SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
------------------------------
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
OR
[ ] TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
--- ---
COMMISSION FILE NUMBER 0 - 26728
TALK AMERICA HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 23-2827736
(State of incorporation) (I.R.S. Employer Identification No.)
12020 SUNRISE VALLEY DRIVE, SUITE 250, RESTON, VIRGINIA 20191
(Address of principal executive offices) (Zip Code)
(703) 391-7500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
---- ---
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
27,296,166 shares of Common Stock, par value of $0.01 per share, were
issued and outstanding as of November 1, 2002.
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
INDEX
PAGE
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PART I - FINANCIAL INFORMATION:
Item 1. Consolidated Financial Statements:
Consolidated Statements of Operations - Three and Nine
Months Ended September 30, 2002 and 2001 (unaudited) 3
Consolidated Balance Sheets - September 30, 2002
(unaudited) and December 31, 2001 4
Consolidated Statements of Cash Flows - Nine Months Ended
September 30, 2002 and 2001 (unaudited) 5
Notes to Consolidated Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 14
Item 3. Quantitative and Qualitative Disclosure About Market Risk 27
Item 4. Controls and Procedures 27
PART II - OTHER INFORMATION:
Item 2. Changes in Securities 28
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits 28
(b) Reports on Form 8-K 28
2
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
(UNAUDITED)
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
--------------------------- ---------------------------
2002 2001 2002 2001
----------- ----------- ----------- -----------
Sales $ 79,133 $ 126,335 $ 236,253 $ 390,560
Costs and expenses:
Network and line costs 37,792 58,679 115,663 186,897
General and administrative expenses 11,958 20,537 40,166 64,248
Provision for doubtful accounts 2,190 28,888 8,998 79,437
Sales and marketing expenses 6,829 12,123 19,637 68,581
Depreciation and amortization 4,611 10,338 13,483 29,250
Impairment and restructuring charges -- 171,174 -- 171,174
----------- ----------- ---------- -----------
Total costs and expenses 63,380 301,739 197,947 599,587
----------- ----------- ---------- -----------
Operating income (loss) 15,753 (175,404) 38,306 (209,027)
Other income (expense):
Interest income 299 257 482 1,088
Interest expense (2,568) (1,518) (6,941) (4,644)
Other, net (106) (2,501) (922) (2,581)
----------- ----------- ---------- -----------
Income (loss) before provision for income taxes 13,378 (179,166) 30,925 (215,164)
Provision for income taxes -- -- -- --
----------- ----------- ---------- -----------
Income (loss) before extraordinary gain and cumulative
effect of an accounting change 13,378 (179,166) 30,925 (215,164)
Extraordinary gain from extinguishments of debt -- 16,867 -- 16,867
Cumulative effect of an accounting change -- -- -- (36,837)
----------- ----------- ---------- -----------
Net income (loss) $ 13,378 $ (162,299) $ 30,925 $ (235,134)
=========== =========== ========== ===========
Income (loss) per share - Basic:
Income (loss) before extraordinary gain and
cumulative effect of an accounting change per share $ 0.49 $ (6.82) $ 1.14 $ (8.22)
Extraordinary gain per share -- 0.64 -- 0.64
Cumulative effect of an accounting change per share -- -- -- (1.41)
----------- ----------- ---------- -----------
Net income (loss) per share $ 0.49 $ (6.18) $ 1.14 $ (8.99)
=========== =========== ========== ===========
Weighted average common shares outstanding 27,243 26,247 27,217 26,166
=========== =========== ========== ===========
Income (loss) per share - Diluted:
Income (loss) before extraordinary gain and
cumulative effect of an accounting change per share $ 0.45 $ (6.82) $ 1.09 $ (8.22)
Extraordinary gain per share -- 0.64 -- 0.64
Cumulative effect of an accounting change per share -- -- -- (1.41)
----------- ----------- ---------- -----------
Net income (loss) per share $ 0.45 $ (6.18) $ 1.09 $ (8.99)
=========== =========== ========== ===========
Weighted average common and common equivalent
shares outstanding 29,617 26,247 28,501 26,166
=========== =========== ========== ===========
See accompanying notes to consolidated financial statements.
3
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT FOR SHARE AND PER SHARE DATA)
SEPTEMBER 30, DECEMBER 31,
2002 2001
-------------- -------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 41,067 $ 22,100
Accounts receivable, trade (net of allowance for uncollectible accounts
of $11,956 and $46,404 at September 30, 2002 and December 31,
2001, respectively) 23,628 26,647
Prepaid expenses and other current assets 1,691 1,951
-------------- -------------
Total current assets 66,386 50,698
Property and equipment, net 68,189 75,879
Goodwill 19,503 19,503
Intangibles, net 8,089 10,169
Other assets 8,113 8,972
-------------- -------------
$ 170,280 $ 165,221
============== =============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 29,763 $ 43,098
Sales, use and excise taxes 10,478 8,339
Deferred revenue 6,480 10,193
Current portion of long-term debt 15,257 10,544
4.5% Convertible subordinated notes due 2002 -- 3,910
Accrued compensation 5,352 1,108
Other current liabilities 6,559 10,081
-------------- -------------
Total current liabilities 73,889 87,273
-------------- -------------
Long-term debt:
Senior credit facility -- 12,500
8% Convertible notes due 2011 (includes future accrued interest of
$28,824 and $30,982 at September 30, 2002 and December 31, 2001,
respectively) 63,102 63,755
12% Senior subordinated notes due 2007 71,681 --
8% Convertible senior subordinated notes due 2007 (includes future
accrued interest of $1,281 at September 30, 2002) 4,103 --
4.5% Convertible subordinated notes due 2002 -- 57,934
5% Convertible subordinated notes due 2004 670 18,093
Other long-term debt 42 88
-------------- -------------
Total long-term debt 139,598 152,370
-------------- -------------
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;
27,264,911 and 27,150,907 shares issued and outstanding at
September 30, 2002 and December 31, 2001, respectively 273 272
Additional paid-in capital 351,458 351,169
Accumulated deficit (394,938) (425,863)
-------------- -------------
Total stockholders' equity (deficit) (43,207) (74,422)
-------------- -------------
$ 170,280 $ 165,221
============== =============
See accompanying notes to consolidated financial statements.
4
TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------------
2002 2001
------------- -----------
Cash flows from operating activities:
Net income (loss) $ 30,925 $ (235,134)
Reconciliation of net income (loss) to net cash provided by
(used in) operating activities:
Provision for doubtful accounts 8,998 79,437
Depreciation and amortization 13,483 29,250
Impairment and restructuring charges -- 171,174
Cumulative effect of an accounting change for contingent redemptions -- 36,837
Extraordinary gain from restructuring of contingent redemptions -- (16,867)
Unrealized loss on increase in fair value of contingent redemptions -- 2,372
Gain on legal settlement (1,681) --
Loss on sale and retirement of assets 205 116
Other non-cash charges 1,091 77
Changes in assets and liabilities:
Accounts receivable, trade (5,979) (68,200)
Prepaid expenses and other current assets 393 (61)
Other assets 1,622 529
Accounts payable (13,335) (7,649)
Deferred revenue (3,713) (4,877)
Sales, use and excise taxes 2,139 689
Other liabilities 1,008 4,195
------------- -----------
Net cash provided by (used in) operating activities 35,156 (8,112)
------------- -----------
Cash flows from investing activities:
Capital expenditures (3,011) (2,784)
Capitalized software development costs (1,753) (656)
Acquisition of intangibles (50) (154)
------------- -----------
Net cash used in investing activities (4,814) (3,594)
------------- -----------
Cash flows from financing activities:
Payments of borrowings (4,170) (1,347)
Payments of convertible debt (6,279) --
Payments of capital lease obligations (1,022) --
Payments in connection with restructuring contingent redemptions -- (3,525)
Exercise of stock options 96 --
------------- -----------
Net cash used in financing activities (11,375) (4,872)
------------- -----------
Net increase (decrease) in cash and cash equivalents 18,967 (16,578)
Cash and cash equivalents, beginning of period 22,100 40,604
------------- -----------
Cash and cash equivalents, end of period $ 41,067 $ 24,026
============= ===========
See accompanying notes to consolidated financial statements.
5
NOTE 1. ACCOUNTING POLICIES
(A) BASIC PRESENTATION
The consolidated financial statements include the accounts of Talk America
Holdings, Inc. and its wholly owned subsidiaries, primarily Talk America Inc.
(collectively, the "Company"), and have been prepared as if the entities had
operated as a single consolidated group since their respective dates of
incorporation. All intercompany balances and transactions have been eliminated.
The consolidated financial statements and related notes thereto as of
September 30, 2002 and for the three and nine months ended September 30, 2002
and September 30, 2001 are presented as unaudited but in the opinion of
management include all adjustments necessary to present fairly the information
set forth therein. The consolidated balance sheet information for December 31,
2001 was derived from the audited financial statements included in the Company's
Form 10-K, as amended by its Form 10-K/A filed April 12, 2002. These interim
financial statements should be read in conjunction with the Company's Annual
Report on Form 10-K for the year ended December 31, 2001, as amended by its Form
10-K/A filed April 12, 2002. The interim results are not necessarily indicative
of the results for any future periods. Certain prior year amounts have been
reclassified to conform to the current year's presentation.
Effective October 15, 2002, the Company's stockholders approved a
one-for-three reverse stock split of the Company's common stock, 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.
(B) 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:
- The Company's business strategy with respect to bundled local and long
distance services may not succeed
- Failure to manage, or difficulties in managing, the Company's growth
and operations including attracting and retaining qualified personnel
and expanding into new markets with competitive pricing and favorable
gross margins
- Dependence on the availability and functionality of incumbent local
telephone companies' 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 and/or
adverse judicial interpretations and rulings related to regulation and
enforcement
- Failure of the marketing of the bundle of the Company's local and long
distance services under agreements with its direct marketing channels
and its various marketing partners and failure to successfully add new
marketing partners
- Inability to adapt to technological change
- Inability to manage customer attrition or turnover and bad debt
expense and to lower customer acquisition costs
- Adverse change in the Company's relationship with its vendors or other
third party carriers
- Failure or bankruptcy of other telecommunications companies whom the
Company relies upon for services and revenues
- Ability to realize the full benefit of the net operating loss
carryforwards on future taxable income generated by the Company
Negative developments in these areas could have a material effect on the
Company's business, financial condition and results of operations.
6
(C) 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
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 units' 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. To the extent a reporting
unit's carrying amount exceeded its fair value, an indication would have existed
that the reporting unit's goodwill assets may be impaired and the Company must
perform the second step of the transitional impairment test. In the second step,
the Company must 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. This second step is
required to be completed as soon as possible, but no later than the end of 2002.
Any transitional impairment charge will be recognized as the cumulative effect
of a change in accounting principle in the Company's consolidated statement of
operations. 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. Since the fair value of the
reporting unit exceeded the carrying amount under the transitional assessment,
the Company does not need to perform the second step of the transitional
impairment test. The Company determined that it has one reporting unit under the
guidance of SFAS 142. The fair value 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 September 30, 2002 was $19.5
million. 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 three and nine months
ended September 30, 2001 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.
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- -------------------------
2002 2001 2002 2001
------------ ----------- ------------ ----------
Net income (loss) as reported $ 13,378 $(162,299) $ 30,925 $(235,134)
Goodwill amortization -- 5,502 -- 15,955
------------ ----------- ------------ ----------
Adjusted net income (loss) $ 13,378 $(156,797) $ 30,925 $(219,179)
============ =========== ============ ==========
Basic income (loss) per share:
Net income (loss) as reported per share $ 0.49 $ (6.18) $ 1.14 $ (8.99)
Goodwill amortization per share -- 0.21 -- 0.61
------------ ----------- ------------ ----------
Adjusted net income (loss) per share $ 0.49 $ (5.97) $ 1.14 $ (8.38)
============ =========== ============ ==========
Diluted income (loss) per share:
Net income (loss) as reported per share $ 0.45 $ (6.18) $ 1.09 $ (8.99)
Goodwill amortization per share -- 0.21 -- 0.61
------------ ----------- ------------ ----------
Adjusted net income (loss) per share $ 0.45 $ (5.97) $ 1.09 $ (8.38)
============ =========== ============ ==========
7
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 $0.7 million and $2.1 million for the three and nine months ended
September 30, 2002, and $0.8 million and $3.0 million for the three and nine
months ended September 30, 2001. The Company's balance of intangible assets
with a definite life was $8.1 million at September 30, 2002, net of accumulated
amortization of $5.5 million. Amortization expense on intangible assets with a
definite life for the next 5 years as of September 30, is as follows: 2003 -
$2.8 million, 2004 - $2.8 million, 2005 - $2.4 million and 2006 - $0.1 million.
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 Company expects that the provisions
of SFAS 143 will not have a material effect on its consolidated results of
operations or financial position upon adoption.
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 also 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 of
approximately $7.3 million from sales and marketing expenses to a reduction of
net sales for the nine months ended September 30, 2001 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 three
months ended September 30, 2001 and the three and nine months ended September
30, 2002, as the Company did not have any direct marketing promotion check
campaigns during these periods.
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.
8
NOTE 2. 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 ("4 1/2% Notes") that mature on September 15,
2002 into $53.2 million of new 12% Senior Subordinated PIK Notes due August 2007
("12% Notes") and $2.8 million of new 8% Convertible Senior Subordinated Notes
due August 2007 ("8% 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% Notes") that mature on
December 15, 2004 into $17.4 million of the new 12% Notes.
The new 12% Notes accrue interest at a rate of 12% per year on the
principal amount, payable two times a year on each 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% Notes. The new 8% Notes accrue interest at a rate of 8%
per year on the principal amount, payable two times a year on each February 15
and August 15, beginning on August 15, 2002 and are convertible, at the option
of the holder, into common stock at $15.00 per share. The 12% and 8% Notes are
redeemable at any time at the option of the Company at par value plus accrued
interest to the redemption date, although the AOL Restructuring Agreement
restricts the Company's ability to redeem the 12% and 8% Notes (see Note 3). In
addition, the Company is not required to make mandatory redemption payments to
repurchase the new notes or the 5% Notes in the case of a change of control of
the Company or to repurchase the notes on the termination of trading of the
Company's common stock on a national securities exchange or established
automated over-the-counter trading market.
In accordance with SFAS No. 15, "Accounting by Debtors and Creditors for
Troubled Debt Restructurings," the exchange of the 4 1/2% Notes into $53.2
million of the 12% Notes and $2.8 million of the 8% 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% Notes and 12% 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.
NOTE 3. AOL AGREEMENTS
On September 19, 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 also ended its marketing relationship with
AOL effective September 30, 2001 (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 due September 2011 ("2011 Convertible Notes") and 1,026,209
additional shares of the Company's common stock.
Pursuant to the Restructuring Agreement, in exchange for and in
cancellation of the Company's warrants to purchase 907,328 shares of the common
stock and the Company's related obligations under the Investment Agreement to
repurchase such warrants from AOL, the Company issued the 1,026,209 additional
shares of its common stock to AOL, after which AOL holds a total of 2,400,000
shares of common stock. The Company agreed to provide certain registration
rights to AOL in connection with the shares of common stock issued to it by the
Company.
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 2011
Convertible Note, 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 5).
9
The 2011 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 2011 Convertible Notes delivered to AOL, thereby
reducing the outstanding principal amount of the 2011 Convertible Notes to $34.0
million. The 2011 Convertible Notes are convertible into shares of the Company's
common stock at the rate of $15.00 per share, may be redeemed by the Company at
any time without premium and are subject to mandatory redemption at the option
of the holder on September 15, 2006 and September 15, 2008. The 2011 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; interest is payable in cash,
except that the Company may elect to pay up to 50% (100% in the case of the
first interest payment) of the interest due on any payment date, in kind rather
than in cash. The 2011 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 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.
In connection with this discontinuance, the Company paid AOL $6.0 million under
the marketing agreement, payable in two installments - $2.5 million on September
20, 2001 and the remaining $3.5 million on October 4, 2001. 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 2011 Convertible Notes delivered to AOL as discussed above,
thereby reducing the outstanding principal amount of the 2011 Convertible Notes
to $34 million. The amendment also provided for the payment by the Company of
certain expenses related to marketing services until the discontinuance and for
the continued servicing and transition of telecommunications customer
relationships after the discontinuance of marketing.
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
(representing the $34.0 million of convertible debt and $32.4 million of future
interest expense), 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
will record no interest expense associated with these convertible notes in
future periods in the Company's statements of operations.
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% Notes. Under the letter agreement, the Company also paid AOL approximately
$1.2 million as a prepayment on the 2011 Convertible Note, approximately $0.7
million of which was credited against amounts the Company owed AOL under the
letter agreement for cash payments in the exchange offers. After giving effect
to the prepayment, and taking into account the interest that had been paid on
the 2011 Convertible Notes as additional principal, there was outstanding as of
September 30, 2002, an aggregate of $34.3 million principal amount of the 2011
Convertible Notes and the Company complied with the various conditions of the
letter agreement and did not owe AOL any additional payments related to the
exchange offers.
On January 5, 1999, the Company and AOL entered into an Investment
Agreement. Under the terms of the Investment Agreement, the 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
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.
10
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 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.
NOTE 4. 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
gain 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
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.
NOTE 5. SENIOR CREDIT FACILITY
On October 4, 2002, the principal operating subsidiaries of Company
retired, prior to maturity, all of the debt outstanding under the Senior Credit
Facility Agreement between the subsidiaries and MCG Finance Corporation ("MCG").
Accordingly, the entire principal balance as of September 30, 2002 of $13.8
million has been reflected in the current portion of long-term debt. The Senior
Credit Facility Agreement was secured by a pledge of all of the assets of the
subsidiaries of the Company that were a party to the Senior Credit Facility
Agreement. In addition, the Company had guaranteed the obligations under the
Senior Credit Facility Agreement. The Senior Credit Facility Agreement subjected
the Company and its subsidiaries to certain restrictions and covenants related
to among other things, liquidity, per-subscriber-type of revenue, subscriber
acquisition costs and interest coverage ratio requirements. 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 will incur a one-time, non-cash
extraordinary charge to earnings of approximately $1.1 million in the fourth
quarter of 2002, reflecting the acceleration of the amortization of certain
deferred finance charges and fees.
The Credit Facility Agreement provided for a term loan of up to $20.0
million maturing on June 30, 2005 and a line of credit facility permitting such
subsidiaries to borrow up to an additional $30.0 million available through June
30, 2003. The availability of the line of credit facility was subject, among
other things, to the successful syndication of that facility. No amounts were
outstanding or available under the line of credit facility as of September 30,
2002. Loans under the Credit Facility Agreement bore interest at a rate equal
to either (a) the Prime Rate, or (b) LIBOR, plus, in each case, the applicable
margin. The applicable margin was 7.0% for borrowings accruing interest at LIBOR
and 6.0% for borrowings accruing interest at the Prime Rate. The principal of
the term loan was paid in quarterly installments of $1.25 million on the last
calendar day of each fiscal quarter commencing on September 30, 2001.
11
In connection with the AOL Restructuring, MCG entered into an Intercreditor
Agreement with AOL, which survives the early retirement of debt under the Credit
Facility Agreement (see Note 3).
NOTE 6. IMPAIRMENT AND RESTRUCTURING CHARGES
In the third quarter of 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 Communications Corp., ("Access One"), a private,
local telecommunications service provider to nine states in the southeastern
United States. The goodwill was created by purchase accounting treatment of the
Access One merger transaction that closed in August 2000. 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 Company addressed these operational issues by improving credit quality
through credit scoring the existing and future customer base, slowing down
growth of new expected customers through decreased marketing, and lowering
product pricing. These and other actions taken by the Company resulted in lower
current and future projected growth of bundled revenues and cash flows than
those originally projected at the time of the Access One merger. 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. Accordingly, a $0.6 million credit was recorded in the statement
of operations for the fourth quarter of 2001 for the difference between the
original restructuring charge of $2.5 million and the actual costs incurred of
$1.9 million.
12
NOTE 7. PER SHARE DATA
Basic earnings per common share is calculated by dividing net income by the
average number of common shares outstanding during the period. 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):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS
SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------------- --------------------------
2002 2001 2002 2001
------------ ----------- ------------ ------------
Income (loss) before extraordinary gain and
cumulative effect of an accounting change $ 13,378 $(179,166) $ 30,925 $(215,164)
Extraordinary gain -- 16,867 -- 16,867
Cumulative effect of an accounting change -- -- -- (36,837)
------------ ----------- ------------ ------------
Net income (loss) $ 13,378 $(162,299) $ 30,925 $(235,134)
============ =========== ============ ============
Average shares of common stock outstanding
used to compute basic earnings per share 27,243 26,247 27,217 26,166
Additional common shares to be issued
assuming exercise of stock options and
warrants * 2,374 -- 1,284 --
------------ ----------- ------------ -----------
Average shares of common and common
equivalent stock outstanding used to compute
diluted earnings per share 29,617 26,247 28,501 26,166
============ =========== ============ ============
Income (loss) per share - Basic:
Income (loss) before extraordinary gain and
cumulative effect of an accounting change
per share $ 0.49 $ (6.82) $ 1.14 $ (8.22)
Extraordinary gain per share -- 0.64 -- 0.64
Cumulative effect of an accounting change
per share -- -- -- (1.41)
------------ ----------- ------------ -----------
Net income (loss) per share $ 0.49 $ (6.18) $ 1.14 $ (8.99)
============ =========== ============ ============
Weighted average common shares
outstanding 27,243 26,247 27,217 26,166
============ =========== ============ ============
Income (loss) per share - Diluted:
Income (loss) before extraordinary gain and
cumulative effect of an accounting change
per share $ 0.45 $ (6.82) $ 1.09 $ (8.22)
Extraordinary gain per share -- 0.64 -- 0.64
Cumulative effect of an accounting change
per share -- -- -- (1.41)
------------ ----------- ------------ -----------
Net income (loss) per share $ 0.45 $ (6.18) $ 1.09 $ (8.99)
============ =========== ============ ============
Weighted average common and common
equivalent shares outstanding 29,617 26,247 28,501 26,166
============ =========== ============ ============
* The diluted share basis for the three and nine months ended September 30, 2001
excludes convertible notes, options and warrants due to their antidilutive
effect as a result of the Company's net loss from continuing operations. The
diluted share basis for the three and nine months ended September 30, 2002
excludes convertible notes that are convertible into 2.5 million shares of
common stock due to their antidilutive effect.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
The following discussion should be read in conjunction with the
Consolidated Financial Statements included elsewhere in this Form 10-Q and in
the Company's Annual Report on Form 10-K, as amended by its Form 10-K/A filed
April 12, 2002 and any subsequent filings. 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 elsewhere in this Form 10-Q
(see particularly Note 1(b) of the Notes to the Consolidated Financial
Statements) 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 incumbent local telephone companies' networks as they relate to
the unbundled network element platform, increased price competition for long
distance and local services, failure of the marketing of 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
interpretations and rulings relating to such regulations and enforcement. Except
as otherwise required by law, the Company undertakes no obligation to update its
forward-looking statements.
OVERVIEW
Talk America Holdings, Inc., through its subsidiaries (the "Company"),
provides local and long distance telecommunication services to residential and
small business customers throughout 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, competitively priced telecommunication services to
customers.
The Company's telecommunication services offerings primarily include 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, 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 incumbent local exchange carriers ("ILECs") network to
provide local services and the Company's nationwide network and third party
international call termination to provide long distance services. The FCC is
currently undertaking its triennial review of local phone competition, including
the continued availability of certain unbundled network elements and switching
(see "Liquidity and Capital Resources, Other Matters"). The Company attracts new
customers through referral programs, direct marketing programs, agent and direct
sales, and online partners.
14
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain financial
data of the Company as a percentage of sales:
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------------------------ ------------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
Sales 100.0% 100.0% 100.0% 100.0%
Costs and expenses:
Network and line costs 47.8 46.4 49.0 47.9
General and administrative expenses 15.1 16.2 17.0 16.4
Provision for doubtful accounts 2.8 22.9 3.8 20.3
Sales and marketing expenses 8.6 9.6 8.3 17.6
Depreciation and amortization 5.8 8.2 5.7 7.5
Impairment and restructuring charges -- 135.5 -- 43.8
---------- ---------- ---------- ----------
Total costs and expenses 80.1 238.8 83.8 153.5
---------- ---------- ---------- ----------
Operating income (loss) 19.9 (138.8) 16.2 (53.5)
Other income (expense):
Interest income 0.4 0.2 0.2 0.3
Interest expense (3.3) (1.2) (2.9) (1.2)
Other, net (0.1) (2.0) (0.4) (0.7)
---------- ---------- ---------- ----------
Income (loss) before income taxes 16.9 (141.8) 13.1 (55.1)
Provision for income taxes -- -- -- --
---------- ---------- ---------- ----------
Income (loss) before extraordinary gain
and cumulative effect of an
accounting change 16.9 (141.8) 13.1 (55.1)
Extraordinary gain -- 13.3 -- 4.3
Cumulative effect of an accounting
change -- -- -- (9.4)
---------- ---------- ---------- ----------
Net income (loss) 16.9% (128.5)% 13.1% (60.2)%
========== ========== ========== ==========
QUARTER ENDED SEPTEMBER 30, 2002 COMPARED TO QUARTER ENDED SEPTEMBER 30, 2001
Sales. Sales decreased by 37.4% to $79.1 million for the quarter ended
September 30, 2002 from $126.3 million for the quarter ended September 30, 2001,
but have increased 1.9% sequentially from $77.7 million for the quarter ended
June 30, 2002.
The Company's long distance sales decreased to $34.6 million for the
quarter ended September 30, 2002 from $69.4 million for the quarter ended
September 30, 2001, and have decreased 9.6% sequentially from $38.3 million for
the quarter ended June 30, 2002. 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. 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 for the quarter ended September 30, 2002 and
September 30, 2001 included non-cash amortization of deferred revenue of $1.9
million 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 are expected to decline to between $27 and $32 million in
the fourth quarter of 2002 and for the full year 2003 are expected to be between
$80 and $90 million.
The Company's bundled sales for the quarter ended September 30, 2002 were
$44.5 million compared with $56.9 million for the quarter ended September 30,
2001, but have increased 13.1% sequentially from $39.4 million for the quarter
ended June 30, 2002. The Company had approximately 276,000 bundled lines as of
15
September 30, 2002 compared with 244,000 bundled lines at June 30, 2002.
Approximately 150,000 of the bundled lines at September 30, 2002 and
approximately 71% of the Company's new bundled lines for the third quarter of
2002 were in Michigan. The decrease in bundled sales in the third quarter of
2002 compared to 2001 reflects the Company's decision to slow growth in bundled
sales while the Company pursued its plans to improve the efficiencies of the
Company's bundled business model and improve customer quality and collections
processes. The increase in bundled revenues sequentially from the second quarter
of 2002 to the third quarter of 2002 is attributed to growth in bundled lines
and reductions in customer turnover. In the third quarter of 2002, agent sales
slowed due to implementation issues associated with the Company's new product
offerings in the previous quarter. Bundled revenues are expected to increase to
between $48 and $53 million in the fourth quarter of 2002. Bundled revenues for
the full year 2003 are expected to be between $270 and $280 million.
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 other states. Revenues per bundled line are
expected to decline in the future as the Company continues to market lower
priced products to be more competitive with incumbent and other competitive
local exchange carriers and provide greater value to its customers.
Network and Line Costs. Network and line costs decreased by 35.6% to $37.8
million for the quarter ended September 30, 2002 from $58.7 million for the
quarter ended September 30, 2001. The decrease in network and line costs was
primarily due to a lower number of local and long distance customers, a
reduction in access and usage charges and a reduction in primary interexchange
carrier charges. Network and line costs for the three months ended September 30,
2002 benefited from a credit of $0.4 million in connection with a New York
Public Service Commission-mandated refund from Verizon New York of certain UNE-P
switching costs totaling an aggregate $1.6 million. Of the Verizon New York
refund, $1.2 million was received in the second and third quarters of 2002. The
remaining balance of the credit, an additional $0.4 million, will be provided to
the Company in the form of bill credits from Verizon over the quarter ended
December 31, 2002. Network and line costs also benefited from favorable
resolution of 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 47.8% for the quarter ended September 30, 2002, as
compared to 46.4% for the same quarter last year. The FCC is currently
undertaking its triennial review of local phone competition, including the
continued availability of certain unbundled network elements and switching. As
the Company's long distance customer base declines, the Company could be subject
to higher network and line costs as percentage of sales due to fixed costs of
the Company's long distance network and certain minimum contract commitments.
See "Liquidity and Capital Resources, Other Matters."
Gross profit, defined as sales less network and line costs, decreased by
38.9% for the quarter ended September 30, 2002 to $41.3 million from $67.7
million for the same quarter last year, and gross margin, defined as gross
profit as a percentage of sales, decreased to 52.2% as compared to 53.6% for the
quarter ended September 30, 2001. Gross margin for the long distance product was
60.8% for the third quarter of 2002 as compared to 59.1% for the same quarter
last year and gross margin for the bundled product was 45.6% for the third
quarter of 2002 as compared to 46.7% for the same quarter last year. The growth
of local bundled service as a percentage of total revenue and product mix has
contributed to the decrease in overall gross margin. Excluding the benefit of
the Verizon New York credit and other dispute resolutions, the gross margin for
the bundled product would have been in the low 40% range. Excluding
amortization of deferred revenue related to a telecommunications service
agreement, which expired in October 2002 and various dispute resolutions, gross
margin for the long distance product would have been in the low 50% range. The
FCC is currently considering modifications to the Universal Service Fund ("USF")
program that may go into effect as early as the end of 2002. Changes to the
methodology used in the calculation of the collection and payment of USF charges
may have an adverse impact on the Company's gross margin.
General and Administrative Expenses. General and administrative expenses
decreased by 41.8% to $12.0 million for the quarter ended September 30, 2002
from $20.5 million for the quarter ended September 30, 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 quarter ended September
30, 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. While the
Company expects to realize further general and administrative expense
efficiencies as the customer base grows, realization of such efficiencies will
be dependant on the ability of management to control personnel costs in areas
such as collections and customer service. There can be no assurances that the
Company will be able to realize these efficiencies.
16
Provision for Doubtful Accounts. Provision for doubtful accounts decreased
by 92.4% to $2.2 million for the quarter ended September 30, 2002 from $28.9
million for the same quarter last year and, as a percentage of sales, decreased
to 2.8% as compared to 22.9% for the quarter ended September 30, 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 quarter ended
September 30, 2002. Further, the provision for doubtful accounts for the third
quarter of 2002 reflects a benefit from a reversal of the reserve for doubtful
accounts of $0.7 million. In general, the Company believes that the 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 quarter ended September 30, 2002,
the Company incurred $6.8 million of sales and marketing expenses as compared to
$12.1 million for the same quarter last year, a 43.7% decrease, and, as a
percentage of sales, a decrease to 8.6% as compared to 9.6% for the quarter
ended September 30, 2001. The decrease from the third quarter of 2002 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 as the Company
slowed growth as it pursued its plan to improve efficiencies 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 the fourth quarter of 2002 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
quarter ended September 30, 2002 was $4.6 million, a decrease of $5.7 million
compared to $10.3 million for the quarter ended September 30, 2001, and, as a
percentage of sales, decreased to 5.8% as compared to 8.2% for the quarter ended
September 30, 2001. The Company's amortization expense decreased significantly
for the quarter ended September 30, 2002 due to the write-down in the third
quarter of 2001 of goodwill associated with the acquisition of Access One.
Additionally, the Company implemented 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 $171.2 million for the quarter ended September 30,
2001. Included in the amount for the quarter ended September 30, 2001 was an
impairment charge of $168.7 million, primarily related to the write-down of
goodwill associated with the acquisition of Access One, as discussed above. In
September 2001, the Company approved a plan to close one of its a 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 and
lease exit costs in connection with the call center closure. There were no
impairment or restructuring charges in the third quarter of 2002 (see Note 6 of
the Notes of the Consolidated Financial Statements).
Interest Income. Interest income was $0.3 million for the quarter ended
September 30, 2002 versus $0.3 million for the quarter ended September 30, 2001.
Interest Expense. Interest expense was $2.6 million for the quarter ended
September 30, 2002 as compared to $1.5 million for the quarter ended September
30, 2001. The increase in interest expense is attributed to higher yielding debt
instruments associated with the exchange of the Company's 4 1/2% and 5% Notes
for 8% and 12% Notes and the restructuring of the MCG credit facility (see Notes
2, 3 and 5 of the Notes to Consolidated Financial Statements and "Liquidity and
Capital Resources"). As described in Note 3 of the Notes to Consolidated
Financial Statements, the issuance of the 8% convertible notes due 2011 was
accounted for as a troubled debt restructuring and, as such, interest expense
associated with these notes would not be recorded in future periods in the
Company's statements of operations. For the quarter ended September 30, 2002,
$0.7 million of interest expense associated with the issuance of these notes was
not reflected in net income. Interest expense is expected to decrease in the
17
fourth quarter of 2002 as compared to the third quarter of 2002 due to the early
retirement of the Company's senior credit facility and the retirement of $3.9
million of the 4 1/2% Notes.
Other, Net. Net other expenses were $0.1 million for the quarter ended
September 30, 2002 as compared to $2.5 million for the quarter ended September
30, 2001. The amount for the quarter ended September 30, 2001 primarily consists
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. At September 30, 2002 and 2001, a full
valuation allowance has 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 are 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 has recorded a full valuation allowance on the
net deferred tax assets. For the quarter ended September 30, 2002, although the
Company has net income, no provision for income taxes has been reflected on the
statement of operations due to the full valuation allowance. The Company has not
recorded any income tax expense or benefit for the quarter ended September 30,
2001 because the Company incurred losses during this period as well as
maintained a full valuation allowance at September 30, 2001. The third quarter
of 2002 represents the fourth consecutive quarter of profitability for the
Company. In the fourth quarter of 2002, as part of its 2003 budgeting process,
management will evaluate the valuation allowance and, if appropriate after the
evaluation, will reverse all or a portion of this valuation allowance, resulting
in a non-cash deferred income tax benefit on the statement of operations. At
that time, the Company would record the estimated net realizable value of the
deferred tax asset and, beginning in 2003, would provide for 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 would
be shielded from paying cash income taxes for several years. 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 Gain (Loss). The Company incurred an extraordinary gain in
the quarter ended September 30, 2001 of $16.9 million, which 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," as
discussed above in Note 3 of the Notes to the Consolidated Financial Statements.
As a result of the retirement of the Company's senior credit facility prior to
maturity, the Company will incur a one-time, non-cash 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.
NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
2001
Sales. Sales decreased by 39.5% to $236.3 million for the nine months ended
September 30, 2002 from $390.6 million for the nine months ended September 30,
2001.
The Company's long distance sales decreased to $116.9 million for the nine
months ended September 30, 2002 from $236.3 million for the nine months ended
September 30, 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. 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 for the nine months ended September 30, 2002 and September 30, 2001
included non-cash amortization of deferred revenue of $5.6 million 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.
18
The Company's bundled sales for the nine months ended September 30, 2002
were $119.4 million compared with $154.3 million for the nine months ended
September 30, 2001. The decrease in bundled sales for the nine months ended
September 30, 2002 compared to 2001 reflects the Company's decision to slow
growth in bundled sales while the Company pursued its plans to improve the
efficiencies of the Company's bundled business model and improve customer
quality and collections processes. In addition, a significant portion of the
bundled sales for the nine months ended September 30, 2001 were generated from
bundled service customers acquired through marketing programs that had been
discontinued in 2001. 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 other states. Revenues per
bundled line are expected to decline in the future as the Company continues to
market lower priced products to be more competitive with incumbent and other
competitive local exchange carriers and provide greater value to consumers.
Network and Line Costs. Network and line costs decreased by 38.1% to $115.7
million for the nine months ended September 30, 2002 from $186.9 million for the
nine months ended September 30, 2001. The decrease in costs was primarily due to
a lower number of local and long distance customers, a reduction in access and
usage charges and a reduction in primary interexchange carrier charges. Network
and line costs for the nine months ended September 30, 2002 benefited from the
Verizon New York credit of $1.2 million. Network and line costs also benefited
from favorable resolution of 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 nine months ended September
30, 2002, as compared to 47.9% for the same period last year. The FCC is
currently undertaking its triennial review of local phone competition including
the continued availability of certain unbundled network elements and switching.
As the Company's long distance customer base declines, the Company could be
subject to higher network and line costs as a percentage of sales due to fixed
costs of the Company's long distance network and certain minimum contract
commitments. See "Liquidity and Capital Resources, Other Matters."
Gross profit, defined as sales less network and line costs, decreased by
40.8% for the nine months ended September 30, 2002 to $120.6 million from $203.7
million for the same period last year, and gross margin, defined as gross profit
as a percentage of sales, decreased to 51.0% as compared to 52.1% for the nine
months ended September 30, 2001. Gross margin for the long distance product was
59.1% for the nine months ended September 30, 2002 as compared with 55.9% for
the same period last year and gross margin for the bundled product was 43.1% for
the nine months ended September 30, 2002 as compared to 46.5% for the same
period last year. The growth of local bundled service as a percentage of total
revenue and product mix has contributed to the decrease in overall gross margin.
General and Administrative Expenses. General and administrative expenses
decreased by 37.5% to $40.2 million for the nine months ended September 30, 2002
from $64.2 million for the nine months ended September 30, 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.
The Company had increased personnel costs associated with supporting the
Company's bundled services offerings, including customer service, provisioning
and collections personnel during the nine months ended September 30, 2001 as
compared with 2002. Included in general and administrative expenses for the nine
months ended September 30, 2002 was a non-cash credit of $1.7 million related to
a favorable settlement of a vendor dispute that had previously been reflected as
a liability, partially offset by an increase in legal reserves of $0.5 million.
While the Company expects to realize further general and administrative expense
efficiencies as the customer base grows, realization of such efficiencies will
be dependant on the ability of management to control personnel costs in areas
such as collections and customer service. 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 88.7% to $9.0 million for the nine months ended September 30, 2002 from $79.4
million for the same period last year and, as a percentage of sales, decreased
to 3.8% as compared to 20.3% for the nine months ended September 30, 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 nine months
19
ended September 30, 2002. Further, the provision for doubtful accounts for the
nine months ended September 30, 2002 reflects a benefit from a reversal of the
reserve for doubtful accounts of $2.2 million. In general, the Company believes
that the 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 nine months ended September 30,
2002, the Company incurred $19.6 million of sales and marketing expenses as
compared to $68.6 million for the same period last year, a 71.4% decrease, and,
as a percentage of sales, a decrease to 8.3% as compared to 17.6% for the nine
months ended September 30, 2001. The decrease in 2002 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 as the Company slowed growth as it pursued
its plan to improve efficiencies of the Company's bundled business model.
Currently, substantially all of the sales and marketing expenses relate to the
bundled product.
Depreciation and Amortization. Depreciation and amortization for the nine
months ended September 30, 2002 was $13.5 million, a decrease of $15.8 million
compared to $29.3 million for the nine months ended September 30, 2001, and, as
a percentage of sales, decreased to 5.7% as compared to 7.5% for the nine months
ended September 30, 2001. The Company's amortization expense decreased
significantly for the nine months ended September 30, 2002 due to the write-down
in the third quarter of 2001 of goodwill associated with the acquisition of
Access One. Additionally, the Company implemented 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 for the nine months ended September 30, 2002
(see Note 1 of the Notes to the Consolidated Financial Statements).
Impairment and Restructuring Charges. The Company incurred impairment and
restructuring charges of $171.2 million for the nine months ended September 30,
2001. Included in the amount for the nine months ended September 30, 2001 was an
impairment charge of $168.7 million, primarily related to the write-down of
goodwill associated with the acquisition of Access One, as discussed above. 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 nine months
ended September 30, 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 the nine months ended September
30, 2002 (see Note 6 to the Notes of the Consolidated Financial Statements).
Interest Income. Interest income was $0.5 for the nine months ended
September 30, 2002 versus $1.1 million for the nine months ended September 30,
2001. Interest income for the nine months ended September 30, 2002 was lower due
to decrease in interest rates during the nine months ended September 30, 2002 as
compared to 2001, partially offset by the Company's higher average cash balances
in 2002 as compared to 2001.
Interest Expense. Interest expense was $6.9 million for the nine months
ended September 30, 2002 as compared to $4.6 million for the nine months ended
September 30, 2001. The increase in interest expense is attributed to higher
yielding debt instruments associated with the exchange of the Company's 4 1/2%
and 5% Notes for 8% and 12% Notes and the MCG credit facility restructuring (see
Notes 2, 3 and 5 of the Notes to Consolidated Financial Statements and
"Liquidity and Capital Resources"). In addition, interest expense for the nine
months ended September 30, 2002 includes the write-off of deferred financing
costs of $0.4 million in connection with the bond restructuring. As described
in Note 3 of the Notes to Consolidated Financial Statements, the issuance of the
8% convertible notes due 2011 was accounted for as a troubled debt restructuring
and, as such, interest expense associated with these notes would not be recorded
in future periods in the Company's statements of operations. For the nine
months ended September 30, 2002, $2.0 million of interest expense associated
with the issuance of these notes was not reflected in net income.
Other, Net. Net other expenses were $0.9 for the nine months ended
September 30, 2002 as compared to $2.6 million for the nine months ended
September 30, 2001. The amount for the nine months ended September 30, 2002
primarily consists of costs in connection with the Company's restructuring of
its convertible subordinated notes (see Note 2 of the Notes to Consolidated
Financial Statements). The amount for the nine months ended September 30, 2001
primarily consists of a $2.4 million unrealized loss on the increase in fair
20
value of the AOL contingent redemptions in accordance with the fair value
accounting treatment under EITF Abstract No. 00-19. This amount was not
recurring, as the AOL contingent redemptions had been restructured effective
September 2001.
Provision for Income Taxes. At September 30, 2002 and 2001, a full
valuation allowance has 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 are 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 has recorded a full valuation allowance on the
net deferred tax assets. For the nine months ended September 30, 2002, although
the Company has net income, no provision for income taxes has been reflected on
the statement of operations due to the full valuation allowance. The Company has
not recorded any income tax expense or benefit for the nine months ended
September 30, 2001 because the Company incurred losses during this period as
well as maintained a full valuation allowance at September 30, 2001. The third
quarter of 2002 represents the fourth consecutive quarter of profitability for
the Company. In the fourth quarter of 2002, as part of its 2003 budgeting
process, management will evaluate the valuation allowance and, if appropriate
after the evaluation, will reverse all or a portion of this valuation allowance,
resulting in a non-cash deferred income tax benefit on the statement of
operations. At that time, the Company would record the estimated net realizable
value of the deferred tax asset and, beginning in 2003, would provide for 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 would be shielded from paying cash income taxes for several years. 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 Gain. The Company incurred an extraordinary gain in the nine
months ended September 30, 2001 of $16.9 million, which 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," as
discussed above in Note 2 of the Notes to the Consolidated Financial Statements.
Cumulative Effect of an Accounting Change. The Company adopted Emerging
Issues Task Force Abstract No. 00-19, "Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own Stock," in
the nine months ended September 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 nine months ended September 30, 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.
21
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash requirements arise primarily from the subsidiaries'
operational needs, the subsidiaries' capital expenditures, and the debt service
obligations of the subsidiaries and of Talk America Holdings, Inc. Since Talk
America Holdings, Inc. conducts all of its 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 September 30, 2002 are
summarized by years to maturity as follows (in thousands):
1 year or 2 - 3 4 - 5
Contractual Obligations (4) Total less Years Years Thereafter
------------------------------------------ --------- ---------- ---------- ---------- ------------
Talk America Holdings, Inc.:
----------------------------
8% Convertible notes due 2011(1) $ 64,487 $ 1,384 $ 2,941 $ 3,182 $ 56,980
12% Senior subordinated notes due 2007 71,681 -- -- 71,681 --
8% Convertible senior subordinated
notes due 2007 (2) 4,103 -- -- 4,103 --
5% Convertible subordinated notes due
2004 670 -- 670 -- --
Talk America Inc. and other subsidiaries:
------------------------------------------
Senior credit facility (3) 13,750 13,750 -- -- --
Capital lease obligations 101 60 41 -- --
Other long-term obligations 63 63 -- -- --
--------- ---------- ---------- ---------- ------------
Total Contractual Obligations $ 154,855 $15,257 $ 3,652 $78,966 $ 56,980
========= ========== ========== ========== ============
------------------
(1) The 2011 Convertible Notes include $34.3 million of principal and $30.2
million of future accrued interest (see Note 3 of the Notes to Consolidated
Financial Statements). The 2011 Convertible Notes are subject to mandatory
redemption, at the option of the holder, in September 2006 and September 2008 at
par plus accrued interest.
(2) The 8% Notes include $2.8 million of principal and $1.3 million of future
accrued interest (see Note 2 of the Notes to Consolidated Financial Statements).
(3) On October 4, 2002, the principal operating subsidiaries of Company retired,
prior to maturity, all of the debt outstanding under the MCG Credit Facility
Agreement.
(4) Excluded from these contractual obligations are operating lease obligations
and network service obligations. 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. As of December 31, 2001, the Company had
future minimum annual lease obligations under noncancellable operating leases
with terms in excess of one year as follows: 2002 - $1.8 million, 2003 - $1.7
million, 2004 - $1.4 million, 2005 - $0.9 million, 2006 - $0.4 million and 2007
and thereafter - $0.3 million. The Company is also party to various network
service agreements, which contain certain minimum usage commitments. The largest
contract establishes pricing and provides for annual minimum payments for the
years ended December 31, as follows: 2002 - $22.2 million, 2003 - $22.8 million
and 2004 - $27.9 million. A separate contract with a different vendor
establishes pricing and provides for annual minimum payments for the years ended
December 31, as follows: 2002 - $3.0 million, 2003 - $6.0 million and 2004 -
$3.0 million. As a consequence of these minimum network service obligations,
unless the Company can re-price or restructure these obligations or obtain
additional minutes of usage from the wholesale or other long distance markets,
of which there can be no assurances that the Company will be able to accomplish,
the Company will experience an increase in per minute network costs.
The Company relies on cash generated from operations and cash and cash
equivalents on hand to fund its capital and financing requirements. The Company
had $41.1 million of cash and cash equivalents as of September 30, 2002, and
$22.1 million as of December 31, 2001.
22
Net cash provided by operating activities was $35.2 million for the nine
months ended September 30, 2002 compared to net cash used in operating
activities of $8.1 million for the nine months ended September 30, 2001. For the
nine months ended September 30, 2002, the major contributors to the net cash
provided by operating activities were the net income of $30.9 million and
non-cash charges of $22.1 million, primarily consisting of provision for
doubtful accounts of $9.0 million and depreciation and amortization of $13.5
million. These amounts were offset by an increase in accounts receivable of $6.0
million and a decrease in accounts payable of $13.3 million. For the nine months
ended September 30, 2001, the net cash used in operating activities was mainly
generated by the net loss of $235.1 million, an increase in accounts receivable
of $68.2 million, a decrease in accounts payable and accrued expenses of $7.6
million and a non-cash extraordinary gain on restructuring of contingent
redemptions of $16.9 million, offset by non-cash charges of $319.3 million. The
non-cash items primarily consisted of provision for doubtful accounts of $79.4
million, depreciation and amortization of $29.3 million, impairment and
restructuring charges of $171.2 million and the cumulative effect of an
accounting change for contingent redemptions of $36.8 million.
Net cash used in investing activities was $4.8 million during the nine
months ended September 30, 2002, which consisted of capitalized software
development costs of $1.8 million and capital expenditures for the purchase of
equipment of $3.0 million. Net cash used in investing activities was $3.6
million during the nine months ended September 30, 2001, which primarily
consisted of capitalized software development costs of $0.7 million and capital
expenditures for the purchase of equipment of $2.8 million.
Net cash used in investing activities was $1.5 million during the three
months ended September 30, 2002, which consisted of capitalized software
development costs of $0.6 million and capital expenditures for the purchase of
equipment of $0.9 million. The Company anticipates incurring for the full year
2002 capital expenditures of approximately $4 million and capitalized software
development costs of approximately $2.5 million. The Company expects to incur
capital expenditures of between $8 million and $10 million and capitalized
software development costs of between $2 million and $3 million in 2003,
including approximately $5.5 million of networking equipment and software. The
FCC is currently undertaking its triennial review of local phone competition
including the continued availability of certain unbundled network elements and
switching (see "Liquidity and Capital Resources, Other Matters").
Net cash used in financing activities for the nine months ended September
30, 2002 was $11.4 million compared to $4.9 million for the nine months ended
September 30, 2001. The net cash used in financing activities for the nine
months ended September 30, 2002 was primarily attributable to payment of
borrowings under the Company's Senior Credit Facility of $3.8 million, payments
related to the maturity the remaining $3.9 million principal balance of its
outstanding 4 1/2% Notes, payments under its 8% Convertible notes due 2011 of
$1.9 million, payments in connection with exchange of the Company's 4 1/2% Notes
for 8% Notes of $0.5 million and payments under capital lease obligations of
$1.0 million. The cash used in financing activities for the nine months ended
September 30, 2001 of $4.9 million was primarily attributed to payment of
borrowings under the Company's credit facility of $1.3 million and payments in
connection with the restructuring of the AOL contingent redemptions of $3.5
million. On October 4, 2002, the principal operating subsidiaries of Company
retired, prior to maturity, all of the debt outstanding under the MCG Credit
Facility Agreement of $13.8 million.
For the three months ended September 30, 2002, $1.7 million of interest
expense was recorded as additional principal on the 12% Notes and 8% Convertible
Notes due 2011 due to payment of interest in kind rather than cash.
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.
CONVERTIBLE SUBORDINATED NOTES AND EXCHANGE OFFERS (see Note 2 of the Notes to
Consolidated Financial Statements)
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 mature on September 15, 2002 into $53.2
23
million of new 12% Senior Subordinated PIK Notes due August 2007 ("12% Notes")
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% Notes.
The Company paid at maturity the remaining $3.9 million principal balance
of its outstanding 4 1/2% Convertible Subordinated Notes due September 2002.
AOL AGREEMENTS (see Note 3 of the Notes to Consolidated Financial Statements)
On September 19, 2001, the Company restructured its financial obligations
with AOL that arose under the 1999 Investment Agreement and also ended its
marketing relationship with AOL effective September 30, 2001 (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 had outstanding as of September 30, 2002, $34.3
million principal amount of its 8% secured convertible notes due September 2011.
With the issuance of additional shares under the Restructuring Agreement, AOL
also held 2,400,000 shares of Company common stock.
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 ILEC 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 intends to review all UNEs and determine
whether ILECs should continue to be required to provide them to competitors.
Among other things, the FCC has indicated that it will consider whether ILECs
should continue to be required to provide the "local switching" UNE, an
essential component of the UNE-P combination. Any curtailment by the FCC in the
availability of the local switching UNE would materially impair the Company's
ability to provide local telecommunications services, and 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. On May 24, 2002, the
United States Court of Appeals for the D.C. Circuit released an opinion in
United States Telecom Association v. Federal Communications Commission remanding
to the FCC for further consideration the Unbundled Network Element Remand Order,
which may provide the FCC with justification for significantly reducing the
unbundling obligations of the ILECs as part of the UNE Triennial Review.
The FCC requires the Company and other providers of telecommunication
services to contribute to the USF, 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 FCC is currently considering modifications to the USF
program that may go into effect as early as the end of 2002. Changes to the
methodology used in the calculation of the collection and payment of USF charges
may have an adverse impact on the Company's gross margin.
At December 31, 2001, the Company had net operating loss (NOL)
carryforwards for federal income tax purposes of $262.8 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, 2001, approximately $64.0 million
of NOL carryforwards were not available 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 45% 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
24
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 has provided for a valuation allowance of approximately $80
million for its net deferred tax assets as of September 30, 2002, primarily
related to the Company's NOL carryforwards. The third quarter of 2002 represents
the fourth consecutive quarter of profitability for the Company. In the fourth
quarter of 2002, as part of its 2003 budgeting process, management will evaluate
the valuation allowance and, if appropriate after the evaluation, will reverse
all or a portion of this valuation allowance resulting in a non-cash deferred
income tax benefit on the statement of operations. At that time, the Company
would record the estimated net realizable value of the deferred tax asset and,
beginning in 2003, would provide for 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 would be shielded from
paying cash income taxes for several years.
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 and having
retired the Company's Senior Credit Facility prior to maturity and restructured
most of its outstanding convertible notes through the exchange offers, 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
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
25
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 telecommunication
services and features that are billed one month in advance. In addition, it
includes the amortization of a non-refundable prepayment received in 1997 in
connection with a telecommunications services agreement entered into by the
Company. The payment is amortized over the five-year term of the agreement,
which expired October 2002. The amount included in revenue was $1.9 million in
each of the quarters ended September 30, 2002 and 2001. The remaining amount of
$0.6 million will be included in revenue during the fourth quarter of 2002.
Allowance for Doubtful Accounts. The Company reviews accounts receivable,
historical bad debt, and customer credit-worthiness through customer credit
scores, current economic trends, changes in customer payment history and
acceptance of the Company's calling plans and fees when evaluating the adequacy
of the allowance for doubtful accounts. If the financial condition of the
Company's customers 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 $23.6 million, net of allowance for doubtful
accounts of $12.0 million, as of September 30, 2002.
Valuation of Long-Lived Assets and Intangible Assets with a Definite Life.
The Company continually 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. 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 quarter ended September 30, 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
testing for goodwill is performed at a reporting unit level. 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 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.
26
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
in an amount that is more likely than not to be realized. The Company has
provided for a valuation allowance of approximately $80 million for its net
deferred tax assets as of September 30, 2002, primarily related to the Company's
NOL carryforwards. The third quarter of 2002 represents the fourth consecutive
quarter of profitability for the Company. In the fourth quarter 2002, as part of
its 2003 budgeting process, management will evaluate the valuation allowance
and, if appropriate after the evaluation, will reverse all or a portion of this
valuation allowance, resulting in a non-cash deferred income tax benefit. At
that time, the Company would record the estimated net realizable value of the
deferred tax asset and, beginning in 2003, would provide for 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 would
be shielded from paying cash income taxes for several years.
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.
ITEM 3. 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 realizability of the carrying values of its long-term assets.
The Company's long-term obligations consist primarily of its own notes and
credit facility. The Company does not presently enter into any transactions
involving derivative financial instruments for risk management or other purposes
due to the stability in interest rates in recent times and because management
does not consider the potential impact of changes in interest rates to be
material.
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.
ITEM 4. 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.
27
PART II - OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES.
On October 15, 2002, the stockholders of the Company approved an amendment
to the Company's Amended and Restated Certificate of Incorporation to effect a
one-for-three reverse stock split of the Common Stock of the Company ("Reverse
Split"). The Reverse Split was effective as of 5:00 pm, EDT on October 15, 2002
("Effective Date"). Pursuant to the Reverse Split, each holder of three shares
of Company common stock, par value $0.01 per share ("Old Company Common Stock"),
immediately prior to the Effective Date became the holder of one share of
Company common stock, par value $0.01 per share ("New Company Common Stock")
after the Effective Date. As a result, 27,273,344 shares of Common Stock and no
shares of preferred stock were outstanding immediately following the Effective
Date. Following the Reverse Split, the Company has 100 million shares of
authorized Common Stock, par value $.01 per share and 5 million shares of
authorized preferred stock.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
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.
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.
(b) Reports on Form 8-K
During the quarter ended September 30, 2002, the Company filed no Current
Reports on Form 8-K, although the Company filed Current Reports on Form 8-K on
October 11 and October 16, 2002 in connection with the Company's reverse stock
split and the Company's early retirement of its Senior Credit Facility,
respectively.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TALK AMERICA HOLDINGS, INC.
Date: November 12, 2002 By: /s/ Gabriel Battista
------------------------
Gabriel Battista
Chairman of the Board of Directors,
Chief Executive Officer and Director
Date: November 12, 2002 By: /s/ David G. Zahka
------------------------
David G. Zahka
Chief Financial Officer
(Principal Financial Officer)
Date: November 12, 2002 By: /s/ Thomas M. Walsh
------------------------
Thomas M. Walsh
Senior Vice President - Finance
(Principal Accounting Officer)
29
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 quarterly report on Form 10-Q of Talk America
Holdings, Inc.;
2. Based on my knowledge, this quarterly 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 quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly 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 quarterly
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 quarterly report (the "Evaluation Date"); and
c) presented in this quarterly 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
quarterly 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.
November 12, 2002
/s/ Gabriel Battista
----------------------
Gabriel Battista
Chief Executive Officer
30
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 quarterly report on Form 10-Q of Talk America
Holdings, Inc.;
2. Based on my knowledge, this quarterly 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 quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly 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 quarterly
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 quarterly report (the "Evaluation Date"); and
c) presented in this quarterly 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
quarterly 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.
November 12, 2002
/s/ David G. Zahka
---------------------
David G. Zahka
Chief Financial Officer
31