UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
______________
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended December 31, 2002
Commission File No. 0-26728
TALK AMERICA HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 23-2827736
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
12020 SUNRISE VALLEY DRIVE, SUITE 250 20191
RESTON, VIRGINIA (zip code)
(Address of principal executive offices)
(703) 391-7500
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
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None Not applicable
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $.01 PER SHARE
RIGHTS TO PURCHASE SERIES A JUNIOR PARTICIPATING PREFERRED STOCK
(Title of class)
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Indicate by check mark whether the registrant (1) has filed all documents
and reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports) and (2) has been subject
to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment of this
Form 10-K. [ ]
Indicated by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
As of March 26, 2003, the aggregate market value of voting stock held by
non-affiliates of the registrant, based on the average of the high and low
prices of the Common Stock on March 26, 2003 of $7.24 per share as reported on
the Nasdaq National Market, was approximately $186,849,819 (calculated by
excluding solely for purposes of this form outstanding shares owned by directors
and executive officers).
As of March 26, 2003, the registrant had issued and outstanding 26,160,971
shares of its Common Stock, par value $.01 per share.
DOCUMENTS INCORPORATED BY REFERENCE
None.
TALK AMERICA HOLDINGS, INC.
INDEX TO FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002
ITEM NO. PAGE NO.
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PART I
1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . 14
4. Submission of Matters to a Vote of Security Holders . . . . 14
PART II
5. Market for Registrant's Common Equity and Related
Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . 15
6. Selected Consolidated Financial Data . . . . . . . . . . . . . . 16
7. Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . . . . . . . . . . . . . 17
7a. Quantitative and Qualitative Disclosure About Market Risk . . . . . .33
8. Financial Statements and Supplementary Data . . . . . . . . . . 34
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure . . . . . . . . . . . . . . . . 59
PART III
10. Directors and Executive Officers of the Registrant . . . . . . 60
11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . .62
12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters . . . . . . . . . . . . .67
13. Certain Relationships and Related Transactions . . . . . . . . . 68
PART IV
14. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . 67
15. Exhibits, Financial Statement Schedules and Reports on Form 8-K . . .67
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PART I
ITEM 1. BUSINESS
OVERVIEW
Talk America Holdings, Inc., through its subsidiaries, provides local and
long distance telecommunication services to residential and small business
customers in the United States. The Company has developed integrated order
processing, provisioning, billing, payment, collection, customer service and
information systems that enable the Company to offer and deliver high-quality
service, savings through competitively priced telecommunication products, and
simplicity through consolidated billing and responsive customer service.
The Company offers both local and long distance telecommunication services,
primarily the bundled service offering of local and long distance voice
services, which are billed to customers in one combined invoice. Local phone
services include local dial tone, various local calling plans that include free
member-to-member calling, and a variety of features such as caller
identification, call waiting and three-way calling. Long distance phone services
include traditional 1+ long distance, international and calling cards. The
Company uses the unbundled network element platform ("UNE-P") of the regional
bell operating companies ("RBOCs") network to provide local services and the
Company's nationwide network to provide long distance services. The Federal
Communications Commission ("FCC") has recently concluded its triennial review of
local phone competition. Although the text of the order is not yet available,
the decision appears to preserve the Company's ability to use UNE-P for the
provision of bundled telecommunications services pending further
market-by-market analyses by the respective state commissions.
By the end of 1999, the Company decided to expand beyond its historical
long distance business and utilize UNE-P to enter the large local
telecommunications market and diversify its product portfolio through the
bundling of local service with its core long distance service offerings. The
Company encountered a number of operational and business difficulties during the
rollout of the Company's bundled service offering in 2000 and worked to address
the operational issues that it encountered. The Company focused on improving the
overall efficiency of the bundled business model in 2001. During 2002, the
Company's top operating priorities were to lower bad debt expense, reduce
customer turnover, or "churn," and lower its customer acquisition costs. During
2003, the Company's primary focus will be to increase sales of its bundled
services within the targets established by management for acquisition costs,
customer turnover and bad debt expense.
The Company continues to manage its business to generate free cash flow
(defined as net cash provided by operating activities less net cash used in
investing activities) and has built a scaleable platform to provision, bill and
service bundled customers. The Company continues to focus on delivering better
service and value to customers. During 2002, the Company expanded its product
offerings to appeal to a broader customer base based upon calling patterns and
feature preferences. Although the Company is now operational with respect to its
local service offering in 26 states, the Company has limited the marketing of
its bundled services to those states, or certain areas of a state, where the
Company believes it can currently offer services to customers at competitive
prices. The Company will market to additional states (or certain areas of a
particular state) as the Company believes its pricing and cost structure permit
it to profitably offer services in those areas at competitive rates. While the
Company has actively marketed the bundled product in a number of states, at
present, a majority of the Company's bundled customers are in Michigan. The
Company continually reviews its product offerings, pricing and sales and
marketing programs in an effort to improve the efficiency of its sales and
marketing channels.
During 2002, the Company completed a significant restructuring of its debt
obligations, including (1) an exchange offer, that effectively extended the
final maturity on substantially all of the Company's public debt obligations to
2007; (2) the retirement of the Company's senior credit facility of $13.8
million prior to its scheduled maturity; (3) open market repurchases of $5.7
million principal amount of the Company's 12% Senior Subordinated Notes; (4) the
repurchase of $5.4 million principal amount of the Company's 8% Secured
Convertible Notes; and (5) the restructuring of the 8% Secured Convertible
Notes. In 2003, through March 28, the Company has (i) repurchased a further $9.4
million principal amount of its 12% Senior Subordinated Notes and $3.6 million
principal amount of its 8% Secured Convertible Notes, and (ii) purchased
approximately 1.3 million shares of its common stock for an aggregate purchase
price of $5 million.
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Talk America Inc. (formerly, Talk.com Holding Corp. and Tel-Save, Inc.),
the Company's predecessor and now its principal operating subsidiary, was
incorporated in Pennsylvania in May 1989. The Company was incorporated in June
1995. In connection with the Company's decision to enter the local
telecommunications market, the Company acquired Access One Communications Corp.
("Access One") in August 2000. Access One was a private, local
telecommunication services provider to nine states in the southeastern United
States. The address of the Company's current principal executive offices is
12020 Sunrise Valley Drive, Suite 250, Reston, Virginia 20190, and its telephone
number is (703) 391-7500. The Company's web address is www.talk.com. Unless
the context otherwise requires, references to the "Company" or to "Talk
America" refer to Talk America Holdings, Inc. and its subsidiaries.
The Company makes available free of charge on its website, www.talk.com,
the Company's annual report on Form 10-K, the Company's quarterly reports on
Form 10-Q, the Company's current reports on Form 8-K, and amendments to the
Company's reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934 as soon as reasonably practicable after the
Company files such material with, or furnishes it to, the Securities and
Exchange Commission.
LOCAL AND LONG DISTANCE TELECOMMUNICATION SERVICES
The Company offers both local and long distance telecommunication services
to residential and small business customers. The Company is focused on
providing high-quality service, savings through competitively priced
telecommunication products, and simplicity through consolidated billing and
responsive customer service.
LOCAL
The Company uses the unbundled network element platform, or UNE-P, from,
and, to a lesser extent, resale agreements with, the RBOCs to provide local
telephone services to residential and small business customers. The Company is
currently operational in 26 states. The Company ended 2002 with approximately
330,000 bundled lines (local and long distance services). The Company believes
that it offers and provides consumers value through competitive plans designed
to fit their particular calling patterns, broad feature selections and effective
customer service.
The Company's bundled service generally includes: unlimited local usage
dependent upon the service plan, free member-to-member calling, long distance
service and calling cards, one convenient invoice available both in paper and
electronically, and choices, where available, among the following features:
900 Call Blocking Calling Name Display
976 Call Restriction Custom Toll Restriction
Anonymous Call Reject Distinctive Ring
Auto Redial Priority Call
Automatic Callback Priority Ringing
Call Forwarding Privacy Features
Call Block Remote Call Forwarding
Call Block Denial Repeat Dialing
Call Hold Return Call ( *69 )
Call Return Return Call Block
Call Trace Speed Calling / Speed Dialing
Call Trace Denial Three Way Calling
Call Waiting Touch Tone Service
Caller ID Voice Mail
The provision of local telephone service through use of UNE-P generally
provides the Company with certain advantages, including: (i) offering local
telephone service to customers located virtually anywhere without deploying
costly local switching facilities; (ii) minimizing current capital expenditures
and at the same time maintaining network and service design flexibility for the
next generation of telecommunication technology; (iii) providing practically the
same services as the RBOCs; (iv) the potential for higher margins than
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comparable service offered through resale agreements; and (v) eliminating the
requirement to pay certain local network access fees while collecting local
network access fees for calls delivered to the Company's local telephone
customers. In some instances, however, such as customers having high usage
volumes, resale may provide the Company with a lower cost structure than the use
of UNE-P.
UNE-P became available to the Company and other carriers on November 5,
1999, when the FCC released an order reconfirming that RBOCs nationwide must
offer to competitors, in an individual or combined form, a series of unbundled
network elements, ("UNEs"), that comprise the most important facilities,
features, functions and capabilities of a RBOC's network. The price at which
such elements are offered must correspond to the forward-looking cost of
providing these elements. When offered in the combination known as UNE-P, these
components include the loop and switching elements needed to provide local
telephone service to a customer. Although RBOCs have a general obligation to
provide UNE-P, the obligation is limited in the central business districts of
the top 50 metropolitan statistical areas of the nation. In such markets, the
obligation to provide UNE-P currently is limited to carriers serving customers
with less than four telephone lines. Because the Company's current focus is on
residential and small business markets, the restriction on UNE-P availability in
the central business districts of the top 50 metropolitan statistical areas has
not been a major impediment to its operations to date. On December 12, 2001, the
FCC initiated its UNE Triennial Review rulemaking with respect to local
telecommunication competition in which it reviewed all UNEs and considered
whether RBOCs should continue to be required to provide them to competitors. The
FCC has recently concluded its Triennial Review of local phone competition.
Although the text of the order is not yet available, the decision appears to
preserve the Company's ability to use UNE-P for the provision of bundled
telecommunications services pending further market-by-market analyses by the
respective state commissions. Changes to the current rules and regulations and
adverse judicial and administrative interpretations and rulings relating thereto
that result in any curtailment in the availability of the local switching UNE
would materially impair the Company's ability to provide local
telecommunications services. Such changes could eliminate the Company's
capability to provide local telecommunications services entirely unless the
Company is able to utilize another technology, which may not be available or
available on economically feasible terms, or the Company purchases, builds and
implements its own local switching network, which would require significant
additional capital expenditures by the Company. See "Regulation."
In late 2002, the Company purchased two Lucent 5ESS-2000 switches and
related ancillary equipment. The Company currently intends that one of these
switches will be initially installed in Michigan, primarily for the provision of
long distance telecommunication services (see "Long Distance"). The Company is
also exploring and intends to use this switch to test providing local phone
service to determine the necessary operational processes and information systems
required to provide local switch-based service. The other switch has been
stored temporarily until such testing is complete. Following the testing of the
local switch, the Company will evaluate providing local telephone services to
customers using its own local switch.
The Company believes that UNE-P currently provides it with a cost-effective
means of offering local service bundled together with its long distance service.
The Company also believes that its operational systems are scalable and will
allow it to continue to expand its service offerings in the local
telecommunication market.
LONG DISTANCE
The Company provides 1+ long distance telecommunication services on a
stand-alone basis and bundled with the Company's local services. The Company's
long distance voice services include intrastate, interstate, international and
calling cards, at rates that are competitive within the industry. The Company
generally uses its own nationwide long distance network to provide services
directly to its customers. As of December 31, 2002, the Company provisioned
over its network approximately 90% of the lines using its long distance
services. The Company ended 2002 with approximately 460,000 stand-alone long
distance subscribers.
The Company's network is comprised of equipment and facilities that are
either owned or leased by the Company. The Company contracts for certain
telecommunication services with a variety of other carriers. The Company owns,
operates and maintains five Lucent 5ESS-2000 switches in its network. In late
2002, the Company purchased an additional Lucent 5ESS-2000 switch for use in its
long distance network. The Company plans to locate the switch in Michigan to
service the telecommunication requirements of its Michigan customers. These
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switches are generally considered extremely reliable and feature the Digital
Networking Unit--SONET technology. The Digital Networking Unit is a switching
interface that is designed to increase the reliability of the 5ESS-2000 and to
provide much greater capacity in a significantly smaller footprint.
The switches are connected to each other by connection lines and digital
cross-connect equipment that the Company owns or leases. See "Service
Agreements with Other Carriers." The Company also has installed lines to connect
its long distance switches to switches owned by various local telecommunication
service carriers. The Company is responsible for maintaining these lines and has
entered into a contract with GTE/Verizon with respect to the monitoring,
servicing and maintenance of this equipment.
Since the Company operates its own switches, it is subject to the risk of
significant interruption. Fires or natural disasters, for example, could cause
damage to the Company's switching equipment or to transmission facilities
connecting its switches. Any interruption in the Company's services over its
network caused by such damage could have a material adverse impact on the
Company's financial condition and results of operations. In such circumstances,
the Company could attempt to minimize the interruption of its service by
carrying traffic through its overflow and resale arrangements with other
carriers.
SERVICE AGREEMENTS WITH OTHER CARRIERS
The Company historically obtained services from AT&T through multiple
contract tariffs. With the deployment of its network, the Company requires fewer
such services from AT&T to sell its services. The Company has entered into
contracts with various other long distance and local carriers of
telecommunication services for the provision of both its network and reselling
operations, further reducing its reliance on AT&T. These services enable the
Company to connect the Company's switches to each other, connect the Company's
switches to the switches of local telecommunication service carriers, carry
overflow traffic during peak calling times, connect international calls and
provide directory assistance and other operator assisted services.
With respect to connections to local carriers, overflow, international and
operator assisted services, the Company maintains contracts with more than one
carrier for each of these services. In May 2001, the Company entered into a new
Master Carrier Agreement with AT&T. The agreement provides the Company with a
variety of services, including transmission facilities to connect the Company's
network switches as well as services for international calls, local traffic,
international calling cards, overflow traffic and operator assisted calls. The
Company believes that it is no longer dependent upon any single carrier for
these services. Currently, many price differences exist in the market for
purchasing these services in bulk. Under the terms of the Company's contracts
with its various carriers, the Company is able to choose which services and in
what volume the Company wishes to obtain the services from each carrier.
Several of the network service agreements contain certain minimum usage
commitments. The largest contract establishes pricing and provides for revenue
commitments based upon usage of $52 million for the 18 months ended February
2004 and $40 million for the 9 months ending December 2004. This contract
obligates the Company to pay 65 percent of the revenue shortfall, if any. A
separate contract with a different vendor establishes pricing and provides for
annual minimum payments as follows: 2003 - $6.0 million and 2004 - $3.0 million.
While the Company anticipates that it will not be required to make any shortfall
payments under these contracts as a result of (1) growth in network minutes, (2)
the management of traffic flows on its network, (3) the restructuring of these
obligations, and/or (4) the sale of additional minutes of usage on the wholesale
markets; there can be no assurances that the Company will be successful in its
efforts. In addition, these actions will likely cause the Company to experience
an increase in per minute network costs.
Many of the companies in the telecommunication sector have been adversely
affected by recent business trends and some have filed for bankruptcy
protection. To the extent that the credit quality of these carriers
deteriorates or they seek bankruptcy protection, the Company may have service
disruptions and the transition of the Company's customers to its network or
another carrier's network may cause potential disruptions for the affected
customers' services, although, to date, there has been no significant effect.
INTEGRATED INFORMATION SYSTEMS
The Company has developed and continues to improve and update its
integrated order processing, provisioning, billing, payment, collection,
customer service and information systems that enable the Company to offer and
4
deliver high-quality, competitively priced telecommunication services to
customers. Through dedicated electronic connections with its long distance
network and the RBOCs from which the Company purchases local services through
UNE-P, the Company has designed its systems to process information on a "real
time" basis. In addition, the Company processes millions of call records each
day.
The Company's core operational support systems include the following:
- The Company's leads database system is utilized in the marketing
of its telecommunication services. The leads database system
enables the Company to alter telemarketing campaigns to track
areas where mass advertisements are airing, manage the bundled
sales price by customer, zone and state, maintain customer credit
information, and comply with various regulatory requirements.
- The Company's proprietary automated order processing system
("OPS") enables the Company to shorten the customer provisioning
time cycle and reduce associated costs. Prior to submitting an
order to provision a customer to the Company's service, OPS
processes the customer's credit history, and, once the customer's
credit is approved, the customer's service record detailing the
customer's existing phone service is immediately verified. In
addition, OPS has enabled the Company to significantly increase
its customer provisioning rate for qualified and verified orders
while reducing the number of orders that are rejected by the
RBOC, reducing manual work requirements.
- The Company's automated service provisioning system enhances the
Company's ability to add customer lines to the Company's
telecommunication service and to change the features associated
with that particular customer's service, reducing manual work
requirements.
- The Company's billing system enables the Company to preview and
run a bill cycle each day of the month for the many different,
tailored service packages, increasing customer satisfaction while
minimizing revenue leakage in the provision of local
telecommunication service.
- The Company's proprietary automated collections management system
("CMS") is integrated with the Company's billing and customer
relationship management system. CMS increases the efficiency of
the Company's collection process, accelerates the recovery of
accounts receivable and assists in the retention of valuable
customers.
- The Company continues to develop and implement improvements to
its customer relationship manager system, which enables the
Company's customer service representatives to access data in a
real-time, organized manner, while the representative is speaking
with the customer, reducing the length of customer service calls
and improving the customer experience.
In addition, the Company maintains its own web site at www.talk.com to
provide for customer sign-up and to provide customers and potential customers
with information about the Company's products and services as well as billing
information and customer service. The Company provides these services and
features using the Company's web-enabled technologies that allow it to offer its
customers:
- Detailed rate schedules and product and service related
information.
- Online sign-up for the Company's telecommunication services.
- Credit card billing.
- Real-time and 24 x 7 billing services and online information,
providing customers with up to the hour billing information.
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The information functions of the Company's systems are designed to provide
easy access to all information about a customer, including volumes and patterns
of use. This information can be used to identify emerging customer trends and to
respond with services to meet customers' changing needs. This information also
allows the Company to identify unusual or declining use by an individual
customer, which may indicate fraud or that a customer is switching its service
to a competitor. FCC rules, however, may limit the Company's use of customer
proprietary network information. See "Regulation."
These systems are designed, where applicable, to support the Company's long
distance services and its local services utilizing UNE-P, as currently provided.
If the Company elects or is required to develop local switching capability,
these systems will need to be significantly modified.
SALES AND MARKETING
In 2002, the Company's sales and marketing efforts focused on marketing a
bundle of local and long distance telecommunication services directly to
customers under its own brand. The Company is now operational with respect to
its bundle of local and long distance telecommunication services in 26 states,
but has limited the marketing of its bundled services to those states, or
certain areas of a state, where the Company believes it can currently offer
services to customers at competitive prices to the general market. The Company
will market to additional states where the Company believes its pricing and cost
structure permit it to profitably offer services in those states at competitive
rates. While the Company has actively marketed the bundled product in a number
of states, at present, a majority of the Company's bundled customers are in
Michigan. The Company continually reviews its product offerings, pricing and
sales and marketing programs in an effort to improve the efficiency of its sales
and marketing channels. The Company increased personnel in 2002 to support the
expansion of its sales and marketing efforts from those of 2001.
The Company markets its bundled services within its targeted markets
through the following channels:
- Referrals - the Company solicits, through the use of referral
promotions and its member-to-member free long distance product,
the names of potential customers or referrals from the Company's
existing customers.
- Telemarketing - the Company purchases small business and
residential lead databases utilized for targeted, professional
and courteous outbound telesales campaigns. Telemarketing is an
important sales channel for the Company. Any changes in the
federal or state "do not call" regulations could adversely affect
the Company. See "Regulation."
- Direct Sales - the Company, utilizing both independent agents and
a recently developed internal sales force, acquires new customers
in targeted geographic areas.
- Broadcast Media - the Company receives inbound calls in direct
response to advertising on television, in print and via direct
mail.
- Online Marketing at www.talk.com - the Company has developed a
productive online marketing presence, through traditional media
and business relationships.
While the Company does not actively market its stand alone long distance
telecommunications service, it does promote the long distance telecommunications
service when contacted by persons located in those regions where local service
is unavailable. The Company also adds long distance customers when the customer
requests its local service provider to provide the customer with the Company's
long distance telecommunications service. The Company is focused upon providing
its customers savings, simplicity and service.
The Company continues to seek new marketing partners and arrangements to
expand both its opportunities to attract other customers to its services and the
products and services that it offers to its customer base.
COMPETITION
The telecommunication industry is highly competitive. Major
participants in the industry regularly introduce new services and marketing
activities. Competition in the telecommunication industry is based upon pricing,
customer service, billing services and perceived quality. The Company competes
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against numerous telecommunication companies that offer essentially the same
services as those of the Company. Many of the Company's competitors, including
the RBOCs, are substantially larger and have greater financial, technical and
marketing resources than those of the Company. The Company's success will
depend upon its continued ability to provide high quality, high value services
at prices generally competitive with, or lower than, those charged by the
Company's competitors.
The major carriers, including AT&T, Sprint Corporation, MCI/Worldcom, Inc.,
and the RBOCs have targeted price plans at residential customers - the Company's
primary target market - with significantly simplified rate structures and with
bundles of local services with long distance, which may lower overall local and
long distance prices. Competition is also fierce for the small to medium-sized
businesses that the Company also serves. Additional pricing pressure may also
come from the introduction of new technologies, such as Internet telephony,
which seek to provide voice communications at a cost below that of traditional
circuit-switched long distance service. In addition, wireless carriers have
marketed their services as an alternative to traditional long distance service,
further increasing competition in the long distance sector. Reductions in
prices charged by competitors may have a material adverse effect on the Company.
Consolidation and alliances across geographic regions, in the local and
long distance market and across industry segments may also intensify competition
from significantly larger, well-capitalized carriers.
The entry of the RBOCs into the long distance market has further heightened
competition. Under the Telecommunications Act of 1996 (the "Telecommunications
Act"), the RBOCs were authorized to provide long distance service that
originates outside their traditional services areas, and may gain authority to
provide long distance service that originates within their region after
satisfying certain market opening conditions. The FCC has granted each of the
RBOCs the authority to provide long distance service in a quickly growing number
of states. Verizon has such authority in New York, Massachusetts, Pennsylvania,
Connecticut, Virginia, New Hampshire, Delaware, New Jersey, Maine, Vermont, and
Rhode Island. SBC Communications has such authority in Texas, Kansas, Oklahoma,
Arkansas, California and Missouri. BellSouth has such authority in Florida,
Georgia, Louisiana, Alabama, Kentucky, Mississippi, North Carolina, South
Carolina, and Tennessee. Qwest has such authority in Colorado, Idaho, Iowa,
Montana, Nebraska, North Dakota, Utah, Washington and Wyoming. In addition,
several more applications are currently pending at the FCC, including Verizon in
Maryland, West Virginia and the District of Columbia, SBC in Nevada and
Michigan, and Qwest in New Mexico, Oregon and South Dakota. We cannot predict
if any of these applications will be approved or when such approval is likely to
occur. The Company anticipates that the RBOCs will continue to seek to obtain
similar authority in other states. These actions are likely to increase long
distance competition within the affected states. RBOC entry into the long
distance market means new competition from well-capitalized, well-known
companies that have the capacity to "bundle" other services, such as local and
wireless telephone services and high speed Internet access, with long distance
telephone services. While the Telecommunications Act includes certain
safeguards against anti-competitive conduct by the RBOCs, it is impossible to
predict whether such safeguards will be adequate or what effect such conduct
would have on the Company. Because of the RBOCs' name recognition in their
existing markets, the established relationships that they have with their
existing local service customers, their ability to take advantage of those
relationships, and the possibility that interpretations of the
Telecommunications Act may be favorable to the RBOCs, it may be more difficult
for the Company to compete.
In addition, access to RBOC UNEs at rates competitive with the RBOC's
retail service offerings is critical to the Company's business. The RBOC UNE
rates are ordered by individual state commissions, which have only recently
begun lowering the RBOC UNE rates to a level that allows the Company to offer
rates competitive with the RBOC for similar services in those states. The RBOCs
have petitioned certain state commissions to raise the current RBOC UNE rates.
Failure of the remaining state commissions to lower RBOC UNE rates will have a
significant impact upon the Company's ability to offer services at rates
competitive with the RBOCs. See "Regulation."
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REGULATION
GENERAL
The Company's provision of telecommunication services is subject to
government regulation. Generally speaking, the FCC regulates interstate and
international telecommunications, while the state commissions regulate
telecommunications that originate and terminate within the same state.
The Telecommunications Act provided for a significant deregulation of the
domestic telecommunications industry, including the opening of the local markets
of incumbent local exchange carriers (ILECs) to competition and the ability,
pursuant to certain market-opening conditions, of the RBOCs to reenter the long
distance industry. See "Competition". The Telecommunications Act remains subject
to judicial review and additional FCC rulemaking, and thus it is difficult to
predict what effect the legislation and regulations will have on the Company and
its operations over time. There are currently a number of, and (as a result of
the FCC's recently announced decision concerning the Triennial Review, discussed
below) will soon be many additional, regulatory proceedings underway and being
contemplated by federal and state authorities regarding the availability of the
unbundled network element platform and other unbundled network elements,
interconnection, pricing and other issues that could result in significant
changes to the business conditions in the telecommunication industry and have a
material adverse effect on the Company. In addition, there has been discussion
in Congress of modifying the Telecommunications Act in ways that could prove
detrimental to the Company.
In January 1999, the U.S. Supreme Court confirmed the FCC's role in
establishing national telecommunications policy through implementation of the
Telecommunications Act, and thereby created greater certainty regarding the
rules governing local competition going forward. The FCC's rules which permit
the Company to purchase the UNE-P to provide local and long distance
telecommunications services to its customers are the primary rules governing
competition upon which the Company relies. On December 12, 2001, the FCC
initiated its UNE Triennial Review rulemaking with respect to local
telecommunication competition in which it reviewed all UNEs and considered
whether RBOCs should continue to be required to provide them to competitors.
The FCC has recently concluded its Triennial Review of local phone competition,
announcing a decision on February 20, 2003. Although the text of the order is
not yet available, the decision appears to preserve the Company's ability to use
UNE-P for the provision of bundled telecommunications services pending further
market-by-market analyses by the respective state commissions.
FEDERAL REGULATION OF THE COMPANY'S RATES, TERMS AND CONDITIONS
The FCC has imposed numerous reporting, accounting, record keeping and
other regulatory obligations on the Company. The Company must offer interstate
and international services under rates, terms and conditions that are just,
reasonable and not unreasonably discriminatory. The Company also must post
publicly the rates, terms and conditions of the Company's interstate and
international long distance service on the Company's web site or elsewhere, and
is authorized to file interstate tariffs on an ongoing basis for interstate
access services (rates charged among carriers for access to their networks).
Although the Company's interstate and international service rates, terms, and
conditions are subject to review, they are presumed to be lawful and have never
been formally contested by customers or other consumers. Other FCC rules govern
the procedures the Company uses to solicit customers, its handling of customer
information, its obligation to assist in funding the federal system of universal
service, its billing practices and the like. The Company may be subject to
forfeitures and other penalties if it violates the FCC's rules.
Long distance carriers pay local facilities-based carriers, including the
Company, interstate access charges for both originating and terminating the
interstate calls of long distance customers on the local carriers' networks and
facilities, including UNE-P. Historically, the RBOCs set access charges higher
than cost and justified this pricing to regulators as a subsidy to the cost of
providing local telephone service to higher cost customers. With the
establishment of an explicit and competitively neutral universal service subsidy
mechanism and, as a result of other access reform proceedings, the FCC is under
increasing pressure to revise the current access charge regime to bring the
charges closer to the cost of providing access. In response, the FCC issued a
decision in 2001 setting the rates that competitive local carriers charge to
long distance carriers at a level that will gradually decrease to the rates
8
charged by incumbent carriers. So long as the Company is in compliance with the
FCC's rate schedule, the FCC's order forbids long distance carriers from
challenging our interstate access rates. This FCC decision lowering access
charges may reduce our access charge revenues over time. The FCC is also
considering, in a declaratory ruling proceeding commenced in November 2002, the
question of whether voice over the Internet services or services utilizing an
Internet protocol should be made subject to interstate access charges in the
same manner as traditional telephony. The FCC has indicated on several
occasions that such services are exempt from interstate access charges, but
until the FCC issues its ruling in the current proceeding, it is unclear how
such traffic will be treated for intercarrier compensation purposes.
REGULATION OF ACCESS TO UNBUNDLED NETWORK ELEMENTS
Access to RBOC UNEs at cost-based rates is critical to the Company's
business. The Company's local telecommunications services are provided almost
exclusively through the use of combinations of RBOC UNEs, and it is the
availability of cost-based UNE rates that enables the Company to price its local
telecommunications services competitively. However, the obligation of RBOCs to
provide UNEs at such cost-based rates has been the subject of recent regulatory
and judicial actions which has affected their availability. Additional
proceedings are imminent which could result in them being substantially reduced,
at least in some markets.
Access to RBOC UNEs in a fashion in which they are combined by the RBOCs is
critical to the Company's business. The Company's local telecommunications
services are provided primarily through the use of UNE-P, in which UNEs
necessary to provide service to the Company's customers (unbundled loops,
transport, and local switching) are combined by the RBOCs and then leased to new
entrants. The FCC's yet-to-be-released Triennial Review decision, and
subsequent state proceedings called for by that decision, will determine the
extent to which RBOCs will continue to be required to provide such UNE
combinations to competitors.
The existing set of UNEs were largely established by the FCC in its Local
Interconnection Order in 1996, and updated in a proceeding on remand from the
Supreme Court's Iowa Utilities Board case in 1999. The Supreme Court held that
the FCC did not apply the correct standards when determining which network
elements must be unbundled and made available to competitive telephone companies
such as the Company. In November 1999, the FCC released its "UNE Remand Order"
addressing the deficiencies in the FCC's original ruling cited by the Supreme
Court. The order was generally viewed as favorable to the Company and other
competitive carriers because it ensured that incumbent carriers would be
required to make available those network elements, including UNE-P, that are
crucial to the Company's ability to provide local and other services. The
order was appealed by the incumbent carriers and in May, 2002, the United States
Court of Appeals for the D.C. Circuit released an opinion remanding the UNE
Remand Order to the FCC for further consideration. The Court remanded the UNE
Remand Order because (1) the FCC adopted, as to almost every unbundled element,
a uniform national rule mandating the element's unbundling in every geographic
market and customer class, without regard to the state of competition in any
particular market; and (2) the FCC's concept of the circumstances in which cost
disparities would under the Telecommunications Act's standards, "impair" a
competitor's ability to provide service without unbundled elements was
considered too broad.
As part of its regular periodic review of the list of unbundled elements,
the FCC initiated its so-called UNE Triennial Review rulemaking proceeding on
December 12, 2001. The FCC in its Triennial Review, and in response to the D.C.
Circuit Court's decision, reviewed all UNEs to determine whether RBOCs should
continue to be required to provide them to competitors.
At its Feb. 20, 2003, open meeting, the FCC adopted its Triennial Review
decision. The full text of the order is not yet available so at this time we
only have a broad outline of the FCC's announced actions without the detail
required to fully assess all of the potential ramifications of this important
decision. However, based on the FCC's press release and the FCC Commissioners'
comments at the meeting the decision appears to preserve the Company's ability
to use UNE-P for the provision of bundled telecommunications services and
appears to delegate to each state the overall responsibility for deciding, under
FCC guidelines, what unbundled elements should be available to competitors like
the Company in local markets
9
within the state's jurisdiction as well as the costs that the RBOCs may charge
for such elements. This creates the risk that some states may decide to limit
or eliminate unbundled elements that the Company currently has access to, that
the cost of such elements may increase and that the Company will be faced with
different sets of rules and costs if states issue inconsistent decisions. Among
the broad highlights of the Triennial Review decision that can be discerned at
this time are the following actions that have a significant impact on the
Company:
Unbundled Local Switching and UNE-P: The FCC's current rules generally require
incumbent carriers to offer local circuit switching as an unbundled network
element, and thus UNE-P, to competing carriers at cost-based prices. However,
an incumbent carrier need not make local circuit switching available where it
would be used to serve end users with four or more lines in zones with the
highest density of access lines and greatest traffic volume in the top 50
Metropolitan Statistical Areas, provided that the incumbent carrier provides
nondiscriminatory, cost-based access to the enhanced extended link, or EEL. The
EEL, which consists of an unbundled loop, multiplexing/concentrating equipment
and dedicated transport, allows a competing carrier to serve a customer by
extending the customer's loop from the end office serving that customer to a
different end office in which the competitor is already co-located with its own
network facilities.
During the FCC's Triennial Review proceeding, the incumbents launched a
fierce campaign, at both the FCC and in Congress, in an attempt to limit the
availability of circuit switching and, as a result, UNE-P. Comments made at the
Triennial Review FCC public meeting, during the FCC press conference, and in the
associated press release indicate that the FCC adopted a presumption that access
to unbundled switching for voice grade or DS-0 local circuit switching remains
impaired, which means that UNE-P would still be available to the Company for
residential and most small-business customers (provided unbundled loops and
transport also remain available in those geographic areas where the Company
intends to use UNE-P). Nonetheless, the FCC's presumption of impairment is
rebuttable, and the Company expects that incumbent carriers in all or virtually
all states will press for state commissions to conduct proceedings over the
nine-month period following the effectiveness of the FCC's Triennial Review
order, as contemplated by that decision, to rebut that presumption and to remove
local switching and UNE-P from the incumbent carriers' set of unbundling
obligations. The FCC's order appears to provide that, in that event, UNE-P would
remain available for the limited purpose of a customer acquisition vehicle for
an extended transition period of three years. (Again, the details of the FCC's
plan and the scope of the potential adverse effects on the Company's business
cannot be truly known until the text of the FCC's order is released.) In
addition, we anticipate that the incumbents will challenge the FCC's decisions
regarding unbundled local switching in court, and will also lobby the United
States Congress, in an effort to remove local circuit switching from the list of
UNEs on an even faster basis than could occur under the framework adopted by the
FCC based upon state commission proceedings. If the incumbents' campaign is
successful, this would disadvantage UNE-P providers such as the Company. Further
restrictions upon the availability of local circuit switching beyond those
currently in place would significantly restrict the Company's ability to provide
service on a UNE-P basis. Where circuit switching is not available, the Company
would be unable to offer service on a UNE-P basis and must instead serve
customers on its own facilities or rely on the switching facilities of other,
non-incumbent carriers, which may delay service roll-out in some markets,
increase costs, and negatively impact the Company's business, prospects,
operating margins, results of operations, cash flows and financial condition.
The FCC's anticipated order will adopt a rebuttable presumption that local
circuit switching has been eliminated as an unbundled network element for
high-capacity (DS-1 or T-1 and above) end users; state commissions will have 90
days after the effectiveness of the FCC's order to conduct proceedings to
determine whether to rebut the presumption of no impairment for this level of
unbundled local circuit switching, and UNE-P that relies on this level of
switching.
UNE Pricing: The current UNE pricing rules were established in 1996 in the
FCC's Local Competition Order, wherein the FCC concluded that the rates charged
to new entrants must be based on the forward-looking costs of providing the
interconnection or UNEs ordered. The FCC rejected the use of historical or
embedded costs in setting rates that new entrants pay. The FCC further required
a specific methodology, "total element long-run incremental cost" ("TELRIC"), to
calculate an RBOC's forward-looking costs. The FCC required that TELRIC be
measured based on the use of the most efficient telecommunications technology
currently available and the lowest cost network configuration, given the
location of existing RBOC wire centers. Under the Telecommunications Act, state
commissions set the actual UNE rates based on the federally-adopted methodology.
10
On remand from the U.S. Supreme Court in AT&T v. Iowa Utilities Board, the
Eighth Circuit Court of Appeals concluded in 2000 that the FCC's UNE pricing
rules violated the terms of the Telecommunications Act. The Eighth Circuit
determined that the FCC's TELRIC methodology incorrectly based costs on the most
efficient technology and configuration available, rather than the actual cost of
the particular facilities and equipment deployed by RBOCs. The Eighth Circuit
ruled that the FCC cannot require that UNE prices be calculated at the cost of a
hypothetical network, as opposed to the costs actually incurred, by the RBOCs.
The Eighth Circuit, however, did not vacate the FCC's decision to use a
forward-looking cost methodology. The Court determined that requiring that
forward-looking costs be used to establish UNE rates is a matter within the
FCC's discretion.
The FCC, RBOCs and CLECs (competitive local exchange carriers) all appealed
the Eighth Circuit decision to the U.S. Supreme Court. The Supreme Court
granted certiorari in these cases, styled Verizon Communications v. FCC, and in
May 2002, reversed the Eighth Circuit (except for its decision about the use of
a forward-looking methodology) and upheld the validity of the FCC's TELRIC
pricing methodology for UNEs.
Although the FCC's forward-looking cost model for establishing rates for
unbundled network elements has been upheld by the U.S. Supreme Court, it is
possible that either the FCC will review or revise the methodology in a manner
that raises the Company's costs or the states will review the UNE rates they
have established under a TELRIC methodology. The FCC's methodology and the
manner in which it is applied are under attack from the incumbent carriers and
the U.S. Telecom Association, their trade association, and intense lobbying
efforts by the incumbent carriers could lead the FCC to re-examine its pricing
rules further or even convince Congress to modify the pricing standard for
unbundled network elements in the Telecommunications Act, leading to higher
prices. In fact, the FCC has indicated that it may comprehensively review that
methodology in the near future. Further, as a possible foretaste, in its recent
Triennial Review decision, the FCC appears to have opened the door for
incumbents to utilize a higher cost of capital input and shorter depreciation
lives in establishing rates for unbundled elements. Incumbent carriers also
routinely file petitions with the state commissions seeking to increase the
rates they can charge competitors for unbundled elements. Such modifications to
the incumbents' UNE rates could raise our costs for leasing UNE-P and other UNEs
in the future.
As indicated above, the text of the Triennial Review decision has not yet
been released. It is anticipated that once the FCC's new unbundling rules
become effective, incumbent carriers will pursue review in courts, attempt to
institute proceedings with the FCC and state regulatory agencies, and lobby the
United States Congress in an effort to affect laws and regulations regarding the
availability of UNEs and UNE-P, and the prices competitors pay for them, in a
manner even more favorable to them and against the interests of competitive
carriers. Concomitantly, it is expected that competitive carriers will endeavor
to improve their positions and access to the incumbents' networks at cost-based
rates through similar means.
REGULATION OF MARKETING
The Company's current and past direct and partner marketing efforts all
require compliance with relevant federal and state regulations that govern the
sale of telecommunication services. The FCC and many states have rules that
prohibit switching a customer from one carrier to another without the customer's
express consent and specify how that consent must be obtained and verified.
Most states also have consumer protection laws that further define the framework
within which the Company's marketing activities must be conducted. While
directed at curbing abusive marketing practices, the design and enforcement of
these rules can have the incidental effect of entrenching incumbent carriers and
hindering the growth of new competitors, such as the Company.
The Company's marketing efforts are carried out through a variety of
marketing programs, including referrals from existing customers, outbound
telemarketing, direct sales through independent agents and the Company's own
direct sales force, broadcast media and online marketing initiatives.
Restrictions on the marketing of telecommunication services are becoming
stricter in the wake of widespread consumer complaints throughout the industry
about "slamming" (the unauthorized change of a customer's service from one
carrier to another carrier) and "cramming" (the unauthorized provision of
additional telecommunication services). The Telecommunications Act strengthened
penalties against slamming, and the FCC issued and updated rules tightening
federal requirements for the verification of orders for telecommunication
services and establishing additional financial penalties for slamming. In
11
addition, many states have been active in restricting marketing through new
legislation and regulation, as well as through enhanced enforcement activities.
The Federal Trade Commission and the FCC have proposed rules and regulations
governing the creation and enforcement of national "do not call" databases that
could affect the Company's ability to outbound telemarket. The Company's
marketing activities have subjected the Company to investigations or enforcement
actions by government authorities. The constraints of federal and state
regulation, as well as increased FCC, Federal Trade Commission and state
enforcement attention, could limit the scope and the success of the Company's
marketing efforts and subject them to enforcement actions, which may have an
adverse effect on the Company.
Statutes and regulations designed to protect consumer privacy also may have
the incidental effect of hindering the growth of newer telecommunication
carriers such as the Company. For example, the FCC rules that restrict the use
of "customer proprietary network information" (information that a carrier
obtains and uses about its customers through their use of the carrier's
services) may make it more difficult for the Company to market additional
telecommunication services (such as local and wireless), as well as other
services and products, to its existing customers.
UNIVERSAL SERVICE FUND REGULATION
Pursuant to Section 254 of the Telecommunications Act, the FCC requires the
Company and other providers of telecommunication services to contribute to a
federally administered universal service fund, which helps to subsidize the
provision of local telecommunication services and other services to low-income
consumers, schools, libraries, health care providers, and rural and insular
areas that are costly to serve. The Telecommunications Act requires every
telecommunication carrier that provides interstate telecommunication services to
contribute, on an equitable and nondiscriminatory basis, to the specific,
predictable, and sufficient mechanisms established by the FCC to preserve and
advance universal service. These regulations were recently amended and
contributions to the FCC's universal service funds are now assessed on
telecommunication providers' projected combined interstate and international end
user telecommunication revenues, and no longer permit telecommunication
providers to recover margin on this assessment. The Company's contribution of
revenues to universal service stands at 7.28% of end user telecommunications
revenues for the first quarter of 2003 and 9.0044% for the second quarter of
2003. In a December 2002 Notice of Proposed Rulemaking, the FCC has asked many
broad-ranging questions regarding universal service including, whether to change
its method of assessing contributions due from carriers by basing it on the
number and capacity of connections they provide, rather than on interstate and
international end user revenues they earn. The Company cannot be sure that
legislation or FCC rulemaking will not increase the size of its subsidy
payments, the scope of the subsidy program or the Company's costs of
calculating, collecting and remitting the payments. Some states have similar
universal fund programs, and in those instances the Company may be required to
remit a portion of its intrastate revenue to such funds.
STATE REGULATION
The vast majority of the states require the Company to apply for
certification to provide local and intrastate telecommunication services, or at
least to register or to be found exempt from regulation, before commencing
intrastate service. The majority of states also require the Company to file and
maintain detailed tariffs listing its rates for intrastate service. State law
typically requires charges and terms for the Company's services to meet certain
standards, such that its charges and practices be just, reasonable and not
unreasonably discriminatory. Many states also impose various reporting
requirements and/or require prior approval for transfers of control of certified
carriers, corporate reorganizations, acquisitions of telecommunication
operations, assignments of carrier assets, including subscriber bases, carrier
stock offerings and incurrence by carriers of significant debt obligations.
Certificates of authority can generally be conditioned, modified, canceled,
terminated or revoked by state regulatory authorities for failure to comply with
state law and the rules, regulations and policies of the state regulatory
authorities. Fines and other penalties, including the return of all monies
received for intrastate traffic from residents of a state, may be imposed for
such violations. State regulatory authorities may also place burdensome
requirements on telecommunication companies seeking transfers of control for
licenses and the like. Under the regulatory arrangement contemplated by the
Telecommunications Act, state authorities continue to regulate certain matters
related to universal service, public safety and welfare, quality of service and
12
consumer rights. All of these regulations, however, must be competitively
neutral and consistent with the Telecommunications Act, which generally
prohibits state regulation that has the effect of prohibiting us from providing
telecommunications services in any particular state. State commissions also
enforce some of the Telecommunications Act's local competition provisions,
including those governing the arbitration of interconnection disputes between
the incumbent carriers and competitive telephone companies and the setting of
rates for unbundled network elements.
FINANCIAL RESTRUCTURING
Beginning in the third quarter of 2001, the Company embarked upon a
comprehensive restructuring of its financial obligations with (i) America
Online, Inc. ("AOL"), (ii) its senior secured creditor, and (iii) the holders of
the Company's convertible subordinated notes. References in the following
discussion to numbers of shares of common stock and per share prices reflect
adjustment for the one-for-three reverse stock split as of October 15, 2002.
AOL RESTRUCTURING
In September, 2001, the Company restructured its financial obligations with
AOL that arose under the 1999 Investment Agreement between the Company and AOL
and, effective September 30, 2001, ended its marketing relationship with AOL.
The Company began marketing and providing telecommunication services to AOL
subscribers under the Company's and AOL's brand in 1997. In January, 1999, AOL
made a $55 million investment in the Company at $57 per share and the Company
provided AOL with the ability to protect the value of that investment for a
period of time, permitting AOL, at its election, to require the Company to make
certain "make whole" payments to AOL on or before September 30, 2001. As a
result of the September 2001 restructuring and the termination of the marketing
agreement, the Company issued to AOL $34 million of its 8% Secured Convertible
Notes due September 2011 ("8% Secured Convertible Notes") in exchange for a
release of the Company's reimbursement obligations under the 1999 Investment
Agreement. The Company also issued 1,026,209 additional shares of its common
stock in exchange for warrants to purchase the Company's common stock held by
AOL and the Company's related obligations under the 1999 Investment Agreement to
repurchase those warrants, bringing the total number of shares of the Company's
common stock held by AOL to 2,400,000. On December 23, 2002, the Company
restructured its 8% Secured Convertible Notes. The principal terms of the
restructuring were as follows: the new maturity date is September 19, 2006, a
pay-in-kind interest option was eliminated and interest is thereafter required
to be paid entirely in cash, and the Company was provided additional flexibility
to purchase subordinated debt and common stock through September 30, 2003. In
2002, the Company repurchased $5.4 million of its 8% Secured Convertible Notes.
Through March 28, 2003, the Company has repurchased $3.6 million of its 8%
Secured Convertible Notes, reducing the outstanding principal amount to $26.6
million as of March 28, 2003. In January 2003, the Company purchased 1,315,789
of its common shares from AOL for an aggregate purchase price of approximately
$5.0 million.
SECURED CREDIT FACILITY RESTRUCTURING
By amendments on February 12, 2002, and April 3, 2002, the Company
restructured certain portions, including financial covenants, of its Credit
Facility Agreement with MCG Finance Corporation ("MCG"), and the Consulting
Agreement, and other loan documents between the parties. In October 2002, the
Company retired the facility of $13.8 million prior to its originally scheduled
maturity in 2005.
CONVERTIBLE SUBORDINATED NOTES RESTRUCTURING
As of December 31, 2001, the Company had an aggregate amount of $61.8
million in 4 1/2% Convertible Subordinated Notes due in September 2002 ("4-1/2%
Convertible Subordinated Notes") and $18.1 million in 5% Convertible
Subordinated Notes due in 2004 ("5% Convertible Subordinated Notes"). The
Company decided to offer to exchange the 4-1/2% Convertible Subordinated Notes
and the 5% Convertible Subordinated Notes ("Existing Notes") for new notes,
principally to extend the time that the Company has to pay the Existing Notes,
as part of the Company's efforts to restructure its debt obligations, and
maintain sufficient cash to conduct its operations. On February 22, 2002, the
Company initiated Exchange Offers and Consent Solicitations ("the Exchange
Offers") for all of the Company's outstanding Existing Notes. On April 4, 2002,
the Company completed the exchange for $57.9 million principal amount, or 94% of
the total amount outstanding, of its 4-1/2% Convertible Subordinated Notes that
were
13
tendered for exchange in the Exchange Offers and approximately $17.4 million
principal amount, or 95% of the total amount outstanding, of its 5% Convertible
Subordinated Notes that were tendered for exchange in the Exchange Offers. The
Company issued $53.2 million in principal amount of its new 12% Senior
Subordinated PIK Notes due 2007 ("12% Senior Subordinated Notes") and $2.8
million in principal amount of its new 8% Convertible Senior Subordinated Notes
due 2007 ("8% Convertible Senior Subordinated Notes") (convertible into common
stock at $15.00 per share), and paid approximately $0.5 million in cash, in
exchange for the tendered 4-1/2% Convertible Subordinated Notes. Interest on the
new 12% Senior Subordinated Notes is payable in cash, except that the Company
may, at its election, pay up to one-third of the interest due on any interest
payment date through and including the August 15, 2004 interest payment in
additional 12% Senior Subordinated Notes. The Company also issued $17.4 million
in principal amount of its 12% Senior Subordinated Notes in exchange for the
tendered 5% Convertible Subordinated Notes. In addition, the holders of the
4-1/2% Convertible Subordinated Notes and 5% Convertible Subordinated Notes
consented to amend the respective indentures under which the Existing Notes were
issued to eliminate from the indentures the right to require the Company to
repurchase such notes should the Company's common stock cease to be approved for
trading on an established automated over-the-counter trading market in the
United States. After completion of the Exchange Offers, there were outstanding
approximately $70.7 million principal amount of the Company's 12% Senior
Subordinated Notes, approximately $2.8 million principal amount of the Company's
8% Convertible Senior Subordinated Notes, approximately $3.9 million principal
amount of the 4-1/2% Convertible Subordinated Notes and approximately $0.7
million principal amount of the 5% Convertible Subordinated Notes. In September
2002, the Company retired upon maturity the remaining $3.9 million principal
amount of the 4-1/2% Convertible Subordinated Notes. The Company repurchased
$5.7 million of its 12% Senior Subordinated Notes in 2002 and, in 2003, through
March 28, has repurchased an additional $9.4 million of its 12% Senior
Subordinated Notes, reducing the outstanding principal amount to $56.6 million
as of March 28, 2003.
EMPLOYEES
As of December 31, 2002 the Company employed approximately 1,000 persons.
The Company considers relations with its employees to be good.
ITEM 2. PROPERTIES
The Company leases an approximately 8,000 square foot facility in Reston,
Virginia, that serves as the Company's headquarters and is where a number of the
Company's executives, network and marketing personnel are located. The Company
owns an approximately 24,000 square foot facility in New Hope, Pennsylvania
where certain of the Company's executives and its finance, legal, information
technology development and marketing personnel are located. The Company also
leases properties in the cities in which switches for its network have been or
will be installed (New York, New York; San Francisco, California; Chicago,
Illinois; Dallas, Texas; Jacksonville, Florida; and Southfield, Michigan). The
Company leases an approximately 3,500 square foot facility in Chicago, Illinois
for additional information technology development personnel.
With respect to the Company's sales, provisioning and customer service
operations, the Company owns a 32,000 square foot facility located in Palm
Harbor, Florida. The Company also leases the following facilities for sales,
provisioning and customer service operations: an approximately 29,000 square
foot facility in Orlando, Florida, an approximately 13,000 square foot facility
in Greenville, South Carolina, and an approximately 12,000 square foot facility
in Fort Myers, Florida.
ITEM 3. LEGAL PROCEEDINGS
The Company is party to a number of legal actions and proceedings,
including purported class actions, arising from the Company's provision and
marketing of telecommunications services, as well as certain legal actions and
regulatory investigations and enforcement proceedings arising in the ordinary
course of business. The Company believes that the ultimate outcome of the
foregoing actions will not result in liability that would have a material
adverse effect on the Company's financial condition or results of operations.
However, it is possible that, because of fluctuations in the Company's cash
position, the timing of developments with respect to such matters that require
cash payments by the Company, while such payments are not expected to be
material to the Company's financial condition, could impair the Company's
ability in future interim or annual periods to continue to implement its
business plan, which could affect the Company's results of operations in future
interim or annual periods.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
14
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock, $.01 par value per share, is traded on the
Nasdaq National Market under the symbol "TALK". The Company's stockholders
approved a one-for-three reverse stock split of the Company's common stock,
effective October 15, 2002, decreasing the number of common shares authorized
from 300 million to 100 million. All applicable references to the number of
shares of common stock and per share information, stock option data and market
prices have been restated to reflect this reverse stock split. High and low
quotations listed below are actual closing sales prices as quoted on the Nasdaq
National Market:
COMMON STOCK PRICE RANGE OF COMMON STOCK
------------ ----------------------------
HIGH LOW
-------- --------
2001
First Quarter $ 7.59 $ 3.84
Second Quarter 7.53 2.73
Third Quarter 3.18 0.99
Fourth Quarter 1.56 1.02
2002
First Quarter $ 1.92 $ 1.11
Second Quarter 12.39 1.32
Third Quarter 11.91 6.15
Fourth Quarter 9.18 5.43
2003
First Quarter (through March 26, 2003) $ 7.34 $ 3.52
As of March 26, 2003, there were approximately 910 record holders of
Common Stock.
The Company has never declared or paid any cash dividends on its capital
stock. The Company currently intends generally to retain future earnings to
finance the growth and development of its business and, therefore, does not
anticipate paying cash dividends in the foreseeable future. In addition, the 8%
Secured Convertible Notes prohibit the Company from paying any dividends on its
capital stock.
COMPENSATION PLANS AND SECURITIES
The following table sets forth certain information as of December 31, 2002
with respect to compensation plans under which equity securities of the Company
are authorized for issuance:
NUMBER OF SECURITIES
NUMBER OF SECURITIES TO WEIGHTED-AVERAGE REMAINING AVAILABLE
BE ISSUED UPON EXERCISE EXERCISE PRICE OF FOR FUTURE ISSUANCE
OF OUTSTANDING OPTIONS, OUTSTANDING OPTIONS, UNDER EQUITY
PLAN CATEGORY WARRANTS AND RIGHTS WARRANTS AND RIGHTS COMPENSATION PLANS (1)
------------------------- ----------------------- ------------------- ----------------------
Equity compensation
plans approved by
security holders 2,141,758 $ 5.50 126,097
Equity compensation
plans not approved
by security holders (2) 2,043,942 $ 8.25 774,188(1)
----------------------- ------------------- ----------------------
Total 4,185,700 $ 6.84 900,285
(1) Under all plans, if any shares subject to a previous award are
forfeited, or if any award is terminated without issuance of shares or satisfied
with other consideration, the shares subject to such award shall again be
available for future grants.
(2) The shares are primarily under the Company's 2001 Non-Officer Long Term
Incentive Plan pursuant to which up to 1,666,666 shares of the Company's common
stock may be issued to employees of the Company in the form of options, rights,
restricted stock and incentive shares. The shares also include shares issuable
on exercise of certain options granted in connection with the initial employment
of executive officers and without shareholder approval as permitted by the rules
of Nasdaq. To the extent permitted by the rules of Nasdaq, there may be further
grants of securities by option or otherwise without shareholder approval, both
to non-executive employees and in connection with the initial employment of
executive officers.
15
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data should be read in conjunction
with, and are qualified in their entirety by, "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the Company's
Consolidated Financial Statements included elsewhere in this Form 10-K.
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT FOR PER SHARE AMOUNTS)
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Sales $ 317,507 $ 488,158 $ 525,712 $ 516,548 $ 448,600
Costs and expenses:
Network and line costs 155,567 235,153 292,931 289,029 321,215
General and administrative expenses 53,510 82,202 65,360 39,954 39,393
Provision for doubtful accounts 9,365 92,778 53,772 28,250 37,789
Sales and marketing expenses 27,148 73,973 152,028 96,264 210,552
Depreciation and amortization 17,318 34,390 19,257 6,214 5,499
Impairment and restructuring charges -- 170,571 -- -- --
Significant other charges (income) -- -- -- (2,718) 91,025
--------- --------- --------- --------- ---------
Total costs and expenses 262,908 689,067 583,348 456,993 705,473
--------- --------- --------- --------- ---------
Operating income (loss) 54,599 (200,909) (57,636) 59,555 (256,873)
Other income (expense):
Interest income 802 1,220 4,859 3,875 38,876
Interest expense (9,087) (6,091) (5,297) (4,616) (29,184)
Other, net (892) (2,698) (3,822) (1,115) (20,867)
--------- --------- --------- --------- ---------
Income (loss) before provision for income
taxes 45,422 (208,478) (61,896) 57,699 (268,048)
Provision (benefit) for income taxes (1) (22,300) -- -- -- 40,388
--------- --------- --------- --------- ---------
Income (loss) before extraordinary gains and
cumulative effect of an accounting change 67,722 (208,478) (61,896) 57,699 (308,436)
Extraordinary gains 29,340 20,648 -- 21,230 87,110
Cumulative effect of an accounting change -- (36,837) -- -- --
--------- --------- --------- --------- ---------
Net income (loss) $ 97,062 $(224,667) $ (61,896) $ 78,929 $(221,326)
========= ========= ========= ========= =========
Income (loss) per share - Basic:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per
share $ 2.48 $ (7.89) $ (2.63) $ 2.83 $ (15.61)
Extraordinary gains per share 1.08 0.78 -- 1.04 4.41
Cumulative effect of an accounting change per
share -- (1.40) -- -- --
--------- --------- --------- --------- ---------
Net income (loss) per share $ 3.56 $ (8.51) $ (2.63) $ 3.87 $ (11.20)
========= ========= ========= ========= =========
Weighted average common shares outstanding 27,253 26,414 23,509 20,395 19,761
========= ========= ========= ========= =========
Income (loss) per share - Diluted:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per
share $ 2.20 $ (7.89) $ (2.63) $ 2.69 $ (15.61)
Extraordinary gains per share 0.95 0.78 -- 0.99 4.41
Cumulative effect of an accounting change per
share -- (1.40) -- -- --
--------- --------- --------- --------- ---------
Net income (loss) per share $ 3.15 $ (8.51) $ (2.63) $ 3.68 $ (11.20)
========= ========= ========= ========= =========
Weighted average common and common
equivalent shares outstanding 30,798 26,414 23,509 21,471 19,761
========= ========= ========= ========= =========
16
AT DECEMBER 31,
--------------------------------------------------------------
2002 2001 2000 1999 1998
--------- --------- --------- --------- ---------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents $ 33,588 $ 22,100 $ 40,604 $ 78,937 $ 3,063
Total current assets 81,261 50,698 97,203 150,893 149,769
Goodwill and intangibles, net (4) 26,882 29,672 218,639 1,068 1,150
Total assets 187,511 165,221 407,749 215,008 272,560
Current portion of long-term debt (3) 61 14,454 2,822 -- 49,621
Total current liabilities 63,190 87,273 100,271 71,168 136,708
Contingent obligations -- -- 114,630 114,630 --
Long-term debt (2)(3) 100,855 152,370 103,695 84,985 242,387
Stockholders' equity (deficit) 23,466 (74,422) 82,700 (69,375) (136,785)
-----------------------------------------
(1) The provision for income taxes in 1998 represents a valuation allowance for
deferred tax assets recorded in prior periods and current tax benefits that
may result from the 1998 loss. The Company provided the valuation
allowances in view of the loss incurred in 1998, the uncertainties
resulting from intense competition in the telecommunication industry and
the lack of any assurance that the Company would realize any tax benefits.
The Company has continued to provide a valuation allowance against its
deferred tax assets at December 31, 2001, 2000 and 1999. In 2002, as part
of the Company's 2003 budgeting process, management evaluated the deferred
tax valuation allowance and determined that a portion of this valuation
allowance should be reversed, resulting in a non-cash deferred income tax
benefit of $22.3 million.
(2) Long-term debt at December 31, 2001 included $31.0 million of future
accrued interest in connection with the 8% Secured Convertible Notes in
accordance with SFAS No. 15, "Accounting by Debtors and Creditors for
Troubled Debt Restructuring." In 2002, the 8% Secured Convertible Notes
were restructured, resulting in the elimination of the future accrued
interest in connection therewith. As a result of the 2002 restructuring of
the Company's 8% Secured Convertible Notes in 2002 and retirement of a
portion of such notes, the Company recorded an extraordinary gain of $28.9
million.
(3) The Company restructured substantially all of the 4-1/2% and 5% Convertible
Subordinated Notes in April 2002; accordingly, $57.9 million of the 4-1/2%
Convertible Subordinated Notes are classified as long-term debt as of
December 31, 2001.
(4) In 2001, the Company recorded an impairment charge of $168.7 million
primarily related to the write-down of goodwill associated with the
acquisition of Access One.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements included elsewhere in this Form 10-K. Certain
of the statements contained herein may be considered forward-looking statements.
Such statements are identified by the use of forward-looking words or phrases,
including, but not limited to, "estimates," "expects," "expected,"
"anticipates" and "anticipated." These forward-looking statements are based on
the Company's current expectations. Although the Company believes that the
expectations reflected in such forward-looking statements are reasonable, there
can be no assurance that such expectations will prove to have been correct.
Forward-looking statements involve risks and uncertainties and the
Company's actual results could differ materially from the Company's
expectations. In addition to those factors discussed in this Form 10-K and the
Company's other filings with the Securities and Exchange Commission, important
factors that could cause such actual results to differ materially include, among
others, dependence on the availability and functionality of RBOCs' networks as
they relate to the unbundled network element platform, increased price
competition for long distance and local services, failure of the marketing of
17
the bundle of local and long distance services and long distance services under
its agreements with its direct marketing channels and its various marketing
partners, failure to manage the nonpayment of amounts due the Company from its
customers from bundled and long distance services, attrition in the number of
end users, failure or difficulties in managing the Company's operations,
including attracting and retaining qualified personnel, failure of the Company
to be able to expand its active offering of local bundled services in a greater
number of states, failure to provide timely and accurate billing information to
customers, failure of the Company to manage its collection management systems
and credit controls for customers, interruption in the Company's network and
information systems, failure of the Company to provide adequate customer
service, and changes in government policy, regulation and enforcement and/or
adverse judicial or administrative interpretations and rulings relating to
regulations and enforcement, including, but not limited to, the continued
availability of unbundled network element platform of the local exchange
carriers network.
OVERVIEW
The Company provides local and long distance telecommunication services to
residential and small business customers in the United States. The Company has
developed integrated order processing, provisioning, billing, payment,
collection, customer service and information systems that enable the Company to
offer and deliver high-quality service, savings through competitively priced
telecommunication products, and simplicity through consolidated billing and
responsive customer service.
The Company offers both local and long distance telecommunication services,
primarily the bundled service offering of local and long distance voice
services, which are billed to customers in one combined invoice. Local phone
services include local dial tone, various local calling plans that include free
member-to-member calling, and a variety of features such as caller
identification, call waiting and three-way calling. Long distance phone
services include traditional 1+ long distance, international and calling cards.
The Company uses the unbundled network element platform ("UNE-P") of the
regional bell operating companies ("RBOCs") network to provide local services
and the Company's nationwide network to provide long distance services. The
Federal Communications Commission ("FCC") has recently concluded its triennial
review of local phone competition. Although the text of the order is not yet
available, the decision appears to preserve the Company's ability to use UNE-P
for the provision of bundled telecommunications services pending further
market-by-market analyses by the respective state commissions.
By the end of 1999, the Company decided to expand beyond its historical
long distance business and utilize UNE-P to enter the large local
telecommunications market and diversify its product portfolio through the
bundling of local service with its core long distance service offerings. In
connection therewith, the Company acquired Access One Communications Corp.
("Access One") in August 2000. Access One was a private, local telecommunication
services provider to nine states in the southeastern United States. The Company
encountered a number of operational and business difficulties during the rollout
of the Company's bundled service offering and worked to address the operational
issues that it encountered. The Company focused on improving the overall
efficiency of the bundled business model in 2001. During 2002, the Company's top
operating priorities were to lower bad debt expense, reduce customer turnover,
or "churn," and lower its customer acquisition costs. During 2003, the Company's
primary focus will be to increase sales of its local bundled service within the
targets established by management for acquisition costs, customer turnover and
bad debt expense.
The Company continues to manage its business to generate free cash flow
(defined as net cash provided by operating activities less net cash used in
investing activities) and has built a scaleable platform to provision, bill and
service bundled customers. The Company continues to focus on delivering better
service and value to customers. During 2002, the Company expanded its product
offerings to appeal to a broader customer base based upon calling patterns and
feature preferences. Although the Company is now operational with respect to
its local service offering in 26 states, the Company has limited the marketing
of its bundled services to those states, or certain areas of a state, where the
Company believes it can currently offer services to customers at competitive
prices. The Company will market to additional states (or certain areas of a
particular state) as the Company believes its pricing and cost structure permit
it to profitably offer services in those areas at competitive rates. While the
Company has actively marketed the bundled product in a number of states, at
present, a majority of the Company's bundled customers are inMichigan. The
Company continually reviews its product offerings, pricing and sales and
marketing programs in an effort to improve the efficiency of its sales and
marketing channels.
18
During 2002, the Company completed a significant restructuring of its debt
obligations, including (1) an exchange offer that effectively extended the final
maturity on substantially all of the Company's public debt obligations to 2007;
(2) the retirement of the Company's senior credit facility of $13.8 million
prior to its scheduled maturity; (3) open market repurchases of $5.7 million
principal amount of the Company's 12% Senior Subordinated Notes; (4) the
repurchase of $5.4 million principal amount of the Company's 8% Secured
Convertible Notes; and (5) the restructuring of the 8% Secured Convertible
Notes. In 2003, through March 28, the Company has (i) repurchased a further
$9.4 million principal amount of its 12% Senior Subordinated Notes and $3.6
million principal amount of its 8% Secured Convertible Notes, and (ii) purchased
approximately 1.3 million shares of its common stock for an aggregate purchase
price of $5 million.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain financial
data of the Company as a percentage of sales:
YEAR ENDED DECEMBER 31,
--------------------------------------
2002 2001 2000
-------- -------- --------
Sales 100.0% 100.0% 100.0%
Costs and expenses:
Network and line costs 49.0 48.2 55.7
General and administrative expenses 16.8 16.8 12.5
Provision for doubtful accounts 2.9 19.0 10.2
Sales and marketing expenses 8.6 15.2 28.9
Depreciation and amortization 5.5 7.0 3.7
Impairment and restructuring charges -- 35.0 --
-------- -------- --------
Total costs and expenses 82.8 141.2 111.0
-------- -------- --------
Operating income (loss) 17.2 (41.2) (11.0)
Other income (expense):
Interest income 0.3 0.3 0.9
Interest expense (2.9) (1.2) (1.0)
Other, net (0.3) (0.6) (0.7)
-------- -------- --------
Income (loss) before income taxes 14.3 (42.7) (11.8)
Provision (benefit) for income taxes (7.0) -- --
-------- -------- --------
Income (loss) before extraordinary gains and
cumulative effect of an accounting change 21.3 (42.7) (11.8)
Extraordinary gains 9.3 4.2 --
Cumulative effect of an accounting change -- (7.5) --
-------- -------- --------
Net income (loss) 30.6% (46.0)% (11.8)%
======== ======== ========
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001
Sales. Sales decreased by 35.0% to $317.5 million in 2002 from $488.2
million in 2001. The decrease in sales for 2002 compared to 2001 is due to (i)
lower long distance sales resulting from the Company's continued focus, begun in
2000, on its efforts in the local telecommunication services market by offering
local telecommunication services bundled with long distance services and
significantly reduced sales and marketing related to the long distance product,
and (ii) lower bundled sales resulting primarily from lower average revenues per
line in 2002 as the Company lowered product prices to provide more value to the
consumer.
19
The Company's bundled sales for the year ended December 31, 2002 were
$171.2 million as compared to $196.5 million for the year ended December 31,
2001. The decreases in sales was due to lower average revenue per bundled line
in 2002 as compared to 2001. Such decrease resulted from the Company's ongoing
strategy to market lower priced products to be more competitive with incumbent
and other competitive local exchange carriers. In 2002, bundled revenues
increased sequentially from $35.5 million in the first quarter to $51.8 million
in the fourth quarter. The 2002 quarterly sequential growth reflected both
growth in bundled lines and reductions in customer turnover. The Company had
approximately 333,000 bundled lines as of December 31, 2002 compared with
approximately 179,000 bundled lines at December 31, 2001. Approximately 203,000
of the bundled lines at December 31, 2002 were in Michigan. Bundled revenues for
the quarter ending March 31, 2003 and the year ended 2003 are expected to be
between $57 and $60 million and $270 and $280 million, respectively. Bundled
lines for the quarter ended March 31, 2003 and for the year ended December 31,
2003 are expected to be between 380,000 and 390,000 and 525,000 and 545,000,
respectively. Longer-term growth in revenues will depend upon continued
operating efficiencies, lower customer turnover and the Company's ability to
develop and scale various marketing programs in additional states or areas.
The Company's long distance sales decreased to $146.3 million in 2002 from
$291.7 million in 2001. In 2001, a significant percentage of the Company's
revenues from long distance telecommunication services derived from customers
who were obtained under the AOL marketing agreement. The Company's decision to
focus on the bundled product and the discontinuation of the AOL marketing
relationship effective September 30, 2001, together with customer turnover,
contributed to the decline in long distance customers and revenues. This decline
in long distance customers and revenues is expected to continue so long as the
Company continues to focus its marketing efforts on the bundled product. Long
distance revenues in 2002 and 2001 included non-cash amortization of deferred
revenue of $6.2 million and $7.4 million, respectively, related to a
telecommunications service agreement entered into in 1997. Deferred revenue
relating to this agreement has been amortized over a five-year period. The
agreement and related amortization terminated in October 2002. Long distance
revenues for the quarter ended March 31, 2003, and the year ended 2003 are
expected to be between $24 and $27 million and $80 and $90 million,
respectively.
Recently, the Company has selectively increased certain fees and rates
related to its long distance and bundled products and such changes in rates and
bill presentation may adversely impact customer turnover.
Network and Line Costs. Network and line costs decreased by 33.8% to $155.6
million for the year ended December 31, 2002 from $235.2 million for the year
ended December 31, 2001. The decrease in network and line costs was primarily
due to the lower numbers of local and long distance customers and a reduction in
access and usage rates. Network and line costs for the year ended December 31,
2002 benefited from a credit of $1.7 million in connection with a New York
Public Service Commission mandated refund from Verizon New York of certain UNE-P
switching costs. Network and line costs also benefited from favorable resolution
of certain disputes with vendors. The Company's policy is not to record credits
from such disputes until received.
As a percentage of sales, network and line costs increased to 49.0% for the
year ended December 31, 2002, as compared to 48.2% for the year ended December
31, 2001. The growth of local bundled service as a percentage of total revenue
and product mix has contributed to the increase in overall network and line cost
as a percentage of revenues. Bundled network and lines costs as a percentage of
bundled revenues were 56.1% in 2002 as compared to 54.8% in 2001. Excluding the
benefit of the Verizon New York credit and other dispute resolutions, the
network and line costs as a percentage of sales for the bundled product would
have been approximately 59% in 2002. Long distance network and line costs as a
percentage of long distance revenues were 40.6% in 2002 as compared to 43.7% in
2001. Excluding amortization of deferred revenue related to a telecommunications
service agreement, which expired in October 2002, and various dispute
resolutions, network and line costs as a percentage of long distance revenue
would have been approximately 44% in 2002.
There are several factors that could cause network and line costs as a
percentage of sales to increase in the future, including (i) adverse changes to
the current rules and regulations or adverse judicial and administrative
interpretations and rulings relating to the FCC's recently concluded triennial
review of local phone competition and the pending market-by-market analyses by
the respective state commissions, (ii) greater absorption of fixed network costs
as the Company's long distance customer base declines, and (iii) certain minimum
network service commitments relating to the Company's long distance network.
See "Liquidity and Capital Resources, Other Matters."
General and Administrative Expenses. General and administrative expenses
decreased by 34.9% to $53.5 million for the year ended December 31, 2002 from
$82.2 million for the year ended December 31, 2001. The overall decrease in
general and administrative expenses was due primarily to significant workforce
reductions and other cost cutting efforts by the Company as it pursued
improvements in operating efficiencies of the Company's bundled business model.
Included in general and administrative expenses for the year ended December 31,
20
2002 was a non-cash credit of $1.7 million related to a favorable legal
settlement of a dispute that had previously been reflected as a liability,
partially offset by an increase in legal reserves of $0.5 million. General and
administrative expenses as a percentage of sales were 16.8% for both 2002 and
2001. While the Company expects general and administrative expense as a
percentage of sales to decline as the customer base grows, realization of such
efficiencies will be dependent on the ability of management to continue to
control personnel costs in areas such as customer service and collections. There
can be no assurances that the Company will be able to realize these
efficiencies.
Provision for Doubtful Accounts. Provision for doubtful accounts decreased
by 89.9% to $9.4 million for the year ended December 31, 2002 from $92.8 million
for the year ended December 31, 2001 and, as a percentage of sales, decreased to
2.9% as compared to 19.0% for the year ended December 31, 2001. The Company had
taken several steps during the third and fourth quarters of 2001 to reduce bad
debt expense, improve the overall credit quality of its customer base and
improve its collections of past due amounts. The benefits of the Company's
actions to reduce bad debt expense and improve the overall credit quality of its
customer base are reflected in the lower bad debt expense for the year ended
December 31, 2002. Further, the provision for doubtful accounts for the year
ended December 31, 2002 reflects a benefit from a reversal of the reserve for
doubtful accounts of $1.9 million due to better than expected collections
experience on outstanding accounts receivable at year-end 2001. Adjusting for
the reversal, the provision for doubtful accounts as a percentage of sales would
have been 3.5% for 2002. In general, the Company believes that bad debt
expense as a percentage of sales of the Company's long distance customers is
lower than that of its bundled customers because of the relatively greater
maturity of the long distance customer base.
Sales and Marketing Expenses. During the year ended December 31, 2002, the
Company incurred $27.1 million of sales and marketing expenses as compared to
$74.0 million for the year ended December 31, 2001, a 63.3% decrease, and, as a
percentage of sales, a decrease to 8.6% as compared to 15.2% for the year ended
December 31, 2001. Included in sales and marketing expenses are advertising
expenses of $1.5 million for 2002 and $0.2 million for 2001, respectively. The
decrease in sales and marketing costs from 2002 as compared to 2001 is primarily
attributable to the reduction in marketing fees paid to AOL due to the
termination of the marketing relationship with AOL effective September 30, 2001.
Sales and marketing expenses declined further due to the Company's decision to
slow growth as it pursued its plan in 2002 to improve the efficiency of the
Company's bundled business model. Currently, substantially all of the sales and
marketing expenses relate to the bundled product. Sales and marketing expenses
are expected to increase in 2003 as the Company continues to target growth in
the bundled product and invest in the development of its marketing programs.
Depreciation and Amortization. Depreciation and amortization for the year
ended December 31, 2002 was $17.3 million, a decrease of $17.1 million as
compared to $34.4 million for the year ended December 31, 2001, and, as a
percentage of sales, decreased to 5.5% as compared to 7.0% for the year ended
December 31, 2001. The Company's amortization expense decreased significantly
for the year ended December 31, 2002 due to the write-down in the third quarter
of 2001 of goodwill associated with the acquisition of Access One. Additionally,
the Company adopted Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets," which established the impairment
approach rather than amortization for goodwill, resulting in reduced
amortization in 2002 (see Note 1 of the Notes to Consolidated Financial
Statements).
Impairment and Restructuring Charges. The Company incurred impairment and
restructuring charges of $170.6 million in 2001. Included in the amount for 2001
was an impairment charge of $168.7 million primarily related to the write-down
of goodwill associated with the acquisition of Access One. In September 2001,
the Company approved a plan to close one of its call center operations. The
Company incurred expenses of $1.9 million during 2001 to reflect the elimination
of approximately 225 positions and lease exit costs in connection with the call
center closure. There were no impairment or restructuring charges in 2002 (see
Note 4 of the Notes to Consolidated Financial Statements).
Interest Income. Interest income was $0.8 million in 2002 versus $1.2
million in 2001. Interest income in 2002 was lower due to lower interest rates
as compared to 2001.
Interest Expense. Interest expense was $9.1 million in 2002 as compared to
$6.1 million in 2001. The increase in interest expense is attributed to the
higher yielding debt instruments delivered in the exchange of the Company's
4-1/2% and 5% Convertible Subordinated Notes for 8% Convertible Senior
21
Subordinated Notes and 12% Senior Subordinated Notes and the restructuring of
the Company's senior credit facility (see Note 7 of the Notes to Consolidated
Financial Statements and "Liquidity and Capital Resources"). As described in
Note 2 of the Notes to Consolidated Financial Statements, the issuance in 2001
of the 8% Secured Convertible Notes was initially accounted for as a troubled
debt restructuring. As such, the aggregate interest expense for these notes was
recorded as a liability at such time and the subsequent interest expense
associated with these notes of $2.7 million and $0.8 million for 2002 and 2001,
respectively, were not reflected in the statement of operations. With the
restructuring of the Company's 8% Secured Convertible Notes in December 2002,
these notes will not be accounted for as a troubled debt restructuring and,
accordingly, interest expense will now be reflected on the statement of
operations. Interest expense is expected to increase in 2003 as compared to 2002
primarily due to interest expense on the 8% Secured Convertible Notes being
reflected in the statement of operations and a full year of interest expense on
the 8% Convertible Senior Subordinated Notes and 12% Senior Subordinated Notes,
partially offset by the early retirement of the Company's senior credit facility
and the Company's repurchase of 12% Senior Subordinated Notes and 8% Secured
Convertible Notes in 2002 and 2003.
Other, Net. Net other expenses were $0.8 million in 2002 as compared to
$2.7 million in 2001. The amount for the year ended December 31, 2001 primarily
consisted of a $2.4 million unrealized loss on the increase in fair value of the
AOL contingent redemptions in accordance with the fair value accounting
treatment under EITF Abstract No. 00-19. This amount did not recur, as the AOL
contingent redemptions had been restructured effective September 2001.
Provision for Income Taxes. In 2001, a full valuation allowance had been
provided against the Company's net operating loss carryforwards and other
deferred tax assets since the amounts and extent of the Company's future
earnings were not determinable with a sufficient degree of probability to
recognize the deferred tax assets in accordance with the requirements of
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes." The fourth quarter of 2002 represented the fifth consecutive quarter of
profitability for the Company. In the fourth quarter of 2002, as part of the
Company's 2003 budgeting process, management evaluated the deferred tax
valuation allowance and determined that a portion of this valuation allowance
should be reversed, resulting in a non-cash deferred income tax benefit in the
fourth quarter of $22.3 million. Beginning in 2003, the Company will record
income taxes at a rate equal to the Company's combined federal and state
effective rates. However, to the extent of available net operating loss
carryforwards, the Company will be shielded from paying cash income taxes for
several years, other than possibly alternative minimum taxes and some state
taxes. There can be no assurances that the Company will realize the full
benefit of the net operating loss carryforwards on future taxable income
generated by the Company due to the "change of ownership" provisions of the
Internal Revenue Code Section 382 (see "Liquidity and Capital Resources, Other
Matters").
Extraordinary Gains. The Company incurred extraordinary gains of $29.3
million in 2002 as compared to $20.6 million in 2001. The extraordinary gains in
2002 include $28.9 million attributed to the restructuring and repurchase of a
portion of the 8% Secured Convertible Notes and $1.6 million attributed to the
repurchase of a portion of the Company's 12% Senior Subordinated Notes,
partially offset by an extraordinary loss of $1.1 million related to the
retirement of the Company's senior credit facility. On December 23, 2002, the
Company restructured its 8% Secured Convertible Notes and, accordingly, these
notes will no longer be accounted for as a troubled debt restructuring. The
$28.9 million extraordinary gain from the restructuring and repurchase of these
notes was related to the decrease in future accrued interest, which was
reflected as a $28.9 million reduction in long-term debt. On October 4, 2002,
the Company retired its senior credit facility prior to its scheduled maturity.
As a result of this early retirement, the Company incurred an extraordinary loss
of approximately $1.1 million in the fourth quarter of 2002, reflecting the
acceleration of the amortization of certain deferred finance charges and fees.
In addition, the Company repurchased $5.7 million of its 12% Senior Subordinated
Notes at a $1.6 million discount from the face amount, which was reflected as an
extraordinary gain in the fourth quarter of 2002. The extraordinary gains in
2001 of $20.6 million include a $16.9 million gain on the restructuring of the
AOL contingent redemptions in accordance with SFAS No. 15, "Accounting by
Debtors and Creditors for Troubled Debt Restructurings," (see Note 2 of the
Notes of the Consolidated Financial Statements). In addition, the Company
reacquired $5.0 million of the 4-1/2% Convertible Subordinated Notes due 2002 at
a $3.8 million discount from the face amount, which was reflected as an
extraordinary gain in the fourth quarter of 2001.
22
Cumulative Effect of an Accounting Change. The Company adopted Emerging
Issues Task Force (EITF) Abstract No. 00-19, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock," in the quarter ended June 30, 2001. The cumulative effect of the
adoption of this change in accounting principle resulted in a non-cash charge to
operations of $36.8 million in the second quarter of 2001, representing the
change in fair value of contingent redemption features of warrants and Common
Stock held by AOL from issuance on January 5, 1999 through June 30, 2001. The
requirements under EITF 00-19 will not apply to future changes in the value of
these instruments, as the AOL contingent redemptions have been restructured
effective September 2001.
Net Income (Loss). Net income for the year ended 2002 was $97.1 million, or
$3.15 per share, compared with a net loss of $224.7 million, or $8.51 loss per
share, for the year ended 2001. The net income for the year ended 2002 reflects
extraordinary gains of $28.9 million due to the restructuring and repurchase of
the 8% Secured Convertible Notes, $1.6 million due to the repurchase of a
portion of the Company's convertible bonds, and an extraordinary loss of $1.1
million related to the retirement of the Company's senior credit facility. In
addition, the year ended 2002 included $22.3 million from the reversal of a
portion of the Company's deferred tax valuation allowance. The net loss for the
year ended 2001 reflects a non-cash impairment charge of $168.7 million to write
down the goodwill associated with the acquisition of Access One Communications,
restructuring charges of $1.9 million, extraordinary gains of $16.9 million
related to restructuring of the certain obligations with AOL and $3.8 million
associated with the repurchase of a portion of its convertible bonds. The net
loss for the year ended 2001 also reflects a non-cash charge to operations of
$36.8 million in connection with the adoption of Emerging Issues Task Force
(EITF) Abstract No. 00-19, "Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled in, a Company's Own Stock."
YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000
Sales. Sales decreased by 7.1% to $488.2 million in 2001 from $525.7
million in 2000. The decrease in sales reflects lower long distance sales as a
result of (i) the Company's decision in 2000 to focus its efforts in the local
telecommunication services market by offering local telecommunication services
bundled with long distance services and significantly reducing sales and
marketing related to the long distance product; (ii) the termination of the AOL
marketing agreement as of September 30, 2001; (iii) the Company's election to
exit the international wholesale business in the second quarter of 2000; and
(iv) a decrease in Company's other sales. The decline in long distance sales was
partially offset by an increase in bundled sales.
Effective January 1, 2002, the Company adopted Emerging Issues Task Force
(EITF) 01-09, "Accounting for Consideration Given by a Vendor to a Customer or a
Reseller of the Vendor's Products." The adoption of this issue resulted in a
reclassification of approximately $7.3 million and $18.8 million from sales and
marketing expenses to a reduction of net sales for 2001 and 2000, respectively,
attributed to direct marketing promotion check campaigns.
The Company's long distance sales decreased to $291.7 million for the year
ended December 31, 2001 from $482.5 million for the year ended December 31,
2000. Included in long distance revenues for 2000 were international wholesale
sales of $29.7 million. The Company elected to exit the international wholesale
business in the second quarter of 2000 because of the low gross profit margins
associated therewith; consequently, the Company had no international sales in
2001. A significant percentage of the Company's revenues were derived from long
distance telecommunication services provided to customers who were obtained
under the AOL marketing agreement. Effective June 30, 2001, AOL exercised its
right to terminate the Company's long distance exclusivity under the marketing
agreement and continue on a non-exclusive basis, which contributed to the
decline in long-distance customers and revenues. The AOL marketing relationship
was discontinued effective September 30, 2001. Long distance revenues also
decreased in 2001 due to customer turnover as the Company focused its marketing
efforts on the bundled product.
The Company's bundled sales for the year ended December 31, 2001 were
$196.5 million as compared to $43.2 million for year ended December 31, 2000.
Bundled sales decreased, however, during the fourth quarter of 2001 after five
consecutive quarters of increases. The decrease in bundled sales in the fourth
quarter reflects the Company's decision to slow growth in bundled sales while
the Company pursued its plans to improve efficiencies of the Company's bundled
business model and improved customer collections.
23
Network and Line Costs. Network and line costs decreased by 19.7% to
$235.2 million in 2001 from $292.9 million in 2000. The decrease in costs was
primarily due to a decrease in network costs as a result of exiting the
international wholesale business, a lower number of long distance customers, a
reduction in access and usage rates and a reduction in primary interexchange
carrier charges ("PICC"). This decrease in network costs was offset by an
increase in costs paid to incumbent local telephone companies related to the
provision of local telecommunications services in connection with the Company's
bundled service.
As a percentage of sales, network and line costs decreased to 48.2% for
2001 as compared to 55.7% for 2000. The decrease in network and line costs as a
percentage of sales was primarily due to lower network, partition and billing
costs, offset by increased costs associated with the local telecommunications
business.
General and Administrative Expenses. General and administrative expenses
increased by 25.8% to $82.2 million in 2001 from $65.4 million in 2000, and, as
a percentage of sales, increased to 16.8% as compared to 12.5% for 2000. The
increase in general and administrative expenses was due primarily to increased
personnel costs associated with supporting the Company's growth in the local
services business, including customer service, provisioning and collections
personnel. This overall increase in general and administrative expenses was
offset, in part, by significant workforce reductions and other cost cutting
efforts by the Company during the third and fourth quarters of 2001 as it
pursued improvements in operating efficiencies of the Company's bundled business
model.
Provision for Doubtful Accounts. Provision for doubtful accounts increased
by 72.5% to $92.8 million in 2001 from $53.8 million in 2000, and, as a
percentage of sales, increased to 19.0% as compared to 10.2% for 2000. A
significant portion of the bad debt expense was incurred in connection with
bundled service customers acquired through marketing programs that have been
discontinued. The Company has taken several steps to reduce bad debt expense,
improve the overall credit quality of its customer base and increase its
collections of past due amounts, including the following: (a) adoption of more
stringent credit controls through the implementation of credit scoring of the
existing customer base and pre-screening of new customers based on specific
levels and criteria; (b) implementation of a new collections management system
in the third quarter of 2001 that is integrated with the billing and payment
applications; (c) improved in-house and third party collection efforts; and (d)
enhanced credit card and paper invoicing processes.
Sales and Marketing Expenses. During 2001, the Company incurred $74.0
million of sales and marketing expenses as compared to $152.0 million in 2000, a
51.3% decrease, and, as a percentage of sales, a decrease to 15.2% as compared
to 28.9% for 2000. Included in sales and marketing expenses are advertising
expenses of $0.2 million for 2001 and $1.8 million for 2000, respectively. The
decrease in sales and marketing costs is primarily attributable to the reduction
in marketing fees paid to AOL. Several events occurred during 2001 in the
relationship between the Company and AOL, including (i) a change in the AOL
marketing agreement from an exclusive to a non-exclusive basis on July 1, 2001,
(ii) the cessation of the AOL rewards points program in the second half of 2000
and (iii) the termination of the marketing relationship with AOL effective
September 30, 2001. The decline is also attributable to decreased direct
promotional and advertising campaigns, partially offset by expanded sales and
marketing efforts for the Company's bundled customer base. Sales and marketing
expenses declined further in the second half of 2001 as the Company slowed
growth as it pursued its plan to improve efficiencies of the Company's bundled
business model.
Depreciation and Amortization. Depreciation and amortization for 2001 was
$34.4 million, an increase of $15.1 million compared to $19.3 million for 2000,
and, as a percentage of sales, an increase to 7.0% as compared to 3.7% for 2000.
This increase is due primarily to a full year of depreciation and amortization
of the goodwill, intangibles and property from the Access One acquisition that
occurred in August 2000, as well as additional property and equipment that was
acquired by the Company in 2001 and 2000. The excess of the purchase price over
the fair value of the net assets acquired in the Access One acquisition was
approximately $225.9 million and was recorded as goodwill and intangible assets.
In third quarter of 2001, the Company incurred an impairment charge of $168.7
million resulting in decreased amortization expense in the fourth quarter of
2001.
Impairment and Restructuring Charges. The Company incurred impairment and
restructuring charges of $170.6 million in 2001. Included in the amount for 2001
was an impairment charge of $168.7 million primarily related to the write-down
of goodwill associated with the acquisition of Access One. In September 2001,
the Company approved a plan to close one of its call center operations. The
24
Company incurred expenses of $1.9 million during 2001 to reflect the elimination
of approximately 225 positions and lease exit costs in connection with the call
center closure. There were no impairment or restructuring charges in 2000 (see
Note 4 to the Notes of the Consolidated Financial Statements).
Interest Income. Interest income was $1.2 million in 2001 versus $4.9
million in 2000. Interest income in 2001 was lower due to the Company's lower
average cash balances during 2001 as compared to 2000.
Interest Expense. Interest expense was $6.1 million in 2001 versus $5.3
million in 2000. The increase in interest expense is due to interest on debt
assumed with the acquisition of Access One and interest on additional borrowings
by the Company in the second half of 2000.
Other, Net. Net other expense was $2.7 million in 2001 as compared to $3.8
million in 2000. The amount for 2001 primarily represents a $2.4 million
unrealized loss on the increase in fair value of the AOL contingent redemptions
in accordance with the fair value accounting treatment under EITF Abstract No.
00-19. This amount will not be recurring, as the AOL contingent redemptions have
been restructured effective September 2001. The amount for 2000 primarily
reflects a $2.5 million increase in the reserve on a note receivable and AOL
investment fees of $1.3 million.
Provision for Income Taxes. The Company has not recorded any income tax
expense or benefit in 2001 or 2000 because the Company incurred losses during
these periods. No taxable income was available in prior periods against which
the Company could carry back losses. Also, at December 31, 2001 and 2000, a full
valuation allowance has been provided against the Company's net operating losses
and other deferred tax assets. Since the amounts and extent of the Company's
future earnings were not determinable with a sufficient degree of probability to
recognize the deferred tax assets in accordance with the requirements of
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes", the Company recorded a full valuation allowance on the net deferred tax
assets for 2001 and 2000.
Extraordinary Gains. The Company incurred extraordinary gains in 2001 of
$20.6 million, of which $16.9 million represents the gain on restructuring of
the AOL contingent redemptions in accordance with SFAS No. 15, "Accounting by
Debtors and Creditors for Troubled Debt Restructurings," (see Note 2 of the
Notes of the Consolidated Financial Statements). In addition, the Company
reacquired $5.0 million of the 4.5% Convertible Subordinated Notes due 2002 at a
$3.8 million discount from the face amount, which was reflected as an
extraordinary gain in the fourth quarter of 2001.
Cumulative Effect of an Accounting Change. The Company adopted Emerging
Issues Task Force (EITF) Abstract No. 00-19, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock," in the quarter ended June 30, 2001. The cumulative effect of the
adoption of this change in accounting principle resulted in a non-cash charge to
operations of $36.8 million in the second quarter of 2001, representing the
change in fair value of contingent redemption features of warrants and Common
Stock held by AOL from issuance on January 5, 1999 through June 30, 2001. The
requirements under EITF 00-19 will not apply to future changes in the value of
these instruments, as the AOL contingent redemptions have been restructured
effective September 2001.
Net Loss. Net loss for the year ended 2001 was $224.7 million, or $8.51
per share, compared with a net loss of $61.9 million, or $2.63 loss per share,
for the year ended 2000. The net loss for the year ended 2001 reflects a
non-cash impairment charge of $168.7 million to write down the goodwill
associated with the acquisition of Access One Communications, which was created
by purchase accounting, restructuring charges of $1.9 million, extraordinary
gains of $16.9 million related to restructuring of the certain obligations with
AOL and $3.8 million associated with the repurchase of a portion of its
convertible bonds. The net loss for the year ended 2001 also reflects a non-cash
charge to operations of $36.8 million in connection with the adoption of
Emerging Issues Task Force (EITF) Abstract No. 00-19, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock." The net loss for the year ended 2000 reflects international wholesale
sales of $29.7 million and associated network costs of $57.7 million. The
Company elected to exit this business during 2000. The net loss for 2000 also
reflects $78.0 million of sales and marketing costs attributable to the
exclusive marketing agreement between the company and AOL, which was terminated
during 2001.
25
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash requirements arise primarily from its subsidiaries'
operational needs, its subsidiaries' capital expenditures and the debt service
obligations of the Company. Since Talk America Holdings, Inc. conducts all of
it operations through its subsidiaries, primarily Talk America Inc., it relies
on dividends, distributions and other payments from its subsidiaries to fund its
obligations.
Contractual obligations of the Company as of December 31, 2002 are
summarized by years to maturity as follows (in thousands):
1 year or 2 - 3 4 - 5
Contractual Obligations (2) Total less Years Years Thereafter
------------------------------- --------- --------- --------- --------- ---------
Talk America Holdings, Inc.:
-------------------------------
8% Secured Convertible Notes
due 2006 $ 30,150 $ -- $ -- $ 30,150 $ --
12% Senior Subordinated Notes
due 2007 65,970 -- -- 65,970 --
8% Convertible Senior
Subordinated Notes due 2007 (1) 4,038 -- -- 4,038 --
5% Convertible Subordinated
Notes due 2004 670 -- 670 -- --
Talk America Inc. and other
subsidiaries:
-------------------------------
Capital lease obligations 27 27 -- -- --
--------- --------- --------- --------- ---------
$ 100,855 $ 27 $ 670 $ 100,158 $ --
Operating leases 5,408 1,887 2,634 728 159
--------- --------- --------- --------- ---------
Total Contractual Obligations $ 106,263 $ 1,914 $ 3,304 $ 100,886 $ 159
========= ========= ========= ========= =========
------------------
(1) The 8% Convertible Senior Subordinated Notes include $2.8 million of
principal and $1.2 million of future accrued interest (see Note 7 of the Notes
to Consolidated Financial Statements).
(2) Excluded from these contractual obligations are various network service
agreements for long distance services that contain certain minimum usage
commitments. The largest contract establishes pricing and provides for revenue
commitments based upon usage of $52 million for the 18 months ended February
2004 and $40 million for the 9 months ended December 2004. This contract
obligates the Company to pay 65 percent of the shortfall, if any. A separate
contract with a different vendor establishes pricing and provides for annual
minimum payments for the years ended December 31, as follows: 2003 - $6.0
million and 2004 - $3.0 million. While the Company anticipates that it will not
be required to make any shortfall payments under these contracts as a result of
(1) growth in network minutes, (2) the management of traffic flows on its
network, (3) the restructuring of these obligations, and/or (4) the sale of
additional minutes of usage from the wholesale or other long distance markets;
there can be no assurances that the Company will be successful in its efforts.
In addition, these actions will likely cause the Company to experience an
increase in per minute network costs.
The Company relies on internally generated funds and cash and cash
equivalents on hand to fund its capital and financing requirements. The Company
had $33.6 million of cash and cash equivalents as of December 31, 2002, and
$22.1 million as of December 31, 2001.
Net cash provided by operating activities was $51.9 million in 2002 as
compared to net cash used in operating activities of $5.6 million in 2001 and
$14.9 million in 2000. In 2002, the major contributors to the net cash provided
by operating activities were the net income of $97.1 million and non-cash
charges of $27.9 million, primarily consisting of provision for doubtful
accounts of $9.4 million and depreciation and amortization of $17.3 million.
26
These amounts were offset by an increase in accounts receivable of $10.6
million, a decrease in accounts payable and accrued expenses and other
liabilities of $9.9 million and non-cash items of $53.3 million, primarily
consisting of an extraordinary gain from restructuring and redemption of
convertible debt of $28.9 million and the deferred income tax valuation reserve
reversal of $22.3 million. In 2001, the major contributors to the net cash used
in operating activities were the net loss of $224.7 million, an increase in
accounts receivable of $65.8 million, a decrease in accounts payable and accrued
expenses and other liabilities of $22.3 million and non-cash extraordinary gains
of $20.6 million. These amounts were offset by non-cash charges of $335.3
million, primarily consisting of provision for doubtful accounts of $92.8
million, depreciation and amortization of $34.4 million, impairment and
restructuring charges of $168.7 million and the cumulative effect of an
accounting change for contingent redemptions of $36.8 million. For 2000, the net
cash used in operating activities was mainly generated by the net loss of $61.9
million and an increase in accounts receivable of $43.4 million, offset by a
decrease in prepaid expenses and other current assets of $8.1 million, an
increase of accounts payable and accrued expenses and other liabilities of $8.6
million and adjustments to net income for non-cash items of $76.3 million.
Net cash used in investing activities was $7.3 million during 2002,
consisting of capitalized software development costs of $2.5 million and capital
expenditures primarily for the purchase of equipment of $4.8 million. Net cash
used in investing activities of $4.5 million during 2001 related primarily to
the purchase of property and equipment of $2.9 million and capitalized software
development costs of $1.4 million. For 2000, the net cash used in investing
activities related primarily to the purchase of property, equipment and
intangibles of $35.4 million and net cash paid in connection with the Access One
acquisition of $3.6 million. The Company expects to incur capital expenditures
of between $10 and $12 million and capitalized software development costs of
between $2 and $3 million in 2003. The 2003 capital expenditures include
approximately $4.5 million of networking equipment and software. The FCC has
recently concluded its triennial review of local phone competition. Although
the text of the order is not yet available, the decision appears to preserve the
Company's ability to use UNE-P for the provision of bundled telecommunications
services pending further market-by-market analyses by the respective state
commissions. Changes to the current rules and regulations or adverse judicial
and administrative interpretations and rulings relating thereto that result in
any curtailment in the availability of the local switching UNE could require the
Company to significantly increase its capital expenditures. (See "Liquidity and
Capital Resources, Other Matters").
Net cash used in financing activities was $33.1 million during 2002 as
compared to $8.4 million in 2001, and net cash provided by financing activities
of $15.6 million in 2000. The net cash used in financing activities during 2002
was primarily attributable to payment of borrowings under the Company's senior
credit facility, including retirement of this facility prior to maturity, of
$18.0 million, payments related to the repurchase of a portion of the Company's
12% Senior Subordinated Notes of $4.1 million, payments related to the maturity
of the remaining $3.9 million principal balance of its outstanding 4-1/2%
Convertible Subordinated Notes, payments of principal and future accrued
interest payments under its 8% Secured Convertible Notes of $6.2 million,
payments in connection with the exchange of the Company's 4-1/2% Convertible
Subordinated Notes for 8% Convertible Senior Subordinated Notes of $0.5 million
and payments under capital lease obligations of $1.0 million. Net cash used in
financing activities for 2001 of $8.4 million was primarily attributable to
payment of borrowings under the Company's credit facility of $2.5 million,
repurchase of convertible bonds of the Company of $1.3 million and payments in
connection with the restructuring of the AOL contingent redemptions of $3.5
million. The net cash provided by financing activities for 2000 of $15.6 million
reflects proceeds from a credit facility of $20.0 million and the proceeds from
exercise of options and warrants and common stock rights of $13.6 million
partially offset by repayments of debt assumed in the Access One acquisition of
$18.0 million.
For the year ended December 31, 2002, $2.8 million of interest was recorded
as additional principal on the 12% Senior Subordinated Notes and 8% Secured
Convertible Notes for payment of interest in kind rather than in cash.
In January 2003, the Company announced a share buyback program of $10
million or 2,500,000 shares. In January 2003, the Company purchased 1,315,789 of
its common shares from AOL at a per share price of $3.80 (the average closing
price for the five days ended January 15, 2003). The aggregate purchase price
was approximately $5.0 million. Through March 28, 2003, the Company has
repurchased $9.4 million of its 12% Senior Subordinated Notes at a $2.2 million
discount from face amount that will be reported as other income in the
consolidated statement of operations and, in connection with the purchases, has
also repurchased $3.6 million of its 8% Secured Convertible Notes.
27
The Company generally does not have a significant concentration of credit
risk with respect to net trade accounts receivable, due to the large number of
end-users comprising the Company's customer base.
8% SECURED CONVERTIBLE NOTES
In September 2001, the Company restructured its financial obligations with
AOL that arose under the 1999 Investment Agreement and, effective September 30,
2001, also ended its marketing relationship with AOL. In connection therewith,
the Company and AOL entered into a Restructuring and Note Agreement, pursuant to
which the Company had outstanding as of December 31, 2002, $30.2 million
principal amount of its 8% Secured Convertible Notes. On December 23, 2002, the
Company restructured its 8% Secured Convertible Notes. The principal terms of
the restructuring were as follows: the new maturity date is September 19, 2006,
a pay-in-kind interest option was eliminated and interest will thereafter be
required to be paid entirely in cash, and the Company will be provided
additional flexibility to purchase subordinated debt and common stock through
September 30, 2003. As a result of the repurchase of $9.4 million of its 12%
Senior Subordinated Notes in 2003, through March 28, 2003, the Company has
repurchased $3.6 million of its 8% Secured Convertible Notes due 2006 since
December 31, 2002. (See Note 2 of the Notes to Consolidated Financial
Statements).
CONVERTIBLE SUBORDINATED NOTES AND EXCHANGE OFFERS
Effective April 4, 2002, the Company completed the exchange of $57.9
million of the $61.8 million outstanding principal balance of its 4-1/2%
Convertible Subordinated Notes that matured on September 15, 2002 into $53.2
million of new 12% Senior Subordinated PIK Notes due August 2007 and $2.8
million of new 8% Convertible Senior Subordinated Notes due August 2007 and cash
paid of $0.5 million. In addition, the Company exchanged $17.4 million of the
$18.1 million outstanding principal balance of its 5% Convertible Subordinated
Notes that mature on December 15, 2004 into $17.4 million of the new 12% Senior
Subordinated Notes. The Company repurchased $5.7 million of the 12% Senior
Subordinated Notes at a $1.6 million discount from the face amount, which was
reflected as an extraordinary gain in the fourth quarter of 2002. The Company
paid at maturity the remaining $3.9 million principal balance of its outstanding
4-1/2% Convertible Subordinated Notes due September 2002. In 2003, through March
28, the Company repurchased $9.4 million of its 12% Senior Subordinated Notes at
a $2.2 million discount from face amount that will be reported as other income
in the consolidated statement of operations. (See Note 7 of the Notes to
Consolidated Financial Statements).
OTHER MATTERS
The Company's provision of telecommunication services is subject to
government regulation. Changes in existing regulations could have a material
adverse effect on the Company. The Company's local telecommunication services
are provided almost exclusively through the use of RBOC Unbundled Network
Elements ("UNE"), and it is primarily the availability of costs-based UNE rates
that enables the Company to price its local telecommunications services
competitively. On December 12, 2001, the FCC initiated its so-called UNE
Triennial Review rulemaking in which it was to review all UNEs and determine
whether RBOCs should continue to be required to provide them to competitors. The
FCC has recently concluded its Triennial Review of local phone competition.
Although the text of the order is not yet available, the decision appears to
preserve the Company's ability to use the UNEP for the provision of bundled
telecommunications services pending further market-by-market analyses by the
respective state commissions. Changes to the current rules and regulations or
adverse judicial and administrative interpretations and rulings relating thereto
that result in any curtailment in the availability of the local switching UNE or
increase in costs that RBOCs may charge for such elements would materially
impair the Company's ability to provide local telecommunications services. Such
changes could eliminate the Company's capability to provide local
telecommunications services entirely unless the Company is able to utilize
another technology, which may not be available or available on economically
feasible terms, or the Company purchases, builds and implements its own local
switching network, which would require significant additional capital
expenditures by the Company.
At December 31, 2001, a full valuation allowance had been provided against
the Company's net operating loss carryforwards and other deferred tax assets
since the amounts and extent of the Company's future earnings were not then
determinable with a sufficient degree of probability to recognize the deferred
tax assets in accordance with the requirements of Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes." The fourth quarter
of 2002 represented the fifth consecutive quarter of profitability for the
28
Company. In the fourth quarter of 2002, as part of the Company's 2003 budgeting
process, management evaluated the deferred tax valuation allowance and
determined that a portion of this valuation allowance should be reversed,
resulting in a non-cash deferred income tax benefit in the fourth quarter of
$22.3 million. Beginning in 2003, the Company will record income taxes at a
rate equal to the Company's combined federal and state effective rates. However,
to the extent of available net operating loss carryforwards, the Company will be
shielded from paying cash income taxes for several years, other than alternative
minimum taxes and some state taxes. The Company reviews the valuation
allowances on a quarterly basis.
At December 31, 2002, the Company had net operating loss (NOL)
carryforwards for federal income tax purposes of approximately $262 million. Due
to the "change of ownership" provisions of the Internal Revenue Code Section
382, the availability of the Company's net operating loss and credit
carryforwards may be subject to an annual limitation against taxable income in
future periods if a change of ownership of more than 50% of the value of the
Company's stock should occur within a three-year testing period. Many of the
changes that affect these percentage change determinations, such as changes in
the Company's stock ownership, are outside the Company's control. A
more-than-50% cumulative change in ownership for purposes of the Section 382
limitation occurred on August 31, 1998 and October 26, 1999. As a result of such
changes, certain of the Company's carryforwards are limited. As of December 31,
2002, approximately $15 million of NOL carryforwards were limited to offset
future income. In addition, based on information currently available to the
Company, the Company believes that the change of ownership percentage was
approximately 38% for the currently applicable three-year testing period. If,
during the current three-year testing period, the Company experiences an
additional more-than-50% ownership change under Section 382, the amount of the
NOL carryforward available to offset future taxable income may be further and
substantially reduced. To the extent the Company's ability to use these net
operating loss carryforwards against any future income is limited, its cash flow
available for operations and debt service would be reduced. There can be no
assurance that the Company will realize the full benefit of the carryforwards.
The Company is a party to a number of legal actions and proceedings arising
from the Company's provision and marketing of telecommunications services, as
well as certain legal actions and regulatory investigations and enforcement
proceedings arising in the ordinary course of business. The Company believes
that the ultimate outcome of the foregoing actions will not result in liability
that would have a material adverse effect on the Company's financial condition
or results of operations. However, it is possible that, because of fluctuations
in the Company's cash position, the timing of developments with respect to such
matters that require cash payments by the Company, while such payments are not
expected to be material to the Company's financial condition, could impair the
Company's ability in future interim or annual periods to continue to implement
its business plan, which could affect its results of operations in future
interim or annual periods.
While the Company believes that it has access, albeit limited, to new
capital in the public or private markets to fund its ongoing cash requirements,
there can be no assurance as to the timing, amounts, terms or conditions of any
such new capital or whether it could be obtained on terms acceptable to the
Company. Accordingly, the Company anticipates that its cash requirements
generally must be met from the Company's cash-on-hand and from cash generated
from operations. Based on its current projections for operations, the Company
believes that its cash-on-hand and its cash flow from operations will be
sufficient to fund its currently contemplated capital expenditures, its debt
service obligations, including the increased interest expense of its outstanding
indebtedness, and the expenses of conducting its operations for at least the
next twelve months. However, there can be no assurance that the Company will be
able to realize its projected cash flows from operations, which is subject to
the risks and uncertainties discussed above, or that the Company will not be
required to consider capital expenditures in excess of those currently
contemplated, as discussed above.
CRITICAL ACCOUNTING POLICIES
The Company's discussion and analysis of its financial condition and
results of operations are based upon the Company's consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial
statements requires the Company to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. On an on-going basis, the
Company evaluates its estimates, including those related to bad debt, goodwill
and intangible assets, income taxes, contingencies and litigation. The Company
bases its estimates and judgments on historical experience and on various other
29
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ from these estimates.
RECOGNITION OF REVENUE
The Company derives its revenues from local and long distance phone
services, primarily local services bundled with long distance services, long
distance services, inbound toll-free service and dedicated private line services
for data transmission. The Company recognizes revenue from voice, data and other
telecommunications-related services in the period in which subscribers use the
related service.
Deferred revenue represents the unearned portion of local telecommunication
services and features that are billed one month in advance. In addition,
deferred revenue at December 31, 2001 included a non-refundable prepayment
received in 1997 in connection with an amended telecommunications services
agreement with Shared Technologies Fairchild, Inc. The prepayment was amortized
over the five-year term of the agreement, which expired October 2002. The amount
included in revenue was $6.2 million in 2002, and $7.4 million in each of 2001
and 2000.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
Allowances for doubtful accounts are maintained for estimated losses
resulting from the failure of customers to make required payments on their
accounts. The Company reviews accounts receivable aging trends, historical bad
debt trends, and customer credit-worthiness through customer credit scores,
current economic trends and changes in customer payment history when evaluating
the adequacy of the allowance for doubtful accounts. If the financial condition
of the Company's carriers that pay access charges were to deteriorate, resulting
in an impairment of their ability to make payments, additional allowances may be
required. The Company's accounts receivable balance was $27.8 million, net of
allowance for doubtful accounts of $7.8 million, as of December 31, 2002.
VALUATION OF LONG-LIVED ASSETS AND INTANGIBLE ASSETS WITH A DEFINITE LIFE
The Company reviews the recoverability of the carrying value of long-lived
assets, including intangibles with a definite life, for impairment whenever
events or changes in circumstances indicate that the carrying amount of such
assets may not be recoverable. When such events occur, the Company compares the
carrying amount of the assets to the undiscounted expected future cash flows
from them. Factors the Company considers important that could trigger an
impairment review include the following:
- Significant underperformance relative to historical or projected
future operating results
- Significant changes in the manner of the Company's use of the acquired
assets or the strategy for the Company's overall business
- Significant negative industry or economic trends
- Significant decline in the Company's stock price for a sustained
period and market capitalization relative to net book value
If this comparison indicates there is impairment, the amount of the
impairment loss to be recorded is calculated by the excess of the net assets'
carrying value over their fair value and is typically calculated using
discounted expected future cash flows. Management of the Company believes that,
for the year ended December 31, 2002, no events or changes in circumstances have
occurred to trigger an impairment review.
GOODWILL
Goodwill represents the cost in excess of net assets of acquired companies.
Effective January 1, 2002, with the adoption of SFAS No. 142, goodwill
(comprised of goodwill acquired in the Access One acquisition in August 2000)
will not be amortized, but rather will be tested for impairment annually, and
will be tested for impairment between annual tests if an event occurs or
circumstances change that would indicate the carrying amount may be impaired.
Prior to January 1, 2002, goodwill and intangibles were amortized on a
straight-line basis over periods ranging from 5 years to 15 years. Impairment
30
testing for goodwill is performed at a reporting unit level; the Company
determined that it has one reporting unit under the guidance of SFAS No. 142. An
impairment loss would generally be recognized when the carrying amount of the
reporting unit's net assets exceeds the estimated fair value of the reporting
unit. Prior to January 1, 2002, goodwill was tested for impairment in a manner
consistent with long-lived assets and intangible assets with a definite life.
The Company completed the transitional assessment of goodwill under the
requirements of SFAS 142 and determined that the fair value of the reporting
unit exceeds the carrying amount, thus the goodwill is not considered impaired.
SOFTWARE DEVELOPMENT COSTS
Direct development costs associated with internal-use computer software are
accounted for under Statement of Position 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use" and are capitalized,
including external direct costs of material and services and payroll costs and
benefits for employees devoting time to the software projects. Costs incurred
during the preliminary project stage, as well as for maintenance and training,
are expensed as incurred. Amortization is provided on a straight-line basis over
the shorter of 3 years or the estimated useful life of the software.
INCOME TAXES
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the estimated future tax
consequences attributable to the differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates in effect for the year in which
those temporary differences are expected to be recovered or settled.
The Company records a valuation allowance to reduce its deferred tax assets
and reviews the amount of such allowance annually. At December 2001, a full
valuation allowance had been provided against the Company's net operating loss
carryforwards and other deferred tax assets since the amounts and extent of the
Company's future earnings were not determinable with a sufficient degree of
probability to recognize the deferred tax assets in accordance with the
requirements of Statement of Financial Accounting Standards No. 109, "Accounting
for Income Taxes." The fourth quarter of 2002 represented the fifth consecutive
quarter of profitability for the Company. In the fourth quarter of 2002, as
part of the Company's 2003 budgeting process, management evaluated the deferred
tax valuation allowance and determined that a portion of this valuation
allowance should be reversed, resulting in a non-cash deferred income tax
benefit in the fourth quarter of $22.3 million. Beginning in 2003, the Company
will record income taxes at a rate equal to the Company's combined federal and
state effective rates. However, to the extent of available net operating loss
carryforwards, the Company will be shielded from paying cash income taxes for
several years, other than possibly alternative minimum taxes and some state
taxes.
LEGAL PROCEEDINGS
The Company is a party to a number of legal actions and proceedings arising
from the Company's provision and marketing of telecommunications services, as
well as certain legal actions and regulatory investigations and enforcement
proceedings arising in the ordinary course of business. Management's current
estimated range of liability related to some of the pending litigation is based
on claims for which management can estimate the amount and range of loss. The
Company recorded the minimum estimated liability related to those claims, where
there is a range of loss. Because of the uncertainties related to both the
amount and range of loss on the remaining pending litigation, management is
unable to make a reasonable estimate of the liability that could result from an
unfavorable outcome. As additional information becomes available, the Company
will assess the potential liability related to the Company's pending litigation
and revise its estimates. Such revisions in the Company's estimates of the
potential liability could materially affect its results of operations and
financial position.
NEW ACCOUNTING PRONOUNCEMENTS
Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets," which
establishes the impairment approach rather than amortization for goodwill.
Effective January 1, 2002, the Company was no longer required to record
amortization expense on goodwill, but instead is required to evaluate these
assets for potential impairment at least annually and will test for impairment
31
between annual tests if an event occurs or circumstances change that would
indicate the carrying amount may be impaired. An impairment loss would generally
be recognized when the carrying amount of the reporting unit's net assets
exceeds the estimated fair value of a reporting unit.
In order to complete the transitional assessment of goodwill as required by
SFAS 142, the Company was required to determine by June 30, 2002, the fair value
of the reporting unit associated with the goodwill and compare it to the
reporting unit's carrying amount, including goodwill. The Company determined
that it has one reporting unit under the guidance of SFAS 142. The fair value of
the reporting unit was determined primarily using a discounted cash flow
approach and quoted market price of the Company's stock. The amount of goodwill
reflected in the balance sheet as of December 31, 2002 was $19.5 million. To the
extent a reporting unit's carrying amount exceeds its fair value, an indication
would exist that the reporting unit's goodwill assets may be impaired and the
Company will have to perform the second step of the transitional impairment
test. The Company completed the transitional assessment of goodwill and
determined that the fair value of the reporting unit exceeds its carrying
amount, thus goodwill is not considered impaired. If, in the future, the Company
has to perform the second step of the transitional impairment test, the Company
will have to compare the implied fair value of the reporting unit's goodwill,
determined by allocating the reporting unit's fair value to all of its assets
and liabilities in a manner similar to a purchase price allocation in accordance
with SFAS 141, "Business Combinations," to its carrying amount, both of which
would be measured as of the date of adoption. Any transitional impairment charge
would then be recognized as the cumulative effect of a change in accounting
principle in the Company's consolidated statement of operations. The required
impairment tests of goodwill may result in future period write-downs.
In August 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 143, "Accounting for Obligations
Associated with the Retirement of Long-Lived Assets." SFAS 143 establishes
accounting standards for the recognition and measurement of an asset retirement
obligation and its associated asset retirement cost. It also provides accounting
guidance for legal obligations associated with the retirement of tangible
long-lived assets. SFAS 143 is effective in fiscal years beginning after June
15, 2002, with early adoption permitted. The provisions of SFAS 143 are not
expected to have a material effect on the Company's consolidated results of
operations or financial position.
Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets." SFAS 144 establishes a single accounting model for the
impairment or disposal of long-lived assets, including discontinued operations.
SFAS 144 superseded Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," and APB Opinion No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions." Adoption of SFAS
144 has had no impact on the Company's consolidated results of operations or
financial position.
Effective January 1, 2002, the Company adopted Emerging Issues Task Force
(EITF) 01-09, "Accounting for Consideration Given by a Vendor to a Customer or a
Reseller of the Vendor's Products." This issue presumes that consideration from
a vendor to a customer or reseller of the vendor's products is a reduction of
the selling prices of the vendor's products and, therefore, should be
characterized as a reduction of revenue when recognized in the vendor's
statement of operations and could lead to negative revenue under certain
circumstances. Revenue reduction is required unless the consideration relates to
a separate, identifiable benefit and the benefit's fair value can be
established. The adoption of this issue resulted in a reclassification from
sales and marketing expenses to a reduction of net sales of $7.3 million and
$18.8 million for the year ended December 31, 2001 and 2000, respectively, in
each case attributed to direct marketing promotion check campaigns. The adoption
of EITF 01-09 did not have a material effect on the Company's consolidated
financial statements for the year ended December 31, 2002, as the Company did
not have any direct marketing promotion check campaigns during this period.
In May 2002, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statements No. 13, and Technical Corrections as of
April 2002." SFAS 145 eliminates the requirement to report gains and losses
from extinguishment of debt as extraordinary items. Gains and losses from
extinguishment of debt will now be classified as extraordinary items only if
they meet the criteria of APB Opinion No. 30. Generally, SFAS 145 is effective
in fiscal years beginning after May 15, 2002, with early adoption encouraged.
32
The Company will adopt SFAS 145 effective January 1, 2003. The adoption of SFAS
145 will result in a reclassification from extraordinary gains (losses) from the
extinguishment of debt to other income (expense).
In July 2002, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 146, "Accounting for Costs Associated with
Exit or Disposal Activities." SFAS 146 requires that a liability for a cost
that is associated with an exit or disposal activity be recognized when the
liability is incurred. SFAS 146 also establishes that fair value is the
objective for the initial measurement of the liability. SFAS 146 is effective
for exit or disposal activities that are initiated after December 31, 2002.
In November 2002, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 45 ("FIN 45"), "Guarantees," an interpretation of FASB
Statement No. 5, "Accounting for Contingencies." This interpretation elaborates
on the disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued.
(See Note 1 of the Notes to Consolidated Financial Statements).
In December 2002, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure - an amendment of SFAS 123." SFAS 148
is effective for fiscal years ending after December 15, 2002 and provides for
additional annual and interim financial statement disclosures. (See Note 1 of
the Notes to Consolidated Financial Statements).
In January 2003, FASB issued FASB Interpretation No. 46, Consolidation of
Variable Interest Entities ("FIN 46"). FIN 46 requires a variable interest
entity to be consolidated by a company if that company is subject to a majority
of the risk of loss from the variable interest entity's activities or entitled
to receive a majority of the entity's residual returns or both. FIN 46 also
requires disclosures about variable interest entities that a company is not
required to consolidate but in which it has a significant variable interest.
(See Note 1 of the Notes to Consolidated Financial Statements).
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
In the normal course of business, the financial position of the Company is
subject to a variety of risks, such as the collectibility of its accounts
receivable and the receivability of the carrying values of its long-term assets.
The Company's long-term obligations consist primarily of long term debt with
fixed interest rates. The Company does not presently enter into any transactions
involving derivative financial instruments for risk management or other
purposes.
The Company's available cash balances are invested on a short-term basis
(generally overnight) and, accordingly, are not subject to significant risks
associated with changes in interest rates. Substantially all of the Company's
cash flows are derived from its operations within the United States and the
Company is not subject to market risk associated with changes in foreign
exchange rates.
33
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Reports of Independent Accountants . . . . . . . . . . . . . . . . . . .35
Consolidated statements of operations for the years ended
December 31, 2002, 2001 and 2000 . . . . . . . . . . . . . . . . . 36
Consolidated balance sheets as of December 31, 2002
and 2001 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Consolidated statements of cash flows for the years ended
December 31, 2002, 2001 and 2000 . . . . . . . . . . . . . . . . . . 38
Consolidated statements of stockholders' equity (deficit)
for the years ended December 31, 2002, 2001 and 2000 . . . . . . 39
Notes to consolidated financial statements . . . . . . . . . . . . . . 40
34
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and
Shareholders of Talk America Holdings, Inc.:
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15 (a) (1) of this Annual Report on Form 10-K
present fairly, in all material respects, the financial position of Talk America
Holdings, Inc. and subsidiaries at December 31, 2002 and December 31, 2001, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 2002 in conformity with accounting principles
generally accepted in the United States of America. In addition, in our opinion,
the financial statement schedule listed in the index appearing under Item 15 (a)
(2), presents fairly, in all material respects, the information set
forth therein when read in conjunction with the related consolidated financial
statements. These financial statements and the financial statement schedule are
the responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements and the financial statement schedule
based on our audits. We conducted our audits of these statements in accordance
with auditing standards generally accepted in the United States of America,
which require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the
Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill
and Other Intangible Assets", effective January 1, 2002.
PricewaterhouseCoopers LLP
Philadelphia, Pennsylvania
February 6, 2003
35
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
YEAR ENDED DECEMBER 31,
------------------------------------------
2002 2001 2000
------------ ------------ ------------
Sales $ 317,507 $ 488,158 $ 525,712
Costs and expenses:
Network and line costs 155,567 235,153 292,931
General and administrative expenses 53,510 82,202 65,360
Provision for doubtful accounts 9,365 92,778 53,772
Sales and marketing expenses 27,148 73,973 152,028
Depreciation and amortization 17,318 34,390 19,257
Impairment and restructuring charges -- 170,571 --
------------ ------------ ------------
Total costs and expenses 262,908 689,067 583,348
------------ ------------ ------------
Operating income (loss) 54,599 (200,909) (57,636)
Other income (expense):
Interest income 802 1,220 4,859
Interest expense (9,087) (6,091) (5,297)
Other, net (892) (2,698) (3,822)
------------ ------------ ------------
Income (loss) before provision for income taxes 45,422 (208,478) (61,896)
Provision (benefit) for income taxes (22,300) -- --
------------ ------------ ------------
Income (loss) before extraordinary gains and cumulative
effect of an accounting change 67,722 (208,478) (61,896)
Extraordinary gains 29,340 20,648 --
Cumulative effect of an accounting change -- (36,837) --
------------ ------------ ------------
Net income (loss) $ 97,062 $ (224,667) $ (61,896)
============ ============ ============
Income (loss) per share - Basic:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per share $ 2.48 $ (7.89) $ (2.63)
Extraordinary gains per share 1.08 0.78 --
Cumulative effect of an accounting change per share -- (1.40) --
------------ ------------ ------------
Net income (loss) per share $ 3.56 $ (8.51) $ (2.63)
============ ============ ============
Weighted average common shares outstanding 27,253 26,414 23,509
============ ============ ============
Income (loss) per share - Diluted:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per share $ 2.20 $ (7.89) $ (2.63)
Extraordinary gains per share 0.95 0.78 --
Cumulative effect of an accounting change per share -- (1.40) --
------------ ------------ ------------
Net income (loss) per share $ 3.15 $ (8.51) $ (2.63)
============ ============ ============
Weighted average common and common equivalent
shares outstanding 30,798 26,414 23,509
============ ============ ============
See accompanying notes to consolidated financial statements.
36
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT FOR SHARE AND PER SHARE DATA)
DECEMBER 31, DECEMBER 31,
2002 2001
-------------- --------------
ASSETS
Current assets:
Cash and cash equivalents $ 33,588 $ 22,100
Accounts receivable, trade (net of allowance for uncollectible accounts of
$7,821 and $46,404 at December 31, 2002 and 2001, respectively) 27,843 26,647
Deferred income taxes 17,500 --
Prepaid expenses and other current assets 2,330 1,951
-------------- --------------
Total current assets 81,261 50,698
Property and equipment, net 66,915 75,879
Goodwill 19,503 19,503
Intangibles, net 7,379 10,169
Deferred income taxes 4,800 --
Other assets 7,653 8,972
-------------- --------------
$ 187,511 $ 165,221
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 30,588 $ 43,098
Sales, use and excise taxes 11,439 8,339
Deferred revenue 6,480 10,193
Current portion of long-term debt 61 10,544
4-1/2% Convertible subordinated notes due 2002 -- 3,910
Accrued compensation 5,609 1,108
Other current liabilities 9,013 10,081
-------------- --------------
Total current liabilities 63,190 87,273
-------------- --------------
Long-term debt:
Senior credit facility -- 12,500
8% Secured convertible notes due 2006 (includes principal of $32,773 and future
accrued interest of $30,982 at December 31, 2001) 30,150 63,755
12% Senior subordinated notes due 2007 65,970 --
8% Convertible senior subordinated notes due 2007 (includes future accrued
interest of $1,216 at December 31, 2002) 4,038 --
4-1/2% Convertible subordinated notes due 2002 -- 57,934
5% Convertible subordinated notes due 2004 670 18,093
Other long-term debt 27 88
-------------- --------------
Total long-term debt 100,855 152,370
-------------- --------------
Commitments and contingencies
Stockholders' equity (deficit):
Preferred stock - $.01 par value, 5,000,000 shares authorized; no shares
outstanding. -- --
Common stock - $.01 par value, 100,000,000 shares authorized;
27,469,593 and 27,150,907 shares issued and outstanding at December 31, 2002
and 2001, respectively 275 272
Additional paid-in capital 351,992 351,169
Accumulated deficit (328,801) (425,863)
-------------- --------------
Total stockholders' equity (deficit) 23,466 (74,422)
-------------- --------------
$ 187,511 $ 165,221
============== ==============
See accompanying notes to consolidated financial statements.
37
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31,
------------------------------------------
2002 2001 2000
------------ ------------ ------------
Cash flows from operating activities:
Net income (loss) $ 97,062 $ (224,667) $ (61,896)
Adjustments to reconcile net income (loss) to net cash provided by (used
in) operating activities:
Provision for doubtful accounts 9,365 92,778 53,772
Depreciation and amortization 17,318 34,390 19,257
Non-cash compensation 194 -- 706
Non-cash interest 832 -- --
Provision for uncollectible note -- 77 2,500
Loss on sale and retirement of assets 205 116 68
Impairment of goodwill and intangibles -- 168,684 --
Cumulative effect of accounting change of contingent redemptions -- 36,837 --
Extraordinary gain from restructuring of convertible debt (28,909) -- --
Extraordinary gain from restructuring of contingent redemptions -- (16,867) --
Extraordinary gain from extinguishment of debt (431) (3,781) --
Unrealized loss on increase in fair value of contingent redemptions -- 2,372 --
Deferred income tax valuation reserve reversal (22,300) -- --
Gain on legal settlement (1,681) -- --
Changes in assets and liabilities, net of acquisition of business:
Accounts receivable, trade (10,561) (65,788) (43,390)
Prepaid expenses and other current assets (246) 808 8,066
Other assets 1,605 322 (1,252)
Accounts payable (12,510) (27,696) 12,763
Deferred revenue (3,713) (9,004) (1,433)
Sales, use and excise taxes 3,100 404 84
Accrued expenses and other liabilities 2,568 5,418 (4,181)
------------ ------------ ------------
Net cash provided by (used in) operating activities 51,898 (5,597) (14,936)
------------ ------------ ------------
Cash flows from investing activities:
Acquisition of intangibles (50) (154) (515)
Acquisition of Access One, net of cash acquired -- -- (3,617)
Capital expenditures (4,781) (2,949) (34,862)
Capitalized software development costs (2,501) (1,406) --
------------ ------------ ------------
Net cash used in investing activities (7,332) (4,509) (38,994)
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from borrowings -- -- 20,000
Payments of borrowings (17,983) (2,624) (18,025)
Payments of capital lease obligations (1,036) (1,022) --
Repurchase of debt (14,691) (1,227) --
Proceeds from exercise of options and warrants 632 -- 2,528
Payments in connection with restructuring contingent redemptions -- (3,525) --
Proceeds from exercise of common stock rights -- -- 11,094
------------ ------------ ------------
Net cash provided by (used in) financing activities (33,078) (8,398) 15,597
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents 11,488 (18,504) (38,333)
Cash and cash equivalents, beginning of year 22,100 40,604 78,937
------------ ------------ ------------
Cash and cash equivalents, end of year $ 33,588 $ 22,100 $ 40,604
============ ============ ============
See accompanying notes to consolidated financial statements.
38
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS)
COMMON STOCK ADDITIONAL TREASURY STOCK
----------------- PAID-IN ACCUMULATED -----------------
SHARES AMOUNT CAPITAL DEFICIT SHARES AMOUNT TOTAL
------ ------ --------- ----------- ------ -------- ----------
Balance, December 31, 1999 22,324 $ 223 $ 99,422 $(139,300) (706) $(29,720) $ (69,375)
Net income (loss) -- -- -- (61,896) -- -- (61,896)
Exercise of common stock options -- -- (2,274) -- 114 4,802 2,528
Exercise of common stock rights -- -- 1,940 -- 217 9,154 11,094
Issued in connection with
acquisition 3,824 38 188,002 -- 233 9,796 197,836
Warrants issued for consulting -- -- 2,175 -- -- -- 2,175
Issuance of common stock
for convertible debt -- -- 17 -- 1 23 40
Issuance of common stock
for compensation -- -- (1,796) -- 50 2,094 298
------ ------ --------- ----------- ------ -------- ----------
Balance, December 31, 2000 26,148 261 287,486 (201,196) (91) (3,851) 82,700
Net income (loss) -- -- -- (224,667) -- -- (224,667)
Issuance of common stock
for compensation -- -- (2,451) -- 68 2,858 407
Cumulative effect of an
accounting change -- -- 65,617 -- -- -- 65,617
Issuance of common stock in
connection with AOL
restructuring 1,003 11 440 -- 24 993 1,444
Acquisition of treasury stock -- -- -- -- (1) -- --
Issuance of warrants for
Services -- -- 77 -- -- -- 77
------ ------ --------- ----------- ------ -------- ----------
Balance, December 31, 2001 27,151 272 351,169 (425,863) -- -- (74,422)
Net income (loss) -- -- -- 97,062 -- -- 97,062
Issuance of common stock
for services 67 1 82 -- -- -- 83
Exercise of common stock options 252 2 741 -- -- -- 743
------ ------ --------- ----------- ------ -------- ----------
Balance, December 31, 2002 27,470 $ 275 $ 351,992 $(328,801) -- $ -- $ 23,466
====== ====== ========= =========== ====== ======== ==========
See accompanying notes to consolidated financial statements.
39
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF ACCOUNTING POLICIES
(A) BUSINESS
Talk America Holdings, Inc. a Delaware corporation (the "Company"), through
its consolidated subsidiaries, primarily Talk America Inc., provides local and
long distance telecommunication services to residential and small business
customers. The Company's telecommunication services offerings include local and
long distance phone services, primarily local services bundled with long
distance services, long distance service, inbound toll-free service and
dedicated private line services for data transmission. The Company seeks to
expand its customer base through referrals from existing customers, outbound
telemarketing, direct sales through independent agents and recently developed
internal sales force, broadcast media, online marketing initiatives including
its own website.
(B) BASIS OF FINANCIAL STATEMENTS PRESENTATION
The consolidated financial statements include the accounts of Talk America
Holdings, Inc. and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated.
The Company's stockholders approved a one-for-three reverse stock split of
the Company's common stock, effective October 15, 2002, decreasing the number of
common shares authorized from 300 million to 100 million. The reverse stock
split has been reflected retroactively in the accompanying financial statements
and notes for all periods presented and all applicable references as to the
number of common shares and per share information, stock option data and market
prices have been restated to reflect this reverse stock split. In addition,
stockholders' equity (deficit) has been restated retroactively for all periods
presented for the par value of the number of shares that were eliminated as a
result of the reverse stock split.
(C) USE OF ESTIMATES
In preparing financial statements in conformity with generally accepted
accounting principles in the United States, management is required 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 and revenues and expenses during the reporting
period. Actual results could differ from those estimates.
(D) RECLASSIFICATIONS
Certain amounts for 2001 and 2000 have been reclassified to conform to the
current year presentation.
(E) RISKS AND UNCERTAINTIES
Future results of operations involve a number of risks and uncertainties.
Factors that could affect future operating results and cash flows and cause
actual results to vary materially from historical results include, but are not
limited to:
- Failure or difficulties in managing the Company's operations,
including attracting and retaining qualified personnel
- Dependence on the availability and functionality of RBOCs' networks as
they relate to the unbundled network element platform
- Increased price competition in local and long distance services and
overall competition within the telecommunications industry
- Failure or interruption in the Company's network and technology and
information systems
- Changes in government policy, regulation and enforcement or adverse
judicial or administrative interpretations and rulings relating to
regulations and enforcement, including, but not limited to, changes
that affect the continued availability of the unbundled network
element platform of the local exchange carriers network.
- Failure of the marketing of the bundle of the Company's local and long
40
distance services under agreements with its direct marketing channels
and its various marketing partners
- Inability to adapt to technological change
- Failure to manage the nonpayment of amounts due the Company from its
customers from bundled and long distance services
- Attrition in the number of end users
- Failure of the Company to be able to expand its active offering of
local bundled services in a greater number of states
- Failure to provide timely and accurate billing information to
customers
- Failure of the Company to manage its collection management systems and
credit controls for customers
- Interruption in the Company's network and information systems
- Failure of the Company to provide adequate customer service
Negative developments in these areas could have a material effect on the
Company's business, financial condition and results of operations.
(F) CONCENTRATION OF CREDIT RISK
The Company maintains its cash and cash equivalents in bank deposit
accounts, which at times may exceed federally insured limits. The Company
generally does not have a significant concentration of credit risk with respect
to net trade accounts receivable, due to the large number of end users
comprising the Company's customer base.
(G) RECOGNITION OF REVENUE
The Company derives its revenues from local and long distance phone
services, primarily local services bundled with long distance services, long
distance services, inbound toll-free service and dedicated private line services
for data transmission. The Company recognizes revenue from voice, data and other
telecommunications-related services in the period in which subscribers use the
related service. Allowances for doubtful accounts are maintained for estimated
losses resulting from the failure of its customers to make required payments and
for uncollectible usage.
Deferred revenue represents the unearned portion of local service and
features that are billed a month in advance. In addition, deferred revenue at
December 31, 2001 included a non-refundable prepayment received in 1997 in
connection with an amended telecommunications services agreement with Shared
Technologies Fairchild, Inc. The prepayment was amortized over the five-year
term of the agreement, which expired October 2002. The amount included in
revenue was $6.2 million in 2002, and $7.4 million in each of 2001 and 2000.
(H) CASH AND CASH EQUIVALENTS
The Company considers all temporary cash investments purchased with an
initial maturity of three months or less to be cash equivalents.
(I) PROPERTY AND EQUIPMENT AND DEPRECIATION
Property and equipment are recorded at historical cost. Depreciation and
amortization are calculated using the straight-line method over the estimated
useful lives of the assets from 3 to 39 years. Leasehold improvements are
depreciated over the life of the related lease or asset, if shorter.
Amortization of assets acquired under capital leases is included in depreciation
and amortization expense (see Note 6).
(J) COMPUTER SOFTWARE DEVELOPMENT COSTS
Direct development costs associated with internal-use computer software are
accounted for under Statement of Position 98-1 "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use" and are capitalized
including external direct costs of material and services and payroll costs for
employees devoting time to the software projects. Costs incurred during the
preliminary project stage, as well as for maintenance and training are expensed
as incurred. Amortization is provided on a straight-line basis over the shorter
of 3 years or the estimated useful life of the software.
41
Computer software developed or obtained for internal use included other
assets at December 31, 2002 and 2001 were $3.9 million and $1.4 million,
respectively, net of accumulated amortization of $0.6 million at December 31,
2002. Amortization expense was $0.6 million for the year ended December 31,
2002.
(K) GOODWILL AND INTANGIBLES
Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets," which
establishes the impairment approach rather than amortization for goodwill.
Effective January 1, 2002, the Company was no longer required to record
amortization expense on goodwill, but instead is required to evaluate these
assets for potential impairment at least annually and will test for impairment
between annual tests if an event occurs or circumstances change that would
indicate the carrying amount may be impaired. An impairment loss would generally
be recognized when the carrying amount of the reporting unit's net assets
exceeds the estimated fair value of the reporting unit.
In order to complete the transitional assessment of goodwill as required by
SFAS 142, the Company was required to determine by June 30, 2002, the fair value
of the reporting unit associated with the goodwill and compare it to the
reporting unit's carrying amount, including goodwill. The Company determined
that it has one reporting unit under the guidance of SFAS 142. The fair value of
the reporting unit was determined primarily using a discounted cash flow
approach and quoted market price of the Company's stock. The amount of goodwill
reflected in the balance sheet as of December 31, 2001 was $19.5 million. To
the extent a reporting unit's carrying amount exceeds its fair value, an
indication would exist that the reporting unit's goodwill assets may be impaired
and the Company will have to perform the second step of the transitional
impairment test. The Company completed the transitional assessment of goodwill
and determined that the fair value of the reporting unit exceeds its carrying
amount, thus goodwill is not considered impaired. If, in the future, the
Company has to perform the second step of the impairment test, the Company will
have to compare the implied fair value of the reporting unit's goodwill,
determined by allocating the reporting unit's fair value to all of its assets
and liabilities in a manner similar to a purchase price allocation in accordance
with SFAS 141, "Business Combinations," to its carrying amount. The required
impairment tests of goodwill may result in future period write-downs.
The following unaudited pro forma summary presents the adoption of SFAS 142
as of the beginning of the periods presented to eliminate the amortization
expense recognized in those periods related to goodwill that are no longer
required to be amortized. The pro forma amounts for the years ended December 31,
2001 and 2000 do not include any write-downs of goodwill that could have
resulted had the Company adopted SFAS 142 as of the beginning of the periods
presented and performed the required impairment test under this standard.
(In thousands, except for per share data) Year Ended December 31,
------------------------------------------
2002 2001 2000
------------- ------------- -----------
Net income (loss) as reported $ 97,062 $(224,667) $ (61,896)
Add back: Goodwill amortization -- 17,271 9,735
------------- ------------- -----------
Adjusted net income (loss) $ 97,062 $(207,396) $ (52,161)
============= ============= ===========
Basic income (loss) per share:
Net income (loss) as reported per share $ 3.56 $ (8.51) $ (2.63)
Goodwill amortization per share -- 0.66 0.41
------------- ------------- -----------
Adjusted net income (loss) per share $ 3.56 $ (7.85) $ (2.22)
============= ============= ===========
Diluted income (loss) per share:
Net income (loss) as reported per share $ 3.15 $ (8.51) $ (2.63)
Goodwill amortization per share -- 0.66 0.41
------------- ------------- -----------
Adjusted net income (loss) per share $ 3.15 $ (7.85) $ (2.22)
============= ============= ===========
42
Intangible assets consisted primarily of purchased customer accounts with
a definite life and are being amortized on a straight-line basis over 5 years.
The Company incurred amortization expense on intangible assets with a definite
life of $2.8 million, $3.2 million and $1.0 million for the years ended December
31, 2002, 2001 and 2000, respectively. The Company's balance of intangible
assets with a definite life was $7.4 million at December 31, 2002, net of
accumulated amortization of $6.2 million. Amortization expense on intangible
assets with a definite life for the next 5 years as of December 31, is as
follows: 2003 - $2.8 million, 2004 - $2.8 million and 2005 - $1.7 million.
(L) VALUATION OF LONG-LIVED ASSETS
Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets." SFAS 144 establishes a single accounting model for the
impairment or disposal of long-lived assets, including discontinued operations.
The Company continually reviews the recoverability of the carrying value of
its long-lived assets, including intangibles using the methodology prescribed in
SFAS 144. Long-lived assets are reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of such assets may
not be recoverable. When such events occur, the Company compares the carrying
amount of the assets to the undiscounted expected future cash flows. If this
comparison indicates there is impairment, the amount of the impairment is
typically calculated using discounted expected future cash flows. Certain of the
Company's long-lived assets were considered impaired during the year ended
December 31, 2001 (see Note 4).
(M) INCOME TAXES
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the estimated future tax
consequences attributable to the differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates in effect for the year in which
those temporary differences are expected to be recovered or settled.
(N) NET INCOME (LOSS) PER SHARE
Basic earnings per share is computed by dividing income available to common
shareholders by the weighted average number of common shares outstanding for the
period. Diluted earnings per share reflects the effect of common shares issuable
upon exercise of stock options, warrants and conversion of convertible debt,
when such effect is not antidilutive (see Note 14).
(O) FINANCIAL INSTRUMENTS
The carrying values of accounts receivable, prepaid expenses and other
current assets, accounts payable and accrued expenses approximate their fair
values. Convertible debt is recorded at face amount but such debt has traded in
the open market at discounts to face amount (see Note 7). The market value of
the Company's public debt securities was approximately 75% and 25% of face
amount at December 31, 2002 and 2001, respectively.
(P) STOCK-BASED COMPENSATION
The Company accounts for its stock option awards under the intrinsic value
based method of accounting prescribed by APB Opinion No. 25, "Accounting for
Stock Issued to Employees," and related interpretations, including FASB
Interpretation No. 44 "Accounting for Certain Transactions Including Stock
Compensation," an interpretation of APB Opinion No. 25. Under the intrinsic
value based method, compensation cost is the excess, if any, of the quoted
market price of the stock at grant date or other measurement date over the
amount an employee must pay to acquire the stock. The Company makes pro forma
disclosures of net income and earnings per share as if the fair value based
method of accounting had been applied as required by SFAS No. 123, "Accounting
for Stock-Based Compensation" and SFAS 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure - an amendment of SFAS 123" (see Note
10).
43
(Q) COMPREHENSIVE INCOME
The Company has no items of comprehensive income or expense. Accordingly,
the Company's comprehensive income (loss) and net income (loss) are equal for
all periods presented.
(R) NEW ACCOUNTING PRONOUNCEMENTS
In August 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 143, "Accounting for Obligations
Associated with the Retirement of Long-Lived Assets." SFAS 143 establishes
accounting standards for the recognition and measurement of an asset retirement
obligation and its associated asset retirement cost. It also provides accounting
guidance for legal obligations associated with the retirement of tangible
long-lived assets. SFAS 143 is effective in fiscal years beginning after June
15, 2002, with early adoption permitted. The provisions of SFAS 143 will not
have a material effect on the Company's consolidated results of operations or
financial position.
Effective January 1, 2002, the Company adopted Emerging Issues Task Force
(EITF) 01-09, "Accounting for Consideration Given by a Vendor to a Customer or a
Reseller of the Vendor's Products." This issue presumes that consideration from
a vendor to a customer or reseller of the vendor's products is a reduction of
the selling prices of the vendor's products and, therefore, should be
characterized as a reduction of revenue when recognized in the vendor's
statement of operations and could lead to negative revenue under certain
circumstances. Revenue reduction is required unless the consideration relates to
a separate, identifiable benefit and the benefit's fair value can be
established. The adoption of this issue resulted in a reclassification from
sales and marketing expenses of $7.3 million and $18.8 million to a reduction of
net sales for the year ended December 31, 2001 and 2000, respectively, in each
case attributed to direct marketing promotion check campaigns. The adoption of
EITF 01-09 did not have a material effect on the Company's consolidated
financial statements for the year ended December 31, 2002, as the Company did
not have any direct marketing promotion check campaigns during this period.
In May 2002, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statements No. 13, and Technical Corrections as of
April 2002." SFAS 145 eliminates the requirement to report gains and losses
from extinguishment of debt as extraordinary items. Gains and losses from
extinguishment of debt will now be classified as extraordinary items only if
they meet the criteria of APB Opinion No. 30. Generally, SFAS 145 is effective
in fiscal years beginning after May 15, 2002, with early adoption encouraged.
The Company will adopt SFAS 145 effective January 1, 2003. The adoption of SFAS
145 will result in a reclassification from extraordinary gains (losses) from the
extinguishment of debt to other income (expense).
In July 2002, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 146, "Accounting for Costs Associated with
Exit or Disposal Activities." SFAS 146 requires that a liability for a cost that
is associated with an exit or disposal activity be recognized when the liability
is incurred. SFAS 146 also establishes that fair value is the objective for the
initial measurement of the liability. SFAS 146 is effective for exit or disposal
activities that are initiated after December 31, 2002.
In November 2002, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 45 ("FIN 45"), "Guarantees," an interpretation of FASB
Statement No. 5, "Accounting for Contingencies." This interpretation elaborates
on the disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued. It
also clarifies that a guarantor is required to recognize, at the inception of
certain guarantees, a liability for the fair value of the obligation undertaken
in issuing the guarantees. This interpretation is effective on a prospective
basis for guarantees issued or modified after December 31, 2002 and for
financial statements of interim or annual periods ending after December 15,
2002. The Company believes that the adoption of this standard will have no
material impact on its financial statements.
44
The Company has adopted the disclosure provisions of Statement of Financial
Accounting Standards ("SFAS") No. 123, amended by SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure - an amendment of FASB
Statement No. 123". This Statement amends the disclosure requirements of
Statement 123 to require prominent disclosures in the summary of significant
accounting policies in the financial statements. The Company adopted the
disclosure requirements of SFAS No. 148 effective December 31, 2002. There was
no impact on the Company's basic financial statements resulting from its
adoption. The following disclosure complies with the adoption of this statement
and includes pro forma net loss as if the fair value based method of accounting
had been applied:
(In thousands) Year Ended December 31,
------------------------------------------
2002 2001 2000
------------ ------------ ------------
Net income (loss) as reported $ 97,062 $(224,667) $ (61,896)
Stock-based employee compensation
expense included in reported net
income (loss) -- -- --
Total stock-based employee
compensation expense determined
under fair value based method for all
options 5,208 1,380 37,524
Proforma net income (loss) $ 91,854 $(226,047) $ (99,420)
============ ============ ============
YEAR ENDED DECEMBER 31,
-----------------------------------------
2002 2001 2000
---------- ----------- --------------
BASIC EARNINGS (LOSS) PER SHARE:
As reported $ 3.56 $ (8.51) $ (2.63)
Pro forma $ 3.37 $ (8.56) $ (4.23)
DILUTED EARNINGS (LOSS) PER SHARE:
As reported $ 3.15 $ (8.51) $ (2.63)
Pro forma $ 2.96 $ (8.56) $ (4.23)
In January 2003, FASB issued FASB Interpretation No. 46, Consolidation of
Variable Interest Entities ("FIN 46"). FIN 46 requires a variable interest
entity to be consolidated by a company if that company is subject to a majority
of the risk of loss from the variable interest entity's activities or entitled
to receive a majority of the entity's residual returns or both. FIN 46 also
requires disclosures about variable interest entities that a company is not
required to consolidate but in which it has a significant variable interest. The
consolidation requirements of FIN 46 apply immediately to variable interest
entities created after January 31, 2003. The consolidation requirements apply to
existing entities in the first fiscal year or interim period beginning after
June 15, 2003. Certain of the disclosure requirements apply in all financial
statements issued after January 31, 2003, regardless of when the variable
interest entity was established. The Company is currently evaluating the impact
of FIN 46 on its financial statements and related disclosures but does not
expect that there will be any material impact.
(S) SEGMENT DISCLOSURE
The Company manages its business as one reportable operating segment.
NOTE 2. AOL AGREEMENTS
In September 2001, the Company restructured its financial obligations with
America Online, Inc. ("AOL") that arose under the Investment Agreement entered
into on January 5, 1999 and, effective September 30, 2001, also ended its
marketing relationship with AOL (collectively the "AOL Restructuring"). In
connection with the AOL Restructuring, the Company and AOL entered into a
Restructuring and Note Agreement ("Restructuring Agreement") pursuant to which
the Company issued to AOL $54.0 million principal amount of its 8% Secured
Convertible Notes ("8% Secured Convertible Notes") and 1,026,209 additional
shares of the Company's common stock (see Note 7), after which AOL held a total
of 2,400,000 shares of common stock (see Note 9). The Company agreed to provide
certain registration rights to AOL in connection with the shares of common stock
issued to it by the Company.
In addition to the restructuring of the financial obligations discussed
above, the Company and AOL agreed, in a further amendment to their marketing
agreement, dated as of September 19, 2001, to discontinue, effective as of
September 30, 2001, their marketing relationship under the marketing agreement.
AOL, in lieu of any other payment for the early discontinuance of the marketing
relationship, paid the Company $20 million by surrender and cancellation of $20
million principal amount of the 8% Secured Convertible Notes delivered to AOL as
discussed above, thereby reducing the outstanding principal amount of the 8%
Secured Convertible Notes to $34 million.
In accordance with SFAS No. 15, "Accounting by Debtors and Creditors for
Troubled Debt Restructurings," the AOL Restructuring transaction was accounted
for as a troubled debt restructuring. The Company combined all liabilities due
AOL at the time of the Restructuring Agreement, including the contingent
redemption feature of the warrants with a value of $34.2 million and the
contingent redemption feature of the common stock with a value of $54.0 million.
The total liability of $88.2 million was reduced by the fair value of the
1,026,209 incremental shares provided to AOL of $1.4 million and cash paid in
connection with the AOL Restructuring of $3.5 million. Since the remaining value
of $83.3 million was greater than the future cash flows to AOL of $66.4 million,
the liability was written down to the value of the future cash flows due to AOL
and an extraordinary gain of $16.9 million was recorded in the third quarter of
2001. As a result of this accounting treatment, the Company recorded no interest
expense associated with these convertible notes during 2001 and 2002 in the
Company's statements of operations.
Under the terms of the Investment Agreement, the had Company agreed to
reimburse AOL for losses AOL may incur on the sale of certain shares of the
Company's common stock. In addition, AOL also had the right to require the
Company to repurchase warrants held by AOL. Upon the occurrence of certain
45
events, including material defaults by the Company under its AOL agreements and
a "change of control" of the Company, the Company could have been required to
repurchase for cash all of the shares held by AOL for $78.3 million ($57 per
share), and the warrants for $36.3 million. The Company had originally recorded
the contingent redemption value of the common stock and warrants at $78.3 and
$36.3 million, respectively, with a corresponding reduction in additional
paid-in capital. In connection with the implementation of EITF 00-19, the
contingent redemption feature of the common stock and warrants were recorded as
a liability at their fair values of $53.5 and $32.3 million, respectively, as of
June 30, 2001. The increase in the fair value of these contingent redemption
instruments from issuance on January 5, 1999 to June 30, 2001 was $36.8 million,
which has been presented as a cumulative effect of a change in accounting
principle in the statement of operations for the year ended December 31, 2002.
For the quarter ended September 30, 2001, the Company recorded an unrealized
loss of $2.4 million on the increase in the fair value of the contingent
redemption instruments, which was reflected in other (income) expense on the
statement of operations. As discussed above, these contingent redemption
instruments were satisfied through the Restructuring Agreement entered into with
AOL on September 19, 2001.
On February 21, 2002, by letter agreement, AOL agreed, subject to certain
conditions, to waive certain rights that it had under the Restructuring
Agreement with respect to the Company's restructuring of its existing 4-1/2% and
5% Convertible Subordinated Notes. Under the letter agreement, the Company also
paid AOL approximately $1.2 million as a prepayment on the 8% Secured
Convertible Notes, approximately $0.7 million of which was credited against
amounts the Company owed AOL under the letter agreement for cash payments in the
restructuring of these other notes. The Company complied with the various
conditions of the letter agreement and did not owe AOL any additional payments
related to this restructuring of its other notes.
On December 23, 2002, by letter agreement, the Company and AOL amended
certain provisions of the Restructuring Agreement (the "Amendment"). Pursuant to
the Amendment, the maturity date for the 8% Secured Convertible Notes issued
under the Restructuring Agreement was advanced to September 19, 2006 from 2011,
and the Company's right to elect to pay a portion of the interest on the 8%
Secured Convertible Notes in kind rather than in cash was eliminated. The
Amendment also provided that certain limitations on the Company's purchase of
its outstanding subordinated indebtedness ("Sub Debt") and common stock were
amended, to permit the Company, through September 30, 2003, to: (i) repurchase
outstanding Sub Debt provided it does not pay more than 80% of the face amount
and, for every dollar used to repurchase Sub Debt, it repurchases $0.50 of
principal amount of 8% Secured Convertible Notes from AOL; and (ii) purchase
shares of its common stock, provided it purchases the shares at or below market
value and it concurrently purchases an equal number of shares of the common
stock from AOL. The aggregate amount that the Company may utilize with respect
to both the repurchase of Sub Debt and of common stock cannot exceed $10
million.
As a consequence of the Amendment and the repurchase of $4.1 million of
the 8% Secured Convertible Notes in the fourth quarter of 2002, the Company
recorded an extraordinary non-cash gain of $28.9 million from the decrease in
the future accrued interest relating to the 8% Secured Convertible Notes, which
was reflected as a $28.9 million reduction in long-term debt. As a further
consequence, the Company will begin recording the interest expense associated
with the 8% Secured Convertible Notes on its statements of operations.
The Restructuring Agreement provided that the Investment Agreement, the
Security Agreement securing the Company's obligations under the Investment
Agreement and the existing Registration Rights Agreement with AOL were
terminated in their entirety and the parties were released from any further
obligation under these agreements. In addition, AOL, as the holder of the 8%
Secured Convertible Notes, entered into an intercreditor agreement with the
lender under the Company's existing secured credit facility, which survives the
early retirement of debt under the Company's Senior Credit Facility (see Note
7).
NOTE 3. ACQUISITIONS
On August 9, 2000, a wholly owned subsidiary of the Company merged with and
into Access One Communications Corp., ("Access One"). Access One was a private,
local telecommunications service provider to nine states in the southeastern
United States. As a result of such merger, Access One became a wholly owned
subsidiary of the Company and Access One stockholders received an aggregate of
approximately 4.1 million shares of the Company's common stock, and outstanding
46
options and warrants to purchase shares of Access One common stock converted to
options and warrants to purchase an aggregate of 0.7 million shares of the
Company's common stock. The total purchase price was approximately $201.6
million and the merger was accounted for under the purchase method of accounting
for business combinations. Accordingly, the consolidated financial statements
include the results of operations of Access One from the merger date. The merger
resulted in the recording of intangible assets of approximately $15.9 million
and goodwill of $210.0 million (see Notes 1 and 4). The Company became liable
for $19.6 million of notes payable as part of the acquisition of Access One.
The following unaudited pro forma information presents a summary of the
consolidated results of operations of the Company as if the Access One merger
had taken place at the beginning of the periods presented (In thousands, except
share data):
Year Ended
December 31, 2000
-----------------
Sales $ 556,918
-----------------
Net income (loss) $ (86,424)
=================
Basic earnings (loss) per common share:
Net income (loss) $ (3.68)
Diluted earnings (loss) per common share:
Net income (loss) $ (3.68)
The pro forma consolidated results of operations include adjustments to
give effect to amortization of intangibles, consulting fees and shares of common
stock issued. These unaudited pro forma results have been prepared for
comparative purposes only and do not purport to be indicative of the results of
operations that actually would have occurred had the merger been made at the
beginning of the periods presented or the future results of the combined
operations.
NOTE 4. IMPAIRMENT AND RESTRUCTURING CHARGES
In 2001, the Company recorded an impairment charge of $168.7 million
primarily related to the write-down of goodwill associated with the acquisition
of Access One (see Note 3). SFAS 121 "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of," required the
evaluation of impairment of long-lived assets and identifiable intangibles
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. Management determined that goodwill should be
evaluated for impairment in accordance with the provisions of SFAS 121 due to
the increased bad debt rate and increased customer turnover, as well as the AOL
Restructuring that occurred in the quarter ended September 30, 2001. The
write-down of goodwill was based on an analysis of projected discounted cash
flows using a discount rate of 18%, which results determined that the fair value
of the goodwill was substantially less than the carrying value.
In September 2001, the Company approved a plan to close one of its call
center operations. The Company recorded a charge of $2.5 million in the quarter
ended September 30, 2001 to reflect the elimination of approximately 225
positions amounting to $1.0 million and lease exit costs amounting to $1.5
million in connection with the call center closure. The employees identified in
the plan were notified in September 2001 and terminated in October 2001. Actual
restructuring costs were $1.9 million, comprised of $1.2 million of employee
severance costs and $0.7 million of lease termination and other call center
closure costs.
47
NOTE 5. COMMITMENTS AND CONTINGENCIES
(A) LEASE AGREEMENTS
The Company leases office space and equipment under operating lease
agreements. Certain leases contain renewal options and purchase options, and
generally provide that the Company shall pay for insurance, taxes and
maintenance. Total rent expense for all operating leases for the years ended
December 31, 2002, 2001 and 2000 was $2.4, $2.5, and $1.4 million, respectively.
As of December 31, 2002, the Company had future minimum annual lease obligations
under noncancellable operating leases with terms in excess of one year as
follows (in thousands):
OPERATING
YEAR ENDED DECEMBER 31, LEASES
---------------------------- ---------
2003 $ 1,887
2004 1,548
2005 1,086
2006 486
2007 242
Thereafter 159
---------
Total minimum lease payments $ 5,408
=========
(B) LEGAL PROCEEDINGS
In the third quarter of 2002, the Company paid $140,000 in connection with
the favorable settlement of litigation relating to an obligation with a third
party that had previously been reflected as a liability, and recorded a non-cash
reduction of expense in the amount of $1.7 million.
On November 12, 2001, the Company received an award of arbitrators awarding
Traffix, Inc. approximately $6.2 million in an arbitration concerning the
termination of a marketing agreement between the Company and Traffix, which the
parties agreed would be paid in two installments - $3.7 million paid in November
2001 and the remaining $2.5 million paid on April 1, 2002. The Company's
obligations to Traffix have been satisfied.
The Company also is a party to a number of legal actions and proceedings
arising from the Company's provision and marketing of telecommunications
services, as well as certain legal actions and regulatory investigations and tax
audits and enforcement proceedings arising in the ordinary course of business.
The Company believes that the ultimate outcome of the foregoing actions will not
result in liability that would have a material adverse effect on the Company's
financial condition or results of operations. However, it is possible that,
because of fluctuations in the Company's cash position, the timing of
developments with respect to such matters that require cash payments by the
Company, while such payments are not expected to be material to the Company's
financial condition, could impair the Company's ability in future interim or
annual periods to continue to implement its business plan, which could affect
its results of operations in future interim or annual periods.
(C) NETWORK COMMITMENTS
The Company is also party to various network service agreements, which
contain certain minimum usage commitments. The largest contract establishes
pricing and provides for revenue commitments based upon usage of $52 million for
the 18 months ended February 2004 and $40 million for the 9 months ended
December 2004. This contract obligates the Company to pay 65 percent of the
revenue shortfall, if any. A separate contract with a different vendor
establishes pricing and provides for annual minimum payments as follows: 2003 -
$6.0 million and 2004 - $3.0 million. While the Company anticipates that it will
not be required to make any shortfall payments under these contracts as a result
of (1) growth in network minutes, (2) the management of traffic flows on its
network, (3) the restructuring of these obligations, and/or (4) the sale of
additional minutes of usage on the wholesale markets; there can be no assurances
that the Company will be successful in its efforts. In addition, these actions
will likely cause the Company to experience an increase in per minute network
costs.
48
NOTE 6. PROPERTY AND EQUIPMENT
The following is a summary of property and equipment, at cost, less
accumulated depreciation (in thousands):
DECEMBER 31,
-----------------------
LIVES 2002 2001
-------------- ---------- ----------
Land $ 330 $ 330
Buildings and building
improvements 39 years 6,782 6,589
Leasehold improvements 3-10 years 397 464
Switching equipment 10-15 years 59,289 57,991
Software 3 years 6,366 4,916
Equipment and other 3-10 years 44,770 43,676
---------- ----------
117,934 113,966
Less: Accumulated depreciation (51,019) (38,087)
---------- ----------
$ 66,915 $ 75,879
========== ==========
For the years ended December 31, 2002, 2001 and 2000, depreciation expense
amounted to $13.3 million, $13.6 million and $9.6 million, respectively.
NOTE 7. DEBT
(A) 12% SENIOR SUBORDINATED NOTES DUE 2007 AND 8% CONVERTIBLE SENIOR
SUBORDINATED NOTES DUE 2007
Effective April 4, 2002, the Company completed the exchange of $57.9
million of the $61.8 million outstanding principal balance of its 4-1/2%
Convertible Subordinated Notes due September 15, 2002 ("4-1/2% Convertible
Subordinated Notes") into $53.2 million of new 12% Senior Subordinated PIK Notes
due August 2007 ("12% Senior Subordinated Notes") and $2.8 million of new 8%
Convertible Senior Subordinated Notes due August 2007 ("8% Convertible Senior
Subordinated Notes") and cash paid of $0.5 million. In addition, the Company
exchanged $17.4 million of the $18.1 million outstanding principal balance of
its 5% Convertible Subordinated Notes ("5% Convertible Subordinated Notes") that
mature on December 15, 2004 into $17.4 million of the new 12% Senior
Subordinated Notes.
The new 12% Senior Subordinated Notes accrue interest at a rate of 12% per
year on the principal amount, payable semiannually on February 15 and August 15,
beginning on August 15, 2002. Interest is payable in cash, except that the
Company may, at its option, pay up to one-third of the interest due on any
interest payment date through and including the August 15, 2004 interest payment
date in additional 12% Senior Subordinated Notes. The new 8% Convertible Senior
Subordinated Notes accrue interest at a rate of 8% per year on the principal
amount, also payable semiannually on February 15 and August 15, and are
convertible, at the option of the holder, into common stock at $15.00 per share.
The 12% Senior Subordinated Notes and 8% Convertible Senior Subordinated Notes
are redeemable at any time at the option of the Company at par value plus
accrued interest to the redemption date. The AOL Restructuring Agreement
obligates the Company's to redeem 8% Secured Convertible Notes upon the
redemption of subordinated debt (see Note 2). As of December 31, 2002, the
Company had $66.0 and $2.8 million principal amount outstanding of the 12%
Senior Subordinated Notes and 8% Convertible Senior Subordinated Notes,
respectively.
In accordance with SFAS No. 15, "Accounting by Debtors and Creditors for
Troubled Debt Restructurings," the exchange of the 4-1/2% Convertible
Subordinated Notes into $53.2 million of the 12% Senior Subordinated Notes and
$2.8 million of the 8% Convertible Senior Subordinated Notes is accounted for as
a troubled debt restructuring. Since the total liability of $57.4 million ($57.9
million of principal as of the exchange date, less cash payments of $0.5
million) is less than the future cash flows to holders of 8% Convertible Senior
Subordinated Notes and 12% Senior Subordinated Notes of $91.5 million
(representing the $56.0 million of principal and $35.5 million of future
interest expense), the liability remained on the balance sheet at $57.4 million
as long-term debt. The difference of $1.4 million between principal and the
carrying amount is being recognized as a reduction of interest expense over the
life of the new notes.
The Company reacquired $5.7 million of 12% Senior Subordinated Notes in
2002 at a $1.6 million discount from face amount. This amount is reported as an
extraordinary gain in the consolidated statement of operations.
49
(B) 5% CONVERTIBLE SUBORDINATED NOTES DUE 2004
As of December 31, 2002, the Company has $0.7 million principal amount
outstanding of 5% Convertible Subordinated Notes that mature on December 15,
2004. Interest on these notes is due and payable two times a year on June 15 and
December 15. The notes are convertible, at the option of the holder, at a
conversion price of $76.14 per share, as adjusted for the dilutive effect of the
exercise of rights pursuant to the Company's rights offering (see Note 9). The
5% Convertible Subordinated Notes are redeemable, in whole or in part at the
Company's option, at 101.43% of par prior to December 14, 2003 and 100.71% of
par thereafter.
(C) 8% SECURED CONVERTIBLE NOTES DUE 2006
In connection with the AOL Restructuring discussed in Note 2, the Company
and AOL entered into a Restructuring Agreement pursuant to which the Company
issued to AOL $54.0 million principal amount of its 8% Secured Convertible
Notes. The 8% Secured Convertible Notes were issued in exchange for a release of
the Company's reimbursement obligations under the Investment Agreement. AOL, in
lieu of any other payment for the early discontinuance of the marketing
relationship, paid the Company $20.0 million by surrender and cancellation of
$20.0 million principal amount of the 8% Secured Convertible Notes delivered to
AOL, thereby reducing the outstanding principal amount of the 8% Secured
Convertible Notes to $34.0 million.
The 8% Secured Convertible Notes are convertible into shares of the
Company's common stock at the rate of $15.00 per share and may be redeemed by
the Company at any time without premium. The 8% Secured Convertible Notes accrue
interest at the rate of 8% per year on the principal amount, payable two times a
year on January 1 and July 1. The 8% Secured Convertible Notes are guaranteed
by the Company's principal operating subsidiaries and are secured by a pledge of
the Company's and the subsidiaries' assets. In addition, AOL, as the holder of
the 8% Secured Convertible Notes, entered into an intercreditor agreement with
the lender under the Company's existing secured credit facility, which survives
the early retirement of debt under the Company's Senior Credit Facility.
On December 23, 2002, by letter agreement, the Company and AOL amended
certain provisions of the Restructuring Agreement between them (the
"Amendment"). Pursuant to the Amendment, the maturity date for the 8% Secured
Convertible Notes issued under the Restructuring Agreement was advanced to
September 19, 2006 (four days later than the first date of mandatory redemption
at the option of the holder) from 2011, and the Company's right to elect to pay
a portion (50%) of the interest on the 8% Secured Convertible Notes in kind
rather than in cash was eliminated.
In addition, the Amendment provided that certain limitations on the
Company's purchase of its outstanding subordinated indebtedness ("Sub Debt") and
common stock were amended, to permit the Company, through September 30, 2003,
to: (i) repurchase outstanding Sub Debt provided it does not pay more than 80%
of the face amount and, for every dollar used to repurchase Sub Debt, it
repurchases $0.50 of principal amount of 8% Secured Convertible Notes from AOL;
and (ii) purchase shares of its common stock, provided it purchases the shares
at or below market value and it concurrently purchases an equal number of shares
of common stock from AOL. The aggregate amount that the Company may utilize with
respect to both the repurchase of Sub Debt and of common stock cannot exceed $10
million.
As a consequence of the Amendment and the repurchase of $4.1 million of the
8% Secured Convertible Notes in the fourth quarter of 2002, the Company recorded
an extraordinary non-cash gain of $28.9 million from the decrease in the future
accrued interest relating to the 8% Secured Convertible Notes which was
reflected as a $28.9 million reduction in long-term debt. As a further
consequence, the Company will begin recording the interest expense associated
with the 8% Secured Convertible Notes on its consolidated statement of
operations. As of December 31, 2002, the Company had $30.2 million principal
amount outstanding of 8% Secured Convertible Notes.
50
(D) SENIOR CREDIT FACILITY
On October 4, 2002, the principal operating subsidiaries of the Company
retired, prior to maturity, all of the debt outstanding under the Senior Credit
Facility Agreement between the subsidiaries and MCG Finance Corporation ("MCG").
As a result of the retirement of the debt under the Senior Credit Facility
Agreement, the pledge of assets and the restrictions and covenants under the
Senior Credit Facility Agreement were terminated and the Company incurred a
one-time, non-cash extraordinary charge to earnings of $1.1 million in the
fourth quarter of 2002, reflecting the acceleration of the amortization of
certain deferred finance charges and fees.
The Senior Credit Facility Agreement provided for a term loan of up to
$20.0 million maturing on June 30, 2005. Loans under the Credit Facility
Agreement bore interest at a rate equal to either (a) the Prime Rate plus 6.0%
or (b) LIBOR plus 7.0%. The principal of the term loan was payable in quarterly
installments of $1.25 million commencing on September 30, 2001. In connection
with the AOL Restructuring, MCG entered into an Intercreditor Agreement with
AOL, providing for the subordination of the 8% Secured Convertible Notes to the
obligations under the Senior Credit Facility and successor and replacement
senior credit facilities of the Company, which Intercreditor Agreement survives
the early retirement of debt under the Credit Facility Agreement (see Notes 2
and 7, above).
By amendments on February 12, 2002 and April 3, 2002, the Company
restructured certain portions of the Credit Facility Agreement and the related
consulting agreement and other loan documents. This restructuring amended
certain financial covenants and increased the interest rate. The restructuring
also added mandatory prepayment provisions if the Company used a total of $10.0
million or more of cash to repurchase or otherwise prepay our other debt
obligations, including the 4-1/2% and 5% Convertible Subordinated Notes, the 8%
Secured Convertible Notes and the 8% Convertible Senior Subordinated Notes and
12% Senior Subordinated Notes and, effectively required the Company to elect to
pay in kind, rather than cash, interest on its 8% Secured Convertible Notes and
its 12% Senior Subordinated Notes to the fullest extent it is permitted to do so
under such notes. In addition, the Company had issued 66,666 shares of common
stock to MCG with a value of $84,000 upon issuance and agreed to register such
shares in the future.
(E) MINIMUM ANNUAL PAYMENTS
As of December 31, 2002, the required minimum annual principal payments of
long-term debt obligations, including capital leases, for each of the next five
fiscal years is as follows (in thousands):
Year Ended December 31,
-----------------------
2003 $ 61
2004 697
2005 --
2006 30,150
2007 70,008
--------
$100,916
========
NOTE 8. RELATED PARTY TRANSACTION
The Company had a note receivable with an officer of the Company with a
balance of $1.0 million as of December 31, 2002 for relocation and construction
of a new residence in Florida. The note receivable bore interest at 6.25% and
the principal balance together with unpaid accrued interest was payable to the
Company in November 2004. The note was collateralized by the new residence. In
the first quarter of 2003, the note was prepaid in full.
NOTE 9. STOCKHOLDERS' EQUITY (DEFICIT)
(A) REVERSE STOCK SPLIT
The Company's stockholders approved a one-for-three reverse stock split of
the Company's common stock, effective October 15, 2002, decreasing the number of
common shares authorized from 300 million to 100 million.
51
(B) STOCKHOLDERS RIGHTS PLAN
On August 19, 1999, the Company adopted a Stockholders Rights Plan designed
to deter coercive takeover tactics and prevent an acquirer from gaining control
of the Company without offering a fair price to all of the Company's
stockholders.
Under the terms of the plan, preferred stock purchase rights were
distributed as a dividend at the rate of one right for each share of Common
Stock of the Company held as of the close of business on August 30, 1999. Until
the rights become exercisable, Common Stock issued by the Company will also have
one right attached. Each right will entitle holders to buy one three-hundredth
of a share of Series A Junior Participating Preferred Stock of the Company at an
exercise price of $165. Each right will thereafter entitle the holder to receive
upon exercise Common Stock (or, in certain circumstances, cash, property or
other securities of the Company) having a value equal to two times the exercise
price of the right.
The rights will be exercisable only if a person or group acquires
beneficial ownership of 20% or more of Common Stock or announces a tender or
exchange offer which would result in such person or group owning 20% or more of
Common Stock, or if the Board of Directors declares that a 15% or more
stockholder has become an "adverse person" as defined in the plan.
The Company, except as otherwise provided in the plan, will generally be
able to redeem the rights at $0.001 per right at any time during a ten-day
period following public announcement that a 20% position in the Company has been
acquired or after the Company's Board of Directors declares that a 15% or more
stockholder has become an "adverse person." The rights are not exercisable until
the expiration of the redemption period. The rights will expire on August 19,
2009, subject to extension by the Board of Directors.
NOTE 10. STOCK OPTIONS, WARRANTS AND RIGHTS
(A) STOCK BASED COMPENSATION PLAN
Incentive stock options, non-qualified stock options and other stock based
awards may be granted by a committee of the Board of Directors of the Company to
employees, directors and consultants under the 2000 Long Term Incentive Plan
("2000 Plan"), 1998 Long Term Incentive Plan ("1998 Plan") and otherwise in
connection with employment and to employees under the 2001 Non-Officer Long Term
Incentive Plan ("2001 Plan"). Generally, the options vest over a three-year
period and expire five to ten years from the date of grant. At December 31,
2002, 60,541, 65,556, and 774,188 shares of common stock were available under
the 2000 Plan, 1998 Plan and 2001 Plan, respectively, for possible future
issuances. The exercise price of the options is 100% of the market value of the
common stock on the grant date.
Stock options granted in 2002 generally have contractual terms of 10 years.
The options granted to employees have an exercise price equal to the fair market
value of the stock at grant date. The vast majority of options granted in 2002
vest one-third each year, beginning on the first anniversary of the date of
grant.
On August 29, 2001, the Company commenced a voluntary stock option exchange
program to certain eligible employees of the Company. Under the program,
eligible employees were given the option to cancel each outstanding stock option
previously granted to them at an exercise price greater than or equal to $16.50
per share, in exchange for a new option to buy shares of the Company's common
stock to be granted on April 5, 2002, six months and one day from October 4,
2001, the date the old options were cancelled. The exercise price of these new
options was equal to the fair market value of the Company's common stock on the
date of grant. The exchange program did not result in any additional
compensation charges or variable option plan accounting. The Company issued
52
options to purchase 1.9 million stock shares on April 5, 2002, at $1.53 per
share, market value on the date of issue, in satisfaction of the obligations
under the Company's exchange offer.
Information with respect to options under the Company's plans is as
follows:
EXERCISE WEIGHTED
OPTIONS PRICE RANGE AVERAGE
SHARES PER SHARE EXERCISE PRICE
---------- ------------- ---------------
Outstanding, December 31, 1999 2,282,977 $13.74-$51.75 $ 29.16
Granted 3,226,269 $ 3.39-$48.54 $ 23.94
Exercised (114,112) $13.74-$35.82 $ 22.17
Cancelled (372,028) $ 7.89-$47.64 $ 27.09
Outstanding, December 31, 2000 5,023,106 $ 2.64-$51.75 $ 25.80
Granted 365,733 $ 0.99-$5.94 $ 2.58
Exercised -- -- --
Cancelled (2,912,700) $ 4.02-$51.75 $ 34.02
Outstanding, December 31, 2001 2,476,139 $ 0.99-$47.64 $ 12.72
Granted 2,248,685 $ 1.11-$11.91 $ 1.78
Exercised (250,906) $ 0.99-$7.88 $ 2.50
Cancelled (288,218) $ 1.26-$47.64 $ 21.66
Outstanding, December 31, 2002 4,185,700 $ 1.11-$48.54 $ 6.84
The following table summarizes options exercisable at December 31, 2002,
2001 and 2000:
EXERCISE PRICE WEIGHTED
RANGE AVERAGE
OPTION SHARES PER SHARE EXERCISE PRICE
-------------- --------------- --------------
2000 1,865,857 $2.64-$51.75 $21.93
2001 1,285,508 $2.64-$47.64 $16.74
2002 2,942,999 $0.99-$48.54 $ 6.84
53
The following table summarizes the status of stock options outstanding at
December 31, 2002:
WEIGHTED
NUMBER AVERAGE NUMBER
OUTSTANDING AT WEIGHTED REMAINING EXERCISABLE AT WEIGHTED
RANGE OF DECEMBER 31, AVERAGE CONTRACTUAL DECEMBER 31, AVERAGE
EXERCISE PRICES 2002 EXERCISE PRICE LIFE (YEARS) 2002 EXERCISE PRICE
---------------- -------------- -------------- ------------ -------------- --------------
$0.99 to $10.50 3,085,900 $ 2.76 7.4 2,054,031 $ 2.26
$10.51 to $21.00 853,027 $ 15.10 7.4 642,417 $15.44
$21.01 to $30.00 134,998 $ 28.16 6.3 134,998 $28.16
$30.01 to $32.00 104,388 $ 30.45 6.4 104,388 $30.45
$32.00 to $48.54 7,387 $ 36.18 6.4 7,165 $35.82
The weighted average estimated fair values of the stock options granted
during the years ended December 31 2002, 2001 and 2000 based on the
Black-Scholes option pricing model were $.57, $1.71 and $19.68, respectively.
The fair value of stock options used to compute pro forma net income (loss) and
basic and diluted earnings (loss) per share disclosures is the estimated fair
value at grant date using the Black-Scholes option-pricing model with the
following assumptions:
ASSUMPTION 2002 2001 2000
----------------------- --------- --------- ----------
Expected Term 5 years 5 years 5 years
Expected Volatility 98.13% 78.95% 87.46%
Expected Dividend Yield --% --% --%
Risk-Free Interest Rate 4.33% 5.92% 6.27%
(B) WARRANTS
In connection with the Access One acquisition, the Company assumed certain
warrants to purchase shares of Access One, which, upon consummation of the
Merger, converted to warrants to purchase an aggregate of 290,472 shares of the
Company common stock at an exercise price of $6.30 per share and expiring August
2005. In connection with certain consulting services that MCG Credit Corporation
was to provide to the Company, the Company issued a warrant to MCG to purchase
100,000 shares of its common stock, at an exercisable price of $14.19 per share
and expiring August 2007. Upon its execution of the Credit Facility Agreement
with MCG Finance Corporation in October, 2000, the Company issued warrants for
100,000 shares of its common stock, at an exercise price of $13.08 per share and
expiring October 20, 2005 of which only 50,000 vested. In connection with the
waiver from the MCG lenders in the second quarter of 2001 and certain other
amendments under the Credit Facility Agreement, the Company issued warrants with
a value of $77,000 upon issuance to purchase 50,000 shares of its common stock
at an exercise price of $2.04 per share and expire August 16, 2006, to such
lenders.
NOTE 11. INCOME TAXES
The Company reports the effects of income taxes under SFAS No. 109,
"Accounting for Income Taxes". The objective of income tax reporting is to
recognize (a) the amount of taxes payable or refundable for the current year and
(b) deferred tax liabilities and assets for the future tax consequences of
events that have been recognized in the financial statements or tax returns.
Under SFAS No. 109, the measurement of deferred tax assets is reduced, if
necessary, by the amount of any tax benefits that, based on available evidence,
are not expected to be realized. Realization of deferred tax assets is
determined on a more-likely-than-not basis.
The Company considers all available evidence, both positive and negative,
to determine whether, based on the weight of that evidence, a valuation
allowance is needed for some portion or all of a net deferred tax asset.
Judgment is used in considering the relative impact of negative and positive
evidence. In arriving at these judgments, the weight given to the potential
effect of negative and positive evidence is commensurate with the extent to
which it can be objectively verified.
54
At December 2001, a full valuation allowance had been provided against the
Company's net operating loss carry-forwards and other deferred tax assets since
the amounts and extent of the Company's future earnings were not determinable
with a sufficient degree of probability to recognize the deferred tax assets.
The fourth quarter of 2002 represented the fifth consecutive quarter of
profitability for the Company. In the fourth quarter of 2002, as part of the
Company's 2003 budgeting process, management evaluated the deferred tax
valuation allowance and determined that a portion of this valuation allowance
should be reversed, resulting in a non-cash deferred income tax benefit in the
fourth quarter of 2002 of $22.3 million. Beginning in 2003, the Company will
record income taxes at a rate equal to the Company's combined federal and state
effective rates. However, to the extent of available net operating loss
carry-forwards, the Company will be shielded from paying cash income taxes for
several years, other than possibly alternative minimum taxes and some state
taxes.
There were no current or deferred provisions for income taxes for any of
the years ended December 31, 2002, 2001 and 2000.
A reconciliation of the Federal statutory rate to the provision (benefit)
for income taxes is as follows:
Year Ended December 31,
------------------------------------------------------------------------
2002 2001 2000
---------------------- ---------------------- ----------------------
Federal income taxes
computed at the statutory
rate $ 33,972 35.0% $(78,633) (35.0)% $(21,664) (35.0)%
Increase (decrease) in
income taxes resulting
from:
State income taxes less
Federal benefit -- 0.0 -- 0.0 (2,338) (3.8)
Goodwill impairment -- 0.0 59,039 26.3 -- --
Goodwill and intangible
asset amortization 981 0.4 7,137 3.2 3,310 5.3
Interest expense on
restructured long-term
debt (1,220) (0.5) -- 0.0 -- 0.0
Bad debt write-offs, net
of provision and
recoveries (13,513) (6.0) -- 0.0 -- 0.0
Gain on long-term debt
restructuring (10,118) (4.5) -- 0.0 -- 0.0
Capitalized software
costs, net of
amortization (1,148) (0.5) -- 0.0 -- 0.0
Recognition of deferred
revenue (2,142) (1.0) -- 0.0 -- 0.0
Legal settlement
payments, net of
reserves (1,299) (0.6) -- 0.0 -- 0.0
Cumulative effect of
accounting change -- 0.0 12,893 5.7 -- --
Valuation allowance
changes affecting the
provision for income
taxes (27,580) (12.3) (648) (0.3) 20,561 33.2
Other (233) (0.1) 212 0.1 131 0.3
--------- ------ --------- ----- -------- ------
Total provision (benefit)
for income taxes $(22,300) (9.9) $ -- -- $ -- --
========= ====== ========= ===== ======== ======
55
Deferred tax (assets) liabilities at December 31, 2002 and 2001 are
comprised of the following elements:
YEAR ENDED DECEMBER 31,
----------------------------------
2002 2001
---------------- ---------------
Net operating loss carry-forwards $(102,357) $(102,495)
Deferred revenue not taxable currently (31) (2,418)
Compensation for options granted below
market price (893) (893)
Allowance for uncollectible accounts (1,837) (16,894)
Warrants issued for compensation (878) (431)
Depreciation and amortization 18,259 16,806
Accruals not currently deductible (1,309) (2,843)
Net capital loss carry-forwards -- (9,122)
---------------- ---------------
Deferred tax (assets) liabilities, net (89,046) (118,290)
Less valuation allowance 66,746 118,290
---------------- ---------------
Net deferred tax $ (22,300) $ --
================ ===============
The Company has net operating loss carry-forwards for income tax purposes
and other deferred tax benefits that are available to offset future taxable
income. Only a portion of the net operating loss carry-forwards are attributable
to operating activities. The remainder of the net operating loss carry-forwards
are attributable to tax deductions related to the exercise of stock options.
In accounting for income taxes, the Company recognizes the tax benefits
from current stock option deductions after utilization of net operating loss
carry-forwards from operations (i.e., net operating loss carry-forwards
determined without deductions for exercised stock options) to reduce income tax
expense. Because stock option deductions are not recognized as an expense for
financial reporting purposes, the tax benefit of stock option deductions must be
credited to additional paid-in capital. Such benefit has not been recorded
because of the Company's full valuation allowances.
At December 31, 2002, the Company had net operating loss (NOL)
carry-forwards for federal income tax purposes of $262 million. Due to the
"change of ownership" provisions of the Internal Revenue Code Section 382, the
availability of the Company's net operating loss and credit carry-forwards may
be subject to an annual limitation against taxable income in future periods if a
change of ownership of more than 50% of the value of the Company's stock should
occur within a three-year testing period. Many of the changes that affect these
percentage change determinations, such as changes in the Company's stock
ownership, are outside the Company's control. A more-than-50% cumulative change
in ownership occurred on August 31, 1998 and October 26, 1999. As a result of
such changes, certain of the Company's carryforwards are limited. As of
December 31, 2002; approximately $15 million of NOL carryforwards were limited
to offset income. In addition, as of December 31, 2002, based on information
currently available to the Company, the change of ownership percentage was
approximately 38% for the applicable three-year testing period. If, during the
current three-year testing period, the Company experiences an additional
more-than-50% ownership change under Section 382, the amount of the NOL
carry-forward available to offset future taxable income may be substantially
reduced. There can be no assurance that the Company will realize the benefit of
any carry-forwards.
56
NOTE 12. SUPPLEMENTAL CASH FLOW INFORMATION
2002 2001 2000
-------- -------- ----------
Supplemental disclosure of cash flow
information:
Cash paid during the year for interest $6,252 $ 5,620 $ 4,218
======== ======== ==========
Supplemental schedule of non-cash investing and
financing activities:
Acquisition of equipment under capital lease
obligations $ -- $ 2,145 $ --
Interest expense paid in additional principal 2,824 -- --
Issuance of warrants for services -- 77 2,175
Common stock issued for compensation -- -- 706
Contingent redemptions exchanged for
convertible debt -- 32,400 --
Acquisitions:
Fair value of assets acquired -- 835 21,718
Goodwill -- 54 209,978
Less: Fair value of stock issued -- -- (170,388)
Less: Fair value of options/warrants issued -- -- (27,448)
Less: liabilities assumed -- (889) (30,243)
-------- -------- ----------
Acquisitions, net cash acquired -- -- 3,617
Cumulative effect of accounting change
attributed to implementation of EITF 00-19
for the contingent redemption feature of
common stock and warrants:
Increase in additional paid-in capital -- 65,617 --
Net change in contingent redemption value
of warrants and common stock -- (28,780) --
-------- -------- ----------
Cumulative effect of accounting change -- 36,837 --
NOTE 13. EMPLOYEE BENEFIT PLANS
The Company sponsors a defined contribution pension plan (the "Plan"). The
Plan qualifies as a deferred salary arrangement under Section 401(k) of the
Internal Revenue Code. Eligible employees may contribute up to 15% of their
compensation (subject to Internal Revenue Code limitations). The Plan allows
employees to choose among a variety of investment alternatives. The Company is
not required to contribute to the Plan. During the years ended December 31,
2002, 2001 and 2000, the Company elected to contribute $131,000, $108,000 and
$85,000 to the Plan, respectively. No significant administration costs were
incurred during 2002, 2001 or 2000.
57
NOTE 14. PER SHARE DATA
Basic earnings per common share is calculated by dividing net income by the
average number of common shares outstanding during the year. Diluted earnings
per common share is calculated by adjusting outstanding shares, assuming
conversion of all potentially dilutive stock options, warrants and convertible
bonds. Earnings per share are computed as follows (in thousands):
YEAR ENDED DECEMBER 31,
----------------------------------------
2002 2001 2000
----------- ------------ -------------
Income (loss) before extraordinary gains and
cumulative effect of an accounting change $ 67,722 $(208,478) $ (61,896)
Extraordinary gains 29,340 20,648 --
Cumulative effect of an accounting change -- (36,837) --
----------- ------------ -------------
Income available to common stockholders used to
compute basic income (loss) per share $ 97,062 $(224,667) $ (61,896)
Interest expense on convertible bonds 18 -- --
----------- ------------ -------------
Income available for common stockholders after
assumed conversion of dilutive securities used to
compute diluted income (loss) per share $ 97,080 $(224,667) $ (61,896)
=========== ============ =============
Weighted average number of common shares
outstanding used to compute basic income (loss) per
share 27,253 26,414 23,509
Effect of dilutive securities*:
Stock options and warrants 1,347 -- --
8% Secured convertible bonds due 2006 2,010 -- --
8% Senior convertible subordinated notes due 2007 188 -- --
----------- ------------ -------------
Weighted average number of common and common
equivalent shares outstanding used to compute diluted
income (loss) per share 30,798 26,414 23,509
=========== ============ =============
Income (loss) per share - Basic:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per share $ 2.48 $ (7.89) $ (2.63)
Extraordinary gains per share 1.08 0.78 --
Cumulative effect of an accounting change per share -- (1.40) --
----------- ------------ -------------
Net income (loss) per share $ 3.56 $ (8.51) $ (2.63)
=========== ============ =============
Weighted average common shares outstanding 27,253 26,414 23,509
=========== ============ =============
Income (loss) per share - Diluted:
Income (loss) before extraordinary gains and
cumulative effect of an accounting change per share $ 2.20 $ (7.89) $ (2.63)
Extraordinary gains per share 0.95 0.78 --
Cumulative effect of an accounting change per share -- (1.40) --
----------- ------------ -------------
Net income (loss) per share $ 3.15 $ (8.51) $ (2.63)
=========== ============ =============
Weighted average common and common equivalent
shares outstanding 30,798 26,414 23,509
=========== ============ =============
* The diluted share basis for the years ended December 31, 2002, 2001 and 2000
excludes options and warrants to purchase 1.7 million, 3.0 million and 6.4
million shares of common stock, respectively and convertible bonds that are
convertible into 9 thousand, 3.3 million and 1.4 million shares of common stock,
respectively, due to their antidilutive effect.
58
NOTE 15. SUBSEQUENT EVENTS (UNAUDITED)
In 2003, through March 28, the Company has repurchased $9.4 million of its
12% Senior Subordinated Notes at a $2.2 million discount from face amount that
will be reported as other income, and approximately $3.6 million of its 8%
Secured Convertible Notes at face value. In January 2003, the Company announced
a share buyback program of $10 million or 2,500,000 shares, and purchased
1,315,789 of its common shares from America Online, Inc. at a per share price of
$3.80 (the average closing price for the five days ended January 15, 2003). The
aggregate purchase price was approximately $5.0 million.
The Company had a note receivable with an officer of the Company with a
balance of $1.0 million as of December 31, 2002 for relocation and construction
of a new residence in Florida (See Note 8 above). As of March 27, 2003, the
note was prepaid in full.
NOTE 16. QUARTERLY FINANCIAL DATA (UNAUDITED)
(In thousands, except per share data) FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
--------- --------- ---------- ---------
2002
----
Sales $ 79,447 $ 77,673 $ 79,133 $ 81,254
Operating income $ 10,322 $ 12,231 $ 15,753 $ 16,293
Income before extraordinary gains $ 8,130 $ 9,417 $ 13,378 $ 36,797
Extraordinary gains -- -- -- $ 29,340
Net income $ 8,130 $ 9,417 $ 13,378 $ 66,137
Net income per share - Basic $ 0.30 $ 0.35 $ 0.49 $ 2.42
Net income per share - Diluted $ 0.28 $ 0.30 $ 0.42 $ 2.10
2001
----
Sales $131,780 $132,445 $ 126,335 $ 97,598
Operating income (loss) $ (8,735) $(24,888) $(175,404) $ 8,118
Income (loss) before extraordinary
gains and cumulative effect of an
accounting change $(10,148) $(25,850) $(179,166) $ 6,686
Extraordinary gains $ -- $ -- $ 16,867 $ 3,781
Cumulative effect of an accounting
change. $ -- $(36,837) $ -- $ --
Net income (loss) $(10,148) $(62,687) $(162,299) $ 10,467
Net income (loss) per share - Basic $ (0.39) $ (2.40) $ (6.18) $ 0.39
Net income (loss) per share - Diluted $ (0.39) $ (2.40) $ (6.18) $ 0.36
* Fully diluted earnings per share for the quarters ended December 31, 2001,
March 31, 2002, June 30, 2002, and September 30, 2002 have been revised.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
59
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS AND EXECUTIVE OFFICERS
The directors and executive officers of the Company as of March [ ],
2003 were as follows:
NAME AGE POSITION
--- -----------------------------------------------------------
Gabriel Battista (3) 58 Chairman of the Board of Directors, Chief Executive Officer
and Director
Warren Brasselle 45 Senior Vice President - Operations
Jeffrey Earhart 41 Senior Vice President - Customer Operations
Mark S. Fowler (1) 60 Director
Kevin D. Griffo 42 Executive Vice President - Sales and Marketing
Aloysius T. Lawn, IV 44 Executive Vice President - General Counsel and Secretary
Arthur J. Marks (2). 58 Director
Edward B. Meyercord, III (2) 37 President and Director
Ronald R. Thoma (3) 68 Director
George Vinall 47 Executive Vice President - Business Development
Thomas Walsh 43 Senior Vice President - Finance and Treasurer
David G. Zahka 43 Chief Financial Officer
(1) Director whose term expires in 2005.
(2) Director whose term expires in 2003.
(3) Director whose term expires in 2004.
All officers are elected annually by the Board of Directors and hold office
until their successors are elected and qualified.
GABRIEL BATTISTA. Mr. Battista currently serves as Chairman of the Board of
Directors and Chief Executive Officer of the Company. Prior to joining the
Company in January of 1999 as a Director and Chief Executive Officer, Mr.
Battista served as Chief Executive Officer of Network Solutions Inc., an
Internet domain name registration company. Prior to joining Network Solutions,
Mr. Battista served both as CEO and as President and Chief Operating Officer of
Cable & Wireless, Inc., a telecommunication provider. His career also included
management positions at US Sprint, GTE Telenet and The General Electric Company.
Mr. Battista serves as a director of Capitol College, and Systems & Computer
Technology Corporation (SCTC).
WARREN BRASSELLE. Since April 2000, Mr. Brasselle has served as Senior Vice
President - Operations for the Company. Prior to joining the Company, Mr.
Brasselle was Vice President of Operations for Cable and Wireless North America
since 1996, where he was broadly responsible for the design, provisioning, and
maintenance of Cable & Wireless' voice, data, and IP network. Mr. Brasselle also
held a variety of operational positions at MCI, now MCI WorldCom Inc. and
Williams Telecommunications.
JEFFREY EARHART. Mr. Earhart currently serves as Senior Vice President -
Customer Operations of the Company. Between 1997 and 2000, he served the
Company as Vice President, Operations. Mr. Earhart originally joined the Company
as its Director of Retail Sales and Provisioning in 1990, a position he held
until 1992. Prior to rejoining the Company in 1997, Mr. Earhart served as
President of Collective Communications Services, an independent long distance
reseller of long distance services of the Company.
MARK S. FOWLER. Mr. Fowler has been a director of the Company since September
1999. From 1981 to 1987, he was the Chairman of the FCC. From 1987 to 1994,
Mr. Fowler was Senior Communications Counsel at Latham & Watkins, a law firm,
and of counsel from 1994 to 2000. From 1991 to 1994, he was the founder,
Chairman and Chief Executive Officer of PowerFone Holdings Inc., a
telecommunications company. From 1994 to 2000 he was a founder and chairman of
UniSite, Inc., a developer of antenna sites for use by multiple wireless
60
operators. From 1999 to December 2002, Mr. Fowler served as a director of
Pac-West Telecomm, Inc., a competitive local exchange carrier. From 1999 to
date, Mr. Fowler has served as a director of Beasley Broadcast Group, a radio
broadcasting company. Mr. Fowler is also a founder and serves as Chairman of the
Board of Directors of AssureSat, Inc., a provider of telecommunications
satellite backup services.
KEVIN D. GRIFFO. Mr. Griffo has served as the Company's Executive Vice
President - Sales and Marketing since March 2000. Prior to joining the Company,
Mr. Griffo was the President and Chief Operating Officer of Access One. Mr.
Griffo was also employed by AMNEX from January 1995 to December 1997, holding
various positions, including Chief Operating Officer and President of AMNEX's
Telecommunications Division.
ALOYSIUS T. LAWN, IV. Mr. Lawn joined the Company in January 1996 and currently
serves as Executive Vice President - General Counsel and Secretary. Prior to
joining the Company, from 1985 through 1995, Mr. Lawn was an attorney in private
practice. Mr. Lawn is a director of Stonepath Group, Inc., a global, integrated
logistics services organization.
ARTHUR J. MARKS. Mr. Marks has been a director of the Company since August 1999.
He is currently a general partner of Valhalla Partners, a private equity fund.
From 1984 through 2001, Mr. Marks was a General Partner of New Enterprise
Associates, a private equity fund that invests in early stage companies in
information technology and medical and life sciences. Mr. Marks serves as a
director of two publicly traded software companies, Mobius Management Systems
and Progress Software Corp., as well as one publicly traded communications
equipment company, Advanced Switching Communications. He is also a director of a
number of privately held companies.
EDWARD B. MEYERCORD, III. Mr. Meyercord currently serves as the President and
Director of the Company. Mr. Meyercord was elected to the Board of Directors and
President of the Company in May 2001. He served as Chief Financial Officer of
the Company between August 1999 and December 2001 and Chief Operating Officer of
the Company between January 2000 and May 2001. He joined the Company in
September of 1996 as the Executive Vice President, Marketing and Corporate
Development. Prior to joining the Company, Mr. Meyercord served as Vice
President in the Global Telecommunications Corporate Finance Group at Salomon
Brothers, Inc., based in New York. Prior to Salomon Brothers he worked in the
corporate finance department at PaineWebber Incorporated.
RONALD R. THOMA. Mr. Thoma is currently a business consultant, having retired
in early 2000 as an Executive Vice President of Crown Cork and Seal Company,
Inc., a manufacturer of packaging products, where he had been employed since
1955. Mr. Thoma has served as a director of the Company since 1995.
GEORGE VINALL. Mr. Vinall joined the Company in January of 1999 as Executive
Vice President - Business Development. Prior to joining the Company, he served
as President of International Protocol LLC, a telecommunication consulting
business, as General Manager of Cable & Wireless Internet Exchange, an
international Internet service provider, and as Vice President, Regulatory &
Government Affairs of Cable and Wireless North America, a telecommunication
provider.
THOMAS M. WALSH. Mr. Walsh joined the Company in September of 2000 and
currently serves as Senior Vice President - Finance and Treasurer. Before
joining the Company, he served as a director at Comcast Cellular Communications,
a telecommunications company, from 1996 to 1999, and Regional Controller of
Southwestern Mobil Systems, a successor corporation, from 1999 to 2000. Prior
to Comcast Cellular Communications, he worked for Call Technology Corporation, a
telecommunications company, where he was responsible for all finance and
accounting functions as Chief Financial Officer. Prior to his tenure with Call
Technology Corporation, Mr. Walsh served as Audit Manager for Ernst & Young.
Mr. Walsh is a Certified Public Accountant.
DAVID G. ZAHKA. Mr. Zahka joined the Company in December of 2001 as Chief
Financial Officer. Before joining the Company, he spent more than 15 years with
PaineWebber Incorporated, and its successor UBS Warburg, where he served most
recently as Executive Director of the Financial Sponsors Group. At PaineWebber,
Mr. Zahka also served as Senior Vice President of Debt Capital Markets and First
Vice President of the Utility Finance Group.
61
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
Under Section 16(a) of the Securities Exchange Act of 1934, as amended, the
Company's directors and certain officers and persons who are the beneficial
owners of more than 10 percent of the Common Stock of the Company are required
to report their ownership of the Common Stock, options and certain related
securities and any changes in that ownership to the SEC. Specific due dates for
these reports have been established, and the Company is required to report any
failure to file by such dates in 2002. The Company believes that all of the
required filings have been made in a timely manner, except that the executive
officers of the Company who participated in the Company's Employee Option
Exchange (described in "STOCK OPTION GRANTS" below) that was completed in April
2002, including Messrs. Battista, Meyercord, Lawn, Earhart, Brasselle, Griffo,
and Vinall, reported the cancellation of their options that were exchanged in
their timely filed Form 4 reports of the issuance of the new options delivered
in the exchange, rather than in an earlier Form 5 report. In making this
statement, the Company has relied on copies of the reporting forms received by
it.
ITEM 11. EXECUTIVE COMPENSATION.
The following table sets forth information for the fiscal years ended
December 31, 2002, 2001 and 2000 as to the compensation for services rendered
paid by the Company to the Chief Executive Officer and to the four other most
highly compensated executive officers of the Company whose annual salary and
bonus exceeded $100,000.
SUMMARY COMPENSATION TABLE
LONG TERM
ANNUAL COMPENSATION COMPENSATION
-------------------------------------------------------------
SECURITIES
UNDERLYING
OPTIONS/SARS
NAME AND PRINCIPAL POSITION YEAR SALARY (1) BONUS (1)
------------------------------------------------------------------------------------------------------------
Gabriel Battista, Chairman of the Board 2002 $ 500,000 $ 535,000 440,488(4)
of Directors, Chief Executive Officer and 2001 --(2) -- --
Director 2000 --(2) $ 50,000 166,666(3)
Edward B. Meyercord, III, President and. 2002 $ 350,000 $ 381,500 150,000(4)
Director 2001 $ 300,000 -- --
2000 $ 298,000 $ 30,000 116,666(3)
Aloysius T. Lawn, IV, Executive Vice 2002 $ 275,000 $ 245,400 70,000(4)
President - General Counsel and 2001 $ 275,000 -- --
Secretary. 2000 $ 260,500 $ 27,500 104,166(3)
Warren A. Brasselle, Senior Vice 2002 $ 250,000 $ 233,500 68,333(4)(5)
President - Operations 2001 $ 250,000 -- --
2000 $ 186,539(7) $ 188,000 85,000(6)
David G. Zahka, Chief Financial Officer 2002 $ 250,000 $ 233,500 --
2001 $ 13,462(7) -- 100,000(6)
2000 -- -- --
Jeffrey Earhart, Senior Vice President - 2002 $ 230,000 $ 333,000 63,889(4)
Customer Operations 2001 $ 230,000 -- --
2000 $ 216,615 $ 140,000 106,000(3)(5)(6)
(1) The costs of certain benefits not properly categorized as salary or
benefits are not included because they did not exceed, in the case of any
executive officer named in the table, the lesser of $50,000 or 10% of the total
annual salary and bonus reported in the above table.
(2) Under his employment agreement with the Company, Mr. Battista is
entitled to a minimum annual salary of $500,000. Mr. Battista's salary for 1999
included, in addition to the $500,000 annual base salary for 1999, $1,000,000
representing a prepayment of $500,000 in salary for each of the years 2000 and
2001 as provided in Mr. Battista's employment agreement with the Company.
62
(3) Options to purchase the Company's common stock. The options granted to
Messrs. Battista, Meyercord, Lawn and Earhart were granted under the Company's
2000 Long Term Incentive Plan. In 2000, Mr. Battista was granted (i) options to
purchase 83,333 shares of the Company's common stock at an exercise price of
$6.00 per share that vest in five years and (ii) options to purchase 83,333
shares of the Company's common stock at an exercise price of $14.25 per share
that vest over three years. In 2000, Mr. Meyercord was granted (i) options to
purchase 50,000 shares of the Company's common stock at an exercise price of
$6.00 per share that vest in five years and (ii) options to purchase 66,666
shares of the Company's common stock at an exercise price of $14.25 per share
that vest over three years. In 2000, Mr. Lawn was granted (i) options to
purchase 45,833 shares of the Company's common stock at an exercise price of
$6.00 per share that vest in five years, (ii) options to purchase 16,666 shares
of the Company's common stock at an exercise price of $6.93, half of which
vested upon grant and the remainder of which vested six months thereafter, and
(iii) options to purchase 41,666 shares of the Company's common stock at an
exercise price of $14.25 per share that vest over three years. In 2000, Mr.
Earhart was granted options to purchase 31,000 shares of the Company's common
stock at an exercise price of $6.00 per share that vest in five years. Each of
the employment agreements for Messrs. Battista, Meyercord, Lawn and Earhart
provide for immediate vesting of options in event of a "change of control" (as
defined in such agreements).
(4) Messrs. Meyercord, Lawn, Earhart and Brasselle were reissued options
under the 1998 Long Term Incentive Plan to purchase the Company's common stock
on April 5, 2002, in exchange for options to purchase the Company's common stock
exchanged and cancelled pursuant to the Company's Employee Option Exchange
(described in "STOCK OPTION GRANTS" below): 150,000, 70,000, 63,889, and 60,000,
respectively, at an exercise price of $1.53. On April 5, 2002, Mr. Battista was
reissued options under the: (i) 1998 Long Term Incentive Plan to purchase
107,155 shares of the Company's common stock and (ii) 2000 Long Term Incentive
Plan to purchase 333,000 shares of the Company's common stock; in exchange for
options to purchase the Company's common stock exchanged and cancelled pursuant
to the Company's Employee Option Exchange (described in "STOCK OPTION GRANTS"
below).
(5) Options to purchase the Company's common stock. The options granted to
Messrs. Earhart and Brasselle were granted under the Company's 1998 Long Term
Incentive Plan. In 2000, Mr. Earhart was granted options to purchase 50,000
shares of the Company's common stock at an exercise price of $14.25 per share
that vest over three years. In 2002, Mr. Brasselle was granted options that
vest over three years to purchase 8,333 shares of the Company's common stock at
an exercise price of $1.53 per share.
(6) Options to purchase the Company's common stock. The options granted to
Mr. Zahka and certain options granted to Messrs. Earhart and Brasselle were not
granted under a stock option plan. In 2000, prior to Mr. Earhart becoming an
executive officer of the Company, Mr. Earhart was granted options to purchase
25,000 shares of the Company's common stock at an exercise price of $14.25 per
share that vest over three years. In 2000, Brasselle was granted (i) in
connection with his hiring by the Company, options to purchase 60,000 shares of
the Company's common stock at an exercise price of $43.14 per share, 10,000
vested immediately and the remainder vest over three years (these options were
subsequently reissued pursuant to the Company's Employee Option Exchange as
described in footnote 4 above), and (ii) prior to becoming an executive officer
of the Company, options to purchase 25,000 shares of the Company's common stock
at an exercise price of $14.25 per share that vest over three years. In 2001,
in connection with his hiring by the Company, Mr. Zahka was granted options to
purchase 100,000 shares of the Company's common stock at an exercise price of
$1.20 per share that vest over three years.
(7) Messrs. Brasselle and Zahka commenced employment with the Company on
April 3, 2000 and December 7, 2001, respectively.
63
STOCK OPTION GRANTS
The following table sets forth further information regarding grants of
options to purchase the Company common stock made by the Company during the
fiscal year ended December 31, 2002 to the executive officers named in the
Summary Compensation Table, above.
OPTION/SAR GRANTS IN LAST FISCAL YEAR
NUMBER OF PERCENT OF TOTAL
SECURITIES OPTIONS/SARS
UNDERLYING GRANTED TO EXERCISE POTENTIAL REALIZABLE VALUE
OPTIONS/SARS EMPLOYEES IN PRICE PER EXPIRATION AT ASSUMED ANNUAL RATES
NAME GRANTED 2002 SHARE (1) DATE OF STOCK OPTION TERM (5)
----------------------------------------------------------------------------------------------------------------
5%($) 10%($)
------------ -----------
Gabriel Battista 107,155(2) 4.8% $ 1.53 11/12/08 $ 62,431 $144,184
333,333(3) 14.8% $ 1.53 11/12/08 $194,209 $448,520
Edward B. 150,000(2) 6.7% $ 1.53 11/1/09 $102,752 $243,636
Meyercord, III
Aloysius T. 70,000(2) 3.1% $ 1.53 4/1/09 $ 43,588 $101,750
Lawn, IV
Jeffrey Earhart 3,889(2) 0.2% $ 1.53 12/17/02 $ 220 $ 440
10,000(2) 0.4% $ 1.53 10/5/09 $ 6,801 $ 16,109
50,000(2) 2.2% $ 1.53 1/28/10 $ 35,553 $ 84,833
Warren A. 60,000(2) 2.7% $ 1.53 3/8/10 $ 43,379 $103,852
Brasselle 8,333(4) 0.4% $ 1.53 4/5/12 $ 8,030 $ 20,384
David G. Zahka . 0 -- -- -- -- --
(1) All options have been granted at market price on the date of issue.
(2) The options granted to Messrs. Battista, Meyercord, Lawn, Earhart and
Brasselle were granted under the Company's 1998 Long Term Incentive Plan. The
options were reissued options to purchase the Company's common stock on April 5,
2002, in exchange for options to purchase the Company's common stock exchanged
and cancelled pursuant to the Company's Employee Option Exchange (described
below).
(3) The options granted to Mr. Battista were granted under the Company's
2000 Long Term Incentive Plan. The options were reissued options to purchase
the Company's common stock on April 5, 2002, in exchange for options to purchase
the Company's common stock exchanged and cancelled pursuant to the Company's
Employee Option Exchange (described below).
(4) The options granted to Mr. Brasselle were granted under the Company's
1998 Long Term Incentive Plan.
(5) Disclosure of the 5% and 10% assumed annual compound rates of stock
appreciation based on exercise prices are mandated by the rules of the SEC and
do not represent the Company's estimate or projection of future common stock
prices. The actual value realized may be greater or less than the potential
realizable value set forth in the table.
Of the executive officers in the Summary Compensation Table above, Mr.
Earhart acquired 3,889 shares of the Company's common stock upon the exercise of
options in 2002.
64
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY
OPTIONS/SARS OPTIONS/SARS (1)
SHARES ACQUIRED VALUE ------------------------- ----------------------------
NAME ON EXERCISE REALIZED EXERCISABLE/UNEXERCISABLE EXERCISABLE/UNEXERCISABLE
------------------------------------------------------------------------------------------------------------
Jeffrey Earhart 3,889 $20,883.93 60,001/55,999 176,369.38/$67,830.62
(1) Calculated as the difference between the exercise/base-price of the
options/SARs and a year-end fair market value of the underlying securities equal
to $5.60.
On August 29, 2001, the Company initiated an offer to exchange all
outstanding stock options previously issued by the Company to employees that had
an exercise price of $16.50 or more and did not expire before April 5, 2002, for
new options to be granted under one of the Company's various stock option plans
(the "Employee Option Exchange"). On October 4, 2001, the Company accepted for
cancellation options to purchase a total of 1,938,211 shares of Common Stock.
On April 5, 2002, the Company granted new options pursuant to the Employee
Option Exchange in exchange for the exchanged and cancelled options.
COMPENSATION OF DIRECTORS
The Company currently pays non-employee directors an annual retainer of
$10,000. Directors are eligible to receive, and have been granted in the past,
options to purchase shares of common stock of the Company. No options were
granted in 2002. Non-employee directors are also reimbursed for reasonable
expenses incurred in connection with attendance at Board meetings or meetings of
committees thereof.
EMPLOYMENT CONTRACTS
Gabriel Battista is party to an employment agreement with the Company,
dated as of November 13, 1998, that was amended as of March 28, 2001 and now
expires on December 31, 2004. Under the terms of the agreement, as amended, Mr.
Battista received a signing bonus of $3,000,000 at the time of the original
agreement and is entitled to a minimum annual base salary of $500,000, plus a
discretionary bonus. The initial three years of salary under the original
agreement were paid in advance. Mr. Battista is also entitled to other benefits
and perquisites. In addition, upon execution of the original agreement in 1998,
Mr. Battista was granted options that vested over three years to purchase
333,333 shares of the Company common stock at an exercise price of $31.32 per
share, and options that vested immediately upon execution of the agreement to
purchase an additional 216,666 shares at an exercise price of $21.00 per share.
A portion of these options were exchanged and cancelled pursuant to the
Company's Employee Option Exchange (described in "STOCK OPTION GRANTS").
In the event of certain transactions (including an acquisition of the
Company's assets, a merger into another entity or a transaction that results in
the Company common stock no longer being required to be registered under the
Securities Exchange Act of 1934), Mr. Battista will receive an additional bonus
of $1,000,000 if the price per share for the Company common stock in such
transaction was less than or equal to $60.00 per share, or $3,000,000 if the
consideration is greater than $60.00 per share.
Edward B. Meyercord, III entered into a three-year employment agreement
with the Company effective as of March 26, 2001. Commencing in 2002, under the
contract, Mr. Meyercord is entitled to a minimum annual base salary of $350,000
and certain other perquisites made generally available by the Company to its
senior executive officers.
Aloysius T. Lawn, IV entered into a three-year employment agreement with
the Company effective as of March 26, 2001. Under the contract, Mr. Lawn is
entitled to a minimum annual base salary of $275,000 and certain other
perquisites made generally available by the Company to its senior executive
officers.
65
Jeffrey Earhart entered into a three-year employment agreement with the
Company effective as of October 2, 2001. Under the contract, Mr. Earhart is
entitled to a minimum annual base salary of $230,000 and certain other
perquisites made generally available by the Company to its senior executive
officers.
Warren Brasselle entered into a three-year employment agreement with the
Company effective as of April 3, 2000. Under the contract, Mr. Brasselle
received a signing bonus of $100,000, payable in two equal installments on June
31, 2000 and September 30, 2000, and is entitled to a minimum annual base
salary of $250,000 and certain other perquisites made generally available by the
Company to its senior executive officers. In addition, upon execution of the
agreement, Mr. Brasselle was granted options to purchase 60,000 shares of the
Company's common stock at an exercise price of $43.14 per share, 10,000 vested
immediately and the remainder vest over three years (these options were
exchanged and cancelled pursuant to the Company's Employee Option Exchange
(described in "STOCK OPTION GRANTS").
David G. Zahka entered into a three-year employment agreement with the
Company effective as of December 7, 2001. Under the contract, Mr. Zahka is
entitled to a minimum annual base salary of $250,000 and certain other
perquisites made generally available by the Company to its senior executive
officers. In addition, upon execution of the agreement, Mr. Zahka was granted
options to purchase 100,000 shares of the Company's common stock at an exercise
price of $1.20 per share that vest over three years.
Each of the employment agreements for Messrs. Battista, Meyercord, Lawn,
Earhart, Brasselle and Zahka provide for immediate vesting of options in event
of a "change of control" (as defined in the agreements) of the Company and
provide for severance benefits in the event employment is terminated by the
Company without cause prior to the end of the term and for a certain period
beyond the end of the term in the event of a "change of control." The severance
benefits are generally the payment of an amount equal to two years' base salary
plus the average annual incentive bonus earned by the executive in the preceding
four years, as well as the continuation of various employee benefits for two
years.
Each of the above-described agreements requires the executive to maintain
the confidentiality of Company information and assign any inventions to the
Company. In addition, each of the executive officers has agreed that he will not
compete with the Company by engaging in any capacity in any business that is
competitive with the business of the Company during the term of his respective
agreement and thereafter for specified periods.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
None.
66
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
The Compensation Plans and Securities table from Item 5 of this Annual
Report is incorporated herein by reference.
The following table sets forth certain information known to the Company
with respect to beneficial ownership of the Company common stock as of March 26,
2003 (except as otherwise noted) by (i) each stockholder who is known by the
Company to own beneficially more than five percent of the outstanding common
stock, (ii) each of the Company's directors and nominees for director, (iii)
each of the executive officers named below and (iv) all current directors and
executive officers of the Company as a group. Except as otherwise indicated
below, the Company believes that the beneficial owners of the common stock
listed below have sole investment and voting power with respect to such shares.
NUMBER OF SHARES PERCENT OF SHARES
NAME OF BENEFICIAL OWNER OR IDENTITY OF GROUP BENEFICIALLY OWNED (1) BENEFICIALLY OWNED
----------------------------------------------- --------------------- ------------------
Paul Rosenberg 1,919,995 (2) 7.3%
650 N. E. 5th Avenue
Boca Raton, Fl 33432
Gabriel Battista 655,555 (3) 2.4%
Mark S. Fowler 108,674 (3) *
Arthur J. Marks 61,666 (3) *
Edward B. Meyercord, III 244,820 (3) *
Ronald R. Thoma 39,311 (3) *
Jeffrey Earhart 81,434 (3) *
Aloysius T. Lawn, IV 145,660 (3) *
Warren Brasselle 89,278 (3) *
David G. Zahka 40,000 (3) *
All directors and executive officers as a group
(12 persons) 2,186,005 (3) 7.8%
* Less than 1%
(1) The securities "beneficially owned" by a person are determined in
accordance with the definition of "beneficial ownership" set forth in the
regulations of the SEC and, accordingly, may include securities owned by or for,
among others, the spouse, children or certain other relatives of such person.
The same shares may be beneficially owned by more than one person. Beneficial
ownership may be disclaimed as to certain of the securities.
(2) The foregoing information is derived from the Schedule 13D/A filed by
Paul Rosenberg, the Rosenberg Family Limited Partnership, PBR, Inc. and the New
Millennium Charitable Foundation on February 12, 1999.
(3) Includes shares of the Company common stock that could be acquired upon
exercise of options exercisable within 60 days after March 28, 2003 and that
have been tendered for exchange and cancelled pursuant to the Company's Employee
Option Exchange on the assumption that the new options will be exchanged
therefore. Includes shares of Company common stock that could be acquired upon
exercise of options exercisable within sixty (60) days after March 31, 2003 as
follows: Gabriel Battista-605,555; Edward B. Meyercord III-194,444; Aloysius T.
Lawn IV-114,444; Jeffrey Earhart-76,666; Warren Brasselle-79,445, and; David G.
Zahka-33,334.
67
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
In 1999, the principal operating subsidiary of the Company requested an
employee, Jeffrey Earhart, to relocate from Pennsylvania to Florida in order to
take over the management of its customer service centers in Florida. In
connection with the relocation, the Company agreed to make advances or a loan to
Mr. Earhart for the relocation and the construction of a new residence in
Florida. In 2000, the Company and Mr. Earhart memorialized this agreement
regarding relocation with a loan that was secured by the new residence and bore
interest at the rate of 8.25 percent per annum. The loan was refinanced in July
2002 and bore interest at the rate of 6.25 percent per annum to reflect current
market rates. As of March 27, 2003, Mr. Earhart retired the loan in its
entirety. The largest aggregate amount of the loan outstanding during 2002 was
$1.04 million, and, as of March 28, 2003, no money was outstanding on the loan
and advances. In May 2001, Mr. Earhart was elected an executive officer of the
Company.
ITEM 14. CONTROLS AND PROCEDURES.
Within the 90-day period prior to the filing of this report, an Evaluation
was carried out under the supervision and with the participation of the
Company's management, including the Chief Executive Officer ("CEO") and Chief
Financial Officer ("CFO"), of the effectiveness of the Company's disclosure
controls and procedures. Based on that evaluation, the CEO and CFO have
concluded that the Company's disclosure controls and procedures are effective to
ensure that information required to be disclosed by the Company in reports that
it files or submits under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported within the time periods specified in
Securities and Exchange Commission rules and forms. Subsequent to the date of
their evaluation, there were no significant changes in the Company's internal
controls or in other factors that could significantly affect the disclosure
controls, including any corrective actions with regard to significant
deficiencies and material weaknesses.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 8-K
(a) The following documents are filed as part of this Annual Report on
Form 10-K.
1. Consolidated Financial Statements:
The Consolidated Financial Statements filed as part of this Form 10-K are
listed in the "Index to Consolidated Financial Statements" in Item 8.
2. Consolidated Financial Statement Schedule:
The Consolidated Financial Statement Schedule filed as part of this
report is listed in the "Index to S-X Schedule."
Schedules other than those listed in the accompanying Index to S-X
Schedule are omitted for the reason that they are either not required, not
applicable or the required information is included in the Consolidated
Financial Statements or notes thereto.
68
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
INDEX TO S-X SCHEDULE
PAGE
----
Schedule II -- Valuation & Qualifying Accounts 70
69
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
ADDITIONS
BALANCE AT CHARGED TO DEDUCTIONS BALANCE
BEGINNING COSTS AND FOR WRITE- AT END OF
DESCRIPTION DEDUCTIONS OF PERIOD EXPENSES OFFS PERIOD
------------------------------- ---------- ----------- ---------- ---------
YEAR ENDED DECEMBER 31, 2002:
Reserve and allowances deducted
from asset accounts:
Allowance for uncollectible
Accounts $ 46,404 $ 9,365 $ (47,948) $ 7,821
========== =========== ========== ==========
YEAR ENDED DECEMBER 31, 2001:
Reserve and allowances deducted
from asset accounts:
Allowance for uncollectible
Accounts $ 29,429 $ 92,778 $ (75,803) $ 46,404
========== =========== ========== ==========
YEAR ENDED DECEMBER 31, 2000:
Reserve and allowances deducted
from asset accounts:
Allowance for uncollectible
Accounts $ 5,021 $ 53,772 $ (29,334) $ 29,459
========== =========== ========== ==========
70
(3) EXHIBITS:
EXHIBIT
NUMBER DESCRIPTION
--------------------------------------------
3.1 Composite form of Amended and Restated Certificate of Incorporation of the
Company, as amended through October 15, 2002 (incorporated by reference to
Exhibit 3.2 to the Company's Current Report on Form 8-K, dated October 16,
2002).
3.2 Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the
Company's registration statement on Form S-1 (File No. 33-94940)).
3.3 Certificate of Designation of Series A Junior Participating Preferred Stock
of Company dated August 27, 1999 (incorporated by reference to Exhibit A to
Exhibit 1 to the Company's registration statement on Form 8-A (File No.
000-26728)).
4.1 Specimen of Talk America Holdings, Inc. common stock certificate (filed
herewith).
4.2 Form of Warrant Agreement for Elec Communications, Kenneth Baritz, Joel
Dupre, Keith Minella, Rafael Scolari, and William Rogers dated August 9,
2000 (incorporated by reference to Exhibit 4.2 to the Company's Annual
Report on Form 10-K for the year ended December 31, 2000).
4.3 Form of Warrant Agreement for MCG Credit Corporation dated August 9, 2000
(incorporated by reference to Exhibit 4.3 to the Company's Annual Report on
Form 10-K for the year ended December 31, 2000).
4.4 Form of Warrant Agreement for MCG Credit Corporation dated October 20, 2000
(incorporated by reference to Exhibit 4.4 to the Company's Annual Report on
Form 10-K for the year ended December 31, 2000).
4.5 Form of Warrant Agreement for MCG Finance Corporation dated October 20,
2000 (incorporated by reference to Exhibit 4.5 to the Company's Annual
Report on Form 10-K for the year ended December 31, 2000).
4.6 Indenture dated as of December 10, 1997 between the Company and First Trust
of New York, N.A. (incorporated by reference to Exhibit 10.34 to the
Company's Annual Report on Form 10-K for the year ended December 31, 1997).
4.7 Indenture dated as of April 2, 2002, between Talk America Holdings, Inc.
and Wilmington Trust Company (incorporated by reference to Exhibit 10.69 to
the Company's Annual Report on Form 10-K for the year ended December 31,
2001).
4.8 Supplemental Indenture No. 1 dated as of April 2, 2002, between Talk
America Holdings, Inc. and Wilmington Trust Company, to the Indenture dated
as of April 2, 2002, between Talk America Holdings, Inc. and Wilmington
Trust Company (incorporated by reference to Exhibit 10.70 to the Company's
Annual Report on Form 10-K for the year ended December 31, 2001).
4.9 Supplemental Indenture No. 2 dated as of April 2, 2002, between Talk
America Holdings, Inc. and Wilmington Trust Company, to the Indenture dated
as of April 2, 2002 (incorporated by reference to Exhibit 10.71 to the
Company's Annual Report on Form 10-K for the year ended December 31, 2001).
4.10 First Supplemental Indenture dated as of April 2, 2002, between Talk
America Holdings, Inc. and U.S. Bank Trust National Association, to the
Indenture dated as of September 9, 1997 (incorporated by reference to
Exhibit 10.72 to the Company's Annual Report on Form 10-K for the year
ended December 31, 2001).
71
4.11 First Supplemental Indenture dated as of April 2, 2002, between Talk
America Holdings, Inc. and U.S. Bank Trust National Association, to the
Indenture dated as of December 10, 1997 (incorporated by reference to
Exhibit 10.73 to the Company's Annual Report on Form 10-K for the year
ended December 31, 2001).
10.1 Employment Agreement between the Company and Aloysius T. Lawn, IV dated
March 28, 2001 (incorporated by reference to Exhibit 10.1 to the Company's
Annual Report on Form 10-K for the year ended December 31, 2000).*
10.2 Employment Agreement between the Company and Edward B. Meyercord, III dated
March 28, 2001 (incorporated by reference to Exhibit 10.2 to the Company's
Annual Report on Form 10-K for the year ended December 31, 2000).*
10.3 Indemnification Agreement between the Company and Aloysius T. Lawn, IV
dated March 28, 2001(incorporated by reference to Exhibit 10.3 to the
Company's Annual Report on Form 10-K for the year ended December 31, 2000).
*
10.4 Indemnification Agreement between the Company and Edward B. Meyercord, III
(incorporated by reference to Exhibit 10.14 to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1996). *
10.5 Tel-Save Holdings, Inc. 1995 Employee Stock Option Plan (incorporated by
reference to Exhibit 10.15 to the Company's registration statement on Form
S-1 (File No. 33-94940)).*
10.6 Employment Agreement, dated as of November 13, 1998, between the Company
and Gabriel Battista (incorporated by reference to Exhibit 10.1 to the
Company's Current Report on Form 8-K dated January 20, 1999).*
10.7 Amendment to Employment Agreement, dated March 28, 2001, between the
Company and Gabriel Battista (incorporated by reference to Exhibit 10.16 to
the Company's Annual Report on Form 10-K for the year ended December 31,
2000).*
10.8 Indemnification Agreement, dated as of December 28, 1998, between the
Company and Gabriel Battista (incorporated by reference to Exhibit 10.2 to
the Company's Current Report on Form 8-K dated January 20, 1999). *
10.9 Stock Option Agreement, dated as of November 13, 1998, between the Company
and Gabriel Battista (incorporated by reference to Exhibit 10.3 to the
Company's Current Report on Form 8-K dated January 20, 1999).*
10.10 Stock Option Agreement, dated as of November 13, 1998, between the Company
and Gabriel Battista (incorporated by reference to Exhibit 10.4 to the
Company's Current Report on Form 8-K dated January 20, 1999).*
10.11 1998 Long-Term Incentive Plan of the Company (incorporated by reference to
Exhibit 10.14 to the Company's Current Report on Form 8-K dated January 20,
1999).*
10.12 Investment Agreement, dated as of December 31, 1998, as amended on
February 22, 1999, among the Company, America Online, Inc., and, solely for
purposes of Sections 4.5, 4.6 and 7.3(g) thereof, Daniel Borislow, and
solely for purposes of Section 4.12 thereof, Tel-Save, Inc. and the D&K
Retained Annuity Trust dated June 15, 1998 by Mark Pavol, Trustee
(incorporated by reference to Exhibit 10.41 to the Company's Annual Report
on Form 10-K for the year ended December 31, 1998).
10.13 Employment Agreement between the Company and Kevin Griffo dated March 24,
2000 (incorporated by reference to Exhibit 10.7 to the Company's
Registration Statement in Form S-4 (File No. 333-40980)).*
72
10.14 Form of Indemnification Agreement, dated as of January 5, 1999, for George
Vinall (incorporated by reference to Exhibit 10.50 to the Company's Annual
Report on Form 10-K for the year ended December 31, 1998). *
10.15 Form of Non-Qualified Stock Option Agreement, dated as of December 16,
1998, for George Vinall, (incorporated by reference to Exhibit 10.51 to the
Company's Annual Report on Form 10-K for the year ended December 31,
1998).*
10.16 2000 Long-Term Incentive Plan (incorporated by reference to Exhibit 10.31
to the Company's Registration Statement on Form S-4 (No. 333-40980)). *
10.17 Form of Non-Qualified Stock Option Agreement, dated December 12, 2000, for
each of Gabriel Battista, Kevin Griffo, Aloysius T. Lawn IV, Edward B.
Meyercord, III, and George Vinall (incorporated by reference to Exhibit
10.40 to the Company's Annual Report on Form 10-K for the year ended
December 31, 2000).*
10.18 Employment Agreement, dated as of December 16, 1998, between the Company
and George Vinall (incorporated by reference to Exhibit 10.62 to the
Company's Annual Report on Form 10-K for the year ended December 31,
1998).*
10.19 Rights Agreement dated as of August 19, 1999 by and between the Company
and First City Transfer Company, as Rights Agent (incorporated by reference
to Exhibit 1 to the Company's registration statement on Form 8-A (File No.
000-26728)).
10.20 Credit Facility Agreement, among Talk.com Holding Corp., Access One
Communications Corp. and certain of their direct and indirect subsidiaries
and MCG Finance Corporation dated as of October 20, 2000 (incorporated by
reference to Exhibit 10.4 to Talk.com's Quarterly Report of Form 10-Q dated
November 14, 2000).
10.21 Guaranty between the Company and MCG Finance Corporation, dated as of
October 20, 2000 (incorporated by reference to Exhibit 10.5 to Talk.com's
Quarterly Report of Form 10-Q dated November 14, 2000).
10.22 Consulting Agreement dated as of July 5, 2000 between MCG Credit
Corporation and Access One Communications Corp. (incorporated by reference
to Exhibit 10.55 to the Company's Registration Statement in Form S-4 (File
No. 333-40980)).
10.23 Employment Agreement by and between Thomas M. Walsh and the Company dated
as of August 7, 2000 (incorporated by reference to Exhibit 10.1 to the
Company's Quarterly Report on Form 10-Q dated November 14, 2000).*
10.24 Indemnification Agreement by and between Thomas M. Walsh and the Company
dated as of August 7, 2000 (incorporated by reference to Exhibit 10.2 to
the Company's Quarterly Report on Form 10-Q dated November 14, 2000).*
10.25 Non-Qualified Stock Option Agreement by and Thomas M. Walsh and the
Company dated as of August 7, 2000 (incorporated by reference to Exhibit
10.3 to the Company's Quarterly Report on Form 10-Q dated November 14,
2000).*
10.26 Lease by and between Talk.com Holding Corp. and University Science Center,
Inc. dated April 10, 2000 (incorporated by reference to Exhibit 10.54 to
the Company's Annual Report on Form 10-K for the year ended December 31,
2000).
10.27 Lease by and between The Other Phone Company, dba Access One
Communications and University Science Center, Inc. dated December 8, 1999
(incorporated by reference to Exhibit 10.55 to the Company's Annual Report
on Form 10-K for the year ended December 31, 2000).
73
10.28 Restated Access One Communications Corp. 1997 Stock Option Plan
(incorporated by reference to Exhibit 4.2 to the Company's registration
statement on Form S-8 (File No. 333-52166).*
10.29 Restated Access One Communications Corp. 1999 Stock Option Plan
(incorporated by reference to Exhibit 4.3 to the Company's registration
statement on Form S-8 (File No. 333-52166).*
10.30 Amendment to Employment Agreement for Kevin Griffo dated March 28, 2001
(incorporated by reference to Exhibit 10.60 to the Company's Annual Report
on Form 10-K for the year ended December 31, 2000).*
10.31 Amendment to Employment Agreement for Kevin Griffo dated June 17, 2002
(incorporated by reference to Exhibit 10.1 to the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 2002).*
10.32 Amendment to Employment Agreement for George Vinall dated March 28, 2001
(incorporated by reference to Exhibit 10.61 to the Company's Annual Report
on Form 10-K for the year ended December 31, 2000.*
10.33 Second Amendment to Investment Agreement dated as of August 2, 2000
between the Company and America Online, Inc. (incorporated by reference to
Exhibit 99.1 to the Company's Current Report on Form 8-K dated August 3,
2000).
10.34 Employment Agreement between the Company and Jeffrey Earhart dated October
2, 2001 (incorporated by reference to Exhibit 10.1 to the Company's
Quarterly Report on Form 10-Q dated November 14, 2001).*
10.35 Employment Agreement between the Company and Warren Brasselle dated March
8, 2000 (incorporated by reference to Exhibit 10.48 to the Company's Annual
Report on Form 10-K for the year ended December 31, 2001).*
10.36 Form of Non-Qualified Stock Option Agreement, dated as of March 24, 2000,
for Kevin Griffo (incorporated by reference to Exhibit 10.49 to the
Company's Annual Report on Form 10-K for the year ended December 31,
2001).*
10.37 Restructuring and Note Agreement, dated as of September 19, 2001, between
the Company and America Online, Inc. (incorporated by reference to Exhibit
10.1 to the Company's Current Report on Form 8-K filed on September 24,
2001).
10.38 Registration Rights Agreement, dated as of September 19, 2001, between the
Company and America Online, Inc. (incorporated by reference to Exhibit 10.2
to the Company's Current Report on Form 8-K filed on September 24, 2001).
10.39 Security and Pledge Agreement, dated as of September 19, 2001, among the
Company as Grantor, and State Street Bank and Trust Company, N.A., as
collateral agent on behalf of America Online, Inc. and America Online, Inc.
(incorporated by reference to Exhibit 10.3 to the Company's Current Report
on Form 8-K filed on September 24, 2001).
10.40 Master Subsidiary Guarantee, Security Agreement Collateral Assignment and
Equity Pledge, dated as of September 19, 2001, among certain subsidiaries
of the Company as Grantors, State Street Bank and Trust Company, N.A., as
Collateral Agent on behalf of America Online, Inc., and America Online,
Inc. (incorporated by reference to Exhibit 10.4 to the Company's Current
Report on Form 8-K filed on September 24, 2001).
10.41 Intercreditor Agreement, dated as of September 19, 2001, between MCG
Finance Corporation, as collateral agent for certain MCG Lenders (as
defined therein) and State Street Bank and Trust Company, N.A., as
collateral agent (incorporated by reference to Exhibit 10.5 to the
Company's Current Report on Form 8-K filed on September 24, 2001).
74
10.42 Consent and Amendment to Talk.com Loan Documents, dated as of August 10,
2001 by and among Talk America Inc., Access One Communications Corp., the
Company, MCG Finance Corporation and MCG Capital Corporation (incorporated
by reference to Exhibit 10.7 to the Company's Current Report on Form 8-K
filed on September 24, 2001).
10.43 Consent and Amendment to Talk.com Loan Documents, dated as of September
19, 2001 by and among Talk America Inc., Access One Communications Corp.,
the Company, MCG Finance Corporation and MCG Capital Corporation
(incorporated by reference to Exhibit 10.8 to the Company's Current Report
on Form 8-K filed on September 24, 2001).
10.44 First Amendment, dated as of September 19, 2001, to the Rights Agreement
dated as of August 19, 1999, by and between Talk America Holdings, Inc. and
First City Transfer Company, as Rights Agent (incorporated by reference to
Exhibit 10.9 to the Company's Current Report on Form 8-K filed on September
24, 2001).
10.45 Letter Agreement between America Online, Inc. and the Company dated
February 21, 2002 (incorporated by reference to Exhibit 10.1 to the
Company's Current Report on Form 8-K filed on February 21, 2002).
10.46 Amendment Number Three to Talk.com Loan Documents, dated as of February
12, 2002, among the Company, Talk America Inc., Access One Communications
Corporation, each other Borrower under and as defined in the Credit
Agreement (referenced therein), Lenders that are parties thereto, and MCG
Capital Corporation (incorporated by reference to Exhibit 10.2 to the
Company's Current Report on Form 8-K filed on February 21, 2002).
10.47 Amended and Restated Consulting Agreement, dated as of February 12, 2002,
among the Company and MCG Capital Corporation (incorporated by reference to
Exhibit 10.3 to the Company's Current Report on Form 8-K filed on February
21, 2002).
10.48 2001 Non-Officer Long Term Incentive Plan of the Company (incorporated by
reference to Exhibit 4.1 to the Company's registration statement on Form
S-8 (File No. 333-74820).*
10.49 Interconnection Agreement under Sections 251 and 252 of the
Telecommunications Act of 1996 dated as of July 13, 2000, between
Southwestern Bell Telephone Company, Nevada Bell Telephone Company, Pacific
Bell Telephone Company, Southern New England Telephone, Ameritech and
Talk.com Holding Corp. (incorporated by reference to Exhibit 10.62 to the
Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.50 Mi2A Amendment to the Interconnection Agreement under Section 271 of the
Telecommunications Act of 1996 dated as of May 15, 2001, between Ameritech
Michigan and Talk.com Holding Corp. (incorporated by reference to Exhibit
10.63 to the Company's Annual Report on Form 10-K for the year ended
December 31, 2001).
10.51 Indenture of Lease by and between Woodruff Properties and Omnicall, Inc.
dated August 1, 1998 (incorporated by reference to Exhibit 10.64 to the
Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.52 Amendment dated February 9, 2001 to the Indenture of Lease by and between
Woodruff Properties and Omnicall, Inc. dated August 1, 1998 (incorporated
by reference to Exhibit 10.65 to the Company's Annual Report on Form 10-K
for the year ended December 31, 2001).
10.53 Lease Agreement by and between Bridge Plaza Partnership and The Furst
Group, Inc. dated as of November 4, 1998 ((incorporated by reference to
Exhibit 10.66 to the Company's Annual Report on Form 10-K for the year
ended December 31, 2001).
10.54 Option dated July , 2001 to Renew the Lease Agreement by and between
Bridge Plaza Partnership and The Furst Group, Inc. dates as of November 4,
1998 (incorporated by reference to Exhibit 10.67 to the Company's Annual
Report on Form 10-K for the year ended December 31, 2001).
75
10.55 Office Lease by and between Reston Plaza I and II, LLC and Talk.com, Inc.
dated as of April 28, 2000 (incorporated by reference to Exhibit 10.68 to
the Company's Annual Report on Form 10-K for the year ended December 31,
2001).
10.56 Amendment Number Four to Talk.com Loan Documents dated as of April 3,
2002, between the Company, Talk America Inc., Access One Communications
Corporation, each other Borrower under and as defined in the Credit
Agreement (referenced therein), Lenders that are parties thereto, and MCG
Capital Corporation (incorporated by reference to Exhibit 10.74 to the
Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.57 Second Amendment to Rights Agreement, dated as of December 13, 2002, to
the Rights Agreement dated as of August 19, 1999, by and between Talk
America Holdings, Inc., First City Transfer Company and Stocktrans, Inc.
(incorporated by reference to Exhibit 10.1 to the Company's Current Report
on Form 8-K filed on December 13, 2002).
10.58 Interconnection Agreement Executed as of September 23, 2002 by and between
Ameritech Michigan and Talk America Inc. (filed herewith).
21.1 Subsidiaries of the Company (incorporated by reference to Exhibit 10.49 to
the Company's Annual Report on Form 10-K for the year ended December 31,
2001).
23.1 Consent of PricewaterhouseCoopers LLP.
99.1 Certification of Gabriel Battista pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
99.2 Certification of David G. Zahka pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed
herewith).
* Management contract or compensatory plan or arrangement. + Confidential
treatment previously has been granted for a portion of this exhibit.
(b) Reports on Form 8-K.
The following Current Reports on Form 8-K were filed by the Company during
the three months ended December 31, 2002:
1. Current Report on Form 8-K dated October 7, 2002.
2. Current Report on Form 8-K dated October 11, 2002.
3. Current Report on Form 8-K dated October 16, 2002.
4. Current Report on Form 8-K dated December 13, 2002.
5. Current Report on Form 8-K dated December 24, 2002.
76
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
Date: March 28, 2003
TALK AMERICA HOLDINGS, INC.
By: Gabriel Battista /s/
---------------------
Gabriel Battista
Chairman of the Board of Directors,
Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant in
the capacities and on the dates indicated.
SIGNATURE TITLE DATE
Gabriel Battista /s/ Chairman of the Board March 28, 2003
--------------------------- of Directors, Chief Executive
Gabriel Battista Officer and Director
(Principal Executive Officer)
David G. Zahka /s/ Chief Financial Officer March 28, 2003
---------------------------- (Principal Financial Officer)
David G. Zahka
Thomas M. Walsh /s/ Vice President - Finance and March 28, 2003
---------------------------- Treasurer
Thomas M. Walsh (Principal Accounting Officer)
Edward B. Meyercord, III /s/ President and Director March 28, 2003
----------------------------
Edward B. Meyercord, III
Mark S. Fowler /s/ Director March 28, 2003
---------------------------
Mark S. Fowler
Arthur J. Marks /s/ Director March 28, 2003
---------------------------
Arthur J. Marks
Ronald R. Thoma /s/ Director March 28, 2003
---------------------------
Ronald R. Thoma
77
CERTIFICATIONS
--------------
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, Gabriel Battista, certify that:
1. I have reviewed this annual report on Form 10-K of Talk America
Holdings, Inc.;
2. Based on my knowledge, this annual 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 annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures 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 annual report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
March 28, 2003
/s/ Gabriel Battista
----------------------
Gabriel Battista
Chief Executive Officer
78
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002
I, David G. Zahka, certify that:
1. I have reviewed this annual report on Form 10-K of Talk America
Holdings, Inc.;
2. Based on my knowledge, this annual 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 annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures 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 annual report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
March 28, 2003
/s/ David G. Zahka
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David G. Zahka
Chief Financial Officer
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