-----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, OBlzP0rHlDQBrM6c4uqQ/dRo1ftr14T1sYH8Z8iSIIyHnH7RKExiUYCNLhRmF3F+ JMqoo++Zqril2g+1ZlUXhw== 0001021408-02-007169.txt : 20020515 0001021408-02-007169.hdr.sgml : 20020515 20020515133143 ACCESSION NUMBER: 0001021408-02-007169 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20020331 FILED AS OF DATE: 20020515 FILER: COMPANY DATA: COMPANY CONFORMED NAME: US LEC CORP CENTRAL INDEX KEY: 0001054290 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 562065535 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-24061 FILM NUMBER: 02650338 BUSINESS ADDRESS: STREET 1: 401 N TRYON ST STREET 2: STE 1000 CITY: CHARLOTTE STATE: NC ZIP: 28251 MAIL ADDRESS: STREET 1: 401 N. TRYON STREET STREET 2: SUITE 1000 CITY: CHARLOTTE STATE: NC ZIP: 28202 10-Q 1 d10q.txt US LEC FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934 For the quarterly period ended March 31, 2002 Commission file number 0-24061 US LEC Corp. ----------- (Exact name of registrant as specified in its charter) Delaware 56-2065535 -------- ---------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) Morrocroft III, 6801 Morrison Boulevard Charlotte, North Carolina 28211 (Address of principal executive offices)(Zip Code) (704) 319-1000 (Registrant's telephone number, including area code) Not Applicable -------------- (Former name, former address and former fiscal year, if changed since last report) 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 (____) --- - ------------------------------------------------------------------------------- As of May 14, 2002, there were 26,388,672 shares of Class A Common Stock outstanding. US LEC Corp. Table of Contents -----------------
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Condensed Consolidated Statements of Operations - Three months ended March 31, 2002 and 2001 Condensed Consolidated Balance Sheets - March 31, 2002 and December 31, 2001 Condensed Consolidated Statements of Cash Flows - Three months ended March 31, 2002 and 2001 Condensed Consolidated Statement of Stockholders' Deficiency - Three months ended March 31, 2002 Notes to Condensed Consolidated Financial Statements ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ITEM 3. DEFAULTS UPON SENIOR SECURITIES ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ITEM 5. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K SIGNATURES
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS US LEC Corp. and Subsidiaries Condensed Consolidated Statements of Operations (In Thousands, Except Per Share Data) (Unaudited)
Three months ended March 31, 2002 2001 Revenue, Net $ 53,938 $ 38,055 Cost of Services 27,283 19,171 -------- --------- Gross Margin 26,655 18,884 Selling, General and Administrative Expenses 25,928 24,228 Depreciation and Amortization 10,553 7,775 -------- --------- Loss from Operations (9,826) (13,119) Other (Income) Expense Interest Income (332) (1,248) Interest Expense 2,233 3,228 -------- --------- Loss Before Income Taxes (11,727) (15,099) Income Tax Benefit - - -------- --------- Net Loss (11,727) (15,099) Preferred Stock Dividends 3,324 3,131 Preferred Stock Accretion of Issuance Costs 127 120 -------- --------- Net Loss Attributable to Common Stockholders $(15,178) $ (18,350) ======== ========= Net Loss Per Common Share: Basic and Diluted $ (0.58) $ (0.66) ======== ========= Weighted Average Number of Shares Outstanding: Basic and Diluted 26,388 27,768 ======== =========
See notes to condensed consolidated financial statements US LEC Corp. and Subsidiaries Condensed Consolidated Balance Sheets (In Thousands, Except Per Share Data)
(Unaudited) March 31, December 31, 2002 2001 ------------- ------------- Assets Current Assets Cash and cash equivalents $ 66,783 $ 80,502 Restricted cash 1,300 1,300 Accounts receivable (net of allowance of $12,099 and $12,263 at March 31, 2002 and December 31, 2001, respectively) 48,189 42,972 Deferred income taxes 1,756 1,840 Prepaid expenses and other assets 8,008 9,030 ------------- ------------- Total current assets 126,036 135,644 Property and Equipment, Net 188,816 188,436 Other Assets 9,123 9,233 ------------- ------------- Total Assets $ 323,975 $ 333,313 ============= ============= Liabilities and Stockholders' Deficiency Current Liabilities Accounts payable $ 11,278 $ 10,747 Accrued network costs 20,615 17,877 Commissions payable 7,672 6,679 Accrued expenses - other 11,891 14,928 Deferred revenue 7,411 6,691 Current portion of long-term debt 23,438 18,750 ------------- ------------- Total current liabilities 82,305 75,672 ------------- ------------- Long-Term Debt 126,562 131,250 Deferred income taxes 1,756 1,840 Other Liabilities - Noncurrent 6,117 5,721 Series A Redeemable Convertible Preferred Stock (see Note 6) 219,606 216,155 Stockholders' Deficiency Common stock-Class A, $.01 par value (122,925 authorized shares, 26,389 outstanding at March 31, 2002 and December 31, 2001, respectively) 264 264 Additional paid-in capital (see Note 8) 76,422 76,421 Accumulated Deficit (187,955) (172,777) Unearned compensation - stock options (1,102) (1,233) ------------- ------------- Total stockholders' deficiency (112,371) (97,325) ------------- ------------- Total Liabilities and Stockholders' Deficiency $ 323,975 $ 333,313 ============= =============
See notes to condensed consolidated financial statements 4 US LEC Corp. and Subsidiaries Condensed Consolidated Statements of Cash Flows (In Thousands) (Unaudited)
Three Months Ended March 31, ---------------------- 2002 2001 Operating Activities Net Loss $ (11,727) $ (15,099) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 10,553 7,775 Loss on resolution of disputed revenue - - Accounts receivable allowance (164) 538 Deferred compensation 131 45 Changes in operating assets and liabilities: Accounts receivable (5,052) (10,309) Prepaid expenses and other assets 1,022 (3,346) Other assets (94) (715) Accounts payable (91) (955) Deferred revenue 720 1,468 Accrued network costs 2,738 232 Customer commissions payable 993 1,471 Accrued expenses - other (2,820) (1,232) --------- ---------- Total adjustments 7,936 (5,028) --------- ---------- Net cash used in operating activities (3,791) (20,127) --------- ---------- Investing Activities Purchase of property and equipment (9,930) (15,904) --------- ---------- Net cash used in investing activities (9,930) (15,904) --------- ---------- Financing Activities Contribution to capital 2 - Payment of loan fees - (55) --------- ---------- Net cash provided (used) by financing activities 2 (55) --------- ---------- Net Decrease in Cash and Cash Equivalents (13,719) (36,086) Cash and Cash Equivalents, Beginning of Period 80,502 105,821 Cash and Cash Equivalents, End of Period $ 66,783 $ 69,735 ========= ========== Supplemental Cash Flow Disclosures Cash Paid for Interest $ 2,499 $ 3,531 ========= ==========
See notes to condensed consolidated financial statements 5 US LEC Corp. and Subsidiaries Condensed Consolidated Statement of Stockholders' Deficiency For the Three Months Ended March 31, 2002 (In Thousands) (Unaudited)
Class A Additional Accumulated Unearned Common Stock Paid-in Capital Deficit Compensation Total ------------- --------------- ------------ ------------- ---------- Balance, December 31, 2001 $ 264 $ 76,421 $(172,777) $ (1,233) $ (97,325) Exercise of stock options and warrants - 1 - - 1 Unearned Compensation - Stock Options - - - 131 131 Preferred Stock Dividends - - (3,324) - (3,324) Accretion of Preferred Stock Issuance Fees - (127) - (127) Net Loss - - (11,727) - (11,727) --------- --------- --------- --------- --------- Balance, March 31, 2002 $ 264 $ 76,422 $(187,955) $ (1,102) $(112,371) ========= ========= ========= ========= =========
See notes to condensed consolidated financial statements US LEC Corp. and Subsidiaries Notes to Condensed Consolidated Financial Statements (In Thousands, Except Per Share Data) (Unaudited) 1. Basis of Presentation and Significant Accounting Policies The accompanying unaudited condensed consolidated financial statements of US LEC Corp. and its subsidiaries ("US LEC" or the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated by the United States Securities and Exchange Commission (the "SEC"). Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation for the periods indicated have been included. Operating results for the three month period ended March 31, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. The balance sheet at December 31, 2001 has been derived from the audited balance sheet at that date, but does not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2001, which is on file with the SEC. Revenue Recognition - The Company recognizes revenue on telecommunications and enhanced communications services in the period that the service is provided. Revenue is recognized when earned based upon the following specific criteria: (1) persuasive evidence of arrangement exists (2) services have been rendered (3) seller's price to the buyer is fixed or determinable and (4) collectibility is reasonably assured. Reciprocal compensation that is earned as revenue from other local exchange carriers represents compensation for local telecommunications traffic terminated on our network that originates on another carrier's network. To date, a majority of our reciprocal compensation revenue has been generated from traffic originated by customers of BellSouth Telecommunications, Inc. ("BellSouth"). The billing, payment and other arrangements for this reciprocal compensation are governed by interconnection agreements between BellSouth and the Company as well as orders of the FCC and PUC's. Revenues are recorded net of amounts that are due to a customer or outside sales agent pursuant to each respective telecommunications service contract. Early termination fees are recognized when paid and revenue related to billings in advance of providing services is deferred and recognized when earned. The Company defers installation revenue from contracts with end customers and with other carriers. The Company is amortizing this revenue over the average life of the related contract. Cost of Services - the Company defers installation charges from ILECs related to new customers contracts associated with Network and end customer facilities. The Company is amortizing these costs over the average life of the related contracts. The Company's cost of services is comprised primarily of two types of charges: leased transport charges which comprise approximately three-quarters of the Company's cost of services and usage sensitive charges (primarily usage charges associated with the Company's off net toll and toll free services and access and reciprocal compensation charges owing to other carriers) which comprise approximately one-quarter of the Company's cost of services. The Company's leased transport charges are the lease payments incurred by US LEC for the transmission facilities used to connect the Company's customers to the Company owned switch that 7 services that customer and to connect to the ILEC and other carrier networks. US LEC, as part of its "smart-build" strategy, does not currently own any fiber or copper transport facilities. These facilities are leased from various providers including, in many cases, the ILEC. The Company's strategy of leasing rather than building its own fiber transport facilities results in the Company's cost of services being a significant component of total costs. Management believes that this strategy has several benefits, including faster time-to-market, more efficient asset utilization, and diverse interconnection opportunities. The Company has to date been successful in negotiating lease agreements which generally match in the aggregate the duration of its customer contracts, thereby allowing the Company to mitigate the risk of incurring charges associated with transmission facilities that are not being utilized by customers. Cash and Cash Equivalents - Cash equivalents consist of highly liquid investments with original maturities of three months or less at the time of purchase. Property and Equipment - Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, except for leasehold improvements as noted below. The estimated useful lives of the Company's principal classes of property and equipment are as follows: Telecommunications switching and other equipment 5 - 9 years Office equipment, furniture and other 5 years Leasehold improvements The lesser of the estimated useful lives or the lease term
The Company capitalizes payroll related costs in accordance with the AICPA Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." Long-Lived Assets - The Company reviews the carrying value of its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. Measurement of any impairment would include a comparison of estimated undiscounted future operating cash flows anticipated to be generated during the remaining life of the assets with their net carrying value. An impairment loss would be recognized as the amount by which the carrying value of the assets exceeds their fair value. Accrued Network Costs - Accrued network costs include management's estimate of charges for direct access lines, facility charges, outgoing and incoming minutes, reciprocal compensation and other costs of revenue for a given period for which bills have not yet been received by the Company. Management's estimate is developed from the number of lines and facilities in service, minutes of use and contractual rates charged by each respective service provider. Subsequent adjustments to this estimate may result when actual costs are billed by the service provider to the Company. However, management does not believe such adjustments will be material to the Company's financial statements. Debt Issuance Cost - The Company capitalizes loan fees associated with securing long-term debt and amortizes such deferred loan fees over the term of the debt agreement. The Company has deferred loan fees recorded in other assets on the accompanying consolidated balance sheets that are being amortized over the life of the related debt agreement. Fair Value of Financial Instruments - Management believes the fair values of the Company's financial instruments, including cash equivalents, restricted cash, accounts receivables, and accounts payable approximate their carrying value. In addition, because the long-term debt consists of variable rate instruments, their carrying values approximate fair values. 8 Income Taxes - Income taxes are provided for temporary differences between the tax and financial accounting basis of assets and liabilities using the liability method. The tax effects of such differences, as reflected in the balance sheet, are at the enacted tax rates expected to be in effect when the differences reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized and are reversed at such time that realization is believed to be more likely than not. Concentration of Risk - The Company is exposed to concentration of credit risk principally from trade accounts receivable due from end customers and carriers. The Company's end customers are located in the southeastern and mid-Atlantic United States. The Company performs ongoing credit evaluations of its end customers but does not require collateral deposits from a majority of its end customers. The Company is exposed to additional credit risk due to the fact that the Company's most significant trade receivables are from large telecommunications entities. The Company is dependent upon certain suppliers for the provision of telecommunications services to its customers. The Company has executed interconnection agreements for all states in which it operates. Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. Significant estimates relate to the allowance for doubtful accounts receivable, estimated end customer contract life, accrual of network costs payable to other telecommunications entities, income tax valuation allowance, and estimated useful lives of fixed assets. Any difference between the amounts recorded and amounts ultimately realized or paid will be adjusted prospectively as new facts become known. Effect of Recent Accounting Pronouncements - SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supersedes SFAS 121, "Accounting for Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to be Disposed of," but retains many of its fundamental provisions, expands the scope of discontinued operations to include more disposal transactions. SFAS No. 144 is effective for the Company for financial statements issued for the fiscal year beginning January 1, 2002. The Company has evaluated the effect the statement will have on its consolidated financial statements and related disclosures and does not believe that the effect will be material. 2. Restricted Cash The restricted cash balance as of March 31, 2002 and December 31, 2001 serves as collateral for letters of credit related to certain office leases. 3. Net Loss Per Common and Common Equivalent Share Net loss per common and common equivalent share are based on net loss, after consideration of preferred stock dividends and the accretion of preferred stock issuance costs, divided by the weighted average number of common shares outstanding during the period. Outstanding options and warrants are included in the calculation of dilutive earnings per common share to the extent they are dilutive. 4. Income Taxes Income taxes are provided for temporary differences between the tax and financial accounting basis of assets and liabilities using the liability method. The tax effects of such differences, as reflected in the balance sheet, are at the enacted tax rates expected to be in effect when the differences reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized and are reversed at such time that realization is believed to be more likely than not. 9 5. Long-Term Debt The Company's senior secured loan agreement, as amended, is comprised of (i) a $125,000 credit facility that converted into a six-year term loan as of June 30, 2001 and (ii) a $25,000 revolving credit facility that matures in December 2005. The Company made its first amortization payment under the term loan on April 1, 2002 of $4,688. The interest rate for the facility is a floating rate based, at the Company's option, on a base rate (as defined in the loan agreement) or the London Interbank Offered Rate ("LIBOR"), plus a specified margin. The amount outstanding under the credit facility at March 31, 2002, was $150,000, of which $23,438 is classified as current on the Company's condensed consolidated balance sheet. Advances under the agreement as of March 31, 2002 bear interest at an average annual rate of 5.9%. The Company's credit facility is subject to certain financial covenants, measured quarterly, the most significant of which relates to the achievement of increasing levels of revenue and earnings and debt ratios. The Company was in compliance with these covenants as of the quarter ended March 31, 2002. Company management believes it will be in compliance with all quarterly financial covenants during 2002 based upon projected operating results. These projected operating results are dependent upon the Company meeting quarterly 2002 targets of new customers, customer retention, customer usage, billing rates, gross margins and SG&A costs, and as a result involve some degree of uncertainty. Should any of these assumptions not be achieved for a particular quarter, it is possible that a financial covenant will not be met during 2002. Although there can be no assurances, Company management believes if this were to occur, it would be able to obtain the necessary waivers or amendments from its lenders. The credit facility is secured by a pledge of the capital stock of the Company's principal operating subsidiaries and a security interest in a substantial portion of the Company's and its operating subsidiaries' equipment, receivables, leasehold improvements and general intangibles. Proceeds from the credit facility have been and will be used to fund capital expenditures and working capital requirements and for other general corporate purposes. 6. Series A Mandatorily Redeemable Convertible Preferred Stock On April 11, 2000, the Company issued $200,000 of its Series A Mandatorily Redeemable Convertible Preferred Stock (the "Series A Preferred Stock") to affiliates of Bain Capital, Inc. ("Bain") and Thomas H. Lee Partners, L.P. ("THL"). The Series A Preferred Stock earns dividends on a cumulative basis at an annual rate of 6%, payable quarterly in shares of Series A Preferred Stock for three years, and at US LEC's option, in cash or shares of Series A Preferred Stock over the next seven years. In addition, the Series A Preferred Stock participates on a pro rata basis in the dividends payable to common shareholders. As of March 31, 2002, the Company had issued $24,892 in shares of Series A Preferred Stock as dividends. In the event of any liquidation, dissolution or other winding up of the affairs of the Company, the holders of Series A Preferred Stock are entitled to be paid in preference to any distribution to holders of junior securities, an amount in cash, equal to $1,000 per share plus all accrued and unpaid dividends on such shares. The holders of Series A Preferred Stock may convert all or a portion of their shares into shares of Class A Common Stock at a set conversion price prior to April 11, 2010 in the event of a change in control or an acquisition event. Each holder of the Series A Preferred Stock may redeem all or a portion of their Series A Preferred Stock at a price equal to 101% of $1,000 per share plus all accrued dividends on such shares after the occurrence of a change in control and for a period of 60 days following such event. At any time on or after April 11, 2003, the Company may redeem all of the outstanding shares of Series A Preferred Stock, at a price equal to $1,000 per share plus all accrued and unpaid dividends on such shares, only if the market price of a share of common stock for 30 consecutive trading days during the 90 day period immediately preceding the date of the notice of redemption is at least 150% of the then effective conversion price and the market price of a share of common stock on the redemption date is also at least 150% of the then effective conversion price. All outstanding shares of the Series A Preferred Stock are subject to mandatory redemption on April 11, 2010. 10 Proceeds to the Company, net of commissions and other transaction costs, were approximately $194,000. The Company incurred $6,240 in expenses related to the issuance of the Series A Preferred Stock. The cost will be accreted against Retained Earnings (Deficit) over the life of the agreement. For the three months ended March 31, 2002, the Company accreted $127 of these costs. As of March 31, 2002, the Company had $5,286 in Series A Preferred Stock issuance costs netted with Series A Mandatorily Redeemable Convertible Preferred Stock on its Consolidated Balance Sheet. 7. Uncertainties and Contingencies The deregulation of the telecommunications industry, the implementation of the Telecom Act on February 8, 1996 and the distress of many carriers in the wake of the downturn in the telecommunications industry have embroiled numerous industry participants, including the Company, in lawsuits, proceedings and arbitrations before state regulatory commissions, private arbitration organizations such as the American Arbitration Association, and courts over many issues important to the financial and operational success of the Company. These issues include the interpretation and enforcement of interconnection agreements, the terms of interconnection agreements the Company may adopt, operating performance obligations, reciprocal compensation, access rates, rates applicable to different categories of traffic and the characterization of traffic for compensation purposes. The Company anticipates that it will continue to be involved in various lawsuits, arbitrations and proceedings over these and other material issues. The Company anticipates also that further legislative and regulatory rulemaking will occur--on the federal and state level--as the industry deregulates and as the Company enters new markets or offers new products. Rulings adverse to the Company, adverse legislation, or changes in governmental policy on issues material to the Company could have a material adverse effect on the Company's financial condition or results of its operations. Reciprocal Compensation - On April 27, 2001, the Federal Communications Commission ("FCC") released an Order on Remand and Report and Order (the "Remand Order") addressing inter-carrier compensation for traffic terminated to Internet service providers ("ISPs"). The interpretation and enforcement of the Remand Order will likely be the most important factor in the Company's efforts to collect reciprocal compensation for ISP-bound traffic in the future. In the Remand Order, the FCC addressed a number of important issues, including the rules under which carriers are to compensate each other for traffic terminated to ISPs and the rates applicable for ISP-bound traffic as well as traffic bound to other customers. While the Remand Order provides greater certainty about the Company's right to bill for traffic terminated to ISPs, the effect of the Remand Order on the Company will depend on how it is interpreted and enforced. In particular, there are uncertainties as to whether the Remand Order has any effect on the Company's pending arbitral, state regulatory commission and judicial proceedings seeking to collect compensation for traffic terminated to ISPs; whether certain provisions of the Remand Order will be applied state-by-state, market-by-market and/or carrier-by-carrier; whether the limitations on growth of ISP traffic in the Remand Order will survive legal challenge; and whether the incumbent carrier will efficiently trigger the rate reductions and other limitations set forth in the Remand Order. On May 3, 2002, the U.S. Court of Appeals for the District of Columbia (the "D.C. Circuit") rejected the FCC's legal analysis in the Remand Order and remanded the order back to the FCC for further review (the "Second Remand"), but the D.C. Circuit did not vacate the Remand Order. As such, the ISP compensation structure established by the FCC in the Remand Order remains in effect. It is unclear at this time whether, how or when the FCC will respond to the Second Remand, how the Second Remand affects pending disputes over reciprocal compensation for ISP traffic, how the Remand Order will be interpreted or whether affected parties will undertake new challenges to the ISP compensation structure established by the Remand Order. 11 If the Remand Order or the Second Remand were to be interpreted in a manner adverse to the Company on all or any of the issues, or if the Remand Order is modified as a result of the Second Remand or other pending or new legal challenges, it could have a material adverse effect on the Company. For a more complete description of the Remand Order, see "Business-Regulation" in the Company's Annual Report on Form 10-K for the year ended December 31, 2001 (the "Form 10-K"). On October 3, 2001 the Company and BellSouth entered into a settlement agreement (the "Settlement Agreement") by which we and BellSouth resolved outstanding reciprocal compensation receivables in the various states in which both of us operate and other past payments. BellSouth agreed to pay US LEC approximately $31,000, in addition to approximately $10,000 it paid in August 2001, to resolve those issues for periods prior to the effective date of the Remand Order. The Settlement Agreement imposed on the parties certain obligations regarding the payment of reciprocal compensation in the future, which are in the process of being implemented. The Settlement Agreement also provides that the payments made for periods prior to the effective date of the Remand Order are not subject to adjustment as a result of subsequent changes in the Remand Order. In September 2001, the Company filed a proceeding with the Virginia State Corporation Commission ("VSCC") and the FCC seeking to collect reciprocal compensation from Verizon payable for traffic bound for ISPs as well as other customers. The VSCC declined jurisdiction over the dispute. In October 2001, the FCC accepted jurisdiction over the dispute. In light of the Second Remand, the Company cannot predict when the FCC will take action on this dispute or whether the Company will ultimately be successful. Disputed Access Revenues - A number of IXCs have refused to pay access charges to CLECs, including the Company, alleging that the access charges exceed the rates charged by the ILEC. Currently there are a number of court cases, regulatory proceedings at the FCC and legislative efforts involving such challenges. The Company cannot predict the outcome of these cases, regulatory proceedings and legislative efforts or their impact on access rates. On April 27, 2001, the FCC released its Seventh Report and Order and Further Notice of Proposed Rulemaking (the "Access Order") in which it established a benchmark rate at which a CLEC's interstate access charges will be presumed to be reasonable and which CLECs may impose on IXCs by tariff. The Access Order addresses a number of issues important to how CLECs charge IXCs for originating and terminating interstate toll and toll free traffic. The Access Order should provide certainty as to the Company's right to bill IXCs for interstate access at rates above those tariffed by the ILECs. Notwithstanding the apparent certainty created by the Access Order, its effect on the Company will depend on how the Access Order is interpreted and enforced and the outcome of appeals currently pending. If the Access Order is interpreted or enforced in a manner adverse to the Company as it relates to periods prior to the effective date, such result could have a material adverse effect on the Company. For a more complete description of the Access Order, please see "Business - Regulation" in the Form 10-K. On May 30, 2001, the FCC issued a decision in AT&T Corp. v. Business Telecom, Inc. (the "BTI Decision"), in which the FCC determined that the interstate access rates charged by Business Telecom, Inc. ("BTI") were not just and reasonable. The FCC determined that just and reasonable rates for BTI were properly based upon the lowest band of rates charged by the National Exchange Carriers Association ("NECA"). The FCC based this holding on the limited evidence before it, tending to show that BTI's operations were similar to those of small, urban ILECs, many of whom charge the lowest band NECA rates. Appeals of the BTI Decision were subsequently withdrawn. As with the Access Order described above, the BTI Decision's effect on the Company will depend on how the order is interpreted. If the BTI Decision is interpreted in a manner adverse to the Company, such result could have a material adverse effect on the Company. By settlement dated October 5, 2001, Sprint and the Company resolved their litigated dispute over access charges. Sprint paid the Company approximately $8,000, in addition to approximately $1,500 it paid in the four months preceding the settlement, in payment of past due invoices for periods through July 2001. 12 Legislation - Periodically, legislation has been introduced in the U.S. House of Representatives or the U.S. Senate to alter or amend the Telecom Act. It is the Telecom Act which opened the local telephone markets for competition and outlines many of the ground rules pursuant to which the ILECs and the CLECs operate with respect to each other. The Company anticipates that additional efforts will be made to alter or amend the Telecom Act. The Company cannot predict whether any particular piece of legislation will become law and how the Telecom Act might be modified. The passage of legislation amending the Telecom Act could have a material adverse effect on the Company and its financial results. Interconnection Agreements with ILECs - The Company has agreements for the interconnection of its networks with the networks of the ILECs covering each market in which US LEC has installed a switching platform. US LEC may be required to negotiate new interconnection agreements as it enters new markets in the future. In addition, as its existing interconnection agreements expire, it will be required to negotiate extension or replacement agreements. The Company recently initiated interconnection arbitrations with Veizon in order to obtain new interconnection agreements on terms acceptable to the Company. There can be no assurance that the Company will successfully negotiate, successfully arbitrate or otherwise obtain such additional agreements for interconnection with the ILECs or renewals of existing interconnection agreements on terms and conditions acceptable to the Company. Interconnection with Other Carriers - The Company anticipates that as its interconnections with various carriers increase, the issue of seeking compensation for the termination or origination of traffic whether by reciprocal arrangements, access charges or other charges will become increasingly complex. The Company does not anticipate that it will be cost effective to negotiate agreements with every carrier with which the Company exchanges originating and/or terminating traffic. The Company will make a case-by-case analysis of the cost effectiveness of committing resources to these interconnection agreements or otherwise billing and paying such carriers. 8. Stockholders' Equity Stock Options - The Company adopted the US LEC Corp. Omnibus Stock Plan (the "Plan") in January 1998. The number of Class A Common Stock reserved for issuance under the Plan is 5,000 shares. As of March 31, 2002, the Company had granted stock options, net of forfeitures, to purchase an aggregate of 4,069 shares of Class A Common Stock under the Plan. In addition, the Company granted an employee an option to purchase 550 shares of Class A Common Stock outside the Plan. Employee Stock Purchase Plan - The Company established an Employee Stock Purchase Plan (the "ESPP") in September 2000. Under the ESPP, employees may elect to invest up to 10% of their compensation in order to purchase shares of the Company's Class A Common Stock at a price equal to 85% of the market value at either the beginning or end of the offering period, whichever is less. The number of Class A Common Stock reserved for issuance under the ESPP is 2,000 shares. As of March 31, 2002, the Company had issued 726 shares under the ESPP. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for the historical information contained herein, this report contains forward-looking statements, subject to uncertainties and risks, including the demand for US LEC's services, the ability of the Company to introduce additional products, the ability of the Company to successfully attract and retain personnel, competition in existing and potential additional markets, uncertainties regarding its dealings with ILECs and other telecommunications carriers and facilities providers, regulatory uncertainties, and the possibility of adverse decisions related to reciprocal compensation and access charges owing to the Company by other carriers. These and other applicable risks are summarized in the "Forward-Looking Statements and Risk Factors" section and elsewhere in the Company's Annual Report on Form 10-K for the period ended December 31, 2001, and in other reports which are on file with the Securities and Exchange Commission. OVERVIEW US LEC is a rapidly growing switch-based competitive local exchange carrier ("CLEC") that provides integrated telecommunications services to its customers, including local and long distance voice services, toll free services, frame relay, high speed internet, ATM and web hosting. The Company primarily serves telecommunication-intensive business customers including hotels, universities, financial institutions, professional service firms, hospitals, and Internet service providers ("ISPs"). US LEC was founded in June 1996 after passage of the Telecommunications Act of 1996 (the "Telecom Act"), which enhanced the competitive environment for local exchange services. US LEC initiated service in North Carolina in March 1997, becoming one of the first CLECs in North Carolina to provide switched local exchange services. US LEC currently offers service to customers in selected markets in North Carolina, Florida, Georgia, Tennessee, Virginia, Alabama, Washington D.C., Pennsylvania, New Jersey, Mississippi, Maryland, South Carolina, Louisiana and Kentucky. In addition, US LEC is currently certified to provide local and long distance telecommunication services in Indiana, Delaware, New York, Ohio, Texas, Connecticut and Massachusetts. As of March 31, 2002, US LEC's network was comprised of 25 Lucent 5ESS(R) AnyMedia(TM) digital switches, 26 Lucent CBX500 ATM data switches and 4 Juniper M20(TM) Internet Gateway routers that are located throughout the Southeast and mid-Atlantic states, in addition to an Alcatel MegaHub(R) 600ES switch in Charlotte, North Carolina. RESULTS OF OPERATIONS Three Months Ended March 31, 2002 Compared With The Three Months Ended March 31, 2001 Net revenue increased to $53.9 million for the quarter ended March 31, 2002 from $38.1 million for the quarter ended March 31, 2001. More than 90% of the Company's net revenue is currently derived from two sources - end users and intercarrier compensation. Less than 10% is derived, in total, from other sources including wholesale customers, installation revenue, and other miscellaneous sources. End customer revenue represented approximately 58% of total net revenue during the quarter ended March 31, 2002, compared to 54% in the quarter ended December 31, 2001, and 50% in the quarter ended March 31, 2001. This shift is the result of growth in end customer revenue and a reduction of intercarrier rates for reciprocal compensation and access revenue billed to other carriers. See Footnote 7 to the Company's Condensed Consolidated Financial Statements for a further discussion related to disputed amounts and recent settlements. Cost of services is comprised primarily of leased transport, facility installation and usage charges. Cost of services increased to $27.3 million, or 51% of revenue, for the quarter ended March 31, 2002, from $19.2 million, or 50% of revenue, for the quarter ended March 31, 2001. The increase in cost of services was primarily a result of the increase in the size of US LEC's network and increased network usage by customers. The increase in cost of services as a percentage of revenue was due to the increase of end customer revenue as a percentage of total revenue, and its related cost of services. 14 Selling, general and administrative expenses for the quarter ended March 31, 2002 increased to $25.9 million, or 48% of revenue, compared to $24.2 million, or 64% of revenue, for the quarter ended March 31, 2001. The increase in expenses were primarily a result of costs associated with developing and expanding the Company's customer base and includes expenses associated with personnel, sales and marketing, occupancy, administration and billing as well as legal expenses associated with litigation and regulatory issues. Depreciation and amortization for the three months ended March 31, 2002 increased to $10.6 million from $7.8 million for the comparable 2001 period. The increase in depreciation and amortization is due to the increase in depreciable assets in service related to US LEC's network expansion. Depreciation and amortization will continue to increase in conjunction with spending on capital asset deployment related to US LEC's ongoing operations. Interest income for the three months ended March 31, 2002 was $0.3 million compared to $1.2 million for the three months ended March 31, 2001, this decrease was primarily due to declining interest rates as well as a decrease in cash balances. Interest expense for the three months ended March 31, 2002 was $2.2 million compared to interest expense of $3.2 million for the three months ended March 31, 2001. This decrease in interest expense was primarily due to declining interest rates on borrowings under the Company's credit facility, partially offset by increased borrowings (from $130 million to $150 million). For the three months ended March 31, 2002 and 2001, the Company did not record an income tax expense or benefit. For the three months ended March 31, 2002 and 2001, the income tax benefit, primarily created from operating losses, was offset by increases in the tax valuation allowance. Net loss for the three months ended March 31, 2002 amounted to $11.7 million. Dividends accrued on Series A Preferred Stock for the three months ended March 31, 2002 amounted to $3.3 million (see Note 6 to the Company's Condensed Consolidated Financial Statements for additional information). The accretion of preferred stock issuance cost for the three months ended March 31, 2002 amounted to $127. As a result of the foregoing, net loss attributable to common shareholders for the three months ended March 31, 2002 amounted to $15.2 million, or ($0.58) per share (diluted) compared to net loss of $18.4 million, or ($0.66) per share (diluted) for the three months ended March 31, 2001. LIQUIDITY AND CAPITAL RESOURCES The Company's credit facility is subject to certain financial covenants, measured quarterly, the most significant of which relates to the achievement of increasing levels of revenue and earnings, and debt ratios. The Company was in compliance with these covenants as of the quarter ended March 31, 2002. Company management believes it will be in compliance with all quarterly financial covenants during 2002 based upon projected operating results. These projected operating results are dependent upon the Company meeting quarterly 2002 targets of new customers, existing customer retention, customer usage, billing rates, gross margin and SG&A and as a result involve some degree of uncertainty. Should any of these assumptions not be achieved for a particular quarter, it is possible that a financial covenant will not be met during 2002. Although there can be no assurances, Company management believes if this were to occur, it would be able to obtain the necessary waivers or amendments from its lenders. US LEC's business is capital intensive and its operations require substantial capital expenditures for the expansion of and capacity additions to network switches, related electronic equipment and facilities. The Company's cash capital expenditures were $9.9 million and $15.9 million for the three months ended March 31 2002 and 2001, respectively. As of March 31, 2002, the outstanding amount under the Company's senior secured credit facility was $150.0 million. While management believes the $66.8 million in cash at March 31, 2002 will 15 fund the Company's capital requirements into 2003, funding to free cash flow is likely to require additional financing. Cash used in operating activities decreased to $3.8 million for the three months ended March 31, 2002 from $20.1 million during the comparable period in 2001. The decrease in cash used in operating activities was primarily due to lower net operating losses and increases in working capital Cash used in investing activities decreased to $9.9 million for the three months ended March 31, 2002 from $15.9 million during the three months ended March 31, 2001. The investing activities are primarily related to purchases of switching and related telecommunications equipment, office equipment, back office and leasehold improvements. Cash provided by financing activities increased to $0.1 million for the three months ended March 31, 2002 from $0.1 million cash used during the first three months of 2001. The increase was primarily due to the receipt of funds from the issuance of common stock during the first quarter of 2002 pursuant to the employee stock purchase plan and employee stock option plan and a decrease in debt issuance fees from the same period in the prior year. Uncertainties and Contingencies The Company's receivables are subject to certain uncertainties and contingencies related to regulatory, judicial and legislative policies and actions as well as resolution of disputes with carriers over reciprocal compensation and access revenue. For further discussion, see Footnote 7 to the Company's Condensed Consolidated Financial Statements. 16 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK US LEC is exposed to various types of market risk in the normal course of business, including the impact of interest rate changes on its investments and debt. As of March 31, 2002, investments consisted primarily of institutional money market funds. All of the Company's long-term debt consists of variable rate instruments with interest rates that are based on a floating rate which, at the Company's option, is determined by either a base rate or the London Interbank Offered Rate ("LIBOR"), plus, in each case, a specified margin. Although US LEC does not currently utilize any interest rate management tools, it continues to evaluate the use of derivatives such as, but not limited to, interest rate swap agreements to manage its interest rate risk. As the Company's investments are all short-term in nature and its long-term debt is at variable short-term rates, management believes the carrying values of the Company's financial instruments approximate fair values. PART II OTHER INFORMATION Item 1. Legal Proceedings US LEC is not currently a party to any material legal proceedings, other than proceedings, arbitrations, and any appeals thereof, related to reciprocal compensation, intercarrier access and other amounts due from other carriers and from time to time claims are made by former employees alleging improper termination Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: Exhibit No. Description ----------- ----------- 11.1 Statement Regarding Computation of Earnings per Share/(1)/ /(1)/ Incorporated by reference to the Company's Condensed Consolidated Statements of Operations appearing in Part I of this report. 17 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. US LEC Corp. By: /s/ Michael K. Robinson --------------------------- May 15, 2002 Michael K. Robinson Executive Vice President and Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----