements with respect to Fiber-to-the-Curb (“FTTC”), defined as a local loop consisting of fiber optic cable connecting to a copper distribution plant that is not more than 500 feet from the customer’s premises. The FCC concluded that mass market FTTC loops will be regulated the same as mass market Fiber-to-the-Home (“FTTH”) loops, i.e., in new construction, FTTC loops are not required to be unbundled and when an ILEC replaces copper with fiber, the ILEC must either provide access to a 64 kbps transmission path over the fiber loop or unbundled access to a spare copper loop.
At the same time, the FCC clarified a conclusion in the TRO by noting that ILECs are not required to build Time Division Multiplexing (“TDM”) (TDM is used in a network as a technique to combine several low-speed channels into a high-speed channel for transmission; a network that employs TDM techniques must have TDM equipment installed to perform the multiplexing necessary for transmission) capability into new packet-based networks or into existing packet-based networks that never had TDM capability. The FCC also clarified that a “TDM handoff” to a customer on either FTTC or FTTH loops does not require unbundling of these loops. The conclusion that ILECs are not required to build TDM capability into new or existing packet-based networks could impact the Company’s ability to provision broadband services over the hybrid loops (which consist of a mix of fiber and copper line) even where unbundled access to DS1 loops survives. Under the FCC rules, when a CLEC seeks access to a hybrid loop for broadband services (e.g. DS1 loop), the ILEC is only required to provide access to the TDM features, functions and capabilities that already exist on that hybrid loop. With the FCC’s clarification, the ILECs may deploy new packet based networks over hybrid loops with no TDM features, functions and capabilities, and would not be required to provide unbundled access to those new packet based networks.
On December 15, 2004, the FCC adopted an order establishing new rules for UNEs (“Triennial Review Remand Order” or “TRRO”); the text of the decision was released on February 4, 2005. In the TRRO, the FCC modified the unbundling obligations of ILECs. The FCC removed, under certain circumstances, an ILEC’s obligation to unbundle high capacity local loops and dedicated transport and eliminated the obligation to provide local switching. There is a cap of 10 DS1 loops from an ILEC to any single building in an area in which DS1 loops are unbundled. Similarly, there is a cap of 1 DS3 loop from an ILEC to any single building in an area in which DS3 loops are unbundled. A 12-month transition period from March 11, 2005 is provided to transition any embedded UNE DS1 or DS3 Loops that are no longer available as UNEs to another service. During the transition period, the circuit price is increased to the greater of 115% of the rate paid by the carrier as of June 15, 2004 or the price established by a state commission between June 16, 2004 and March 11, 2005. Dark fiber loops are no longer available as UNEs. An 18-month transition period is provided to transition these loops to another service.
The FCC eliminated the “qualifying service” definition, but held that UNE loops cannot be provisioned to provide mobile wireless services or stand-alone long distance services. Other than the restrictions on high capacity EELs, no further restrictions were placed on the use of UNE loops. Also the FCC concluded that carriers may continue to convert special access to UNEs or EELs.
There is a cap of 12 DS3 transport circuits available on an unbundled basis from an ILEC. A 12-month transition period from the effective date of the TRRO is provided for any current UNE transport that is no longer
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available as a UNE under the new rules. During the transition period, the circuit price is increased to the greater of 115% of the TELRIC rate previously paid by the carrier or the price established by a state commission between June 16, 2004 and March 11, 2005.
UNE-P providers have a 12-month transition from March 11, 2005 to transition the embedded customer base to other services, and may not order any new UNE-P upon the effective date of the TRRO.
On February 14, 2005, the ILECs filed a Supplemental Petition for a Writ of Mandamus with the D.C. Circuit asking the Court to issue an order directing the FCC to issue a rule prohibiting the conversion of special access circuits to UNEs and to issue new unbundling rules for high capacity loops and transport that takes into account the availability of tariffed special access services. Several ILECs have appealed the TRRO and, on February 25, 2005, Verizon filed with the FCC a petition for a stay pending appeal of that portion of the TRRO that permits CLECs to convert special access circuits to UNE’s. The Company intends to participate in the appeal of the TRRO as well as in any proceedings seeking a stay of that Order.
Given the uncertainty surrounding the determination of which wire centers meet the requirements for both loops and transport (the FCC has asked the ILECs to identify the wire centers that will be affected), and the ultimate impact of the caps imposed on per-building and per-route UNEs, the Company cannot predict the ultimate effect the TRRO will have in the near future. However, the vast majority of our customers’ circuits currently are not UNE-based; rather, the Company has continued to purchase the majority of customer circuits and other transport facilities either from ILECs at their special access pricing or from other carriers. Thus, while the FCC’s decision to permit, but limit, the availability of UNE loops and transport will not, in and of itself, have a material adverse impact on the Company, it ultimately could remove a significant opportunity for future cost-savings unless the Company is able to circumvent the caps by purchasing either loops or transport from other carriers at competitive prices. The TRRO decision also has implications in the marketplace, where the Company’s UNE-based competitors have had a cost advantage over the Company. The elimination of UNEs in certain key markets, combined with limited availability and higher prices for those UNEs that remain available will reduce this cost advantage. While not directly related, the elimination of some UNEs, and the limitations on others could lead the ILECs to attempt to increase the costs for special access, which the Company would oppose. The elimination of, or higher prices for UNE’s, combined with increases in prices for Special Access could have a material adverse effect on the Company.
Concurrent with the release of the TRRO, the FCC also released a Notice of Proposed Rulemaking (“NPRM”) to initiate a comprehensive review of rules governing the pricing of special access service offered by ILECs subject to price cap regulation. Special access pricing by these carriers currently is subject to price cap rules as well as pricing flexibility rules which permit these carriers to offer volume and term discounts and contract tariffs (Phase I pricing flexibility) and remove special access service in a defined geographic area from price caps regulation (Phase II pricing flexibility) based on showings of competition. The NPRM tentatively concludes that the FCC should continue to permit pricing flexibility where competitive market forces are sufficient to constrain special access prices, but it will undertake an examination of whether the current triggers for pricing flexibility (based on certain levels of collocation by competitors within the defined geographic area) accurately assess competition and have worked as intended. The NPRM also asks for comment on whether certain aspects of ILEC special access tariff offerings, some of which are particularly important to the Company (e.g., basing discounts on previous volumes of service; tying nonrecurring charges and termination penalties to term commitments; and imposing use restrictions in connection with discounts), are unreasonable. Given the early phase of the proceeding, the Company cannot predict the impact, if any, the NPRM will have on the Company’s network cost structure; however, if any of these matters addressed in the NPRM are decided adversely to the Company, it could have a material adverse effect on the Company.
On February 10, 2005, the FCC also released a Further NPRM in the Unified Intercarrier Compensation docket. The FCC had been expected to resolve a number of pending petitions addressing various compensation matters, but did not do so. Instead, the FCC simply announced that it is seeking comment on seven
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comprehensive reform proposals submitted by the industry in order to develop a compensation framework that will address the four common themes for reform that had emerged from the record: (1) encouraging efficient competition and the use of the network; (2) preserving universal service support; (3) fostering technological and competitive neutrality; and (4) minimizing regulatory intervention and enforcement. The Company cannot predict the impact, if any, the FNPRM will have on the Company’s intercarrier compensation revenue; however, if any of these matters addressed in the FNPRM are decided adversely to the Company, it could have a material adverse effect on the Company.
In May 1997, the FCC released an order establishing a significantly expanded federal universal service program which subsidized certain eligible services. For example, the FCC established new subsidies for services provided to qualifying schools, libraries and rural health care providers. The FCC also expanded the federal subsidies to low-income consumers and consumers in high-cost areas. Providers of interstate telecommunications service, such as the Company, as well as certain other entities, must pay for these programs. The Company’s share of the schools, libraries and rural health care funds is based on its share of the total industry telecommunications service and certain defined telecommunications end user revenues. The Company’s share of all other federal subsidy funds is based on its share of the total interstate telecommunications service and certain defined telecommunications end user revenues. Although the Company has made its required contributions to the fund, the amount of the Company’s contribution changes each quarter. As a result, the Company cannot predict the effect these regulations will have on the Company in the future.
Due to the growing deployment of VoIP services, the FCC and state public utility commissions are conducting regulatory proceedings that could affect the regulatory duties and rights of entities such as the Company that plan to provide IP-based voice applications. There is also regulatory uncertainty as to the imposition of access charges and other taxes, fees and surcharges on VoIP services that use the public switched telephone network. There is also regulatory uncertainty as to the imposition of traditional retail, common carrier regulation on VoIP products and services.
In October 2002, AT&T Corporation (“AT&T”) filed a petition for declaratory ruling with the FCC with respect to phone-to-phone Internet Protocol telephony. The petition requested that the FCC affirm that such services are exempt from the access charges applicable to circuit switched inter-exchange calls and that it is lawful to provide such service through local end user services. On April 21, 2004, the FCC denied AT&T’s Petition, finding that AT&T’s specific service offering is a telecommunications service; and (2) that access charges apply to the service. The FCC reasoned that AT&T’s offering involved an interexchange service that: (1) uses ordinary customer premises equipment with no enhanced functionality; (2) originates and terminates on the public switched telephone network; and (3) undergoes no net protocol conversion and provides no enhanced functionality to end users due to the provider’s use of IP technology. In contrast, in February 2003, Pulver.com filed a petition for declaratory ruling that asked the FCC to determine whether computer-to-computer calls over the Internet constituted a “telecommunications service” and, thus, were subject to access charges. On February 12, 2004, the FCC held that Pulver.com’s service is neither telecommunications nor a telecommunications service. The FCC determined that because Pulver.com’s peer-to-peer IP communications service does not offer or provide a transmission service, it is not offering “telecommunications” as defined under the Communications Act. The FCC ruled that the service could not be classified as a “telecommunications service” under the Act because it is a free service not offered to the public for a fee. The FCC also decided to classify Pulver.com’s service as an information service and intends to preempt state regulation of that service. These decisions, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.
On September 22, 2003, Vonage Holdings Corporation, or Vonage, filed a petition with the FCC requesting a declaration that its offerings, which originate on a broadband network in IP format and terminate on the PSTN, or vice versa, are interstate information services not subject to state regulation under the federal Communications Act and existing FCC rules. On November 10, 2004, the FCC adopted an order ruling that Vonage’s service was an interstate service not subject to state regulation. The FCC did not rule whether the service was a
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telecommunications service or an information service under the Act. This decision, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.
On December 23, 2003, Level 3 filed a forbearance petition with the FCC with respect to intercarrier compensation for certain types of IP-based voice communications. Specifically, it requested that the FCC forbear from enforcing provisions of the Communications Act that might otherwise result in the application of interstate and intrastate access charges to certain IP communications. The forbearance petition extends only to communications that either originate on the PSTN and terminate on an IP network, originate on an IP network and terminate on the PSTN, and certain traffic that originates and terminates on the PSTN that is incidental to an IP-PSTN service. The petition does not request forbearance with respect to IP-based voice communications that both originate and terminate on the PSTN, other than incidental traffic, or that originate and terminate on an IP network. The FCC has sought public comment with respect to the forbearance petition. Under the Communications Act, the FCC must make a decision on the petition within one year of the petition’s filing (plus one 90-day extension available at the FCC’s discretion) or the petition is deemed granted as a matter of law. On October 21, 2004, the FCC extended the time period in which it can consider the Petition until March 22, 2005. The Company cannot predict the outcome of this proceeding; however, a decision in this proceeding, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.
On February 5, 2004, SBC Communications Inc. filed two petitions with the FCC relating to IP communications. The first requests a declaratory ruling that all services offered on an IP platform are interstate information services, not telecommunications services, and that they are immune from state regulation as a result. The second requests that the FCC forbear from applying certain common carrier regulation to services offered on IP platforms. The FCC has sought public comment with respect to SBC’s forbearance petition, and, under the Communications Act, the FCC must make a decision on the petition within one year of the petition’s filing (with the possibility of a single 90-day extension available at the FCC’s discretion). If the FCC does not act with respect to SBC’s forbearance petition, the petition is deemed granted as a matter of law. On December 7, 2004, the FCC extended the time to respond to the forbearance petition to May 5, 2005. The FCC has requested comment with respect to SBC’s petition for declaratory ruling. The Company cannot predict the outcome of this proceeding; however, a decision in this proceeding, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.
The state public utility commissions are also conducting regulatory proceedings that could impact our rights and obligations with respect to IP-based voice applications. Previously, the Minnesota Public Utilities Commission or MPUC ruled that Vonage’s Digital Voice service was a telephone service under state law, and ordered Vonage to obtain state certification, file tariffs, and comply with 911 requirements before continuing to offer the service in the state. Vonage filed a request in the Federal District Court for the District of Minnesota to enjoin the MPUC’s decision. On October 16, 2004, a federal judge granted Vonage’s request for an injunction, concluding that Vonage provides an information service immune from state regulation and thereby barring the MPUC from enforcing its decision. On December 22, 2004, the U.S. Court of Appeals for the 8th Circuit affirmed the District Court based on the FCC’s decision that the calls were interstate. This decision, together with the results of other proceedings decided by, or pending before, the FCC could impact the terms and conditions under which the Company offers VoIP products and services.
Proceedings and petitions relating to IP-based voice applications are under consideration in a number of other states, including but not limited to Alabama, California, Kansas, New York, North Dakota, Ohio, Oregon, Pennsylvania, Virginia, Washington, and Wisconsin.
The FCC also adopted a Notice of Proposed Rulemaking seeking comment on the various regulatory issues surrounding “IP-enabled” services. The FCC sought comment on how it might categorize particular types of IP-based services, such as by distinguishing IP services that interconnect with the Public Switched Telephone
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Network or are being utilized as a substitute for traditional telephone services. The Company cannot predict the outcome of these proceedings or other FCC or state proceedings that may affect the Company’s operations or impose additional requirements, regulations or charges upon the Company’s provision of Internet access and related Internet Protocol-based telephony services or the Company’s announced plans to add a voice over IP product.
The FCC has initiated rulemaking proceedings to consider whether advanced services offered by ILECs should be regulated as services offered by a dominant or nondominant carrier, as defined. If the service offerings are deemed nondominant, the ILEC will be subject to lessened regulation. In a related proceeding, the FCC is seeking to determine whether advanced services are information services and what regulations should apply, if that is the case. A finding that advanced services are information services, and not telephone services, could result in significantly lower levels of regulation. The Company cannot predict the outcome of these proceedings.
State Regulation. The Company has all of the state certifications necessary to offer its current services. To the extent that an area within a state in which the Company operates is served by a small (in line counts) or rural ILEC not currently subject to competition, the Company generally does not have authority to service those areas at this time. Most states regulate entry into local exchange and other intrastate service markets, and states’ regulation of CLECs vary in their intensity. The majority of states mandate that companies seeking to provide local exchange and other intrastate services apply for and obtain the requisite authorization from the PUC. This authorization process generally requires the carrier to demonstrate that it has sufficient financial, technical, and managerial capabilities and that granting the authorization will serve the public interest.
In all of the states where US LEC is certified, the Company is required to file tariffs or price lists setting forth the terms, conditions and/or prices for services which are classified as intrastate. In some states, the Company’s tariff may list a range of prices or a ceiling price for particular services, and in others, such prices can be set on an individual customer basis, although the Company may be required to file tariff addenda of the contract terms. The Company is not subject to price cap or to rate of return regulation in any state in which it currently provides services. Some states where the Company operates have adopted detariffing rules.
As noted above, the states have the primary regulatory role over intrastate services under the Telecom Act. The Telecom Act allows state regulatory authorities to continue to impose competitively neutral and nondiscriminatory requirements designed to promote universal service, protect the public safety and welfare, maintain the quality of service and safeguard the rights of consumers. PUCs will implement and enforce most of the Telecom Act’s local competition provisions, including those governing the specific charges for local network interconnection. In some states, those charges are being determined by generic cost proceedings and in other states they are being established through arbitration proceedings. Depending on how such charges are ultimately determined, such charges could become a material expense to the Company.
COMPETITION
ILECs. In each market served by its networks, the Company faces, and expects to continue facing, significant competition from the ILECs, which currently dominate their local telecommunications markets as a result of their historic monopoly position. The ILECs have also entered the long distance markets in virtually all of their service areas. They also offer data and Internet services.
The Company competes with the ILECs on the basis of product offerings, bundling, reliability, state-of-the-art technology, price, network design, ease of ordering and customer service. However, the ILECs have long-standing relationships with their customers and provide those customers with various services, a number of which the Company does not currently offer. In addition, ILECs enjoy a competitive advantage due to their vast financial resources and established brand names. The Company has sought, and will continue to seek, to achieve parity with the ILECs.
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IXCs. Inter-exchange carriers that provide long distance services and other telecommunications services offer or have the capability to offer switched local, long distance, data and Internet services. Some of these carriers have a much larger service footprint than the Company. In addition, there have been a number of mergers and consolidations among IXCs, and some ILECs have sought to merge with or acquire IXCs, in an effort to expand dramatically the reach of their services and, thus, to gain a significant competitive advantage. Both of these groups may have the ability to offer more services and more competitive rates than the Company can offer.
Other CLECs. In the markets where US LEC has a digital switching center, numerous CLECs are also operating. In some cases, the Company competes head-to-head with other CLECs and in some cases the other CLECs seek to serve a different customer base. The Company competes with other CLECs in its markets on the basis of product offerings, bundling, reliability, state-of-the-art technology, price, network design, ease of ordering and customer service. Some of these carriers have competitive advantages over us, including substantially greater financial, personnel and other resources, including brand name recognition and long-standing relationships with customers. In addition, the industry has seen a number of mergers and consolidations among CLECs in an effort to gain a competitive advantage in the sector, while some have entered and subsequently emerged from bankruptcy with dramatically altered business plans and financial structures. Both of these groups may have the ability to offer more competitive rates than the Company can offer.
Internet Service Providers (ISPs). Throughout the Company’s service area, various Internet service providers also operate. In some cases, the Company competes head-to-head with other ISPs, and in some cases, the other ISPs seek to serve a different customer base. The Company competes with other ISPs in its markets on the basis of product offerings, bundling, reliability, state-of-the-art technology, price, network design, ease of ordering and customer service. Some of these carriers have entered and subsequently emerged from bankruptcy, which may give those entities the ability to offer more competitive pricing arrangements than the Company can offer.
Other Competitors. The Company also faces, and expects to continue facing, competition from other potential competitors in certain markets in which the Company offers services. In addition to the ILECs, IXCs and other CLECs, potential competitors capable of offering telecommunications services include long distance carriers, digital subscriber line companies, cable television companies, electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end-users. Another more recent entry has been the VoIP companies, who offer service via voice delivered through the Internet. Many of these potential competitors enjoy competitive advantages based upon existing relationships with subscribers, brand name recognition and vast financial resources. A continuing trend toward business combinations and alliances in the telecommunications industry may create significant new competitors to the Company.
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RISK FACTORS
In addition to the risks described below, you should consider carefully the information contained under the heading “Business—Regulation” and the discussion in Note 7 to our consolidated financial statements.
The Company’s continued success depends on the ability to manage and expand operations effectively.
The Company’s ability to manage and expand operations effectively will depend on the ability to:
| • | offer high-quality, reliable services at reasonable costs; |
| • | install and operate telecommunications switches and related equipment; |
| • | lease access to suitable transmission facilities at competitive prices; |
| • | scale operations; |
| • | obtain successful outcomes in disputes with IXC’s and in litigation, rule-making and regulatory proceedings; |
| • | successfully negotiate, adopt or arbitrate interconnection agreements with other carriers; |
| • | acquire necessary equipment, software and facilities; |
| • | integrate existing and newly acquired technology and facilities, such as switches and related equipment; |
| • | evaluate markets; |
| • | add products; |
| • | monitor operations; |
| • | control costs; |
| • | maintain effective quality controls; |
| • | hire, train and retain qualified personnel; |
| • | enhance operating and accounting systems; |
| • | address operating challenges; adapt to market and regulatory developments; and |
| • | obtain and maintain required governmental authorizations. |
In order for the Company to succeed, these objectives must be achieved in a timely manner and on a cost-effective basis. If these objectives are not achieved, the Company may not be able to compete in existing markets or expand into new markets. A failure to achieve one or more of these objectives could have a material adverse effect on the Company’s business.
In addition, the Company has grown rapidly since inception and expects to continue to grow primarily by expanding our product offerings, adding and retaining customers, acquisitions and entering new markets. The Company expects this growth to place a strain on operational, human and financial resources, particularly if the growth is through acquisitions. The ability to manage operations and expansion effectively depends on the continued development of plans, systems and controls for operational, financial and management needs. The Company cannot give any assurance that these requirements can be satisfied or that the Company’s operations and growth can be managed effectively. A failure to satisfy these requirements could have a material adverse effect on the Company’s financial condition and the ability to implement fully the growth and operating plans.
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The Company will not be able to expand operations if capital is not available when it is needed.
The development and expansion of the Company’s networks requires substantial capital investment. If this capital is not available when needed, the Company’s business could be adversely affected. Capital expenditures totaled $33.4 million in 2004 and are expected to be about the same in 2005, unless the Company’s deployment of future service offerings results in somewhat higher spending levels. The Company also expects to have substantial capital expenditures in 2006 and thereafter.
The Company may be required to seek additional debt or equity financing if business plans and cost estimates are not achieved; operating activities do not generate sufficient cash flow to service debt, fund capital expenditures and finance business operations, or if disputes with IXCs continue; the expansion of our business and existing networks is accelerated significantly; or acquisitions or joint ventures that require incremental capital are consummated.
The indenture governing the Company’s senior secured notes limits our ability to incur additional debt. If the Company were to seek additional debt financing, the terms offered may place significant limits on our financial and operating flexibility, or may not be acceptable. The failure to raise sufficient funds through debt or equity financing on reasonable terms may require the Company to modify or significantly curtail our business plan. This could have a material adverse impact on the Company’s growth, ability to compete, and ability to service debt.
If the Company makes acquisitions, it will incur additional risks that could be harmful to our business.
US LEC may acquire other businesses as a means to expand into new markets, to capture additional market share, or to provide new services. The Company is unable to predict whether or when any prospective acquisitions will occur or the likelihood of completing an acquisition on favorable terms and conditions. Any acquisition involves certain risks including, but not limited to:
| • | difficulties assimilating acquired operations and personnel; |
| • | potential disruptions of the Company’s ongoing business; |
| • | the diversion of resources and management time; |
| • | the possibility that uniform standards, controls, procedures and policies may not be maintained; |
| • | risks associated with entering new markets in which the Company has little or no experience; |
| • | risks related to providing new services with which the Company has little experience; |
| • | the potential impairment of relationships with employees or customers as a result of changes in management; |
| • | difficulties in evaluating the historical or future financial performance of the acquired business; |
| • | integration of network equipment and operating support systems; |
| • |