================================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2001
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period ______________ to ________________
Commission file number 0-20763
McLEODUSA INCORPORATED
(Exact name of registrant as specified in its charter)
Delaware 42-1407240
(State of Incorporation) (IRS Employer Identification No.)
McLeodUSA Technology Park
6400 C Street SW
P.O. Box 3177
Cedar Rapids, Iowa 52406-3177
(Address of principal executive office) (Zip Code)
319-364-0000
(Registrant's telephone number,
including area code)
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 [ ]
The number of shares outstanding of each class of the issuer's common stock as
of November 5, 2001:
Common Stock Class A: ($.01 par value)....... 627,734,497 shares
Common Stock Class B: ($.01 par value)....... None
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INDEX
Page
----
PART I. Financial Information
------------------------------
Item 1. Financial Statements............................................. 3
Consolidated Balance Sheets, September 30, 2001 (unaudited) and
December 31, 2000................................................ 3
Unaudited Consolidated Statements of Operations and Comprehensive
Loss for the three and nine months ended September 30, 2001
and 2000......................................................... 4
Unaudited Consolidated Statements of Cash Flows for the nine
months ended September 30, 2001 and 2000......................... 5
Notes to Consolidated Financial Statements (unaudited)........... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 12
PART II. Other Information
---------------------------
Item 2. Changes in Securities and Use of Proceeds........................ 19
Item 3. Defaults Upon Senior Securities.................................. 19
Item 6. Exhibits and Reports on Form 8-K................................. 19
Signatures................................................................ 21
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
McLEODUSA INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In millions, except shares)
September 30, December 31,
2001 2000
------------- ------------
(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents.................................................. $ 63.4 $ 15.7
Investment in available-for-sale securities................................ 3.6 64.7
Trade receivables, net..................................................... 314.0 337.8
Inventory.................................................................. 14.9 25.1
Deferred expenses.......................................................... 47.9 48.3
Prepaid expenses and other................................................. 23.4 55.0
--------- ---------
TOTAL CURRENT ASSETS...................................................... 467.2 546.6
--------- ---------
Property and equipment
Land and buildings......................................................... 117.9 118.4
Communications networks.................................................... 1,656.7 1,411.4
Furniture, fixtures and equipment.......................................... 498.1 428.6
Networks in progress....................................................... 1,057.8 1,497.7
--------- ---------
3,330.5 3,456.1
Less accumulated depreciation............................................... 650.0 437.0
--------- ---------
2,680.5 3,019.1
--------- ---------
Investments, Intangibles and Other Assets
Other investments.......................................................... 31.6 29.2
Goodwill, net.............................................................. 1,092.7 3,226.2
Other intangibles, net..................................................... 398.5 391.0
Other...................................................................... 122.1 137.3
--------- ---------
1,644.9 3,783.7
--------- ---------
$ 4,792.6 $ 7,349.4
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt....................................... $ 12.6 $ 27.3
Accounts payable........................................................... 192.6 275.9
Accrued payroll and payroll related expenses............................... 39.5 43.0
Other accrued liabilities.................................................. 393.8 393.8
Deferred revenue, current portion.......................................... 19.0 36.4
Customer deposits.......................................................... 35.2 53.8
--------- ---------
TOTAL CURRENT LIABILITIES................................................. 692.7 830.2
Long-term debt, less current maturities..................................... 3,694.0 2,732.2
Deferred revenue, less current portion...................................... 16.0 12.1
Other long-term liabilities................................................. 16.5 18.8
--------- ---------
4,419.2 3,593.3
--------- ---------
Redeemable convertible preferred stock
Preferred, Series B, redeemable, convertible, $.01 par value, authorized,
issued and outstanding 2001 none; 2000 275,000............................ --- 687.5
Preferred, Series C, redeemable, convertible, $.01 par value, authorized,
issued and outstanding 2001 none; 2000 125,000............................ --- 312.5
Preferred, Series D, redeemable, convertible, $.01 par value, authorized,
issued and outstanding 2001 275,000; 2000 none............................ 104.0 ---
Preferred, Series E, redeemable, convertible, $.01 par value, authorized,
issued and outstanding 2001 125,000; 2000 none............................ 43.0 ---
--------- ---------
147.0 1,000.0
--------- ---------
Stockholders' Equity
Capital Stock:
Preferred, Series A, $.01 par value: authorized, issued and outstanding
2001 1,149,375 shares; 2000 1,149,400 shares............................ --- ---
Common, Class A, $.01 par value; authorized 2,000,000,000 shares;
issued and outstanding 2001 626,950,228 shares; 2000 606,596,945
shares................................................................... 6.3 6.1
Common, Class B, convertible, $.01 par value; authorized 22,000,000
shares; issued and outstanding 2001 and 2000 none........................ --- ---
Additional paid-in capital................................................. 3,843.2 3,749.7
Accumulated deficit........................................................ (3,621.1) (1,027.1)
Accumulated other comprehensive income..................................... (2.0) 27.4
--------- ---------
226.4 2,756.1
--------- ---------
$ 4,792.6 $ 7,349.4
========= =========
The accompanying notes are an integral part of these
consolidated financial statements
3
McLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(In millions, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2001 2000 2001 2000
--------- ------- --------- --------
Revenues:
Communications services.......................................... $ 354.7 $ 278.2 $ 1,057.6 $ 721.6
Local exchange services.......................................... 21.2 21.6 64.1 63.8
Directory........................................................ 69.8 60.7 221.0 185.3
Other............................................................ 4.8 6.1 14.4 16.0
--------- ------- --------- --------
TOTAL REVENUES.................................................. 450.5 366.6 1,357.1 986.7
Operating expenses:
Cost of service.................................................. 271.4 204.2 791.5 548.6
Selling, general and administrative.............................. 187.4 147.3 517.4 403.9
Depreciation and amortization.................................... 167.2 113.6 471.4 276.8
Restructuring, asset impairment and other charges................ 2,907.2 --- 2,935.4 ---
--------- ------- --------- --------
TOTAL OPERATING EXPENSES........................................ 3,533.2 465.1 4,715.7 1,229.3
--------- ------- --------- --------
OPERATING LOSS.................................................. (3,082.7) (98.5) (3,358.6) (242.6)
Nonoperating income (expense):
Interest income.................................................. 0.8 12.2 9.7 43.1
Interest expense, net of amounts capitalized..................... (66.2) (40.7) (180.8) (113.6)
Other income (expense)........................................... 39.7 (0.7) 116.5 1.2
--------- ------- --------- --------
TOTAL NONOPERATING INCOME (EXPENSE)............................. (25.7) (29.2) (54.6) (69.3)
--------- ------- --------- --------
LOSS BEFORE EXTRAORDINARY CHARGE................................ (3,108.4) (127.7) (3,413.2) (311.9)
Extraordinary charge on early retirement of debt.................. --- (24.5) --- (24.5)
--------- ------- --------- --------
NET LOSS........................................................ (3,108.4) (152.2) (3,413.2) (336.4)
Gain on exchange of preferred stock............................... 851.2 ---- 851.2 ----
Preferred stock dividend.......................................... (4.8) (13.6) (32.0) (40.8)
--------- ------- --------- --------
NET LOSS APPLICABLE TO COMMON SHARES............................ $(2,262.0) $(165.8) $(2,594.0) $ (377.2)
========= ======= ========= ========
Loss per common share:
Loss before extraordinary charge........................... $ (3.62) $ (0.24) $ (4.20) $ (0.65)
Extraordinary charge....................................... --- (0.04) --- (0.04)
--------- ------- --------- --------
Loss per common share...................................... $ (3.62) $ (0.28) $ (4.20) $ (0.69)
========= ======= ========= ========
Weighted average common shares outstanding........................ 625.5 583.3 617.8 547.3
========= ======= ========= ========
Other comprehensive loss, net of tax:
Unrealized holding losses arising during the period.............. (3.8) (30.5) (5.6) (21.1)
Less: reclassification adjustment for gains included in
net income..................................................... 10.5 (0.5) 23.8 1.8
--------- ------- --------- --------
TOTAL OTHER COMPREHENSIVE LOSS.................................. (14.3) (30.0) (29.4) (22.9)
--------- ------- --------- --------
COMPREHENSIVE LOSS.............................................. $(2,276.3) $(195.8) $(2,623.4) $ (400.1)
========= ======= ========= ========
The accompanying notes are an integral part of these consolidated
financial statements
4
McLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
Nine Months Ended
September 30,
---------------------------------------
2001 2000
--------- --------
Cash Flows from Operating Activities
Net loss............................................................................... $(3,413.2) $ (336.4)
Adjustments to reconcile net loss to net cash (used in) provided by operating
activities:
Depreciation.......................................................................... 280.0 142.7
Amortization.......................................................................... 191.4 134.1
Accretion of interest on senior discount notes........................................ 36.1 31.7
Gain on the sale of assets............................................................ (121.7) ---
Restructuring, asset impairment and other charges..................................... 2,926.8 ---
Changes in assets and liabilities, net of acquisitions:
Trade receivables................................................................. (26.3) (59.0)
Inventory......................................................................... 10.2 (3.2)
Deferred expenses................................................................. 0.4 (3.6)
Prepaid expenses and other........................................................ 8.5 49.2
Accounts payable and accrued expenses............................................. (255.8) 32.0
Deferred revenue.................................................................. (13.5) 23.1
Customer deposits................................................................. (18.6) 17.4
--------- --------
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES............................. (395.7) 28.0
--------- --------
Cash Flows from Investing Activities
Purchases of property and equipment.................................................... (578.4) (876.5)
Other assets........................................................................... (47.6) (32.4)
Available-for-sale securities:
Purchases............................................................................. (69.6) (556.9)
Sales................................................................................. 129.4 34.4
Maturities............................................................................ --- 1,232.3
Proceeds from the sale of assets....................................................... 132.8 ---
Business acquisitions.................................................................. (21.8) (25.3)
Other.................................................................................. (3.7) (42.8)
--------- --------
NET CASH USED IN INVESTING ACTIVITIES........................................... (458.9) (267.2)
--------- --------
Cash Flows from Financing Activities
Net proceeds from long-term debt....................................................... 909.3 554.6
Payments on long-term debt............................................................. (15.4) (313.2)
Net proceeds from issuance of common stock............................................. 34.7 42.0
Payments of preferred stock dividends.................................................. (26.3) (17.5)
--------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES...................................... 902.3 265.9
--------- --------
NET INCREASE IN CASH AND CASH EQUIVALENTS...................................... 47.7 26.7
Cash and cash equivalents:
Beginning.............................................................................. 15.7 326.9
--------- --------
Ending................................................................................. $ 63.4 $ 353.6
========= ========
Supplemental Disclosure of Cash Flow Information:
Cash payment for interest.............................................................. $216.8 $117.6
====== ======
Supplemental Schedule of Noncash Investing and Financing Activities
Capital leases incurred for the acquisition of property and equipment.................. $ 9.8 $ 7.7
====== ======
The accompanying notes are an integral part of these
consolidated financial statements
5
McLEODUSA INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of and for the Three and Nine Months Ended
September 30, 2001 and 2000 is Unaudited)
Note 1: Basis of Presentation
Interim Financial Information (unaudited): The financial statements and related
notes as of September 30, 2001, and for the three and nine month periods ended
September 30, 2001 and 2000, are unaudited, but in the opinion of management
include all adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of our financial position and results of
operations. The operating results for the interim periods are not indicative of
the operating results to be expected for a full year or for other interim
periods. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles in the United States have been condensed or omitted pursuant to
instructions, rules and regulations prescribed by the Securities and Exchange
Commission ("SEC"). Although management believes that the disclosures provided
are adequate to make the information presented not misleading, management
recommends that you read these consolidated condensed financial statements in
conjunction with the audited consolidated financial statements and the related
footnotes included in the Company's Annual Report on Form 10-K for the fiscal
year ended December 31, 2000, filed with the SEC on March 30, 2001.
Reclassifications: Certain items in the consolidated balance sheet for the
period ending December 31, 2000 have been reclassified to be consistent with the
presentation in the September 30, 2001 unaudited financial statements.
Note 2: Supplemental Asset Data
Trade Receivables: The composition of trade receivables, net, is as follows:
September 30, December 31,
2001 2000
-------- --------
(In millions)
Trade Receivables:
Billed.......................................... $ 344.1 $ 323.4
Unbilled........................................ 86.3 120.4
------- -------
430.4 443.8
Allowance for doubtful accounts and discounts.... (116.4) (106.0)
------- -------
$ 314.0 $ 337.8
======= =======
Note 3: Acquisitions
Splitrock Services, Inc. (Splitrock): On March 30, 2000, the Company acquired
Splitrock pursuant to the Amended Plan of Merger dated February 11, 2000, in
exchange for approximately 93.2 million shares of Class A common stock. The
total purchase price was approximately $2.3 billion based on the average closing
price of the Company's Class A common stock five days before and after January
6, 2000, the initial date of signing the Merger Agreement. Approximately $261
million in Splitrock debt remained outstanding after the closing. This debt has
been retired.
CapRock Communications Corp. (CapRock): On December 7, 2000, the Company
acquired CapRock pursuant to an Agreement and Plan of Merger, dated October 2,
2000, in exchange for approximately 15.0 million shares of Class A common stock.
The total purchase price was approximately $579 million based on the average
closing price of the Company's Class A common stock for the ten trading days
beginning five days prior to October 2, 2000, the date the merger was announced,
plus the principal amount of outstanding CapRock senior notes of $360 million.
These CapRock senior notes were exchanged for senior notes of the Company.
6
The following table summarizes the purchase price allocations for business
acquisitions in the nine months ended September 30, 2001 and 2000 (in millions):
Transaction Year: 2001 2000
----------------- ------- ----------
Cash purchase price $21.8 $ 25.4
Acquisition costs 0.9 43.7
Promissory notes 4.8 56.7
Stock issued 37.8 1,838.3
Option agreements -- 103.3
----- --------
$65.3 $2,067.4
===== ========
Working capital acquired, net $(0.7) $ 15.8
Fair value of other assets acquired 4.0 184.5
Intangibles 62.0 2,157.8
Liabilities assumed -- (290.7)
----- --------
$65.3 $2,067.4
===== ========
The 2001 figures above include two minor acquisitions made during the first six
months of the year. These acquisitions have been accounted for as purchases and
the results of operations are included in the consolidated financial statements
since the dates of acquisition.
The following is the unaudited consolidated results of operations for the nine
months ended September 30, 2000 on a pro forma basis as though Splitrock and
CapRock had been acquired as of January 1, 2000 (in millions, except per share
data):
Revenue.................................................. $1,208.7
Net loss applicable to common shares..................... (422.1)
Loss per common share.................................... (0.71)
The pro forma financial information is presented for informational purposes only
and is not necessarily indicative of the operating results that would have
occurred had the acquisitions been consummated as of the above dates, nor are
such operating results necessarily indicative of future operating results.
Note 4: Restructuring and Impairment Charges
During the second quarter of 2001, the Company instituted a plan to reduce costs
and focus operations on its core 25 state footprint. In conjunction with this
plan, the Company recorded a $28.2 million charge for the reduction of its
workforce by approximately 900 employees and the termination of leases
associated with the abandonment of office and equipment space. During the third
quarter of 2001, the Company decided on a comprehensive restructuring of its
business. Under this restructuring the Company decided to (1) abandon its plans
for a national network and place the associated assets up for sale; (2) sell
other non-core and non-operating assets; (3) further reduce the workforce by
approximately 1,500 employees and (4) consolidate and eliminate certain existing
duplicative facilities.
The third quarter restructuring resulted in a $2.9 billion charge to write down
goodwill and other long-lived assets associated with the national network, other
non-core assets and construction work-in-progress ($2.7 billion), provide for
involuntary employee separations ($11.5 million), provide for facilities
consolidations ($127.9 million) and other contractual commitments related to
national network and software development projects ($60.9 million). The Company
also recorded a charge to operating income of approximately $35 million in the
third quarter associated with balance sheet adjustments to various accounts such
as prepaid expenses, receivables and bad debt reserves.
Included in the write down is approximately $2.1 billion in goodwill and other
intangible assets which originated from numerous acquisitions, most notably
Splitrock. In addition, the Company reduced long-lived assets and construction
work-in-progress associated with Splitrock by approximately $260 million to
appropriately mark those assets to fair value. As a result of abandoning the
Company's plans for a national network, the Company has decided to sell certain
assets acquired in the Splitrock transaction and other businesses which are no
longer considered core strategic businesses.
In addition to the operating assets above, the Company has reduced other long-
lived assets and construction work-in-progress by $313.0 million to reflect the
net realizable value of certain non-core assets which the Company plans to
actively market and sell over the next twelve months.
7
The following table shows the charges, uses and remaining liability by segment
for the nine months ended September 30, 2001 (in millions):
Reductions
through
Second quarter Third quarter September 30, Remaining
Communication Services charges charges 2001 liability
---------------------- -------------- ------------- ------------- ---------
Goodwill and other intangible assets $ -- $2,123.8 $2,123.8 $ --
Long-lived assets and construction
work-in-progress -- 573.1 573.1 --
Employee separations 9.6 10.1 7.6 12.1
Facility closure costs 7.4 127.9 39.3 96.0
Other contractual commitments -- 60.9 -- 60.9
------ -------- -------- -------
Total $ 17.0 $2,895.8 $2,743.8 $ 169.0
====== ======== ======== =======
Reductions
through
Second quarter Third quarter September 30, Remaining
Other charges charges 2001 liability
----- -------------- ------------- ------------- ---------
Employee separations $ 3.2 $ 1.4 $ 2.1 $ 2.5
Facility closure costs 8.0 -- 0.4 7.6
------ -------- -------- -------
Total $ 11.2 $ 1.4 $ 2.5 $ 10.1
====== ======== ======== =======
Note 5: Information by Business Segment
The Company operates predominantly in two reportable operating segments:
(1) Communications Services: providing communications and related services, such
as local and long distance service, providing end-to-end data communications,
telecommunications network sales and expanding fiber optic network; and
(2) Directory: selling advertising space in telephone directories, and
publishing and distributing directories to local area subscribers. These
business segments have separate management teams and infrastructures that offer
different products and services.
The Company previously reported under three operating segments after the
acquisition of Splitrock on March 30, 2000. The former Splitrock entity
operations were reported under the Data segment. Due to changes in the
Company's structure and the way it evaluates performance, the Data segment has
been combined with the Communications Services segment. The three and nine
month periods ended September 30, 2000 have been restated for this change.
The Company evaluates the performance of its operating segments based on
earnings before interest, taxes, depreciation and amortization, excluding
general corporate expenses ("EBITDA"). The accounting policies of the
reportable segments are the same as those described in Note 1 of Notes to
Consolidated Financial Statements in the Company's Annual Report on 10-K.
Identifiable assets (excluding intersegment receivables) are the Company's
assets that are identified in each business segment. Other primarily includes
cash and cash equivalents, investments in available-for-sale securities,
administrative headquarters and goodwill recorded as a result of acquisitions.
In 2001 and 2000, no single customer or group under common control represented
10% or more of the Company's sales.
8
Segment information for the three and nine months ended September 30, 2001 and
2000 was as follows (in millions):
Three months ended Communications
September 30, 2001 Services Directory Other Total
------------------- -------------- ---------- ----------- -----------
Revenues $ 380.7 $ 69.8 $ -- $ 450.5
====================================================
EBITDA $ (11.9) $ 11.3 $ (7.7) $ (8.3)
Depreciation and Amortization (109.8) (8.9) (48.5) (167.2)
Interest Income -- -- 0.8 0.8
Interest Expense (1.3) -- (64.9) (66.2)
Restructuring Charge and Other (2,895.8) -- (11.4) (2,907.2)
Taxes and Other 4.3 -- 35.4 39.7
-------------------------------------------------
Net Income (Loss) $(3,014.5) $ 2.4 $ (96.3) $(3,108.4)
=====================================================
Nine months ended
September 30, 2001
Revenues $ 1,136.1 $221.0 $ -- $ 1,357.1
=====================================================
EBITDA $ 23.3 $ 40.4 $ (15.5) $ 48.2
Depreciation and Amortization (293.5) (26.9) (151.0) (471.4)
Interest Income 0.3 0.1 9.3 9.7
Interest Expense (3.3) -- (177.5) (180.8)
Restructuring Charge and Other (2,912.8) -- (22.8) (2,935.4)
Taxes and Other (2.4) (0.3) 119.2 116.5
-------------------------------------------------
Net Income (Loss) $(1,068.3) $ 13.3 $(2,358.2) $(3,413.2)
=====================================================
As of September 30, 2001
Total assets $ 2,986.7 $515.5 $ 1,290.4 $ 4,792.6
Three months ended
September 30, 2001
Capital expenditures, including
acquisitions $ 120.3 $ 0.6 $ 4.7 $ 125.6
Nine months ended
September 30, 2001
Capital expenditures, including
acquisitions $ 538.3 $ 32.4 $ 68.1 $ 638.8
Three months ended Communications
September 30, 2001 Services Directory Other Total
------------------- -------------- ---------- ----------- -----------
Revenues $ 304.7 $ 61.9 $ -- $ 366.6
=====================================================
EBITDA $ 14.9 $ 9.5 $ (9.3) $ 15.1
Depreciation and Amortization (62.1) (8.6) (42.9) (113.6)
Interest Income 0.5 0.1 11.6 12.2
Interest Expense (1.7) -- (39.0) (40.7)
Taxes and Other (1.4) -- 0.7 (0.7)
-------------------------------------------------
Net Income (Loss)
before extraordinary charge (49.8) 1.0 (78.9) (127.7)
Extraordinary charge (24.5) (24.5)
-------------------------------------------------
Net Income (Loss) $ (49.8) $ 1.0 $ (103.4) $ (152.2)
=====================================================
Nine months ended
September 30, 2000
Revenues $ 798.6 $188.1 $ -- $ 986.7
=====================================================
EBITDA $ 21.8 $ 36.0 $ (23.6) $ 34.2
Depreciation and Amortization (151.7) (23.6) (101.5) (276.8)
Interest Income 1.8 0.5 40.8 43.1
Interest Expense (11.8) -- (101.8) (113.6)
Taxes and Other (5.0) (0.1) 6.3 1.2
-------------------------------------------------
Net Income (Loss)
before extraordinary charge (144.9) 12.8 (179.8) (311.9)
Extraordinary charge (24.5) (24.5)
-------------------------------------------------
Net Income (Loss) $ (144.9) $ 12.8 $ (204.3) $ (336.4)
=====================================================
As of September 30, 2000
Total assets $ 2,523.5 $498.9 $ 3,647.3 $ 6,669.7
Three months ended
September 30, 2000
Capital expenditures, including
acquisitions $ 308.5 $ 16.2 $ 7.2 $ 331.9
Nine months ended
September 30, 2000
Capital expenditures, including
acquisitions $ 860.6 $ 59.2 $ 2,024.9 $ 2,944.7
9
Note 6: Effects of New Accounting Standards
Accounting for Business Combinations
In July 2001, the FASB issued SFAS No. 141, "Accounting for Business
Combinations," effective for all business combinations initiated and made after
June 30, 2001. SFAS 141 requires all business combinations be accounted for
under the purchase method and establishes additional reporting requirements for
business combinations. The Company currently accounts for all business
combinations under the purchase method and does not expect adoption of this
statement to have an effect on the Company's operations.
Accounting for Goodwill and Other Intangible Assets
In July 2001, the FASB issued SFAS No. 142, "Accounting for Goodwill and Other
Intangible Assets," effective for fiscal years beginning after December 15,
2001. Early implementation is not allowed. SFAS 142 requires the use of a non-
amortization approach to account for purchased goodwill and for separately
recognized (non-goodwill) intangible assets that have an indefinite useful life.
Under this approach, goodwill and intangibles with indefinite lives will not be
amortized, but will be periodically reviewed for impairment and expensed against
earnings only in periods in which the recorded value exceeds the fair value.
The Company has not yet quantified the impacts of adopting this statement, but
it could result in significant changes to amortization expense and the
classification and recording of intangibles currently on the books, as well as
any future acquisitions.
Accounting for Asset Retirement Obligations
In July 2001 the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations." The Statement requires entities to record the fair value of a
liability for an asset retirement obligation in the period in which the legal or
contractual removal obligation is incurred. The statement is effective for
fiscal years beginning after June 15, 2002, with earlier application encouraged.
The Company is currently evaluating the impact that the statement will have on
its financial position and the results of operations.
Accounting for the Impairment or Disposal of Long-Lived Assets
SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets"was
issued in October, 2001. The statement covers a variety of implementation issues
inherent in SFAS No. 121, unifies the framework used in accounting for assets to
be disposed of and discontinued operations, and broadens the reporting of
discontinued operations to include all components of an entity with operations
that can be distinguished from the rest of the entity and that will be
eliminated from the ongoing operations of the entity in a disposal transaction.
The Company is currently evaluating the impact that the statement will have on
its financial position and the results of operations.
Note 7: Asset Sales
During the nine months ended September 30, 2001, the Company received aggregate
net proceeds of $167.6 million and recorded gains of $121.7 million related to
sales of its PCS licenses, available-for-sale equity securities and two
incumbent local telephone service exchanges.
Note 8: Redeemable Convertible Preferred Stock
Pursuant to an Exchange Agreement, dated September 30, 2001, (the "Exchange
Agreement") the Company and the holders of the Series B and C Preferred Shares
executed a one-for-one exchange of all 275,000 shares of Series B Preferred and
all 125,000 shares of Series C Preferred (collectively referred to as the
"Original Redeemable Preferred Shares") for 275,000 shares of Series D Preferred
and 125,000 shares of Series E Preferred (collectively referred to as the "New
Redeemable Preferred Shares") in a non-cash transaction. The provisions of the
New Redeemable Preferred Shares essentially mirror those of the Original
Redeemable Preferred Shares except no dividends (other than the common
equivalent
10
dividend as provided for in the Original Redeemable Preferred Shares) will be
paid on the New Redeemable Preferred Shares and the New Redeemable Preferred
Shares shall be convertible into the shares of the Company's Class A common
stock at a rate of (a) the liquidation preference of $2,500 per share divided by
(b) $6.10 (unless subsequently adjusted). The New Redeemable Preferred Shares
rank on a parity with the Company's 6.75% Series A Cumulative Convertible
Preferred Stock, par value $.01 per share (the "Series A Preferred Stock"), with
respect to dividend rights and rights on liquidation.
The exchange of the Original Redeemable Preferred Shares for the New Redeemable
Preferred Shares was based on the fair value of those securities at the date of
the Exchange Agreement. For financial accounting purposes, the carrying value
of the Original Redeemable Preferred Shares ($1.0 billion) over the fair value
of the New Redeemable Preferred Shares ($147.0 million) was recorded as a gain
on preferred stock exchange, net of transaction costs, and has reduced the
Company's reported net loss to arrive at net loss available to common
stockholders for the period ended September 30, 2001. The New Redeemable
Preferred Shares are redeemable on a proportionally equal basis, in whole or in
part, by the holders within 180 days following September 15, 2009. The Company
can declare mandatory conversion after September 15, 2006 if the 60 day average
market price of the Class A common stock exceeds the conversion price by at
least 1%. The New Redeemable Preferred Shares will accrete for book purposes to
its liquidation value of $1 billion by September 15, 2009, using the effective
interest method, which will reduce prospective earnings available to common
stockholders.
Note 9: Cumulative Convertible Preferred Stock
The Company elected not to declare the quarterly stock dividend on its 6.75%
Series A Cumulative Convertible Preferred Stock that otherwise would have been
payable on November 15, 2001. The dividend is payable in cash or in shares of
McLeodUSA Class A Common Stock at a rate of $4.21875 per share of Series A
Preferred Stock owned. The dividend will continue to accumulate at the rate of
6.75% annually. As of September 30, 2001, cumulative unpaid dividends totaled
approximately $2.4 million.
Note 10: Subsequent Event
Debt Draw
On October 19, 2001, the Company drew an additional $200 million under its $1.3
billion Secured Credit Facility, leaving an undrawn committed balance of
approximately $342 million.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Statements included in this discussion relating, but not limited, to future
revenues, operating expenses, capital requirements, growth rates, cash flows,
operational performance, sources and uses of funds, acquisitions, and
technological changes and developments, are forward-looking statements that
involve certain risks and uncertainties. Factors that may cause the actual
results, performance, achievements or investments expressed or implied by such
forward-looking statements to differ materially from any future results,
performance, achievements or investments expressed or implied by such forward-
looking statements include, among other things, the availability of financing
and regulatory approvals, the number of potential customers in a target market,
the existence of strategic alliances and relationships, technological,
regulatory or other developments in our business, changes in the competitive
climate in which we operate and the emergence of future opportunities and other
factors more fully described under the caption "Business--Risk Factors" in the
our Annual Report on Form 10-K for the fiscal year ended December 31, 2000,
filed with the Securities and Exchange Commission on March 30, 2001 and which
section is incorporated herein by reference.
Unless otherwise indicated, all dollar amounts in the following Management's
Discussion and Analysis of Financial Condition and Results of Operations that
exceed $1 million have been rounded to one decimal place and all dollar amounts
less than $1 million have been rounded to the nearest thousand.
Overview
We provide integrated communications services, including local services, in 25
Midwest, Southwest, Northwest and Rocky Mountain states. We are a facilities-
based telecommunications provider with, as of September 30, 2001, 393 ATM
switches, 58 voice switches, 437 collocations, 520 DSLAMS, over 31,000 route
miles of fiber optic network and approximately 10,700 employees. In the next 12
months, we plan to distribute 34 million telephone directories in 26 states,
serving a population of 58 million. McLeodUSA is traded on The Nasdaq Stock
Market under the Symbol MCLD.
We derive most of our revenue from our core competitive telecommunications
business and related communications services, including:
o local and long distance services
o dial and dedicated Internet access
o High speed Internet access services, such as digital subscriber line
(DSL) and cable modem
o bandwidth leasing and colocation services
o facilities and services dedicated for a particular customer's use
o value-added services such as virtual private networks and web hosting
We also derive revenue from the following additional services related to our
core business:
o sale of advertising in print and electronic telephone directories
o traditional local telephone company services in east central Illinois
and southeast South Dakota
o telemarketing services
o telephone and computer sales, leasing, networking, service and
installation
o other communications services, including video, cellular, operator,
payphone, mobile radio and paging services
The table set forth below summarizes our percentage of revenues from these
sources:
Quarter Ended September 30,
---------------------------
2001 2000
---- ----
Communications services.............. 79% 76%
Local exchange services.............. 5 6
Directory............................ 15 16
Other................................ 1 2
---- ----
100% 100%
==== ====
12
Our principal operating expenses consist of cost of service; selling, general
and administrative expenses ("SG&A"); and depreciation and amortization. Cost
of service primarily includes local and long distance services purchased from
certain MegaBells and interexchange carriers, the cost of providing local
exchange services in the independent local exchange service areas, the cost of
fiber related to bandwidth leasing and the cost of printing and distributing
telephone directories. SG&A consists of sales and marketing, customer service
and administrative expenses, including the costs associated with operating our
communications network. Depreciation and amortization include depreciation of
our communications network and equipment; amortization of goodwill and other
intangibles related to our acquisitions; and amortization over the life of the
customer contract of one-time direct installation costs associated with
transferring customers' local line service from the MegaBells to our local
telecommunications service.
On September 30, 2001, our Board of Directors approved a plan to revise our
corporate strategy to focus primarily on providing voice and data services to
small and medium size businesses and residential customers within our 25 state
footprint. As a result we have abandoned our plans for a national network and
will de-emphasize certain wholesale services. Our revised strategy is to focus
company resources on our core competitive local exchange services and publishing
business. In connection with this revised corporate strategy we have also
decided to take the following actions:
o Abandon the development of our national network and place the associated
assets for sale and, in addition, sell other non-core assets and excess
inventory.
o Reduce employment by approximately 15% and execute plans to consolidate
certain existing facilities and eliminate certain others.
o Reduce capital expenditure plans for 2002 from $400 million to $350
million, primarily focused on completing current construction work-in-
process , augmenting existing capacity where needed, and new customer
requirements.
o Take non-cash charges of approximately $2.9 billion in the third quarter
to reflect write-downs of goodwill and other long-lived assets, write off
inventory and construction work-in-process for discontinued operations
and establish a restructuring reserve for a reduction in force and
facility consolidation. The Company also recorded a charge to operating
income of approximately $35 million in the third quarter associated with
balance sheet adjustments to various accounts such as prepaid expenses,
receivables and bad debt reserves.
As part of the revised corporate strategy, we have also established five cross-
functional teams to strengthen business processes and bring improvements to the
operations of the Company. These teams are focused on sales efficiencies,
provisioning and customer installation, billing and revenue assurance, cash
management and business forecasting and planning.
We have experienced operating losses since our inception as a result of efforts
to build our customer base, develop and construct our communications network
infrastructure, build our internal staffing, develop our systems and expand into
new markets. While we will continue to focus on increasing our customer base
and bringing our customer base onto our network, our focus will shift more
towards improving our operating margins by grooming our network to deliver
service in the most effective and efficient manner, as well as scaling back
certain general and administrative functions. This approach could have a
negative impact on our revenue growth, but should better leverage our existing
assets to produce more profitable revenues.
We may be forced to change our strategy to respond to a changing competitive
environment and we cannot assure you that we will be able to maintain our
operating margin. We cannot assure you that through our revised strategy we
will be able to achieve or sustain profitability or positive cash flows.
We have generated net operating losses since our inception and, accordingly,
have incurred no income tax expense. We have reduced the net deferred tax
assets generated by these losses by a valuation allowance which offsets the net
deferred tax asset due to the uncertainty of realizing the benefit of the tax
loss carry forwards. We will reduce the valuation allowance when, based on the
weight of available evidence, it is more likely than not that some portion or
all of the deferred tax assets will be realized.
Three Months Ended September 30, 2001 Compared with Three Months Ended September
30, 2000
Our total revenue grew $83.9 million or 23% in the quarter ended September 30,
2001. Communications services revenues accounted for $76.5 million of this
increase, primarily comprised of increases in retail and wholesale revenues of
$33.3 million and $35.2 million, respectively. The increase in retail revenues
13
is driven by a 34% increase in our customer base from September 30, 2000 to
September 30, 2001, excluding the customers added through the acquisition of
CapRock. The increase to wholesale is largely due to the inclusion of CapRock
wholesale fiber revenues in 2001. CapRock was not acquired until the fourth
quarter of 2000, and is due largely to reductions in personnel and elimination
of duplicative facilities during the second and third quarters of 2001.
Cost of service increased from $204.2 million for the three months ended
September 30, 2000, to $271.4 million for the three months ended September 30,
2001, representing an increase of $67.2 million or 33%. Cost of service
primarily includes local and long distance services purchased from certain
MegaBells and interexchange carriers, the cost of providing local exchange
services in the independent local exchange service areas, the cost of fiber
related to bandwidth leasing, and the cost of printing and distributing
telephone directories. Excluding our wholesale dial-up internet business,
identified in our restructuring as a non-core asset to be sold, our margins have
dropped to 42%, from 44% during the quarter ended September 30, 2000, resulting
from a decline in both long distance and access rates from the prior year.
SG&A increased from $147.3 million for the three months ended September 30, 2000
to $187.4 million for the three months ended September 30, 2001, an increase of
$40.1 million or 27%. The increase was driven by bad debt expense of $26.4
million in the third quarter of 2001 versus $5.2 million in bad debt expense for
the three months ended September 30, 2000 and is attributed to the acquisition
of CapRock and the impact of the slowing economy. The remaining increase in
SG&A is primarily due to the cost of additional resources to grow and support
our customer base. Excluding the incremental bad debt expense in the quarter
ended September 30, 2001 of $21.2 million, our SG&A has decreased as a
percentage of revenues to 37% from 40% when comparing the third quarter of 2001
to the third quarter of 2000, and is due largely to reductions in personnel and
elimination of duplicate facilities during the second and third quarters of
2001.
Depreciation and amortization expenses increased from $113.6 million for the
three months ended September 30, 2000 to $167.2 million for the three months
ended September 30, 2001. The increase is attributed to a higher depreciable
asset base as a result of increased assets placed in service.
During the second quarter of 2001, the Company instituted a plan to reduce costs
and focus operations on its core 25 state footprint. In conjunction with this
plan, the Company recorded a $28.2 million charge for the reduction of its
workforce by approximately 900 employees and the termination of leases
associated with the abandonment of office and equipment space. During the third
quarter of 2001, the Company decided on a comprehensive restructuring of its
business. Under this restructuring the Company decided to (1) abandon its plans
for a national network and place the associated assets up for sale; (2) sell
other non-core and non-operating assets; (3) further reduce the workforce by
approximately 1,500 employees and (4) consolidate and eliminate certain existing
duplicative facilities.
The third quarter restructuring resulted in a $2.9 billion charge to write down
goodwill and other long-lived assets associated with the national network, other
non-core assets and construction work-in-progress ($2.7 billion), provide for
involuntary employee separations ($11.5 million), provide for facilities
consolidations ($127.9 million) and other contractual commitments related to
national network and software development projects ($60.9 million). The Company
also recorded a charge to operating income of approximatley $35 million in the
third quarter associated with balance sheet adjustments to various accounts such
as prepaid expenses, receivables and bad debt reserves.
Included in the write down is approximately $2.1 billion in goodwill and other
intangible assets which originated from numerous acquisitions, most notably
Splitrock. In addition, the Company reduced long-lived assets and construction
work-in-progress associated with Splitrock by approximately $260 million to
appropriately mark those assets to fair value. As a result of abandoning the
Company's plans for a national network, the Company has decided to sell certain
assets acquired in the Splitrock transaction and other businesses which are no
longer considered core strategic businesses.
In addition to the operating assets above, the Company has reduced other long-
lived assets and construction work-in-progress by $313.0 million to reflect the
net realizable value of certain non-core assets which the Company plans to
actively market and sell over the next twelve months.
14
The following table shows the charges, uses and remaining liability by segment
for the nine months ended September 30, 2001 (in millions):
Second quarter Third quarter Reductions through Remaining
Communication Services charges charges September 30, 2001 liability
---------------------- -------------- ------------- ------------------ ---------
Goodwill and other intangible assets $ --- $2,123.8 $2,123.8 $ ---
Long-lived assets and construction
work-in-progress --- 573.1 573.1 ---
Employee separations 9.6 10.1 7.6 12.1
Facility closure costs 7.4 127.9 39.3 96.0
Other contractual commitments --- 60.9 --- 60.9
--------- -------- -------- ---------
Total $ 17.0 $2,895.8 $2,743.8 $ 169.0
========= ======== ======== =========
Second quarter Third quarter Reductions through Remaining
Other charges charges September 30, 2001 liability
----- -------------- ------------- ------------------ ---------
Employee separations $ 3.2 $ 1.4 $ 2.1 $ 2.5
Facility closure costs 8.0 --- 0.4 7.6
--------- -------- -------- ---------
Total $ 11.2 $ 1.4 $ 2.5 $ 10.1
========= ======== ======== =========
Interest income decreased from $12.2 million for the three month period ended
September 30, 2000, to $0.8 million for the same period in 2001 as a result of a
lower average investment balance.
Gross interest expense increased from $59.6 million for the third quarter of
2000 to $90.8 million for the third quarter of 2001. The incremental $31.2
million of interest incurred relates to the additional draw of $175 million on
our Credit Facilities in July 2001, our 12% senior notes, 11 1/2% senior notes,
and 11 3/8% senior notes, all outstanding for the entire quarter in 2001,
partially offset by lower floating interest rates on the Tranche B Term Facility
borrowing under the Credit Facilities. Interest expense of approximately $24.6
million and $18.9 million was capitalized as part of our construction of fiber
optic network during the third quarter of 2001 and 2000, respectively.
Other income increased to $39.7 million from a loss of $0.7 million for the
three months ended September 30, 2000 resulting from the gain on the sale of
certain assets, primarily our remaining PCS licenses and available-for-sale
equity investments.
Net loss applicable to common shares increased from $165.8 million for the three
months ended September 30, 2000 to $2,262.0 million for the three months ended
September 30, 2001, an increase of $2,096.2 million. This increase resulted
primarily from the following factors: (1) the restructuring and asset impairment
charges totaling $2,907.2 million; (2) the expansion of our local and long
distance services, which requires significant expenditures, a substantial
portion of which is incurred before the realization of revenues; (3) the
increased depreciation expense related to the construction and expansion of our
communications networks; and (4) net interest expense on indebtedness to fund
market expansion and network development. These items were partially offset by
the gain on the preferred stock exchange discussed in Note 8 to the financial
statements.
Nine Months Ended September 30, 2001 Compared with Nine Months Ended September
30, 2000
Revenues increased by $370.4 million or 38% to $1,357.1 million during the nine
months ended September 30, 2001. The increase in revenues is attributed to the
growth in our customer base, which has grown by 34% from September 30, 2000
excluding CapRock, as well as additional wholesale revenues associated with our
acquisition of CapRock. Directory revenues increased by $35.7 million to
$221.0 million primarily through acquisitions.
Cost of service increased by $242.9 million to $791.5 million for the period
ending September 30, 2001. Gross margins have declined from 44% during 2000 to
42% in 2001. The deterioration in margins is principally driven by lower long
distance and access rates.
SG&A increased $113.5 million or 28% for the nine months ended September 30,
2001. The increase was driven by the incremental bad debt expense during
the third quarter 2001, primarily as a result of the acquisition of CapRock and
general market conditions. Excluding the third quarter 2001 incremental bad debt
expense, SG&A decreased as a percentage of revenues from 41% to 37%, and is
largely due to reductions in personnel and elimination of duplicative facilities
during the second and third quarters of 2001. The remaining increase in SG&A is
principally due to the cost of additional resources to grow and support our
customer base.
Excluding the the incremental bad debt expense incurred during the third
quarter primarily$as a result of general market conditions, SG&A decreased as a
percentage of revenues from 41% to 37%.
15
Depreciation and amortization expenses increased from $276.8 million for the
nine months ended September 30, 2000 to $471.4 million for the nine months ended
September 30, 2001, representing an increase of $194.6 million. The increase is
attributed to a higher depreciable asset base as a result of continued
infrastructure investment and increased assets placed in service.
Interest income decreased to $9.7 million for the period ended September 30,
2001, from $43.1 million for the same period in 2000. This decrease resulted
from a lower average investment balance during 2001.
Gross interest expense increased from $156.1 million for the first nine months
of 2000 to $269.9 million for the first nine months of 2001. This rise in gross
interest expense is the result of increased borrowings primarily to finance
capital expenditures for the expansion and installation of our fiber optic
communications network. Our total debt increased by $1.3 billion through the
issuance of our 12%, 11 1/2%, and 11 3/8% senior notes totaling $1.1 billion
and the draw of $175 million on our Credit Facilities. Interest expense of
approximately $89.0 million and $42.5 million was capitalized as part of our
construction of fiber optic network during the first nine months of 2001 and
2000, respectively.
Net loss applicable to common shares increased from $377.2 million in 2000 to
$2,594.0 million during 2001, an increase of $2,216.8 million. This increase
resulted primarily from the following factors: (1) the restructuring and asset
impairment charges totaling $2,935.4 million; (2) the expansion of our local and
long distance services, which requires significant expenditures, a substantial
portion of which is incurred before the realization of revenues; (3) the
increased depreciation expense related to the construction and expansion of our
communications networks; and (4) net interest expense on indebtedness to fund
market expansion and network development. These items were partially offset by
the gain on preferred stock exchange discussed in Note 8 to the financial
statements.
Liquidity and Capital Resources
Cash used in operating activities was $395.7 million for the nine months ended
September 30, 2001. Cash was used to fund the incremental interest expense of
$67.2 million caused by our higher outstanding debt balance during 2001. Cash
was also used to fund the decrease in accounts payable and accrued liabilites
primarily to pay CapRock liabilites assumed in the acquisition.
Cash used in investing activities during 2001 totaled $458.9 million, compared
to $267.2 million in the first nine months of 2000. Capital expenditures,
totaling $578.4 million in 2001, continue to be our primary use of capital
resources to fund the expansion of our communications networks. We expect to
significantly reduce our capital expenditures in 2002 due to our focus on market
growth within our 25-state footprint. This usage for capital expenditures was
partially offset by proceeds of $125.6 million from the sale of our PCS licenses
and $136.6 million from the sale of other assets and equity securities.
Cash provided by financing activities totaled $902.3 million in 2001, compared
to $265.9 million provided in the nine months ended September 30, 2001. The net
cash proceeds from the increases in our total debt from December 31, 2000 was
primarily due to the issuance of our $750 million 11 3/8% senior notes and the
draw of $175 million on our Credit Facilities. Other net proceeds included
$34.7 million from the issuance of common stock offset by payments on long-term
debt and payments of preferred stock dividends of $15.4 million and $26.3
million in 2001 and 2000, respectively.
As of September 30, 2001, our total debt was $3.7 billion, an increase of
approximately $950 million from December 31, 2000. At September 30, 2001, we
had available cash, cash equivalents and short-term investments of $67.1 million
and $550 million available under our Credit Facilities. In October 2001, we
borrowed an additional $200 million under the Credit Facilities, leaving an
undrawn committed balance of approximately $342 million.
In addition, as part of implementing our revised corporate strategy, we are
reviewing our current capital structure and have discussed with our senior
banks various long-term capital alternatives. We have also, as part of our
revised corporate strategy, discussed the possible sale of certain assets with
potential buyers. We have not reached any final decisions with respect to such
matters.
Pursuant to an Exchange Agreement, dated September 30, 2001, (the "Exchange
Agreement") the Company and the holders of the Series B and C Preferred Shares
executed a one-for-one exchange of all 275,000 shares of Series B Preferred and
all 125,000 shares of Series C Preferred (collectively referred to as the
"Original Redeemable Preferred Shares") for 275,000 shares of Series D Preferred
and 125,000 shares of Series E Preferred (collectively referred to as the "New
Redeemable Preferred Shares") in a non-cash transaction. The provisions of the
New Redeemable Preferred Shares essentially mirror those of the Original
Redeemable Preferred Shares except no dividends (other than the common
equivalent dividend as provided for in the Original Redeemable Preferred Shares)
will be paid on the New Redeemable Preferred Shares and the New Redeemable
Preferred Shares shall be convertible into the shares of the Company's Class A
common stock at a rate of (a) the liquidation preference of $2,500 per share
divided by (b) $6.10 (unless subsequently adjusted). The New Redeemable
Preferred Shares rank on a parity with the Company's 6.75% Series A Cumulative
Convertible Preferred Stock, par value $.01 per share (the "Series A Preferred
Stock"), with respect to dividend rights and rights on liquidation.
16
The exchange of the Original Redeemable Preferred Shares for the New Redeemable
Preferred Shares was based on the fair value of those securities at the date of
the Exchange Agreement. For financial accounting purposes, the carrying value
of the Original Redeemable Preferred Shares ($1.0 billion) over the fair value
of the New Redeemable Preferred Shares ($147.0 million) was recorded as a gain
on preferred stock exchange, net of transaction costs, and has reduced the
Company's reported net loss to arrive at net loss available to common
stockholders for the period ended September 30, 2001. The New Redeemable
Preferred Shares are redeemable on a proportionally equal basis, in whole or in
part, by the holders within 180 days following September 15, 2009. The Company
can declare mandatory conversion after September 15, 2006 if the 60 day average
market price of the Class A common stock exceeds the conversion price by at
least 1%. The New Redeemable Preferred Shares will accrete for book purposes to
its liquidation value of $1 billion by September 15, 2009, using the effective
interest method, which will reduce prospective earning available to common
stockholders.
The Company elected not to declare the quarterly stock dividend on its Series A
Preferred Stock that otherwise would have been payable on November 15, 2001. The
dividend is payable in cash or in shares of McLeodUSA Class A Common Stock at a
rate of $4.21875 per share of Series A Preferred Stock owned. The dividend will
continue to accumulate at the rate of 6.75% annually. As of September 30, 2001,
cumulative unpaid dividends totaled approximately $2.4 million.
As of November 7, 2001 based on our business plan, capital requirements and
growth projections as of that date, we estimate that we will spend approximately
$475 million from September 30, 2001 through the end of 2002 on our planned
capital expenditures. Our estimated aggregate capital expenditures include the
projected costs of completing current construction work-in-progress, augmenting
existing capacity and meeting new customer requirements.
We expect to have funds available for these needs from various sources,
including existing cash balances, the existing McLeodUSA lines of credit,
prospective sales of selected non-core assets and cash flow from future
operations.
Our estimate of future capital requirements is a forward-looking statement
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. The actual amount and timing of our future
capital requirements may differ substantially from our estimate due to factors
such as:
o strategic acquisition costs and effects of acquisitions on our business
plan, capital requirements and growth projections
o unforeseen delays
o cost overruns
o engineering design changes
o changes in demand for our services
o regulatory, technological or competitive developments
o new opportunities
We also expect to evaluate potential acquisitions, joint ventures and strategic
alliances on an ongoing basis. We may require additional financing if we pursue
any of these opportunities. We also require substantial funds for general
corporate and other expenses and may require additional funds for working
capital fluctuations.
Although we do not anticipate any inability to draw on our existing lines of
credit under the Secured Credit Facility, any failure to comply with the
affirmative or negative covenants or any other event of default could restrict
our ability to draw additional amounts thereunder and such restrictions could
have a material adverse effect on our business, results of operations or
financial condition.
We may meet any additional capital needs by issuing additional debt or equity
securities or borrowing funds from one or more lenders. In addition, in the
event vendor financing arrangements are available on terms that allow rates of
return comparable to current capital projects and are otherwise favorable to us,
we may use such financing to accelerate or increment the development of our
network. We cannot assure you that we will have timely access to additional
debt or equity sources on acceptable terms.
17
Failure to generate or raise sufficient funds may require us to delay or abandon
some of our expansion plans or expenditures, which could have a material adverse
effect on our business, results of operations or financial condition. See
"Business--Risk Factors--Failure to Raise Necessary Capital Could Restrict Our
Ability to Develop Our Network and Services and Engage in Strategic
Acquisitions" in our Annual Report on Form 10-K.
Market Risk
At September 30, 2001, we recorded the marketable equity securities that we hold
at a fair value of $3.6 million. These securities have exposure to price risk.
A hypothetical ten percent adverse change in quoted market prices would amount
to a decrease in the recorded value of investments of approximately $0.4
million. We believe our exposure to market price fluctuations on all other
investments is nominal due to the short-term nature of our investment portfolio.
Substantially all of our long-term debt obligations are fixed rate obligations
which do not expose us to material future earnings or cash flow exposure from
changes in interest rates. We have variable rate debt of $575 million under the
Tranche B Term Facility and $175 million under the Tranche A Term Facility
outstanding at September 30, 2001. If market interest rates average 1% more in
subsequent quarters than the rates during the quarter ended September 30, 2001,
quarterly interest expense would increase by $1.9 million. This amount was
determined by calculating the effect of the hypothetical interest rate increase
on our variable rate debt for the quarter and does not assume changes in our
financial structure.
Effects of New Accounting Standards
Accounting for Business Combinations
In July 2001, the FASB issued SFAS No. 141, "Accounting for Business
Combinations," effective for all business combinations initiated and made after
June 30, 2001. SFAS 141 requires all business combinations be accounted for
under the purchase method and establishes additional reporting requirements for
business combinations. The Company currently accounts for all business
combinations under the purchase method and does not expect adoption of this
statement to have an effect on the Company's operations.
Accounting for Goodwill and Other Intangible Assets
In July 2001, the FASB issued SFAS No. 142, "Accounting for Goodwill and Other
Intangible Assets," effective for fiscal years beginning after December 15,
2001. Early implementation is not allowed. SFAS 142 requires the use of a non-
amortization approach to account for purchased goodwill and for separately
recognized (non-goodwill) intangible assets that have an indefinite useful life.
Under this approach, goodwill and intangibles with indefinite lives will not be
amortized, but will be periodically reviewed for impairment and expensed against
earnings only in periods in which the recorded value exceeds the fair value.
The Company has not yet quantified the impacts of adopting this statement, but
it could result in significant changes to amortization expense and the
classification and recording of intangibles currently on the books, as well as
any future acquisitions.
Accounting for Asset Retirement Obligations
In July 2001 the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations." The statement requires entities to record the fair value of a
liability for an asset retirement obligation in the period in which the legal or
contractual removal obligation is incurred. The statement is effective for
fiscal years beginning after June 15, 2002, with earlier application encouraged.
The Company is currently evaluating the impact that the statement will have on
its financial position and the results of operations.
Accounting for the Impairment or Disposal of Long-Lived Assets
SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets"was
issued in October, 2001. The statement covers a variety of implementation issues
inherent in SFAS No. 121, unifies the framework used in accounting for assets to
be disposed of and discontinued operations, and broadens the reporting of
discontinued operations to include all components of an entity with operations
that can be distinguished from the rest of the entity and that will be
eliminated from the ongoing operations of the entity in a disposal transaction.
The Company is currently evaluating the impact that the statement will have on
its financial position and the results of operations.
Inflation
We do not believe that inflation has had a significant impact on our
consolidated operations.
18
PART II
OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds
During the period from July 1, 2001 through September 30, 2001, we issued the
following equity securities not registered under the Securities Act of 1933, as
amended:
o We issued 2,120,254 shares of Class A common stock on August 15, 2001,
representing a dividend due to the holders of our Series A Preferred Stock.
The issuance of these securities was made in reliance upon an exemption from
registration under the Securities Act of 1933, as amended.
o We issued on September 30, 2001 (a) 275,000 shares of Series D Preferred
Stock in exchange for all of the outstanding shares of Series B Preferred
Stock and (b) 125,000 shares of Series E Preferred Stock in exchange for all
of the outstanding shares of Series C Preferred Stock. These exchanges were
made with three affiliates of Forstmann, Little & Co. and the issuance was
made in reliance upon an exemption from registration under the Securities Act
of 1933, as amended.
The Certificates of Designation for the Series D Preferred Stock and the Series
E Preferred Stock are substantially similar to the Certificates of Designation
for the Series B Preferred Stock and the Series C Preferred Stock (which shares
were retired); provided, however, that the cash dividend payments were
eliminated and the conversion price of the new preferred securities was reduced
to $6.10 per share of Class A Common Stock from the $12.17 price of the old
preferred securities.
Item 3. Defaults Upon Senior Securities
On October 19, 2001 we announced our election not to declare a quarterly
dividend on our 6.75% Series A Preferred Stock that otherwise would have been
payable on November 15, 2001. The dividends on the Series A Preferred Stock are
cumulative and the amount of this arrearage will, after November 15, 2001, total
approximately $4.9 million.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit
-------
Number Exhibit Description
------ -------------------
3.1 Amended and Restated Certificate of Incorporation of McLeod, Inc.
(Filed as Exhibit 3.1 to Registration Statement on Form S-1,
File No. 333-3112 ("Initial Form S-1") and incorporated herein by
reference).
3.2 Certificate of Amendment of Amended and Restated Certificate of
Incorporation of McLeod Inc. (Filed as Exhibit 3.3 to Registration
Statement on Form S-4, File No. 333-27647 (the "July 1997 Form S-4")
and incorporated herein by reference).
3.3 Certificate of Amendment to the Amended and Restated Certificate of
Incorporation of McLeodUSA (filed as Exhibit 3.8 to the Quarterly
Report on Form 10-Q, File No. 0-20763, filed with the SEC on May 15,
2000 (the "May 2000 Form 10-Q", and incorporated herein by
reference).
3.4 Certificate of Amendment to the Amended and Restated Certificate of
Incorporation of McLeodUSA (filed as Exhibit 3.9 to the Quarterly
Report on Form 10-Q, File No. 0-20763, filed with the SEC on August
14, 2000 (the "August 2000 Form 10-Q"), and incorporated herein by
reference).
19
3.5 Certificate of Change of Registered Agent and Registered Office of
McLeodUSA Incorporated. (Filed as Exhibit 3.4 to Annual Report on
Form 10-K, File No. 0-20763, filed with the Commission on March 6,
1998 (the "1997 Form 10-K") and incorporated herein by reference).
3.6 Certificate of Designations of the 6.75% Series A preferred
stock. (Filed as Exhibit 3.1 to Current Report on Form 8-K, file
number 0-20763, filed with the Commission on August 9, 1999 and
incorporated herein by reference).
3.7 Certificate of Designations of the Series B preferred stock.
(Filed as Exhibit 3.6 to February 2000 Form S-4 and incorporated
herein by reference).
3.8 Certificate of Designations of the Series C preferred stock. (Filed
as Exhibit 3.7 to February 2000 Form S-4 and incorporated herein by
reference).
3.9 Amended and Restated Bylaws of McLeod, Inc.
3.10 Amendment No. 1, adopted September 28, 2001, to the Amended and
Restated Bylaws of McLeodUSA Incorporated.
3.11 Certificate of Designations of the Series D preferred stock.
3.12 Certificate of Designations of the Series E preferred stock.
4.44 Amendment No. 2 to Third Amended and Restated November 1998
Stockholders' Agreement, dated as of August 1, 2001.
4.45 Amendment No. 2 to Third Amended and Restated January 1999
Stockholders' Agreement, dated as of August 1, 2001.
4.46 Waiver dated as of August 29, 2001 to the Senior Credit Agreement.
4.47 Form of Series D preferred stock certificate.
4.48 Form of Series E preferred stock certificate.
*10.54 Eighth Amendment to Cost Sharing National IRU Agreement by and
between Level 3 Communications, LLC and McLeodUSA Information
Services, Inc.
10.55 Exchange Agreement dated as of September 30, 2001 by and between
McLeodUSA and three Forstmann Little Partnerships.
10.56 Termination Agreement dated as of September 30, 2001 by and between
McLeodUSA and three Forstmann Little Partnerships.
10.57 Registration Rights Agreement dated as of September 30, 2001 by and
between McLeodUSA and three Forstmann Little Partnerships.
10.58 Full Services Agreement between McLeodUSA and Prodigy dated July 1,
2001.
10.59 Offer letter to Chris Davis from McLeodUSA dated July 20, 2001.
10.60 Employment Agreement dated August 1, 2001 between McLeodUSA and
Chris Davis.
__________________
* Confidential treatment has been requested. The copy filed as an exhibit
omits the information subject to the confidential treatment request.
(b) Reports on Form 8-K
None.
20
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
McLEODUSA INCORPORATED
(registrant)
Date: November 14, 2001 By: /s/ Stephen C. Gray
-------------------------------------
Stephen C. Gray
President and Chief Executive Officer
Date: November 14, 2001 By: /s/ Chris Davis
-------------------------------------
Chris Davis
Chief Operating and Financial Officer
21
INDEX TO EXHIBITS
Exhibit
-------
Number Exhibit Description
------ -------------------
3.9 Amended and Restated Bylaws of McLeod, Inc.
3.10 Amendment No. 1, adopted September 28, 2001, to the Amended and Restated Bylaws of
McLeodUSA Incorporated.
3.11 Certificate of Designations of the Series D preferred stock.
3.12 Certificate of Designations of the Series E preferred stock.
4.44 Amendment No. 2 to Third Amended and Restated November 1998
Stockholders' Agreement, dated as of August 1, 2001.
4.45 Amendment No. 2 to Third Amended and Restated January 1999 Stockholders'
Agreement, dated as of August 1, 2001.
4.46 Waiver dated as of August 29, 2001 to the Senior Credit Agreement.
4.47 Form of Series D preferred stock certificate.
4.48 Form of Series E preferred stock certificate.
*10.54 Eighth Amendment to Cost Sharing National IRU Agreement by and between
Level 3 Communications, LLC and McLeodUSA Information Services, Inc.
10.55 Exchange Agreement dated as of September 30, 2001 by and between
McLeodUSA and three Forstmann Little Partnerships.
10.56 Termination Agreement dated as of September 30, 2001 by and between
McLeodUSA and three Forstmann Little Partnerships.
10.57 Registration Rights Agreement dated as of September 30, 2001 by and
between McLeodUSA and three Forstmann Little Partnerships.
10.58 Full Services Agreement between McLeodUSA and Prodigy dated July 1,
2001.
10.59 Offer letter to Chris Davis from McLeodUSA dated July 20, 2001.
10.60 Employment Agreement dated August 1, 2001 between McLeodUSA and Chris
Davis.
* Confidential treatment has been requested. The copy filed as an exhibit
omits the information subject to the confidential treatment request.
22