-----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, PMqh9IJIhPLiZNC5E0a+72RGqJBNojqZcSgYd/+F/z13D8OJ6xCv3DMr66xIzW0J vnHuGxAOhmWUXBZ1Pi/KvA== 0001035704-01-500481.txt : 20020410 0001035704-01-500481.hdr.sgml : 20020410 ACCESSION NUMBER: 0001035704-01-500481 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011114 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-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-15577 FILM NUMBER: 1790539 BUSINESS ADDRESS: STREET 1: 1801 CALIFORNIA ST CITY: DENVER STATE: CO ZIP: 80202 BUSINESS PHONE: 3039921400 MAIL ADDRESS: STREET 1: 1801 CALIFORNIA ST CITY: DENVER STATE: CO ZIP: 80202 FORMER COMPANY: FORMER CONFORMED NAME: QUEST COMMUNICATIONS INTERNATIONAL INC DATE OF NAME CHANGE: 19970416 10-Q 1 d92251e10-q.txt FORM 10-Q FOR QUARTER ENDED SEPTEMBER 30, 2001 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------- FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 000-22609 QWEST COMMUNICATIONS INTERNATIONAL INC. (Exact name of registrant as specified in its charter) DELAWARE 84-1339282 (State or other jurisdiction of (I.R.S. Employer incorporation of organization) Identification No.)
1801 CALIFORNIA STREET, DENVER, COLORADO 80202 (Address of principal executive offices and zip code) TELEPHONE NUMBER (303) 992-1400 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] At October 31, 2001, 1,664,945,725 shares of common stock were outstanding. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- QWEST COMMUNICATIONS INTERNATIONAL INC. FORM 10-Q TABLE OF CONTENTS
ITEM PAGE - ---- ---- PART I -- FINANCIAL INFORMATION 1. Financial Statements Condensed Consolidated Statements of Operations -- Three and nine months ended September 30, 2001 and 2000..... 1 Condensed Consolidated Balance Sheets -- September 30, 2001 and December 31, 2000.................... 2 Condensed Consolidated Statements of Cash Flows -- Nine months ended September 30, 2001 and 2000............... 3 Notes to Condensed Consolidated Financial Statements........ 4 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 16 3. Quantitative and Qualitative Disclosures About Market Risk........................................................ 28 PART II -- OTHER INFORMATION 1. Legal Proceedings........................................... II-1 6. Exhibits and Reports on Form 8-K............................ II-2 Signature page.............................................. II-5
i QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ------------------ 2001 2000 2001 2000 ------- ------- ------- ------- Operating revenues: Commercial services................................... $2,373 $2,421 $ 8,020 $ 4,880 Consumer and small business services.................. 1,752 1,694 5,144 4,666 Directory services.................................... 371 351 1,061 1,029 Switched access services.............................. 270 299 814 1,017 ------ ------ ------- ------- Total operating revenues...................... 4,766 4,765 15,039 11,592 ------ ------ ------- ------- Operating expenses: Cost of services...................................... 1,697 1,558 5,343 3,253 Selling, general and administrative................... 1,304 1,343 3,905 3,408 Depreciation.......................................... 996 727 2,693 1,913 Depreciation adjustment for access lines returned to service............................................ -- -- 222 -- Goodwill and other intangible amortization............ 315 317 1,026 317 Merger-related and other one-time charges............. -- 1,030 624 1,336 ------ ------ ------- ------- Total operating expenses...................... 4,312 4,975 13,813 10,227 ------ ------ ------- ------- Operating income (loss)................................. 454 (210) 1,226 1,365 Other expense (income) - net: Interest expense - net................................ 380 314 1,061 732 Investment write-downs................................ -- -- 3,247 447 Decline (increase) in market value of financial instruments........................................ 7 (58) 7 263 (Gain) loss on sales of rural exchanges and fixed assets............................................. -- 39 (50) 39 Gain on sales of investments.......................... -- (252) -- (331) Other expense - net................................... 17 5 51 19 ------ ------ ------- ------- Total other expense - net..................... 404 48 4,316 1,169 ------ ------ ------- ------- Income (loss) before income taxes and extraordinary item.................................................. 50 (258) (3,090) 196 Income tax provision (benefit).......................... 192 (10) 339 160 ------ ------ ------- ------- (Loss) income before extraordinary item................. (142) (248) (3,429) 36 Extraordinary item - early retirement of debt, net of tax................................................... -- -- (65) -- ------ ------ ------- ------- Net (loss) income....................................... $ (142) $ (248) $(3,494) $ 36 ====== ====== ======= ======= Basic (loss) earnings per share: (Loss) income before extraordinary item............... $(0.09) $(0.15) $ (2.07) $ 0.02 Extraordinary item - early retirement of debt, net of tax................................................ -- -- (0.03) -- ------ ------ ------- ------- Basic (loss) earnings per share......................... $(0.09) $(0.15) $ (2.10) $ 0.02 ====== ====== ======= ======= Basic average shares outstanding........................ 1,664 1,662 1,660 1,644 ====== ====== ======= ======= Diluted (loss) earnings per share: (Loss) income before extraordinary item............... $(0.09) $(0.15) $ (2.07) $ 0.02 Extraordinary item - early retirement of debt, net of tax................................................ -- -- (0.03) -- ------ ------ ------- ------- Diluted (loss) earnings per share....................... $(0.09) $(0.15) $ (2.10) $ 0.02 ====== ====== ======= ======= Diluted average shares outstanding...................... 1,664 1,662 1,660 1,686 ====== ====== ======= ======= Dividends per share..................................... $ -- $ -- $ 0.05 $ 0.31 ====== ====== ======= =======
The accompanying notes are an integral part of these condensed consolidated financial statements. 1 QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
SEPTEMBER 30, DECEMBER 31, 2001 2000 ------------- ------------ (UNAUDITED) ASSETS Current assets: Cash and cash equivalents................................. $ 425 $ 154 Accounts receivable - net................................. 4,453 4,235 Inventories and supplies.................................. 357 275 Prepaid and other......................................... 817 535 ------- ------- Total current assets........................................ 6,052 5,199 Property, plant and equipment - net......................... 30,117 25,760 Goodwill and other intangible assets - net.................. 34,791 32,327 Investments................................................. 1,533 8,186 Other assets................................................ 2,207 2,029 ------- ------- Total assets................................................ $74,700 $73,501 ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current borrowings........................................ $ 4,369 $ 3,645 Accounts payable.......................................... 1,938 2,049 Accrued expenses and other current liabilities............ 3,000 3,806 Advance billings and customer deposits.................... 378 393 ------- ------- Total current liabilities................................... 9,685 9,893 Long-term borrowings........................................ 20,436 15,421 Post-retirement and other post-employment benefit obligations............................................... 2,897 2,735 Deferred taxes, credits and other........................... 4,484 4,148 Commitments and contingencies (Note 8) Stockholders' equity: Preferred stock - $1.00 par value, 200 million shares authorized, none issued and outstanding................ -- -- Common stock - $0.01 par value, 5 billion shares authorized; 1,687 million and 1,672 million issued; 1,665 million and 1,672 million outstanding............ 17 17 Additional paid-in capital................................ 41,733 41,289 Treasury stock, at cost................................... (1,000) -- Retained (deficit) earnings............................... (3,523) 24 Accumulated other comprehensive loss...................... (29) (26) ------- ------- Total stockholders' equity.................................. 37,198 41,304 ------- ------- Total liabilities and stockholders' equity.................. $74,700 $73,501 ======= =======
The accompanying notes are an integral part of these condensed consolidated financial statements. 2 QWEST COMMUNICATIONS INTERNATIONAL INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, ----------------- 2001 2000 ------- ------- Cash provided by operating activities..................... $ 3,356 $ 2,804 ------- ------- INVESTING ACTIVITIES Expenditures for property, plant and equipment............ (7,791) (5,006) Proceeds from sale of equity securities................... -- 1,838 Cash acquired in connection with the Merger............... -- 407 Investment in equity securities........................... -- (250) Proceeds from sale of access lines........................ 91 -- Other..................................................... (125) (44) ------- ------- Cash used for investing activities........................ (7,825) (3,055) ------- ------- FINANCING ACTIVITIES Net proceeds (repayments) from current borrowings......... 965 (3,134) Proceeds from issuance of long-term borrowings - net...... 6,937 4,267 Repayments of long-term borrowings........................ (2,269) (316) Costs relating to the early retirement of debt............ (106) -- Proceeds from issuance of common stock.................... 296 315 Repurchase of stock....................................... (1,000) -- Dividends paid on common stock............................ (83) (542) ------- ------- Cash provided by financing activities..................... 4,740 590 ------- ------- CASH AND CASH EQUIVALENTS Increase.................................................. 271 339 Beginning balance......................................... 154 78 ------- ------- Ending balance............................................ $ 425 $ 417 ======= ======= SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid for interest.................................... $ 1,019 $ 647 ======= ======= Cash paid for income taxes................................ $ 15 $ 127 ======= =======
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2001 (UNAUDITED) NOTE 1: BASIS OF PRESENTATION The condensed consolidated interim financial statements are unaudited. Qwest Communications International Inc. ("Qwest" or the "Company" or "we" or "us" or "our") prepared these financial statements in accordance with the instructions for Form 10-Q. In compliance with those instructions, certain information and footnote disclosures normally included in the financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. In management's opinion, all adjustments (consisting only of normal recurring adjustments) necessary to fairly present the consolidated results of operations, financial position and cash flows as of September 30, 2001 and for all periods presented were made. These financial statements should be read in conjunction with the audited financial statements incorporated by reference in Qwest's Annual Report on Form 10-K for the year ended December 31, 2000. The consolidated results of operations for the three and nine months ended September 30, 2001 are not necessarily indicative of the results expected for the full year. Certain reclassifications have been made to previously reported balances to conform with the current year presentation. See Qwest's Current Report on Form 8-K, filed July 20, 2001, for additional information. NOTE 2: MERGER WITH U S WEST Final purchase price allocation. On June 30, 2000, Qwest completed its acquisition (the "Merger") of U S WEST, Inc. ("U S WEST"). U S WEST was deemed the accounting acquirer and its historical financial statements have been carried forward as those of the combined company. In connection with the Merger, each outstanding share of U S WEST common stock was converted into the right to receive 1.72932 shares of Qwest common stock. In addition, all outstanding U S WEST stock options were converted into options to acquire Qwest common stock. All share and per share amounts have been restated to give retroactive effect to the exchange ratio. The Merger has been accounted for as a reverse acquisition under the purchase method of accounting with U S WEST being deemed the accounting acquirer and Qwest (prior to the Merger or "pre-Merger Qwest") the acquired entity. The total value of the consideration was approximately $40.0 billion, which has been allocated to the identifiable tangible and intangible assets and liabilities of pre-Merger Qwest. During the second quarter of 2001, we completed the allocation of the purchase price to the acquired net assets of pre-Merger Qwest and adjustments to the preliminary purchase price allocation were recorded as follows:
PRELIMINARY FINAL PURCHASE PURCHASE PRICE PRICE ALLOCATION ADJUSTMENT ALLOCATION (DOLLARS IN BILLIONS) ----------- ---------- ---------- Identified intangibles............................. $ 4.1 $ -- $ 4.1 Investment in KPNQwest, N.V........................ 7.9 (3.1) 4.8 Tangible assets and liabilities, net............... 0.8 0.3 1.1 Deferred income taxes.............................. (0.7) (0.1) (0.8) Goodwill........................................... 27.9 2.9 30.8 ----- ----- ----- Purchase consideration............................. $40.0 $ -- $40.0 ===== ===== =====
The identifiable intangibles consist of the following (including related amortization periods): $2.2 billion in product technology (10 years), $1.2 billion in customer relationships (10 years), $100 million in assembled workforce (3 years) and $600 million in tradename value (40 years). There was no change between the preliminary purchase price allocation of identifiable intangibles and the final independent appraisal. 4 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Prior to the Merger, pre-Merger Qwest's investment in KPNQwest, N.V. ("KPNQwest") was approximately $552 million. The preliminary purchase price allocation of $7.9 billion was based upon the publicly traded share price at the date of the Merger and did not consider restrictions related to our investment in KPNQwest. To properly value the investment, we obtained an independent appraisal that was completed in June 2001. The appraisal resulted in a final purchase price allocation of $4.8 billion, requiring an adjustment to the preliminary purchase price allocation of $3.1 billion. The excess carrying value of our investment in KPNQwest over our proportionate share of KPNQwest's net equity will be amortized over 10 years. (See Note 4 for information on other adjustments made subsequent to the final purchase price allocation relating to the KPNQwest equity investment.) At the time of the Merger, pre-Merger Qwest had net tangible assets with a book value of approximately $3.0 billion. To properly record the fiber optic network at fair value, we obtained an independent appraisal that was completed in June 2001. The appraisal resulted in a reduction of property, plant and equipment of approximately $1.1 billion. The reduction in carrying value was principally due to declining replacement costs for fiber optic network assets. There were no significant differences between the preliminary purchase price allocation and the final appraised values for property, plant and equipment. The remaining reduction in net tangible assets related principally to increased liabilities associated with severance costs for pre-Merger Qwest employees, costs to terminate redundant contracts, adjustments to the fair value of pre-Merger Qwest's obligations and transaction costs incurred by Qwest (the legal acquirer) to consummate the Merger. The preliminary allocation of purchase price to net tangible assets has been adjusted upward by approximately $300 million based upon information obtained subsequent to the preliminary purchase price allocation. We recorded deferred income taxes in the purchase price allocation, resulting from adjustments to the Company's tangible assets and liabilities and from recording the identifiable intangible assets. Because of the tax-free nature of the Merger, there was no corresponding increase in the tax basis of those assets and liabilities. The final purchase price allocation has resulted in goodwill of approximately $30.8 billion which will be amortized on a straight-line basis over 40 years. The operating results of pre-Merger Qwest have been included in the consolidated statement of operations from the Merger date (June 30, 2000). The unaudited results of operations for the three and nine months ended September 30, 2001, the three months ended September 30, 2000 and the unaudited pro forma results of operations for the nine months ended September 30, 2000 (as though the Merger had been completed as of the beginning of 2000) are as follows (dollars in millions, except for per share amounts):
NINE MONTHS ENDED THREE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------- ------------------ PRO FORMA 2001 2000 2001 2000 ------- ------- ------- --------- Revenues..................................... $4,766 $4,765 $15,039 $13,936 Net loss..................................... $ (142) $ (248) $(3,494) $ (414) Diluted loss per share....................... $(0.09) $(0.15) $ (2.10) $ (0.25)
The unaudited pro forma results of operations for the nine-month period ended September 30, 2000, are not necessarily indicative of what the actual results of operations might have been if the Merger had been effective at the beginning of 2000. 5 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Merger-related and other one-time charges. We consider only those costs that are incremental and directly related to the Merger to be "Merger-related." For the three- and nine-month periods ended September 30, 2001 and 2000, we incurred the following Merger-related and other one-time charges:
THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, -------------- -------------- 2001 2000 2001 2000 (DOLLARS IN MILLIONS) ---- ------ ---- ------ Contractual settlements and legal contingencies.... $ -- $ 80 $274 $ 80 Severance and headcount-related charges............ -- 161 199 238 Other Merger-related and one-time charges.......... -- 789 151 1,018 ---- ------ ---- ------ Total Merger-related and other one-time charges................................ $ -- $1,030 $624 $1,336 ==== ====== ==== ======
For the nine months ended September 30, 2001, other Merger-related and one-time charges include professional fees, asset impairment charges, re-branding costs and other costs related to the integration of U S WEST and Qwest. Since the Merger, we have reduced staffing levels by approximately 13,400 employees and contractors. For the three and nine months ended September 30, 2000, we incurred $1.030 billion and $1.336 billion, respectively in Merger-related costs. These included severance and headcount charges resulting from payments to employees who left the business upon the consummation of the Merger and retention bonus payments that were subject to the successful completion of the Merger. Other Merger-related and one-time charges included professional fees, re-branding costs and other costs related to the integration of U S WEST and Qwest. Also included in the Merger-related costs were asset impairment charges of $324 million for the three and nine months ended September 30, 2000. A summary, as of September 30, 2001, of Merger-related and other one-time charges accrued at December 31, 2000 and subsequent provisions and charges against those accruals and provisions follows:
CURRENT CURRENT DECEMBER 31, YEAR YEAR SEPTEMBER 30, 2000 BALANCE PROVISION UTILIZATION 2001 BALANCE (DOLLARS IN MILLIONS) ------------- --------- ----------- ------------- Contractual settlements and legal contingencies...................... $376 $274 $218 $432 Severance and headcount-related charges............................ 130 199 261 68 Other Merger-related and one-time charges............................ 17 151 158 10 ---- ---- ---- ---- Total Merger-related and other one-time charges... $523 $624 $637 $510 ==== ==== ==== ====
We do not foresee any additional Merger-related charges and anticipate that the majority of the contractual settlements, severance and other Merger-related and one-time charge accruals will be paid by the end of the current fiscal year. Legal contingencies will be paid as the related matters are resolved. When matters are finalized, any differences between amounts accrued and actual payments will be reflected in results of operations as an adjustment to Merger-related and other one-time charges. NOTE 3: ACCESS LINES RETURNED TO SERVICE During 1999 and 2000, U S WEST committed to sell approximately 800,000 access lines to third-party telecommunications service providers, including approximately 570,000 access lines to Citizens Communications Company ("Citizens"). Because these access lines were "held for sale," we discontinued recognizing 6 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) depreciation expense on these assets and recorded them at the lower of their cost or fair value, less estimated cost to sell. On July 20, 2001, we terminated our agreement with Citizens under which the majority of the remaining access lines were to have been sold and ceased actively marketing the remaining lines. As a result, the remaining access lines were reclassified as being "held for use" as of June 30, 2001. The access lines were measured individually at the lower of their (a) carrying value before they were classified as held for sale, adjusted for any depreciation (amortization) expense or impairment losses that would have been recognized had the assets been continuously classified as held for use, or (b) their fair value at June 30, 2001. The required adjustments to the carrying value of the individual access lines are included in income from continuing operations for the nine months ended September 30, 2001. This resulted in a charge to depreciation of $222 million. In April 2001, we sold approximately 38,000 access lines resulting in a gain for the nine months ended September 30, 2001 of $50 million. NOTE 4: INVESTMENT WRITE-DOWNS AND DECLINE IN MARKET VALUE OF FINANCIAL INSTRUMENTS Investment write-downs. The following is a summary of the investment write-downs recorded during the nine months ended September 30, 2001 and 2000. There were no investment write-downs for the three months ended September 30, 2001 or 2000.
FOR THE NINE MONTHS ENDED SEPTEMBER 30, -------------- 2001 2000 (DOLLARS IN MILLIONS) ------ ---- KPNQwest investment......................................... $3,048 $ -- Lucent Technology, Inc. investment.......................... 36 -- Other investment losses..................................... 163 447 ------ ---- Total investment write-downs................................ $3,247 $447 ====== ====
We review our portfolio of equity securities on a quarterly basis. Many factors are considered in assessing whether a decline in value is other than temporary, including, as may be appropriate: - Earnings trends and asset quality - Near term prospects and financial condition of the issuer - Financial condition and prospects of the issuer's region and industry - The cause and severity of the decline in market price - Analysts recommendations and stock price projections - The length of time market value was less than the carrying value - Stock price volatility and near term potential for recovery - Qwest's intent and ability to retain the investment As a result of the review of our portfolio of equity securities for the three months ended September 30, 2001 and 2000, no charges were recorded to reduce the carrying values of our investments to their estimated fair values. For the nine months ended September 30, 2001 and 2000, charges of $3.247 billion and $447 million, respectively, were recorded to reduce the carrying values of our investments to their estimated fair values. 7 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) KPNQwest equity investment. In March 1999, KPN Telecom B.V. ("KPN") and pre-Merger Qwest formed the corporate joint venture, KPNQwest. The carrying value of Qwest's investment in KPNQwest at the date of the Merger was $552 million. On June 30, 2000, our preliminary estimate of the value of our investment in KPNQwest was $7.9 billion, based upon the closing price of the 11% publicly traded minority stake of $39.625 per share on that date. However, because our investment in KPNQwest is subject to a number of restrictions, the fair value of our investment was ultimately determined by an independent appraisal. As part of the finalization of the purchase price allocation associated with the Merger, we engaged an independent appraiser to perform a valuation of our investment in KPNQwest as of June 30, 2000. The appraisal was completed in June 2001, and indicated a fair value for our investment in KPNQwest of $4.8 billion or $23.775 per share. Accordingly, the carrying value of the KPNQwest investment was adjusted, in accordance with purchase accounting, to equal the $4.8 billion fair value. At June 30, 2001, we evaluated our investment in KPNQwest and concluded that the decline in fair value from $4.8 billion was other than temporary. Factors considered in reaching this conclusion included the following, among others: 1. KPNQwest's stock price had remained at approximately $11 per share throughout the second quarter. The period of time the market price was below our carrying value of $23.775 per share and the severity of the decline indicated that the decline had become other than temporary. 2. Analysts had released new recommendations during the quarter of their stock price targets for KPNQwest which showed a significant decline from the first quarter. 3. The European telecom sector had experienced a severe deterioration during the quarter, including numerous bankruptcies, making the near term prospects of KPNQwest's stock recovery less certain at June 30, 2001. As a result of the evaluation of our investment in KPNQwest, we concluded that the fair value of our investment at June 30, 2001 was $1.3 billion and took a charge of $3.048 billion to reduce the carrying value to the estimated fair value of the investment. Other investments. During the nine months ended September 30, 2001, we concluded that several other investments in equity securities had experienced declines in fair value that were other than temporary and we recognized a loss of $199 million for the nine months ended September 30, 2001. Included in this charge for the nine months ended September 30, 2001 was a charge for $36 million relating to our investment in Lucent Technology, Inc. ("Lucent") based on our conclusion at June 30, 2001 detailed below. Although the market price for Lucent stock had declined below our carrying value as of March 31, 2001, we concluded that insufficient evidence existed to reach a conclusion that the decline was not temporary. Factors considered in reaching that conclusion included Lucent's earnings trends, financial health (including debt and analyst ratings), asset quality, executive management changes, restructuring plans, large customer contract announcements and actions taken to reduce headcount, capital and other expenditures. In addition, we considered the potential acquisition of Lucent by a large European telecommunications equipment manufacturer. At June 30, 2001, we again evaluated our investment in Lucent and concluded that the decline in fair value was other than temporary. Factors considered in reaching this conclusion included the following: 1. An additional three months of declines in the Lucent stock price. 2. The magnitude by which Lucent did not meet analysts' first quarter 2001 earnings estimates. 8 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 3. A decline in the number of analysts with buy recommendations. 4. The announced termination of merger discussions with the large European telecommunications equipment manufacturer. As a result of the evaluation of our investment in Lucent, we concluded that the fair value of the investment at June 30, 2001 was $4.2 million and took a charge of $36 million to reduce the investment from its carrying value to its fair value. For the nine months ended September 30, 2000, we recorded charges of $447 million associated with an other than temporary decline in our Global Crossing Ltd. ("Global Crossing") investment. Decline in market value of derivatives. On August 22, 2001, we settled derivative contracts associated with our previously-owned equity investment in Global Crossing. These derivatives were recorded at market value with any change in market value taken immediately to income. Due to a decline in the market value of the derivatives, we recorded a charge of $7 million for the three and nine months ended September 30, 2001. For the three and nine months ended September 30, 2000, the increase (decrease) in market value was $58 million and ($263) million, respectively. NOTE 5: WEIGHTED AVERAGE SHARES The following table is a reconciliation of basic weighted average shares to diluted weighted average shares. The 2000 shares have been adjusted to reflect the conversion of the U S WEST shares into Qwest shares due to the Merger.
THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, -------------- -------------- 2001 2000 2001 2000 (SHARES IN MILLIONS) ----- ----- ----- ----- Basic weighted average shares outstanding........... 1,664 1,662 1,660 1,644 Dilutive effect of stock options.................... -- -- -- 42 ----- ----- ----- ----- Diluted weighted average shares outstanding......... 1,664 1,662 1,660 1,686 ===== ===== ===== =====
For the three and nine months ended September 30, 2001, 121 million options were excluded from the earnings per share computation solely because their effect was anti-dilutive. For the three and nine months ended September 30, 2000, 128 million and 11 million options, respectively, were excluded because their effect was also anti-dilutive. NOTE 6: SEGMENT INFORMATION We operate in four segments: retail services, wholesale services, network services and directory services. The retail services segment provides local telephone and data services, long-distance voice and data services and wireless services. The wholesale services segment provides exchange access services that connect customers to the facilities of interexchange carriers ("IXCs") and interconnection to our local telecommunications network to competitive local exchange carriers ("CLECs"). The network services segment provides access to our telecommunications network, including our information technologies, primarily to our retail services and wholesale services segments. The directory services segment publishes White and Yellow Pages telephone directories and provides electronic directory and other information services. We provide the majority of our services to more than 25 million residential and business customers in Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming (our "local service area"). 9 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Following is a breakout of our segments. The accounting principles used are the same as those used in the condensed consolidated financial statements. The "other" category includes unallocated corporate expenses and revenues. We internally track, separately, only the assets of our directory services segment and all remaining assets are included as a reconciling item. The "Reconciling Items" category also includes other adjustments. The figures presented below for the three and nine months ended September 30, 2000 have been adjusted to reflect certain reclassifications to conform with the presentation of the corresponding periods of 2001.
TOTAL COMMUNICATIONS RETAIL WHOLESALE NETWORK AND RELATED DIRECTORY RECONCILING CONSOLIDATED SERVICES SERVICES SERVICES SERVICES SERVICES OTHER ITEMS TOTAL -------- --------- -------- -------------- --------- ----- ----------- ------------ (DOLLARS IN MILLIONS) THREE MONTHS ENDED SEPTEMBER 30, 2001 External revenues..... $3,603 $777 $ 13 $4,393 $ 371 $ 2 $ -- $ 4,766 EBITDA(1)............. 2,718 664 (1,598) 1,784 260 (279) -- 1,765 Assets................ -- -- -- -- 1,819 -- 72,881 74,700 Capital expenditures........ 287 -- 1,880 2,167 -- 65 -- 2,232 2000 External revenues..... 3,484 823 88 4,395 351 19 -- 4,765 EBITDA(1)............. 2,758 696 (1,341) 2,113 216 (465) -- 1,864 Assets................ -- -- -- -- 1,194 -- 70,894 72,088 Capital expenditures........ 198 15 1,820 2,033 12 33 -- 2,078
TOTAL COMMUNICATIONS RETAIL WHOLESALE NETWORK AND RELATED DIRECTORY RECONCILING CONSOLIDATED SERVICES SERVICES SERVICES SERVICES SERVICES OTHER ITEMS TOTAL -------- --------- -------- -------------- --------- ------- ----------- ------------ (DOLLARS IN MILLIONS) NINE MONTHS ENDED SEPTEMBER 30, 2001 External revenues..... $11,558 $2,292 $ 104 $13,954 $1,061 $ 24 $ -- $15,039 EBITDA(1)............. 9,062 1,925 (5,090) 5,897 698 (804) -- 5,791 Assets................ -- -- -- -- 1,819 -- 72,881 74,700 Capital expenditures........ 655 -- 6,966 7,621 2 168 -- 7,791 2000 External revenues..... 8,154 2,337 113 10,604 1,029 (41) -- 11,592 EBITDA(1)............. 6,336 1,954 (2,945) 5,345 634 (1,048) -- 4,931 Assets................ -- -- -- -- 1,194 -- 70,894 72,088 Capital expenditures........ 527 97 4,314 4,938 35 33 -- 5,006
- --------------- (1) Earnings before interest, income taxes, depreciation and amortization ("EBITDA") does not include non-recurring and non-operating items such as Merger-related and other one-time charges, investment write-downs, gains/losses on the sale of investments, declines in the market value of financial instruments and gains/losses on sales of rural exchanges and fixed assets. 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 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. 10 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A reconciliation from Segment EBITDA to earnings (loss) before income taxes and extraordinary item follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 2001 2000 2001 2000 (DOLLARS IN MILLIONS) ------- ------- ------- ------ Segment EBITDA................................ $1,765 $1,864 $ 5,791 $4,931 Less: Depreciation and amortization............... 1,311 1,044 3,941 2,230 Merger-related and other one-time charges... -- 1,030 624 1,336 Other expense -- net........................ 404 48 4,316 1,169 ------ ------ ------- ------ Earnings (loss) before income taxes and extraordinary item.......................... $ 50 $ (258) $(3,090) $ 196 ====== ====== ======= ======
NOTE 7: OTHER COMPREHENSIVE INCOME Comprehensive income (loss) for the three- and nine-month periods ended September 30, 2001 and 2000 is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- ----------------- 2001 2000 2001 2000 (DOLLARS IN MILLIONS) ------- ------- ------- ----- Net (loss) income............................. $(142) $(248) $(3,494) $ 36 Other comprehensive (loss) income: Net unrealized gains (losses) on available-for-sale marketable securities, net of deferred taxes....................... (5) (72) 16 (132) Foreign currency translation.................. 36 (83) (19) (83) ----- ----- ------- ----- Comprehensive loss............................ $(111) $(403) $(3,497) $(179) ===== ===== ======= =====
Net unrealized losses for the quarters ended September 30, 2001 and 2000 were net of deferred tax benefits of $3 million and $46 million, respectively. Net unrealized gains and losses for the nine months ended September 30, 2001 and 2000 were net of deferred tax expenses (benefits) of $10 million and ($86) million, respectively. Embedded in net unrealized gains and losses on available-for-sale marketable securities are reclassification adjustments. Reclassification adjustments are comprised of amounts that have been removed from comprehensive income and recognized in income or loss from operations in the condensed consolidated statement of operations during the periods cited below. For the nine months ended September 30, 2001, unrealized gains and losses on marketable securities included reclassification adjustments of $36 million of losses (net of deferred tax benefits of $23 million) pertaining to other than temporary impairments of our investments in certain marketable equity securities. For the nine months ended September 30, 2000, net unrealized losses on marketable securities include reclassification adjustments of $319 million (net of deferred tax benefits of $128 million) pertaining to an other than temporary decline in our investment in Global Crossing common stock, offset by realized gains from the sale of marketable securities. 11 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 8: COMMITMENTS AND CONTINGENCIES COMMITMENTS Minimum Usage Requirements and Other Commitments. We have agreements with IXCs and third party vendors that require us to maintain minimum monthly and/or annual billings based on usage. We believe that we will meet substantially all minimum usage commitments. We also have certain agreements with third party vendors that require payments that are unconditional. Where requirements have not been met, we have recorded appropriate charges. We have reflected in our financial statements the financial impact of all current, unmet minimum usage requirements. CONTINGENCIES In January 2001, an amended purported class action complaint was filed in Denver District Court against us and certain current and former officers and directors on behalf of stockholders of U S WEST. The complaint alleges that we have a duty to pay a quarterly dividend to U S WEST stockholders of record as of June 30, 2000. Plaintiffs further claim that the defendants' efforts to close the Merger in advance of the record date and the defendants' failure to pay the dividend breaches fiduciary duties owed to stockholders of U S WEST. In June 2000, the court rejected the plaintiffs' motion for a temporary restraining order attempting to prevent the closing of the Merger. In October 2001, our motion to dismiss the complaint was denied. Discovery has now commenced. Through September 2001, seven purported class action complaints had been filed in various state courts against us and U S WEST on behalf of customers in the states of Arizona, Colorado, Minnesota, New Mexico, Oregon, Utah and Washington. The complaints alleged, among other things, that from 1993 to the present, U S WEST, in violation of alleged statutory and common law obligations, willfully delayed the provision of local telephone service to the purported class members. The complaints also alleged that U S WEST misrepresented the date on which such local telephone service was to be provided to the purported class members. The complaints sought compensatory damages for purported class members, disgorgement of profits and punitive damages. The parties have signed agreements to settle the complaints. As of September 2001, the settlements have been approved by all of the courts. In April 1999, CSX Transportation, Inc. filed a complaint in federal district court in Jacksonville, Florida against us claiming breach of a 1995 contract. Discovery in the case is ongoing, and trial is scheduled to commence in May 2002. Through September 2001, several purported class actions have been filed in various courts against us on behalf of landowners in Alabama, California, Colorado, Georgia, Illinois, Indiana, Kansas, Louisiana, Mississippi, Missouri, North Carolina, Oregon, South Carolina, Tennessee and Texas. The complaints challenge our right to install our fiber optic cable network in railroad rights-of-way and in California, Colorado, Illinois, South Carolina and Texas, also challenge our right to install fiber optic cable in utility and pipeline rights-of-way. In Alabama, the complaint challenges our right to install fiber optic cable in any right of way, including public highway. The complaints allege that the railroads, utilities and pipeline companies own a limited property right-of-way that did not include the right to permit us to install our fiber optic cable network on the plaintiffs' property. The Indiana action purports to be on behalf of a national class of landowners adjacent to railroad rights-of-way over which our network passes. The Alabama, California, Colorado, Georgia, Kansas, Louisiana, Mississippi, Missouri, North Carolina, Oregon, Tennessee and Texas actions purport to be on behalf of a class of such landowners in Alabama, California, Colorado, Georgia, Kansas, Louisiana, Mississippi, Missouri, North Carolina, Oregon, Tennessee and Texas, respectively. The Illinois action purports to be on behalf of landowners adjacent to railroad rights-of-way over which our network passes in Illinois, Iowa, Kentucky, Michigan, Minnesota, Nebraska, Ohio and Wisconsin. The South Carolina action purports to be on behalf of landowners adjacent to railroad rights-of-way over which our network passes in Georgia, North Carolina, South Carolina and Virginia. The complaints seek damages on theories of trespass and unjust enrichment, as well as punitive damages. None of the complaints have been 12 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) certified by a court as an appropriate state-wide or national class action. In Tennessee, the court certified a class of a small number of counties, and that ruling is on appeal. We have received, and may in the future receive, additional claims and demands that may be based on similar or different legal theories. From March 2, 2000 to March 9, 2000, five purported class action complaints were filed against us in state court in Delaware on behalf of our stockholders. The complaints allege that we and our directors breached our fiduciary duty by entering into the Merger and by agreeing not to solicit alternative transactions. Since the filing of the complaints, there has been no discovery or other activity in the cases. On March 17, 2000 and March 20, 2000, two class action complaints were filed in federal district court in Delaware against us and our Chairman and Chief Executive Officer, Joseph P. Nacchio, on behalf of U S WEST stockholders. The complaints allege, among other things, that Qwest and Mr. Nacchio made material false statements regarding our intent to solicit an alternative transaction to the Merger. Since the filing of the complaints, there has been no discovery or other activity in the cases. In 1999, twelve purported class action complaints were filed against U S WEST and its directors on behalf of U S WEST stockholders. Each of the complaints allege that the defendants breached their fiduciary duties to the class members by entering into a merger agreement with Global Crossing thereby refusing to seek all bona fide offers for U S WEST and refusing to consider an acquisition proposal from Qwest. Since the filing of the complaints, there has been no discovery or other activity in the cases. From time to time we receive complaints and become subject to investigations regarding tariffs, "slamming" (the practice of changing long-distance carriers without the customer's consent) and other matters. In 2000, the California Public Utilities Commission opened an investigation relating to certain slamming complaints. An administrative hearing was held in May 2001, and we are awaiting a recommendation from the administrative law judge. A purported class action complaint was filed in federal court in Connecticut containing slamming allegations. We continue to analyze regulatory and governmental requirements and may modify our practices as a result. We may receive complaints or become subject to investigations in the future. Such complaints or investigations could result in the imposition of certain fines and other penalties or awards of damages. On July 23, 2001, we filed a demand for arbitration against Citizens alleging that it breached Agreements for Purchase and Sale of Telephone Exchanges dated as of June 16, 1999, between Citizens Utilities Company and U S WEST Communications, Inc., with respect to the purchase and sale of exchanges in Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska and Wyoming. The demand for arbitration was filed after Citizens failed to close the exchange sales in violation of the terms of the Purchase Agreements. Citizens in turn filed a demand alleging claims against us in connection with the sale of those same exchanges. In the arbitration, we seek a determination that Citizens breached the agreements and, as a result, we are entitled to retain the letters of credit Citizens provided in connection with the transactions and other damages. Citizens seeks a determination that we breached the agreements and, as a result, they are entitled to damages. This dispute is still at a preliminary stage. In August 2001, we filed a complaint in state court in Colorado and an arbitration demand against Touch America, Inc. ("Touch America"). In response, also in August 2001, Touch America filed a complaint against us in federal district court in Montana and removed our state court complaint to federal district court in Colorado. Touch America's complaint was dismissed on November 5, 2001. The disputes between us and Touch America relate to various billing, reimbursement and other commercial disputes arising under agreements entered into for the sale of our interLATA (local access transport area) business in our local service area to Touch America on June 30, 2000. Each party seeks damages against the other for amounts billed and unpaid and for other disputes. The maters are in a preliminary stage, discovery has not begun in these cases and no dates have been set for trial or arbitration. From July 27, 2001 to October 1, 2001, seven purported class action complaints were filed in federal district court in Colorado against us, our Chairman and Chief Executive Officer, Joseph P. Nacchio, and our 13 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Chief Financial Officer, Robin R. Szeliga on behalf of purchasers of our publicly traded stock between March 22, 2001 and July 23, 2001. One of the seven complaints has been voluntarily dismissed. The remaining six complaints, which have been consolidated, allege, among other things, that Qwest, Mr. Nacchio and Ms. Szeliga made material false statements regarding the results of operations for the quarter ended March 31, 2001 in violation of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and that, during the above period, the individual defendants sold shares of our common stock. The complaints allege that our first quarter 2001 results and the statements regarding those results were false and misleading due to our alleged improper valuation of KPNQwest in violation of generally accepted accounting principles, and due to the following alleged facts which the plaintiffs claim were undisclosed: (1) first quarter earnings were better than expected because of a change in the discount rate used to calculate our pension obligations; (2) we failed to properly "write-down" the value of our holdings in KPNQwest; (3) our aggressive use of capitalization to classify interest and software development costs as assets rather than expenses increased first quarter earnings; and (4) our selling, general and administrative expenses were 22% of sales, not due to tight expense controls but to improper classification of selling, general and administrative expenses as cost of sales. The complaints seek unspecified compensatory damages and other relief. Since the filing and consolidation of the actions, the court has appointed a lead plaintiff and lead counsel; otherwise, there has been no discovery or other activity in these cases. We have also been named as a defendant in various other litigation matters. We intend to vigorously defend these outstanding claims. We have provided for these matters in our condensed consolidated financial statements as of September 30, 2001. We do not expect any material adverse impacts in excess of such provision as a result of the ultimate resolution of these matters. NOTE 9: SUBSEQUENT EVENTS In October 2001, we entered into agreements under which we will purchase approximately 14 million shares of KPNQwest common stock, and Anschutz Company, our principal stockholder, will purchase approximately 6 million shares, from Koninklijke KPN N.V., the Dutch telecommunications company. The agreed upon purchase price was $4.58 per share. After completion of the purchase, we will own approximately 47.5% of the voting power of the KPNQwest stock. As part of the agreement, KPN granted us an option to purchase some or all of KPN's shares in KPNQwest. The purchase, which is subject to several conditions including antitrust approval in several European jurisdictions and KPNQwest shareholder approval of certain amendments to the KPNQwest articles of association, is expected to be completed before December 31, 2001. We will continue to account for our proportionate share of KPNQwest's operations under the equity method of accounting. On October 31, 2001, we announced a voluntary stock option exchange. Under the terms of the offer and subject to certain restrictions, Qwest employees may exchange all or a portion of their stock options with an exercise price of $35 or more. The offer is available only to our full-time, non-union employees (excluding 15 senior executives), with options granted by Qwest or U S WEST. Options surrendered by an employee will be cancelled and new options will be issued no earlier than six months and one day after the termination of the option exchange offer. The exercise price on the new options will equal the closing market price on the day the new options are granted. The options will vest ratably over a four-year period commencing on the new option grant date. For more information, see Amendment No. 1 to Schedule TO which we filed with the Securities and Exchange Commission on November 5, 2001. NOTE 10: NEW ACCOUNTING STANDARDS In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations." This pronouncement eliminated the use of the "pooling of interests" method of accounting for all mergers and acquisitions. As a result, all mergers 14 QWEST COMMUNICATIONS INTERNATIONAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and acquisitions will be accounted for using the "purchase" method of accounting. SFAS No. 141 is effective for all mergers and acquisitions initiated after June 30, 2001. Adoption of this pronouncement has no impact on our results from operations or our financial position. In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets." This statement addresses financial accounting and reporting for intangible assets (excluding goodwill) acquired individually or with a group of other assets at the time of their acquisition. It also addresses financial accounting and reporting for goodwill and other intangible assets subsequent to their acquisition. Intangible assets (excluding goodwill) acquired outside of a business combination will be initially recorded at their estimated fair value. If the intangible asset has a finite useful life, it will be amortized over that life. Intangible assets with an indefinite life are not amortized. Both types of intangible assets will be reviewed annually for impairment and a loss recorded when the asset's carrying value exceeds its estimated fair value. Goodwill will be treated similar to an intangible asset with an indefinite life. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. We currently estimate the adoption of SFAS No. 142 will reduce our amortization expense by approximately $850-$950 million annually, beginning January 1, 2002. We are currently evaluating the impact this pronouncement will have on the value of our intangible assets. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This statement deals with the costs of closing facilities and removing assets. SFAS No. 143 requires entities to record the fair value of a legal liability for an asset retirement obligation in the period it is incurred. This cost is initially capitalized and amortized over the remaining life of the underlying asset. Once the obligation is ultimately settled, any difference between the final cost and the recorded liability is recognized as a gain or loss on disposition. SFAS No. 143 is effective for years beginning after June 15, 2002. We are currently evaluating the impact this pronouncement will have on our future consolidated financial results. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This pronouncement addresses how to account for and report impairments or disposals of long-lived assets. Under SFAS No. 144, an impairment loss is to be recorded on long-lived assets being held or used when the carrying amount of the asset is not recoverable from its undiscounted cash flows. The impairment loss is equal to the difference between the asset's carrying amount and estimated fair value. Long-lived assets to be disposed of by other than a sale for cash are to be accounted for and reported like assets being held or used except the impairment loss is recognized at the time of the disposition. Long-lived assets to be disposed of by sale are to be recorded at the lower of their carrying amount or estimated fair value (less costs to sell) at the time the plan of disposition has been approved and committed to by the appropriate company management. In addition, depreciation is to cease at the same time. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. We are currently evaluating the impact this pronouncement will have on our future consolidated financial results. On July 19, 2001, the Emerging Issues Task Force ("EITF") issued EITF Issue 00-11, "Meeting the Ownership Transfer Requirements of FASB Statement No. 13 for Leases of Real Estate." This issue is primarily concerned with ownership transfer requirements for a sales-type lease of property under SFAS No. 13. According to EITF 00-11, a nominal purchase option contained in a lease does not satisfy the transfer of ownership criterion in SFAS No. 13 for transfers of real property, if the failure to pay the nominal amount results in ownership not being transferred to the lessee. EITF 00-11 provides, however, that this criterion will be met in cases involving integral equipment or property improvements when the lessor agrees, regardless of whether or not the lessee pays any amount, to execute and deliver to the lessee all documents (including, if applicable, a bill of sale) that may be required to release the property from the lease and transfer ownership to the lessee. EITF 00-11 applies to leases entered into after July 19, 2001 and to certain leases modified after that date. We are in compliance with SFAS No. 13 with respect to these ownership transfer requirements. 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This Form 10-Q contains or incorporates by reference "forward-looking statements," as that term is used in federal securities laws, about Qwest Communications International Inc.'s ("Qwest" or the "Company" or "us" or "we" or "our") financial condition, results of operations and business. These statements include, among others: - statements concerning the benefits that we expect will result from our business activities and certain transactions we have completed, such as increased revenues, decreased expenses and avoided expenses and expenditures and - statements of our 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 we will file with the Securities and Exchange Commission. 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 our actual results to be materially different from any future results expressed or implied by us in those statements. The most important factors that could prevent us from achieving our stated goals include, but are not limited to, the following: - intense competition in the markets in which we compete; - changes in demand for our products and services; - the duration and extent of the current economic downturn; - adverse economic conditions in the markets served by us or by companies in which we have substantial investments; - dependence on new product development and acceleration of the deployment of advanced new services, such as broadband data, wireless and video services, which could require substantial expenditure of financial and other resources in excess of contemplated levels; - higher than anticipated employee levels, capital expenditures and operating expenses; - rapid and significant changes in technology and markets; - adverse changes in the regulatory or legislative environment affecting Qwest's business; - delays in Qwest's ability to provide interLATA services within its 14-state local service area; - failure to maintain rights-of-way; and - failure to achieve the projected synergies and financial results expected to result from the acquisition of U S WEST, Inc. ("U S WEST"), by Qwest on June 30, 2000 (the "Merger"), and difficulties in combining the operations of the combined company, which could affect our revenues, levels of expenses and operating results. Because these statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the forward-looking statements. We caution you not to place undue reliance on the statements, which speak only as of the date of this report. 16 Further, the information contained in this document or in a document incorporated or deemed to be incorporated by reference herein is a statement of our present intention and is based upon, among other things, the existing regulatory environment, industry conditions, market conditions and prices, the economy in general and our assumptions. We may change our intentions, at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise. 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 our behalf may issue. We do not undertake any obligation to review or confirm analyst's 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. In addition, we make no representation with respect to any materials available on the Internet, including materials available on our website. MERGER WITH U S WEST The Merger has been accounted for as a reverse acquisition under the purchase method of accounting. For accounting purposes, U S WEST was deemed the acquirer and Qwest the acquired entity. As U S WEST was deemed the accounting acquirer, its historical financial statements have been carried forward as those of the combined company. In connection with the Merger, each outstanding share of U S WEST common stock was converted into the right to receive 1.72932 shares of Qwest common stock. In addition, all outstanding U S WEST stock options were converted into options to acquire Qwest common stock. All share and per share amounts have been restated to give retroactive effect to the exchange ratio. The results of operations for Qwest (the acquired entity for accounting purposes) before the Merger ("pre-Merger Qwest"), are not reflected in the accompanying condensed consolidated statements of operations. However, due to the significance of the Merger, the comparison of 2001 to 2000 results in Management's Discussion and Analysis of Financial Condition and Results of Operations will be based upon the 2001 financial statements prepared in accordance with generally accepted accounting principles ("GAAP") (referred to as "As Reported"), the As Reported financial statement for the three months ended September 30, 2000 and the unaudited pro forma financial statement for the nine months ended September 30, 2000. The unaudited pro forma financial statement for the nine months ended September 30, 2000 was prepared as if the Merger occurred on January 1, 2000 and the financial statements of pre-Merger Qwest and U S WEST were combined as of that date. This pro forma financial statement has been adjusted to reflect the elimination of pre-Merger Qwest's in-region long-distance activity, the inclusion of interest expense on pre- Merger Qwest borrowings and the amortization of intangible assets arising out of the Merger. The unaudited pro forma results of operations for the nine-month period ended September 30, 2000, are not necessarily indicative of what the actual results of operations might have been if the Merger had been effective at the beginning of 2000. 17
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, ---------------------------------------- --------------------------------------- 2001 2000 2001 2000 AS AS INCREASE AS PRO INCREASE REPORTED REPORTED (DECREASE) REPORTED FORMA (DECREASE) (DOLLARS IN MILLIONS) -------- -------- ------------------ -------- ------- ------------------ Operating revenues: Commercial services........... $2,373 $2,421 $ (48) (2.0)% $ 8,020 $ 6,881 $ 1,139 16.6% Consumer and small business services.................... 1,752 1,694 58 3.4% 5,144 5,009 135 2.7% Directory services............ 371 351 20 5.7% 1,061 1,029 32 3.1% Switched access services...... 270 299 (29) (9.7)% 814 1,017 (203) (20.0)% ------ ------ ------- -------- ------- ------- ------- -------- Total operating revenues............. 4,766 4,765 1 0.0% 15,039 13,936 1,103 7.9% ------ ------ ------- -------- ------- ------- ------- -------- Operating expenses: Cost of services.............. 1,697 1,558 139 8.9% 5,343 4,577 766 16.7% Selling, general and administrative.............. 1,304 1,343 (39) (2.9)% 3,905 4,064 (159) (3.9)% ------ ------ ------- -------- ------- ------- ------- -------- EBITDA........................ 1,765 1,864 (99) (5.3)% 5,791 5,295 496 9.4% Depreciation.................. 996 727 269 37.0% 2,693 2,002 691 34.5% Depreciation adjustment for access lines returned to service..................... -- -- -- N/A 222 -- 222 N/A Goodwill and other intangible amortization................ 315 317 (2) (0.6)% 1,026 951 75 7.9% Merger-related and other one-time charges............ -- 1,030 (1,030) (100.0)% 624 1,336 (712) (53.3)% ------ ------ ------- -------- ------- ------- ------- -------- Total operating expenses............. 1,311 2,074 (763) (36.8)% 4,565 4,289 276 6.4% ------ ------ ------- -------- ------- ------- ------- -------- Operating income (loss)......... 454 (210) 664 316.2% 1,226 1,006 220 21.9% Other expense (income)-net: Interest expense-net.......... 380 314 66 21.0% 1,061 807 254 31.5% Investment write-downs........ -- -- -- N/A 3,247 447 2,800 626.4% Decline (increase) in market value of financial instruments................. 7 (58) 65 (112.1)% 7 263 (256) (97.3)% (Gain) loss on sales of rural exchanges and fixed assets...................... -- 39 (39) 100.0% (50) 39 (89) 228.2% Gain on sales of investments................. -- (252) 252 (100.0)% -- (375) 375 (100.0)% Other expense-net............. 17 5 12 240.0% 51 24 27 112.5% ------ ------ ------- -------- ------- ------- ------- -------- Total other expense-net.......... 404 48 356 741.7% 4,316 1,205 3,111 258.2% ------ ------ ------- -------- ------- ------- ------- -------- Income (loss) before income taxes and extraordinary item.......................... 50 (258) 308 119.4% (3,090) (199) (2,891) (1,452.8)% Income tax provision (benefit)..................... 192 (10) 202 (2,020.0)% 339 215 124 57.7% ------ ------ ------- -------- ------- ------- ------- -------- Loss before extraordinary item.......................... (142) (248) 106 42.7% (3,429) (414) (3,015) (728.3)% Extraordinary item -- early retirement of debt, net of tax........................... -- -- -- N/A (65) -- (65) N/A ------ ------ ------- -------- ------- ------- ------- -------- Net loss........................ $ (142) $ (248) $ 106 42.7% $(3,494) $ (414) $(3,080) (744.0)% ====== ====== ======= ======== ======= ======= ======= ======== Diluted loss per share.......... $(0.09) $(0.15) $ 0.06 40.0% $ (2.10) $ (0.25) $ (1.85) (740.0)% ====== ====== ======= ======== ======= ======= ======= ========
RESULTS OF OPERATIONS Three and Nine Months Ended September 30, 2001 Compared with 2000 REVENUES: Total Revenues. Total revenues for the three months and nine months ended September 30, 2001 were $4.766 billion and $15.039 billion, respectively. When compared to the same periods in 2000, revenues were flat for the three months ended September 30, 2001 while they grew $1.103 billion or 7.9% for the nine months ended September 30, 2001. Although total revenue did not grow during the three months ended September 30, 2001, certain areas within the business continued to generate increasing revenues such as Internet Protocol ("IP"), which includes, among other things, digital subscriber lines ("DSL"), dedicated Internet 18 access ("DIA"), virtual private networks ("VPN"), professional services and web hosting, traditional private lines and wireless products and services. DSL subscribers grew by 84% over the same period in 2000 to 391,000 customers in Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming (our "local service area"). These increases were offset, however, by declines in optical capacity asset sales, IP equipment sales and local service revenues. The major contributors to the growth for the nine months ended September 30, 2001 over the nine months ended September 30, 2000 were sales of optical capacity assets, traditional private lines, DSL, DIA, VPN, professional services, web hosting and wireless products and services. Data and IP products and services revenues represent more than 23% of total revenue for the three months ended September 30, 2001. We believe revenues from data and IP products and services will account for an increasingly larger portion of our revenues in future periods. Revenues for the foreseeable future may reflect the continuing impact of a slowing economy as well as a fundamental shift in the wholesale buying behavior for optical capacity as customers shift away from network asset purchases to shorter-term agreements. In addition, our CyberCenters may experience lower than expected utilization if the current economic conditions persist. Commercial Services Revenues. Commercial services revenues are derived from sales of IP, data, voice and wireless products and services provided to both retail and wholesale business customers. For the three months ended September 30, 2001, commercial services revenues decreased by $48 million or 2.0% from the comparable period in 2000. While sales of our IP and certain data services (DSL, DIA, VPN, traditional private line, professional services, web hosting and dial Internet access) continued to grow, these increases were more than offset by the reduction in optical capacity asset revenues and IP equipment sales. Declining optical capacity asset revenue sales were the result of softening wholesale demand and a shift in customer purchasing behavior away from network asset purchases to shorter-term agreements. The increase in commercial services revenues for the nine months ended September 30, 2001 as compared to the same period last year was $1.139 billion or 16.6%, and was primarily attributable to growth in our data services and IP (DSL, DIA, VPN, professional services, web hosting and dial Internet access) and optical capacity asset sales. During the three-and nine-month periods ended September 30, 2001, we recognized $133 million and $989 million, respectively, in revenues from optical capacity asset sales under indefeasible right of use ("IRU") agreements versus $232 million and $648 million, respectively, for the comparable periods in 2000. Certain rule-making bodies, such as the Financial Accounting Standards Board ("FASB") and the Emerging Issues Task Force ("EITF"), are currently discussing matters that may impact the accounting for sales-type leases. We actively monitor these rule-making activities and evaluate their impact on our current accounting practices. Consumer and Small Business Services Revenues. Consumer and small business services revenues are derived from sales of IP, data, voice and wireless products and services to the consumer and small business markets. The increases in consumer and small business services revenues for the three and nine months ended September 30, 2001 over comparable periods in 2000, were principally attributable to sales of wireless products and data services such as DSL whose revenue grew by approximately 80%. Wireless products and services revenue in the three- and nine-month periods ended September 30, 2001 grew by 68% and 55%, respectively, over the three- and nine-month periods ended September 30, 2000. Average revenue per user increased for the second straight quarter, increasing from $52 in the second quarter of 2001 to $55 in the third quarter as we continued to focus on high-value customers and exited the low-usage, pre-paid business. Sales of bundled packages (which include the phone line, calling features and/or wireless services) to our small business and consumer customers for these periods also contributed to the revenue growth. Partially offsetting these increases were declines in local service revenues and intra-LATA toll revenues in our local service area as a result of the slowing economy, competitive losses and technology displacement. In addition, the number of consumer local access lines declined 2.2% from September 30, 2000. Directory Services Revenues. Directory services revenues are derived primarily from selling advertising in our published directories. Directory services revenues increased 5.7% for the three months ended September 30, 2001 and 3.1% for the nine months ended September 30, 2001 primarily due to increased 19 advertising rates and a change in the mix and length of directories published as compared to the same periods in the prior year. Switched Access Services Revenues. Switched access services revenues are derived from inter- and intrastate switched access from interexchange carriers ("IXCs"). The decreases in switched access services revenues for the three and nine months ended September 30, 2001 as compared to the same periods in 2000 were principally attributable to increased competition and federal access reform that reduced the rates we are able to collect for switched access services. We believe revenues from switched access services will continue to be negatively impacted by federal access reform. OPERATING EXPENSES Cost of services. Cost of services, as a percent of revenues, increased to 35.6% for the three months ended September 30, 2001 from 32.7% for the three months ended September 30, 2000. For the nine months ended September 30, 2001, cost of services, as a percent of revenues, increased to 35.5% versus 32.8% for the comparable period in 2000. The increase in cost of services for the three months ended September 30, 2001 was primarily attributable to an increase in switched and special access charges associated with increased volumes for our long-distance voice services and growth in our data and DIA services offered outside our local service area. Partially offsetting this growth was a decrease in cost of goods sold associated with declining optical capacity asset sales. For the nine months ended September 30, 2001 as compared to the same period in 2000, the increase was principally due to increased cost of goods sold associated with increased optical capacity asset sales and an increase in switched and special access charges associated with increased volumes for our long-distance voice services and growth in our data and DIA services offered outside our local service area. In addition, for both the three- and nine-month periods, a shift in our product mix to higher growth services, costs associated with the sales of data and wireless products and services, introduction of new product platforms (including Qwest's Internet dial and hosting infrastructure), expenses associated with improving local service and costs related to our re-entry into the long-distance business in our local service area contributed to the increases. Partially offsetting these increases were decreases in employee-related costs due to the reduction in the overall number of employees and contractors and other savings generated through cost controls and operational efficiencies since June 30, 2000. Operational efficiencies have been realized through the consolidation of core operational units that provide common services and by leveraging our purchasing power throughout the Company. Selling, general and administrative. Selling, general and administrative expenses, as a percentage of revenues, decreased from 28.2% for the three months ended September 30, 2000, to 27.4% for the three months ended September 30, 2001. For the nine months ended September 30, 2001, selling, general and administrative expenses, as a percentage of revenues, decreased to 26.0% as compared to 29.2% for the nine months ended September 30, 2000. The percentage decreases were primarily attributable to the reduction in employee headcount and the number of contractors, an increase in the pension credit (net of other post- retirement benefits) and lower taxes (other than income taxes). Selling, general and administrative expenses for the three months ended September 30, 2001 decreased $39 million when compared to the same period of 2000. The decrease was primarily due to a higher pension credit (net of other post-retirement benefits) and lower commissions due to changes in our commission compensation plan. These lower costs were offset somewhat by higher professional fees, uncollectible expenses, marketing costs and occupancy costs relating to the opening of several new CyberCenters. For the nine months ended September 30, 2001, selling, general and administrative expenses decreased $159 million compared to the same period in 2000. The decrease was primarily attributable to decreased employee headcount and contractors, a reduction in advertising, lower taxes (other than income taxes), higher pension credit (net of other post-retirement benefits) and lower commissions due to changes in our commission compensation plan. Since June 30, 2000, we have reduced our employee headcount and contractors by approximately 13,400, a portion of which also impacts cost of services. Increases in professional fees, uncollectible expenses and occupancy costs relating to the opening of several new CyberCenters partially offset some of the cost decreases. 20 For the three months ended September 30, 2001, results include a pension credit, net of other post-retirement expenses, of $83 million ($52 million after-tax or $0.03 per diluted share) compared to $71 million ($44 million after-tax or $0.03 per diluted share) for the three months ended September 30, 2000. For the nine months ended September 30, 2001, results include a pension credit, net of post-retirement expenses, of $253 million ($157 million after-tax or $0.09 per diluted share) compared to $212 million ($131 million after-tax or $0.08 per pro forma diluted share) for the same period in 2000. We anticipate that our pension credit, net of other post-retirement expenses, will be negatively impacted by lower interest rates and market conditions in 2002. However, we do not anticipate a need to make a contribution to the pension plan in 2002. Depreciation. The increases in depreciation expense for the three- and nine-month periods ended September 30, 2001 compared to the same periods in 2000, were primarily attributable to higher overall property, plant and equipment balances resulting from our capital program. In addition, for the nine months ended September 30, 2001 there was an increase in depreciation related to a one-time charge for access lines returned to service. We continue to invest in our network and service platforms to support re-entry into the long-distance business in our local service area, meet forecasted customer demand and make service improvements. During 1999 and 2000, U S WEST committed to sell approximately 800,000 access lines to third-party telecommunications service providers, including approximately 570,000 access lines to Citizens Communications Company ("Citizens"). Because these access lines were "held for sale," we discontinued recognizing depreciation expense on these assets and recorded these assets at the lower of their cost or fair value less estimated cost to sell. On July 20, 2001, we terminated our agreement with Citizens under which the majority of the remaining access lines were to have been sold and ceased actively marketing the remaining lines. As a result, the remaining access lines were reclassified as being "held for use" as of June 30, 2001. The access lines were measured individually at the lower of their (a) carrying value before they were classified as held for sale, adjusted for any depreciation (amortization) expense or impairment losses that would have been recognized had the assets been continuously classified as held for use, or (b) their estimated fair value at June 30, 2001. The required adjustments to the carrying value of the individual access lines are included in income from continuing operations for the nine months ended September 30, 2001. This resulted in a charge to depreciation of $222 million. Goodwill and other intangible amortization. Amortization expense is directly attributable to goodwill and other intangibles recorded as a result of the Merger. The final purchase price allocation to identifiable intangible assets and goodwill was $4.1 billion and $30.8 billion, respectively. Additionally, $4.8 billion was allocated to our investment in KPNQwest, N.V. ("KPNQwest"), which created a preliminary excess carrying value of $4.2 billion to be amortized over 10 years. For the quarter, amortization was flat as compared to the same quarter in 2000. For the nine months ended September 30, 2001, amortization decreased by $77 million versus the same period in 2000. The decrease was primarily associated with the second quarter 2001 KPNQwest write-down of $3.048 billion. The average amortization period for all identifiable intangibles, the excess basis in KPNQwest and goodwill is 25 years. Merger-related and other one-time charges. No Merger-related and other one-time charges were incurred for the three months ended September 30, 2001. For the nine months ended September 30, 2001, we incurred Merger-related and other one-time charges totaling $624 million. We considered only those costs that were incremental and directly related to the Merger to be Merger-related. For the nine months ended September 30, 2001, the Merger-related costs include $274 million of contractual settlements and legal contingencies, $199 million of severance and headcount-related charges and $151 million of other Merger- related and one-time charges. Other Merger-related and one-time charges include professional fees, re-branding costs, other integration-related costs and asset impairment charges. We do not foresee any additional Merger-related charges and anticipate that the majority of the contractual, severance and other Merger-related and one-time charge accruals will be paid by the end of the current fiscal year. Legal contingencies will be paid as the related matters are resolved. When matters are 21 finalized, any differences between amounts accrued and actual payments will be reflected in results of operations as an adjustment to Merger-related and other one-time charges. Other expense (income)-net. Interest expense was $380 million and $1.061 billion for the three and nine months ended September 30, 2001, respectively, compared to $314 million and $807 million for the three and nine months ended September 30, 2000. The increases in interest expense were primarily attributable to increased borrowings required to fund the capital improvements to our network and the repurchase of shares from BellSouth Corporation ("BellSouth"). We follow a process of reviewing our portfolio of equity securities on a quarterly basis. We evaluate for other than temporary declines when the carrying value of an investment exceeds its fair value. For a further discussion of the factors we use to determine the fair value of our equity investments, see Note 4 to the condensed consolidated financial statements. For the three months ended September 30, 2001, we recorded a write-down of $7 million for a decline in the fair value of our derivative financial instruments. The nine-month period ended September 30, 2001 included a $3.048 billion write-down of our KPNQwest investment, $199 million in other unrealized investment losses and a $7 million write-down for the decline in the fair value of our derivative financial instruments (as described in Note 4 to the condensed consolidated financial statements). The $3.2 billion write-down on our investment in KPNQwest and other marketable equity securities represents a non-cash charge against earnings. At September 30, 2001, subsequent to the charge for other than temporary declines in fair value, these investments had a carrying value of $1.3 billion for KPNQwest and $8 million for our portfolio of other marketable securities. An increase of $58 million in the fair value of our derivative financial instruments was reported in the quarter ended September 30, 2000. For the nine months ended September 30, 2000, we recorded a $263 million decline in the market value of our derivative financial instruments and a $447 million write-down of our Global Crossing Ltd. ("Global Crossing") investment. In addition, we generated gains on the sales of various marketable equity securities of $252 million and $375 million for the three and nine months ended September 30, 2000, respectively. We also incurred a loss of $39 million on the sale of fixed assets for the three and nine months ended September 30, 2000. During the nine months ended September 30, 2001, we completed a sale of approximately 38,000 access lines in Utah resulting in a gain of $50 million. Other expenses include losses from our investments accounted for under the equity method and regulatory interest expense, net of interest income on short-term investments. Provision for income taxes. The effective tax rates for all periods presented were impacted by the non-deductible goodwill and KPNQwest excess basis amortization and foreign losses associated with our investment in KPNQwest. All periods presented except for the three months ended September 30, 2001 were also affected by certain non-deductible Merger-related costs. In addition, the nine months ended September 30, 2001 was impacted by the non-deductible KPNQwest investment write-down. Excluding the impact of these items, the effective tax rates for the three months ended September 30, 2001 and 2000 were 61.3% and 36.8%, respectively. The increase in our effective tax rate was due to an increase in our non-deductible expenses and other permanent differences as a percentage of our revised estimated 2001 annual pre-tax income. A one-time, $150 million catch-up adjustment to tax expense was recorded in the three-month period ended September 30, 2001 to reflect the effective tax rate change. For the nine months ended September 30, 2001 and September 30, 2000, the effective tax rates after adjustment for the items discussed above, were 42.5% and 38.0%, respectively. The changes in these adjusted effective tax rates were primarily due to miscellaneous non-deductible expenses and other permanent differences and tax credits. Extraordinary item -- early retirement of debt. During the nine months ended September 30, 2001, we completed a tender offer to buy back certain outstanding debt. In the tender offer, we repurchased approximately $995 million in principal ($1.2 billion in face value) of outstanding debt. As a result of the repurchase, we incurred a pre-tax charge of $106 million ($65 million after tax) in premium payments. 22 Net loss. Net loss for the three months ended September 30, 2001 was $142 million compared to a net loss of $248 million in the third quarter of 2000. The change was primarily due to a decrease in Merger-related expenses combined with flat revenue growth. This was offset somewhat by a decrease in the gains on sale of investments and increases in depreciation, interest and higher tax expense due to a cumulative catch-up adjustment. Our net loss increased from $414 million in the first nine months of 2000 to a $3.494 billion loss during the same period in 2001. The change was primarily due to the write-down of our investment in KPNQwest. Other contributors were the one-time depreciation charge to return access lines to service, higher depreciation driven by the continued investment in our network, an increase in interest expense and higher tax expense due to a cumulative adjustment. A reduction in Merger-related costs helped to reduce the impact of these additional charges. Diluted loss per share for the three months ended September 30, 2001 and 2000 were $0.09 and $0.15, respectively. The decrease in diluted loss per share from the quarter ended September 30, 2000 as compared to the same period in 2001 was due to the decrease in Merger-related costs combined with flat revenue growth. This charge was partially offset by a decrease in the gains on sale of investments and increases in depreciation, interest and higher tax expense due to a cumulative catch-up adjustment. For the nine months ended September 30, 2001 and 2000, the diluted loss per share was $2.10 and $0.25, respectively. The increase in diluted loss per share for the comparable nine-month periods ended September 30, 2001 and 2000 resulted from the loss generated during 2001 primarily relating to the write-down of our KPNQwest investment, the one-time depreciation charge to return access lines to service, higher depreciation driven by the continued investment in our network, an increase in interest expense and higher tax expense due to a cumulative catch-up adjustment. The increased loss was partially offset by a reduction in Merger-related costs. The diluted losses per share for the three and nine months ended September 30, 2001 were impacted by the repurchase of our common stock from BellSouth that offset some of the increase in shares outstanding at September 30, 2001. LIQUIDITY AND CAPITAL RESOURCES The liquidity and capital resources analysis is based upon "As Reported" results. Consequently, operating, investing and financing activities for the nine months ended September 30, 2001 as compared to the nine months ended September 30, 2000 were impacted significantly by the Merger. Operating Activities. Cash provided by operations increased to $3.356 billion for the nine months ended September 30, 2001 from $2.804 billion for the same period in 2000. The change was primarily due to the growth in net income after adjusting for depreciation, amortization, the write-down of our KPNQwest investment and gains and losses on the sale of investments. In addition, cash flow from operations was impacted by an increase in net accounts receivable ($217 million), inventories and supplies ($105 million) and a decrease in other accrued expenses ($1.086 billion). The change in other accrued expenses was due to higher than anticipated health care payments and a net reduction in our plant, property and equipment accruals. On January 16, 2001, we entered into an agreement with BellSouth under which BellSouth committed to acquire services from us over a five-year period. The agreement provides that BellSouth will make payment for the services in Qwest common stock based upon values contained in the agreement. At September 30, 2001, we had invoiced BellSouth for approximately $70 million which, along with services invoiced prior to the settlement date, will be settled with our common stock in December 2001. Due to a net tax loss being generated during the current tax year, we have made minimal income tax payments in 2001. Investing Activities. Capital expenditures were $7.791 billion for the nine months ended September 30, 2001 and $5.006 billion for the nine months ended September 30, 2000. Capital expenditures have been, and continue to be, focused on the modernization and expansion of our telecommunications network, expansion of our wireless, local broadband, Internet and data communications networks, re-entry into the long-distance business in our local service area and service improvements. Our capital expenditures through September 30, 2001 represent over 90% of our expected capital spending for the year of approximately $8.5 billion. The 23 disproportionate capital costs for the first three quarters of the year are primarily attributable to capital spending associated with our re-entry into the long-distance business in our local service area, service quality improvements and infrastructure built to meet forecasted demand at such time. Included in our expenditures for property, plant and equipment are cash expenditures for optical capacity purchase agreements. The purchases are principally for capacity outside the United States. These agreements provide us with the right, among other things, to network capacity provided by major carriers on specific routes at current market rates for periods of 20 to 25 years. Several of these carriers have also acquired optical capacity from us, principally in the United States, during 2001 in separate cash transactions at market rates. These transactions are accounted for separately as purchases of property, plant and equipment used in our operations and as sales of inventory. Property, plant and equipment increased by approximately $418 million and $868 million due to these purchases during the three- and nine-month periods ended September 30, 2001, respectively. Of these purchases during the nine months, $672 million was acquired with cash and $196 million with a note. With these same vendors, we also entered into sales contracts valued at $870 million during the nine months ended September 30, 2001. Revenue recognized for optical capacity sold to these vendors was $124 million and $664 million for the three- and nine-month periods ended September 30, 2001, respectively. During the nine months ended September 30, 2001, we sold approximately 38,000 access lines resulting in a gain of $50 million and generating cash proceeds of $91 million. Future cash needs could be impacted by the pursuit of new business opportunities, including the acceleration of the deployment of additional and/or advanced new services to customers, such as broadband data, wireless and video services. In addition, the expansion and upgrades of our network could affect our future cash requirements. We expect that such cash needs, if any, will be funded through operations, the sale of assets and, when necessary, the issuance of debt. Financing Activities. Cash provided by financing activities was $4.740 billion and $590 million for the nine months ended September 30, 2001 and 2000, respectively. In 2001, we increased our commercial paper balances to finance the acquisition of telecommunications equipment for the upgrade and expansion of our network and to fund general Company operations. Long-term borrowings increased during 2001 to refinance maturing commercial paper obligations, finance the acquisition of telecommunications equipment for the upgrade and expansion of our network and to fund general Company operations. During the nine months ended September 30, 2001 we reacquired 22.22 million shares of our common stock from BellSouth for $1.0 billion. In March 2001, we completed a cash tender offer to buy back certain outstanding debt. In the tender offer, we repurchased approximately $995 million in principal ($1.2 billion in face value) of outstanding debt. As a result of the repurchase, we incurred $106 million ($65 million after tax) in premium payments. On May 2, 2001, our Board of Directors approved a dividend of five cents per share on our common stock which was paid to stockholders of record as of the close of business on June 1, 2001 in satisfaction of any prior statement by us in connection with or following the Merger regarding the payment or declaration of dividends. As a result, dividends of $83 million were paid on common stock for the nine months ended September 30, 2001 compared to $542 million in the comparable 2000 period. The decline was due to a change in the dividend policy after the Merger. We maintain commercial paper programs to finance purchases of telecommunications equipment. As of September 30, 2001, we had a $4.0 billion syndicated credit facility to support our commercial paper programs. The syndicated credit facility matures on May 3, 2002. We currently believe that cash flow from operations and available debt financing will be sufficient to satisfy our anticipated cash requirements for the next 12 months. Currently, we do not anticipate a need for any additional equity or debt financing beyond that period. However, depending upon, among other things, the impact of the current economic slowdown on our future operating results, changes in the strategic direction of the Company and the success of our cost cutting initiatives, we may be required to fund some of our cash requirements with additional equity or debt financing. 24 NEW ACCOUNTING STANDARDS In June 1998, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards for derivative instruments and hedging activities. SFAS No. 133 requires, among other things, that all derivative instruments be recognized at fair value as assets or liabilities in the consolidated balance sheets and changes in fair value generally be recognized currently in earnings unless specific hedge accounting criteria are met. The adoption of SFAS No. 133 on January 1, 2001 did not have a material impact on our consolidated financial results. In September 2000, the FASB issued SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishment of liabilities. SFAS No. 140 requires that after a transfer of financial assets, an entity continues to recognize the financial and servicing assets it controls and the liabilities it has incurred and does not recognize those financial and servicing assets when control has been surrendered and the liability has been extinguished. SFAS No. 140 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. Adoption of SFAS No. 140 did not have a material impact on our consolidated financial results. In June 2001, the FASB issued SFAS No. 141, "Business Combinations." This pronouncement eliminated the use of the "pooling of interests" method of accounting for all mergers and acquisitions. As a result, all mergers and acquisitions will be accounted for using the "purchase" method of accounting. SFAS No. 141 is effective for all mergers and acquisitions initiated after June 30, 2001. Adoption of this pronouncement has no impact on our results from operations or our financial position. In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets." This statement addresses financial accounting and reporting for intangible assets (excluding goodwill) acquired individually or with a group of other assets at the time of their acquisition. It also addresses financial accounting and reporting for goodwill and other intangible assets subsequent to their acquisition. Intangible assets (excluding goodwill) acquired outside of a business combination will be initially recorded at their estimated fair value. If the intangible asset has a finite useful life, it will be amortized over that life. Intangible assets with an indefinite life are not amortized. Both types of intangible assets will be reviewed annually for impairment and a loss recorded when the asset's carrying value exceeds its estimated fair value. Goodwill will be treated similar to an intangible asset with an indefinite life. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. We currently estimate the adoption of SFAS No. 142 will reduce our amortization expense by approximately $850-$950 million annually beginning January 1, 2002. We are currently evaluating the impact this pronouncement will have on the value of our intangible assets. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This statement deals with the costs of closing facilities and removing assets. SFAS No. 143 requires entities to record the fair value of a legal liability for an asset retirement obligation in the period it is incurred. This cost is initially capitalized and amortized over the remaining life of the underlying asset. Once the obligation is ultimately settled, any difference between the final cost and the recorded liability is recognized as a gain or loss on disposition. SFAS No. 143 is effective for years beginning after June 15, 2002. We are currently evaluating the impact this pronouncement will have on our future consolidated financial results. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This pronouncement addresses how to account for and report impairments or disposals of long-lived assets. Under SFAS No. 144, an impairment loss is to be recorded on long-lived assets being held or used when the carrying amount of the asset is not recoverable from its undiscounted cash flows. The impairment loss is equal to the difference between the asset's carrying amount and estimated fair value. Long-lived assets to be disposed of by other than a sale for cash are to be accounted for and reported like assets being held or used except the impairment loss is recognized at the time of the disposition. Long-lived assets to be disposed of by sale are to be recorded at the lower of their carrying amount or estimated fair value (less costs to sell) at the time the plan of disposition has been approved and committed to by the appropriate company management. In addition, depreciation is to cease at the same time. SFAS No. 144 is effective for fiscal years 25 beginning after December 15, 2001. We are currently evaluating the impact this pronouncement will have on our future consolidated financial results. On July 19, 2001, the EITF issued EITF Issue 00-11, "Meeting the Ownership Transfer Requirements of FASB Statement No. 13 for Leases of Real Estate." This issue is primarily concerned with ownership transfer requirements for a sales-type lease of property under SFAS No. 13. According to EITF 00-11, a nominal purchase option contained in a lease does not satisfy the transfer of ownership criterion in SFAS No. 13 for transfers of real property, if the failure to pay the nominal amount results in ownership not being transferred to the lessee. EITF 00-11 provides, however, that this criterion will be met in cases involving integral equipment or property improvements when the lessor agrees, regardless of whether or not the lessee pays any amount, to execute and deliver to the lessee all documents (including, if applicable, a bill of sale) that may be required to release the property from the lease and transfer ownership to the lessee. EITF 00-11 applies to leases entered into after July 19, 2001 and to certain leases modified after that date. We are in compliance with SFAS No. 13 with respect to these ownership transfer requirements. MARKET RISK We are exposed to market risks arising from changes in interest rates. The objective of our interest rate risk management program is to manage the level and volatility of our interest expense. We may employ derivative financial instruments to manage our interest rate risk exposure. We may also employ financial derivatives to hedge foreign currency exposures associated with particular debt. As of September 30, 2001 and December 31, 2000, approximately $3.3 billion and $2.4 billion, respectively, of floating-rate debt was exposed to changes in interest rates. This exposure is linked to commercial paper rates and London Interbank Offered Rates ("LIBOR"). A hypothetical increase of one-percentage point in commercial paper rates and LIBOR would increase annual pre-tax interest expense by $33 million. As of September 30, 2001 and December 31, 2000, we also had approximately $1.0 billion and $1.2 billion, respectively, of long-term fixed rate debt obligations maturing in the following 12 months. Any new debt obtained to refinance this debt would be exposed to changes in interest rates. A hypothetical 10% change in the interest rates on this debt would not have had a material effect on our earnings. As of September 30, 2001 and December 31, 2000, we had entered into cross-currency swaps with notional amounts of $133 million. The cross-currency swaps hedge our exposure to movements in the Swiss Franc to the U.S. dollar exchange rate. The effect of the cross-currency swap is to synthetically transform the Swiss Franc borrowings into $93 million of U.S. dollar borrowings at September 30, 2001 and December 31, 2000, respectively. Any foreign exchange gains (losses) on the cross-currency swaps would be offset by foreign exchange losses (gains) on the Swiss Franc debt obligations. The Swiss Franc borrowings mature in November 2001. As of December 31, 2000, we had entered into equity swaps with notional amounts of $761 million relating to the sale of 24 million shares of Global Crossing common stock we previously owned. Of the 24 million shares subject to equity swaps, one-third matured in February 2001, one-third matured in May 2001 and the final one-third matured in August 2001. As of September 30, 2001, we no longer own any equity swaps of shares of Global Crossing common stock. We currently hold 200 million shares of stock in KPNQwest. At September 30, 2001 and December 31, 2000, the 11% minority stake in KPNQwest was trading at $4.19 and $18.94 per share, respectively. The carrying value of our KPNQwest investment was approximately $6.64 per share at September 30, 2001. The decline in KPNQwest's stock price during the quarter ended September 30, 2001 was considered temporary as evidenced by its closing stock price of $7.05 on October 25, 2001. The per share value of our investment in KPNQwest may be less than the publicly traded minority stake because of the restrictions on the marketability of our shares. Given the foregoing, a hypothetical 10% decline in the public trading price of KPNQwest at September 30, 2001 could decrease the value of our investment by approximately $100 million. Upon the completion of the additional purchase of KPNQwest shares of common stock as described in Note 9 to the condensed consolidated financial statements, restrictions on the marketability of all shares of 26 KPNQwest we own will be eliminated. KPN will have certain tag along rights with respect to any future KPNQwest stock offerings. Equity investments in other publicly traded companies consists of the following (dollars in millions):
SEPTEMBER 30, 2001 DECEMBER 31, 2000 - ------------------------------------------- ------------------------------------------- UNREALIZED UNREALIZED UNREALIZED UNREALIZED COST GAINS LOSSES FAIR VALUE COST GAINS LOSSES FAIR VALUE - ---- ---------- ---------- ---------- ---- ---------- ---------- ---------- $112 $ -- $(104) $8 $90 $30 $(62) $58 ==== ===== ===== == === === ==== ===
The estimated potential loss in fair value resulting from a hypothetical 10% decrease in the September 30, 2001 prices quoted by stock exchanges would decrease the fair value of our other equity investments by less than $1 million. RECENT REGULATORY DEVELOPMENTS As a general matter, we are subject to substantial regulation, including requirements and restrictions arising under the Telecommunication Act of 1996 (the "Act") and state utility laws, and the rules and policies of the Federal Communications Commission ("FCC"), state Public Utility Commissions ("PUCs") and other governmental entities. This regulation, among other matters, currently prohibits us (with certain exceptions) from providing retail or wholesale interLATA telecommunications services within our local service area, and governs the terms and conditions under which we provide services to our customers (including competitive local exchange carriers ("CLECs") and IXCs in our local service area). Interconnection. The FCC is continuing to interpret the obligations of incumbent local exchange carriers ("ILECs") under the Act to interconnect their networks with, and make unbundled network elements available to, CLECs. These decisions establish our obligations in our local service area, and our rights when we compete outside of our local service area. In addition, the United States Supreme Court is now considering an appeal from a ruling of the Eighth Circuit Court of Appeals that the FCC's rules for the pricing of interconnection and unbundled network elements by ILECs unlawfully preclude ILECs from recovering their actual costs as required by the Act. Access Pricing. The FCC has initiated a number of proceedings that directly affect the rates and charges for access services that we sold or purchased. It is expected that these proceedings and related implementation of resulting FCC decisions will continue through 2002. On May 31, 2000, the FCC adopted the access reform and universal service plan developed by the Coalition for Affordable Local and Long-Distance Service ("CALLS"). The adoption of the CALLS proposal resolved many outstanding issues before the FCC including: the court remand of the 6.5% productivity factor; the treatment of implicit universal service support; the treatment of low-volume long-distance users; and the next scheduled price cap review. The CALLS plan has a five-year life and provides for the following: elimination of the residential presubscribed interexchange carrier charge; increases in subscriber line charges; reductions in switched access usage rates; the removal of certain implicit universal service support from access charges and direct recovery from end users; and commitments from participating IXCs to pass through access charge reductions to end users. We have opted into the five-year CALLS plan. Advanced Telecommunications Services. On two separate occasions the FCC has ruled that advanced services provided by an ILEC are covered by those provisions of the Act that govern telephone exchange and exchange access services. We have challenged this finding, contending that advanced services fit within neither category and are not properly treated as exchange services. On April 20, 2001, the Court of Appeals vacated and remanded to the FCC its classification of DS2-based advanced services. InterLATA Long-Distance Entry. Several Regional Bell Operating Companies ("RBOCs") have filed for entry into the interLATA long-distance business. Although many of these applications have been supported by state PUCs, the FCC had rejected all applications until December 1999. As of September 30, 27 2001, long-distance authority has been granted in the states of Connecticut, Kansas, Massachusetts, New York, Oklahoma, Pennsylvania and Texas. We filed applications with all of our local service area state PUCs for support of our planned applications to the FCC for authority to enter the interLATA long-distance business. Workshops and related proceedings are underway at the state level to evaluate our satisfaction of requirements under the Act that must be met in order for an RBOC to obtain long-distance authority. We have agreed to test operational support systems on a regional basis in thirteen states, and testing of those systems began in March 2001. Testing in Arizona is being conducted separately, and began in February 2001. We are on track to receive FCC approval to provide long-distance service in each of our 14 states by mid-2002. Reciprocal Compensation for Internet Service Providers ("ISPs"). On April 27, 2001, the FCC issued an Order with regard to Intercarrier Compensation for ISP bound traffic. The Order required carriers serving ISP bound traffic to reduce reciprocal compensation rates over a 36-month period beginning with an initial reduction to $0.0015 per minute of use and ending with a rate of $0.0007 per minute of use. In addition, a cap was placed on the number of minutes of use on which the terminating carrier may charge such rates. This reduction will lower costs that Qwest pays CLECs for delivering such traffic to other carriers. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Information relating to market risk is included in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, in the section under the caption "Market Risk." 28 PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In October 2001, a derivative action was filed in federal district court in Colorado against Qwest's board of directors. Qwest is also named in the lawsuit, as a nominal defendant. This complaint alleges, among other things, that the entire board of directors of Qwest breached fiduciary duties to Qwest by (1) misusing internal nonpublic information that allowed three directors to profit by insider trading, (2) failing to oversee the implementation of the securities laws that prohibit insider trading, and (3) causing Qwest to be sued for securities fraud in the In re Qwest Communications International Inc. Securities Litigation. The plaintiffs seek restitution and unspecified damages against each of the named parties, punitive damages and other relief. We may in the future receive additional claims and demands that may be based on similar or different legal theories. There has been no discovery or other activity in this case, which is still in a preliminary stage. For a discussion of other claims and proceedings arising in the ordinary course of business, see Note 8: "Commitments and Contingencies" -- to the condensed consolidated financial statements. II-1 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits required by Item 601 of Regulation S-K.
EXHIBIT NUMBER DESCRIPTION ------- ----------- (2.1) -- Separation Agreement, dated June 5,1998, between U S WEST, Inc. (renamed "MediaOne Group, Inc.") ("MediaOne Group") and USW-C, Inc (renamed U S WEST, Inc.) ("U S WEST"), (incorporated by reference to U S WEST's Current Report on Form 8-K/A dated June 26, 1998). (2.2) -- Amendment to the Separation Agreement between MediaOne Group and U S WEST dated June 12, 1998 (incorporated by reference to U S WEST's Annual Report on Form 10-K/A for the year ended December 31, 1998). (3.1) -- Amended and Restated Certificate of Incorporation of Qwest (incorporated by reference to Qwest's Registration Statement on Form S-4/A, File No. 333-81149, filed September 17, 1999). (3.2) -- Amended and Restated Bylaws of Qwest (incorporated by reference to Qwest's Annual Report on Form 10-K for the year ended December 31, 2000). (4.1)*** -- 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). (4.2)**** -- Indenture dated, as of August 28, 1997, with Bankers Trust Company (including form of Qwest's 10 7/8% Series B Senior Discount Notes due 2007 as an exhibit thereto). (4.3)**** -- 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). (4.4) -- 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). (4.5) -- 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). (4.6) -- 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). (4.7) -- 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).
II-2
EXHIBIT NUMBER DESCRIPTION ------- ----------- (4.8) -- Registration Rights Agreement, dated August 20, 1999, between U S WEST Capital Funding, Inc., U S WEST, Inc., J.P. Morgan Securities, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated by reference to U S WEST's Form S-4 Registration Statement, File No. 333-92523, filed December 10, 1999). (4.9) -- Indenture, dated as of June 29, 1998, by and among U S WEST Capital Funding, Inc., U S WEST, Inc., and The First National Bank of Chicago (now known as Bank One Trust Company, National Association), as Trustee (incorporated by reference to U S WEST's Current Report on Form 8-K, dated November 18, 1998). (4.10) -- First Supplemental Indenture, dated as of June 30, 2000, by and among U S WEST Capital Funding, Inc., U S WEST, Inc., Qwest Communications International Inc., and Bank One Trust Company, as Trustee (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended June 30, 2000). (4.11) -- First Supplemental Indenture, dated as of February 16, 2001, to the 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) (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 2001). (4.12) -- First Supplemental Indenture, dated as of February 16, 2001, to the 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) (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 2001). (4.13) -- First Supplemental Indenture, dated as of February 16, 2001, to the Indenture dated as of August 28, 1997 with Bankers Trust Company (including form of Qwest's 10 7/8% Series B Senior Discount Notes due 2007 as an exhibit thereto) (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 2001). 10.1 -- Third Amended and Restated Operating Agreement of Qwest Digital Media, LLC (formerly known as Slingshot Networks, LLC) entered into as of January 2, 2001 between Anschutz Digital Media, Inc. and U.S. Telesource, Inc.
- --------------- ( ) Previously filed. *** 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 to Qwest's Annual Report on Form 10-K for the year ended December 31, 1997. (b) Reports on Form 8-K: (i) On July 20, 2001, Qwest filed a report on Form 8-K to restate its cost of sales and selling, general and administrative expenses for 2000 and 2001. (ii) On July 26, 2001, Qwest filed a report on Form 8-K/A, amending and restating, in its entirety, a report on Form 8-K filed on July 24, 2001 regarding its 2001 second quarter results of operations. (iii) On August 13, 2001, Qwest filed a report on Form 8-K/A, amending and restating, in its entirety, a report on Form 8-K filed on August 7, 2001 regarding a speech by its Chief Executive Officer. II-3 (iv) On September 10, 2001, Qwest filed a report on Form 8-K regarding an update on its financial guidance for 2001 and 2002. II-4 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. QWEST COMMUNICATIONS INTERNATIONAL INC. By: /s/ ROBIN R. SZELIGA ------------------------------------- Robin R. Szeliga Executive Vice President -- Finance and Chief Financial Officer November 14, 2001 II-5 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- ----------- (2.1) -- Separation Agreement, dated June 5,1998, between U S WEST, Inc. (renamed "MediaOne Group, Inc.") ("MediaOne Group") and USW-C, Inc (renamed U S WEST, Inc.) ("U S WEST"), (incorporated by reference to U S WEST's Current Report on Form 8-K/A dated June 26, 1998). (2.2) -- Amendment to the Separation Agreement between MediaOne Group and U S WEST dated June 12, 1998 (incorporated by reference to U S WEST's Annual Report on Form 10-K/A for the year ended December 31, 1998). (3.1) -- Amended and Restated Certificate of Incorporation of Qwest (incorporated by reference to Qwest's Registration Statement on Form S-4/A, File No. 333-81149, filed September 17, 1999). (3.2) -- Amended and Restated Bylaws of Qwest (incorporated by reference to Qwest's Annual Report on Form 10-K for the year ended December 31, 2000). (4.1)*** -- 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). (4.2)**** -- Indenture dated, as of August 28, 1997, with Bankers Trust Company (including form of Qwest's 10 7/8% Series B Senior Discount Notes due 2007 as an exhibit thereto). (4.3)**** -- 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). (4.4) -- 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). (4.5) -- 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). (4.6) -- 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). (4.7) -- 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). (4.8) -- Registration Rights Agreement, dated August 20, 1999, between U S WEST Capital Funding, Inc., U S WEST, Inc., J.P. Morgan Securities, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (incorporated by reference to U S WEST's Form S-4 Registration Statement, File No. 333-92523, filed December 10, 1999).
EXHIBIT NUMBER DESCRIPTION ------- ----------- (4.9) -- Indenture, dated as of June 29, 1998, by and among U S WEST Capital Funding, Inc., U S WEST, Inc., and The First National Bank of Chicago (now known as Bank One Trust Company, National Association), as Trustee (incorporated by reference to U S WEST's Current Report on Form 8-K, dated November 18, 1998). (4.10) -- First Supplemental Indenture, dated as of June 30, 2000, by and among U S WEST Capital Funding, Inc., U S WEST, Inc., Qwest Communications International Inc., and Bank One Trust Company, as Trustee (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended June 30, 2000). (4.11) -- First Supplemental Indenture, dated as of February 16, 2001, to the 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) (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 2001). (4.12) -- First Supplemental Indenture, dated as of February 16, 2001, to the 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) (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 2001). (4.13) -- First Supplemental Indenture, dated as of February 16, 2001, to the Indenture dated as of August 28, 1997 with Bankers Trust Company (including form of Qwest's 10 7/8% Series B Senior Discount Notes due 2007 as an exhibit thereto) (incorporated by reference to Qwest's quarterly report on Form 10-Q for the quarter ended March 31, 2001). 10.1 -- Third Amended and Restated Operating Agreement of Qwest Digital Media, LLC (formerly known as Slingshot Networks, LLC) entered into as of January 2, 2001 between Anschutz Digital Media, Inc. and U.S. Telesource, Inc.
- --------------- ( ) Previously filed. *** 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 to Qwest's Annual Report on Form 10-K for the year ended December 31, 1997. EX-10.1 3 d92251ex10-1.txt THIRD AMENDED AND RESTATED OPERATING AGREEMENT EXHIBIT 10.1 THIRD AMENDED AND RESTATED OPERATING AGREEMENT OF QWEST DIGITAL MEDIA, LLC This THIRD AMENDED AND RESTATED OPERATING AGREEMENT (this "Agreement") is entered into as of January 2, 2001, between Anschutz Digital Media, Inc., a Colorado corporation ("ADMI"), and U.S. Telesource, Inc., a Delaware corporation ("UST"), both of which are referred to as the "Members" and individually as a "Member." A limited liability company was formed in accordance with the provisions of the Delaware Limited Liability Company Act (the "Act") under the name of Slingshot Networks, LLC (the "Company") pursuant to a Certificate of Formation filed July 14, 1999, with the Delaware Secretary of State. An Operating Agreement of the Company was entered into as of that same date, under which ADMI was the sole member. Pursuant to a Subscription Agreement by and between Qwest Communications International Inc., a Delaware corporation ("Qwest"), and the Company dated as of October 22, 1999 (the "Subscription Agreement"), Qwest agreed to purchase an equity interest in the Company. Additionally, ADMI agreed under a Contribution Agreement dated as of October 22, 1999 by and among ADMI and the Company (the "Contribution Agreement") to contribute certain assets (the "ADMI Contributed Assets") to the Company. In conjunction with the Subscription Agreement and the Contribution Agreement, on October 22, 1999 ADMI and Qwest entered into an Amended and Restated Operating Agreement. Subsequently, Qwest transferred its interest in the Company to its wholly owned subsidiary UST (references to UST herein shall be deemed to include Qwest as its predecessor in interest). On June 21, 2000 ADMI and UST entered into a Unit Purchase Agreement (the "Purchase Agreement") pursuant to which UST purchased a portion of ADMI's equity interest in the Company in exchange for cash and a promissory note (the "Purchase Note"). On October 17, 2000 the name of the Company was changed from Slingshot Networks, LLC to Qwest Digital Media, LLC. On January 2, 2001 UST paid in full the outstanding amount due under the Purchase Note. In light of the foregoing, the Members now desire to amend and restate the Second Amended and Restated Operating Agreement of the Company. Accordingly, from and after the date hereof, the affairs of the Company will be governed by this Third Amended and Restated Operating Agreement. In consideration of the foregoing, and of the mutual promises contained herein, the Members agree as follows: ARTICLE 1 THE LIMITED LIABILITY COMPANY 1.1 Name. The name of the limited liability company shall be Qwest Digital Media, LLC. 1.2 Certificate of Formation. A Certificate of Formation that complies with the requirements of the Act has been properly filed with the Delaware Secretary of State. In the future, the Managers shall execute such further documents (including amendments to the Certificate of Formation) and take such further action as shall be appropriate or necessary to comply with the requirements of law for the formation and operation of a limited liability company in all states and counties where the Company elects to carry on its business. 1.3 Business. The business of the Company shall be (a) 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; (b) to do any and all other things necessary, desirable or incidental to the foregoing purposes; and (c) to engage in such other legal and lawful business activities as the Management Committee may deem desirable. The Company may sell or otherwise dispose of all or substantially all of its assets and any such sale or disposition shall be considered to be within the scope of the Company's business. 1.4 Registered Office; Agent. The registered office of the Company shall be at 950 Seventeenth Street, Suite 2050, Denver, Colorado 80202, or such other place in Colorado as may be selected by the Management Committee. The Company's registered agent at such address shall be Brad Hamilton. ARTICLE 2 DEFINITIONS 2.1 Cash Flow. "Cash Flow" shall mean the excess of all cash receipts of the Company over all cash disbursements of the Company. 2.2 Code. "Code" shall mean the Internal Revenue Code of 1986, as amended, or any successor statute. 2.3 Conversion Date. "Conversion Date" shall mean the earliest to occur of the following dates (a) January 2, 2004, (b) the date of completion by the Company of an initial public offering of its equity securities in accordance with the rules and regulations of the Securities Act of 1933, as amended, by means of an effective registration statement under Form S-1 (or any successor form thereto), (c) the date of payment in full by UST of the outstanding amount due under the Capital Note (as defined below), and (d) any date on which UST will have a Sharing Ratio, after giving effect to a Conversion (as defined below), that would result in Qwest not having to consolidate the Company for financial accounting purposes. 2.4 Manager. "Manager" is defined in Section 7.1(a). 2.5 Profit or Loss. "Profit" or "Loss" shall mean the profit or loss of the Company as determined under the capital accounting rules of Treasury Regulation Section 1.704-1(b)(2)(iv) for purposes of adjusting the capital accounts of the Members including, without limitation, the provisions of paragraphs (b), (f) and (g) of those regulations relating to the computation of items of income, gain, deduction and loss. 2.6 Sharing Ratio. "Sharing Ratio" shall mean the percentage representing the ratio that the number of Units owned by a Member bears to the aggregate number of Units owned by 2 all of the Members. Upon the issuance of additional Units or the transfer, repurchase or cancellation of any outstanding Units, the Sharing Ratios of the Members shall be recalculated as of the date of such issuance, transfer, repurchase or cancellation. The recalculated Sharing Ratio of each Member shall be the percentage representing the ratio that the number of Units owned by the Member bears to the aggregate number of Units owned by all of the Members after giving effect to the issuance, transfer, repurchase or cancellation. 2.7 Treasury Regulations. "Treasury Regulations" shall mean regulations issued by the Department of Treasury under the Code. Any reference to a specific section or sections of the Treasury Regulations shall be deemed to include a reference to any corresponding provision of future regulations under the Code. 2.8 Units. "Unit" shall mean an equity interest in the Company. The Company shall have three classes of Units: Class A, Class B and Class C. The three classes of Units shall be identical in all respects except for their respective Voting Interests. The number of Units owned by each Member shall be determined in connection with the issuance of a membership interest in the Company in exchange for the capital contribution made by such Member. Initially the Units shall not be represented by certificates. If the Management Committee determines that it is in the interest of the Company to issue certificates representing the Units, certificates shall be issued and the Units shall be represented by such certificates. The Company is authorized to issue 400,000,000 Class A Units, 200,000,000 Class B Units and 200,000,000 Class C Units. 2.9 Voting Interest. (a) With respect to the Class A Units, "Voting Interest" shall mean that number of Class A Units held by a Member, and (b) with respect to the Class B Units, "Voting Interest" shall mean that number of Class B Units held by a Member divided by 10. ARTICLE 3 CAPITAL CONTRIBUTIONS 3.1 Initial Capital Contributions. (a) In accordance with the terms of the Contribution Agreement, ADMI contributed to the Company all of its right, title and interest in and to the ADMI Contributed Assets. As a result of such contribution, ADMI was initially credited with a capital account equal to $84,816,696, and received 84,816,696 Class A Units. (b) In accordance with the terms of the Subscription Agreement, UST contributed to the Company, a promissory note (the "Capital Note") in the amount of $84,816,696, and such amount shall be credited to UST's capital account when and as the payments of principal are made on the Capital Note. As a result of UST's agreement to make such contribution and pursuant to the Subscription Agreement, UST was admitted as a Member of the Company, and received 84,816,696 Class A Units. (c) From October 22, 1999 through June 21, 2000, each of UST and ADMI have made contributions of $11,578,518.50 to their respective capital accounts in exchange for 3 11,578,518 Class A Units. In accordance with the terms of the Purchase Agreement, UST acquired 48,197,607 Class A Units from ADMI in exchange for cash and the Purchase Note. As a result, 48,197,607 Class A Units were transferred from ADMI to UST. From June 21, 2000 through January 2, 2001, UST has made additional contributions to its capital account in exchange for 10,200,000 Class A Units and ADMI has made additional contributions to its capital account in exchange for 3,400,000 Class A Units. (d) On January 2, 2001, the Company authorized the issuance of 200,000,000 Class C Units and UST exchanged 103,195,214 Class A Units for 103,195,214 Class C Units. (e) As a result of the transactions described above, the Members own the number and classes of Units set forth below:
Class A Units Class B Units Class C Units ------------- ------------- ------------- ADMI 51,597,607 -0- -0- UST 51,597,607 -0- 103,195,214
(f) Based on the above (i) the Sharing Ratio of ADMI is 25% and the Sharing Ratio of UST is 75%, and (ii) the Voting Interest of ADMI is 51,597,607 and the Voting Interest of UST is 51,597,607. (g) On the Conversion Date, all issued and outstanding Class C Units will automatically convert into an equal number of Class A Units (the "Conversion") without any further action on the part of the Company or the Members, as a result of which the aggregate number of issued and outstanding Class C Units on such date will be zero. Accordingly, on the Conversion Date the Voting Interest of each Member will be recalculated to reflect the Conversion. The Sharing Ratios of the Members will not be affected by the Conversion. 3.2 Additional Capital Contributions. (a) If, from time to time in the reasonable judgment of the Management Committee, the Company requires additional capital for any purpose, the Management Committee is hereby authorized to cause the Company to issue additional Units, on terms and conditions and with repayment priorities as approved by the Management Committee. Notwithstanding the foregoing, until a third party becomes a Member, Units shall not be issued at a price per Unit that is less than $1.00. (b) If the Company desires to issue additional Units pursuant to (a) above, the Company hereby grants to the Members the right of first refusal to purchase a pro rata share (equaling the Member's respective Sharing Ratio on the day before such additional Units are to be issued) of the additional Units which the Company proposes to issue. If the Company proposes to issue such additional Units, it shall give the Members written notice of its intention, describing the price and terms upon which the Company proposes to issue the Units. Each Member shall have 15 days from the date such notice is sent by the Company to agree to purchase the portion of the additional Units issued which it is entitled to purchase for the price 4 and upon the terms so specified in the notice. Such notice shall be in writing and shall specify the quantity of additional Units to be purchased. If any Member fails to exercise the right of first refusal within the 15-day period, the Company shall have the right thereafter to sell or issue those additional Units upon terms no more favorable to the purchasers of the additional Units than specified in the Company's notice to Members. 3.3 Return of Capital Contributions. Capital contributions shall be expended in furtherance of the business of the Company. All costs and expenses of the Company shall be paid from its funds. No interest shall be paid on capital contributions. No Manager shall have any personal liability for the repayment of any capital contribution to a Member. 3.4 Loans. (a) The Company may borrow additional capital from any source, including any Member. No Member shall be obligated to make a loan to the Company. (b) If from time to time in the reasonable judgment of the Management Committee the Company requires additional capital for any purpose related to the business of the Company, the Management Committee is authorized to cause the Company to borrow such capital, on terms and conditions as approved by the Management Committee. If the Management Committee decides to borrow such capital from a Member (the "Loan Amount), each Member shall be given the opportunity, but shall not be obligated, to loan its share of the Loan Amount to the Company. A Member's share of the Loan Amount shall be the Loan Amount multiplied by the Member's Sharing Ratio. The loans shall be made within 10 days after request by the Management Committee to the Members. Such request shall be in writing and shall specify the amount of the Loan Amount. If a Member does not loan its share of the Loan Amount (the "Shortfall Amount") and the other Member does loan its share (a "Participating Member"), the Participating Member shall have the right, exercisable within 10 days after notice, to loan the Company the Shortfall Amount. The loans to the Company by the Participating Members shall be unsecured, evidenced by promissory Note of the Company, shall accrue interest at a rate determined by the Management Committee, shall be payable on a pro rata basis solely from Cash Flow prior to any distributions to Members, and shall not contain any default interest or penalty provisions. ARTICLE 4 DISTRIBUTIONS 4.1 Nonliquidating Distributions. Cash Flow shall be distributed to the Members in amounts deemed appropriate by the Management Committee after establishing appropriate reserves. Except as provided in Section 4.2, all distributions of Cash Flow shall be made among the Members in accordance with their respective Sharing Ratios. 4.2 Liquidating Distributions. All distributions made in connection with the sale or exchange of all or substantially all of the Company assets and all distributions made in 5 connection with the liquidation of the Company shall be made to the Members in accordance with their relative capital account balances at the time of distribution. ARTICLE 5 ALLOCATION OF PROFIT AND LOSS 5.1 Determination of Profit and Loss. Profit or Loss shall be determined on an annual basis and for such other periods as may be required. 5.2 Loss Allocation. Except as provided in Section 5.4, Loss shall be allocated among the Members in accordance with their relative Sharing Ratios. 5.3 Profit Allocation. (a) Except as provided in Section 5.3(b) and Section 5.4, Profit shall be allocated among the Members in accordance with their relative Sharing Ratios. (b) Any Profit with respect to the sale, exchange or other disposition of all or substantially all of the Company assets or with respect to the liquidation of the Company shall be allocated among the Members so that their capital account balances are proportionate to their Sharing Ratios. (c) For purposes of Section 5.3(b), the capital accounts of the Members shall be determined (i) before giving effect to distributions under Section 4.2; (ii) after allocating all other items of Profit and Loss; and (iii) after making all distributions under Section 4.1. 5.4 Regulatory Allocations and Curative Provision. (a) The "qualified income offset" provisions of Treasury Regulation Section 1.704-1(b)(2)(ii)(d) are incorporated herein by reference and shall apply to adjust the allocation of Profit and Loss otherwise provided for under Sections 5.2 and 5.3 to the extent provided in that regulation. (b) The "minimum gain" provisions of Treasury Regulation Section 1.704-2 are incorporated herein by reference and shall apply to adjust the allocation of Profit and Loss otherwise provided for under Sections 5.2 and 5.3 to the extent provided in that regulation. (c) Notwithstanding the provisions of Section 5.2, if during any fiscal year of the Company the allocation of any loss or deduction, net of any income or gain, to a Member would cause or increase a negative balance in a Member's capital account as of the end of that fiscal year, only the amount of such loss or deduction that reduces the balance to zero shall be allocated to the Member and the remaining amount shall be allocated to the other Member. For the purpose of the preceding sentence, a capital account shall be reduced by the adjustments, allocations and distributions described in Treasury Regulations Sections 1.704-1(b)(2)(d)(4), (5) and (6), and increased by the amount, if any, that the Member is obligated to restore to the Member's 6 capital account within the meaning of Treasury Regulation Section 1.704-1(b)(2)(ii)(c) as of that time or is deemed obligated to restore under Treasury Regulation Section 1.704-2(g)(1) or Section 1.704-2(i)(5). (d) All allocations pursuant to the foregoing provisions of this Section 5.4 (the "Regulatory Allocations") shall be taken into account in computing allocations of other items under Sections 5.2 and 5.3, including, if necessary, allocations in subsequent fiscal years, so that the net amounts reflected in the Members' capital accounts and the character for income tax purposes of the taxable income recognized (e.g., as capital or ordinary) will, to the extent possible, be the same as if no Regulatory Allocations had been given effect. ARTICLE 6 ALLOCATION OF TAXABLE INCOME AND LOSS 6.1 In General. (a) Except as provided in Section 6.2, each item of income, gain, loss and deduction of the Company for federal income tax purposes shall be allocated among the Members in the same manner as such item is allocated for capital account purposes under Article 5. (b) To the extent of any recapture income (as defined below) resulting from the sale or other taxable disposition of a Company asset, the amount of any gain from such disposition allocated to (or recognized by) a Member (or its successor in interest) for federal income tax purposes shall be deemed to consist of recapture income to the extent such Member (or such Member's predecessor in interest) has been allocated or has claimed any deduction directly or indirectly giving rise to the treatment of such gain as recapture income. For this purpose "recapture income" shall mean any gain recognized by the Company (but computed without regard to any adjustment required by sections 734 and 743 of the Code) upon the disposition of any property or asset of the Company that does not constitute capital gain for federal income tax purposes because such gain represents the recapture of deductions previously taken with respect to such property or assets. 6.2 Allocation of Section 704(c) Items. The Members recognize that with respect to property contributed to the Company by a Member and with respect to property revalued in accordance with Treasury Regulation Section 1.704-1(b)(2)(iv)(f), there will be a difference between the agreed values or "carrying values" of such property at the time of contribution or revaluation and the adjusted tax basis of such property at that time. All items of tax depreciation, cost recovery, amortization, amount realized and gain or loss with respect to such assets shall be allocated among the Members to take into account the book-tax disparities in accordance with the provisions of sections 704(b) and 704(c) of the Code and the Treasury Regulations under those sections. 6.3 Integration With Section 754 Election. All items of income, gain, loss, deduction and credit recognized by the Company for federal income tax purposes and allocated to the Members in accordance with the provisions hereof and all basis allocations to the Members shall be determined without regard to any election under section 754 of the Code that may be made by 7 the Company; provided, however, such allocations, once made, shall be adjusted as necessary or appropriate to take into account the adjustments permitted by sections 734 and 743 of the Code. ARTICLE 7 MANAGEMENT 7.1 Management Committee. (a) Management of the Company shall be vested in a management committee (the "Management Committee"). Until the Conversion Date, the Management Committee shall consist of ten Managers, four of whom shall be appointed by ADMI, four of whom shall be appointed by UST, one of whom shall be appointed by ADMI and UST as mutually agreed upon, and one of whom shall be the Chief Executive Officer of the Company. Following the Conversion Date, the Management Committee shall consist of nine Managers, three of whom shall be appointed by ADMI, four of whom shall be appointed by UST, one of whom shall be appointed by ADMI and UST as mutually agreed upon, and one of whom shall be the Chief Executive Officer of the Company. Subject to the limitations of Section 8.9, the Management Committee shall have the exclusive power and authority to conduct the business of the Company. In conducting the business of the Company, the Management Committee shall have all rights, duties and powers conferred by the Act, except as limited hereby. The Management Committee is hereby expressly authorized on behalf of the Company to make all decisions with respect to the Company's business and to take all actions necessary to carry out such decisions. No actions shall be taken, nor any decisions made, by any Manager or officer of the Company without the prior approval of, or pursuant to an express delegation of authority by, the Management Committee. Subject to the limitations of Section 8.9 and clauses (b) and (c) below, the act of the majority of the members of the Management Committee shall be the act of the Management Committee. Notwithstanding the foregoing, all documents executed on behalf of the Company need only be signed by a Manager or by an officer of the Company who has been given the power and authority to do so by the Management Committee. (b) The Management Committee shall have the power to appoint individuals to serve as the Chief Executive Officer, Chief Financial Officer and Chief Operating Officer of the Company. In addition, the Management Committee shall have the right to delegate all or portions of its management authority to one or more officers of the Company. Any officer may be removed or its authority withdrawn at any time by the Management Committee. Notwithstanding any other provision of this Operating Agreement to the contrary, until the Conversion Date (i) no individual may be appointed or terminated as Chief Executive Officer, Chief Financial Officer or Chief Operating Officer of the Company without the prior approval of a majority of the Management Committee, which majority shall consist of at least one Manager appointed by UST and at least one Manager appointed by ADMI, and (ii) all determinations as to compensation and benefits to be paid or granted to the Chief Executive Officer, Chief Financial Officer or Chief Operating Officer shall require the approval of a majority of the Management Committee, which majority shall consist of at least one Manager appointed by UST and at least one Manager appointed by ADMI. 8 (c) Until the Conversion Date, without the prior approval of a majority of the Management Committee, which majority shall consist of at least one Manager appointed by UST and at least one Manager appointed by ADMI, the Company may not directly or indirectly through a subsidiary or other controlled entity (i) incur Indebtedness (as defined below) for an amount individually or in the aggregate in excess of $10 million, (ii) issue equity interests or securities for consideration individually or in the aggregate in excess of $10 million, (iii) make any single capital expenditure in excess of $2 million, (iv) acquire or dispose of assets with a value in excess of $2 million in any single transaction, (v) approve or enact any annual budget of the Company or (vi) amend or repeal any material provision of the Company's Operating Agreement. For purposes of this Agreement, "Indebtedness" shall mean with respect to any person, without duplication, all indebtedness in respect of money borrowed, including without limitation, all obligations under capital leases, all synthetic lease obligations, the deferred purchase price of any property or services, the aggregate face amount of all surety bonds, letters of credit, and bankers' acceptances, and all payment and reimbursement obligations in respect thereof whether or not matured, evidenced by a promissory note, bond, debenture or similar written obligation for the payment of money (including reimbursement agreements and conditional sales or similar title retention agreements), including all such items incurred by any partnership or joint venture as to which such person is liable as a general partner or joint venturer, other than trade payables and accrued expenses incurred in the ordinary course of business. 7.2 Management Committee Meetings. (a) The Management Committee will hold regular quarterly meetings without call or notice at such time as will from time to time be fixed by standing resolution of the Management Committee. (b) Special meetings of the Management Committee may be called by any two Managers. All meetings will be held upon 10 days' notice by mail or 72 hours' notice delivered personally or by telephone or facsimile. A notice need not specify the purpose of any meeting. Notice of a special meeting need not be given to any Manager who signs a waiver of notice or a consent to holding the meeting or an approval of the minutes thereof, whether before or after the meeting, or who attends the meeting without protesting, prior to its commencement, the lack of notice to such Manager. All such waivers, consents and approvals will be filed with the Company records or made a part of the minutes of the meeting. (c) Meetings of the Management Committee may be held at any place within or without the State of Delaware that has been designated in the notice of the meeting or at such place as may be approved by the Management Committee. Managers may participate in a meeting through use of conference telephone or similar communications equipment, so long as all Managers participating in such meeting can hear one another. Participation in a meeting in such manner constitutes a presence in person at such meeting. 7.3 Duties. The Managers shall carry out their duties in good faith, in a manner the Managers believe to be in the best interests of the Company, and with such care as an ordinarily prudent person in a like position would use under similar circumstances. A Manager who so 9 performs its duties shall not have any liability by reason of being or having been a Manager of the Company. 7.4 Time Devoted to Business. The Members and the Managers shall devote such time to the business of the Company as they, in their discretion, deem necessary for the efficient carrying on of the Company's business. The Members and the Managers shall at all times be free to engage for their own account in any business that competes with any business of the Company. 7.5 Reliance by Third Parties. No third party dealing with the Company shall be required to ascertain whether any Manager is acting in accordance with the provisions of this Agreement. All third parties may rely on a document executed by a Manager (or an officer duly authorized by the Management Committee to execute such document) as binding the Company. The foregoing provisions shall not apply to third parties who are affiliates of a Member, the Managers, or an officer of the Company. A Manager or officer acting without authority shall be liable to the Members for any damages arising out of its unauthorized actions. 7.6 Resignation. Any Manager may be removed at any time with or without cause by the Member who appointed such Manager. Any Manager may resign at any time by giving written notice to the Members. Unless otherwise specified in the notice, the resignation shall take effect upon receipt by the Members, and the acceptance of the resignation shall not be necessary to make it effective. Upon the resignation, retirement, death or removal of any Manager, the Member who appointed such Manager will nominate and appoint a replacement Manager. 7.7 Transactions Between Company and Managers. The Members hereby acknowledge that the Company may be required to borrow funds from any Manager or such Manager's affiliates, from time to time and at any time, in connection with the business of the Company. Each Manager is hereby authorized, without further approval by the Members, to execute all documents and take all action necessary to consummate any loans, secured and/or unsecured by the assets of the Company, to the Company by such Manager or an affiliate of such Manager, on terms and conditions that are acceptable to such Manager and consistent with the provisions of Section 3.4. In addition, each Manager is hereby authorized to contract and deal with the Company, or cause any person or entity affiliated with such Manager to otherwise contract or deal with the Company, provided such contracts and dealings either are on terms comparable to and competitive with those available to the Company from others dealing at arm's length or are approved by disinterested Members having more than 50% of the Voting Interests of all disinterested Members. 7.8 Reimbursements. Each Manager and each officer shall be reimbursed by the Company for any reasonable out-of-pocket costs incurred on behalf of the Company and a reasonable charge for the cost of general office and administrative overhead attributable to the performance of their duties to the Company, together with reasonable interest that has accrued on such amounts from the date incurred until paid. 10 7.9 Insurance. The Company shall maintain for the protection of the Company and all of its Members such insurance as the Management Committee, in its sole discretion, deems necessary for the operations being conducted. 7.10 Exculpation. The Management Committee and any officer appointed by the Management Committee shall not be liable to the Company or to any Member for any act or failure to act, nor for any errors of judgment, but only for willful misconduct or gross negligence. The Company shall indemnify and hold harmless each member of the Management Committee, each officer and their agents and employees against and from any liability other than such person's willful misconduct or gross negligence. Any such indemnification shall be paid only from the assets of the Company, and no Member, Manager, officer or third party shall have recourse against the personal assets of any Member for such indemnification. 7.11 Informal Action. Any action required or permitted to be taken by the Management Committee may be taken without a meeting if the action is evidenced by a written consent describing the action taken, signed by each member of the Management Committee. Action taken under this section is effective when all members of the Management Committee have signed the consent, unless the consent specifies a different effective date. ARTICLE 8 MEMBERS 8.1 Participation. A Member, in its capacity as a Member, shall take no part in the control, management, direction or operation of the affairs of the Company and shall have no power to bind the Company. 8.2 Quorum. A majority of the outstanding Voting Interests, represented in person or by proxy, shall be necessary to constitute a quorum at meetings of the Members. Each of the Members hereby consents and agrees that one or more Members may participate in a meeting of the Members by means of conference telephone or similar communication equipment by which all persons participating in the meeting can hear one another at the same time, and such participation shall constitute presence in person at the meeting. If a quorum is present, the affirmative vote of the majority of the Voting Interests represented at the meeting and entitled to vote on the subject matter shall be the act of the Members, unless a greater number is required by the Act. In the absence of a quorum, those present may adjourn the meeting for any period, but in no event shall such period exceed 60 days. 8.3 Informal Action. Any action required or permitted to be taken at a meeting of the Members may be taken without a meeting if the action is evidenced by a written consent describing the action taken, signed by each Member entitled to vote. Action taken under this section is effective when all Members entitled to vote have signed the consent, unless the consent specifies a different effective date. 11 8.4 Meetings. Meetings of the Members for any purpose or purposes may be called by the Management Committee or by holders of not less than 10% of all Voting Interests. The place of meeting shall be the registered office of the Company. 8.5 Notice of Meeting. Written notice stating the place, day and hour of the meeting of the Members and the purpose or purposes for which the meeting is called, shall be delivered either personally or by mail, by or at the direction of the Management Committee or other person calling the meeting, to each Member of record entitled to vote at such meeting. If mailed, such notice shall be deemed delivered as provided in the Act. Waiver of notice and actions taken at a meeting shall be effective as provided in the Act. 8.6 Proxies. At all meetings of Members, a Member may vote in person or by proxy executed in writing by the Member or by his duly authorized attorney-in-fact. Such proxy shall be filed with the Management Committee before or at the time of the meeting. No proxy shall be valid after eleven months from the date of its execution, unless otherwise provided in the proxy. 8.7 Conduct of Meeting. At each meeting of the Members, a Chairman for that particular meeting shall be elected. The Chairman shall be the Member in attendance who has received the vote of the majority of the Voting Interests represented at the meeting. The Chairman shall preside over and conduct the meeting and shall appoint someone in attendance to make accurate minutes of the meeting. Following each meeting, the minutes of the meeting shall be sent to the Management Committee and each Member. 8.8 Tax Matters Member. UST is hereby designated as the tax matters Member for the Company pursuant to section 6231(a) of the Code. UST is authorized to perform, on behalf of the Company or any Member, any act that may be necessary to make this designation effective. 8.9 Minority Protections. Notwithstanding any other provision of this Operating Agreement to the contrary, without the approval of ADMI or its successor, until such time as ADMI (a) holds less than 10% of the voting equity of the Company on a fully diluted basis or (b) sells or otherwise transfers to a non-affiliate more than 50% of its equity holdings in the Company as of June 21, 2000, the Company may not (i) authorize (w) a liquidation, dissolution winding up of the affairs of the Company (or any of its subsidiaries), (x) a recapitalization or reorganization of the Company that would be reasonably likely to have a material adverse effect on ADMI's (1) Units, (2) Capital Account, (3) relative rights or obligations under this Agreement or (4) status as a Member generally, (y) a Change in Ownership (as defined below), or (z) a Fundamental Change (as defined below); (ii) permit any subsidiary to issue or sell, or obligate itself to issue or sell, except to the Company or any wholly-owned subsidiary of the Company, any capital stock of such subsidiary in excess of 20% in the aggregate of the outstanding capital stock of such subsidiary on a fully diluted basis as of the date hereof (as the same may be adjusted by any transaction approved by ADMI); 12 (iii) permit the Company or any of its subsidiaries to enter into any agreement for the acquisition of any business through purchase of assets, purchase of stock, licensing arrangement or otherwise involving consideration of $100,000,000 or more; (iv) increase or decrease the outstanding equity ownership available in the Company, or authorize the same, other than additional issuances of equity (or a reduction in the amount of outstanding equity) not to exceed 20% in the aggregate of the outstanding equity of the Company on a fully diluted basis as of the date hereof (as the same may be adjusted by any transaction approved by ADMI); (v) authorize the issuance or restructuring of any debt securities of the Company or any of its subsidiaries or otherwise incur Indebtedness directly or through a subsidiary, including increases to any revolving line of credit maximum limits, other than (1) purchase money indebtedness, (2) nonrecourse indebtedness on receivables and (3) unsecured indebtedness in an aggregate amount not to exceed $75,000,000; (vi) authorize the payment of any dividends or distributions, except as may be required to allow for the payment of taxes when due attributable to a Member as the result of the allocation of income in accordance with the terms of this Agreement; (vii) enter into any transaction with an affiliate with an aggregate transaction value (based on goods or services provided or received or to be provided or received) in excess of $25,000,000; (viii) increase or decrease the authorized size of the Company's Management Committee or alter the representative composition thereof; (ix) increase the equity interests available to employees, advisors, management or consultants in excess of 10% in the aggregate of the outstanding equity of the Company on a fully diluted basis as of the date hereof (as the same may be adjusted by any transaction approved by ADMI); or (x) amend or repeal any provision of the Company's Operating Agreement that would be reasonably likely to have a material adverse effect on ADMI's (w) Units, (x) Capital Account, (y) relative rights or obligations under this Agreement or (z) status as a Member generally. For purposes of clauses (i) and (x) of this Section 8.9, any alteration of the Company's Operating Agreement that would be reasonably likely to have an adverse financial impact to ADMI shall be deemed material. For purposes of this Section 8.9: (1) "Change in Ownership" means any sale, transfer or issuance or series of sales, transfers and/or issuances of equity interests in the Company by the Company or any holders thereof which results in any Person or group of Persons (as the term "group" is used under the Securities Exchange Act of 1934, as amended), other than the holders of 13 equity interests as of June 21, 2000, owning equity interests of the Company possessing the voting power (under ordinary circumstances) to elect at least 50% of the Company's Management Committee; (2) "Fundamental Change" means (A) any sale or transfer of more than 50% of the assets of the Company and its subsidiaries on a consolidated basis (measured either by book value in accordance with generally accepted accounting principles consistently applied or by fair market value determined in the reasonable good faith judgment of the Management Committee) in any transaction or series of transactions (other than sales in the ordinary course of business), and (B) any merger or consolidation to which the Company is a party, except for a merger in which the Company is the surviving entity, the terms of the outstanding equity interests of all holders thereof are not changed and none of the outstanding equity interests are exchanged for cash, securities or other property, and after giving effect to such merger, the holders of the Company's outstanding equity interests possessing the voting power (under ordinary circumstances) to elect a majority of the Company's Management Committee immediately prior to the merger shall continue to own the Company's outstanding equity interests possessing the voting power (under ordinary circumstances) to elect a majority of the Company's Management Committee; (3) "Person" means an individual, a partnership, a corporation, a limited liability company, a limited liability partnership, an association, a joint stock company, a trust, a joint venture, an unincorporated organization and a governmental entity or any department, agency or political subdivision thereof; and (4) "subsidiary" means, with respect to any Person, any other Person of which securities or other ownership interests having ordinary voting power to elect a majority of the board of directors or other persons performing similar functions are at the time directly or indirectly owned by the Person. Notwithstanding any other provision of this Operating Agreement to the contrary, all rights of ADMI or its successors under this Section 8.9 shall lapse upon the completion by the Company of an initial public offering of its equity securities in accordance with the rules and regulations of the Securities Act of 1933, as amended, by means of an effective registration statement under Form S-1 (or any successor form thereto). ARTICLE 9 ACCOUNTING AND REPORTING 9.1 Books. The Management Committee shall maintain complete and accurate books of account at the registered office of the Company. The Management Committee shall provide any Member any information requested relating to the business of the Company. During ordinary business hours any Member or its authorized representative shall have access to all books, records and materials regarding the Company and its activities. 9.2 Capital Accounts. The Management Committee shall maintain a separate capital account for each Member in accordance with the Treasury Regulations under section 704(b) of the Code and such other accounts as may be necessary or desirable to comply with the requirements of applicable laws and regulations. 9.3 Transfers During Year. In order to avoid an interim closing of the Company's books, the share of profits and losses under Article 5 of a Member who transfers part or all of its interest in the Company during the Company's accounting year may be determined by taking its 14 pro rata share of the amount of such profits and losses for the year. The proration shall be based on the portion of the Company's accounting year that has elapsed prior to the transfer or may be determined under any other reasonable method; provided, however, that any gain or loss from the sale of Company assets shall be allocated to the owner of the Company interest at the time of such sale. The balance of the profits and losses attributable to the Company interest transferred shall be allocated to the transferee of such interest. 9.4 Reports. The books of account shall be closed promptly after the end of each fiscal year. As soon as practicable thereafter, the Management Committee shall deliver a written report to each Member, which shall include a statement of receipts, expenditures, profits and losses for the year, a statement of each Member's capital account and such additional statements with respect to the status of the Company's assets and the distribution of Company funds as are necessary to advise the Members properly about their investment in the Company. Prior to March 15th of each year, the Members shall also be provided with a copy of the Company federal income tax return (Form 1065) to be filed for the preceding year. 9.5 Section 754 Election. If requested by a Member the Company shall make the election provided for under section 754 of the Code. Any costs attributable to making such election shall be borne solely by the requesting Member. ARTICLE 10 TRANSFERS; RIGHT OF FIRST REFUSAL 10.1 Additional Members. Additional Members shall not be admitted to the Company without the written consent of Members having a Voting Interest of more than 50%. 10.2 Offer to Other Members. If at any time any Member proposes to sell, assign or otherwise transfer all or any part of its interest in the Company, such Member ("Offeror") shall first make a written offer to sell such interest in the Company to the other Members on the same terms and subject to the same conditions as those on which the Offeror proposes to transfer the interest in the Company. Such offer shall state the name of the proposed transferee and all the terms and conditions of the proposed transfer, including the price to the proposed transferee. Notwithstanding anything in this Section 10.2 to the contrary, any Member shall be free to transfer all or any portion of its interest in the Company free of the right of first refusal provided that such Member transfers its interest to an entity controlled by the transferor. A transferee of a Member pursuant to the foregoing sentence shall be subject to the right of first refusal contained in this Section 10.2. 10.3 Acceptance of Offer. The other Members shall have the right for a period of 30 days after receipt of the offer from the Offeror, or such longer period as may be required under Section 10.5, to elect to purchase all of the interest in the Company offered. In exercising their right to purchase, the other Members may divide the interest offered in any manner to which they all agree and in the absence of agreement the offered interest shall be divided among the Members in proportion to the relative Sharing Ratios of the Members who choose to participate. To exercise their rights to purchase, the other Members shall give written notice to 15 the Offeror. Upon the exercise of a right to purchase and provided the right is exercised with respect to all of the interest in the Company offered, the purchase shall be closed and payment made on the same terms and conditions as those on which the Offeror proposes to transfer the interest in the Company. 10.4 Failure to Accept Offer. If the other Members do not elect to purchase all of the interest in the Company offered, the Offeror may transfer the offered interest to the proposed transferee named in the offer to the Company. However, if that transfer is not made within 90 days after the end of the period provided for in Section 10.3, a new offer shall be made to the other Members and the provisions of Sections 10.1, 10.2 and 10.3 shall again apply. 10.5 Cash Equivalents. If the proposed offer under Section 10.2 is for consideration other than cash or cash plus deferred payments of cash, the purchasing Members may pay the present value cash equivalent of such other consideration or may pay using the same instrument as contemplated by the proposed offer. The Offeror and the purchasing Members shall attempt to agree upon a cash equivalent of such other consideration. If they cannot agree within 20 days after the beginning of the 30-day period under Section 10.3, any of such Members may, by five days' written notice to the others, initiate arbitration proceedings for determination of the cash equivalent without regard to income tax consequences to the Offeror as a result of receiving cash rather than the other consideration. The purchasing Members may elect to purchase the interest at the determined cash equivalent by notice of such election to the Offeror within 10 days after the arbitrator's decision. 10.6 Direct and Indirect Transfers. For purposes of this agreement, restrictions upon the sale, assignment or other transfer of a Member's interest shall extend to any direct or indirect transfer including, without limitation, an involuntary transfer such as a transfer pursuant to a foreclosure sale or a transfer resulting by operation of law. 10.7 Substitution of a Member. (a) No assignee, legatee, or transferee (by conveyance, operation of law or otherwise) of the whole or any portion of a Member's interest in the Company shall have the right to become a substituted Member without the written consent of Members other than the assignor, legator or transferor, as the case may be, having a Voting Interest of more than 50%. The granting or denial of a request for such written consent shall be within the absolute discretion of each Member. A substituted Member shall succeed to all the rights and interest of its assignor in the Company. An assignee of a Member that is not admitted as a Member shall be entitled only to the distributions to which its assignor would otherwise be entitled. (b) If a Member shall be dissolved, merged or consolidated, its successor in interest shall have the same rights and obligations that such Member would have had if it had not been dissolved, merged or consolidated, except that the successor shall not become a substituted Member without the prior written consent of Members other than the predecessor Member having a Voting Interest of more than 50%. 16 (c) As conditions to its substitution as a Member (a) any successor of a Member shall execute and deliver such instruments, in form and substance satisfactory to the Management Committee, as the Management Committee shall deem necessary, and (b) such successor shall pay all reasonable expenses in connection with its admission as a substituted Member. 10.8 Conditions to Transfer. No transfer of any interest in the Company otherwise permitted under this agreement shall be effective for any purpose whatsoever until the transferee shall have assumed the transferor's obligations to the extent of the interest transferred and shall have agreed to be bound by all the terms and conditions hereof, by written instrument, duly acknowledged, in form and substance reasonably satisfactory to the Management Committee. ARTICLE 11 TAG-ALONG RIGHTS Subject to the provisions of Section 10, in the event a Member (an "Offering Member") intends to transfer all or any part of its interest in the Company (also referred to as "Offered Interests"), such Offering Member shall notify each other Member who has a Sharing Ratio of more than 10%, in writing, of such proposed transfer and its terms and conditions, including, without limitation, (i) its bona fide intention to sell or transfer the Offered Interests, (ii) the number and class of Units of Offered Interests to be transferred, (iii) the price and terms, if any, for which it proposes to transfer the Offered Interests and (iv) the name and address of the proposed purchaser or transferee and that such purchaser or transferee is committed to acquire the stated number of Units on the stated price and terms ("Offering Member Notice"). Within ten days of the date of such notice, each Member (other than the Offering Member) shall notify the Offering Member in writing (the "Co-Sale Notice") if it elects to participate in such transfer. Each Member that so notifies the Offering Member shall have the right to sell, at the same price and on the same terms as the Offering Member, an amount of Units equal to the Units the third party proposes to purchase multiplied by a fraction, the numerator of which shall be the number of Units owned by such Member and the denominator of which shall be the aggregate number of Units owned by the Offering Member and each Member exercising its rights under this Section 11. Nothing contained in this Section 11 shall in any way limit or restrict the Offering Member's ability to amend, modify or terminate any agreement with a third party with respect to any transfer of its Units pursuant to this Section 11, and the Offering Member shall have no liability to any Member with respect to such amendment, modification or termination unless any of the foregoing breaches this Agreement. If no Co-Sale Notice is received during the ten-day period referred to above (or if the Co-Sale Notice does not cover all of the Units proposed to be transferred), the Offering Member shall have the right, for a sixty-day period after the expiration of the ten-day period referred to above, to transfer the Units so specified in the Offering Member Notice (or the remaining Units) at the same or a lower price and on other terms and conditions no more favorable than those stated in the Offering Member Notice. 17 ARTICLE 12 TERM Subject to Section 8.9, the Company shall continue until dissolved by the written consent of Members having a Voting Interest of more than 50% or upon sale of all or substantially all of its assets. ARTICLE 13 INITIAL PUBLIC OFFERING 13.1 Conversion to Corporation. If the Company decides to initiate an initial public offering, and if that decision requires that the Company be restructured into a corporation (the "Resulting Corporation"), then, subject to the approval of the Management Committee pursuant to Section 7.1: (a) the Resulting Corporation will be organized and incorporated under the Laws of the State of Delaware; (b) the Certificate of Incorporation and Bylaws of the Resulting Corporation will include standard and customary provisions as will then be applicable to public corporations incorporated under the Laws of the State of Delaware, and such other provisions as may be agreed upon by the Management Committee; and (c) the Members and the Company will negotiate in good faith with the intent of entering into a shareholders' agreement that will contain customary provisions, including "tag along" rights. ARTICLE 14 DISSOLUTION AND TERMINATION 14.1 Final Accounting. In case of the dissolution of the Company, a proper accounting shall be made as provided in Section 9.4 from the date of the last previous accounting to the date of dissolution. 14.2 Liquidation. Upon the dissolution of the Company, the Management Committee shall select a person to act as liquidator to wind up the Company. The liquidator shall have full power and authority to sell, assign and encumber any or all of the Company's assets and to wind up and liquidate the affairs of the Company in an orderly and businesslike manner. All proceeds from liquidation shall be distributed in the following order of priority: (i) to the payment of debts and liabilities of the Company and the expenses of liquidation; (ii) to the setting up of such reserves as the liquidator may reasonably deem necessary for any contingent liabilities of the Company; and (iii) to the Members in accordance with Article 4. 14.3 Distribution in Kind. If the liquidator shall determine that a Company asset should be distributed in kind, the liquidator shall obtain an independent appraisal of the fair market value of the asset as of a date reasonably close to the date of liquidation. Any unrealized appreciation or depreciation with respect to such asset shall be allocated among the Members (in 18 accordance with the provisions of Article 5 assuming that the asset was sold for the appraised value) and taken into consideration in determining the balance in the Members' capital accounts as of the date of liquidation. Distribution of any such asset in kind to a Member shall be considered a distribution of an amount equal to the asset's fair market value for purposes of Section 14.2. The liquidator, in its sole discretion, may distribute any percentage of any asset in kind to a Member even if such percentage exceeds the percentage in which the Member shares in distributions as long as the sum of the cash and fair market value of all the assets distributed to each Member equals the amount of the distribution to which each Member is entitled. 14.4 Waiver of Right to Court Decree of Dissolution. The Members agree that irreparable damage would be done to the Company if any Member brought an action in court to dissolve the Company. Accordingly, each of the Members accepts the provisions of this Agreement as its sole entitlement on termination of the Member's membership in the Company. Each Member hereby waives and renounces all rights to seek a court decree of dissolution or to seek the appointment by a court of a liquidator for the Company. 14.5 Articles of Dissolution. Upon the completion of the distribution of Company assets as provided in this Article 14, the Company shall be terminated and the person acting as liquidator shall file articles of dissolution and shall take such other actions as may be necessary to terminate the Company. ARTICLE 15 NOTICES 15.1 Method of Notices. All notices required or permitted by this agreement shall be in writing and shall be hand delivered or sent by registered or certified mail, postage prepaid, and shall be effective when received or, if mailed, on the date set forth on the receipt of registered or certified mail, or on the fifth day after mailing, whichever is earlier. 15.2 Computation of Time. In computing any period of time under this agreement, the day of the act, event or default from which the designated period of time begins to run shall not be included. The last day of the period so computed shall be included, unless it is a Saturday, Sunday or legal holiday, in which event the period shall run until the end of the next day which is not a Saturday, Sunday or legal holiday. ARTICLE 16 INVESTMENT REPRESENTATIONS 16.1 Investment Purpose. In acquiring an interest in the Company, each Member represents and warrants to the Company that it is acquiring such interest for its own account for investment and not with a view to its sale or distribution. Each Member recognizes that investments such as those contemplated by the Company are speculative and involve substantial risk. Each Member further represents and warrants that it has not received any guaranty or 19 representation upon which it has relied concerning the possibility or probability of profit or loss as a result of its acquisition of an interest in the Company. 16.2 Investment Restriction. Each Member recognizes that: (a) its Units have not been registered under the Securities Act of 1933, as amended, in reliance upon an exemption from such registration, (b) a Member may not sell, offer for sale, transfer, pledge or hypothecate all or any part of its interest in the Company in the absence of an effective registration statement covering such interest under the Securities Act of 1933, as amended, unless such sale, offer of sale, transfer, pledge or hypothecation is exempt from registration under the Securities Act of 1933, as amended, (c) the Company has no obligation to register any Member's interest for sale, or to assist in establishing an exemption from registration for any proposed sale, and (d) the restrictions on transfer may severely affect the liquidity of a Member's investment. ARTICLE 17 GENERAL PROVISIONS 17.1 Entire Agreement. This Agreement embodies the entire understanding and agreement among the parties concerning the Company and supersedes any and all prior negotiations, understandings or agreements in regard thereto. 17.2 Amendment. Except as otherwise specifically provided in this Agreement, this Agreement may not be amended nor may any rights hereunder be waived except by an instrument in writing signed by Members having a Voting Interest of more than 50% in the aggregate. 17.3 Applicable Law. This Agreement shall be construed in accordance with and governed by the laws of the State of Delaware. 17.4 Pronouns. References to a Member, including by use of a pronoun, shall be deemed to include masculine, feminine, singular, plural, individuals, partnerships, corporations or other legal entities where applicable. 17.5 Counterparts. This instrument may be executed in any number of counterparts each of which shall be considered an original. * * * * * * * [SIGNATURE PAGE FOLLOWS] 20 IN WITNESS WHEREOF the parties have executed this Agreement effective as of the date first above written. ANSCHUTZ DIGITAL MEDIA, INC. By: --------------------------------- Name: Craig D. Slater Title: Vice President U.S. TELESOURCE, INC. By: --------------------------------- Name: Marc B. Weisberg Title: President and Chief Executive Officer S-1 -----END PRIVACY-ENHANCED MESSAGE-----