For the quarterly period ended September 30, 2004

-----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, PR+gLj9rbXeos/VJnWqRozR3X/b0wNoBECT3OAjnD8WRjvaUoM8BW7mGmFZGBfLI ZxihzwEM/4MLoEmEzPBKdQ== 0001193125-04-192795.txt : 20041110 0001193125-04-192795.hdr.sgml : 20041110 20041110160029 ACCESSION NUMBER: 0001193125-04-192795 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20040930 FILED AS OF DATE: 20041110 DATE AS OF CHANGE: 20041110 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: 041133212 BUSINESS ADDRESS: STREET 1: 6801 MORRISON BOULEVARD STREET 2: MORROCROFT III CITY: CHARLOTTE STATE: NC ZIP: 28211 BUSINESS PHONE: 704-319-1000 MAIL ADDRESS: STREET 1: 6801 MORRISON BOULEVARD STREET 2: MORROCROFT III CITY: CHARLOTTE STATE: NC ZIP: 28211 10-Q 1 d10q.htm FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004 For the quarterly period ended September 30, 2004

UNITED STATES

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 September 30, 2004

Commission file number 0-24061

US LEC Corp.

(Exact name of registrant as specified in its charter)

Delaware

56-2065535

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

Morrocroft III, 6801 Morrison Boulevard

Charlotte, North Carolina 28211

(Address of principal executive offices)(Zip Code)

(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 ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

As of November 10, 2004, there were 30,086,142 shares of Class A Common Stock outstanding.

US LEC Corp.

Table of Contents


		Page
PART I.	FINANCIAL INFORMATION

ITEM 1.	FINANCIAL STATEMENTS

	Condensed Consolidated Statements of Operations – Three and nine months ended September 30, 2004 and 2003	3

	Condensed Consolidated Balance Sheets – September 30, 2004 and December 31, 2003	4

	Condensed Consolidated Statements of Cash Flows – Nine months ended September 30, 2004 and 2003	5

	Condensed Consolidated Statement of Stockholders’ Deficiency – Nine months ended September 30, 2004	6

	Notes to Condensed Consolidated Financial Statements	7

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	14

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	21

ITEM 4.	CONTROLS AND PROCEDURES	21

PART II.	OTHER INFORMATION

ITEM 1.	LEGAL PROCEEDINGS	22

ITEM 6.	EXHIBITS	22

SIGNATURES		23

PART 1. 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 September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Revenue	$	87,262		$	79,723		$	264,082		$	231,130
Network Expenses		44,016			38,267			127,788			109,946
Depreciation and Amortization		12,570			12,960			36,877			36,766
Charges Related to Early Extinguishment of Debt (Note 3)		2,375			—			2,375			—
Selling, General and Administrative Expenses		32,876			31,056			101,664			91,927

Loss from Operations		(4,575	)		(2,560	)		(4,622	)		(7,509	)

Other (Income) Expense

Interest Income		(135	)		(111	)		(345	)		(300	)
Interest Expense (Note 3)		4,986			2,171			9,624			6,351

Net Loss		(9,426	)		(4,620	)		(13,901	)		(13,560	)

Preferred Stock Dividends		3,857			3,634			11,401			10,742
Preferred Stock Accretion of Issuance Cost		148			139			436			411

Net Loss Attributable to Common Stockholders	$	(13,431	)	$	(8,393	)	$	(25,738	)	$	(24,713	)

Net Loss Attributable to Common Stockholders Per Common Share
Basic and Diluted	$	(0.45	)	$	(0.31	)	$	(0.86	)	$	(0.92	)

Weighted Average Number of Shares Outstanding
Basic and Diluted		30,045			27,176			29,884			27,002

See notes to condensed consolidated financial statements

US LEC Corp. and Subsidiaries

Condensed Consolidated Balance Sheets

(In Thousands)

(Unaudited)


	September 30, 2004			December 31, 2003
Assets

Current Assets
Cash and cash equivalents	$	50,606		$	43,126
Restricted cash		169			61
Accounts receivable (net of allowance of $12,871 and $10,998 at September 30, 2004 and December 31, 2003, respectively)		62,505			48,294
Deferred income taxes		617			346
Prepaid expenses and other assets		10,332			9,795

Total current assets		124,229			101,622

Property and Equipment, Net		154,953			165,793
Other Assets		17,831			17,884

Total Assets	$	297,013		$	285,299

Liabilities and Stockholders’ Deficiency

Current Liabilities
Accounts payable	$	8,325		$	4,884
Notes payable		87			1,300
Accrued network costs		29,650			25,088
Commissions payable		12,887			15,459
Accrued expenses - other		15,063			17,495
Deferred revenue		13,861			14,046
Long-term debt - current portion		—			10,776

Total current liabilities		79,873			89,048

Long-Term Debt (Note 3)		149,250			115,042
Deferred Income Taxes		617			346
Other Liabilities		6,154			6,769

Series A Mandatorily Redeemable Convertible Preferred Stock		257,093			245,255

Stockholders’ Deficiency
Common stock-Class A, $.01 par value (122,925 authorized shares, 30,086 and 29,677 shares outstanding at September 30, 2004 and December 31, 2003)		301			297
Additional paid-in capital		91,773			90,852
Accumulated deficit		(288,048	)		(262,310	)

Total stockholders’ deficiency		(195,974	)		(171,161	)

Total Liabilities, Convertable Preferred Stock and Stockholders’ Deficiency	$	297,013		$	285,299

See notes to condensed consolidated financial statements

US LEC Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(In Thousands)

(Unaudited)


	Nine Months Ended September 30,
	2004			2003
Operating Activities
Net Loss	$	(13,901	)	$	(13,560	)

Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		36,877			36,766
Charges related to early extinguishment of debt (Note 3)		2,375			—
Accretion of debt		2,512			471
Accretion of lease exit costs		31			—
Other income		54			—

Changes in operating assets and liabilities:
Accounts receivable		(14,211	)		12,324
Prepaid expenses and other assets		(520	)		(1,576	)
Other assets		928			(430	)
Accounts payable		1,411			(2,518	)
Deferred revenue		(185	)		1,413
Accrued network costs		4,562			(8,199	)
Customer commissions payable		(2,572	)		10,434
Other liabilities - non-current		(659	)		(489	)
Accrued expenses - other		(3,031	)		5,715

Total adjustments		27,572			53,911

Net cash provided by operating activities		13,671			40,351

Investing Activities
Purchase of property and equipment		(22,002	)		(24,480	)
Net assets acquired		(220	)		(1,302	)
Proceeds from insurance claim		—			1,000
Decrease in restricted cash		(8	)		(421	)

Net cash used in investing activities		(22,230	)		(25,203	)

Financing Activities
Proceeds from issuance of floating rate notes		149,250			—
Proceeds from issuance of debentures and related warrants		—			350
Payments on long-term debt		(128,280	)		(222	)
Payments on notes payable		(1,214	)		—
Payment of deferred loan fees		(4,642	)		(191	)
Proceeds from issuance of stock options and warrants		925			521

Net cash provided by financing activities		16,039			458

Net Increase in Cash and Cash Equivalents		7,480			15,606

Cash and Cash Equivalents, Beginning of Period		43,126			25,715

Cash and Cash Equivalents, End of Period	$	50,606		$	41,321

Supplemental Cash Flow Disclosures
Cash Paid for Interest	$	7,551		$	7,152

See notes to condensed consolidated financial statements

US LEC Corp. and Subsidiaries

Condensed Consolidated Statement of Stockholders’ Deficiency

For the Nine Months Ended September 30, 2004

(In Thousands)

(Unaudited)


	Class A Common Stock			Additional Paid-in Capital		Accumulated Deficit			Total
	Shares	Amount		Additional Paid-in Capital		Accumulated Deficit			Total
Balance, December 31, 2003	29,677	$	297	$	90,852	$	(262,310	)	$	(171,161	)
Issuance of ESPP Stock	183		2		630					632
Exercise of Stock Options and Warrants	226		2		291					293
Preferred Stock Dividends							(11,401	)		(11,401	)
Accretion of Preferred Stock Issuance Costs							(436	)		(436	)
Net Loss							(13,901	)		(13,901	)

Balance, September 30, 2004	30,086	$	301	$	91,773	$	(288,048	)	$	(195,974	)

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

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 and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. 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, 2003, which is on file with the SEC.

2. Significant Accounting Policies

There have been no changes to the Company’s significant accounting policies as set forth in Note 2 to the audited consolidated financial statements in the Annual Report on Form 10-K for the year ended December 31, 2003.

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 expenses 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 or circumstances become known.

Stock Based Compensation - The Company measures the compensation cost of its stock plans under the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, as permitted under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”. Under the provisions of APB No. 25, compensation cost is measured based on the intrinsic value of the equity instrument awarded. Under the provisions of SFAS No. 123, compensation cost is measured based on the fair value of the equity instrument awarded.

Had compensation cost for the employee stock plans been determined consistent with SFAS No. 123, the Company’s net loss and net loss per share would approximate the following pro forma amounts:


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
Net loss, as reported	$	(9,426	)	$	(4,620	)	$	(13,901	)	$	(13,560	)
Preferred dividends		(3,857	)		(3,634	)		(11,401	)		(10,742	)
Accretion of preferred stock issuance fees		(148	)		(139	)		(436	)		(411	)

Net loss attributable to common stockholders, as reported		(13,431	)		(8,393	)		(25,738	)		(24,713	)

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(1,886	)		(5,293	)		(5,602	)		(6,517	)

Pro forma net loss attributable to common stockholders	$	(15,317	)	$	(13,686	)	$	(31,340	)	$	(31,230	)

Weighted average shares outstanding		30,045			27,176			29,884			27,002

Loss per share:
Basic and diluted, as reported	$	(0.45	)	$	(0.31	)	$	(0.86	)	$	(0.92	)

Basic and diluted, pro forma	$	(0.51	)	$	(0.50	)	$	(1.05	)	$	(1.16	)

The Company estimated the fair value for stock options using the Black-Scholes model assuming no dividend yield; volatility of 80%, an average risk-free interest rate of 3.38% and 3.13% for the quarter ended September 30, 2004 and 2003, respectively, and an expected life of 5.1 years. The weighted average remaining contractual life of stock options outstanding at September 30, 2004 was 8.5 years.

The Company estimated the fair value of the Employee Stock Purchase Plan for the three and nine months ended September 30, 2004, using the Black-Scholes model assuming no dividend yield, volatility of 80%, an average risk-free interest rate of 3.81%, and an expected life of 0.5 years.

3. Long-Term Debt

On September 30, 2004, the Company issued $150,000 in aggregate principal amount of Second Priority Senior Secured Floating Rate Notes due 2009 (the “Notes”) in a private placement to qualified institutional buyers. The Notes were issued at a price of 99.5% and bear interest at an annual rate of the six-month London Interbank Offered Rate (“LIBOR”) plus 8.50%. Interest is reset semi-annually and is payable on April 1 and October 1 of each year, beginning April 1, 2005. The current six-month rate is approximately 10.7%. The maturity date of the Notes is October 1, 2009. As of September 30, 2004, the fair market value of the Notes was $149,250. The Notes are guaranteed by all of the Company’s subsidiaries and are secured on a second priority basis by substantially all of the assets of the Company and its subsidiaries. In connection with the issuance on September 30, 2004, the Company entered into an indenture, a registration rights agreement and a security agreement.

The indenture governing the Notes contains covenants which, subject to certain exceptions, limit the ability of the Company and its subsidiaries to incur additional indebtedness, engage in certain asset sales, make certain types of restricted payments, engage in transactions with affiliates and create certain liens on the assets of the Company or its subsidiaries. Upon a change of control, the indenture requires the Company to make an offer to repurchase the Notes at 101% of the principal amount, plus accrued interest. The indenture allows the Company to redeem the Notes at redemption prices of 105.5%, 103.5% and 100.0% of the principal amount during the 12-month period beginning on October 1 of the years 2006, 2007 and 2008 and thereafter, respectively.

The registration rights agreement requires the Company to register under the Securities Act of 1933 notes having substantially identical terms within specified time periods and to complete an exchange of the privately placed Notes for the publicly registered notes or, if the exchange cannot be effected, to file and keep effective a shelf registration statement for resale of the privately placed Notes. Failure of the Company to comply with the registration and exchange requirements in the registration rights agreement within specified time periods would require the Company to pay as liquidated damages additional interest on the privately placed Notes until the failure to comply is cured. Under the security agreement, the Company and its subsidiaries pledged and granted to the trustee under the indenture, for the trustee’s benefit and for the benefit of the noteholders, a security interest in substantially all their assets, including the capital stock of the Company’s subsidiaries.

The Company used substantially all of the net proceeds from the sale of the Notes to repay in full $120,325 under its senior credit facility and $6,750 on its senior subordinated notes. The Company also paid $2,071 in additional interest due on the deferred portion of the senior credit facility term loan which included a $255 termination amount. The senior credit facility was terminated and all of the senior subordinated notes were retired following repayment of the outstanding indebtedness. Unamortized debt issuance fees totaling $2,375 related to the senior credit facility and the senior subordinated notes and the remaining unamortized discount on the subordinated notes of $2,041 were expensed as of September 30, 2004. Debt issuance fees associated with the Notes totaled $5,554 and are being amortized through the maturity date of October 1, 2009.

4. Uncertainties and Contingencies

The deregulation of the telecommunications industry, the implementation of the Telecommunications Act of 1996 (“Telecom Act”), regulatory uncertainty, and the distress of many carriers in the wake of the downturn in the telecommunications industry have involved numerous industry participants, including us, in lawsuits, proceedings, disputes and arbitrations before state and federal regulatory commissions, private arbitration organizations and courts over many issues important to our financial and operational success. These issues include the interpretation and enforcement of interconnection agreements and tariffs, the terms of new interconnection agreements, operating performance obligations, inter-carrier compensation, including compensation issues such as the access rates applicable to different categories of traffic (including calls placed by or to wireless carriers’ end-users) and the jurisdiction of traffic for inter-carrier compensation purposes, the services and facilities available to us from incumbent carriers, the price we will pay for those services and facilities and the regulatory treatment of new technologies and services. We anticipate that we will continue to be involved in various lawsuits, arbitrations, disputes and proceedings over these and other material issues. We also anticipate that further legislative and regulatory rulemaking will occur—on the federal and state level—as the industry deregulates and as we enter new markets or offer new products. Rulings adverse to us, adverse legislation, new regulations or changes in governmental policy on issues material to us could have a material adverse effect on our operations, results of operations, revenue and cash flow. Revenue recognized and amounts recorded as allowances for doubtful accounts in the accompanying financial statements have been determined considering the impact, if any, of the items described below. Currently, we are involved in several legal and regulatory proceedings including the following, as well as other disputes, which, if resolved unfavorably to us, could have a material adverse effect on our results of operations, cash flow and financial position.

Federal Regulation and Related Proceedings – On March 2, 2004, the United States Court of Appeals for the D.C. Circuit (“D.C. Circuit”) issued an order (the “TRO Court Order”) reversing a substantial portion of the Triennial Review Order (“TRO”) previously issued by the FCC. The Court vacated the FCC’s decision to order unbundling of mass market switches, DS3 and DS1 loops and dark fiber. The Court affirmed the FCC’s decision not to require unbundling of hybrid loops, fiber-to-the-home loops, and line sharing. The Court found reasonable the specific EEL eligibility standards pursuant to which CLECs may obtain high capacity EELs; however, given the availability of Special Access, the Court expressed skepticism that carriers providing long distance services or otherwise using Special Access circuits to provide competitive local exchange services were

impaired without access to EELs, and remanded the conversion requirement to the FCC for further consideration. The FCC chose not to appeal the TRO Court Order to the U.S. Supreme Court. A number of parties did file an appeal, but on October 12, 2004, the Court declined to accept the appeal. All requests for additional stays of the TRO Court Order were denied and the Order became effective on June 16, 2004.

On August 20, 2004, the FCC released an Order adopting interim rules and issued a Notice of Proposed Rulemaking (“NPRM”) for final UNE rules. The interim rules contemplate a standstill for six months (up to and including March 2005) after which some UNEs may no longer be available and, for those UNEs that remain, some price increases likely will be permitted. In light of the standstill and proposed interim rules, we believe we will be able to continue to order UNE circuits for at least another six months. On August 24, 2004, Verizon, Qwest and the United States Telecom Association filed a petition for a writ of mandamus with the D.C. Circuit asking the Court to vacate the FCC’s standstill and interim rules and to direct the FCC to implement new rules that comply with the mandate of the TRO Court Order. On October 7, 2004, the D.C. Circuit issued a decision that, in essence, holds the mandamus petition in abeyance until January 4, 2005, allowing the FCC to follow through on its commitment to complete new UNE rules by the end of 2004.

Given the uncertainty surrounding the standstill, interim rules, the nature and scope of the NPRM and its outcome, and the framework that will govern UNE arrangements following the NPRM or in the event new rules are not in place when the interim rules expire, we cannot predict the ultimate effect the TRO, or the TRO Court Order, will have on us in the near future. However, the vast majority of our customers’ circuits are not UNE-based; rather, we purchase the majority of our customer circuits and other transport facilities either from ILECs at their Special Access pricing or from other carriers. Thus, while a decision by the FCC to eliminate UNEs entirely or to permit significant price increases on those products would not, in and of itself, have a material adverse impact on us, it would remove a significant opportunity for future cost-savings. At the same time, a decision eliminating UNE’s or raising UNE pricing would have implications in the marketplace, where our UNE-based competitors currently have a cost advantage over us. Either the elimination of UNEs altogether or significantly higher prices for those UNEs that remain available will reduce this cost advantage. Management does not believe that the amounts previously recorded as network cost need to be adjusted as a result of the aforementioned decisions. While not directly related, if UNEs are eliminated, or priced significantly higher, the ILECs could attempt to increase our costs for Special Access, which we would oppose. The elimination of, or higher prices for UNE’s, combined with increases in prices for Special Access could have a material adverse effect on us.

If the TRO or the TRO Court Order were to be interpreted in a manner adverse to us on all or any of the issues, or if the FCC materially modifies the availability, rules and prices governing UNEs pursuant to the NPRM in response to the TRO Court Order or other pending or new legal challenges, it could have a material adverse effect on our ability to order UNEs and/or the prices we pay for the UNEs that we are permitted to order.

On October 14, 2004, the FCC adopted an Order in which it granted a petition filed by BellSouth and SureWest seeking reconsideration of the TRO in connection with the ILEC’s unbundling requirements with respect to Fiber-to-the-Curb (“FTTC”), defined as a local loop consisting of fiber optic cable connecting to a copper distribution plant that is not more than 500 feet from the customer’s premises. The FCC concluded that mass market FTTC loops will be regulated the same as mass market Fiber-to-the-Home (“FTTH”) loops, i.e., in new construction, FTTC loops are not required to be unbundled and when an ILEC replaces copper with fiber, the ILEC must either provide access to a 64 kbps transmission path over the fiber loop or unbundled access to a spare copper loop.

At the same time, the FCC clarified a conclusion in the TRO by noting that ILECs are not required to build Time Division Multiplexing (TDM) (TDM is used in a network as a technique to combine several low-speed channels into a high-speed channel for transmission; a network that employs TDM techniques must have TDM equipment installed to perform the multiplexing necessary for transmission) capability into new packet-based networks or into existing packet-based networks that never had TDM capability. The FCC also clarified

that a “TDM handoff” to a customer on either FTTC or FTTH loops does not require unbundling of these loops. The conclusion that ILECs are not required to build TDM capability into new or existing packet-based networks could impact our ability to provision broadband services over the hybrid loops (which consist of a mix of fiber and copper line) even if unbundled access to DS1 loops survives. Under the FCC rules, when a CLEC seeks access to a hybrid loop for broadband services (e.g. DS1 loop), the ILEC is only required to provide access to the TDM features, functions and capabilities that already exist on that hybrid loop. With the FCC’s clarification, the ILECs may deploy new packet based networks over hybrid loops with no TDM features, functions and capabilities, and would not be required to provide unbundled access to those new packet based networks.

Changes to the regulatory environment in which US LEC and other CLEC’s acquire local loops from ILECs represent a challenge to our, and other CLECs, ability to compete successfully with the ILECs. While neither the UNE NPRM nor the FCC’s interim rules constitute a material adverse change in our outlook at this time, collectively they, along with other changes, if decided adversely to us, could have a material adverse effect on our results of operations, cash flow and financial position.

Reciprocal Compensation – On April 27, 2001, the FCC released an Order on Remand and Report and Order (the “ISP Remand Order”) addressing inter-carrier compensation for traffic terminated to Internet service providers (“ISPs”). On May 3, 2002, the D.C. Circuit rejected the FCC’s legal analysis in the Remand Order and returned the order to the FCC for further review, 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 (rate reductions, growth caps and new market limitations) remained in effect.

On October 8, 2004, the FCC adopted an order in response to a July 2003 Petition for Forbearance filed by Core Communications (“Core Petition”) asking the FCC to forbear from enforcing the rate caps, growth caps, new market rules and mirroring rules of the ISP Remand Order. The FCC granted the Core Petition with respect to growth caps and the new markets rule, but denied the Petition as to the rate caps and mirroring rules (“Core Order”). The FCC still has open a proceeding to address rules for intercarrier compensation that could result in changes to current rules governing what traffic is compensable and at what rates, including compensation for traffic to ISPs, so it remains unclear at this time whether or how those proceedings will affect pending disputes over reciprocal compensation for ISP traffic; how the Remand Order will be interpreted and enforced; or whether affected parties will undertake new challenges to the ISP compensation structure established by the Core Order or the Remand Order. Although reciprocal compensation accounted for only 3.2% of our revenue for the nine months ended September 30, 2004, if the FCC were to significantly change its policy for this traffic, and if such changes were approved by the courts, it could have a material adverse impact on the Company.

On September 5, 2002, we filed a Formal Complaint with the FCC’s Enforcement Bureau seeking to collect reciprocal compensation from Verizon for traffic bound for ISPs under an interconnection agreement between the parties. On July 18, 2003, the D.C. Circuit issued a decision in a separate, but related case, holding that the FCC had erred when it concluded that an interconnection agreement between Verizon and an unrelated party (the same interconnection agreement we had adopted) did not obligate the parties to pay reciprocal compensation for traffic bound for ISPs, and remanded the case to the FCC for further proceedings. Pending the outcome of the appeal in the related case, the FCC had converted our case against Verizon into an informal complaint and placed it on administrative hold. The parties to the related case have since resolved their dispute. In light of these developments, as well as the Second Remand, we cannot predict when this dispute with Verizon will be resolved or whether we ultimately will be successful.

Disputed Access Revenues – Prior to April 2001, a number of inter-exchange carriers (“IXCs”) had refused to pay access charges to competitive local exchange carriers (“CLECs”), including the Company, alleging that the access charges exceeded the rates charged by the incumbent local exchange carriers (“ILECs”), as well as disputing the rates applicable to different categories of traffic and the jurisdiction of traffic for compensation purposes. On April 27, 2001, the FCC released its Seventh Report and Order and Further Notice of Proposed Rulemaking (the “Seventh Report and Order”) in which it established a benchmark rate at which a

CLEC’s interstate access charges would be presumed to be reasonable and which CLECs could impose on IXCs by tariff. Several requests for reconsideration were filed addressing various aspects of the Seventh Report and Order. The FCC resolved those requests in the Eighth Report and Order and Fifth Order on Reconsideration released on May 18, 2004 (“Eighth Report and Order”) in ways that, except as noted below, do not affect the Company. Carrier access revenue, including revenue for traffic originating from wireless carriers’ end users, accounted for approximately 14% of our revenue for the nine months ended September 30, 2004.

The Seventh Report and Order provides some certainty as to our right to bill IXCs for interstate access at rates at or below the FCC-set benchmark rate even though, up until June 20, 2004, those rates might have been above those tariffed by the ILECs. Notwithstanding the apparent certainty created by the Seventh Report and Order, its effect on us continues to depend on how it is interpreted and enforced and the outcome of appeals and requests for reconsideration. If the Seventh Report and Order is interpreted or enforced in a manner adverse to us, such result could have a material adverse effect on us.

In September 2002, we filed a Petition for Declaratory Ruling asking the FCC to reaffirm its prior positions that access charges can be collected by local exchange carriers in connection with calls originating or terminating on the networks of wireless carriers. In the Eighth Report and Order, the FCC announced a prospective rule that confirms a CLEC’s right to bill for calls from other than its own end users as long as it bills only for the components of the access service that it provides. Addressing prior billings for wireless traffic as requested in our Petition, the FCC made it clear that it had not been unreasonable for US LEC, or any other CLEC, to bill an IXC at the benchmark rates provided that the CLEC’s charges were otherwise in compliance with and supported by its tariff, and the wireless carrier had not separately billed the IXC for those services. In light of that decision, we withdrew our petition as moot.

We also received, and responded to requests for information from the Enforcement Bureau of the FCC concerning our billing for wireless traffic and our methods of billing. We believe that the Enforcement Bureau has completed its review of the matter and we do not anticipate that the Enforcement Bureau will take any materially adverse action or initiate any proceedings related to the requests for information.

On June 14, 2004, Qwest Communications Corporation (“Qwest”) sued us in Colorado state court alleging breach of contract, unjust enrichment, fraud and negligent misrepresentation based on our billing for wireless traffic. We removed the case to federal court in Colorado and intend to defend the case aggressively. Notwithstanding the prospective nature of the Eighth Report and Order, other IXCs in addition to Qwest are disputing access charges for wireless traffic for periods prior to the release of the Eighth Report and Order, and some have elected to withhold current payments, in whole or in part, pending resolution of their disputes. It is possible that some IXC’s may initiate litigation to challenge our prior billing of access charges for traffic from wireless carriers. We believe that such billing was and remains consistent with industry practice as reflected in the FCC’s Eighth Report and Order and our tariffs, and we will vigorously defend the Qwest suit and any other such claims. Neither the repayment of access charges already paid by Qwest nor the inability to collect charges from Qwest would have a material adverse impact on our results of operations or financial conditions. However, Qwest’s suit and our disputes with other IXC’s, if ultimately resolved unfavorably to us, could, in the aggregate, have a material adverse effect on our results of operations and financial condition.

In addition, in light of the general conditions prevailing in the telecommunications industry, there is a risk of further delinquencies, nonpayment or bankruptcies by other telecommunications carriers that owe outstanding amounts derived from access and facility revenues we have billed. Such events, in the aggregate, could have an adverse effect on our performance in future periods. We are unable to predict such events at this time.

Interconnection Agreements with ILECs – We have agreements for the interconnection of our networks with the networks of the ILECs covering each market in which we have installed a switching platform. We may be required to negotiate new interconnection agreements as we enter new markets in the future. In addition, as

our existing interconnection agreements expire, we will be required to negotiate extension or replacement agreements. We recently concluded interconnection negotiations with BellSouth and have filed new agreements in all BellSouth states. Additionally, we have concluded contract arbitrations with Verizon in several Verizon states. We have filed new agreements in most of those states based on the decisions of the Public Utility Commissions (“PUCs”) in those states, and we are still awaiting a final decision from one PUC.

In an order issued on July 13, 2004, the FCC reinterpreted Section 252(i) of the Telecom Act to eliminate the so-called “pick and choose” rule. In its 1996 Local Competition Order, the FCC had interpreted Section 252(i) to permit CLECs to obtain access to any individual interconnection, service or network element arrangement on the same terms as in any other previously approved interconnection agreement of that ILEC in that state. Under the FCC’s new interpretation, referred to as the “all or nothing” rule, CLECs seeking to adopt an existing interconnection agreement now will be required to take the entire agreement, rather than individual components. We do not believe that the new rule will have a significant impact on our negotiations with ILECs because, in practice, most ILECs previously sought to require CLECs to adopt entire agreements and resisted efforts to “pick and choose” individual services or elements.

Interconnection with Other Carriers - We anticipate that as our interconnection with various carriers increases, 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. We do not anticipate that it will be cost effective to negotiate agreements with every carrier with which we exchange originating and/or terminating traffic. We 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.

Other Litigation - We are involved, and expect to continue to be involved, in other proceedings arising out of the regular conduct of our business, including litigation with other carriers, employment related lawsuits and regulatory proceedings. The results of these matters cannot be predicted with certainty, and an unfavorable resolution of one or more of these matters, including the matters specifically discussed above, could have a material adverse effect on our business, financial condition, results of operations, cash flows and business prospects.

5. Stockholders’ Equity

Stock Option Plan – In January 1998, the Company adopted the US LEC Corp. 1998 Omnibus Stock Plan (the “Plan”). Under the amended Plan, 5,000 shares of Class A Common Stock have been reserved for issuance for stock options, stock appreciation rights, restricted stock, performance awards or other stock-based awards of which 250 were available for grant at September 30, 2004. Options granted under the Plan are at exercise prices determined by the Board of Directors or its Compensation Committee. For incentive stock options, the option price may not be less than the market value of the Class A common stock on the date of grant (110% of market value for greater than 10% stockholders).

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 Company is presently authorized to issue 2,000 shares of common stock under the ESPP of which 208 were available for issuance as of September 30, 2004. Based on current employee participation, the Company expects to exhaust the existing authorized shares during the second half of 2004. The Board of Directors has authorized management to seek stockholder approval for 1,000 additional shares for the ESPP at the next annual stockholders meeting. We believe this continues to align the interest of employees with those of common stockholders.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding, among other items, our expected financial position, business, risk factors and financing plans. These statements are identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “estimates” or “anticipates” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. These forward-looking statements are based on a number of assumptions concerning future events, including the outcome of judicial and regulatory proceedings, the adoption of balanced and effective rules and regulations by the Federal Communications Commission and state public utility commissions, and US LEC’s ability to successfully execute its business plan. These forward-looking statements are also subject to a number of uncertainties and risks, many of which are outside of US LEC’s control, that could cause actual results to differ materially from such statements. Important factors that could cause actual results to differ materially from the expectations described in this report are set forth in Notes 1 and 4 to the condensed consolidated financial statements appearing in this report and related discussion in Exhibit 99.1 “Risk Factors” filed as an exhibit to this report and in other reports which are on file with the Securities Exchange Commission (the “SEC”). Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date they are made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

General. US LEC is a Charlotte, North Carolina-based telecommunications carrier providing voice, data and Internet services to over 20,600 mid-to-large-sized business class customers throughout the eastern United States. We primarily serve telecommunications-intensive customers in a wide variety of industries. The Company also provides shared Web hosting and dial-up Internet services to approximately 16,000 additional residential and small business customers.

In evaluating US LEC’s operating performance, we consider the following measures to be the most important:

•

total revenue,

•

end customer revenue in total, and as a percentage of total revenue,

•

customer retention,

•

control of network expense, general and administrative expenses, and

•

working capital management.

During the nine months ended September 30, 2004, which includes three full quarters of operations following the acquisition of Fastnet, US LEC achieved positive results in each of these measures. We believe this demonstrates the continuing validity of our business plan and our ability to execute it.

Revenue. The following table provides a breakdown of the components of our revenue for the three and nine months ended September 30, 2004 and 2003:


	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
End Customer Revenue
Voice Monthly Recurring Charges	$	36,628		$	31,318		$	106,323		$	88,702
Data Monthly Recurring Charges		23,449			11,821			66,178			32,498
Long Distance		12,876			11,294			36,685			31,975

		72,953			54,433			209,186			153,175
Percent of Total Revenue		84	%		68	%		79	%		66	%

Carrier Charges
Carrier Access		8,702			19,181			37,917			62,245
Reciprocal Compensation		2,175			2,490			8,511			8,150

		10,877			21,671			46,428			70,395
Percent of Total Revenue		12	%		27	%		18	%		30	%

Other Revenue		3,432			3,619			8,468			7,560
Percent of Total Revenue		4	%		5	%		3	%		3	%

Total Revenue	$	87,262		$	79,723		$	264,082		$	231,130

As illustrated by the table above, substantially all of the increase in total revenue resulted from growth in end customer revenue. A small portion of the growth reflected in the results for the nine months ended September 30, 2004 came from a non-recurring revenue event which occurred during the second quarter of 2004 resulting from the previously announced settlement with BellSouth Telecommunications, Inc. (“BellSouth”) regarding intercarrier compensation. The growth in end customer revenue was primarily attributable to an increase in the number of customers, achieved through a combination of increased penetration of established markets, continued development and acceptance of new services, geographic expansion and the impact of the December 2003 acquisition of Fastnet. In addition, high rates of customer retention facilitate end customer revenue growth through maintenance of their recurring revenue and increased opportunities to provide additional services to existing customers. During the quarter ended September 30, 2004, our end customer base increased from approximately 19,300 to over 20,600.

A key source of growth in end customer revenue has been the increase in data services, a portion of which relates to the Fastnet acquisition, and we anticipate this growth to continue in future periods. From the period September 30, 2003 to September 30, 2004, approximately 6,000 new or existing customers purchased data services. End customer revenue from data services increased from approximately 14% of total revenue to 25% of total revenue when comparing the nine months ended September 30, 2003 to the nine months ended September 30, 2004. From September 30, 2003 to September 30, 2004, end customer revenue from data services increased from approximately 15% of total revenue to 27% of total revenue.

Uncertainties That Could Adversely Affect Revenue. The deregulation of the telecommunications industry, the implementation of the Telecom Act, and the financial 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, and courts over many issues important to the financial and operational success of the Company. Rulings adverse to the Company, adverse legislation, new regulations or changes in governmental policy on issues material to the Company could have a material adverse effect on the Company’s revenue and cash flow. For a detailed description of the regulatory and judicial proceedings in which the Company is currently involved, see Note 4 to the condensed consolidated financial statements appearing elsewhere in this report and related discussion in Exhibit 99.1 “Risk Factors” filed as an exhibit to this report and in other reports which are on file with the SEC.

Customer Retention. One of the measures that we use to gauge our success in providing quality services to our customers and also to gauge our success in competing against the incumbent and other carriers in our markets is our customer retention rate. As we add more customers to our base, it is important that we retain as many of our current customers as possible, because the cost of obtaining a new customer is greater than keeping an existing one. We include every category of customer loss when we calculate the customer retention rate for US LEC, including customers that are deactivated due to non-payment of their bills and customers that do not renew their contract. We believe that US LEC has one of the highest retention rates among any of the carriers in our footprint. Our quarterly customer churn was approximately 1.8% as of September 30, 2004. In addition, as our customer base has grown, we have had more customers’ contracts come up for renewal. Based on our renewal efforts through September 30, 2004, we expect to renew approximately 90% of the customers up for renewal in 2004. Almost all of our new customers are on three-year contracts and the majority of our renewals are for an additional three year term.

Network Expense. During the quarter ended September 30, 2004, we continued to execute a controlled growth strategy that included an extensive re-configuring and streamlining of our network, purchasing controls, network design changes, improved purchasing terms and the addition of lower cost circuits to our network as we continued to provision some UNE loops. Approximately 10% of our total customer circuits are UNE loops, and approximately 30% of new customer circuits currently being added are provisioned as UNE loops. The results of these efforts are reflected in the total per circuit cost of our local network and customer loops, which decreased 13% from the third quarter of 2003 to the third quarter of 2004. Overall, network expense increased slightly as a percentage of total revenue for the three months ended September 30, 2004, and remained at approximately 48% for the nine months ended September 30, 2004. The increase this quarter was the result of the change in revenue mix from a lower percentage of carrier charges toward end customer revenue, which carries higher network costs.

Working Capital Management. During the quarter ended September 30, 2004, we continued to focus on working capital management that included management of customer and carrier receivables and disputes, accounts payable and vendor relationships and strict controls on selling, general and administrative expenses. As a result of increased revenue and effective management of our working capital, the third quarter of 2004 was the eighth consecutive quarter that resulted in positive cash flow from operations. In addition, working capital as of September 30, 2004 was positively impacted by the net cash proceeds of approximately $15.0 million related to the issuance of $150.0 million of Second Priority Senior Secured Floating Rate Notes due 2009 after repaying in full the Company’s senior credit facility and senior subordinated notes as well as the decrease in the current portion of long term debt associated with this repayment of the Company’s existing debt.

Results of Operations

Three and Nine Months Ended September 30, 2004 Compared With the Three and Nine Months Ended September 30, 2003

Revenue. Approximately 97% of the Company’s revenue is currently derived from two sources – end users and carrier charges. The balance of the Company’s revenue is derived from other sources, including wholesale customers, installation revenue, and other miscellaneous sources. Revenue increased to $87.3 million for the three months ended September 30, 2004 from $79.7 million for the three months ended September 30, 2003. For the nine months ended September 30, 2004 and 2003, revenue was $264.1 million and $231.1 million, respectively. Substantially all of the increase in total revenue was due to an increase in end customer revenue, as carrier charges decreased significantly from 2003 to 2004. For the three months ended September 30, 2004, the

Company’s end customer revenue increased to $73.0 million, or 84% of total revenue, from $54.4 million, or 68% of total revenue, for the same period in 2003. The growth in end customer revenue was due to an increase in the number of end customers and in the services utilized by each customer. This increase in customers and in end customer revenue was primarily achieved through a combination of increased penetration of established markets, continued development and acceptance of new services, geographic expansion and the impact of the December 2003 acquisition of Fastnet. Of particular note is that the majority of the increase in end customer revenue was due to an increase of approximately 6,000 customers purchasing data services, resulting in an $11.6 million increase in data revenue from the third quarter of 2003 to the third quarter of 2004. Our product take rate – the number of services utilized by each customer – increased from 4.1 as of September 30, 2003 to 4.7 as of September 30, 2004.

Revenue from carrier charges decreased to $10.9 million for the three months ended September 30, 2004 from $21.7 million for the same period in 2003. For the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003, revenue from carrier charges decreased to $46.4 million from $70.4 million, respectively. These results include the revenue impact of the recently concluded resolution of intercarrier compensation issues with BellSouth which resulted in the recognition of $1.7 million in revenue during the three months ended June 30, 2004. We expect total carrier revenue to remain relatively flat or slightly decrease in the future periods due to additional minutes on our network offset by lower rates. We expect total revenue to increase in future periods as a result of end customer growth being somewhat offset by a slight decrease in carrier revenue.

Network Expenses. Network expenses are comprised primarily of leased transport, facility installation, and usage charges. Network expenses increased to $44.0 million for the three months ended September 30, 2004 from $38.3 million for the three months ended September 30, 2003, and increased as a percentage of revenue to 50% from 48% for the same periods. For the nine months ended September 30, 2004 and September 30, 2003, network expenses increased to $127.8 million from $109.9 million, and both periods remained at 48% of revenue. This increase in network expenses was primarily a result of the increase in the size of US LEC’s network and an increase in customers and usage by customers, all of which were also affected by the acquisition of Fastnet in December 2003. Most notably this quarter, the increase as a percent of revenue was due to higher end customer revenue, which has a higher network expense to revenue ratio. This increase was partially offset by the Company’s controlled growth strategy, continued evaluation of accruals required for disputes with other carriers and the continued efforts to keep our network efficient.

Depreciation and Amortization. Depreciation and amortization for the quarter ended September 30, 2004 decreased to $12.6 million from $13.0 million for the quarter ended September 30, 2003. The decrease in depreciation and amortization for the quarter was due to the aging of the depreciable assets in service as some of our older locations were established prior to 1999.

Charges Related to Early Extinguishment of Debt. Charges related to the early extinguishment of debt for the quarter and nine months ended September 30, 2004 were due to the acceleration of debt issuance amortization of $2.4 million related to the retirement of the Company’s senior credit facility and senior subordinated notes.

Selling, General and Administrative Expenses. Selling, general and administrative (“SG&A”) expenses for the quarter ended September 30, 2004 increased to $32.9 million compared to $31.1 million for the quarter ended September 30, 2003 and decreased slightly as a percentage of revenue to 38% from 39%. For the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003, SG&A increased to $101.7 million, or 38% of revenue, from $91.9 million, or 40% of revenue. This increase was primarily due to an increase in salary and related costs which continue to account for over 60% of the Company’s total SG&A, as well as an increase in bad debt, advertising and marketing, and agent commission expenses. Total headcount increased 11% to 1,034 as of September 30, 2004 from 934 as of September 30, 2003, with the majority of the increase related to the Fastnet acquisition and hiring sales and sales support

employees. The Company increased its business class customer base by 48% from September 30, 2003 to September 30, 2004. The increase in employees and customer base includes those additions resulting from the Fastnet acquisition in December 2003.

Other SG&A expenses are primarily comprised of costs associated with developing and expanding the infrastructure of the Company as it expands into new markets and adds new services. Such expenses are associated with marketing, occupancy, bad debt, administration and billing. Other SG&A expenses also include legal fees associated with disputes and loss on disposal of fixed assets. The improvement in SG&A expenses as a percentage of revenue was primarily due to expense control, an improvement in back office efficiencies and growth in revenue. An illustration of our productivity improvement is the amount of end customer revenue per employee, which increased from $58,300 in the third quarter of 2003 to $70,600 in the third quarter of 2004. We expect continued improvements in this measure as we continue to focus on efficiency in our back office operations.

Interest income. Interest income for the three and nine months ended September 30, 2004 was $0.1 million and $0.3 million, respectively, compared to interest income of $0.1 million and $0.3 million, respectively, for the three and nine months ended September 30, 2003.

Interest expense. Interest expense for the three and nine months ended September 30, 2004 was $5.0 million and $9.6 million, respectively, compared to $2.2 million and $6.4 million for the comparable periods in 2003. The increase in interest expense was primarily related to the early retirement of the Company’s subordinated debt and the related acceleration of the $2.0 million discount associated with this subordinated debt. This increase was partially offset by a decrease in year over year borrowings and lower interest rates.

Income Taxes. For the three months ended September 30, 2004 and 2003 the Company did not record an income tax benefit. The Company has provided a full valuation allowance against deferred tax assets resulting from net operating losses, as management cannot predict, based on available evidence, that it is more likely than not that such assets will be ultimately realized.

Net Loss. Net loss for the three and nine months ended September 30, 2004 amounted to $9.4 million and $13.9 million, respectively. Dividends paid in kind and accrued on preferred stock for the three and nine months ended September 30, 2004 amounted to $3.9 million and $11.4 million, respectively. The accretion of preferred stock issuance costs for the three and nine months ended September 30, 2004 amounted to $0.1 million and $0.4 million, respectively.

As a result of the foregoing, net loss attributable to common stockholders for the three months ended September 30, 2004 amounted to $13.4 million, or $0.45 per diluted share, as compared to $8.4 million, or $0.31 per diluted share for the three months ended September 30, 2003. For the nine months ended September 30, 2004 net loss attributable to common stockholders amounted to $25.7 million, or $0.86 per diluted share, as compared to $24.7 million, or $0.92 per diluted share for the nine months ended September 30, 2003. The increase in net loss and net loss per share was attributable to the factors discussed above.

Liquidity and Capital Resources

On September 30, 2004 the Company issued $150,000 in aggregate principal amount of Second Priority Senior Secured Floating Rate Notes due 2009 (the “Notes”) in a private placement to qualified institutional buyers. The Notes were issued at a price of 99.5% and bear interest at an annual rate of six-month LIBOR plus 8.50%. Interest is reset semi-annually and is payable on April 1 and October 1 of each year, beginning April 1, 2005. The current six-month rate is approximately 10.7%. The maturity date of the Notes is October 1, 2009. The Notes are guaranteed by all of the Company’s subsidiaries and are secured on a second priority basis by substantially all of the assets of the Company and its subsidiaries. In connection with the issuance and sale on September 30, 2004, the Company entered into an indenture, a registration rights agreement and a security agreement.

The Company used substantially all the net proceeds from the sale of the Notes to repay in full $120,325 under its senior credit facility and $6,750 on its senior subordinated notes. The Company also paid $2,071 in additional interest due on the deferred portion of the senior credit facility term loan which included a $255 termination amount. The senior credit facility was terminated and all of the senior subordinated notes were retired following repayment of the outstanding indebtedness. Unamortized debt issuance fees totaling $2,375 related to the senior credit facility and the senior subordinated notes and the remaining unamortized discount on the subordinated notes of $2,041 were expensed as of September 30, 2004. Debt issuance fees associated with the Notes totaled $5,554 and are being amortized through the maturity date of October 1, 2009.

The following table provides a summary of the Company’s contractual obligations and commercial commitments:


	Payment Due by Period (in millions)
	Total		Less than 1 year		1-3 years		4-5 years		After 5 years
Contractual Obligations
Long-term debt (1)	$	150.0	$	—	$	—	$	—	$	150.0
Operating leases		44.0		7.9		21.3		10.8		4.0

Total contractual cash obligations	$	194.0	$	7.9	$	21.3	$	10.8	$	154.0

1)	Interest is payable semi-annually on the $150.0 million face value of the Notes at an annual rate of six-month LIBOR plus 8.50%. The discount on the Notes, totaling $0.75 million, is being amortized to interest expense on the statement of operations through the maturity date of October 1, 2009.

Cash provided by operating activities was approximately $13.7 million and $40.4 million for the nine months ended September 30, 2004 and 2003, respectively. The decrease in cash provided by operating activities of $26.7 million was primarily due to a decrease in cash of $31.0 million relating to changes in working capital

accounts. Cash provided by accounts receivable decreased by $26.5 million, due to the collection of $11.4 million related to the finalization of a contract with an inter-exchange carrier for switched access services in the first quarter of 2003, an increase in accounts receivable from inter-exchange carriers in 2004 and a decrease in amounts accrued to customers in connection with certain revenue sharing arrangements. The increase in accounts receivable of $14.2 million since December 31, 2003 was comprised of an increase in end-customer and carrier receivables of approximately $7.0 million each. The increase in end-customer receivables was primarily due to an increase in our end-customer billings over the period. The increase in carrier receivables is primarily a result of unresolved disputes with inter-exchange carriers which we continue to work through.

Cash used in investing activities decreased to $22.2 million for the nine months ended September 30, 2004 from $25.2 million for the nine months ended September 30, 2003. Cash purchases of property and equipment of $22.0 million and $24.5 million for the nine months ended September 30, 2004 and 2003, respectively, consisted of purchases of switching and related telecommunications equipment, including customer premises equipment, back office information systems, office equipment and leasehold improvements. Total capital expenditures for the purchase of property and equipment in 2004 are expected to be slightly less than those in 2003, depending on the rate of the Company’s deployment of future service offerings. Use of cash for assets acquired was higher in 2003 due to the acquisition of the assets of Eagle Communications in the first quarter of 2003. These uses of cash were partially offset by proceeds from an insurance claim related to damage experienced in one of the Company’s telecommunications switch facilities during the quarter ended March 31, 2003.

Cash provided by financing activities was $16.0 million for the nine months ended September 30, 2004 compared to cash provided by financing activities of $0.5 million for the nine months ended September 30, 2003. This change was primarily due to the receipt of $149.3 million related to the placement of the Notes offset by the $120.3 million repayment of the Company’s senior credit facility, the $6.7 million repayment of the Company’s senior subordinated notes, deferred loan fees paid and payments on notes payable.

The restricted cash balance of $0.1 million as of December 31, 2003 and $0.2 million as of September 30, 2004, serves as collateral for letters of credit related to certain office leases. In addition, the non-current portion of restricted cash of $1.1 million is included in other assets in the consolidated balance sheet as of December 31, 2003 and $0.6 million as of September 30, 2004. Restricted cash is utilized to secure the Company’s performance of obligations such as letters of credit to support leases or deposits in restricted use accounts.

Cash paid for capital expenditures identified above of approximately $22.0 million for the nine months ended September 30, 2004, was primarily incurred to support new customer growth. We expect capital expenditures in the fourth quarter of 2004 to be consistent with the first three quarters of 2004. We estimate that our debt service requirements through September 2005 will be approximately $16.6 million for interest assuming no increase in interest rates. There are no scheduled principal payments on the Notes until October 2009. We believe our existing cash on hand of approximately $50.6 million and cash flow from operations will be sufficient to fund our operating, investing and debt service requirements through at least September 2005.

We may seek additional financing to undertake other initiatives not contemplated by our current business plan. Future financings may include a range of different sizes or types of financing, including the sale of additional debt or equity securities. However, we may not be able to raise additional funds on favorable terms or at all. Our ability to obtain additional financing depends on several factors, including future market conditions, our success in executing our business plan, our future creditworthiness, and restrictions contained in agreements with our equity investors and the indenture governing the Notes. These financings could increase our level of indebtedness or result in dilution to our equity holders.

Critical Accounting Policies and Estimates

There have been no changes to the Company’s significant accounting policies and estimates as set forth in the Annual Report on Form 10-K for the year ended December 31, 2003.

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 September 30, 2004, investments consisted primarily of institutional money market funds. All of the Company’s long-term debt consists of variable rate debt with an interest rate that is based on the six-month London Interbank Offered Rate (“LIBOR”), plus 8.5%, which is reset semi-annually. The Company anticipates that variable rate interest expense for the next six months will be approximately $8.0 million based on the six-month interest rate set on September 30, 2004. Although it is difficult to predict the impact of interest rate changes on the Company’s financial statements, the Company has total variable rate debt with a face value of $150.0 million as of September 30, 2004. At this level, each one percent increase or decrease in interest rates will have approximately a $1.5 million annual impact on the financial statements of the Company.

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 and cap agreements to manage its interest rate risk. As the Company’s investments are all short-term in nature and all of its long-term debt is currently at variable short-term rates, management believes the carrying values of the Company’s financial instruments approximate fair values.

ITEM 4. CONTROLS AND PROCEDURES

Our management, under the supervision and with the participation of our principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures are effective as of the end of the period covered by this Quarterly Report on Form 10-Q. During the last fiscal quarter, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal control over financial reporting.

PART II OTHER INFORMATION

Item 1. Legal Proceedings

US LEC is not currently a party to any material legal proceeding, other than proceedings, arbitrations, and any appeals thereof, related to reciprocal compensation, intercarrier access and other amounts due from other carriers. For a description of these proceedings and developments that have occurred during the quarter ended September 30, 2004, see Note 4 to the condensed consolidated financial statements appearing elsewhere in this report.

Item 6. Exhibits

Exhibits:


Exhibit No.		Description
31.1		Rule 13a-14(a) Certification of Chief Executive Officer

31.2		Rule 13a –14(a) Certification of Chief Financial Officer

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.1		Risk Factors

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
		Michael K. Robinson
		Executive Vice President and
		Chief Financial Officer November 10, 2004

Exhibit Index


Exhibit No.		Description
31.1		Rule 13a-14(a) Certification of Chief Executive Officer

31.2		Rule 13a –14(a) Certification of Chief Financial Officer

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.1		Risk Factors

EX-31.1 2 dex311.htm SECTION 302 CEO CERTIFICATION Section 302 CEO Certification

Exhibit 31.1

CERTIFICATION

I, Aaron D. Cowell, Jr., certify that:

1. I have reviewed this quarterly report on Form 10-Q of US LEC Corp.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a)

Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)

Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c)

Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)

All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 10, 2004


By:		/s/ Aaron D. Cowell, Jr.
		Aaron D. Cowell, Jr.
		Chief Executive Officer

EX-31.2 3 dex312.htm SECTION 302 CFO CERTIFICATION Section 302 CFO Certification

Exhibit 31.2

CERTIFICATION

I, Michael K. Robinson, certify that:

1. I have reviewed this quarterly report on Form 10-Q of US LEC Corp.;

(a)

(b)

(c)

(a)

(b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 10, 2004


By:		/s/ Michael K. Robinson
		Michael K. Robinson
		Executive Vice President and Chief Financial Officer

EX-32.1 4 dex321.htm SECTION 906 CEO CERTIFICATION Section 906 CEO Certification

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of US LEC Corp. (the “Company”) on Form 10-Q for the period ended September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Aaron D. Cowell, Jr., Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Aaron D. Cowell, Jr.

Aaron D. Cowell, Jr.

Chief Executive Officer

November 10, 2004

EX-32.2 5 dex322.htm SECTION 906 CFO CERTIFICATION Section 906 CFO Certification

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of US LEC Corp. (the “Company”) on Form 10-Q for the period ended September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Michael K. Robinson, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Michael K. Robinson

Michael K. Robinson

Chief Financial Officer

November 10, 2004

EX-99.1 6 dex991.htm RISK FACTORS Risk Factors

EXHIBIT 99.1

US LEC Corp. and Subsidiaries

Risks Related to Our Business

Our continued success depends on our ability to manage and expand operations effectively.

Our ability to manage and expand operations effectively will depend on a variety of factors, including our ability to:

•

offer high-quality, reliable services at reasonable costs;

•

install and operate telecommunications switches and related equipment;

•

acquire necessary equipment, software and facilities;

•

integrate our existing and newly acquired technology and facilities, such as switches and related equipment;

•

lease access to suitable fiber optic transmission facilities at competitive prices;

•

scale operations;

•

evaluate markets;

•

monitor operations;

•

control costs;

•

maintain effective quality controls;

•

hire, train and retain qualified personnel;

•

enhance operating and accounting systems;

•

address operating challenges;

•

adapt to market and regulatory developments;

•

obtain and maintain required governmental authorizations; and

•

obtain successful outcomes in disputes with IXC’s and in litigation and regulatory proceedings.

In order for us to succeed, we must achieve these objectives in a timely manner and on a cost-effective basis. If we do not achieve these objectives, we may not be able to compete in our existing markets or expand into new markets. A failure to achieve one or more of these objectives could have a material adverse effect on our business.

In addition, we have grown rapidly since our inception and expect to continue to grow by expanding our product offerings and entering new markets. We expect our growth to place a strain on operational, human and

financial resources, particularly if we grow through acquisitions. Our ability to manage operations and expansion effectively depends on the continued development of plans, systems and controls for our operational, financial and management needs. We cannot assure you that we will be able to satisfy these requirements or otherwise manage our operations and growth effectively. A failure to satisfy these requirements could have a material adverse effect on our financial condition and ability to implement fully our growth and operating plans.

We will not be able to expand our operations if capital is not available when we need it.

The development and expansion of our networks requires substantial capital investment. If this capital is not available when needed, our business will be adversely affected. Our 2003 capital expenditures were $36.0 million, and are expected to be slightly less in 2004, depending on the Company’s deployment of future service offerings. We also expect to have substantial capital expenditures in 2005 and thereafter.

We may be required to seek additional debt or equity financing if:

•

our business plans and cost estimates are not achieved;

•

we are not able to generate sufficient cash flow from operating activities to service our debt, fund our capital expenditures and finance our business operations, or if disputes with IXC’s continue;

•

we decide to significantly accelerate the expansion of our business and existing networks; or

•

we consummate acquisitions or joint ventures that require incremental capital.

The indenture governing our Second Priority Senior Secured Floating Rate Notes due 2009 limits our ability to incur additional debt. If we were to seek additional debt financing, the terms offered may place significant limits on our financial and operating flexibility, or may not be acceptable to us. The failure to raise sufficient funds through debt or equity financing on reasonable terms may require us to modify or significantly curtail our business plan. This could have a material adverse impact on our growth, ability to compete, and ability to service our debt.

If we make acquisitions, we will incur additional risks that could be harmful to our business.

We may acquire other businesses to grow our customer base, to expand into new markets or to provide new services. We cannot predict whether or when any prospective acquisitions will occur or the likelihood of completing an acquisition on favorable terms and conditions. Any acquisition involves certain risks including:

•

difficulties assimilating acquired operations and personnel;

•

potential disruptions of our ongoing business;

•

diversion of resources and management time;

•

the possibility that uniform standards, controls, procedures and policies may not be maintained;

•

risks associated with entering new markets in which we have little or no experience;

•

risks related to providing new services with which we have little experience;

•

the potential impairment of relationships with employees or customers as a result of changes in management;

•

difficulties in evaluating the historical or future financial performance of the business;

•

integration of network equipment and operating support systems;

•

brand awareness issues related to the acquired assets or customers; and

•

prepayment of assumed liabilities from acquired companies.

If we decide to acquire a business or its customers, we cannot assure you that financing would be available on satisfactory terms or that the acquired business would perform as expected.

An inability to market and develop additional services may adversely affect our ability to retain existing customers or attract new customers.

We currently offer local, long distance, data, Internet and other telecommunications services. In order to address the future needs of our customers, we will be required to market and develop additional services. We may not be able to continue to provide the range of telecommunication services that our customers need or desire. We may lose some of our customers or be unable to attract new customers if we cannot offer the services our customers need or desire.

We face intense competition that could adversely affect our business.

The market for telecommunications services is highly competitive. We are an integrated telecommunications carrier that provides voice, data and Internet services to mid- to large-sized business class customers throughout most of the eastern United States. We compete, and expect to continue to compete, with current and potential market entrants, including:

•

long-distance carriers;

•

incumbent local exchange carriers, or ILECs;

•

other competitive local exchange carriers, or CLECs;

•

competitive access providers, or CAPS;

•

cable television companies;

•

electric utilities;

•

microwave carriers;

•

wireless telephone system operators; and

•

private networks built by large end-users.

In addition, the possibility of combinations and strategic alliances in the telecommunications industry could give rise to significant new competitors. Moreover, some competitors have emerged from the protection of Chapter 11 with dramatically altered financial structures that could give those entities the ability to offer more competitive rates than we can. We also expect increased competition from wireless service and VoIP providers as wireless and VoIP technologies improve.

We believe our network, service offerings and customer-focused approach distinguishes us from our competitors. However, many of our current and potential competitors have competitive advantages over us, including substantially greater financial, personnel and other resources, including brand name recognition and long-standing relationships with customers. Many also own their own transport and local loop facilities, and we depend on regulations or their willingness to lease those facilities to us. These resources may place us at a competitive disadvantage in our existing markets and may impair our ability to expand into new markets, which could adversely affect our business. We cannot assure you that we will be able to compete successfully in our existing markets or in new markets.

The loss of key personnel could adversely affect our operations and growth.

The loss of the services of our chief executive officer and president, our executive vice president and chief financial officer, or other senior officers could materially and adversely affect our business and prospects. None of these officers has an employment agreement with us nor do we maintain key man life insurance on them or any of our other officers or key employees. The competition for qualified managers in the telecommunications industry is intense. We may not be able to hire and retain necessary personnel in the future to replace any of our key executive officers or key employees.

In addition to our dependence on those who manage our business, hiring and retaining additional qualified managerial, sales and technical personnel is critical to our success. Since our inception, we have experienced significant competition in hiring and retaining personnel possessing necessary skills and telecommunications experience. Although we have been successful in hiring and retaining qualified personnel, we may not be able to do so in the future.

A failure to effectively manage processes and systems for ordering, provisioning and billing, or the failure of third parties to deliver these services on a timely and accurate basis, could have a material adverse effect on our ability to retain our existing customers or to attract and retain new customers.

We have processes and procedures and are working with external vendors, including the ILECs, to implement customer orders for services, the provisioning, installation and delivery of services and monthly billing for those services. Our inability to effectively manage processes and systems for these service elements or the failure of the vendors serving ILECs to deliver ordering provisioning and billing services on a timely and accurate basis could have a material adverse effect on our ability to retain our existing customers or attract and retain new customers.

Our failure to operate switches and other network equipment successfully could have a material adverse effect on our operations and our ability to attract and retain customers or to enter additional markets.

The provision of switched voice and data services is essential to our current strategy. If the switches and associated equipment necessary to operate our network, or the networks operated by our underlying carriers, experience technological or operational problems, or are affected by a natural or man-made disaster, that cannot be resolved in a satisfactory or timely manner, our ability to retain customers or to attract new ones would be adversely affected. The loss of any significant number of customers would adversely affect our results of operations and financial condition.

Our inability to negotiate new interconnection agreements, or extensions or replacements of existing interconnection agreements, on acceptable terms and conditions could adversely affect our results of operations.

We have agreements for the interconnection of our networks with the networks of the ILECs covering each market in which we have a switching platform. These agreements also provide the framework for service to our customers when other local carriers are involved. We may be required to negotiate new interconnection agreements to enter new markets in the future. In addition, we will be required to negotiate amendments to,

extensions of, or replacements for our existing interconnection agreements as they expire. We may not be able to successfully negotiate amendments to existing agreements, negotiate new interconnection agreements, renew our existing interconnection agreements, opt in to new agreements or successfully arbitrate replacement agreements for interconnection on terms and conditions acceptable to us. Our inability to do so would adversely affect our existing operations and opportunities to grow our business in existing and new markets.

System disruptions could cause delays or interruptions of service, which could cause us to lose customers.

Our success depends on providing reliable service. Although we have designed our customer service system to minimize the possibility of service disruptions or other outages, our service may be disrupted by problems on our system, such as malfunctions in our software or other facilities, and problems with a competitor’s system, such as physical damage to telephone lines or power surges and outages. Any disruption in our network could cause us to lose customers and incur additional expenses.

Risks Related to Our Indebtedness

The interest expense associated with our Second Priority Senior Secured Floating Rate Notes due 2009 will reduce the cash available to fund our operations, execute our growth strategy and repay the principal amount of the notes.

We had approximately $50.0 million of cash on hand at September 30, 2004 which, together with cash we expect to generate from operations in future periods, will be available to fund our capital expenditures, working capital requirements and growth plans. We will be required to dedicate a substantial portion of our cash flow to pay interest on the notes. This will reduce the cash flow available to fund future capital expenditures, working capital requirements and our growth strategy. The use of cash for debt service on the notes could also:

•

increase our vulnerability to general adverse economic and industry conditions and adverse changes in governmental regulations;

•

limit our flexibility to plan for, and react to, changes in our business;

•

limit our ability to borrow additional funds; and

•

limit our ability to accumulate cash to satisfy our obligations to repay the outstanding principal amount of the notes.

These risks may be accentuated by increases in interest rates that affect the variable interest rate on the notes.

The indenture relating to the notes contains restrictive covenants that may limit our flexibility, and a breach of those covenants may cause us to be in default under the indenture or instruments governing our other debt.

The indenture relating to the notes limits, and in some circumstances prohibits, us from, among other things:

•

incurring additional debt;

•

paying dividends;

•

making investments or other restricted payments;

•

engaging in sale-leaseback transactions;

•

engaging in transactions with stockholders and affiliates;

•

guaranteeing debts;

•

creating liens;

•

selling assets;

•

issuing or selling capital stock of subsidiaries; and

•

engaging in mergers and acquisitions.

These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand a future downturn in our business or the economy in general, conduct operations or otherwise take advantage of business opportunities that may arise. In addition, if we do not comply with these covenants or financial covenants under the terms of any other indebtedness we may then have, the notes and that other indebtedness could become immediately due and payable. If we are unable to repay those amounts, our lenders, including the holders of the notes, could accelerate the debt we owe them and/or initiate a bankruptcy proceeding or liquidation proceeding or proceed against the collateral granted to them to secure that indebtedness. If either of these events were to occur, we might not have sufficient assets to repay our indebtedness, including the notes.

We are a holding company and, as a result, rely on the receipt of funds from our subsidiaries in order to meet our cash needs and service our indebtedness, including the notes.

We are a holding company and our principal assets consist of the shares of capital stock or other equity instruments of our subsidiaries. As a holding company without independent means of generating operating revenues, we depend on dividends, distributions, loans and other payments from our subsidiaries to fund our obligations and meet our cash needs. The payment of these dividends, distributions and other payments from our subsidiaries to us may be subject to regulatory or contractual restrictions. We cannot assure you that the operating results of our subsidiaries at any given time will be sufficient to make distributions to us in order to allow us to make interest payments on the notes or to pay the notes when they mature in 2009.

The collateral securing the notes may be subjected to a first priority claim by creditors with first priority liens. If there is a default, the value of the collateral may not be sufficient to repay both the first priority creditors and the holders of the notes.

Future indebtedness, including capital lease obligations and purchase money indebtedness, may be secured by a first priority lien on the collateral securing the notes. The notes have the benefit of a second priority lien on the collateral and therefore will effectively rank junior in right of payment to all amounts owed under such future indebtedness to the extent of the value of the collateral securing a first priority lien. In addition, subject to the restrictions contained in the indenture, we may incur additional indebtedness that will be secured by liens on assets that are not pledged to the holders of the notes, all of which would effectively rank senior in right of payment to the notes to the extent of the value of the assets securing the indebtedness. Holders of obligations secured by first priority liens on the collateral will be entitled to receive proceeds from any realization of the collateral to repay their obligations in full before the holders of the notes and other obligations secured by second priority liens will be entitled to any recovery from the collateral.

The proceeds from the sale or sales of the assets that make up the collateral may not be sufficient to satisfy the amounts outstanding under the notes and other obligations secured by the second priority liens, if any, after payment in full of the obligations secured by first priority liens on the collateral. The value of the collateral securing the notes in the event of a liquidation will depend upon market and economic conditions, the availability of suitable buyers and similar factors that are beyond our control. A sale of the collateral in a bankruptcy or similar proceeding will likely generate less proceeds than a sale in the ordinary course, which would reduce the amounts that could be recovered.

Further, a sale could occur when other companies in our industry also are distressed, which might increase the supply of similar assets and therefore reduce the amounts that could be recovered. The condition of the collateral is likely to deteriorate during any period of financial distress preceding a sale of the collateral. Accordingly, the proceeds of any sale of the collateral following an acceleration of maturity with respect to the notes may not be sufficient to satisfy, and may be substantially less than, amounts due on the notes after satisfying our obligations that are secured on a first priority basis. If such proceeds were not sufficient to repay amounts outstanding under the notes, holders of the notes (to the extent not repaid from the proceeds of the sale of the collateral) would only have an unsecured claim against our remaining assets.

Risks Related to Regulation, Litigation and Disputes

We and other industry participants are frequently involved in disputes over issues that are important to our financial and operational success. Further legislation and regulatory rulemaking is expected to occur as the industry continues to deregulate and as we enter new markets or offer new products. Rulings or legislation adverse to us could have a material adverse effect on our operations and financial well being.

The deregulation of the telecommunications industry, the implementation of the Telecommunications Act of 1996 (“Telecom Act”) and the distress of many carriers in the wake of the downturn in the telecommunications industry have involved numerous industry participants, including us, in lawsuits, proceedings, disputes and arbitrations before state and federal regulatory commissions, private arbitration organizations and courts over many issues important to our financial and operational success. These issues include the interpretation and enforcement of interconnection agreements and tariffs, the terms of new interconnection agreements, operating performance obligations, inter-carrier compensation, including compensation issues such as the access rates applicable to different categories of traffic (including calls placed by or to wireless carriers’ end-users) and the jurisdiction of traffic for inter-carrier compensation purposes, the services and facilities available to us from incumbent carriers, the price we will pay for those services and facilities, and the regulatory treatment of new technologies and services. We anticipate that we will continue to be involved in various lawsuits, arbitrations, disputes and regulatory proceedings over these and other material issues. We also anticipate that further legislative and regulatory rulemaking will occur—on the federal and state level—as the industry deregulates and as we enter new markets or offer new products. Rulings adverse to us, adverse legislation, new regulations or changes in governmental policy on issues material to us could have a material adverse effect on our operations, results of operations, cash flow and financial position.

While a recent decision by the Federal Communications Commission (“FCC”) addressing a number of issues among carriers concerning compensation for access service has ended much of the uncertainty on these issues, we do not anticipate that it will eliminate all billing disputes for these services.

Prior to April 2001, a number of inter-exchange carriers (“IXCs”) had refused to pay access charges to CLECs, including us, alleging that the access charges exceeded the rates charged by ILECs and disputing the rates applicable to different categories of traffic and the jurisdiction of traffic for compensation purposes. On April 27, 2001, the FCC released its Seventh Report and Order and Further Notice of Proposed Rulemaking (the “Seventh Report and Order”) in which it established sliding benchmark rates at which a CLEC’s interstate

access charges would be presumed to be reasonable and which CLECs could impose on IXCs by tariff. Several requests for reconsideration were filed addressing various aspects of the Seventh Report and Order. The FCC addressed those requests in the Eighth Report and Order and Fifth Order on Reconsideration released on May 18, 2004 (“Eighth Report and Order”) in ways that, except as noted below, do not affect us. Carrier access revenue, including revenue for traffic originating from wireless carriers, accounted for approximately 14% of our revenue for the nine months ended September 30, 2004.

The Seventh Report and Order provides some certainty as to our right to bill IXCs for interstate access at rates at or below the FCC-set benchmark rate even though, up until June 20, 2004, those rates might have been above those tariffed by the ILECs. Notwithstanding the apparent certainty created by the Seventh Report and Order, its effect on us continues to depend on how it is interpreted and enforced, as well as the outcome of appeals and requests for reconsideration. If the Seventh Report and Order is interpreted or enforced in a manner adverse to us, such result could have a material adverse effect on us.

In September 2002, we filed a Petition for Declaratory Ruling asking the FCC to reaffirm its prior positions that access charges can be collected by local exchange carriers in connection with calls originating or terminating on the networks of wireless carriers. In the Eighth Report and Order, the FCC announced a prospective rule that confirms a CLEC’s right to bill for calls from other than its own end-users as long as it bills only for the components of the access service that it provides. Addressing prior billings for wireless traffic as requested in our Petition, the FCC made it clear that it had not been unreasonable for US LEC, or any other CLEC, to bill an IXC at the benchmark rates provided that the CLEC’s charges were otherwise in compliance with and supported by its tariff, and the wireless carrier had not separately billed the IXC for those services. In light of that decision, we withdrew our petition as moot.

We also received and responded to requests for information from the Enforcement Bureau of the FCC concerning our billing for wireless traffic and our methods of signaling and billing. We believe that the Enforcement Bureau has completed its review of the matter, and we do not anticipate that the Enforcement Bureau will take any materially adverse action or initiate any proceedings related to the requests for information.

An adverse outcome in pending litigation with an IXC involving access charges, while itself not anticipated to be material, could prompt other IXCs to file similar suits which, if ultimately successful, could have a material adverse impact on our financial condition, results of operations and cash flow.

On June 14, 2004, Qwest Communications Corporation (“Qwest”) sued us in Colorado state court alleging breach of contract, unjust enrichment, fraud and negligent misrepresentation based on our signaling and billing for wireless traffic. Among the theories argued by Qwest is the argument that US LEC’s tariff did not give US LEC the right to bill Qwest access charges for wireless originated calls. We removed the case to federal court in Colorado and intend to defend the case aggressively. Notwithstanding the prospective nature of the Eighth Report and Order, other IXCs in addition to Qwest are disputing access charges for wireless traffic and some have elected to withhold current payments, in whole or in part, pending resolution of their disputes. It is possible that some IXCs may initiate litigation to challenge our prior billing of access charges for traffic from wireless carriers. We believe that such billing was and remains consistent with industry practice as reflected in the FCC’s Eighth Report and Order, interstate access service and our tariffs, and we will vigorously defend the Qwest suit and any other such claims. Neither the repayment of access charges already paid by Qwest nor the inability to collect charges from Qwest would have a material adverse impact on our results of operations or financial conditions. However, Qwest’s suit and our disputes with other IXCs, if ultimately resolved unfavorably to us, could, in the aggregate, have a material adverse effect on our results of operations and financial condition.

There are significant uncertainties about the future availability and pricing of unbundled network elements and related elements from incumbent local exchange carriers.

On March 2, 2004, the United States Court of Appeals for the D.C. Circuit (“D.C. Circuit”) issued an order (the “TRO Court Order”) reversing a substantial portion of the Triennial Review Order (“TRO”) previously issued by the FCC. The Court vacated the FCC’s decision to order unbundling of mass-market switches, DS3 and DS1 loops and dark fiber. The Court affirmed the FCC’s decision not to require unbundling of hybrid loops, fiber-to-the-home loops and line sharing. The Court found reasonable the specific enhanced extended link (“EEL”) eligibility standards pursuant to which CLECs may obtain high capacity EELs; however, given the availability of Special Access, the Court expressed skepticism that carriers providing long distance services or otherwise using Special Access circuits to provide competitive local exchange services were impaired without access to EELs, and remanded the conversion requirement to the FCC for further consideration.

Given the uncertainty surrounding the standstill, interim rules, the nature and scope of the NPRM and its outcome, and the framework that will govern UNE arrangements following the NPRM or in the event new rules are not in place when the interim rules expire, we cannot predict the ultimate effect the TRO, or the TRO Court Order, will have on us in the near future. However, the vast majority of our customers’ circuits are not UNE-based; rather, we purchase the majority of our customer circuits and other transport facilities either from ILECs at their Special Access pricing or from other carriers. Thus, while a decision by the FCC to eliminate UNEs entirely or to permit significant price increases on those products would not, in and of itself, have a material adverse impact on us, it would remove a significant opportunity for future cost-savings. At the same time, a decision eliminating UNE’s or raising UNE pricing would have implications in the marketplace, where our UNE-based competitors currently have a cost advantage over us. Either the elimination of UNEs altogether or significantly higher prices for those UNEs that remain available will reduce this cost advantage. While not directly related, if UNEs are eliminated, or priced significantly higher, the ILECs could attempt to increase our costs for Special Access, which we would oppose. The elimination of, or higher prices for UNE’s, combined with increases in prices for Special Access could have a material adverse effect on us.

The outcome of administrative proceedings related to inter-carrier compensation for traffic terminated to Internet service providers could have an adverse effect on our results of operations and cash flow.

On April 27, 2001, the FCC released an Order on Remand and Report and Order (the “ISP Remand Order”) addressing inter-carrier compensation for traffic terminated to Internet service providers (“ISPs”). On May 3, 2002, the D.C. Circuit rejected the FCC’s legal analysis in the ISP Remand Order and returned the order

to the FCC for further review (the “Second Remand”), but the D.C. Circuit did not vacate the ISP Remand Order. As such, the ISP compensation structure established by the FCC in the ISP Remand Order (rate reductions, growth caps and new market limitations) remained in effect. On October 8, 2004, the FCC adopted an order in response to a July 2003 Petition for Forbearance filed by Core Communications (“Core Petition”) asking the FCC to forbear from enforcing the rate caps, growth caps, new market rules and mirroring rules of the ISP Remand Order. The FCC granted the Core Petition with respect to growth caps and the new markets rule, but denied the Petition as to the rate caps and mirroring rules (“Core Order”). The FCC still has open a proceeding to address rules for intercarrier compensation that could result in changes to current rules governing what traffic is compensable and at what rates, including compensation for traffic to ISPs, so it remains unclear at this time whether or how those proceedings will affect pending disputes over reciprocal compensation for ISP traffic; how the ISP Remand Order will be interpreted and enforced; or whether affected parties will undertake new challenges to the ISP compensation structure established by the Core Order or the ISP Remand Order. If the FCC were to significantly change its policy for this traffic, and if such changes were approved by the courts, it could have a material adverse impact on the Company.

General Risks Related to Investing in Our Securities

The interests of the holders of our preferred stock may not be aligned with the interests of the holders of our other securities.

As of August 15, 2004, affiliates of Thomas H. Lee Partners, L.P. and Bain Capital, LLC held 257,604 shares of our Series A Convertible Preferred Stock (the “Preferred Stock”) and controlled in the aggregate, on an as-if-converted basis, approximately 23% of the voting power of our common stock. Consequently, these equity holders can exert significant influence over our affairs and policies. Circumstances may occur in which the interests of these equity holders could be in conflict with the interest of the holders of our common stock and the Notes. In addition, these equity holders may have an interest in pursuing acquisitions, divestitures or other transactions that, in their judgment, could enhance their equity investment, even though such transactions might involve increased risks to holders of our common stock and Notes.

The change of control provision in the indenture may deter a third party from acquiring us or reduce the value that our common stockholders might realize if we are acquired.

The indenture governing our Second Priority Senior Secured Notes due 2009 requires us to offer to repurchase the notes at a price equal to 101% of the outstanding principal amount upon a change of control. If we are acquired in a transaction that would constitute a change of control as defined in the indenture, this could force us to repurchase the notes for $151.5 million if all outstanding notes were tendered for repurchase. This could deter a third party from acquiring us and reduce the value our common stockholders might realize if we are acquired.

Our results of operations could be adversely affected if we are required to account for the fair value of options under our employee stock plans as a compensation expense.

There has been an increasing public debate about the accounting treatment for employee stock options. Currently, we record compensation expense only in connection with option grants that have an exercise price below fair market value at the date of grant. As permitted by U.S. GAAP, we have not elected to record compensation expense under the fair value method in our consolidated statements of operations for option grants that have an exercise price at or in excess of fair market value, which represents the vast majority of options we have granted. On March 31, 2004, the Financial Accounting Standards Board issued a proposed Statement, Share-Based Payment. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that such transactions be accounted using a fair-value based method. Although we expect the impact of recording expense upon the grant of stock-based compensation awards would be material to our results of operations, we cannot quantify the impact that a new standard would have at this time.

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