-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, CSrjClrCIfJZ6lvguVvXQyVJKV5fhmZPvu9fWPZ2hAhI+E3OVlBrb+4sbSuiusWy me5tu9wnOF624uxgHV1jfg== 0000927356-00-000463.txt : 20000320 0000927356-00-000463.hdr.sgml : 20000320 ACCESSION NUMBER: 0000927356-00-000463 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000317 FILER: COMPANY DATA: COMPANY CONFORMED NAME: QWEST COMMUNICATIONS INTERNATIONAL INC CENTRAL INDEX KEY: 0001037949 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 841339282 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-15577 FILM NUMBER: 572884 BUSINESS ADDRESS: STREET 1: 700 QWEST TOWER STREET 2: 555 SEVENTEENTH STREET CITY: DENVER STATE: CO ZIP: 80202 BUSINESS PHONE: 3032911400 MAIL ADDRESS: STREET 1: 700 QWEST TOWER STREET 2: 555 SEVENTEENTH STREET CITY: DENVER STATE: CO ZIP: 80202 FORMER COMPANY: FORMER CONFORMED NAME: QUEST COMMUNICATIONS INTERNATIONAL INC DATE OF NAME CHANGE: 19970416 10-K405 1 FORM 10-K405 FOR PERIOD ENDING 12/31/1999 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 _________________ FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM_____TO _____ _____________________________________________ COMMISSION FILE NUMBER 000-22609 QWEST COMMUNICATIONS INTERNATIONAL INC. (EXACT NAME OF REGISTRANT SPECIFIED IN ITS CHARTER) DELAWARE 84-1339282 -------- ---------- (STATE OR OTHER JURISDICTION OF INCORPORATION OR (I.R.S. EMPLOYER ORGANIZATION) IDENTIFICATION NO.) 700 QWEST TOWER 555 SEVENTEENTH STREET DENVER, COLORADO 80202 ---------------------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (303) 992-1400 -------------- (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: TITLE OF EACH CLASS: COMMON STOCK, $.01 PAR VALUE Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ] As of March 7, 2000, approximately 753 million shares of the Registrant's Common Stock, $.01 par value, were issued and outstanding. The aggregate market value of the Common Stock held by non-affiliates of the Registrant, based on the closing price of the Common Stock as reported on the New York Stock Exchange on March 7, 2000 was approximately $42.2 billion. DOCUMENTS INCORPORATED BY REFERENCE Document Where Incorporated - -------- ------------------ Annual Report for the year ended Part II, Items 5, 6, 7, 7A, and 8 December 31, 1999 Proxy Statement for Qwest's Annual Meeting Part III, Items 10, 11, 12 and 13 of Stockholders to be held May 3, 2000 QWEST COMMUNICATIONS INTERNATIONAL INC. FISCAL YEAR ENDED DECEMBER 31, 1999 TABLE OF CONTENTS Page ---- Part I Item 1 Business................................................. 4 Item 2 Properties............................................... 20 Item 3 Legal Proceedings........................................ 20 Item 4 Submission of Matters to a Vote of Security Holders...... 21 Part II Item 5 Market for Registrant's Common Equity and Related Stockholder Matters...................................... 22 Item 6 Selected Financial Data.................................. 22 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations...................... 22 Item 7A Quantitative and Qualitative Disclosures About Market Risk.............................................. 22 Item 8 Financial Statements and Supplementary Data.............. 22 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...................... 22 Part III Item 10 Directors and Executive Officers of the Registrant....... 22 Item 11 Executive Compensation................................... 22 Item 12 Security Ownership of Certain Beneficial Owners and Management............................................... 22 Item 13 Certain Relationships and Related Transactions........... 22 Part IV Item 14 Exhibits, Financial Statement Schedules, and Reports on Form 8-K.............................................. 23 Signature Page........................................... 26 2 Information Regarding Forward-Looking Statements This report contains or incorporates by reference "forward-looking statements" as that term is used in federal securities laws about Qwest's financial condition, results of operations and business. These statements include, among others: . statements concerning the benefits that Qwest expects will result from its business activities and certain transactions Qwest has completed, such as increased revenues, decreased expenses and avoided expenses and expenditures, and . statements of Qwest's expectations, beliefs, future plans and strategies, anticipated developments and other matters that are not historical facts. These statements may be made expressly in this document, or may be incorporated by reference to other documents Qwest has filed with the Securities and Exchange Commission ("SEC"). You can find many of these statements by looking for words such as "believes", "expects", "anticipates", "estimates", or similar expressions used in this report or incorporated by reference in this report. These forward-looking statements are subject to numerous assumptions, risks and uncertainties that may cause Qwest's actual results to be materially different from any future results expressed or implied by Qwest in these statements. The risks and uncertainties include those risks, uncertainties and risk factors identified, among other places, under "Risk Factors" in Qwest's registration statement on Form S-4, SEC file number 333-81149. The most important factors that could prevent Qwest from achieving its stated goals include, but are not limited to, the following: . operating and financial risks related to managing rapid growth, integrating acquired businesses and sustaining operating cash flow to meet Qwest's debt service requirements, make capital expenditures and fund operations; . potential fluctuation in quarterly results; . volatility of stock price; . intense competition in the communications services market; . dependence on new product development; . Qwest's ability to achieve year 2000 compliance; . rapid and significant changes in technology and markets; . adverse changes in the regulatory or legislative environment affecting Qwest's business; . failure to maintain necessary rights of way; and . failure to complete the merger with U S WEST or achieve the projected synergies and financial results timely or at all and difficulties in combining the operations of Qwest and U S WEST. Qwest cautions you not to place undue reliance on the statements, which speak only as of the date of this report or, in the case of documents incorporated by reference, the date of the document. The cautionary statements contained or referred to in this section should be considered in connection with any subsequent written or oral forward-looking statements that Qwest or persons acting on its behalf may issue. Qwest undertakes no obligation to review or confirm analysts' expectations or estimates or to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events. 3 Part I. Item 1. Business Qwest Communications International Inc. ("Qwest") is a leading broadband Internet communications company engaged in two core businesses: communications services and construction services. Communications services includes Internet, multimedia, data and voice services sold to business, consumer and government customers. Internet and multimedia services include Internet Protocol ("IP")-enabled services such as dedicated and dial up Internet access, web hosting, co-location access, voice over IP, application hosting and mass storage services. Qwest also provides high-volume voice and conventional private line services to other communications providers, as well as to Internet service providers ("ISPs"), and other data service companies. Qwest's network uses both Internet communications technology and traditional telephone communications technology. Communications on the Internet are governed by Internet Protocol, a standard that allows communication across the Internet regardless of the hardware and software used. Construction services constructs and installs fiber optic systems for other communications providers, as well as for Qwest's own use. Qwest is developing Internet and multimedia services in alignment with existing and anticipated market demand in partnership with leading information technology companies, including the following: . Microsoft Corporation for business applications and service; . KPMG LLP (through the Qwest Cyber.Solutions joint venture) for application service provider, application hosting and application management services; . SAP America, Inc. and Hewlett Packard Company for hosting and systems management services; . Covad Communications Group, Inc. ("Covad") and Rhythms NetConnections Inc. ("Rhythms") for digital subscriber line ("DSL") technology for high-speed local network connectivity; . Oracle Corporation and Siebel Systems, Inc. for application hosting services; and . Hewlett Packard Company for high-end data storage. Qwest's principal asset is its high-capacity fiber optic network. The network reaches over 25,500 miles in North America, and is designed to allow customers to seamlessly exchange multimedia content - images, data and voice over the public circuit switched telephone network without the need to dial access codes or follow other similar special procedures. The technologically advanced network is designed to instantaneously re-route traffic in the event of a fiber cut to prevent interruption in service to Qwest's customers. This is accomplished by automatically re-routing traffic in the opposite direction around the Sonet ring. The network is equipped with technologically advanced fiber and state-of-the-art transmission electronics. At full capacity, Qwest's network could transmit two trillion bits of multimedia information per second. Qwest's network is designed to support Internet Protocol, as well as traditional circuit-switched services, and alternative information transfer standards used for data transmission. The network connects approximately 150 metropolitan areas coast-to-coast. Qwest was the first network service provider to complete a transcontinental Internet Protocol fiber network when it activated the Qwest network from Los Angeles to San Francisco to New York in April 1998. KPNQwest, a European joint venture of Qwest and KPN, the Dutch telecommunications company, is building and will operate a high-capacity European fiber optic, Internet-based network that is currently expected to connect 46 cities throughout Europe when it is completed. Qwest has also built a 1,400 route-mile network in Mexico, and is part of a consortium of communications companies that is building a 13,125-mile underwater cable network connecting the United States to Japan. 4 In addition to significant advantages in speed, reliability, scalability, and security, the Qwest network's advanced technologies should also provide a cost advantage over older fiber systems generally in commercial use today. Qwest received an additional cost benefit from the sale of dark fiber along the network, which reduced its net cost in the network retained for its own use. Mergers and Acquisitions Qwest continually evaluates opportunities to become a stronger competitor and to accelerate the growth of its business. A key strategy has been to add strength through investments in or acquisitions of businesses, facilities or other assets that build on Qwest's service and technology base. In July 1999, Qwest entered into a definitive merger agreement with U S WEST, Inc ("U S West"). Under the terms of the merger agreement, Qwest will issue shares of its common stock having a value of $69.00 for each share of U S WEST common stock, subject to a "collar" on Qwest's average stock price between $28.26 and $39.90 per share. The number of Qwest shares to be issued for each U S WEST share will be determined by dividing $69.00 by the average of the daily volume weighted average prices of Qwest common stock for 15 randomly selected trading days over a 30-day measurement period ending three days before the closing of the transaction, provided that Qwest will not issue more than 2.44161 shares for each U S WEST share or less than 1.72932 shares for each U S WEST share. The transaction will be accounted for as a purchase with U S WEST deemed the accounting acquiror and is structured to be tax-free to U S WEST shareowners to the extent of the Qwest stock delivered in the transaction. If Qwest's average stock price is below $38.70 per share, the obligation under the "collar" for the amount which the price is below $38.70 per share may be satisfied in whole or in part with cash. In determining the cash amount for the collar, Qwest and U S WEST will consider Qwest's desire to reduce dilution to its stockholders, U S WEST's potential desire to provide a cash element to its stockholders and both companies' desire to maintain the combined company's strong financial condition. If the companies decide to provide cash as part of the collar consideration, the minimum exchange ratio would be 1.783. U S WEST may terminate the merger agreement if the closing price of Qwest's shares is below $22.00 for 20 consecutive trading days before the closing, or if the average Qwest share price during the measurement period is less than $22.00. The Boards of Directors and stockholders of both Qwest and U S WEST have approved the proposed transaction. The transaction is subject to federal and state regulatory approvals and other customary closing conditions. Closing of the transaction is expected in mid-2000. As a result of the transaction, Qwest will become subject to the regulations applicable to U S WEST, a Regional Bell Operating Company ("RBOC"). Generally, effective as of the closing of the transaction, Qwest may not provide inter-LATA transport services within U S WEST's 14-state region until U S WEST receives approval to provide such services under Section 271 of the Telecommunications Act of 1996, as amended. Therefore, Qwest is in the process of divesting the prohibited services. In connection with the termination of the U S WEST and Global Crossing merger agreement, U S WEST paid Global Crossing a break-up fee of $140.0 million in cash and agreed to return $140.0 million in Global Crossing shares, valued at $62.75 per share, purchased by U S WEST in connection with its agreement with Global Crossing. Qwest advanced to U S WEST the $140.0 million cash payment and agreed to purchase $140.0 million in services from Global Crossing over four years at the best commercially available prices. In December 1998, Qwest acquired Icon CMT Corp. ("Icon"), a leading Internet solutions provider, for approximately $254.1 million in Qwest common stock. Qwest issued approximately 11.8 million shares of Qwest's common stock (including outstanding Icon stock options and warrants assumed by Qwest). The addition of Icon's sales channels, data centers and more than 400 information technology professionals gave Qwest new resources for developing, integrating and maintaining advanced web hosting services and electronic commerce solutions. In June 1998, Qwest acquired LCI for approximately 259.8 million shares of Qwest's common stock (including outstanding LCI stock options assumed by Qwest), then valued at approximately $3.9 billion. LCI has brought to Qwest 5 a nationwide customer base, sales, marketing and support facilities, an intelligent network platform and customer care and billing system. In April 1998, Qwest acquired Amsterdam-based EUnet International Limited for approximately $4.2 million in cash and approximately 7.9 million shares of Qwest's common stock, then valued at approximately $154.0 million. EUnet, a leading European Internet service provider, had business operations in 14 European countries. In March 1998, Qwest acquired Phoenix Network, Inc., a reseller of long distance services, for approximately 1.6 million shares of Qwest's common stock, then valued at approximately $27.2 million. Strategic Investments and Other Alliances Investment in Slingshot Networks LLC/ Purchase of Certain Assets of ADMI. In September 1999, Qwest and Anschutz Digital Media, Inc. ("ADMI"), an affiliate of Qwest's principal stockholder, Anschutz Company, entered into an agreement to form a joint venture called Slingshot Networks LLC to provide advanced digital production, post-production and transmission facilities, digital media storage and distribution services, telephony-based data storage and enhanced services, access and routing services. Qwest and ADMI each own 50% of the joint venture. Qwest contributed approximately $84.8 million consisting of a promissory note payable over nine years at an annual interest rate of 6%. Qwest's investment in the joint venture is accounted for under the equity method. The agreement between Qwest and ADMI also provided that Qwest would purchase certain telephony-related assets and all of the stock of Precision Systems, Inc., a telecommunications solutions provider, from ADMI in exchange for a promissory note in the amount of $34 million. The promissory note is payable over nine years and bears interest at an annual rate of 6%. Investment in Advanced Radio Telecom Corp. In September 1999, Qwest invested $90.0 million for an approximate 19% stake in Advanced Radio Telecom Corp. ("ART"), a facilities-based, broadband ISP that provides a direct connection from customer location to the Internet, to help support the construction of ART's fixed, high-speed wireless networks. In connection with this transaction, a separate group of investors also invested $161.0 million. Investment in Qwest Cyber.Solutions LLC. In June 1999, Qwest and KPMG LLP, a leading professional services firm, formed a joint venture called Qwest Cyber.Solutions LLC, to provide Internet-based end-to-end application service provider, application hosting, and application management services. The venture will offer customers a broad set of vendor products available for Enterprise Resource Planning ("ERP"), Customer Relationship Management ("CRM") and back office solutions, a state-of-the-art Internet Protocol ("IP") broadband network, and technologically advanced CyberCenters. Qwest contributed approximately $60.0 million consisting of cash and other assets, and owns a 51% stake in the venture. The financial position and results of operation of the venture have been consolidated in the accompanying financial statements from the date of formation and the minority interest represents KPMG's stake in the venture. Strategic Relationship With BellSouth. In April 1999, BellSouth Corporation (together with its subsidiaries, "BellSouth") and Qwest announced a strategic relationship whereby BellSouth invested approximately $3.5 billion for an approximate 10% equity stake in Qwest. Qwest issued approximately 40.7 million shares to BellSouth in exchange for approximately $1.9 billion in cash. Qwest's principal stockholder, Anschutz Company, sold approximately 33.3 million existing shares to BellSouth for approximately $1.6 billion. At the same time, a BellSouth affiliate and Qwest entered into a commercial arrangement for provisioning of a full range of integrated digital data, image and voice communications services for customers. These services will include Qwest's portfolio of data networking, Internet and voice services and BellSouth's local networking services. Once BellSouth is allowed to enter the long distance market, the companies will jointly develop and deliver a comprehensive set of end-to-end, high-speed data, image and voice communications services to business customers, with an emphasis on broadband and Internet-based data services. KPNQwest Joint Venture. In April 1999, Qwest and KPN Telecom B.V. ("KPN"), the Dutch telecommunications company, formed a joint venture to create a pan- European IP-based fiber optic network, linked to Qwest's network in North America, for data and multimedia services. Qwest and KPN each initially owned 50 percent of KPNQwest, which was initially governed by a six person supervisory board to which Qwest and KPN had each named three members.. Upon formation of KPNQwest, KPN contributed two partially completed bi-directional, self-healing fiber optic rings (EuroRings(TM) 1 and 2) and certain communications services contracts to KPNQwest. Qwest contributed Xlink Internet Service Gmbh ("Xlink"), the operating subsidiaries of EUnet and cash. Also, Qwest and KPN contributed transatlantic capacity that connects KPNQwest's European network with Qwest's network in North America, and also contributed certain other assets. The net book value of total assets contributed by Qwest totaled approximately $300.0 million. 6 Qwest deconsolidated EUnet and Xlink in April 1999. Qwest's investment in KPNQwest is accounted for under the equity method. KPNQwest offers managed broadband services, IP transit, Internet connectivity and value-added IP services, including consulting, hosting, and the transmission of live events over the Internet. KPNQwest also sells dark fiber along its network. Customers of KPNQwest include Internet services and content providers, multinational firms in Europe and North America, as well as telecommunications carriers, operators and others who want to purchase wholesale or retail network capacity, fiber or services. On November 12, 1999 KPNQwest consummated an initial public offering in which 50.6 million shares of common stock were issued generating approximately $1.0 billion in net proceeds. The consummation of KPNQwest's IPO has resulted in approximately 11% of KPNQwest's shares being owned by the public and the remainder of KPNQwest's shares being owned by each of Qwest and KPN equally. As a result of the change in ownership structure of KPNQwest, two outside directors were added to the supervisory board. Also as a result of KPNQwest's initial public offering, Qwest recognized a gain of $414.0 million, representing its proportionate share of the increase in KPNQwest's equity. As of December 31, 1999, the fair market value of Qwest's investment in KPNQwest was approximately $12.8 billion, based on the closing price of KPNQwest's common stock on the Nasdaq stock market. Investment in Rhythms. In April 1999, Qwest made an equity investment, totaling $15.0 million in cash, in DSL local networks through an agreement with Rhythms NetConnections Inc. ("Rhythms"), a packet-based Competitive Local Exchange Carrier ("CLEC") that provides high-speed networking solutions for remote access to private networks and the Internet. Under this agreement, Qwest will have access to 29 metropolitan areas (10 of which are in addition to the areas covered by an agreement that Qwest has with Covad Communications Group Inc.), while further enhancing its ability to provide its customers with high- speed DSL connectivity to its network. Qwest has committed to place a minimum number of orders for DSL service over a seven-year term commencing on the date that Rhythms is operational in the 29 metropolitan areas. In the event that Qwest fails to meet the order target, Qwest is committed to pay Rhythms for the difference between the order target and the number of actual orders placed. Qwest's investment in Rhythms is accounted for under the cost method. Investment in Covad. In January 1999, Qwest made an equity investment, totaling $15.0 million in cash, in high-speed, DSL local networks through an agreement with Covad Communications Group, Inc. ("Covad"), a packet-based CLEC. Under this agreement, Qwest will have access to 22 metropolitan areas, while enhancing its ability to provide its customers with high-speed DSL connectivity to its network. Qwest has committed to purchase DSL services for approximately $20.0 million over a five-year term commencing on the date that Covad's DSL services are commercially available in all 22 metropolitan areas. Qwest's investment in Covad is accounted for under the cost method. Alliance With Microsoft. In December 1998, Qwest entered into a strategic alliance with Microsoft that will enable businesses to utilize high-speed network services that maximize network resources, reduce costs, generate new sources of revenue and optimize management of computing operations. Qwest's service, to be built on the Microsoft(R) operating systems and application platforms, when integrated with Qwest's IP-based fiber optic network, is designed for businesses of all sizes. Microsoft will license a broad range of its software to Qwest. The parties will jointly market and sell the services. In addition, Microsoft purchased 8.8 million shares of Qwest for $200.0 million. Communications Industry Overview Communications services consist primarily of local exchange services, long distance services and Internet access services. A local call is one that does not require the services of a long distance carrier. It originates and terminates along a local exchange network. Local exchange carriers connect end user customers within their local exchange areas and also provide the local portion of most long distance calls. A long distance telephone call originates with a customer within a local exchange network and travels along the local exchange network to a long distance carrier. The long distance carrier combines the call with other calls and sends them along a long distance network to a different local exchange network where the call terminates. Long distance 7 carriers provide only the connection between the two local networks, and pay access charges to local exchange carriers for originating and terminating calls. The Internet is a global collection of interconnected computer networks that allows commercial organizations, educational institutions, government agencies and individuals to communicate electronically, access and share information and conduct business. Internet access services require a local network connection from a customer to an Internet service provider's local facility. For large, communication- intensive users, these connections are typically dedicated connections direct from the customer to the Internet service provider. For residential and small and medium sized business users, these connections are generally achieved by cable modem, Digital Subscriber Line, or dial-up access into a local exchange. Once a local connection is made to the Internet service provider's local facilities, information can be transmitted and obtained over a packet-switched data network. This network may consist of segments provided by many interconnected networks operated by a number of Internet service providers. This collection of interconnected networks makes up the Internet. Communications on the Internet are governed by Internet Protocol, an inter-networking standard that enables communication across the Internet regardless of the hardware and software used. In addition, businesses can utilize the facilities of communications service providers for web hosting and Application Service Provider ("ASP") enabled services. Through web hosting, customers can outsource the maintenance and connectivity to accommodate businesses multimedia, corporate intranet/extranet and e-commerce applications. ASP services allows independent service vendors and systems integrators to deliver software and technical media from centralized, secured locations. Switching is the critical process of selecting paths for the transmission of data, voice and images to a specific recipient. Switches on a network route traffic to the designated recipient. There are two widely used switching technologies in communications networks: circuit-switching systems, generally used in traditional telephone communication, and packet-switching systems, generally used to provide communication services over the Internet, such as Qwest's services. Circuit-switch based communications systems establish a dedicated channel for each communication (such as a telephone call for voice or fax), maintain the channel for the duration of the call, and disconnect the channel at the conclusion of the call. Packet-switch based communications systems format the information to be transmitted, such as e-mail, voice, fax and data, into a series of shorter digital messages called "packets," and a single dedicated channel between communication points is never established. Each packet consists of a portion of the complete message plus the addressing information to identify the destination and return address. Packet-switch based systems offer several advantages over circuit-switch based systems, particularly the ability to commingle packets from several communications sources together simultaneously onto a single channel. For most communications, particularly those with bursts of information followed by periods of "silence," the ability to commingle packets provides for superior network use and efficiency, resulting in more information being transmitted through a given communication channel. There are, however, certain disadvantages to packet-switch based systems as currently implemented. Rapidly increasing demands for data, in part driven by the Internet traffic volumes, are straining capacity and contributing to delays and interruptions in communications transmissions. With current technology, the desired voice quality and real-time communications features of a traditional telephone call can only be achieved by having in place a substantial network capacity. The Qwest network allows the transmission of traffic seamlessly between an Internet Protocol network and the circuit-based traditional telephone communication network, providing the Qwest network with the same comprehensive coverage as the traditional telephone communication network. Specifically, Qwest is able to (1) originate traditional telephone communication network traffic from a local exchange carrier's switch (when the origination point is not on Qwest's network), (2) route the traffic over the Qwest network and (3) deliver the traffic either (a) directly to its destination (if the destination is on the Qwest network) or (b) to an interconnection point where the traffic is transferred back to the traditional telephone communication network. The routing of traffic to this interconnection point is determined based on a least- cost routing criteria. This gives Qwest the ability to obtain the benefits of packet-switch based communications protocols on its network, while allowing its customers to use their existing equipment, telephone numbers and dialing procedures, without additional access codes, for routing the call to the Qwest network. 8 Qwest's Macro Capacity(SM) Fiber Network Qwest's Macro Capacity(SM) Fiber Network has approximately 350 Internet protocol routers, 150 data switches and 26 voice switches in various locations across the United States. Qwest expects to activate approximately 1,500 additional Internet protocol routers and 75 additional data switches in 2000. As of December 31, 1999, Qwest's network assets and physical components included: . High-density polyethylene conduits, which is hollow tubing 1 1/2 to 2 inches in diameter; . Each fiber optic cable contains 96 to 288 fiber strands, which is placed inside the conduits and strengthened by metal, and at least 2 to 8 fibers activated on Qwest's behalf; Each fiber strand is capable of transmitting information at an OC-192 level. . Electronic equipment necessary to activate the fiber for transmission; . Data and voice switches that enable Qwest to provide a variety of basic and enhanced data, voice and image services to customers; and . Approximately 150 points of presence. With the completion of its network, Qwest is providing communications services nationally to its customers primarily over its own network, using leased facilities in those portions of the country not covered by its network. Qwest's approach to building its network, and the features of the network itself, offer a range of competitive performance and cost advantages. Qwest is expanding its worldwide broadband services portfolio to include end- to-end connectivity for Qwest local internet services to large and multi- location enterprises and carriers in key metropolitan U.S. markets. Qwest is leveraging the many completed metropolitan area fiber rings and right-of-ways that were built as part of the nationwide backbone build. Qwest expects to complete construction of extensive fiber and DSL networks in 25 major cities by 2001. Eleven major cities are expected to be completed by the end of 2000 and the remainder by the end of 2001. Qwest also continues to evaluate opportunities to acquire or invest in businesses, facilities and other assets that would allow it to improve and expand services, compete more effectively and create new opportunities for growth. Advanced Technology. Using advanced technologies, Qwest installed technologically advanced fiber optic cable and electronic equipment throughout its network, and is testing the next generation equipment for deployment in the latter half of 2000. Qwest's network uses Dense Wavelength Division Multiplexing capable fiber and electronic technologies in a bi-directional line switch ring topology to give the network transmission capacity and high reliability levels. Qwest's network is designed for superior security and reliability, based on: . Two-way ring architecture, known as "Sonet rings", a self-healing system that allows for nearly instantaneous re-routing and virtually eliminates downtime in the event of a fiber cut by automatically re-routing traffic in the opposite direction around the ring; . Fiber cable installed in high-density polyethylene conduit generally buried 48-60 inches below the ground; . Extensive use of railroad rights of way. This approach typically offers greater protection of the fiber system than systems built over more public rights of way, such as highways, telephone poles or overhead power transmission lines. Qwest's network is also designed for expandability and flexibility. It contains two conduits along virtually the entire route. The first conduit contains a cable generally housing 96 to 288 fibers. The second conduit serves as a spare, allowing for future technology upgrades and capacity expansion at costs far below the cost of new construction. Network Management. Qwest monitors its network 24 hours a day, seven days a week from its Network Management Centers in Denver, Colorado, Dublin, Ohio and Arlington, Virginia. These facilities provide network surveillance, troubleshooting and customer service, using technology that enables Qwest to reduce service costs and customer downtime. The system currently allows Qwest technicians to detect a component malfunction in the network, quickly re-route the customer to an available alternate path and handle the repair. When the network is completed, two-way ring architecture will allow the re-routing to be fully automated. 9 In addition, Qwest has placed more network control in the hands of large business customers. Customers will be able to monitor and instantly reconfigure their leased capacity from their own network management centers. The system's software allows management of equipment inventory, bandwidth inventory, configuration and fault isolation, as well as "point-and-click" supply of communications services and alarm monitoring. Rights of Way. As of December 31, 1999, Qwest has in place agreements for all of the rights of way needed on its network. Approximately 70% of the domestic network is installed on railroad rights of way. In addition to greater security and protection than afforded systems built along public rights of way, railroad rights of way also generally provide the network with a direct, continuous route between cities. This eliminates the time and costs typically needed to piece together rights of way using a combination of agreements with private owners and state or municipal agencies. Also, railroad rights of way typically extend into downtown areas of strategically important cities. Qwest's right-of-way agreements provide for cash payments, exchanges of rights of way for network capacity or a combination of both. Qwest has other right-of-way agreements in place, where necessary or economically preferable, with highway commissions, utilities, political subdivisions and others. Network Installation. Qwest employs experienced construction personnel and uses its own fleet of equipment, as well as leased equipment, and supplements these resources with independent contractors. Dark Fiber Sales. Qwest entered into agreements with three significant customers (during 1996 and 1997) and with others for the purchase of dark fiber along Qwest's network. The proceeds from these contracts for the sale of dark fiber provide cash for a significant portion of the total estimated costs to construct the network and to provide the dark fiber that is being sold. Qwest believes that there continue to be opportunities to sell additional dark fiber throughout its network, and management continues to explore these opportunities with potential customers. However, Qwest does not expect to enter into additional agreements of the size and scope of the three significant contracts entered into during 1996 and 1997. Potential new customers include other inter-exchange carriers, cable, entertainment and data transmission companies, federal and state governments, Internet service providers, local exchange carriers and competitive local exchange carriers. To meet the needs of a diverse group of existing and potential customers, Qwest offers a wide variety of pricing and system options to meet specific needs of each customer. Customers may purchase or lease dark fiber or purchase capacity on a short- or long-term basis. Significant Customers Two customers accounted for 31.2% and 36.6% of consolidated revenue, respectively, in 1997 primarily from construction contracts for the sale of dark fiber. No individual customer accounted for 10% or more of such revenue in 1998 or 1999. Business Segments Qwest has two distinct business segments: communications services and construction services. Communications services provides a full array of traditional telecommunications, Internet protocol communications, web-based multimedia services and other data products and services to customers. Construction services provides turnkey fiber optic systems for major inter- exchange carriers and for Qwest's own use. Communications Services Total revenue from communications services was approximately $3,703.1 million, $1,554.3 million and $115.3 million in 1999, 1998 and 1997, respectively. 10 Business Services. Qwest markets the following products and services to businesses: . Dedicated Internet Access -- offer a premium level of performance and security because traffic is transmitted over a nationwide OC-48 Internet Protocol network at the highest rates available with nearly zero percent packet loss. Public and private peering arrangements are extensive for inter- provider data transmission . DSL -- Digital Subscriber Line technology utilizes the copper wire between a customer's business and the Regional Bell Operating Company's (RBOC's) central office, to allow data transfer faster. Qwest offers a suite of solutions for accessing both the public Internet and private intranets . Dedicated Hosting -- locates customer servers and equipment in secure, state-of- the-art Qwest CyberCenters(SM), which are supported 24/7 by highly trained staff. Applications are protected with redundant HVAC air filtration, fire suppression systems, UPS power protection, and diesel generator backup . Virtual Private Network -- private network systems provided over Qwest's network, and includes customized dialing plans, routing and calling privileges and customized billing features . Online Commerce -- Qwest's Q.commerce(sm) retail offers a complete e-commerce solution for retailers, business-to-business companies and direct mail outlets . Private Line -- dedicated point-to-point voice, data, video and fax in a range of products, packages and speeds . ATM -- comprehensive, state-of-the-art networking technology that leverages the power of the Qwest Macro CapacityO Fiber Network to handle Internet, data, images and voice traffic . Frame Relay -- a proven high-speed data packet service. Ideal for LAN-to-LAN connectivity allowing geographically dispersed locations to exchange Internet, data, images and voice communications . Switched Voice -- voice service throughout the U.S. and to 230 countries . Operator Services -- services covering intra-LATA, intrastate, interstate and international automated (0+) and operator assisted (0-) calls . Qwest Professional Services -- taps into Qwest's industry-leading strategists, interactive designers and engineers to collaborate with customers to define and implement corporate information infrastructures . Enhanced Services: . Text Messaging -- local, regional and nationwide coverage . Broadcast Fax -- standard and totally-automated service . Teleconferencing -- conference calling for an unlimited number of participants, and customized options . Campus Talk -- customized calling plans for higher education institutions . Worldcard -- toll-free access from domestic and international locations. These and other services can be bundled into service packages: . Q.guaranteed(SM) -- allows customers to combine domestic and international voice, data and Internet protocol services under a single plan, with rate advantages, rate and service guarantees and a single monthly invoice . Q.biz(SM) -- combined voice, data and Internet protocol services for small businesses . Q.integrity(SM) -- a major national account plan designed for large national and international businesses, offering voice and data service and integrated pricing, billing, reporting and support. Consumer Services. Qwest's Consumer Services group provides a full range of voice, data, video and related services and products geared to consumers and home business markets. In 1999, Qwest introduced a new line of web- 11 based services for consumers under the name Q.home (sm) Internet Service. The service is delivered through an alliance with AOL/Netscape, which houses the service on its Internet portal. These services include: . Q.home Internet Access -- offering national dial-up Internet access for a competitive flat monthly rate for unlimited access, e-mail and news. The access software is provided by Netscape. Subscribers to Qwest long distance services receive a reduced fee . Q.home Send-A-Page -- a web-based paging service that allows customers to send text or numeric pages to other subscribers of the Qwest paging service. Subscribers enter the number, message and return number right on the Qwest paging web site . Q.home Click-to-Fax -- offers U. S. and international fax service through a web browser - just like an email. The recipient can receive the document through the fax or download it to a hard drive . Long distance -- competitive rates and simple terms on U. S. long distance, international, calling card and home 800 service, with all calls billed to the exact second after the first full minute . Prepaid calling cards -- toll-free connections billed in six-second increments. Wholesale Services. Products offered by Wholesale Services fall into the following four categories: . High-Volume Capacity -- Qwest provides high-volume transmission through lease and service agreements for terms of one year or longer. Qwest is targeting potential large users in the long distance market that may seek to augment their own networks or provide more diverse routing in strategic areas of their systems. . Dedicated Private Line -- Qwest provides dedicated private line services to a wide range of customers, generally for terms of one year or less. Qwest expects to offer these services over a significantly expanded geographic area now that its network is completed. In addition, Qwest provides high-speed voice and data services to carriers, Internet service providers and other communications entities. . Switched -- Qwest provides originating and terminating switched services over its switched services network to long distance carriers. This business increases volume on Qwest's switched services network and allows for more efficient utilization of circuits between switches. While carrier switched services generate revenue at lower margins than dedicated private line services, they contribute to the overall profitability of Qwest's network. . Other -- Wholesale Services also offers Dedicated Internet Access, Dedicated Hosting and Professional Services. These services are discussed in greater detail under Business Services. Customers are typically billed on a monthly basis and also may incur an installation or equipment charge. After contracts expire, they may be renewed or the services may be provided on a month-to-month basis. Switched services agreements are generally offered on a month-to-month basis, and the service is billed on a minutes-of-use basis. QwestLink. This new division is responsible for Qwest's local market expansion throughout the U. S., including the 25 cities recently announced. The Qwestlink division is creating a local access network for use by Qwest's customers by constructing or swapping fiber facilities in targeted markets. Qwestlink will also be responsible for overall procurement and management of access services from Incumbent Local Exchange Carriers ("ILECs"), Competitive Local Exchange Carriers ("CLECs"), and Data Local Exchange Carriers ("DLECs") on behalf of all Qwest groups. Construction Services Construction Services builds fiber optic and conduit systems for other carriers and for its own use and sells dark fiber to other communications entities. Qwest used its Construction Services resources to implement its strategic plan to complete its network, in addition to providing Construction Services to third-party customers along the network routes. Total revenue from Construction Services was approximately $224.5 million, $688.4 million and $581.4 million in 1999, 1998 and 1997, respectively. Competition The telecommunications industry is highly competitive. Any of Qwest's existing and potential competitors particularly in its communications services markets, compete with significantly greater financial, personnel, marketing and other resources, and have other competitive advantages. 12 The telecommunications industry is in a period of rapid technological evolution, marked by increasing fiber, wireless and satellite transmission capacity, new technologies and the introduction of new products and services. Recent technological advances enable substantial increases in transmission capacity of both new and existing fiber, which could affect capacity supply and demand. Also, the introduction of new products or emergence of new technologies may reduce the cost or increase the supply of certain services similar to those provided by Qwest. High initial network cost and low marginal costs of carrying long distance traffic have led to a trend among non-facilities-based carriers to consolidate in order to achieve economies of scale. Such consolidation could result in larger, better-capitalized competitors. However, Qwest believes that owning its own network will offer an advantage over carriers that lease network capacity. Increased consolidation and strategic alliances in the industry resulting from the Telecommunications Act of 1996 (the "Telecommunications Act") have allowed significant new competitors to enter the industry, including local exchange carriers, previously prohibited from the inter-exchange market. In recent years, competition has increased dramatically in all areas of Qwest's communications services market. Qwest's primary competitors include AT&T, Sprint and MCI WorldCom, all of whom have extensive experience in the traditional long distance market. The impact of continuing consolidation in the industry, such as last year's merger of MCI and WorldCom and the pending merger between Sprint and MCI WorldCom, is uncertain. In addition, the Telecommunications Act will eventually allow the local exchange carriers and others to enter the long distance market. As Qwest expands its business into Internet Protocol services, it also competes with a wide range of companies besides AT&T, Sprint and MCI WorldCom that provide web hosting, Internet access and other Internet Protocol products and services. Significant competitors include GTE, UUNet (a subsidiary of MCI WorldCom), Digex, Abovenet, Intel and Exodus. In addition, many smaller companies have entered the market for web site design. Qwest's main advantage in this market is offering a complete line of Internet Protocol services, hosting offers, web development services and application provider service offers through the Company's joint venture with KPMG, combined with the advantages of its comprehensive network. Qwest's disadvantages in the Internet protocol services market vary by type of competitor and the specific needs of individual customers. Some customers may choose larger competitors, such as IBM, Sprint or GTE, due to their scale and name recognition. Smaller companies may have an advantage through their concentration in just one segment of the Internet protocol market. Such companies may appeal to smaller, more specialized companies. In addition to Qwest, there are currently three other principal facilities- based long distance fiber optic networks (AT&T, Sprint and MCI WorldCom). Others are building or planning additional networks that, if constructed, could employ advanced technology similar to Qwest's network. Global Crossing, GTE, Broadwing and Williams Communications each may have a fiber network smaller in geographic scope and similar in potential operating capability to Qwest's network. Level 3 Communications may have a fiber network similar in geographic scope and potential operating capability to Qwest's network. However, Qwest's network was completed in mid-1999, at least a year ahead of the planned completion of the other networks mentioned above. Also, Qwest will be able to extend and expand the capacity of its network along secured rights of way, using the additional fibers retained by Qwest and the empty conduit installed along the initial build-out. Additionally, competitors such as MCI WorldCom and Level 3 have announced plans to construct local networks connected to their inter-city networks similar to the network Qwest is building. The opportunity to provide customers with end-to-end broadband capacity increases the value of the inter-city network. Global Crossing, which recently acquired Frontier Communications, announced major international fiber optic cable construction projects to expand high capacity access around the globe. Coupled with Frontier's domestic assets, Global Crossing will have significant reach into key market segments. Qwest, through its KPNQwest venture, is developing a pan-European network that combines both local broadband access and inter-city capabilities, which will utilize the multiple cables Qwest has capacity on across the Atlantic. The broadband access, both domestically and with KPNQwest, plus the expansion into Canada provide Qwest with broad geographic reach and scale. Both Level 3 and MCI WorldCom have announced international broadband networks that will compete with Qwest. 13 Research and Development In connection with the acquisitions of LCI, EUnet and Icon in 1998, Qwest expensed $760.0 million for in-process research and development projects since the development of these projects had not yet reached technological feasibility and the in-process research and development had no alternative future uses as of the acquisition date. These projects relate to the development of advanced voice and data services as well as sophisticated network management and administration functions. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations") Research and development costs incurred in the normal course of business are expensed as incurred. The Company incurred approximately $36.3 million and $ 27.7 million of such costs in 1999 and 1998, respectively. R&D costs were insignificant in 1997. Regulatory Matters Qwest's communications services business is subject to federal, state, local, and international regulation. Regulatory Background. The telecommunications industry is in the process of fundamental change set in motion by the rise of digital technology and the Internet and the Telecommunications Act of 1996. These developments are breaking down traditionally distinct communications market categories, such as long distance and local, that had served as clear regulatory boundaries. As a result, there has been a lot of activity in recent years both at the state and federal levels to accommodate existing regulatory regimes to new legislative directives and technological and market imperatives. Historically, AT&T monopolized telecommunications services in the United States and the present structure of the U.S. telecommunications market, though now changing, is largely the result of the AT&T break-up. The break-up created seven Regional Bell Operating Companies (RBOCs), which continue to provide local exchange service in their geographically defined areas, and a single, national long distance carrier, which kept the AT&T name. The RBOCs were not permitted under the terms of the break-up to provide long distance telephone service between Local Access Transport Areas (LATAs) in the regions they serve. The breakup resulted in the creation of two distinct telecommunications market segments, which are only beginning to break down: the local exchange segment and the long distance segment. Over time, the long distance market has become competitive while the local exchange markets continue to be dominated by the RBOCs and other incumbent carriers. In 1996, Congress enacted the Telecommunications Act of 1996, which amended the Communications Act of 1934 in a manner intended to promote competition and deregulation in all U.S. communications markets. Among other things, the Act ordered the FCC to make rules requiring the RBOCs and other incumbent local exchange carriers to take steps to open their local networks to competition. The Act requires incumbent local exchange carriers to give nondominant carriers: . the ability to lease facilities, features, and functions of the incumbent local exchange carriers' local exchange networks; . the ability to interconnect nondominant carrier facilities with the incumbent local exchange carriers' networks; and . the ability to purchase and resell certain services provided by the incumbent local exchange carriers. The Telecommunications Act also included provisions allowing the RBOCs to enter the inter-LATA long distance market in the regions they serve once they have opened their local markets to competition. The Telecommunications Act has been the subject of many court challenges. Federal Regulation. The Federal Communications Commission (FCC) is the federal entity responsible for regulating interstate and international telecommunications services under the Communications Act of 1934, as amended. The Communications Act imposes more extensive requirements on incumbent common carriers that have some degree of market power, such as the RBOCs and other, longstanding independent local exchange carriers, than it imposes on nondominant common carriers that lack market power, such as Qwest. The FCC permits nondominant carriers to provide domestic long distance services without prior authorization. However, the FCC requires such carriers to obtain authorizations to construct and operate telecommunications facilities, and to provide or resell telecommunications services, between the United States and international points. Qwest has obtained FCC authorization to provide international services. 14 State Regulation. Intrastate telecommunications services (including local exchange services) are regulated primarily by the state public utility commissions. Qwest must obtain and maintain certificates of authority from regulatory bodies in most states in which it offers intrastate services. In most states, Qwest also must file and obtain prior regulatory approval of tariffs for its intrastate services. State regulatory authorities can condition, modify, terminate or revoke certificates of authority for failure to comply with state law or the rules, regulations and policies of the state regulatory authorities. State regulatory authorities also may impose fines and other penalties for violations. Foreign Regulation. To the extent Qwest, its affiliates or its joint ventures have authorizations to provide telecommunications services in foreign countries, it is subject to the regulatory, licensing, operational, and other requirements in those countries. Access Charge Reform. Qwest's costs of providing long distance services could be affected by changes in the rules controlling the form and amount of "access charges" local exchange carriers (LECs) are permitted to impose on inter-exchange carriers (IXCs) to originate and terminate long distance calls over local networks. There has been a great deal of regulatory activity over the past three years at the federal level, and in some states, to reform the access charge system. There were several significant developments in 1999 in ongoing proceedings and litigation surrounding access charge reform. First, the US Court of Appeals for the DC Circuit remanded to the FCC for "further explanation" the agency's calculation of a key productivity factor in the formula price cap LECs use to calculate per minute access charges. The FCC has not yet responded to the Court, but did ask for and receive a stay of the Court's order, which expires on March 31, 2000. The stay permitted the productivity factor being questioned by the Court to be used in LEC access tariff filings made in June, 1999, which generally had the effect of reducing the per minute rates for interstate switched access. Second, a group of LECs and IXCs submitted a proposal to the FCC for further reform of access charges. If adopted as proposed, interstate access charges paid by Qwest would be reduced in future years more quickly than is currently planned. The FCC has sought comment on the proposal and has indicated that final action on it is a high priority for 2000. Third, in August 1999, the FCC issued an Order permitting LECs greater flexibility in pricing certain interstate access services and establishing a framework for further pricing relief once greater competition for access services develops. The Order also allows LECs to charge access rates that more closely approximate the true cost of providing access service in a given geographic area. Changes in the interstate access charge structure also could affect the costs of providing long distance "phone-to-phone" voice services using Internet Protocol technology. Traditionally, providers of long distance voice services over the Internet and companies that use Internet protocol technology to provide long distance services have been exempt from access charges. The FCC has suggested, however, that access charges might appropriately be imposed on long distance phone-to-phone voice services that use the Internet Protocol. If the FCC allows local exchange carriers to levy access charges on carriers providing such services, Qwest's costs to provide such services could increase. Qwest cannot predict the outcome of the ongoing access charge proceedings or whether they will have a material impact on the company. Universal Service. Qwest also incurs costs through its payments to state and federal universal service funds. These universal service funds generally provide subsidies to qualified providers of local exchange service to ensure that low-income customers and those living in areas that are expensive to serve have affordable basic phone service. The federal Universal Service Fund, through the Schools and Libraries Program ("E-Rate") and the Rural Health Care Program, also helps subsidize telecommunications and Internet connections to qualified schools, libraries and rural health care providers. Qwest's payments to the funds are based on a percentage of its telecommunications revenues. Individual states generally assess for universal service support based on revenues from intrastate services, while the federal fund bases all contributions on revenues from interstate and international telecommunications services. Several recent regulatory and legal developments may affect the amount of Qwest's universal service liability. First, the US Court of Appeals for the Fifth Circuit ruled in July 1999 that the FCC does not have authority to include intrastate revenues in the revenue base for calculating carriers' federal universal service contributions. The Court's ruling may tend to increase the universal service contributions of carriers that are primarily long distance providers, like Qwest. In that decision, the Court also upheld the "E-Rate." The FCC announced in May its intention to fund the program fully at $2.25 billion per year for the second funding year. Second, the FCC adopted a new high-cost universal service support mechanism for non-rural local carriers. The new mechanism, which includes a $230 million increase in 15 the federal universal Service Fund, went into effect January 1, 2000, although the FCC has deferred provision of forward-looking high-cost support for non- rural carriers until the third quarter of 2000. At that time, Qwest's payments to the USF are likely to increase, although the amount of the increase cannot be predicted at this time. Qwest is unable to predict the effect on its operations of future action in FCC proceedings or pending judicial appeals concerning universal service. FCC Inquiry into Flat-Rate Charges on Long Distance Bills. In July, 1999, the FCC initiated an inquiry into the impact of flat-rate charges on long distance customers who make fewer calls, including charges to recover carriers' costs related to access charges, universal service and other federal regulatory action. The inquiry is not a rulemaking proceeding. However, the adoption of rules by the FCC in the future that limit or prohibit IXCs' from charging flat monthly fees to customers could negatively impact Qwest. Local Exchange Carrier Applications to Provide Long Distance Service. The Telecommunications Act permits RBOCs to enter the inter-LATA long distance markets within their service areas when the FCC determines that they have complied with the requirements of the Telecommunications Act and opened their local exchange networks to competition. On December 22, 1999, the FCC granted Bell Atlantic's application to provide inter-LATA services originating in New York. On January 10, 2000, SBC, Inc. filed an application with the FCC to provide inter-LATA services originating in Texas. Although other RBOCs have filed applications in the past, this is the only application pending before the FCC. Qwest is unable to predict when RBOCs will receive authority to compete in the long distance markets in other in-region states. Qwest expects, however, that the RBOCs will gain a significant share of the long distance markets in their service territories at the expense of current IXCs, including Qwest, once they obtain long distance authority. Supreme Court Decision on FCC Rules Implementing the Telecommunications Act. On January 25, 1999, the U.S. Supreme Court issued a decision that upheld many of the rules the FCC had promulgated to implement the portions of the Telecommunications Act that are designed to bring competition to local exchange markets. In the decision, the Supreme Court upheld the FCC's authority to implement the Telecommunications Act through rules binding on the states. The Supreme Court also upheld the FCC's regulations regarding state review of interconnection agreements, the granting of certain exemptions to rural incumbent local exchange carriers, and dialing parity. "Dialing parity" means that consumers can use nondominant carriers by dialing as they normally do, rather than having to dial extra access codes. The Supreme Court upheld several prior FCC rulings. First, the Court upheld the FCC's ruling that competitors need not own facilities in order to lease network elements from incumbent local exchange carriers. Second, it upheld the ruling that incumbent local exchange carriers may not separate combinations of network elements before providing them to nondominant carriers unless requested to do so. Third, the FCC was upheld in its ruling that network elements include the features, functions, and capabilities provided by means of network equipment. The Supreme Court also held that nondominant carriers may adopt particular provisions of another carrier's interconnection agreement without adopting the entire agreement. In the January 25, 1999 decision, however, the Supreme Court vacated the FCC's rules setting forth a national list of unbundled network elements (UNEs) which incumbents must provide, at a minimum, to competitors. The Court instructed the FCC to reconsider the list in light of the statutory criteria for defining UNEs. The FCC subsequently did so and completed its reconsideration in September 1999. In the new rules, the FCC required ILECs to make available five basic network elements that had been included in the 1996 list of network elements (local loops, network interface devices, interoffice transmission facilities, signaling networks and call-related databases, and operations support systems). The new rules include elements not on the original list, specifically subloops, dark fiber loops, and dark fiber transport. A sixth element on the original list, local circuit switching, will be restricted when used to serve business customers with four or more lines in the densest portions of the top 50 metropolitan statistical areas (MSAs). The seventh original element, operator services and directory assistance, is eliminated as a network element under the new rules. The Commission generally declined to designate as network elements those ILEC facilities used to provide data services, such as digital subscriber line access multiplexers (DSLAMs) and packet switches. The FCC did require ILECs to unbundle DSLAMs only when a requesting carrier is unable to install its DSLAM at the ILEC's remote terminal and when the ILEC provides packet switching for its own use. The unbundling rules adopted in the FCC's decision apply nationwide. State commissions may require ILECs to unbundle additional elements as long as the obligations are consistent with the requirements of Section 251 and the national policy framework established by the Commission. Neither the FCC nor state commissions can remove elements from the national list on a state-by-state basis. The FCC will reevaluate the list of elements in three years. Qwest is unable to predict how these new rules will affect its business. In 16 addition, these new rules may be appealed to federal court. Qwest cannot predict the outcome of such a court challenge to the rules. The US Court of Appeals for the Eighth Circuit still must review the method adopted by the FCC in 1996 for establishing prices for network elements and interconnection. Qwest is unable to predict what actions the court will take on pricing. The Supreme Court's decision is likely to have an impact on interconnection agreements between nondominant carriers and incumbents, the rules the states have adopted concerning local exchange competition, and the RBOCs' applications for entry into the inter-LATA long distance market. Qwest is unable to predict, however, how the decision will impact those matters or how the decision will affect competition. "Slamming" -- Unauthorized Changes of Consumers' Presubscribed Carriers. In 1997, the FCC began drafting rules designed to prevent "slamming," which is defined as the intentional, unauthorized switching of a customer's chosen local or long-distance carrier. In December 1998, the FCC released new rules governing slamming. These rules include: more stringent requirements for verifying a consumer's consent to change carriers, stronger liability provisions for carriers responsible for slamming, and procedures for determining customer and carrier liability after slamming has occurred. The FCC's new rules also broaden the scope of the prior carrier switch rules to cover not only switching of long distance services, but also the switching of local exchange and other services. In addition to issuing new rules, the FCC also sought comment on more proposed changes to the carrier change rules. These proposed changes include: the use of electronic and Internet procedures for verifying a consumer's consent to change carriers, modification of the procedures for using third parties to verify a consumer's consent to change carriers, and other carrier liability issues. The new slamming rules, except those dealing with liability, became effective in April of 1999. The effectiveness of the rules dealing with liability has been stayed indefinitely by the US Court of Appeals for the DC Circuit while the FCC considers petitions for reconsideration. In addition, an industry group has filed a proposal with the FCC that would establish an independent third party administrator to resolve carrier switch disputes. Qwest has taken steps to implement the new slamming rules that have gone into effect. However, Qwest is unable to predict the outcome of ongoing FCC proceedings or the impact of these rules. In October, 1999, the FCC issued a Notice of Apparent Liability for Forfeiture (NAL) for $2.08 million against Qwest, thereby initiating an enforcement action against Qwest for "apparently willfully or repeatedly violating section 258 of the Communications Act of 1934, as amended (the Act), as well as Commission rules and orders, by changing the designated preferred carriers of thirty consumers without their authorization." Qwest has issued a public response to the NAL and held settlement discussions with the FCC, but there has been no final resolution of the matter. Truth-in-billing. In April 1999, the FCC adopted guidelines governing the format and content of telephone bills. These guidelines, which became effective on November 12, 1999, require carriers to (1) clearly identify the service provider responsible for each charge on the bill; (2) clarify when customers may withhold payment to dispute a charge without risking the loss of their basic local service; (3) identify on the bill the carrier to whom a customer should direct his or her complaint about a particular charge; and (4) utilize uniform descriptions for line item charges related to federal regulatory action. The adoption of these new rules will impact the way Qwest presents its bills to customers and Qwest expects to incur costs in complying with the new rules. The FCC also sought public comment on the uniform descriptions it should adopt for line item charges related to regulatory action, but no final determination has been made. Advanced Telecommunications Services. Advanced telecommunications services provide high-speed, switched, broadband telecommunications capability that enables users to originate and receive high-quality voice, data, graphics, and video telecommunications using any technology. In March of 1999, the FCC issued an Order intended to facilitate competitors' ability to lease space in the incumbent's central office (collocation space). The Commission adopted rules to strengthen collocation requirements and reduce the costs and delays associated with collocation. In particular, the Commission required incumbent LECs to make new collocation arrangements, including cageless and shared collocation, available to competing carriers. In November 1999, the FCC amended its unbundling rules to require incumbent LECs to provide unbundled access to a new network element, the high frequency portion of the local loop. The purpose is to enable "line sharing," which permits a competitive LEC to offer advanced services such as digital subscriber line service over the same line an incumbent offers voice service. The FCC hopes linesharing will enable competitive LECs to compete with incumbent LECs to provide xDSL-based services. In the same order, the FCC adopted spectrum management policies and rules to 17 facilitate the competitive deployment of advanced services. The steps taken by the FCC with respect to line sharing may benefit Qwest by facilitating the provision of advanced local telecommunications services by new entrants in the local markets. Also in November 1999, the FCC clarified that digital subscriber line services (xDSL) used to provide high-speed Internet service are not subject to the discounted resale obligations of the 1996 Telecommunications Act when sold in bulk to Internet Service Providers (ISPs). Qwest is unable to predict the affect of matters pending in the advanced services proceedings. Qwest also is unable to predict what impact FCC action in this area would have on the nature of competition. Several companies also asked the FCC to require cable television companies to provide competitors with access to high capacity cable television lines, such as those used to provide Internet access services to cable television subscribers. To date, the FCC has declined to address this issue. Reciprocal Compensation for Internet Service Provider Transmissions. The Telecommunications Act requires local exchange carriers to pay each other reciprocal compensation for transporting and terminating each others' local calls. In June 1997, however, the incumbent local exchange carriers asserted that they were not required to pay reciprocal compensation to nondominant carriers for the transport and termination of calls to Internet service providers because they were not "local calls." On February 25, 1999, the FCC ruled that calls to Internet service providers are interstate calls, not local calls. However, the FCC said that state commissions could examine whether existing contracts specifically required ILECs to pay reciprocal compensation on calls destined for ISPs. A number of state commissions have concluded that existing interconnection contracts do require ILECs to pay reciprocal compensation for such calls. The FCC's ruling has been appealed in the courts. The FCC has sought comment on proposed federal rules that would govern the payment of reciprocal compensation for such calls, but no final action has been taken. 1+ Dialing Parity. In many states, consumers wishing to use carriers other than the incumbent local exchange carrier for intra-LATA long distance services have had to dial special access codes to do so. The need to dial extra digits in these states makes it more difficult for Qwest to attract customers for its intra-LATA long distance service. If a nondominant carrier's customer attempts to make one of these calls by simply dialing "1" plus the desired number, the call will automatically be routed to the incumbent local exchange carrier in those states that have not required 1+ dialing parity. The Supreme Court's January 25, 1999 decision, which is discussed above, upheld the FCC's original rule requiring states to implement intra-LATA toll dialing parity by February 8, 1999. Due to the timing of the Supreme Court decision, the FCC permitted additional time, until the late summer of 1999, for states to complete implementation. With the exception of a few limited, rural areas for which incumbents were granted extensions, dialing parity should now be implemented nationwide. Qwest expects to benefit from the implementation of this 1+ calling capability. Federal Tariff Requirements. Qwest is required to file tariffs for its interstate and international long distance services with the FCC. In October 1996, the FCC adopted an order concluding that nondominant carriers, such as Qwest, would no longer be permitted to maintain tariffs on file with the FCC for domestic interstate services. This order applies to all nondominant interstate carriers, including AT&T. The order does not apply to local exchange providers. The FCC order was issued based on a provision in the Telecommunications Act, which generally permits the FCC to "forbear" from a given regulation if the FCC determines that forbearance will serve the public interest. In February 1997, the U.S. Court of Appeals for the District of Columbia Circuit halted implementation of the FCC order pending the Court's review of the order. Implementation of the order remains halted. If the FCC order is allowed to become effective, telecommunications carriers such as Qwest would no longer be able to rely on the filing of tariffs with the FCC as a means of providing notice to customers of prices, terms, and conditions on which they offer their interstate services. Instead, carriers such as Qwest would be required to maintain and make publicly available their rate and service information. In that situation, Qwest would rely on its sales force and direct marketing to provide pricing information to its customers. Qwest Joint Marketing Agreements. Based upon a complaint brought by AT&T, MCI WorldCom and other long distance carriers, the FCC in September 1998 disapproved two separate joint marketing agreements entered into by Qwest with US West and Ameritech. The FCC disapproved these agreements because it found that under those agreements, US West and Ameritech would be providing long distance services outside of their local areas in violation of the Telecommunications Act. The FCC did not find that Qwest had engaged in any unlawful conduct. Qwest, US West and Ameritech appealed the FCC's decision to the U.S. Court of Appeals for the District of Columbia Circuit, arguing that the agreements were lawful efforts under the Telecommunications Act to jointly market the local services of US West and 18 Ameritech with the long distance services of Qwest, and did not involve US West or Ameritech providing long distance service in their local areas. In June 1999, the court ruled against Qwest, US West, and Ameritech. Petitions by US West and Ameritech for re-hearing and for writ of certiori were subsequently denied. State Regulation. As discussed above, Qwest's local and intrastate long distance telecommunications operations are subject to various state laws and regulations. Many of these state laws and regulations address competition in the local exchange and intrastate long distance markets even though the FCC also has authority to implement rules governing competition in these markets. The U.S. Supreme Court's January 25, 1999 decision upholding many of the FCC's local competition rules and the FCC's subsequent adoption of new local competition rules, will likely impact many of the regulations the states have implemented and are in the process of implementing. Qwest is unable to predict, however, exactly what this impact will be or what actions the various states will take in light of the Supreme Court's decision. Municipal and Other Local Regulation. Municipalities occasionally require Qwest to obtain street use and construction permits and licenses or franchises in order to install and expand its fiber optic network using municipal rights- of-way. A municipality's decision to terminate existing franchise or license agreements before they expire or a municipality's decision to not renew franchise or license agreements could adversely affect Qwest. A municipality's decision to require Qwest to remove its facilities or abandon its network in place also could adversely affect Qwest. In some municipalities where Qwest has installed or expects to construct networks, it will be required to pay license or franchise fees based on a percentage of gross revenue or on a per-linear-foot basis. There is no guarantee that franchise fees will remain at their current levels after existing franchises expire. In addition, Qwest could be placed at a competitive disadvantage if its competitors do not pay the same level of fees as Qwest. However, the Telecommunications Act requires municipalities to manage public rights-of-way in a competitively neutral and non-discriminatory manner. Regulation of International Services. In April, 1999, the FCC approved reform of the longstanding international settlements policy, deregulating inter-carrier settlement arrangements between U.S. carriers and foreign non-dominant carriers on competitive routes. The international settlements policy, which prohibits U.S. carriers from accepting discriminatory terms and conditions for the termination of traffic in overseas markets, was originally designed to prevent monopoly foreign carriers from taking advantage of the competitive marketplace in the United States by playing one carrier off against another. The reform eliminated the international settlements policy for arrangements with foreign carriers that lack market power and for all arrangements on routes where rates to terminate U.S. calls are sufficiently low. Merger Applications. Qwest and U S WEST have stated their intention to merge and have filed applications with federal and state agencies seeking approval for the merger. Applications have been filed at the FCC and with the Public Service Commissions in the following nine states in the U S WEST region: Arizona, Colorado, New Mexico, Utah, Washington, Montana, Wyoming, Minnesota, and Iowa. Applications for merger approval were not required to be filed in the remaining five states in the US WEST region. In addition, Qwest has filed applications in connection with its merger in certain other states outside the US WEST service territory. All of these applications are currently under review by the appropriate federal and state government officials. On January 7, 2000, the Colorado Public Utility Commission issued a decision unanimously approving the merger application. The only condition adopted imposes a periodic audit requirement with respect to local network investment and maintenance. Other. Qwest monitors compliance with federal, state, and local regulations governing the discharge and disposal of hazardous and environmentally sensitive materials. These materials include the emission of electromagnetic radiation. Qwest believes that it is in compliance with such regulations. However, a discharge, disposal or emission of hazardous or environmentally sensitive materials could expose Qwest to claims or actions that could adversely affect Qwest. Employees As of December 31, 1999, Qwest employed approximately 10,000 employees. None of Qwest's employees are currently represented by a collective bargaining agreement. Qwest believes that its relations with its employees are good. Corporate and Other Information Qwest is a Delaware corporation, organized in 1997 to hold the stock of its indirect principal subsidiary, Qwest Communications Corporation, which started its telecommunications business in 1988. 19 Qwest's principal executive offices are located at 700 Qwest Tower, 555 Seventeenth Street, Denver, Colorado 80202, and its telephone number is (303) 992-1400. Qwest's web site is http://www.qwest.com. Item 2. Properties Qwest's network and its component assets are the principal properties owned by Qwest. Qwest owns substantially all of the telecommunications equipment required for its business. Qwest's installed fiber optic cable is laid under the various rights of way held by Qwest. Other fixed assets are located at various locations in geographic areas served by Qwest. Qwest leases sales offices for its communications services business unit in major metropolitan locations in the United States and internationally. Qwest's executive and administrative offices are located at its principal office in Denver, Colorado. Qwest leases this space from an affiliate of Anschutz Company at market rates under an agreement that expires in October 2004. Qwest leases additional space in the following locations: Arlington, Virginia, housing a network operating center, customer service operations and administrative offices; Dublin, Ohio, Weehawken, New Jersey and San Francisco, California, each housing administrative offices and data centers; and Dallas, Texas, housing the headquarters for operation of Qwest's microwave system. Qwest has network management centers in the following locations: its principal office in Denver, Colorado, Dublin, Ohio, Weehawken, New Jersey, Arlington, Virginia, and San Antonio, Texas, all of which are leased. Qwest's communications services business unit has customer service operations in Denver, Colorado, Dublin, Ohio, Greenville, South Carolina, San Antonio, Texas, and Weehawken, New Jersey. Item 3. Legal Proceedings Qwest has been named as a defendant in Drawhorn v. Qwest Communications International Inc. et al., Hudson v. Qwest Communications International Inc., Hord v. Qwest Communications International Inc. et al., and Cirese Construction v. Qwest Communications, et al. The cases are purported class actions, filed in Texas, Indiana, Tennessee and Missouri, respectively, which involve the Company's right to install its fiber optic cable network in easements and right- of-ways crossing the plaintiff's land. In general, the Company obtained the rights to construct its network from railroads, utilities, and others, and installed its network along the rights of way so granted. Plaintiffs in the purported class actions assert that they are the owners of lands over which Qwest's fiber optic cable network passes, and that the railroads, utilities, and others who granted to Qwest the right to construct and maintain its network did not have the legal ability to do so. The Indiana and Texas actions purport to be on behalf of a national class of owners of land over which Qwest's network passes; the Tennessee and Missouri actions purport to be on behalf of a class of such owners in Tennessee and Missouri. The complaints seek damages on theories of trespass and unjust enrichment, and punitive damages as well. Qwest has received, and may in the future receive, claims and demands related to rights of way issues similar to the issues in these cases that may be based on similar or different legal theories. Management believes that the Company has substantial defenses to the claims asserted in these actions, and intends to defend them vigorously. On September 15, 1998, in an action captioned Aaron Parnes v. Scott A. Baxter, Wayne B. Weisman, Richard M. Brown, Scott Harmolin, Samuel A. Plum, Icon CMT Corp. and Qwest Communications International Inc., the plaintiff filed a putative class action complaint in the Court of Chancery of the State of Delaware in and for New Castle County (the "Court") against Icon, its directors and Qwest. In the suit, the plaintiff alleged that consummation of the Icon merger would subject the Icon stockholders to the control of the principal stockholder of Qwest after the consummation of the merger. The plaintiff further alleged that the Icon merger would constitute a change in control of Icon and impose heightened fiduciary duties on the members of the Icon board of directors to maximize stockholder value. The plaintiff also alleged that the members of the Icon board of directors violated their fiduciary duties by failing to auction Icon or to undertake an active "market check" for other potential bidders. The plaintiff sought, among other things, to have the Court declare the suit a proper class action, enjoin the Icon merger and require the members of the Icon board of directors to auction Icon and/or conduct a "market check," and to award monetary damages, together with costs and disbursements. The defendants filed answers denying the allegations of the complaint. No proceedings occurred in the case. On 20 February 17, 2000, the plaintiff filed a Notice of Dismissal, voluntarily dismissing the action without prejudice. Pursuant to the Notice, the Court ordered dismissal of the case on February 18, 2000. On April 3, 1998, in an action captioned Lionel Phillips v. LCI International Inc. and H. Brian Thompson, the plaintiffs filed a putative class action complaint in the United States District Court for the Eastern District of Virginia against LCI and H. Brian Thompson, the Chairman and Chief Executive Officer of LCI. The plaintiffs brought the action as a class action purportedly on behalf of stockholders of LCI who sold LCI Common Stock between February 17, 1998 and March 9, 1998. The plaintiffs alleged, among other things, that the defendants violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder by making materially false and misleading statements that LCI was not for sale at a time when negotiations between Qwest and LCI regarding a potential merger were allegedly ongoing. On June 25, 1998, defendants moved to dismiss the complaint on the grounds that it failed to state a claim against defendants. The complaint was dismissed, an amended complaint was filed and, on September 30, 1998, the District Court granted defendants' motion to dismiss the amended complaint. In a decision dated September 15, 1999, the United States Court of Appeals for the Fourth Circuit affirmed the lower court's dismissal of the amended complaint. Judgment was entered on October 13, 1999. Qwest also has been named as a defendant in various other litigation matters. Management intends to vigorously defend these outstanding claims. Qwest believes it has adequate accrued loss contingencies and that, although the ultimate outcome of these claims cannot be ascertained at this time, current pending or threatened litigation matters are not expected to have a material adverse impact on Qwest's results of operations or financial position. Item 4. Submission of Matters to a Vote of Security Holders On November 2, 1999, the Qwest held a special shareholder meeting to vote on the approval of the merger and the adoption of the merger agreement between Qwest and U S WEST, Inc., and the approval and ratification of the Qwest Communications International, Inc. Equity Incentive Plan. There were 746,444,769 shares of Common Stock of Qwest that could be voted at the meeting, and 85.67%, or 639,479,234 shares, of Common Stock were represented at the meeting, in person or by proxy, which constituted a quorum. The results were as follows: 1. Approval and adoption of the merger and the Agreement and Plan of Merger dated as of July 18, 1999 between Qwest and U S WEST, Inc., as amended: For Against Abstain --- ------- ------- 611,830,544 20,116,831 7,531,859 2. Approval and ratification of the Qwest Communications International Inc. Equity Incentive Plan: For Against Abstain --- ------- ------- 597,355,907 32,728,560 9,394,767 21 Part II. Item 5. Market for the Registrant's Common Stock and Related Shareholder Matters The information under the caption "Market for the Registrant's Common Stock and Related Shareholder Matters" on page 51 of Qwest's 1999 Annual Report is incorporated herein by reference. Item 6. Selected Financial Data The financial information in the table under the caption "Selected Financial Data" on page 21 of Qwest's 1999 Annual Report is incorporated herein by reference. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 22-30 of Qwest's 1999 Annual Report is incorporated herein by reference. Item 7A. Quantitative and Qualitative Disclosures About Market Risk The information under the caption "Quantitative and Qualitative Disclosures About Market Risk" on page 31 of Qwest's 1999 Annual Report is incorporated herein by reference. Item 8. Financial Statements and Supplementary Data Qwest's Consolidated Financial Statements and related Notes thereto and the Independent Auditors' Report on pages 32-50 of Qwest's 1999 Annual Report, as well as the unaudited information set forth in Note 15 - Selected Consolidated Quarterly Financial Data on page 50 of Qwest's 1999 Annual Report, are incorporated herein by reference. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None. Part III. Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions The information required by Items 10, 11, 12 and 13 of Part III of this annual report on Form 10-K is incorporated by reference from and will be contained in Qwest's definitive proxy statement for its annual meeting of stockholders to be filed with the commission by April 30, 2000. 22 Part IV. Item 14. Exhibits, Financial Statements, and Reports on Form 8-K (a) List of documents filed as part of this report:
1. Financial Statements: The following items are incorporated herein by reference from the pages indicated in the Company's 1999 Annual Report: Page ---- Consolidated Statements of Operations for the three years ended December 31, 1999 33 Consolidated Balance Sheets as of December 31, 1999 and 1998 34 Consolidated Statements of Stockholders' Equity for the three years ended December 31, 1999 35 Consolidated Statements of Cash Flows for the three years ended December 31, 1999 36 Notes to Consolidated Financial Statements 37
2.1 Agreement and Plan of Merger dated as of July 18, 1999 between U S WEST, Inc. and Qwest, as amended (incorporated herein by reference to Amendment No. 2 to Qwest's Registration Statement on Form S-4/A filed September 17, 1999 3.1** Amended and Restated Certificate of Incorporation of Qwest. 3.2***** Certificate of Amendment of Amended and Restated Certificate of Incorporation of Qwest. 3.3 Certificate of Amendment to the Amended and Restated Certificate of Incorporation, as amended (incorporated herein by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 1999). 3.4 Amended and Restated Bylaws (incorporated by reference to Qwest's Annual Report on Form 10-K for the year ended December 31, 1998). 4.1(a)*** Indenture dated as of October 15, 1997 with Bankers Trust Company (including form of Qwest's 9.47% Senior Discount Notes due 2007 and 9.47% Series B Senior Discount Notes due 2007 as an exhibit thereto). 4.1(b)**** Indenture dated as of August 28, 1997 with Bankers Trust Company (including form of Qwest's 10 7/8% Series B Senior Notes due 2007 as an exhibit thereto). 4.1 (c)**** Indenture dated as of January 29, 1998 with Bankers Trust Company (including form of Qwest's 8.29% Senior Discount Notes due 2008 and 8.29% Series B Senior Discount Notes due 2008 as an exhibit thereto). 4.1(d) Indenture dated as of November 4, 1998 with Bankers Trust Company (including form of Qwest's 7.50% Senior Discount Notes due 2008 and 7.50% Series B Senior Discount Notes due 2008 as an exhibit thereto) (incorporated by reference to Qwest's Registration Statement on Form S-4 (File No. 333-71603) filed February 2, 1999). 4.1(e) Indenture dated as of November 27, 1998 with Bankers Trust Company (including form of Qwest's 7.25% Senior Discount Notes due 2008 and 7.25% Series B Senior Discount Notes due 2008 as an exhibit thereto) (incorporated by reference to Qwest's Registration Statement on Form S-4 (File No. 333-71603) filed February 2, 1999). 4.2(b) Registration Agreement dated November 27, 1998 with Salomon Brothers Inc relating to Qwest's 7.25% Senior Discount Notes due 2008 (incorporated by reference to Qwest's Registration Statement on Form S-4 (File No. 333-71603) filed February 2, 1999). 4.3 Indenture dated as of June 23, 1997 between LCI International, Inc., and First Trust National Association, as trustee, Providing for the Issuance of Senior Debt Securities, including Resolutions of the Pricing Committee of the Board of Directors establishing the terms of the 7.25% Senior Notes due June 15, 2007 (incorporated by reference to exhibit 4(c) in LCI's Current Report on Form 8-K dated June 23, 1997). 4.4 Credit Agreement, dated as of March 31, 1999, among Qwest Communications International Inc., as Borrower, NationsBank, N.A., as Administrative Agent, and the Lenders party thereto (incorporated herein by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 1999). 10.1** Growth Share Plan, as amended, effective October 1, 1996.* 10.2 Equity Incentive Plan, as amended.* (incorporated herein by reference to Qwest's quarterly report on Form 10-Q for the quarter ended June 30, 1999)
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10.3 Qwest Communications International Inc. Employee Stock Purchase Plan (incorporated by reference to Qwest's Preliminary Proxy Statement for the Annual Meeting of Stockholders, filed February 26, 1999).* 10.4 Qwest Communications International Inc. Deferred Compensation Plan (incorporated by reference to Qwest's Annual Report on Form 10-K for the year ended December 31, 1998).* 10.5**** Equity Compensation Plan for Non-Employee Directors.* 10.6 Qwest Communications International Inc. 401-K Plan (incorporated by reference to Qwest's Annual Report on Form 10-K for the year ended December 31, 1998).* 10.7** Employment Agreement dated December 21, 1996 with Joseph P. Nacchio.* 10.8**** Growth Share Plan Agreement with Joseph P. Nacchio, effective January 1, 1997, and Amendment thereto.* 10.9**** Non-Qualified Stock Option Agreement with Joseph P. Nacchio, effective June 23, 1997.* 10.11** Promissory Note dated November 20, 1996 and Severance Agreement dated December 1, 1996 with Robert S. Woodruff.* 10.12**** Employment Agreement dated March 7, 1997 with Stephen M. Jacobsen.* 10.13**** Employment Agreement dated September 19, 1997 with Larry Seese.* 10.15**** Employment Agreement dated October 8, 1997 with Lewis O. Wilks.* 10.16**+ IRU Agreement dated as of October 18, 1996 with Frontier Communications International Inc. 10.17**+ IRU Agreement dated as of February 26, 1996 with WorldCom Network Services, Inc. 10.18**+ IRU Agreement dated as of May 2, 1997 with GTE. 10.19 LCI International, Inc. 1992 Stock Option Plan (incorporated by reference to LCI's Registration Statement No. 33-60558).* 10.20 LiTel Communications, Inc. 1993 Stock Option Plan (incorporated by reference to LCI's Registration Statement No. 33-60558).* 10.21 LCI International, Inc. 1994/1995 Stock Option Plan (incorporated by reference to LCI's Annual Report on Form 10-K for the year ended December 31, 1993).* 10.22 LCI International, Inc. 1995/1996 Stock Option (incorporated by reference to LCI's Proxy Statement for the 1995 Annual Meeting of Shareowners).* 10.23 LCI International Management Services, Inc. Supplemental Executive Retirement Plan (incorporated by reference to LCI's Quarterly Report on Form 10-Q for the quarter ended March 31, 1995).* 10.24 1997/1998 LCI International, Inc. Stock Option Plan (incorporated by reference to LCI's Annual Report on Form 10-K for the year ended December 31, 1996).* 10.25(a) 1995 Stock Option Plan of Icon CMT Corp. (incorporated by reference to Icon CMT Corp.'s Registration Statement on Form S-1/A, No. 333-38339).* 10.25(b) Amendment to Amended and Restated 1995 Stock Option Plan of Icon CMT Corp. (incorporated by reference to Qwest's Annual Report on Form 10-K for the year ended December 31, 1998).* 10.26 U.S. Long Distance Corp. 1990 Employee Stock Option Plan (incorporated by reference to Qwest's Annual Report on Form 10-K for the year ended December 31, 1998).* 10.27+ Contractor Agreement dated January 18, 1993 by and between LCI International Telecom Corp. and American Communications Network, Inc. (incorporated by reference to LCI's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995). 10.28 Participation Agreement dated as of November 1996 among LCI International, Inc., as the Construction Agent and as the Lessee, First Security Bank, National Association, as the Owner Trustee under the Stuart Park Trust the various banks and lending institutions which are parties thereto from time to time as the Holders, the various banks and lending institutions which are parties thereto from time to time as the Lenders and NationsBank of Texas, N.A., as the Agent for the Lenders (incorporated by reference to LCI's Annual Report on Form 10-K for the year ended December 31, 1996). 10.29 Agency Agreement between LCI International, Inc., as the Construction Agent and First Security Bank, National Association, as the Owner Trustee under the Stuart Park Trust as the Lessor dated as of November 15, 1996 (incorporated by reference to LCI's Annual Report on Form 10-K for the year ended December 31, 1996). 10.30 Deed of Lease Agreement dated as of November 15, 1996 between First Security Bank, National Association as the Owner Trustee under the Stuart Park Trust, as Lessor and LCI International, Inc. as Lessee (incorporated by reference to LCI's Annual Report on Form 10-K for the year ended December 31, 1996).
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10.31 Common Stock Purchase Agreement dated as of December 14, 1998 with Microsoft Corporation (incorporated by reference to Qwest's Current Report on Form 8-K filed December 16, 1998). 10.32 Registration Rights Agreement dated December 14, 1998 with Microsoft Corporation (incorporated by reference to Qwest's Current Report on Form 8-K filed December 16, 1998). 10.33 Registration Rights Agreement dated as of April 18, 1999 with Anschutz Company and Anschutz Family Investment Company LLC (incorporated by reference to Qwest's Current Report on Form 8-K/A filed April 28, 1999). 10.34 Common Stock Purchase Agreement dated as of April 19, 1999 with BellSouth Enterprises, Inc. (incorporated by reference to Qwest's Current Report on Form 8-K/A filed April 28, 1999). 10.35 Registration Rights Agreement dated as of April 19, 1999 with BellSouth Enterprises, Inc. (incorporated by reference to Qwest's Current Report on Form 8-K/A filed April 28, 1999). 10.36 Voting Agreement dated as of July 18, 1999 among each of the shareholders listed on the signature page thereto and U S WEST, Inc. (incorporated herein by reference to Qwest's Current Report on Form 8-K dated July 20, 1999) 10.37 Agreement entered into as of July 18, 1999 between Qwest and Global Crossing Ltd. (incorporated herein by reference to Qwest's Current Report on Form 8-K dated July 20, 1999) 10.38 Agreement dated as of July 18, 1999 between Qwest and Global Crossing Holdings Ltd. (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended June 30, 1999). 10.39 Purchase Agreement by and among Qwest, Slingshot Networks, LLC and Anschutz Digital Media, Inc. dated September 26, 1999 (incorporated herein by reference to Qwest's quarterly report on Form 10-Q for the quarter ended September 30, 1999). 10.40 Amended and Restated Operating Agreement of Slingshot Networks, LLC dated October 22, 1999 (incorporated herein by reference to Qwest's quarterly report on Form 10-Q for the quarter ended September 30, 1999). 21.1 Subsidiaries of the Registrant (incorporated herein by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 1999). 23.1 Consent of Independent Public Accountants 23.2 Consent of Independent Auditors 27 Financial Data Schedule * Indicates executive contracts, compensation plans and arrangements. ** Incorporated by reference in Form S-1 as declared effective on June 23, 1997 (File No. 333-25391). *** Incorporated by reference to exhibit 4.1 in Form S-4 as declared effective on January 5, 1998 (File No. 333-42847). **** Incorporated by reference in Qwest's Form 10-K for the year ended December 31, 1997. ***** Incorporated by reference to the exhibit of the same number to Qwest's Registration Statement on Form S-3 (File No. 333-58617) filed July 7, 1998. + Portions have been omitted pursuant to a request for confidential treatment.
(b) Reports on Form 8-K: During the quarter ended December 31, 1999, Qwest filed the following Current Reports on Form 8-K: (i) On October 27, 1999, Qwest filed a Current Report on Form 8-K announcing its third quarter 1999 results of operations. 25 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Qwest Communications International Inc., a Delaware corporation By: /s/ Robert S. Woodruff --------------------------------- Robert S. Woodruff Executive Vice President--Finance and Chief Financial Officer (Principal Accounting Officer) March 17, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Titles Date --------- ------ ---- /s/ Philip F. Anschutz Chairman of the Board of Directors March 17, 2000 - ---------------------- Philip F. Anschutz /s/ Joseph P. Nacchio Director, Chairman and Chief March 17, 2000 - --------------------- Executive Officer Joseph P. Nacchio /s/ Robert S. Woodruff Director, Executive Vice President - March 17, 2000 - ---------------------- Finance and Chief Financial Officer Robert S. Woodruff (Principal Accounting Officer) /s/ Cannon Y. Harvey Director March 17, 2000 - -------------------- Cannon Y. Harvey /s/ Jordan L. Haines Director March 17, 2000 - -------------------- Jordan L. Haines /s/ Douglas M. Karp Director March 17, 2000 - ------------------- Douglas M. Karp /s/ Vinod Khosla Director March 17, 2000 - ---------------- Vinod Khosla /s/ Douglas L. Polson Director March 17, 2000 - --------------------- Douglas L. Polson /s/ Craig D. Slater Director March 17, 2000 - ------------------- Craig D. Slater /s/ W. Thomas Stephens Director March 17, 2000 - ---------------------- W. Thomas Stephens 26 EX-1 2 FINANCIAL STATEMENT'S IN THE COMPANY'S 1999 A/R SELECTED PORTIONS OF QWEST'S 1999 ANNUAL REPORT TO SHAREHOLDERS Following is the financial section of Qwest's 1999 Annual Report. Our 1999 Annual Report will be available on the Internet beginning April 15, 2000. To view the annual report online, visit our website at www.qwest.net/ir/shareholder.html. You may also request that a printed copy be mailed to you in one of three ways: 1) by completing the literature request form at www.qwest.net/ir/invreq.html, 2) by calling 877-877-7978 and responding to the recorded prompts or 3) by writing to Investor Relations, Qwest Communications International Inc., 700 Qwest Tower, 555 Seventeenth Street, Denver, Colorado 80202. FINANCIAL CONTENTS
F-2 F-3 F-12 F-13 F-14 F-18 F-32 Selected Management's Quantitative Independent Financial Statements Notes to Market for the Financial Discussion and and Qualitative Auditors' Report Consolidated Statements Consolidated Registrant's Common Data Analysis of Disclosures About of Operations Financial Stock and Related Financial Market Risk for the Three Years Ended Statements Shareholder Matters Condition December 31, 1999 and Results of Operations Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Stockholders' Equity for the Three Years Ended December 31, 1999 Consolidated Statements of Cash Flows for the Three Years Ended December 31, 1999
These materials may contain forward-looking statements that involve risks and uncertainties. These statements may differ materially from actual future events or results. Readers are referred to the documents filed by Qwest with the SEC, specifically the most recent reports which identify important risk factors that could cause actual results to differ from those contained in the forward-looking statements, including potential fluctuations in quarterly results, dependence on new product development, rapid technological and market change, failure to complete the network on schedule and on budget, financial risk management and future growth subject to risks, Qwest's ability to achieve Year 2000 compliance, and adverse changes in the regulatory or legislative environment. Qwest undertakes no obligation to review or confirm analysts' expectations or estimates or to release publicly any revisions to any forward- looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Selected Financial Data The selected financial data related to the Company's financial condition and results of operations for each of the years in the five-year period ended December 31, 1999 are summarized as follows and should be read in conjunction with the discussion under "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Consolidated Financial Statements of the Company and the notes thereto, appearing elsewhere in this Annual Report.
Year Ended December 31, (In Millions, Except Per Share Information) 1999(1) 1998(1) 1997 1996 1995 ----------------------------------------------------------------------- STATEMENTS OF OPERATIONS: Total revenue .......................................... $ 3,927.6 $ 2,242.7 $ 696.7 $ 231.0 $ 125.1 Total operating expenses ............................... 3,604.0 2,996.4 673.2 243.0 161.2 Earnings (loss) from operations ........................ 323.6 (753.7) 23.5 (12.0) (36.1) Earnings (loss) before income taxes .................... 583.5 (849.8) 23.6 (10.1) (38.5) Net earnings (loss) .................................... $ 458.5 $ (844.0) $ 14.5 $ (6.9) $ (25.1) Net earnings (loss) per share - basic .................................. $ 0.63 $ (1.51) $ 0.04 $ (0.02) $ (0.08) Net earnings (loss) per share - diluted ................................ $ 0.60 $ (1.51) $ 0.04 $ (0.02) $ (0.08)
As of December 31, (In Millions) 1999 1998 1997 1996 1995 ------------------------------------------------------------------------ SUMMARY BALANCE SHEET DATA: Total assets ........................................... $11,058.1 $ 8,067.6 $ 1,398.1 $ 262.6 $ 184.2 Long-term debt ......................................... $ 2,368.3 $ 2,307.1 $ 630.5 $ 109.3 $ 68.8 Total stockholders' equity(2) .......................... $ 7,001.3 $ 4,238.2 $ 381.8 $ 9.5 $ 26.4
Year of December 31, (In Millions) 1999 1998 1997 1996 1995 ------------------------------------------------------------------------ OTHER FINANCIAL DATA: EBITDA(3) .............................................. $ 759.2 $ 294.5 $ 43.7 $ 6.9 $ (26.0) Net cash provided by (used in) operating activities ..................... $ (38.2) $ 44.5 $ (36.4) $ 32.5 $ (56.6) Net cash used in investing activities ......................................... $(2,138.0) $(1,438.8) $ (356.8) $ (52.6) $ (58.9) Net cash provided by financing activities ............................... $ 2,062.6 $ 1,477.3 $ 766.1 $ 25.5 $ 113.9 Capital expenditures ................................... $ 1,900.2 $ 1,413.2 $ 345.8 $ 57.1 $ 48.7
(1) The selected financial and operating data for the years ended and as of December 31, 1999 and 1998 include the effect of the acquisitions of LCI International, Inc., Icon CMT Corp., EUnet International Limited and Phoenix Network, Inc., which occurred during 1998. The financial and operating data for the year ended and as of December 31, 1999 include the effect of the divestiture of EUnet International Limited in conjunction with the formation of the KPNQwest joint venture, which occurred In April 1999. (See further discussion of these acquisitions in "Management's Discussion and Analysis of Financial Condition and Results of Operations.") (2) The Company has not paid cash dividends on its Common Stock since becoming a public company in June 1997. The merger agreement between U S WEST and Qwest provides that the Company initially will pay a dividend of $0.0125 per share per quarter after completion of the merger. The payments of dividends by the combined company after the merger will depend on business conditions, the combined company's financial condition and earnings, as well as other factors. (3) EBITDA represents earnings (loss) from operations before interest, income tax expense (benefit), depreciation and amortization. EBITDA excludes the following non-recurring items: an expense of $2.7 million in the year ended December 31, 1996 to restructure operations; merger-related expenses of $864.5 million in the year ended December 31, 1998; and merger-related expenses of $31.5 million in the year ended December 31, 1999. EBITDA does not represent cash flow for the periods presented and should not be considered as an alternative to net earnings (loss) as an indicator of the Company's operating performance or as an alternative to cash flows as a source of liquidity, and may not be comparable with EBITDA as defined by other companies. F-2 Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the Company's accompanying audited consolidated financial statements and the notes thereto. OVERVIEW Qwest Communications International Inc. ("Qwest" or the "Company") is a leading broadband Internet communications company engaged in two core businesses: Communications Services and Construction Services. Communications Services includes Internet, multimedia, data and voice services sold to business, consumer and government customers. Internet and multimedia services includes Internet Protocol ("IP") -- enabled services such as dedicated and dial-up Internet access, web hosting, co-location access, voice over IP, application hosting and mass storage services. Qwest also provides high-volume voice and conventional private line services to other communications providers, as well as to Internet Service Providers ("ISPs"), and other data service companies. Internet and multimedia services are being developed in alignment with existing and anticipated market demand in partnership with leading information technology companies, including the following: o Microsoft Corporation for business applications and service; o KPMG LLP (through the Qwest Cyber.Solutions joint venture) for application service provider, application hosting and application management services; o SAP America, Inc. and Hewlett Packard Company for hosting and systems management services; o Covad Communications Group, Inc. ("Covad") and Rhythms NetConnections Inc. ("Rhythms") for digital subscriber line ("DSL") technology for high-speed local network connectivity; o Oracle Corporation and Siebel Systems, Inc. for application hosting services; and o Hewlett Packard Company for high-end data storage Construction Services constructs and installs fiber optic systems for other communications providers, as well as for the Company's own use. Central to Qwest's strategy is the Qwest Macro CapacitySM Fiber Network, a high-capacity IP-based fiber optic network designed to allow customers to seamlessly exchange multimedia content -- images, data and voice. The technologically advanced network spans over 25,500 route-miles in North America. The network employs a self-healing SONET ring architecture. It is equipped with advanced fiber and state-of-the-art transmission electronics. Qwest's network architecture supports IP, Asynchronous Transfer Mode ("ATM") and frame relay services, as well as circuit switched services. In 1998, Qwest became the first network service provider to complete a transcontinental IP-based fiber optic network when it activated its network from Los Angeles to San Francisco to New York. The Company announced in late 1999 that it would be the first company in the year 2000 to build a nationwide Internet Protocol OC-192 link carrying commercial traffic at 10 gigabits-per-second with the reliability of SONET architecture. Qwest also will be the first company in 2000 to introduce an all-optical Internet network coast-to-coast with maximum reliability. In addition, Qwest's European joint venture, KPNQwest, is building and will operate an 11,800-mile network spanning 46 business markets in Europe. (See further discussion of the KPNQwest joint venture below.) Qwest is also expanding its network to carry international data and voice traffic to Mexico and the Far East. The 1,400 route-mile Mexico network is complete. The Company is also participating in a consortium of communications companies that is building an underwater cable system connecting the United States to Japan. Scheduled for completion by the fourth quarter of 2000, the 13,125-mile four-fiber pair cable will ultimately be capable of transmitting information at the rate of 640 gigabits per second. F-3 U S WEST MERGER AGREEMENT In July 1999, Qwest entered into a definitive merger agreement with U S WEST, Inc. ("U S WEST"). Under the terms of the merger agreement, Qwest will issue shares of its common stock having a value of $69.00 for each share of U S WEST common stock, subject to a "collar" on Qwest's average stock price between $28.26 and $39.90 per share. The number of Qwest shares to be issued for each U S WEST share will be determined by dividing $69.00 by the average of the daily volume weighted average prices of Qwest common stock for 15 randomly selected trading days over a 30-day measurement period ending three days before the closing of the transaction, provided that Qwest will not issue more than 2.44161 shares for each U S WEST share or less than 1.72932 shares for each U S WEST share. The transaction will be accounted for as a purchase, with U S WEST deemed the accounting acquiror and is structured to be tax-free to U S WEST shareowners to the extent of the Qwest stock delivered in the transaction. If Qwest's average stock price is below $38.70 per share, the obligation under the "collar" for the amount which the price is below $38.70 per share may be satisfied in whole or in part with cash. In determining the cash amount for the collar, Qwest and U S WEST will consider Qwest's desire to reduce dilution to its stockholders, U S WEST's potential desire to provide a cash element to its stockholders and both companies' desire to maintain the combined company's strong financial condition. If the companies decide to provide cash as part of the collar consideration, the minimum exchange ratio would be 1.783. U S WEST may terminate the merger agreement if the closing price of Qwest's shares is below $22.00 for 20 consecutive trading days before the closing, or if the average Qwest share price during the measurement period is less than $22.00. The Boards of Directors and stockholders of both Qwest and U S WEST have approved the proposed transaction. The transaction is subject to federal and state regulatory approvals and other customary closing conditions. Closing of the transaction is expected in mid-2000. As a result of the transaction, Qwest will become subject to the regulations applicable to U S WEST, a Regional Bell Operating Company ("RBOC"). Generally, effective as of the closing of the transaction, Qwest may not provide inter-LATA services within U S WEST's 14-state region until U S WEST receives approval to provide such services under Section 271 of the Telecommunications Act of 1996, as amended. Therefore, Qwest will be required to divest the prohibited services. In connection with the termination of the U S WEST and Global Crossing LTD. merger agreement, U S WEST paid Global Crossing a break-up fee of $140.0 million in cash and agreed to return $140.0 million in Global Crossing shares, valued at $62.75 per share, purchased by U S WEST in connection with its agreement with Global Crossing. Qwest advanced to U S WEST the $140.0 million cash payment and agreed to purchase $140.0 million in services from Global Crossing over four years at the best commercially available prices. STRATEGIC INVESTMENTS AND OTHER ALLIANCES INVESTMENT IN SLINGSHOT NETWORKS LLC/ PURCHASE OF CERTAIN ASSETS OF ADMI. In September 1999, Qwest and Anschutz Digital Media, Inc. ("ADMI"), an affiliate of Qwest's principal stockholder, Anschutz Company, entered into an agreement to form a joint venture called Slingshot Networks LLC to provide advanced digital production, post-production and transmission facilities, digital media storage and distribution services, telephony-based data storage and enhanced services, access and routing services. Qwest and ADMI each own 50% of the joint venture. Qwest contributed approximately $84.8 million consisting of a promissory note payable over nine years at an annual interest rate of 6%. The agreement between Qwest and ADMI also provided that Qwest would purchase certain telephony-related assets and all of the stock of Precision Systems, Inc., a telecommunications solutions provider, from ADMI in exchange for a promissory note in the amount of $34.0 million. The promissory note is payable over nine years and bears interest at an annual rate of 6%. Qwest's investment in the joint venture is accounted for under the equity method. INVESTMENT IN ADVANCED RADIO TELECOM CORP. In September 1999, Qwest invested $90.0 million for an approximate 19% stake in Advanced Radio Telecom Corp. ("ART"), a facilities-based, broadband ISP that provides a direct connection from customer location to the Internet, to help support the construction of ART's fixed, high-speed wireless networks. In connection with this transaction, a separate group of investors also invested $161.0 million. Qwest's investment in ART is accounted for under the cost method. INVESTMENT IN QWEST CYBER.SOLUTIONS LLC. In June 1999, Qwest and KPMG LLP, a leading professional services firm, formed a joint venture called Qwest Cyber.Solutions LLC, to provide F-4 Internet-based end-to-end application service provider, application hosting, and application management services. The venture will offer customers a broad set of vendor products available for Enterprise Resource Planning ("ERP"), Customer Relationship Management ("CRM") and back office solutions, a state-of-the-art IP broadband network, and technologically advanced Cybercenters. Qwest contributed approximately $60.0 million consisting of cash and other assets, and owns a 51% stake in the venture. The financial position and results of operation of the venture have been consolidated in the accompanying financial statements from the date of formation and KPMG's share in the venture is reflected as minority interest. STRATEGIC RELATIONSHIP WITH BELLSOUTH. In April 1999, BellSouth Corporation (together with its subsidiaries, "BellSouth") and Qwest announced a strategic relationship whereby BellSouth invested approximately $3.5 billion for an approximate 10% equity stake in Qwest. Qwest issued approximately 40.7 million shares to BellSouth in exchange for approximately $1.9 billion in cash. Qwest's principal stockholder, Anschutz Company, sold approximately 33.3 million existing shares to BellSouth for approximately $1.6 billion. At the same time, a BellSouth affiliate and Qwest entered into a commercial arrangement for provisioning of a full range of integrated digital data, image and voice communications services for customers. These services will include Qwest's portfolio of data networking, Internet and voice services and BellSouth's local networking services. Once BellSouth is allowed to enter the long distance market, the companies will jointly develop and deliver a comprehensive set of end-to-end, high-speed data, image and voice communications services to business customers, with an emphasis on broadband and Internet-based data services. KPNQWEST. In April 1999, Qwest and KPN Telecom B.V. ("KPN"), the Dutch telecommunications company, formed a joint venture ("KPNQwest") to create a pan-European IP-based fiber optic network, linked to Qwest's network in North America, for data and multimedia services. Qwest and KPN each initially owned 50 percent of KPNQwest which was initially governed by a six person supervisory board to which Qwest and KPN had each named three members. Upon formation of KPNQwest, KPN contributed two partially completed bi-directional, self-healing fiber optic rings (EuroRings(TM) 1 and 2) and certain communications services contracts to KPNQwest. Qwest contributed Xlink Internet Service Gmbh ("Xlink"), the operating subsidiaries of EUnet International Limited ("EUnet") and cash. Also, Qwest and KPN contributed transatlantic capacity that connects KPNQwest's European network with Qwest's network in North America, and also contributed certain other assets. The net book value of total assets contributed by Qwest totaled approximately $300.0 million. Qwest deconsolidated EUnet and Xlink in April 1999. Qwest's investment in KPNQwest is accounted for under the equity method. KPNQwest offers managed broadband services, IP transit, Internet connectivity and value-added IP services, including consulting, hosting, and the broadcasting of live events over the Internet. KPNQwest also sells dark fiber along its network. Customers of KPNQwest include Internet services and content providers, multinational firms in Europe and North America, as well as telecommunications carriers, operators and others who want to purchase wholesale or retail network capacity, fiber or services. On November 12, 1999 KPNQwest consummated an initial public offering ("KPNQwest's IPO") which has resulted in approximately 11% of KPNQwest's shares being owned by the public and the remainder of KPNQwest's shares being owned by each of Qwest and KPN equally. As a result of the change in ownership structure of KPNQwest, two outside directors were added to the supervisory board. Also as a result of KPNQwest's IPO, Qwest recognized a gain of $414.0 million, representing its proportionate share of the increase in KPNQwest's equity. Since Qwest's investment in the foreign corporate joint venture is essentially permanent in duration, Qwest did not record deferred income taxes on the excess of its investment in KPNQwest over its tax basis in the joint venture. INVESTMENT IN RHYTHMS. In April 1999, Qwest made an equity investment, totaling $15.0 million in cash, in DSL local networks through an agreement with Rhythms, a packet-based Competitive Local Exchange Carrier ("CLEC") that provides high-speed networking solutions for remote access to private networks and the Internet. Under this agreement, the Company will have access to the 29 metropolitan areas (10 of which are in addition to the areas covered by an agreement that Qwest has with Covad Communications Group, Inc., as discussed below) by the first quarter of 2000, while further enhancing its ability to provide its customers with high-speed DSL connectivity to its network. The Company has committed to place a minimum number of orders for DSL service over a seven-year term commencing on the date that Rhythms is operational in the 29 metropolitan areas. In the event that the Company fails to meet the order target, the Company is committed to pay Rhythms for the difference between the order target and the number of actual orders placed. Qwest's investment in Rhythms is accounted for under the cost method. INVESTMENT IN COVAD. In January 1999, Qwest made an equity investment, totaling $15.0 million in cash, in high-speed, DSL local networks through an agreement with Covad, a packet-based CLEC. Under this agreement, the Company will have access to 22 metropolitan areas, while enhancing its ability to provide its customers with high-speed DSL connectivity to its network. The Company has committed to purchase DSL services for approximately $20.0 million over a five-year term commencing on the date that Covad's DSL services are commercially available in all 22 metropolitan areas. Qwest's investment in Covad is accounted for under the cost method. ALLIANCE WITH MICROSOFT. In December 1998, the Company entered into a strategic alliance with Microsoft that will enable businesses to utilize high-speed network services that maximize network resources, reduce costs, generate new sources of revenue and optimize management of computing operations. The Company's service, to be built on the Microsoft(R) operating systems and application platforms, when integrated with the Company's IP-based fiber optic network, is designed for businesses of all sizes. Microsoft will license a broad range of its software to Qwest. The parties will jointly market and sell the services. In addition, Microsoft purchased 8.8 million shares of Qwest for $200.0 million. ACQUISITIONS Each of the acquisitions discussed below was accounted for as a purchase. The results of operations of each of these acquisitions have been included in the accompanying consolidated statements of operations of the Company from the date of acquisition. ICON ACQUISITION. In December 1998, the Company completed its acquisition of Icon CMT Corp. ("Icon"), a provider of integrated Internet solutions associated with web hosting and IP integration, for approximately $254.1 million in Company common stock, including approximately $3.5 million of direct acquisition costs. At the close of the acquisition, the Company issued approximately 11.8 million shares of the Company's common stock (including outstanding Icon stock options and warrants assumed by the Company). F-5 In connection with the acquisition of Icon, the Company allocated $10.0 million of the purchase price to in-process research and development ("R&D") projects, $2.3 million to developed technology, $71.8 million to other intangible assets and $194.0 million to goodwill. This allocation to the in-process R&D represents the estimated fair value based on risk-adjusted cash flows related to the incomplete projects. The in-process R&D was expensed at the date of acquisition as the in-process R&D had not reached technological feasibility. The developed technology, other intangible assets and goodwill are being amortized on a straight-line basis from 4 to 15 years. (See further discussion of the Icon acquisition in Results of Operations.) LCI ACQUISITION. In June 1998, the Company acquired LCI International, Inc. and subsidiaries ("LCI"), a communications services provider, for approximately $3.9 billion in Company common stock, including approximately $13.5 million in direct acquisition costs. At the close of the acquisition, the Company issued approximately 259.8 million shares of the Company's common stock (including outstanding LCI stock options assumed by the Company). In connection with the acquisition of LCI, the Company allocated $682.0 million of the purchase price to in-process R&D projects, $318.0 million to developed technology, $65.0 million to other intangible assets and $3,071.0 million to goodwill. The allocation to the in-process R&D represents the estimated fair value based on risk-adjusted cash flows related to the incomplete projects. The in-process R&D was expensed at the date of acquisition as the in-process R&D had not reached technological feasibility. The developed technology, other intangible assets and goodwill are being amortized on a straight-line basis from 10 to 40 years. (See further discussion of the LCI acquisition in Results of Operations.) EUNET ACQUISITION. In April 1998, the Company acquired EUnet, a European ISP with subsidiaries in 14 countries, for approximately $154.0 million in Company common stock, including approximately $3.5 million in direct acquisition costs, and $4.2 million in cash. At the close of the acquisition, the Company issued approximately 7.9 million shares of Company common stock. The results of operations for periods beginning April 1, 1999 exclude the operating results of EUnet, which was contributed to the KPNQwest joint venture on April 1, 1999. PHOENIX ACQUISITION. In March 1998, the Company acquired Phoenix Network, Inc. ("Phoenix"), a non-facilities-based reseller of long distance services. Approximately 1.6 million shares of the Company common stock having a value of approximately $27.2 million were exchanged for the outstanding shares of Phoenix. SUPERNET ACQUISITION. In October 1997, the Company acquired SuperNet, Inc. ("SNI"), an ISP, for $20.0 million in cash, including acquisition costs. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998 The Company reported net earnings of $458.5 million for the year ended December 31, 1999, compared to a net loss of $844.0 million for the prior year. For the comparative periods presented, the Company's results of operations include the acquisitions of the following: Icon from January 1999; LCI from June 1998; Phoenix from March 1998; and SNI from October 1997. The results of operations for periods beginning April 1, 1999 exclude the operating results of EUnet, which was contributed to KPNQwest on April 1, 1999. Excluding the effects of the gain as a result of the KPNQwest IPO and merger-related costs related to the pending merger with U S WEST, Inc. in 1999, merger-related costs and the write-off of in-process R&D costs related to the LCI, EUnet and Icon acquisitions and the charge for the redemption of a total of $87.5 million in principal amount of the Company's 107/8% Senior Notes, due 2007 (the "107/8% Notes") in 1998, the Company's reported net earnings would have been $72.6 million for the year ended December 31, 1999, compared to a net loss of $19.4 million for the same period of the prior year. REVENUE. Components of revenue for the years ended December 31, 1999 and 1998 were as follows: Year Ended December 31, Increase (In Millions) 1999 1998 (Decrease) ------------------------------------- Communications services ............. $3,703.1 $1,554.3 $2,148.8 Construction services ............... 224.5 688.4 (463.9) ------------------------------------- Total revenue ................... $3,927.6 $2,242.7 $1,684.9 ===================================== F-6 During the year ended December 31, 1999, as compared to the prior year, Communications Services revenue increased due to the inclusion of the first full year of revenue from the acquisitions discussed above, and to growth in all aspects of Communications Services. Construction Services revenue decreased during the year ended December 31, 1999, as compared to the prior year, primarily as a result of the completion of the milestones for which the Company had construction contracts. OPERATING EXPENSES. Components of operating expenses for the years ended December 31, 1999 and 1998 were as follows: Year Ended December 31, Increase (In Millions) 1999 1998 (Decrease) ------------------------------------ Access and network operations ....... $2,062.7 $ 961.8 $1,100.9 Construction services ............... 96.4 446.8 (350.4) Selling, general and administrative . 1,009.3 539.6 469.7 Depreciation and amortization ....... 404.1 201.7 202.4 Merger-related costs ................ 31.5 846.5 (815.0) ------------------------------------ Total operating expenses ........ $3,604.0 $2,996.4 $ 607.6 ==================================== Expenses for access and network operations primarily consist of the cost of operating the Company's network, Local Exchange Carrier ("LEC") access charges and the cost of leased capacity. The increase in access and network operations for the year ended December 31, 1999 over the prior year was primarily attributable to the first full year of additional expenses related to acquired entities, as well as internally generated growth in Communications Services revenue. As a result of the completion of the network in 1999, the Company was able to serve more customer needs over its own network, thereby reducing leased capacity costs as a percentage of revenue. Expenses for Construction Services consist primarily of costs to construct the Company's network, including conduit, fiber, cable, construction crews and rights of way. Costs attributable to the construction of the network for the Company's own use are capitalized. Expenses for Construction Services decreased for the year ended December 31, 1999, as compared to the prior year, due to the completion of the milestones for which the Company had construction contracts. Selling, general and administrative ("SG&A") expense includes the cost of salaries, benefits, occupancy costs, commissions, sales and marketing expenses and administrative expenses. The increase in SG&A for the year ended December 31, 1999, as compared to the prior year, was due primarily to the following: the first full year of additional expenses related to acquired entities; increased sales and marketing efforts; additional bad debt expense related to the increase in Communications Services revenues; increased payroll-related costs from the recruiting and hiring of additional sales and administrative personnel; increased commissions expense related to the growth in Communications Services revenue; additional building rent expense related to increased space obtained in response to the Company's infrastructure growth; and increased property taxes and maintenance costs related to the expansion of the Company's network. During the year ended December 31, 1999, as compared to the prior year, the number of employees increased, due to expansion of the sales and customer support infrastructure, from approximately 8,700 employees at December 31, 1998 to approximately 10,000 employees at December 31, 1999. The Company expects SG&A expense to increase as the Company continues expansion of its Communications Services business. The Company's depreciation and amortization expense increased due primarily to activating additional segments of the Company's network during the year ended December 31, 1999, purchases of assets to accommodate the Company's growth and the first full year of depreciation and amortization of assets and goodwill related to the Company's acquisitions. The Company expects that depreciation expense will continue to increase in subsequent periods as the Company continues to activate additional capacity on its network, and continues the build-out of local networks and CyberCenters. During the years ended December 31, 1999 and December 31, 1998, the Company recorded $31.5 million and $846.5 million in merger-related costs, respectively. The merger-related costs incurred in 1999 relate to the pending merger with U S WEST, Inc. and are comprised primarily of fees for professional services. The merger-related costs incurred in 1998 relate to the merger with LCI and Icon, including $760.0 million of in-process R&D, $31.0 million of duplicate facilities, $49.0 million of channel consolidation and duplicate commitments and $6.5 million of other miscellaneous merger costs. Of these merger costs, approximately $4.5 million remain accrued as of December 31, 1999. OTHER EXPENSE (INCOME). Components of other expense (income) for the years ended December 31, 1999 and 1998, were as follows: Year Ended December 31, (In Millions) 1999 1998 Change ------------------------------------ Interest expense, net ............... $ 151.0 $ 97.3 $ 53.7 Gain on KPNQwest investment ......... (414.0) -- (414.0) Other expense (income), net ......... 3.1 (1.2) 4.3 F-7 The increase in interest expense, net of capitalized interest during the year ended December 31, 1999, as compared to the prior year, resulted from the senior notes issued in 1998 being outstanding for the full fiscal year in 1999 (see "Liquidity and Capital Resources" below). The gain on KPNQwest investment represents Qwest's proportionate share of the increase in KPNQwest's equity as a result of KPNQwest's IPO in November 1999. The change in other expense (income), net, is due primarily to Qwest's share of losses from its equity investments, partially offset by an increase in interest income, resulting from higher average cash balances. INCOME TAXES. Effective with the LCI merger, the Company is no longer included in the consolidated federal income tax return of Anschutz Company ("Anschutz"). As a result, the tax-sharing agreement with Anschutz is no longer effective for activity after June 5, 1998. The Company is still subject to the provisions of the tax-sharing agreement for activity through June 5, 1998. The Company previously recognized a deferred tax asset attributable to its net operating loss carry forwards under the tax-sharing agreement. The Company currently believes the tax benefits previously recognized under the tax-sharing agreement may be realized through tax planning strategies. The Company's effective tax rate for the year ended December 31, 1999 differed from the statutory income tax rate primarily as a result of the exclusion of the gain from the KPNQwest IPO and the non-deductibility of amortization of acquisition-related goodwill. The effective tax rate for the year ended December 31, 1998 differed from the statutory rate primarily as a result of the non-deductibility of R&D write-offs and amortization of acquisition-related goodwill. After giving effect to non-deductible charges, the Company expects that its combined provision for federal and state income tax will be approximately 40%. YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 The Company reported a net loss of $844.0 million in the year ended December 31, 1998, compared to net earnings of $14.5 million in the same period of the prior year. For the comparative periods presented, the Company's results of operations include the acquisitions of the following: LCI from June 1998; EUnet from April 1998; Phoenix from March 1998; and SNI from October 1997. Excluding the effects of the merger-related costs and the write-off of in-process R&D costs related to the LCI, EUnet and Icon acquisitions in 1998 and the charge for the redemption of a total of $87.5 million in principal amount of the Company's 107/8% Notes, the Company's reported net loss would have been $19.4 million for the year ended December 31, 1998 compared to net earnings of $14.5 million for the same period of the prior year. REVENUE. Components of revenue for the years ended December 31, 1998 and 1997 were as follows: Year Ended December 31, (In Millions) 1998 1997 Increase ------------------------------------ Communications services ............. $1,554.3 $ 115.3 $1,439.0 Construction services ............... 688.4 581.4 107.0 ------------------------------------ Total revenue ................... $2,242.7 $ 696.7 $1,546.0 ==================================== During the year ended December 31, 1998, as compared to the prior year, Communications Services revenue increased due to the addition of revenue from the acquisitions discussed above, and due to growth in all aspects of Communications Services. Construction Services revenue increased during the year ended December 31, 1998, as compared to the prior year, primarily as a result of additional dark fiber sales to other carriers and the completion of additional milestones for which the Company had construction contracts. OPERATING EXPENSES. Components of operating expenses for the years ended December 31, 1998 and 1997 were as follows: Year Ended December 31, (In Millions) 1998 1997 Increase ------------------------------------ Access and network operations ....... $ 961.8 $ 86.0 $ 875.8 Construction services ............... 446.8 408.3 38.5 Selling, general and administrative . 539.6 158.7 380.9 Depreciation and amortization ....... 201.7 20.2 181.5 Merger-related costs ................ 846.5 -- 846.5 ------------------------------------ Total operating expenses ........ $2,996.4 $ 673.2 $2,323.2 ==================================== Expenses for access and network operations primarily consist of the cost of operating the Company's network, LEC access charges and the cost of leased capacity. The increase in access and network operations for the year ended December 31, 1998 over the prior year was primarily F-8 attributable to growth in revenue from acquisitions, as well as internally generated growth in Communications Services revenue. Expenses for Construction Services consist primarily of costs to construct the Company's network, including conduit, fiber, cable, construction crews and rights of way. Costs attributable to the construction of the network for the Company's own use are capitalized. Expenses for Construction Services increased for the year ended December 31, 1998, as compared to the prior year, due to additional contracts that were signed during 1998 and further completion of the Company's network. Selling, general and administrative ("SG&A") expense includes the cost of salaries, benefits, occupancy costs, commissions, sales and marketing expenses and administrative expenses. The increase in SG&A for the year ended December 31, 1998, as compared to the prior year, was due primarily to the following: additional expenses related to acquired entities; increased sales and marketing efforts; additional bad debt expense related to the increase in Communications Services revenues; increased payroll-related costs from the recruiting and hiring of additional sales and administrative personnel; increased commissions expense related to the growth in Communications Services revenue; additional building rent expense related to increased space obtained in response to the Company's infrastructure growth; and increased property taxes and maintenance costs related to the increase of fixed assets along the Company's network. During the year ended December 31, 1998, as compared to the prior year, the number of employees increased, due to acquisitions and the expansion of the sales and customer support infrastructure, from approximately 1,600 employees at December 31, 1997 to approximately 8,700 employees at December 31, 1998. The increase in SG&A was partially offset by a decrease in expense recognized under the Company's Growth Share Plan (the "Growth Share Plan"), which was established in October 1996 for certain employees and directors of the Company. The Company's depreciation and amortization expense increased due primarily to activating additional segments of the Company's network during the year ended December 31, 1998, purchases of assets to accommodate the Company's growth and depreciation and amortization of assets and goodwill related to the Company's acquisitions. During the year ended December 31, 1998, the Company recorded $86.5 million in merger-related costs related to the merger with LCI, including $31.0 million of duplicate facilities, $49.0 million of channel consolidation and duplicate commitments and $6.5 million of other miscellaneous merger costs. Of these merger costs, approximately $6.0 million remain accrued as of December 31, 1998. In connection with the acquisition of LCI, the Company allocated $682.0 million of the purchase price to in-process R&D projects, $318.0 million to developed technology, $65.0 million to other intangible assets and $3,071.0 million to goodwill. The allocation to the in-process R&D represents the estimated fair value based on risk-adjusted cash flows related to the incomplete projects. At the date of the merger, the development of these projects had not yet reached technological feasibility and the in-process R&D had no alternative future uses. Accordingly, these costs were expensed as of the merger date. The developed technology, other intangible assets and goodwill are being amortized on a straight-line basis from 10 to 40 years. The Company assessed and allocated values to the in-process R&D. The values assigned to these assets were determined by identifying significant research projects for which technological feasibility had not been established. These assets consisted of a significant number of R&D projects grouped into three categories: (1) next-generation network systems automation tools; (2) advanced data services, including frame relay and Internet Protocol technologies; and (3) new operational systems and tools. Taken together, these projects, if successful, will enable the Company to provide advanced voice and data services as well as sophisticated network management and administration functions. A brief description of the three categories of in-process projects is presented below: o R&D RELATED TO NETWORK SYSTEMS AUTOMATION. These R&D projects are intended to create a new method of automating LCI's service provisioning and network management systems, and were valued at approximately $218.0 million. These proprietary projects include the development of data warehousing and new interface technologies to enable the interchange of data across disparate networks. As of the transaction date, the Company believes that the overall project was 60% complete. As of December 31, 1999 these projects were substantially complete. o R&D RELATED TO FRAME RELAY AND IP SERVICES. These projects involve R&D related to the deployment of frame relay and IP technologies within the LCI network, and were valued at approximately $155.0 million. With the completion of this next-generation network, the Company will be able to address emerging new demand trends for data services. Management considers this a complex project due to the customized work required. As of the transaction date, the Company believes the overall project was approximately 60% to 70% complete. As of December 31, 1999 these projects were substantially complete. o R&D RELATED TO OPERATIONAL SYSTEMS AND TOOLS. These projects involve R&D related to the development of new service and network management tools and engineering functions, and were valued at approximately $309.0 million. These proprietary projects are closely associated with LCI's deployment of advanced data services. Applications enabled by these new technologies include the ability to offer new products and service packages. As of the acquisition date, the Company believes the projects were 60% to 70% complete. As of December 31, 1999 these projects were substantially complete. The value assigned to purchased in-process technology was determined by estimating the contribution of the purchased in-process technology to developing commercially viable products, estimating the resulting net cash flows from the expected product sales of such products, and discounting the net cash flows from the expected product sales of such products to their present value using a risk-adjusted discount rate. The Company estimates total revenues from the specific acquired in-process technology will peak in 2003 and will steadily decline from 2004 through 2009 as other new product and service technologies are expected to be introduced by the Company. These projections are based on management's estimates of market size and growth, expected trends in technology, and the expected timing of new product introductions. Discounting the net cash flows back to their present values is based on the weighted average cost of capital ("WACC"). The business enterprise comprises various types of assets, each possessing different degrees of investment risk contributing to LCI's overall WACC. Intangible assets are assessed higher risk factors due to their lack of liquidity and poor versatility for redeployment elsewhere in the business. Reasonable returns on monetary and fixed assets were estimated based on prevailing interest rates. The process for quantifying intangible asset investment risk involved consideration of the uncertainty associated with realizing discernible cash flows over the life of the asset. A discount rate of 19% was used for valuing the in-process R&D. This discount rate is higher than the implied WACC due to the inherent uncertainties surrounding the successful development, the F-9 useful life and the profitability levels of the purchased in-process technology, and the uncertainty of technological advances that are unknown at this time. As is standard in the appraisal of high-growth markets, projected revenues, expenses and discount rates reflect the probability of technical and marketing successes. The value of the in-process projects was adjusted to reflect value and contribution of the acquired R&D. In doing so, consideration was given to the R&D's stage of completion, the complexity of the work completed to date, the difficulty of completing the remaining development, costs already incurred, and the projected cost to complete projects. The Company believes that the foregoing assumptions used in the forecasts were reasonable at the time of the merger. The Company cannot assure, however, that the underlying assumptions used to estimate expected project sales, development costs or profitability, or the events associated with such projects, will transpire as estimated. For these reasons, actual results may vary from the projected results. In connection with the acquisition of EUnet, the Company allocated $68.0 million of the purchase price to in-process R&D projects. These projects include the design and development of several new value-added Internet services as well as the development of the necessary customer care and network management systems. Since these projects had not yet reached technological feasibility and had no alternative future use at the acquisition date, there was no guarantee as to the achievability of the projects or their ascribed values. Accordingly, these costs were expensed as of the acquisition date. In connection with the acquisition of Icon, the Company allocated $10.0 million of the purchase price to in-process R&D projects. These projects include the design and development of several new value-added Internet services, including end-to-end solutions methodology designed to provide system-wide solutions for high-end corporate customers, a next-generation high-speed network system, and an improved network management system with added features. Since these projects had not yet reached technological feasibility and had no alternative future uses as of the acquisition date, there was no guarantee as to the achievability of the projects or their ascribed values. Accordingly, these costs were expensed as of the acquisition date. OTHER EXPENSE (INCOME). Components of other expense (income) for the years ended December 31, 1998 and 1997, were as follows: Year Ended December 31, (In Millions) 1998 1997 Change ------------------------------------ Interest expense, net ............... $ 97.3 $ 18.8 $ 78.5 Other income, net ................... (1.2) (18.9) 17.7 The increase in interest expense, net of capitalized interest during the year ended December 31, 1998, as compared to the prior year, resulted from an increase in long-term indebtedness (see "Liquidity and Capital Resources" below), partially offset by an increase in capitalized interest resulting from construction of the Company's network. Other income, net, decreased due primarily to decreases in interest income, resulting from lower average cash balances, and a charge of $12.9 million for the redemption of a total of $87.5 million in principal amount of the 107/8% Notes. Additionally, in 1997, the Company recorded a $9.3 million gain on sale of contract rights. INCOME TAXES. Effective with the LCI merger, the Company is no longer included in the consolidated federal income tax return of Anschutz. As a result, the tax-sharing agreement with Anschutz is no longer effective for activity after June 5, 1998. The Company is still subject to the provisions of the tax-sharing agreement for activity through June 5, 1998. The Company previously recognized a deferred tax asset attributable to its net operating loss carry forwards under the tax-sharing agreement. The Company currently believes the tax benefits previously recognized under the tax-sharing agreement may be realized through tax planning strategies. The Company's effective tax rate for the year ended December 31, 1998 differed from the statutory income tax rate primarily as a result of the non-deductibility of R&D write-offs and amortization of acquisition-related goodwill. The effective tax rate for the year ended December 31, 1997 differed from the statutory rate primarily as a result of the non-deductibility of a portion of the Growth Share Plan expense and amortization of acquisition-related goodwill. After giving effect to non-deductible charges, the Company expects that its combined provision for federal and state income tax will be approximately 40%. F-10 LIQUIDITY AND CAPITAL RESOURCES For the year ended December 31, 1999, cash used in operations was $38.2 million; cash used in investing activities was $2,138.0 million, including $1,900.2 million of capital expenditures; and cash provided by financing activities was $2,062.6 million. Cash provided by financing activities includes an approximate $1.9 billion equity investment by BellSouth and employee stock transactions of $150.3 million. The Company believes that its available cash and cash equivalent balances at December 31, 1999, cash flow from operations, existing credit facilities and the proposed credit limit increase on its revolving credit facility (described below) will satisfy its currently anticipated cash requirements at least for the next 12 months. The Company anticipates future capital expenditures during 2000 to support its growth in communications services, including continued expansion of data products and services, activation of additional capacity along the Company's network, new CyberCenter construction and local access initiatives to be approximately $2.5 to $2.7 billion. In March 1999, the Company entered into a $1.0 billion credit agreement with a syndicate of banks. This credit agreement provides for two five-year revolving credit facilities for a total of $500.0 million and one 364-day revolving credit facility in the amount of $500.0 million. The credit facilities bear interest at either the bank base rate of interest or LIBOR plus an applicable margin. As of December 31, 1999, there were no borrowings outstanding under the credit agreement. The Company's credit agreement contains a provision whereby all amounts outstanding under the agreement must be repaid as a result of a "change of control" of the Company. While the Company does not believe that a change of control will occur, the Company is currently negotiating an amendment to the existing credit agreement and is taking other actions to ensure that the U S WEST merger does not constitute a "change of control." The Company is also taking such other actions necessary to permit the Company to consummate the merger. Such amendment is expected to be in place prior to the end of the first quarter of 2000. In addition, the Company is in the process of extending the term of the existing $500 million 364-day revolving credit facility and adding an additional $1.0 billion credit facility. Consummation of the additional credit facility is conditioned, among other things, on the execution of a mutually satisfactory credit agreement, which is expected to occur prior to the end of the first quarter of 2000. RECENT ACCOUNTING PRONOUNCEMENTS On December 3, 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB 101"). SAB 101 summarizes certain of the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 was effective upon issuance. The Company believes that the adoption of this standard will not have a material effect on the Company's consolidated results of operations or financial position. YEAR 2000 The Company established a year 2000 program office to prepare for and monitor the rollover to the year 2000 and related dates throughout the 2000 calendar year ("Year 2000 Rollover Events"). Since its inception through December 31, 1999, the program office incurred $20 million in expenses to inventory, assess, modify, test and deploy applications and hardware of the Company as well as to develop contingency plans in the event of failure during a Year 2000 Rollover Event. Costs anticipated to be incurred in 2000 for the continued monitoring of Year 2000 Rollover Events are expected to be less than $1.0 million. The most significant of the Year 2000 Rollover Events was the rollover from December 31, 1999 to January 1, 2000. In preparation for this Rollover Event, the Company established five command centers to monitor for events and coordinate and communicate needed responses. While minor year 2000 issues arose within certain of the Company's internal systems, there were no year 2000 issues which caused disruptions of voice, data or Internet services to customers. Although the Company has not identified a new year 2000 event since January 5, 2000, it is possible that the effects of some events have not yet been identified or that future Year 2000 Rollover Events will have an impact. The Company has contingency plans that can be enacted in the case of such future failures, and additional customer service and technical support resources will be deployed during future Year 2000 Rollover Event dates such as February 29, 2000 and January 1, 2001. INFLATION Inflation has not significantly affected the Company's operations during the past three years. F-11 Quantitative and Qualitative Disclosures about Market Risk During 1997 and 1998, the Company issued $250.0 million of 107/8% Senior Notes, due 2007, $555.9 million of 9.47% Senior Discount Notes, due 2007, $450.5 million of 8.29% Senior Discount Notes, due 2008, $750.0 million of 7.50% Senior Notes, due 2008, and $300.0 million of 7.25% Senior Notes, due 2008 (collectively "the Notes"). In connection with its acquisition of LCI in June 1998, the Company assumed LCI's existing debt instruments, including $350.0 million of 7.25% Notes, due 2007. On December 31, 1998, the Company exercised its option to redeem 35%, or $87.5 million in principal amount, of the 107/8% Notes at a redemption price of 110.875%. The Company's long-term debt obligations are principally fixed interest rate and non-trading in nature, and as a result, the Company is less sensitive to market rate fluctuations. The Company does not use derivative financial instruments to manage its interest rate risk and has no cash flow exposure due to general interest rate changes for its fixed interest rate long-term debt. The table below provides information about the Company's market risk exposure associated with changing interest rates on its fixed rate debt and capital lease and other obligations. Collectively, the fixed rate debt, capital lease and other obligations, with a carrying value of $2,369.7 million, had an estimated fair value of $2,361.5 million at December 31, 1999, based on current interest rates offered for debt of similar terms and maturity. The Company's European-country operations were not material to the Company's consolidated financial position as of December 31, 1999, and results of operations or cash flows for the year ended December 31, 1999. In addition, foreign currency transaction gains and losses were not material to the Company's results of operations for the year ended December 31, 1999, and the Company was not subject to material foreign currency exchange rate risk from the effects of exchange rate movements of foreign currencies on the costs or cash flows the Company would receive from its share of the KPNQwest joint venture. To date, the Company has not entered into any significant foreign currency forward exchange contracts or other derivative financial instruments to hedge the effects of adverse fluctuations in foreign currency exchange rates.
Expected Maturity -------------------------------------------------------------------------------------- Unamortized 2000 2001 2002 2003 2004 Thereafter Discount Total -------------------------------------------------------------------------------------- Long-term fixed rate debt ......... $ -- $ -- $ -- $ -- $ -- $2,568.9 $ (224.8) $2,344.1 Capital lease and other obligations $ 1.4 $ 2.1 $ 2.6 $ 3.0 $ 3.6 $ 12.9 $ -- $ 25.6 Average interest rate ............. 8.2% 8.2% 8.2% 8.2% 8.2% 8.2% 8.2%
F-12 Report of Independent Public Accountants To the Board of Directors and Stockholders of Qwest Communications International Inc.: We have audited the accompanying consolidated balance sheet of Qwest Communications International Inc. (a Delaware corporation) and subsidiaries as of December 31, 1999, and the related consolidated statements of operations, stockholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Qwest Communications International Inc. and subsidiaries as of December 31, 1999, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. /s/ Arthur Andersen LLP ARTHUR ANDERSEN LLP Denver, Colorado, January 31, 2000. Independent Auditors' Report To the Board of Directors Qwest Communications International Inc.: We have audited the accompanying consolidated balance sheet of Qwest Communications International Inc. and subsidiaries as of December 31, 1998, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years ended December 31, 1998 and 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Qwest Communications International Inc. and subsidiaries as of December 31, 1998, and the results of their operations and their cash flows for the years ended December 31, 1998 and 1997 in conformity with generally accepted accounting principles. /s/ KPMG LLP KPMG LLP Denver, Colorado February 2, 1999 F-13 Consolidated Statements of Operations For the Three Years Ended December 31, 1999 (In Millions, Except Per Share Information)
1999 1998 1997 ----------------------------------- Revenue: Communications services ......................... $ 3,703.1 $ 1,554.3 $ 115.3 Construction services ........................... 224.5 688.4 581.4 ----------------------------------- Total revenue ................................ 3,927.6 2,242.7 696.7 ----------------------------------- Operating expenses: Access and network operations ................... 2,062.7 961.8 86.0 Construction services ........................... 96.4 446.8 408.3 Selling, general and administrative ............. 1,009.3 539.6 158.7 Depreciation and amortization ................... 404.1 201.7 20.2 Merger costs .................................... 31.5 86.5 -- Provision for in-process research and development -- 760.0 -- ----------------------------------- Total operating expenses ..................... 3,604.0 2,996.4 673.2 ----------------------------------- Earnings (loss) from operations .............. 323.6 (753.7) 23.5 Other expense (income): Interest expense, net ........................... 151.0 97.3 18.8 Gain on KPNQwest investment ..................... (414.0) -- -- Other expense (income), net ..................... 3.1 (1.2) (18.9) ----------------------------------- Earnings (loss) before income taxes .......... 583.5 (849.8) 23.6 Income tax expense (benefit) ........................ 125.0 (5.8) 9.1 ----------------------------------- Net earnings (loss) ............................. $ 458.5 $ (844.0) $ 14.5 ----------------------------------- Net earnings (loss) per share - basic ............... $ 0.63 $ (1.51) $ 0.04 ----------------------------------- Net earnings (loss) per share - diluted ............. $ 0.60 $ (1.51) $ 0.04 ----------------------------------- Weighted average shares outstanding - basic ......... 727.8 558.2 381.0 ----------------------------------- Weighted average shares outstanding - diluted ....... 764.3 558.2 388.1 ===================================
See accompanying notes to consolidated financial statements. F-14 Consolidated Balance Sheets As of December 31, 1999 and 1998 (In Millions, Except Share Information)
1999 1998 ---------------------- ASSETS Current assets: Cash and cash equivalents ............................... $ 349.2 $ 462.8 Accounts receivable (net of allowance of $68.3 million and $56.2 million) ..................... 1,136.7 628.1 Prepaid expenses and other current assets ............... 299.3 348.2 ---------------------- Total current assets ................................. 1,785.2 1,439.1 Property and equipment, net ................................. 4,108.7 2,655.4 Excess of cost over net assets acquired (net of accumulated amortization of $162.1 million and $59.8 million) ....... 3,290.1 3,402.0 Investment in KPNQwest ...................................... 680.0 -- Intangible and other assets (net of accumulated amortization of $71.3 and $24.1 million) ................ 1,194.1 571.1 ---------------------- TOTAL ASSETS ................................................ $11,058.1 $ 8,067.6 ====================== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ........................................ $ 209.9 $ 205.1 Facility costs accrued and payable ...................... 275.4 300.2 Accrued expenses and other .............................. 753.1 732.2 ---------------------- Total current liabilities ............................ 1,238.4 1,237.5 Debt and capital lease obligations, net of current portion .. 2,368.3 2,307.1 Other long-term liabilities ................................. 394.9 284.8 ---------------------- Total liabilities .................................... 4,001.6 3,829.4 ---------------------- Minority interest ........................................... 55.2 -- Commitments and contingencies Stockholders' equity: Preferred stock - $.01 par value; authorized 200.0 million shares; no shares issued and outstanding -- -- Common stock - $.01 par value; authorized 5.0 billion shares; 750.0 million shares and 694.0 million shares issued and outstanding ............................... 7.5 6.9 Paid-in capital ......................................... 7,278.3 5,105.0 Accumulated other comprehensive income .................. 132.9 2.2 Accumulated deficit ..................................... (417.4) (875.9) ---------------------- Total stockholders' equity ........................... 7,001.3 4,238.2 ---------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .................. $11,058.1 $ 8,067.6 ======================
See accompanying notes to consolidated financial statements. F-15 Consolidated Statements of Stockholders' Equity For the Three Years Ended December 31,1999 (In Millions)
Common Stock Accumulated -------------------- Additional Other Total Number of Paid-in Comprehensive Accumulated Stockholders' Shares Amount Capital Income Deficit Equity -------------------------------------------------------------------------- Balances, January 1, 1997 .............................. 346.0 $ 3.4 $ 52.5 $ -- $ (46.4) $ 9.5 Issuance of common stock in initial public offering, net 62.1 0.8 318.8 -- -- 319.6 Issuance of common stock in employee stock transactions, including related income tax benefits 5.2 -- 38.2 -- -- 38.2 Net earnings ........................................... -- -- -- -- 14.5 14.5 ------------------------------------------------------------------------- Balances, December 31, 1997 ............................ 413.3 4.2 409.5 -- (31.9) 381.8 Issuance of common stock in employee stock transactions, including related income tax benefits 23.6 0.2 167.7 -- -- 167.9 Issuance of common stock, warrants and options in acquisitions ........................ 248.3 2.5 4,327.8 -- -- 4,330.3 Issuance of common stock to Microsoft Corporation ...... 8.8 -- 200.0 -- -- 200.0 Comprehensive income: Currency translation adjustments (net of related taxes of $1.2) .................. -- -- -- 2.2 -- 2.2 Net loss ........................................... -- -- -- -- (844.0) (844.0) ------------------------------------------------------------------------- Total comprehensive income ...................... -- -- -- 2.2 (844.0) (841.8) ------------------------------------------------------------------------- Balances, December 31, 1998 ............................ 694.0 6.9 5,105.0 2.2 (875.9) 4,238.2 Issuance of common stock in employee stock transactions, including related income tax benefits 14.6 0.2 244.7 -- -- 244.9 Issuance of common stock to BellSouth Corporation ...... 40.7 0.4 1,921.3 -- -- 1,921.7 Other .................................................. 0.7 -- 7.3 -- -- 7.3 Comprehensive income: Currency translation adjustments (net of related tax benefit of $0.9) ................................ -- -- -- (1.4) -- (1.4) Net change in unrealized gain on marketable equity securities (net of related taxes of $89.3) ...... -- -- -- 132.1 -- 132.1 Net earnings ....................................... -- -- -- -- 458.5 458.5 ------------------------------------------------------------------------- Total comprehensive income ...................... -- -- -- 130.7 458.5 589.2 ------------------------------------------------------------------------- Balances, December 31, 1999 ............................ 750.0 $ 7.5 $7,278.3 $ 132.9 $ (417.4) $7,001.3 =========================================================================
See accompanying notes to consolidated financial statements. F-16 Consolidated Statements of Cash Flows For the Three Years Ended December 31, 1999 (In Millions)
1999 1998 1997 -------------------------------- Cash flows from operating activities: Net earnings (loss) ......................................... $ 458.5 $ (844.0) $ 14.5 Adjustments to reconcile net earnings (loss) to net cash provided by (used in) operating activities: Depreciation and amortization ............................ 404.1 201.7 20.2 Provision for bad debts .................................. 192.6 82.8 7.8 Interest accretion on discount notes ..................... 66.3 58.4 6.9 Restructuring and merger non-cash charges ................ -- 846.5 -- Deferred income tax expense (benefit) .................... 124.7 (7.8) 9.0 Gain on KPNQwest investment .............................. (414.0) -- -- Equity in subsidiary losses .............................. 33.6 0.9 -- Changes in operating assets and liabilities, net of effect of business combinations: Accounts receivable ............................... (714.7) (317.0) (39.7) Net securitization payment ........................ -- (100.7) -- Accounts payable .................................. 18.2 (33.2) 53.1 Facility costs accrued and payable ................ (24.8) 128.9 4.6 Accrued expenses and other ........................ (3) 210.7 88.0 Other long-term assets ............................ (285.1) (46.5) (2.9) Other long-term liabilities ....................... (20.0) (71.4) (0.1) Other changes ..................................... 125.4 (64.8) (197.8) -------------------------------- Net cash provided by (used in) operating activities (38.2) 44.5 (36.4) -------------------------------- Cash flows from investing activities: Expenditures for property and equipment ..................... (1,900.2) (1,413.2) (345.8) Acquisitions, investments and other ......................... (237.8) (25.6) (11.0) -------------------------------- Net cash used in investing activities ............. (2,138.0) (1,438.8) (356.8) -------------------------------- Cash flows from financing activities: Proceeds from long-term debt ................................ -- 1,403.5 678.0 Repayments of long-term debt ................................ (4.1) (164.3) (200.2) Net short-term debt activity ................................ (5.3) (105.6) -- Proceeds from issuance of common stock, net ................. 1,921.7 200.0 319.5 Proceeds from employee stock transactions, issuance of stock warrants and other ................................. 150.3 143.7 (31.2) -------------------------------- Net cash provided by financing activities ............ 2,062.6 1,477.3 766.1 -------------------------------- Net increase (decrease) in cash and cash equivalents . (113.6) 83.0 372.9 Cash and cash equivalents, beginning of period .............. 462.8 379.8 6.9 -------------------------------- Cash and cash equivalents, end of period .................... $ 349.2 $ 462.8 $ 379.8 ================================
See accompanying notes to consolidated financial statements. F-17 Notes to Consolidated Financial Statements Three Years Ended December 31, 1999 NOTE 1 > BUSINESS AND BACKGROUND Qwest Communications International Inc. ("Qwest" or the "Company") is a leading broadband Internet communications company engaged in two core businesses: Communications Services and Construction Services. Communications Services includes Internet, multimedia, data and voice services sold to business, consumer and government customers. In addition, it provides high-volume voice and conventional private line services to other communications providers, as well as to Internet Service Providers ("ISPs"), and other data service companies. Construction Services constructs and installs fiber optic systems for other communications providers, as well as for the Company's own use. The Company began operations in 1988 constructing fiber optic conduit systems primarily for major long distance carriers in exchange for cash and capacity rights. The Company has entered into construction contracts for the sale of dark fiber with three major customers whereby the Company has agreed to install and provide dark fiber to each along portions of the Company's network. In addition to these contracts, the Company has signed agreements with other communications providers and government agencies for the sale of dark fiber along the Company's network. Revenue from Construction Services generally is recognized under the percentage of completion method as performance milestones relating to the contract are satisfactorily completed. Qwest was wholly-owned by Anschutz Company ("Anschutz") until June 27, 1997, when the Company issued common stock in an initial public offering (the "IPO"). As of December 31, 1999, Anschutz owned approximately 38.3% of the outstanding common stock of the Company. In July 1999, Qwest entered into a definitive merger agreement with U S WEST, Inc. The transaction will be accounted for as a purchase with U S WEST deemed the accounting acquiror and is structured to be tax-free to U S WEST shareowners to the extent of the Qwest stock delivered in the transaction. The Boards of Directors and stockholders of both Qwest and U S WEST have approved the proposed merger. The merger is subject to federal and state regulatory approvals and other customary closing conditions. Closing of the merger is expected by mid-2000 (see Note 3). NOTE 2 > SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION. The accompanying consolidated financial statements as of December 31, 1999 and 1998 and for the years ended December 31, 1999, 1998 and 1997 include the accounts of the Company and all majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. COMMUNICATIONS SERVICES REVENUE. Revenue from communications services is generally recognized monthly as the services are provided. Amounts billed in advance of the service month are recorded as deferred revenue. LONG-TERM CONSTRUCTION CONTRACTS. The Company accounts for long-term construction contracts relating to the development of communications networks using the percentage of completion method. Under the percentage of completion method, progress is generally measured on performance milestones relating to the contract where such milestones fairly refiect progress toward contract completion. Network construction costs include all direct material and labor costs and those indirect costs related to contract performance. General and administrative costs are charged to expense as incurred. When necessary, estimated losses on uncompleted contracts are expensed in the period in which they are identified. Contract costs are estimated using allocations of the total cost of constructing the network. Revisions to estimated profits on contracts are recognized in the period they become known. RESEARCH AND DEVELOPMENT. In connection with the acquisitions of LCI International, Inc. and subsidiaries ("LCI"), EUnet International Limited ("EUnet") and Icon CMT Corp. ("Icon") in 1998, the Company expensed $760.0 million for in-process R&D projects since the development of these projects had not yet reached technological feasibility and the in-process R&D had no alternative future uses as of the acquisition date. These projects related to the development of advanced voice and data services as well as sophisticated network management and administration functions (See Note 3). F-18 R&D costs incurred in the normal course of business are expensed as incurred. The Company incurred approximately $36.3 million and $27.7 million of such costs in 1999 and 1998, respectively. R&D costs were insignificant in 1997. ADVERTISING COSTS. Costs for advertising are generally expensed as incurred within the fiscal year. If it is determined that the advertising qualifies as direct response advertising, the costs are deferred and amortized over the period of benefit, not to exceed one year. COMPREHENSIVE INCOME. Comprehensive income consists of unrealized gains and losses on marketable equity securities, currency translation adjustments and net earnings (loss). CASH AND CASH EQUIVALENTS. The Company classifies cash on hand and deposits in banks, including money market accounts, and any other investments with a maturity of three months or less from the date of purchase, that the Company may hold from time to time, as cash and cash equivalents. SALES OF EQUITY SECURITIES BY EQUITY METHOD INVESTEES. Increases or decreases in the Company's investments resulting from sales of equity securities by the investee company are included as gains or losses in the accompanying consolidated statements of operations (See Note 4). UNREALIZED HOLDING GAIN (LOSS) ON EQUITY SECURITIES. The Company's equity investments in certain publicly traded companies are classified as available-for-sale securities. Accordingly, these investments are included in other assets at fair market value of approximately $259.7 million and $4.0 million at December 31, 1999 and 1998, respectively. The unrealized holding gain on these marketable equity securities, net of taxes, is included as a component of stockholders' equity in the accompanying consolidated financial statements. As of December 31, 1999, the gross unrealized holding gain on these securities was $221.4 million. There were no sales of marketable equity securities for the years ended December 31, 1999, 1998 and 1997. PROPERTY AND EQUIPMENT. Property and equipment is stated at cost. Depreciation of buildings and equipment is computed on a composite straight-line basis. The cost of equipment retired in the ordinary course of business, less proceeds, is charged to accumulated depreciation. Leasehold improvements are amortized over the lesser of the useful lives of the assets or the lease term. Expenditures for maintenance and repairs are expensed as incurred. Network construction costs, including interest during construction, are capitalized. Interest capitalized in the years ended December 31, 1999, 1998 and 1997 was approximately $53.1 million, $41.6 million and $17.7 million, respectively. The useful lives of property and equipment are as follows: Facility and leasehold improvements 5 - 30 years or lease term Communications and construction equipment 3 - 10 years Fiber optic network 10 - 25 years Office equipment 3 - 7 years Capital leases lease term IMPAIRMENT OF LONG-LIVED ASSETS. The Company reviews its long-lived assets, including the excess of cost over net assets acquired, for impairment when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. This review consists of a comparison of the carrying value of the asset with the asset's or the acquired business's expected future undiscounted cash flows without interest costs. If the expected future cash flow exceeds the carrying value of the asset, no impairment is recognized. If the carrying value of the asset exceeds the expected future cash flows, an impairment exists and is measured by the excess of the carrying value over the fair value of the asset. No impairment expense was recognized in 1999, 1998 or 1997. EXCESS OF COST OVER NET ASSETS ACQUIRED, INTANGIBLE AND OTHER LONG-TERM ASSETS. These assets include goodwill, deferred compensation and acquired intangibles such as customer lists, work force and developed technology. Such costs are amortized on a straight-line basis over periods ranging from 3 to 40 years. Amortization is included in depreciation and amortization expense in the accompanying consolidated statements of operations and totaled $154.2 million, $46.5 million and $0.8 million for the years ended December 31, 1999, 1998 and 1997, respectively. FAIR VALUE OF FINANCIAL INSTRUMENTS. The carrying amounts of the Company's financial instruments other than long-term borrowings approximate fair value. The fair value of fixed rate debt is discussed in Note 7. STOCK-BASED COMPENSATION. The Company accounts for stock-based compensation using the intrinsic value method under which no expense is recognized for grants with an exercise price equal to or greater than the fair value of the underlying security. MANAGEMENT ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. RECLASSIFICATIONS. Certain prior year balances have been reclassified to conform to the 1999 presentation. F-19 NOTE 3 > MERGERS & ACQUISITIONS U S WEST In July 1999, Qwest entered into a definitive merger agreement with U S WEST, Inc. Under terms of the merger agreement, Qwest will issue shares of its common stock having a value of $69.00 for each share of U S WEST common stock, subject to a "collar" on Qwest's average stock price between $28.26 and $39.90 per share. The number of Qwest shares to be issued for each U S WEST share will be determined by dividing $69.00 by the average of the daily volume weighted average prices of Qwest common stock for 15 randomly selected trading days over a 30-day measurement period ending three days before the closing of the transaction, provided that Qwest will not issue more than 2.44161 shares for each U S WEST share or less than 1.72932 shares for each U S WEST share. The transaction will be accounted for as a purchase with U S WEST deemed the accounting acquiror and is structured to be tax-free to U S WEST shareowners to the extent of the Qwest stock delivered in the transaction. If Qwest's average stock price is below $38.70 per share, the obligation under the "collar" for the amount which the price is below $38.70 per share may be satisfied in whole or in part with cash. In determining the cash amount for the collar, Qwest and U S WEST will consider Qwest's desire to reduce dilution to its stockholders, U S WEST's potential desire to provide a cash element to its stockholders and both companies' desire to maintain the combined company's strong financial condition. If the companies decide to provide cash as part of the collar consideration, the minimum exchange ratio would be 1.783. U S WEST may terminate the merger agreement if the closing price of Qwest's shares is below $22.00 for 20 consecutive trading days before the closing, or if the average Qwest share price during the measurement period is less than $22.00. The Boards of Directors and stockholders of both Qwest and U S WEST have approved the proposed transaction. The transaction is subject to federal and state regulatory approvals and other customary closing conditions. Closing of the transaction is expected in mid-2000. As a result of the transaction, Qwest will become subject to the regulations applicable to U S WEST, a Regional Bell Operating Company ("RBOC"). Generally, effective as of the closing of the transaction, Qwest may not provide inter-LATA transport services within U S WEST's 14-state region until U S WEST receives approval to provide such services under Section 271 of the Telecommunications Act of 1996, as amended. Therefore, Qwest is in the process of divesting the prohibited services. In connection with the termination of the U S WEST and Global Crossing LTD. merger agreement, U S WEST paid Global Crossing a break-up fee of $140.0 million in cash and agreed to return $140.0 million in Global Crossing shares, valued at $62.75 per share, purchased by U S WEST in connection with its agreement with Global Crossing. Qwest advanced to U S WEST the $140.0 million cash payment and agreed to purchase $140.0 million in services from Global Crossing over four years at the best commercially available prices. OTHER ACQUISITIONS Each of the acquisitions discussed below was accounted for as a purchase. The results of operations of each of these acquisitions have been included in the accompanying consolidated statements of operations of the Company from the date of acquisition. ICON ACQUISITION In December 1998, the Company acquired Icon, a provider of integrated Internet solutions associated with web hosting and IP integration, for approximately $254.1 million in Company common stock, including approximately $3.5 million of direct acquisition costs. At the close of the acquisition, the Company issued approximately 11.8 million shares of the Company's common stock (including outstanding Icon stock options and warrants assumed by the Company). In connection with the acquisition of Icon, the Company allocated $10.0 million of the purchase price to in-process R&D projects. These projects include the design and development of several new value-added Internet services, including end-to-end solutions methodology designed to provide system-wide solutions for high-end corporate customers, a next-generation high-speed network system, and an improved network management system with added features. Since these projects had not yet reached technological feasibility and had no alternative future uses at the acquisition date, there was no guarantee as to the achievability of the projects or their ascribed values. Accordingly, these costs were expensed as of the acquisition date. The Company allocated $2.3 million of the purchase price to developed technology, $71.8 million to other intangible assets and $194.0 million to goodwill. The developed technology, other intangible assets and goodwill will be amortized on a straight-line basis from 4 to 15 years. F-20 LCI ACQUISITION In June 1998, the Company acquired LCI, a communications services provider, for approximately $3.9 billion in Company common stock, including approximately $13.5 million in direct acquisition costs. At the close of the acquisition, the Company issued approximately 259.8 million shares of the Company's common stock (including outstanding LCI stock options assumed by the Company). In connection with the acquisition of LCI, the Company allocated $682.0 million of the purchase price to in-process R&D projects, $318.0 million to developed technology, $65.0 million to other intangible assets and $3,071.0 million to goodwill. This allocation to the in-process R&D represented the estimated fair value based on risk-adjusted cash flows related to the incomplete projects. The developed technology, other intangibles and goodwill are being amortized on a straight-line basis from 10 to 40 years. The acquired R&D represented engineering and test activities associated with the introduction of new services and information systems. Specifically, LCI had been working on a variety of projects that were essential to delivering data services, which are a significant departure in terms of technological complexity from the Company's traditional voice products. These efforts were related to redesigning and scaling the network infrastructure as well as developing the requisite network management systems. These projects were time-consuming and difficult to complete. Since these projects had not yet reached technological feasibility and had no alternative future uses at the acquisition date, there was no guarantee as to the achievability of the projects or their ascribed values. Accordingly, these costs were expensed as of the acquisition date. EUNET ACQUISITION In April 1998, the Company acquired EUnet, a European ISP with subsidiaries in 14 countries, for approximately $154.0 million in Company common stock, including approximately $3.5 million in direct acquisition costs, and $4.2 million in cash. At the close of the acquisition, the Company issued approximately 7.9 million shares of Company common stock. The Company allocated $68.0 million of the purchase price to in-process R&D projects which were expensed as of the acquisition date. The remaining intangibles represented developed technology. EUnet was contributed to KPNQwest on April 1, 1999 and therefore the results of operations for periods beginning April 1, 1999 exclude the operating results of EUnet. PHOENIX ACQUISITION In March 1998, the Company acquired Phoenix Network, Inc. ("Phoenix"), a non-facilities-based reseller of long distance services, for approximately $27.2 million. At the close of the acquisition, the Company issued approximately 1.6 million shares of Company common stock. Goodwill is being amortized on a straight-line basis over 15 years. SUPERNET ACQUISITION In October 1997, the Company acquired SuperNet, Inc. ("SNI"), a regional ISP, for approximately $20.0 million in cash. Goodwill is being amortized on a straight-line basis over 10 years. MERGER COSTS During the year ended December 31, 1999, the Company recorded $31.5 million in merger costs related to the pending merger with U S WEST. During the year ended December 31, 1998, the Company recorded $86.5 million in merger-related costs due to the merger with LCI, including $31.0 million of duplicate facilities, $49.0 million of channel consolidation and duplicate commitments and $6.5 million of other miscellaneous merger costs. Of these merger costs, approximately $4.5 million remain accrued as of December 31, 1999. PRO FORMA RESULTS AND SUMMARY INFORMATION (UNAUDITED) The following pro forma operating results of the Company for the years ended December 31, 1999 and 1998 have been prepared assuming the acquisitions of LCI, Icon, Phoenix and SNI occurred on January 1, 1998. In addition, the following pro forma operating results exclude the results of operations of EUnet, which was acquired in April 1998 and later contributed to the KPNQwest joint venture on April 1, 1999. On a pro forma basis, for the year ended December 31, 1999, revenue was $3,902.7 million and net earnings was $464.3 million, or $0.64 and $0.61 per basic and diluted share, respectively. For the year ended December 31, 1998, revenue was $3,028.9 million and net loss was ($826.6) million, or ($1.24) per basic and diluted share. The pro forma results do not purport to represent what the Company's results of operations would have actually been had the above transactions occurred on the dates indicated and are not indicative of future results. NOTE 4 > INVESTMENTS INVESTMENT IN SLINGSHOT NETWORKS LLC/PURCHASE OF CERTAIN ASSETS OF ADMI. In September 1999, Qwest and Anschutz Digital Media, Inc. ("ADMI"), an affiliate of Qwest's principal stockholder, Anschutz Company, entered into an agreement to form a joint venture called Slingshot Networks LLC to provide advanced digital production, post-production and transmission facilities, digital media storage and distribution services, telephony-based data storage and enhanced services, access and routing services. Qwest and ADMI each own 50% of the joint venture, which is accounted for under the equity method. Qwest contributed approximately $84.8 million consisting of a promissory payable over nine years at an annual interest rate of 6%. The agreement between Qwest and ADMI also provided that Qwest would purchase certain telephony-related assets and all of the stock of Precision Systems, Inc., a telecommunications solutions provider, from ADMI in exchange for a promissory note in the amount of $34.0 million. The promissory note is payable over nine years and bears interest at an annual rate of 6%. INVESTMENT IN ADVANCED RADIO TELECOM CORP. In September 1999, Qwest invested $90.0 million for an approximate 19% stake in Advanced Radio Telecom Corp. ("ART"), a facilities-based, broadband ISP that provides a direct connection from customer location to the Internet, to help support the construction of ART's fixed, high-speed wireless networks. In connection with this transaction, a separate group of investors also invested $161.0 million. Qwest's investment in ART is accounted for under the cost method. INVESTMENT IN QWEST CYBER.SOLUTIONS LLC. In June 1999, Qwest and KPMG LLP, a leading professional services firm, formed a joint venture called Qwest Cyber.Solutions LLC, to provide Internet-based end-to-end application service provider, application hosting, and application management services. The venture will offer customers a broad set of vendor products available for Enterprise Resource Planning ("ERP"), Customer Relationship Management ("CRM") and back office solutions, a state-of-the-art Internet Protocol ("IP") broadband network, and technologically advanced CyberCenters. Qwest contributed approximately $60.0 million consisting of cash and other assets, and owns a 51% stake in the venture. The financial position and results of operation of the venture have been consolidated in the accompanying financial statements from the date of formation and the minority interest represents KPMG's stake in the venture. F-21 KPNQWEST In April 1999, Qwest and KPN Telecom B.V. ("KPN"), the Dutch telecommunications company, formed a joint venture ("KPNQwest") to create a pan-European IP-based fiber optic network, linked to Qwest's network in North America, for data and multimedia services. Qwest and KPN each initially owned 50 percent of KPNQwest, which was initially governed by a six person supervisory board to which Qwest and KPN had each named three members. Upon formation of KPNQwest, KPN contributed two partially completed bi-directional, self-healing fiber optic rings (EuroRings(TM) 1 and 2) and certain communications services contracts to KPNQwest. Qwest contributed Xlink Internet Service Gmbh ("Xlink"), the operating subsidiaries of EUnet International Limited ("EUnet") and cash. Also, Qwest and KPN contributed transatlantic capacity that connects KPNQwest's European network with Qwest's network in North America, and also contributed certain other assets. The net book value of total assets contributed by Qwest totaled approximately $300.0 million. Qwest deconsolidated EUnet and Xlink in April 1999. Qwest's investment in KPNQwest is accounted for under the equity method. KPNQwest offers managed broadband services, IP transit, Internet connectivity and value-added IP services, including consulting, hosting, and the transmission of live events over the Internet. KPNQwest also sells dark fiber along its network. Customers of KPNQwest include Internet services and content providers, multinational firms in Europe and North America, as well as telecommunications carriers, operators and others who want to purchase wholesale or retail network capacity, fiber or services. On November 12, 1999 KPNQwest consummated an initial public offering ("KPNQwest's IPO") in which 50.6 million shares of common stock were issued generating approximately $1.0 billion in net proceeds. The consummation of KPNQwest's IPO has resulted in approximately 11% of KPNQwest's shares being owned by the public and the remainder of KPNQwest's shares being owned by each of Qwest and KPN equally. As a result of the change in ownership structure of KPNQwest, two outside directors were added to the supervisory board. Also as a result of KPNQwest's IPO, Qwest recognized a gain of $414.0 million, representing its proportionate share of the increase in KPNQwest's equity. Qwest's proportionate share of KPNQwest's losses for the nine months ended December 31, 1999 of $31.2 million is included in other expense (income) in the accompanying consolidated statement of operations. At December 31, 1999, the carrying amount of the investment exceeded Qwest's equity in the underlying net assets by approximately $41.0 million which is net of accumulated amortization. As of December 31, 1999, the fair market value of Qwest's investment in KPNQwest was approximately $12.8 billion, based on the closing price of KPNQwest's common stock on the Nasdaq stock market. Summarized financial information of KPNQwest as of and for the nine months ended December 31, 1999 is as follows: (In Millions) Total assets ............................................ $2,574.6 Total liabilities ....................................... $1,169.9 Revenue ................................................. $ 199.0 Loss from operations .................................... $ 76.2 Net loss ................................................ $ 62.4 INVESTMENT IN RHYTHMS. In April 1999, Qwest made an equity investment, totaling $15.0 million in cash, in DSL local networks through an agreement with Rhythms NetConnections Inc. ("Rhythms"), a packet-based Competitive Local Exchange Carrier ("CLEC") that provides high-speed networking solutions for remote access to private networks and the Internet. Under this agreement, the Company will have access to 29 metropolitan areas (10 of which are in addition to the areas covered by an agreement that Qwest has with Covad Communications Group Inc.) by the first quarter of 2000, while further enhancing its ability to provide its customers with high-speed DSL connectivity to its network. The Company has committed to place a minimum number of orders for DSL service over a seven-year term commencing on the date that Rhythms is operational in the 29 metropolitan areas. In the event that the Company fails to meet the order target, the Company is committed to pay Rhythms for the difference between the order target and the number of actual orders placed. Qwest's investment in Rhythms is accounted for under the cost method. INVESTMENT IN COVAD. In January 1999, Qwest made an equity investment, totaling $15.0 million in cash, in high-speed, DSL local networks through an agreement with Covad Communications Group, Inc. ("Covad"), a packet-based CLEC. Under this agreement, the Company will have access to 22 metropolitan areas, while enhancing its ability to provide its customers with high-speed DSL connectivity to its network. The Company has committed to purchase DSL services for approximately F-22 $20.0 million over a five-year term commencing on the date that Covad's DSL services are commercially available in all 22 metropolitan areas. Qwest's investment in Covad is accounted for under the cost method. NOTE 5 > CONSTRUCTION SERVICES Revenue from construction services generally is recognized under the percentage of completion method as performance milestones relating to the contract are satisfactorily completed. Progress billings are made upon customers' acceptance of performance milestones. Costs and estimated earnings in excess of billings, net of uncompleted contracts included in the accompanying consolidated balance sheets were $41.1 million and $222.1 million at December 31, 1999 and December 31, 1998, respectively. The Company has entered into various agreements to provide indefeasible rights of use of multiple fibers along the network. Such agreements include contracts with three major customers for an aggregate purchase price of approximately $1.0 billion. Construction Services revenue relating to the contracts with these major customers was approximately $65.4 million, $356.6 million and $513.0 million for the years ended December 31, 1999, 1998 and 1997, respectively. NOTE 6 > PROPERTY AND EQUIPMENT Property and equipment, net consisted of the following: December 31, (In Millions) 1999 1998 ----------------------- Fiber optic network .............................. $2,295.7 $1,098.3 Communications and construction equipment ........ 116.8 72.9 Facility and leasehold improvements .............. 54.4 52.9 Office equipment ................................. 359.8 250.1 Capital leases ................................... 2.2 3.5 Work in progress ................................. 1,640.0 1,332.9 ----------------------- 4,468.9 2,810.6 Accumulated depreciation ......................... (360.2) (155.2) ----------------------- Property and equipment, net ...................... $4,108.7 $2,655.4 ======================= Depreciation expense was $249.9 million, $155.2 million and $19.4 million for the years ended December 31, 1999, 1998 and 1997, respectively. NOTE 7 > DEBT AND CAPITAL LEASE OBLIGATIONS Debt and capital lease obligations consisted of the following: December 31, (In Millions) 1999 1998 ----------------------- Fixed rate debt at interest rates ranging from 7.25% to 10 7/8%, net of discount ........... $ 2,344.1 $ 2,279.5 Capital lease and other obligations .................. 25.6 30.4 ----------------------- Total debt and capital lease obligations ............. 2,369.7 2,309.9 Less current portion ................................. (1.4) (2.8) ----------------------- Debt and capital lease obligations, net of current portion ............................... $ 2,368.3 $ 2,307.1 ----------------------- In March 1999, the Company entered into a $1.0 billion credit agreement with a syndicate of banks. This credit agreement provides for two five-year revolving credit facilities for a total of $500.0 million and one 364-day revolving credit facility in the amount of $500.0 million. The credit facilities bear interest at either the bank base rate of interest or LIBOR, plus an applicable margin. As of December 31, 1999, there were no borrowings outstanding under the credit agreement. The Company's credit agreement contains a provision whereby all amounts outstanding under the agreement must be repaid as a result of a "change of control" of the Company. While the Company does not believe that a change of control will occur, the Company is currently negotiating an amendment to the existing credit agreement and is taking other actions to ensure that the U S WEST merger does not constitute a "change of control." The Company is also taking such other actions necessary to permit the Company to consummate the merger. Such amendment is expected to be in place prior to the end of the first quarter of 2000. In addition, the Company is in the process of extending the term of the existing $500 million 364-day revolving credit facility and adding an additional $1.0 billion credit facility. Consummation of the additional credit facility is conditioned, among other things, on the execution of a mutually satisfactory credit agreement, which is expected to occur prior to the end of the first quarter of 2000. The Company issued the following senior and senior discount notes during the years ended December 31, 1998 and 1997: the 7.25% Senior Notes, due 2008 (the "7.25% Notes Due 2008"), the 7.50% Senior Notes, due 2008 (the "7.50% Notes"), the 8.29% Senior Discount Notes, due 2008 (the "8.29% Notes"), the 9.47% Senior Discount Notes, due 2007 (the "9.47% Notes") and the 10 7/8% Senior Notes, due 2007 (the "10 7/8% Notes") (each described below, collectively "the Notes"). In November 1998, the Company issued and sold $750.0 million in principal amount of its 7.50% Notes and $300.0 million in principal amount of its 7.25% Notes Due 2008, which together generated net proceeds of approximately $1,038.5 million, after deducting offering costs. Interest on the 7.50% Notes and the 7.25% Notes Due 2008 is payable semiannually in arrears on May 1 and November 1 of each year, commencing May 1, 1999. The 7.50% Notes and the 7.25% Notes Due 2008 are both subject to redemption at the option of the Company, in whole or in part, at specified redemption prices. In January 1998, the Company issued $450.5 million in principal amount at maturity of its 8.29% Notes, generating net proceeds of approximately $299.2 million, after deducting offering costs. Interest on the 8.29% Notes is compounded semiannually. The principal amount of the 8.29% Notes is due and payable in full on February 1, 2008. The 8.29% Notes are redeemable at the Company's F-23 option, in whole or in part, at any time on or after February 1, 2003 at specified redemption prices. In addition, prior to February 1, 2001, the Company may use the net cash proceeds from certain equity transactions to redeem up to 35% of the 8.29% Notes at specified redemption prices. Cash interest on the 8.29% Notes will not accrue until February 1, 2003, and thereafter will accrue at a rate of 8.29% per annum, and will be payable semiannually in arrears commencing on August 1, 2003, and thereafter on February 1 and August 1 of each year. The Company has the option of commencing cash interest on an interest payment date on or after February 1, 2001, in which case the outstanding principal amount at maturity of the 8.29% Notes will, on such interest payment date, be reduced to the then accreted value, and cash interest will be payable on each interest payment date thereafter. In October 1997, the Company issued its 9.47% Notes, having an aggregate principal amount at maturity of $555.9 million, which mature on October 15, 2007. The 9.47% Notes will accrete at a rate of 9.47% per annum, compounded semiannually, to an aggregate principal amount of $555.9 million by October 15, 2002. In March 1997, the Company issued its 10 7/8% Notes, having an aggregate principal amount at maturity of $250.0 million, which mature on April 1, 2007. On December 31, 1998, the Company exercised its option to redeem 35%, or $87.5 million in principal amount, of the 10 7/8% Notes at a redemption price of 110.875%. As a result, the Company recorded a charge of $12.9 million, included in other (income) expense, net, primarily for the redemption premium incurred and write-off of previously deferred debt issue costs. In connection with the LCI merger, the Company assumed LCI's existing debt instruments, including $350.0 million of 7.25% Senior Notes (the "7.25% Notes Due 2007"). The indentures for the Notes (defined above) and the 7.25% Notes Due 2007 contain certain covenants that, among other things, limit the ability of the Company and certain of its subsidiaries (the "Restricted Subsidiaries") to issue preferred stock, pay dividends or make other distributions, repurchase capital stock or subordinated indebtedness, create certain liens, enter into certain transactions with affiliates, sell assets of the Company or its Restricted Subsidiaries, issue or sell capital stock of the Company's Restricted Subsidiaries or enter into certain mergers and consolidations. The Company leases certain network construction equipment and buildings under capital lease agreements. The amortization charge applicable to capital leases is included in depreciation and amortization expense. Future minimum payments under capital lease obligations are included in contractual maturities of long-term debt, as summarized below. Contractual maturities of debt and capital lease obligations as of December 31, 1999 were as follows: December 31, (In Millions) 1999 ----------- 2000 ............................................................. $ 1.4 2001 ............................................................. 2.1 2002 ............................................................. 2.6 2003 ............................................................. 3.0 2004 ............................................................. 3.6 Thereafter ....................................................... $ 2,581.8 ----------- Total contractual maturities ..................................... 2,594.5 Less unamortized discount ........................................ (224.8) ----------- Total contractual maturities, net of unamortized discount ........ $ 2,369.7 ----------- Collectively, the fixed rate debt, capital lease obligations and other debt had a total carrying value of $2,369.7 million and $2,309.9 million and an estimated fair value of $2,361.5 and $2,402.3 million at December 31, 1999 and 1998, respectively, based on current interest rates offered for debt of similar terms and maturity. Unamortized discounts on senior discount notes totaled $224.8 million and $291.1 million as of December 31, 1999 and 1998, respectively. F-24 NOTE 8 > INCOME TAXES Income tax expense (benefit) for the years ended December 31, 1999, 1998 and 1997 was as follows: (In Millions) 1999 1998 1997 ---------------------------- Current: Federal ...................................... $ 0.3 $ 2.0 $ -- State ........................................ -- -- 0.1 ---------------------------- Total current income tax expense .......... 0.3 2.0 0.1 ---------------------------- Deferred: Federal ...................................... 111.5 (7.8) 9.0 State ........................................ 13.2 -- -- ---------------------------- Total deferred income tax expense (benefit) 124.7 (7.8) 9.0 ---------------------------- Total income tax expense (benefit) ........ $ 125.0 $ (5.8) $ 9.1 ---------------------------- Total income tax expense (benefit) differed from the amounts computed by applying the federal statutory income tax rate (35%) to earnings (loss) before income taxes as a result of the following items for the years ended December 31, 1999, 1998 and 1997: 1999 1998 1997 ---------------------------- Statutory income tax expense (benefit) ......... 35.0% (35.0%) 35.0% State income taxes, net of federal income tax expense .............. 2.3 -- 0.3 Goodwill amortization ...................... 5.3 2.0 1.3 In-process R&D ............................. -- 31.3 -- Foreign losses/joint ventures .............. (22.9) 0.8 -- Other, net ................................. 1.7 0.2 2.0 --------------------------- Total income tax expense (benefit) ...... 21.4% (0.7%) 38.6% --------------------------- The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and liabilities at December 31, 1999 and 1998 were as follows: (In Millions) 1999 1998 -------------------- Current deferred tax assets (liabilities): Allowance for doubtful accounts .................. $ 31.8 $ 13.6 Accrued liabilities .............................. 2.9 27.4 Deferred compensation ............................ (3.8) 35.8 Other, net ....................................... (0.2) (1.8) -------------------- Current deferred tax asset, net ............... 30.7 75.0 Long-term deferred tax assets (liabilities): Deferred compensation ............................ 15.3 -- Net operating loss carryforwards ................. 527.4 261.3 Other ............................................ 22.1 22.8 Unrealized gains ................................. (88.6) -- Deferred revenue ................................. (192.3) -- Intangible assets ................................ (240.6) (246.1) Property and equipment ........................... (150.0) (73.8) -------------------- Non-current deferred tax liability, net ....... (106.7) (35.8) -------------------- Net deferred tax asset (liability) ............... $ (76.0) $ 39.2 -------------------- The current deferred tax asset and non-current deferred tax liability is included in prepaid expenses and other current assets and other long-term liabilities, respectively, in the accompanying consolidated balance sheet. The Company has analyzed the sources and expected reversal periods of its deferred tax assets. The Company believes that the tax benefits attributable to deductible temporary differences will be realized by recognition of future taxable amounts. As discussed in Note 4, the Company recognized a $414.0 million gain on its investment in KPNQwest related to KPNQwest's IPO in November 1999. Since Qwest's investment in the foreign corporate joint venture is essentially permanent in duration, Qwest did not record deferred income taxes on the excess of its investment in KPNQwest over its tax basis in the joint venture. Deferred taxes not recognized were $165.6 million. As of December 31, 1999, the Company had net operating loss carryforwards for income tax purposes of approximately $1.4 billion. These net operating loss carryforwards, if not utilized to reduce taxable income in future periods, will expire in various amounts beginning in 2003 and ending in 2019. F-25 Effective with the LCI merger, the Company is no longer included in the consolidated federal income tax return of Anschutz. As a result, the tax-sharing agreement with Anschutz is no longer effective for activity after June 5, 1998. The Company is still subject to the provisions of the tax-sharing agreement for activity through June 5, 1998. The Company previously recognized a deferred tax asset attributable to its net operating loss carryforwards under the tax-sharing agreement. The Company currently believes the tax benefits previously recognized under the tax-sharing agreement may be realized through tax planning strategies. NOTE 9 > COMMITMENTS AND CONTINGENCIES VENDOR AGREEMENTS The Company has agreements with certain telecommunications inter-exchange carriers and third party vendors that require the Company to maintain minimum monthly and/or annual billings based on usage. The Company has historically met all minimum billing requirements and believes the minimum usage commitments will continue to be met. CAPACITY PURCHASE COMMITMENT In July 1999, Qwest and Global Crossing Ltd. ("Global") entered into a purchase agreement under which Qwest agreed to purchase services from Global over a four year period in a total amount of $140.0 million. This agreement was entered into in connection with Qwest's definitive merger agreement with U S WEST and the termination of the U S WEST and Global merger agreement. At the end of the two year period following the signing of the agreement, Qwest must pay Global an amount equal to the difference between $140.0 million and the amount of the services purchased under the agreement at that time. The amount of the differential payment will be credited by Global against all purchases by Qwest of services from Global during the remaining two years of the agreement. Under the agreement, Qwest is entitled to purchase services on any of Global's network segments at the most favorable commercially available prices offered by Global. LEASES AND COMMUNICATIONS SERVICES COMMITMENTS The Company leases certain terminal locations and office space under operating lease agreements. The Company has easement agreements with railroads and public transportation authorities. Future minimum payments under non-cancelable operating leases and right-of-way agreements, together with the present value of the net minimum payments as of December 31, 1999, were as follows: (In Millions) Operating Right-of-Way Total ------------------------------- 2000 ................................ $ 57.9 $ 4.9 $ 62.8 2001 ................................ 119.9 4.9 124.8 2002 ................................ 51.8 6.7 58.5 2003 ................................ 50.3 4.9 55.2 2004 ................................ 45.8 4.9 50.7 Thereafter .......................... 222.9 86.1 309.0 ------------------------------- 548.6 112.4 661.0 Less amount representing interest -- (68.9) (68.9) ------------------------------- Total minimum payments .......... $548.6 $ 43.5 $592.1 ------------------------------- Amounts expensed in the years ended December 31, 1999, 1998 and 1997 related to operating leases were approximately $80.5 million, $22.7 million and $6.2 million, respectively. The present value of net minimum payments of the right-of-way agreements is included in accrued expenses and other and in other long-term liabilities. PACIFIC RIM CABLE CONSORTIUM COMMITMENT The Company is participating in a consortium of communications companies that is building an underwater cable system connecting the United States to Japan. In connection with this transaction, the Company is committed to purchase approximately $56.0 million of fiber optic cable and other network assets of the 13,125-route-mile, four-fiber pair cable system to the Pacific Rim. The total remaining commitment through January 2001 was approximately $28.2 million as of December 31, 1999. LEGAL MATTERS The Company has been named as a defendant in various litigation matters. Management intends to vigorously defend these outstanding claims. The Company believes that it has adequate accrued loss contingencies and that, although the ultimate outcome of these claims cannot be ascertained at this time, current pending or threatened litigation matters are not expected to have a material adverse impact on the Company's results of operations or financial position. F-26 NOTE 10 > BENEFIT PLANS GROWTH SHARE PLAN The Company has a Growth Share Plan (the "Plan") for certain of its employees and directors. A "Growth Share" is a unit of value based on the increase in value of the Company over a specified measurement period. All Growth Share grants have been made based on a beginning Company value that was greater than or equal to the fair value of the Company at the grant date. The total number of Growth Shares is set at 10 million and the maximum presently available for grant under the Plan is 850,000. All participants, except those granted Growth Shares under the October 1996 Plan, vested fully upon completion of the Company's IPO and settlement was made with 5,183,064 common shares, net of amounts relating to tax withholdings of approximately $21.9 million. Growth Shares granted under the October 1996 Plan vest at the rate of 20% for each full year of service completed after the grant date subject to risk of forfeiture and are to be settled with the Company's Common Stock. The future compensation expense associated with the remaining shares has been capped at $5.50 per share, or approximately $13.7 million, and is amortized as expense over the remaining approximately three-year vesting period. At December 31, 1999, approximately $27.8 million is included in other long-term liabilities related to outstanding Growth Shares. The Company does not presently intend to make any additional Growth Share grants under this plan. Certain triggering events, such as a change in control of the Company, cause immediate vesting of the remaining Growth Shares and would result in accelerated expense recognition of all unamortized compensation. Participants receive their vested portion of the increase in value of the Growth Shares upon a triggering event, which includes the end of a Growth Share performance cycle. The Company estimated an increase in value of the Growth Shares during 1997 and recorded approximately $73.5 million of compensation expense for this plan in the year ended December 31, 1997. For the years ended December 31, 1999 and 1998, the Company recorded approximately $6.0 and $9.3 million of expense for this plan, respectively. The following table summarizes Growth Share grants, settlements, forfeitures and Growth Shares outstanding: Outstanding Growth Shares ------------- December 31, 1996 .................................... 275,400 1997 grants ...................................... 358,050 1997 settlements ................................. (253,950) ------------- December 31, 1997 .................................... 379,500 1998 forfeitures ................................. (4,500) 1998 settlements ................................. (12,000) ------------- December 31, 1998 .................................... 363,000 1999 forfeitures ................................. -- 1999 settlements ................................. (12,000) ------------- December 31, 1999 .................................... 351,000 ------------- 401(K) PLAN The Company sponsors defined contribution 401(k) plans (the "Plans") which permit employees to make contributions to the Plans on a pre-tax salary reduction basis in accordance with the provisions of Section 401(k) of the Internal Revenue Code. After one year of service, the Company matches a portion of the employee's voluntary contributions. Company contributions to the 401(k) plans were $5.3 million, $2.1 million and $0.9 million for the years ended December 31, 1999, 1998 and 1997, respectively. NOTE 11 > STOCKHOLDERS' EQUITY CAPITAL STOCK In May 1999, Qwest's stockholders approved an increase in the number of authorized common shares from 600 million to 2 billion. In November 1999, Qwest's stockholders approved an increase in the number of authorized common shares from 2 billion to 5 billion, and an increase in the number of authorized preferred shares from 25 million to 200 million. A total of 101.8 million common shares are reserved for issuance under the Company's 401(k) plans, stock option and incentive plans, the Growth Share Plan and for issuance upon exercise of warrants as described below. In May 1999 and February 1998, Qwest distributed separate two-for-one stock splits in the form of stock dividends. All share and per share information included in the consolidated financial statements and the notes hereto have been adjusted to give retroactive effect to the change in capitalization. In May 1999, Qwest issued approximately 40.7 million shares to BellSouth Corporation (together with its subsidiaries, "BellSouth") in exchange for approximately $1.9 billion in cash. Qwest's principal stockholder, Anschutz Company, sold approximately 33.3 million existing shares to BellSouth for approximately $1.6 billion. The investment by BellSouth represents an approximate 10% equity stake in Qwest. In December 1998, Microsoft Corporation ("Microsoft") purchased approximately 8.8 million shares of Qwest for $200.0 million. Microsoft has agreed not to transfer the Common Stock it purchased for a period of two years except to persons approved by the Company or to certain Microsoft controlled corporations. Further, unless approved by the Company's board of directors, (i) Microsoft is prohibited from acquiring more than 5% of the Company's Common Stock and from becoming a member (with third parties) of a group that owns more than 5% and; (ii) Microsoft may not take certain actions with respect to acquisition proposals or contested proxy solicitations until the earlier of (A) such time as the Company's officers, directors and affiliates own less than 33% of the voting power of the Company, (B) Microsoft otherwise disposes of the Common Stock, (C) the parties terminate the business relationship or (D) December 14, 2003. On May 23, 1997, the Board of Directors declared a stock dividend to the existing stockholder of approximately 346.0 million shares of Common Stock, which was paid immediately prior to the effective date of the registration statement on June 23, 1997. This dividend was accounted for as a stock split. The Company completed the IPO of approximately 62.1 million shares of Common Stock on June 27, 1997, raising net proceeds of approximately $319.5 million. Effective May 23, 1997, the Company sold to an affiliate of Anschutz for $2.3 million in cash, a warrant to acquire 17.2 million shares of Common Stock at an exercise price of $7.00 per share, exercisable on May 23, 2000. The warrant is not transferable. Stock issued upon exercise of the warrant will be subject to restrictions on sale or transfer for two years after exercise. In connection with the acquisition of Icon, the Company issued approximately 0.6 million warrants to acquire F-27 0.6 million shares of Common Stock at an average exercise price of $8.91 per share, exercisable in 2007. The warrants are not transferable. COMMON STOCK OPTIONS Effective June 23, 1997, the Company adopted the Equity Incentive Plan, which was amended and restated on June 1, 1998. This plan permits the grant of non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock, stock units and other stock grants. A maximum of 70.0 million shares of Common Stock may be subject to awards under the Equity Incentive Plan. The Company's Compensation Committee determines the exercise price for each option; however, stock options must have an exercise price that is at least equal to the fair market value of the Common Stock on the date the stock option is granted, subject to certain restrictions. Stock option awards generally vest in equal increments over a five-year period, and awards granted under the Equity Incentive Plan will immediately vest upon any change in control of the Company, as defined, unless provided otherwise by the Compensation Committee at the time of grant. Options granted in 1997, 1998 and 1999 have terms ranging from six to ten years. Stock option transactions during 1997, 1998 and 1999 were as follows: Number Weighted of Average (in thousands) Options Exercise Price ------------------------- Outstanding January 1, 1997 ................ -- $ -- Granted ................................ 27,916 $ 7.94 Exercised .............................. (24) $ 5.50 ------- Outstanding December 31, 1997 .............. 27,892 $ 7.95 Granted ................................ 26,278 $16.84 Assumed ................................ 31,540 $ 8.32 Exercised .............................. (23,314) $ 6.83 Cancelled .............................. (2,094) $13.29 ------- Outstanding December 31, 1998 .............. 60,302 $12.02 Granted ................................ 35,262 $31.69 Exercised .............................. (13,827) $ 9.68 Cancelled .............................. (12,826) $17.12 ------- Outstanding December 31, 1999 .............. 68,911 $21.48 ------- Exercisable December 31, 1997 .............. 2,680 $ 5.50 ------- Exercisable December 31, 1998 .............. 15,483 $ 8.71 ------- Exercisable December 31, 1999 .............. 11,383 $10.57 ------- In connection with the acquisitions of LCI and Icon, the Company assumed the outstanding options on the date of acquisition for each of the acquired companies. Pursuant to the terms of the LCI stock option plans, the acquisition of LCI by the Company triggered a change in control of LCI. As such, all of the outstanding options vested immediately. The weighted average fair value of each option grant is estimated as of the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions: 1999 1998 1997 ---------------------------------------- Weighted average fair value .... $ 15.00 $ 7.59 $ 3.97 Risk-free interest rate ........ 6.0% 4.6% 5.8% Expected option lives .......... 5.4 5.5 7.6 Dividend yield ................. 0.0% 0.0% 0.0% Volatility ..................... 44.9% 41.2% 31.0% F-28 The following table summarizes certain information about the Company's stock options at December 31, 1999:
Options Outstanding Options Exercisable --------------------------------------- ------------------------- Weighted Average Weighted Weighted Number of Remaining Average Number of Average Options Contractual Exercise Options Exercise Range of exercise prices Outstanding Life Price Exercisable Price -------------------------------------------------------------------- (In Thousands) (In Years) (In Thousands) --------------------------------------- --------------------------- $1.65 - $11.00......................... 13,669 4.1 $ 5.66 5,850 $ 5.96 $11.17 - $15.66........................ 14,156 7.8 $ 13.89 4,039 $ 13.70 $15.70 - $18.19........................ 4,200 8.0 $ 17.26 666 $ 17.25 $18.28 - $20.97........................ 1,567 8.0 $ 19.71 341 $ 19.37 $21.03 - $29.06........................ 20,637 9.4 $ 27.93 479 $ 24.50 $29.19 - $33.88........................ 4,248 9.4 $ 30.94 2 $ 30.09 $33.94 - $38.88........................ 6,778 9.5 $ 36.02 -- $ -- $39.03 - $48.06........................ 3,656 9.3 $ 41.33 6 $ 43.83 -------------------------------------------------------------------- 68,911 7.9 $ 21.48 11,383 $ 10.57 --------------------------------------------------------------------
Compensation expense recognized for grants under the Equity Incentive Plan was not material in any period. If compensation expense for the Equity Incentive Plan had been determined using the fair value method described in SFAS No. 123, the Company's net earnings (loss) and net earnings (loss) per share for 1999, 1998 and 1997 would have been reduced to the pro forma amounts shown in the following table:
(In Millions, Except Per Share Information) 1999 1998 1997 ------------------------------------- Net earnings (loss): As reported ........................... $ 458.5 $ (844.0) $ 14.5 Pro forma ............................. $ 393.7 $ (866.6) $ 0.9 Net earnings (loss) per share - basic: As reported ........................... $ 0.63 $ (1.51) $ 0.04 Pro forma ............................. $ 0.54 $ (1.55) $ 0.00 Net earnings (loss) per share - diluted: As reported ........................... $ 0.60 $ (1.51) $ 0.04 Pro forma ............................. $ 0.52 $ (1.55) $ 0.00
EMPLOYEE STOCK PURCHASE PLAN In October 1998, the Company instituted an Employee Stock Purchase Plan ("ESPP"). The Company is authorized to issue approximately 1.6 million shares of Common Stock to eligible employees. Under the terms of the ESPP, eligible employees may authorize payroll deductions of up to 15% of their base compensation, as defined, to purchase Common Stock at a price of 85% of the fair market value of the Company's Common Stock on the last trading day of the month in which the Common Stock is purchased. NOTE 12 > WEIGHTED AVERAGE SHARES OUTSTANDING The weighted average number of shares used for computing basic net earnings (loss) per share for the years ended December 31, 1999, 1998 and 1997 was 727.8 million, 558.2 million and 381.0 million, respectively. For the years ended December 31, 1999 and 1997, the weighted average number of shares used for computing diluted earnings per share was 764.3 million and 388.1 million, respectively (including incremental common shares attributable to dilutive securities related to warrants, options and growth shares of 36.5 million and 7.1 million, respectively). Because the Company had a net loss in 1998, the effect of all options, warrants, and growth shares (28.5 million incremental common shares) on loss per share was anti-dilutive, and therefore not included in the computation of diluted loss per share. F-29 NOTE 13 > BUSINESS SEGMENT INFORMATION The Company's two business segments are Communications Services and Construction Services, each having a separate management team and infrastructure, offering different products and services, and utilizing different marketing strategies to target different types of customers. Communications Services provides multimedia communications services to retail and wholesale customers. Construction Services constructs and installs fiber optic systems for other communications entities, as well as for the Company's own use. The accounting policies of the business segments are the same as those described in Note 2 -- Summary of Significant Accounting Policies. The Company evaluates the performance of its business segments based on their respective earnings (loss) from operations, before other (income) expense and income taxes. The following table presents summarized financial information related to the business segments for the years ended December 31, 1999, 1998 and 1997:
(In Millions) Communications Construction Corporate/ Consolidated Services Services Unallocated Total ------------------------------------------------------------------- 1999 Revenue ....................... $ 3,703.1 $ 224.5 $ -- $ 3,927.6 Earnings (loss) from operations $ 651.8 $ 107.4 $ (435.6) $ 323.6 Assets ........................ $ -- $ -- $11,058.1 $11,058.1 Capital expenditures .......... $ 1,762.6 $ 0.6 $ 137.0 $ 1,900.2 1998 Revenue ....................... $ 1,554.3 $ 688.4 $ -- $ 2,242.7 Earnings (loss) from operations $ 91.9 $ 202.6 $(1,048.2) $ (753.7) Assets ........................ $ -- $ -- $ 8,067.6 $ 8,067.6 Capital expenditures .......... $ 1,382.2 $ 2.2 $ 28.8 $ 1,413.2 1997 Revenue ....................... $ 115.3 $ 581.4 $ -- $ 696.7 Earnings (loss) from operations $ (102.9) $ 146.6 $ (20.2) $ 23.5 Assets ........................ $ -- $ -- $ 1,398.1 $ 1,398.1 Capital expenditures .......... $ 337.7 $ 2.0 $ 6.1 $ 345.8
Corporate/unallocated operating expenses consist of the following: 1999 1998 1997 ------------------------------------- Depreciation and amortization $ 404.1 $ 201.7 $ 20.2 Merger costs ................ $ 31.5 $ 846.5 $ -- The Company's areas of operations are principally in the United States and Europe, and the Company is developing network assets in Mexico. No single European country or geographic area is significant to the Company's consolidated operations. As discussed in Note 4, the Company has a significant investment in Amsterdam-based KPNQwest. As of December 31, 1999, the carrying value of Qwest's investment in KPNQwest was $680.0 million. During the year ended December 31, 1997 two customers accounted for 10% or more of the Company's total revenue; One customer accounted for 37% and the other for 31%. No customer accounted for 10% or more of the Company's total revenue during the years ended December 31, 1999 or 1998. F-30 NOTE 14 > SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Year Ended December 31, (In Millions) 1999 1998 1997 --------------------------------------- Cash paid for interest, net ...... $ 85.5 $ 70.7 $ 16.7 Non-cash assets contributed to KPNQwest joint venture ....... $ 212.1 $ -- $ -- Note payable issued for investment $ 84.8 $ -- $ -- Common stock issued - acquisitions $ -- $4,332.7 $ -- NOTE 15 > SELECTED CONSOLIDATED QUARTERLY FINANCIAL DATA (Unaudited) 1999
(In Millions, Except Per Share Information) First Quarter Second Quarter Third Quarter Fourth Quarter --------------------------------------------------------------- Revenue ................................... $ 878.4 $ 873.7 $ 1,018.1 $ 1,157.4 Gross profit .............................. 368.7 409.5 461.8 528.5 Earnings from operations .................. 59.5 94.0 63.8 106.3 Net earnings (loss) ....................... $ 4.8 $ 18.5 $ (1.8) $ 437.0 Net earnings (loss) per share - basic ..... $ 0.01 $ 0.03 $ -- $ 0.58 Net earnings (loss) per share - diluted ... $ 0.01 $ 0.02 $ -- $ 0.56
1998
First Quarter Second Quarter Third Quarter Fourth Quarter --------------------------------------------------------------- Revenue ................................... $ 177.1 $ 393.7 $ 806.8 $ 865.1 Gross profit .............................. 48.9 132.0 307.0 346.2 Earnings (loss) from operations ........... (3.5) (820.4) 37.7 32.5 Net loss .................................. $ (6.6) $ (808.9) $ (6.9) $ (21.6) Net loss per share - basic ................ $ (0.02) $ (1.67) $ (0.01) $ (0.03) Net loss per share - diluted .............. $ (0.02) $ (1.67) $ (0.01) $ (0.03)
In connection with the pending merger with U S WEST, the Company expensed $25.0 million and $6.5 million in merger-related costs in the third and fourth quarter of 1999, respectively. In connection with the acquisitions of LCI and EUnet in the second quarter of 1998 and the acquisition of Icon in the fourth quarter of 1998, the Company expensed $750.0 million and $10.0 million, respectively, for in-process R&D projects, and $86.5 million in merger-related costs in the second quarter of 1998. F-31 > Market for the Registrant's Common Stock and Related Shareholder Matters During 1999 the Company's Common Stock was listed on the Nasdaq National Market under the trading symbol "QWST." Effective January 3, 2000 the Company moved its listing to the New York Stock Exchange under the trading symbol "Q". As of March 7, 2000, there were approximately 753.1 million shares of Common Stock issued and outstanding held by 6,893 stockholders of record. The following table sets forth, for the periods indicated, the high and low sales prices per share of Common Stock as reported on the Nasdaq National Market (as adjusted to reflect the two-for-one stock splits effected on February 24, 1998 and May 24, 1999 as dividends): High Low -------------------- Fiscal 1998: First Quarter ...................... $20.53 $14.81 Second Quarter ..................... $20.03 $13.94 Third Quarter ...................... $23.75 $11.00 Fourth Quarter ..................... $25.66 $13.38 High Low -------------------- Fiscal 1999: First Quarter ...................... $37.406 $25.625 Second Quarter ..................... $47.000 $32.875 Third Quarter ...................... $35.938 $26.250 Fourth Quarter ..................... $44.000 $29.875 The Company completed its initial public offering on June 27, 1997. The Registrant has not paid cash dividends on its Common Stock since becoming a public company in June 1997. The merger agreement between U S WEST and Qwest provides that the Company initially will pay a dividend of $0.0125 per share per quarter after completion of the merger. The payments of dividends by the combined company after the merger will depend on business conditions, the combined company's financial condition and earnings, as well as other factors. The terms of the Indentures governing its outstanding notes restrict the Company's ability to pay dividends. Any payment of future dividends will be at the discretion of the Company's Board of Directors and will depend upon, among other things, the Company's earnings, operations, capital requirements, level of indebtedness, financial condition, contractual restrictions and other relevant factors. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations.") In April 1999, the Company entered into a strategic relationship with BellSouth Corporation. An affiliate of BellSouth and the Company entered into a commercial arrangement for provisioning of a full range of integrated digital data, image and voice communications services for customers. In addition, in May 1999, BellSouth purchased approximately 40.7 million shares of the Company's common stock for $1.9 billion. BellSouth purchased approximately 33.3 million shares from the Company's principal stockholder, the Anschutz Company, for $1.6 billion. As a result of these two purchases, BellSouth owns approximately 74.0 million shares of the Company's common stock, representing approximately 10% of the Company's issued and outstanding shares. Pursuant to the Common Stock Purchase Agreement, BellSouth agreed (1) to a "standstill" provision under which BellSouth will not acquire more than 20% of the outstanding shares of the Company's common stock, (2) not to transfer the shares to third parties, subject to certain exceptions, and (3) not to take certain actions with respect to the Company that may influence the Company. These restrictions generally terminated upon the Company entering into the U S WEST merger agreement. BellSouth does not have an option or any other right to acquire additional shares of the Company's common stock, and the Company has no obligation to issue or otherwise sell any additional shares to BellSouth. In addition, the Common Stock Purchase Agreement provides that BellSouth has the right, after it obtains regulatory relief to provide inter-LATA service in certain states, to designate one person to serve as a director of the Company. On December 14, 1998, the Company and Microsoft Corporation, a Washington corporation ("Microsoft"), announced that they had agreed to enter into a business relationship to offer data and Internet services. In addition, Microsoft purchased from the Company approximately 8.8 million shares of the Company's common stock, at a price of $22.50 per share, for an aggregate purchase price of $200.0 million. Pursuant to the Common Stock Purchase Agreement, Microsoft has agreed not to transfer the shares for a period of two years except to persons approved by the Company or to certain Microsoft controlled corporations. Further, unless approved by the Company's board of directors, (i) Microsoft is prohibited from acquiring more than 5% of the Company's common stock and from becoming a member (with third parties) of a group that owns more than 5% and (ii) Microsoft may not take certain actions with respect to acquisition proposals or contested proxy solicitations until the earlier of (A) such time as the Company's officers, directors and affiliates own less than 33% of the voting power of the Company, (B) Microsoft otherwise disposes of the shares, (C) the parties terminate the business relationship or (D) December 14, 2003. F-32 EX-23.1 3 CONSENT OF ARTHUR ANDERSEN LLP Exhibit 23.1 Consent of Independent Public Accountants As independent public accountants, we hereby consent to the incorporation of our report dated January 31, 2000, incorporated by reference in this Form 10-K, into the Company's previously filed Registration Statements on Form S-8 (File Nos. 333-84877, 333-47349, 333-50061, 333-56323, 333-60133, 333-61725, 333-65345, and 333-68267) and Form S-3 (File No. 333-58617). Arthur Andersen LLP Denver, Colorado March 15, 2000 EX-23.2 4 CONSENT OF KPMG Exhibit 23.2 Consent of Independent Auditors The Board of Directors Qwest Communications International Inc.: We consent to incorporation by reference in the Registration Statements on Form S-8 (No. 333-47349, No. 333-50061, No. 333-56323, No. 333-60133, No. 333-61725, No. 333-65345 and No. 333-68267), and the Registration Statement on Form S-3 (No. 333-58617), of Qwest Communications International Inc. of our report dated February 2, 1999, relating to the consolidated balance sheet of Qwest Communications International Inc. and subsidiaries as of December 31, 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the two-year period ended December 31, 1998, which appears in the December 31, 1999 annual report on Form 10-K of Qwest Communications International, Inc. KPMG LLP Denver, Colorado March 15, 2000 EX-27 5 FINANCIAL DATA SCHEDULE
5 This schedule contains summary financial information extracted from the consolidated balance sheet as of December 31, 1999 and consolidated statement of operations for the nine months ended December 31, 1999 included in the Company's Form 10-K, and is qualified in its entirety by reference to such financial statements. 1,000,000 YEAR DEC-31-1999 JAN-01-1999 DEC-31-1999 349 0 1,205 68 0 1,785 4,469 360 11,058 1,238 2,344 0 0 8 6,993 11,058 3,928 3,928 2,159 3,604 (411) 0 151 584 125 459 0 0 0 459 0.63 0.60
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