Item 1.
Business
The terms “the Company,” “Pac-West,” “we,” “our,” “us,” and similar terms as used in this Form 10-K, refer to Pac-West Telecomm, Inc.
Our Company
We were incorporated in May 1996 in the State of California. Our predecessor (also known as Pac-West Telecomm, Inc.), which transferred its telephone division to our Company effective September 30, 1996, began offering long distance service in 1982 and local service in 1996 in California. Today we have evolved into a high-value independent broadband provider of integrated business communications solutions within our target markets. Our customers include Internet service providers (ISPs) and enhanced communications service providers, collectively referred to as service providers (SPs), and the enterprise market, also referred to as small and medium sized enterprises (SME) business, many of which are communications-intensive users. We built our facilities-based network to capitalize on the significant growth in Internet usage and in the related demand for local telephone service by SPs, as well as the increasing demand of the enterprise market for customized and integrated voice and data communications services. We believe the statewide footprint of our network, which encompasses all of the major metropolitan areas of California, provides us with a competitive advantage over incumbent local exchange carriers (ILECs), and other competitive local exchange carriers (CLECs), particularly for SPs. Our ubiquitous network in California enables SPs to provide their business and residential customers with access to Internet, paging and other data and voice services from almost any point in the state through a local call. We believe the breadth of our product offerings and the structure of our network enable us to generate high network utilization and strong gross profit margins.
Markets
We believe the opening of local markets to competition, growth in local traffic related to increases in Internet access, and the desire for one-stop integrated services by SME businesses continues to present significant opportunities for us. We have traditionally focused on offering our services to SP and SME businesses, primarily within California.
Enterprise market. We have continued to analyze the business and telecommunication needs of our enterprise customers. Our analysis suggests that certain of our enterprise customers operate within vertical markets that may present significant opportunities to focus our efforts and increase market share. We believe that our existing product set will resonate with potential vertical markets because of greater perceived value. We have analyzed the total market opportunity and available market share in each of these industries with respect to spending for telecommunication services. In all cases we believe that significant opportunity exists to sell deeper into these vertical markets by capitalizing on our past successes in each industry.
We believe that the benefits of vertical marketing can be immense. As competition drives down margins, solution selling into vertical markets enables real competitive differentiation, and allows increasingly sustainable profit margins. By focusing on vertical market solutions, we plan to move further away from the commodity voice sale toward higher-margin, value-added services. We believe the vertical approach to marketing strengthens customer loyalty by developing closer links to the customer’s core business. To that end, we intend to emphasize the customization of our products, services, sales presentations, customer service support, documentation, and training for those vertical markets where we believe we can continue to realize market share gains.
We also believe our horizontal marketing efforts will provide significant benefits for our enterprise business. In particular, we are beginning to capture the attention and brand loyalty of several important and, we believe underserved ethnic markets, including the Hispanic market. We are developing
marketing tools that can help determine buying patterns and propensity to buy, based on generational, psychological, and technical metrics. Our geography and our understanding of how and which of these horizontal markets are growing, will allow us to be more efficient with sales efforts and improve our prospect to close ratios.
We are investing additional resources in our marketing efforts. We believe this will accelerate sales across both enterprise and SP business units by:
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increasing the width of our sales channels;
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increasing the depth of sales opportunities (funnels); and
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supporting the sales force to be more effective at converting opportunity into revenue.
SP market. We continue to focus on the ISP segment, as well as the enhanced service provider (ESP) segments. With the evolution of VoIP technology, many new applications over Internet provider are available through these ESPs and have consequently presented new sales opportunities, as well as new product development efforts. To capitalize on this evolution of technology, we are providing core network technologies that have been part of our product solutions for several years, as well as overlaying applications that ride over the core access technology that is in place today.
One of our first overlay products was our Dial Broadband solution. This solution enables the end user to experience dial up speeds up to two to three times faster than traditional dial up. In our markets, we have also targeted segments in rural locations which have difficulties obtaining high speed Internet access and have presented these areas with this alternative for faster Internet connections. We believe acceleration will become the dial up standard and we are prepared to meet that developing industry standard.
We have also begun leveraging the vertical marketing efforts we have done in our enterprise market for the SP market. We have enabled customers to better serve the Hispanic segment with our Hispanic programs and support. Additionally, we have targeted and supported many of the educational institutions in their requirements for a variety of product solutions through the introduction and enablement of our direct SP customers solutions.
Network
We built our facilities-based network to capitalize on the significant growth in demand for Internet access and data and voice communications in addition to the increasing demands of SME businesses for customized, integrated communications services. We use a ”smart-build” strategy, building and owning intelligent components of our network while leasing high capacity digital loops and transport lines from other carriers. We believe that this strategy provides us with significant cost and time-to-market advantages over competitors that own both their switches and access networks. By owning our switches, we can configure our network to provide high performance, high reliability and cost-effective solutions for our customers’ needs. By leasing our transport lines, we can reduce up-front capital expenditures, rapidly respond to increased demand, and provide low-cost redundancy. In addition to leasing our transport lines, we have an Indefeasible Right of Use (IRU) agreement, which expires in 2020 with a purchase option for dedicated fiber optics circuits of OC-48 capacity connecting the major metropolitan areas within California, which are high volume markets for us. This IRU became operational in July 2002 and is intended to provide us with greater flexibility in creating and managing data and voice services. As we continue to transition existing circuits to the IRU, we anticipate being able to optimize our network costs.
Our ubiquitous network in California enables SPs to provide their business and residential customers with access to Internet, paging and other data and voice services from almost any point in the state through a local call. In this way, our customers can achieve statewide coverage with significantly lower capital and operating expenses. We currently aggregate and concentrate all of our network traffic
into our high volume switching sites, called SuperPOPs. Our switching sites offer SPs highly reliable, tandem switching and the option to build lower cost networks by collocating equipment at our switching sites rather than in each local access and transport area (LATA). Our network includes digital connections in all LATAs in California as well as in key LATAs in Nevada, Washington, Oregon and Arizona. In addition, our interconnection arrangements and statewide leased transport network allow SPs to obtain coverage throughout the West Coast at local calling rates, which reduces switching and transmission costs.
Our facilities-based network also enables us to provide our SME business customers with local and long distance voice services, Internet access and high-speed data transport, giving them the ability to send and receive e-mail, exchange data between branch offices, and quickly download information from the Internet. By capitalizing on the growing demands of our SME business customers, we increase the incremental usage of our network as the peak hours for these customers are during the workday, the opposite of the peak hours of our SP customers, allowing for the maximum utilization of our network.
We believe that our network’s broad market coverage results in:
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a higher volume of communications traffic both originating and terminating on our network, which supports strong operating margins;
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enhanced reliability at competitive prices;
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the ability to leverage our investment in high capacity switching equipment and electronics;
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the opportunity for our network to provide backhaul carriage for other telecommunications service providers, such as long distance and wireless carriers; and
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access to an increased number of buildings with multiple tenants that can be directly connected to our switching network, which aids in maximizing the number of customers to which we can offer our services.
As of December 31, 2003, we had an installed capacity of 998,400 ports in California, Nevada, Washington and Arizona. We currently own and operate eleven Alcatel digital tandem switches in or near Los Angeles (three switches), Oakland (three switches) and Stockton (two switches), California with one switch each in Las Vegas, Nevada, Phoenix, Arizona and Seattle, Washington.
Switching Platform. Currently we exclusively use Alcatel USA’s digital tandem switches to switch calls between originating locations and final destinations. Although the switches we use are no longer in production, on-going maintenance and support for our switches is still provided to us by Alcatel. Our tandem switches have high call carrying capacity and multiple path call routing capabilities. Tandem switches are ideally suited for handling the high call volumes and long duration times involved in serving SP customers. Our uniform switching platform combined with the intelligence of our customized call processing software and adjunct processors enable us to:
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deploy features and functions quickly throughout our entire network;
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expand switch and transport capacity in a cost-effective, demand-based manner; and
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lower maintenance costs through reduced training and spare parts requirements.
With the recent advancements in switch technology, we are currently investigating our options for the deployment of our first next generation network switch, which represents the latest technological improvements in switch capacity and configuration, sometime during 2004.
Transmission Capacity. We currently lease our transmission facilities from inter-exchange carriers, ILECs and other CLECs. We generally seek to lease fiber optic transmission facilities from multiple sources in each of our markets. In addition, as discussed above, we have purchased long-term rights of use and operate a high capacity fiber IRU connecting the major metropolitan areas within California.
Interconnection. We have established interconnection agreements (ICAs) with certain ILECs. The Telecommunications Act of 1996 requires ILECs to enter into ICAs with CLECs, such as us, and other competitors and requires state Public Utilities Commissions (PUCs) to arbitrate such agreements if the parties cannot reach agreement. The ICAs govern, among other items, intercarrier compensation agreements for the exchange of local and local toll calls between the parties. We presently have interconnection agreements with:
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Pacific Bell Telephone Co., d/b/a SBC California (SBC);
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Verizon California, Inc. (Verizon);
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Citizens Telecommunication Company of California, Inc.;
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Roseville Telephone Co. in California;
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Central Telephone Company (d/b/a Sprint of Nevada);
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Cox California Telcom, LLC;
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AT&T Wireless Services, Inc. in California;
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Nevada Bell in Nevada;
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U.S. West Communications, Inc. (Qwest);
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GTE Northwest, Inc. (Verizon) in Washington and Oregon;
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U.S. West Communications, Inc. (Qwest) in Arizona; and
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Sprint Spectrum L.P (network-wide).
As described below under “Significant Relationships,” we derive a significant portion of our revenues from reciprocal compensation payments under ICAs. In addition, as described below under “Regulation,” reciprocal compensation payments and the terms of the ICAs are regularly the subject of disputes among the parties to such agreements.
Strategy
We have positioned ourselves as the high-value, independent broadband provider of integrated business communications solutions within our target markets. We believe that providing superior levels of customer service and network reliability while continuing to focus on reducing our expenses and offering products that provide stronger margins represents the key to our competitive positioning strategy. Our complementary SP and business enterprise markets enable us to achieve maximum network efficiency as they generally have peak periods of use at different times during the day. Our goal is to build on our momentum by pursuing the following initiatives:
Continue to emphasize superior customer service. Our goal is to fully understand our customer needs and to be recognized as the industry leader for customer service. We believe that this focus on superior customer service on a company-wide basis, which we have internally branded as “Five Star,” will provide us with the ability to sustain high levels of customer loyalty and allow us to achieve benchmark industry levels of customer retention and contract renewal.
Grow the SP base through sales and services. We are a leading provider of dial up Internet access and other Internet infrastructure services to SPs in our target markets. In California, we believe we provide our SP customers with the underlying infrastructure utilized by over 20% of the states’ residential dial up Internet subscribers. While the demand for Internet access in our target markets continues to grow, the demand for dial-up Internet access has slowed in recent years. In spite of this market environment, we have continued to achieve significant line growth primarily due to what we believe is our superior value proposition created by our coverage and service reliability. Furthermore, in order to inspire loyalty and to increase usage across our network, we are researching new services to
assist our SP customers with identifying operational improvements in their networks and new revenue enhancement products, which they can re-sell to their customers. For example, in 2003, we launched Dial Broadband, a web acceleration service that more than doubles the speed of a dial-up connection with no additional hardware or software required.
Grow the business enterprise base through sales and services. We believe that SME businesses have significant and increasing needs for advanced communications services. Many of our target customers want technologically advanced communications systems along with high quality bundled local, long distance, data and other enhanced services, but have limited resources and expertise to design, purchase and maintain these kinds of systems and services. Federal Communications Commission (FCC) annual reports indicate that the ILECs have a dominant share of the market in most telecommunication markets in California. We believe that these ILECs, and other CLECs operating within the state, do not adequately serve these target customers. We intend to continue our efforts to become a leading provider of integrated broadband communications services to SME businesses in California and Nevada by providing a complete product offering customers may choose from which include system design, equipment installation and maintenance, voice, data and long distance services, 24/7 support and subscription services with multi-year contracts. We believe that this product mix combined with our new segmentation strategy will enable us to penetrate more deeply our target markets and continue to build customer loyalty.
Develop or acquire the next market opportunity. We are constantly exploring methods of entering new markets and providing new services. For example in the fourth quarter of 2003 we entered into a joint operating agreement with Sentient Group, Inc. (Sentient) to jointly develop opportunities for the application of voice over Internet protocol (VoIP) services to the enterprise market, and in the first quarter of 2004 we acquired substantially all of the assets, and assumed certain specified liabilities of Sentient’s VoIP business. VoIP utilizes high-speed data networks rather than traditional phone lines to complete calls, offering customers enhanced functionality and potential cost savings over traditional carrier networks. VoIP services are rapidly gaining momentum in the enterprise market as the quality and reliability continue to improve and broadband becomes more affordable. This acquisition is a key step in our efforts to increase market share in California. In addition to developing or acquiring new services, we are exploring opportunities to acquire complementary businesses in our existing markets as well as new markets. In particular, we believe there is an opportunity over the next 12 to 18 months to make such acquisitions on attractive terms to us.
Continue improving our financial foundation. We continue to further explore methods of reducing our debt level and cash interest expense. During 2003 and 2002 we made substantial progress in reducing our overall debt level by repurchasing 75.9% of our outstanding Senior Notes due 2009 (Senior Notes) as of December 31, 2001. In addition, in 2003, we attracted $40 million in new debt financing from Deutsche Bank AG - New York, acting through DB Advisors, LLC, as investment advisor (Deutsche Bank) in a difficult funding environment for our industry.
Improve our infrastructure. We have built one of the most comprehensive and reliable networks in California. We carry over 120 million minutes of voice and data traffic per day, and an estimated 20% of the dial-up Internet traffic in California. Through our SP customers, millions of people rely on us every day to access the Internet and other voice and data services through a local dial-up number. Network reliability is critical to our customers. With the recent advancements in switch technology, we are currently investigating our options for the deployment of our first next generation network switch, which represents the latest technological improvements in switch capacity and configuration, sometime during 2004. In addition, we completed a modem replacement program in the first quarter of 2004 which we expect will provide us with increased operational efficiencies. We continue to seek further ways to enhance our infrastructure not only in 2004, but also beyond.
Products and Services
Our products and services are designed to appeal to targeted telecommunications needs of our customers, which fall primarily into two categories: SPs, to whom we provide wholesale services and SME business enterprises, to whom we provide retail services.
Wholesale services to SPs. As a wholesale services provider, we offer a number of network services to several long-standing customers, as well as to new and emerging markets. These services consist of several options which may be combined or purchased from us as stand-alone services. Our primary SP services consist of:
Dial Broadband. In 2003, we launched Dial Broadband, a web acceleration service that more than doubles the speed of an end-user’s dial-up connection with no additional hardware or software required.
High-Volume Multi-Rate Center Local Service. This service offers our customers the ability to establish local points of presence (POPs) throughout our network with minimal capital investment, which dramatically expands their coverage, while at the same time reduces their overall costs.
Dial Access Services. A packaged product that includes incoming call access lines, modems, routers, and authentication services. This product provides SP customers with a non-capital intensive means of quickly establishing local points of presence throughout our coverage area. This service can be delivered through a fixed monthly recurring charge, or as a pay as you go, usage based model. Additionally, we provide customer facing reporting tools that allow our customers to effectively manage their traffic patterns that ride the modem platform.
Collocation. Collocation enables our customers to install their equipment in any or all of our switch facilities and interconnect directly to our central office switching, transport and data equipment. Collocated equipment is protected by the same cooling, power back-up and security systems protecting our switches. An SP’s ability to collocate equipment at a limited number of sites, rather than in each LATA, reduces their capital expenditures and maintenance requirements. We receive monthly rental revenue from the SP for the space and power used.
Retail services for SME businesses. We provide integrated voice and data communications solutions through three primary service packages:
Direct Digital Telephone Service (DDTS). This service is an integrated solution consisting of system design, equipment installation and maintenance combined with voice and data communications services. For a monthly fee, we offer feature-rich digital telephone sets bundled together with local and long distance services, Centrex-type direct inward dialing, voice mail and maintenance. Additionally, our Data Advantage and Data Advantage Internet services are commonly added to this bundled service.
Facilities Based Dial Tone (FBDT). This service is marketed toward SME businesses, that already own their phone system. For a monthly fee, we provide these customers with an integrated solution of voice and data services, typically consisting of local and long distance services, data transport and Internet access services.
Integrated Access Service (IAS). This service is targeted at SME businesses that currently have analog telephone service, such as a key system or Centrex service. IAS offers these customers a cost-effective solution for receiving integrated voice and Internet services over a single T-1.
The primary communication services offered in the service packages noted above are:
Local Services. We provide local dial-tone services to SME business customers, allowing them to complete calls in a local calling area and to access long distance carriers. Local services and long distance services can be bundled together using the same transport facility. Our network is
designed to allow customers to easily increase or decrease capacity and alter enhanced communications services as the communications requirements of their businesses change. In addition to our core local services, we also provide access to third party directory assistance and operator services.
Long Distance Services. We provide domestic and international long distance services. Long distance calls that do not terminate on our network are passed to long distance carriers which route the remaining portion of the call. Our ability to integrate local and long distance services allows us to aggregate customers’ monthly recurring, local usage and long distance charges on a single, consolidated invoice.
Data Transport and Internet Access. We provide data communications solutions that enable SME customers with multiple locations to connect their sites through our data network. Additionally, we offer SME customers the ability to access the public Internet via a dedicated broadband T-1 or fractional T-1 connection.
Enhanced Services. In addition to providing typical enhanced services such as voicemail, call transfer and conference calling, we offer additional value-added enhanced services to compliment our core local and long distance services such as our voice and fax mail service, constant touch, remote call forwarding and four digit dialing between customer locations on our network.
Sales and Marketing
Sales. We have built an experienced direct sales force. We recruit salespeople with strong sales backgrounds in our existing and target markets, including salespeople from long distance companies, telecommunications equipment manufacturers, network systems integrators and ILECs. We plan to continue to attract and retain highly qualified salespeople by offering them an opportunity to work with an experienced management team in an entrepreneurial environment and to participate in the potential economic rewards made available through a results-oriented compensation program that emphasizes sales commissions. We currently have seven retail sales offices, six of which are located in California with one in Nevada. Our retail customer relations team is responsible for renewals and continued growth of our SME customer base. Additionally, we have an experienced sales force to source new customer SP opportunities from around the country. Our SP team members also have customer relations managers to administer the growth and maintenance of our largest SP customers.
Marketing. We seek to position ourselves as a provider of superior customer service and a high-value independent broadband provider of integrated business communications solutions within our target markets by offering a high level of network reliability, superior customer service on a company wide basis, which we have branded as “Five Star” and bundled solutions for competitive value. We have built and intend to continue to build our reputation and brand identity by working closely with our customers to help them grow their businesses and develop services tailored to their particular needs.
Vertical and Horizontal Markets. We have continued to segment and analyze the business and communications needs of our enterprise customers. Our analysis suggests that certain of our enterprise customers operate within vertical markets that may present significant opportunities to focus our efforts and increase market share. We believe our existing product set will resonate with potential customers in these vertical markets because of greater perceived value. We have analyzed the total market opportunity and available market share in each of these vertical markets with respect to spending for telecommunication services. We believe that a significant opportunity exists to sell deeper into these vertical markets by capitalizing on our past successes in each industry.
Customer and Technical Service. We believe that our ability to consistently deliver superior customer and technical service is a key factor in acquiring new customers and maximizing retention of existing customers. We have developed a customer service strategy designed to effectively meet the service requirements of our target customers. The assigned customer relations managers for each customer provides the first line of customer service by identifying and resolving any customer concerns
through real time problem identification and resolution. Our customer relations managers are also supported by our experienced engineering and technical staff who are available to meet customer requests as needed.
Customers
A significant targeted market segment for us is the business enterprise segment. The demands by SMEs for customized integrated voice and data communications services allow us to increase the incremental usage of our networks during workday hours. SP customers tend to utilize our network primarily during evening and weekend hours. These complimentary traffic patterns generated by our two primary customer segments allows for increased utilization of our network.
We also focus on providing integrated broadband communications services to SPs, many of which are communications-intensive users. SP customers offer Internet access, unified messaging platforms, pre-paid platforms, fax mail services, and voice mail services and represent potential large volume users of our services. The characteristics of this market segment not only offer us the potential to sell more trunks and bill more minutes of use but also allow us to improve the utilization of our resources. For the years ended December 31, 2003, 2002 and 2001, direct billings to SP customers accounted for approximately 33.4%, 25.3% and 26.2% respectively, of our total revenues. SP revenues do not include reciprocal compensation, which is earned by terminating calls on our network sent to us by other telecommunication carriers, long distance services and dedicated transport services.
We also have intercarrier customers who pay us to terminate their originating call traffic on our network. These payments consist of meet point, transit traffic and reciprocal compensation payments, collectively referred to as reciprocal compensation. Reciprocal compensation payments are a function of the number of calls we terminate, the minutes of use associated with such calls and the rates we are compensated at by the ILECs. As described below under “Significant Relationships” reciprocal compensation payments have historically been a significant portion of our revenues but the intercarrier payments are not currently a targeted customer.
Financial Information about Industry Segments
We operate in a single industry segment, telecommunications services. Based on criteria established by SFAS No. 131 (SFAS 131), “Disclosures about Segments of an Enterprise and Related Information,” we have determined that we have one reportable operating segment. While our chief decision-maker monitors the revenue streams of various services, the revenue streams share many expenses such as leased transport charges and circuits. In addition, operations are managed and financial performance is evaluated based upon the delivery of multiple services over common networks and facilities. This allows us to leverage our costs in an effort to maximize return. As a result, the revenue streams share almost all of the various operating expenses. Because we believe that any allocation of the expenses to multiple revenue streams would be impractical and arbitrary, we do not currently make such allocations internally. Our chief decision-maker does, however, monitor revenue streams at a more detailed level than those depicted in our consolidated financial statements.
Seasonality
There is no significant seasonality to any of our products or services although some of our customers do experience some seasonality in their business and related demand for telecommunications services. However, we believe that the seasonality effects of the businesses of individual customers does not have a significant impact on our consolidated revenues.
During 2003, we implemented new interconnection agreements and the terms of the related reciprocal compensation obligations with SBC and Verizon in California along with several other smaller carriers. Our reciprocal compensation average rate per minute of use declined later in 2003 largely because of the decision made by Verizon and SBC to implement the Federal rate caps. This resulted in
the withholding of reciprocal compensation payments to us by Verizon for the final five months and SBC for the final month in 2003. If this trend is repeated in 2004 it could mean that reciprocal compensation payments to us in the later months of the calendar year may be substantially less than reciprocal compensation payments to us in earlier periods of the year. Further details relating to the regulatory issues regarding Federal rate caps are further discussed in “Regulation” below.
Significant Relationships
Reciprocal compensation payments from ILECs accounted for 35.0%, 48.7% and 41.6% of our total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. Reciprocal compensation payments recorded as revenue in 2003 includes payments received for settlements in connection with disputes over previously withheld reciprocal compensation payments, which amounted to $5.7 million, or 4.2%, of our total 2003 revenue. The revenues from these ILECs are the result of ICAs we have entered into with them that provide for the transport and termination of local telecommunication traffic. Reciprocal compensation payments are currently an important source of revenue for us, and as a result, the failure, for any reason, of one or more ILECs from which we receive reciprocal compensation payments to make all or a significant portion of such payments in the future could adversely affect our financial condition. Reciprocal compensation payments are a function of the number of calls we terminate, the minutes of use associated with such calls and the rates we are compensated at by ILECs. Though actual calls and minutes increased significantly in 2003 compared to 2002, reciprocal compensation revenues decreased due to lower compensation rates enacted by both SBC’s and Verizon’s adoption of the FCC order. During 2003, we experienced an average decrease of approximately 46.4% in the rate at which we are compensated at by the ILECs. This decrease was due to lower compensation rates enacted by both SBC’s and Verizon’s adoption of the FCC order. This resulted in the withholding of reciprocal compensation payments by Verizon for the final five months and SBC for the last month in 2003. Further details relating to the regulatory issues regarding Federal rate caps are further discussed in “Regulation” below.
Revenues from our three largest customers provided the following percentage of total revenues for the years ended December 31, 2003, 2002 and 2001.
No other entities accounted for more than 10% of our total revenues for these periods.
SBC, from whom we are paid the largest amount of reciprocal compensation, is also our largest source of operating costs, accounting for 37.3%, 32.4% and 34.9% of our network expenses for the years ended December 31, 2003, 2002 and 2001, respectively.
Competition
The telecommunications industry is both highly competitive and dominated by the ILECs who enjoy the benefit of significant market share earned over a time when there was little to no competition in the marketplace. In this environment, we believe that the principal competitive factors differentiating our business from the competition will be customer service, network reliability, accurate billing, pricing levels and policies, and, to a lesser extent, a unique range of products and service offerings. Our ability to compete effectively will depend upon our continued ability to deliver high quality, value added, services at prices which are in accordance with accepted market rates. We believe that our ability to provide exceptional customer service in tandem with our unique statewide network in California will differentiate us in the marketplace. Many of our current and potential competitors have financial, personnel, and other resources, including brand name recognition, substantially greater than ours as well as other
competitive advantages over us. Although we must be in a position to reduce our prices, if necessary, to meet rate reductions by our competitors, any such reductions could adversely affect us.
Incumbent Local Exchange Carriers. We complete principally with the ILECs serving each of the markets we target, such as SBC and Verizon in California, and Qwest in Arizona, Oregon, and Washington. Some ILECs in our territory, including Verizon and SBC in California, and Qwest in Washington, are offering long distance services to their local telephone customers. Qwest, SBC, and Verizon obtained approval to enter the long distance market in their respective territories. We believe ILECs will attempt to further entrench their market share by capitalizing on their strong regional brand names and through the use of extensive advertising campaigns, targeted primarily to the residential and SME segment. For more information, please refer to discussion below in “Regulation”.
Due to the market dominance of the ILECs and other local telephone companies, we have not achieved a significant market share for any of our SME business services. In particular, the ILECs and other incumbent local telephone companies have:
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long-standing relationships with their customers;
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financial, technical and marketing resources substantially greater than ours;
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the potential to subsidize competitive services with revenues from a variety of businesses;
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long-standing relationships with regulatory authorities at the Federal and state levels; and
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currently benefit from certain existing regulations and regulated subsidies that favor the ILECs over their competitors in certain respects.
While regulatory initiatives, which allow CLECs such as ourselves to interconnect with ILEC facilities, provide us with increased business opportunities, such interconnection opportunities have been, and likely will continue to be, accompanied by increased pricing flexibility for, and relaxation of regulatory oversight of, the ILECs.
Competitive Access Carriers/ Competitive Local Exchange Carriers/ Other Market Entrants. We also face, and expect to continue to face, competition from other current and potential market entrants, including long distance carriers seeking to enter, reenter or expand entry into the local exchange market such as AT&T Corporation, MCI, formerly known as WorldCom, Inc and Sprint Corporation and from other CLECs, possibly out-of-region ILECs, resellers of local exchange services, cable television companies, electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end users. In addition, a renewed trend toward consolidation as a result of mergers, acquisitions and strategic alliances in the telecommunications industry could also affect the level of competition we face. Consolidation has already occurred in the ILEC industry, with the consolidations of Qwest and US West, Bell Atlantic Corp., and GTE Corp., and SBC and Pacific Bell. These types of consolidations put us at a greater competitive disadvantage.
The Telecommunications Act of 1996 imposes certain regulatory requirements on all local exchange carriers, including competitors such as ourselves, while granting the FCC expanded authority to reduce the level of regulation applicable to any or all telecommunications carriers, including ILECs. The manner in which these provisions of the Telecommunications Act of 1996 are interpreted, implemented and enforced could have a material adverse effect on our ability to successfully compete against ILECs and other telecommunications service providers.
Due to the readily available sources of capital during the 1990s, many CLECs and other incumbent carriers built their own networks, including fiber transport capacity, as a key component of their operating plans. This resulted in an excess of network capacity in many areas throughout the U.S with insufficient traffic volumes to cover the corresponding cost of capital and debt loads that were necessary to build the network infrastructures. Accordingly, some of the companies have not survived or have been forced to reorganize, often through bankruptcy. When these companies reorganize they generally have
new, lower cost structures which often allow them to aggressively price their products and services, effectively driving down market rates.
Competition for Provision of Long Distance Services. The long distance telecommunications industry has numerous entities competing for the same customers, resulting in low average customer retention rates, as customers frequently change long distance providers in response to the offering of lower rates or promotional incentives by competitors. Prices in the long distance market have declined significantly in recent years and are expected to continue to decline with the advent of the authorization by the FCC to allow ILECs to offer long distance services in many states. Additionally, the continued effect of bundling multiple services into a single product offer will continue to lower the effective rate of long distance service.
Competition from International Telecommunications Providers. Under the World Trade Organization agreement on basic telecommunications services, the United States and 68 other members of the World Trade Organization committed themselves to opening their respective telecommunications markets to foreign ownership and/or to adopting regulatory measures to protect competitors against anticompetitive behavior by dominant telecommunications companies, effective in some cases as early as January 1998. There can be no assurance that the pro-competitive effects of the World Trade Organization agreement will not have a material adverse effect on our business, financial condition and results of operations or that members of the World Trade Organization will implement the terms of the World Trade Organization agreement.
Regulation
The following summary of regulatory developments and legislation does not purport to describe all present and proposed Federal, state and local regulations and legislation affecting the telecommunications industry or the Company, all of which are available in the public record. Other existing Federal and state legislation and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals, which could change, in varying degrees, the manner in which this industry operates. Neither the outcome of these proceedings, nor their impact upon the telecommunications industry or the Company, can be predicted at this time. This section also includes a brief description of regulatory and tariff issues pertaining to the operation of the Company’s business, which is subject to varying degrees of Federal, state and local regulation.
Federal Regulation
The FCC regulates interstate and international telecommunications services. We provide service on a common carrier basis. The FCC imposes certain regulations on common carriers such as the regional Bell operating companies that have some degree of market power. The FCC imposes less regulation on common carriers without market power including, to date, CLECs. Among other obligations, common carriers are generally subject to nondiscrimination requirements, as well as certain service reporting requirements. The FCC also requires common carriers to receive an authorization to construct and operate telecommunications facilities, and to provide or resell telecommunications services, between the United States and international points.
The Telecommunications Act of 1996 is intended to increase competition. The act opens the local services market by requiring ILECs to permit interconnection to their networks and establishing ILEC obligations with respect to:
Reciprocal Compensation. Requires all ILECs and CLECs to complete calls originated by competing carriers under reciprocal arrangements at prices based on a reasonable approximation of incremental cost or through mutual exchange of traffic without explicit payment;
Resale. Requires all ILECs and CLECs to permit resale of their telecommunications services without unreasonable restrictions or conditions. In addition, ILECs are required to offer
wholesale versions of all retail services to other telecommunications carriers for resale at discounted rates, based on the costs avoided by the ILEC in the wholesale offering;
Interconnection. Requires all ILECs and CLECs to permit their competitors to interconnect with their facilities. Requires all ILECs to permit interconnection at any technically feasible point within their networks, on nondiscriminatory terms, at prices based on cost, which may include a reasonable profit. At the option of the carrier seeking interconnection, collocation of the requesting carrier’s equipment in the ILECs’ premises must be offered, except where an ILEC can demonstrate space limitations or other technical impediments to collocation;
Unbundled Access. Requires all ILECs to provide nondiscriminatory access to unbundled network elements (UNEs), including certain network facilities, equipment, features, functions, and capabilities, at any technically feasible point within their networks. Such access must be on nondiscriminatory terms, at prices based on cost, which may include a reasonable profit.
Number Portability. Requires all ILECs and CLECs to permit users of telecommunications services to retain existing telephone numbers without impairment of quality, reliability or convenience when switching from one telecommunications carrier to another;
Dialing Parity. Requires all ILECs and CLECs to provide “1+” equal access to competing providers of telephone exchange service and toll service, and to provide nondiscriminatory access to telephone numbers, operator services, directory assistance, and directory listing, with no unreasonable dialing delays; and
Access to Rights-of-Way. Requires all ILECs and CLECs to permit competing carriers access to poles, ducts, conduits and rights-of-way at regulated prices.
ILECs are required to negotiate in good faith with carriers requesting any or all of the above arrangements. If the negotiating carriers cannot reach agreement within a prescribed time, either carrier may request arbitration of the disputed issues by the state regulatory commission. Where an agreement has not been reached ILECs remain subject to interconnection obligations established by the FCC and state regulatory commissions.
In August 1996, the FCC released an interconnection decision establishing rules implementing the Telecommunications Act of 1996 requirements that ILECs negotiate interconnection agreements and providing guidelines for review of such agreements by state public utilities commissions. In January 1999, the Supreme Court declared that the FCC has general authority under the Telecommunications Act of 1996 to promulgate regulations governing local interconnection pricing, including regulations governing reciprocal compensation. The Supreme Court also upheld most of the FCC’s rules governing access to UNEs. The Court, however, remanded to the FCC its designation of UNEs based on the FCC’s use of an improper standard to determine whether an unbundled element must be made available. In November 1999, the FCC released an order largely retaining its list of UNEs. On May 24, 2002, the U.S. Court of Appeals for the District of Columbia Circuit remanded the decision back to the FCC for further consideration of the standard it had employed. On February 20, 2003, the FCC approved an order in its Triennial Review proceeding concerning the appropriateness of its unbundled network element designations. That order is the subject of petitions for reconsideration before the FCC and appeals to the U.S. Court of Appeals for the District of Columbia. That order limits the availability, on an unbundled basis, of certain fiber loops, establishes standards to eliminate unbundling requirements for local switching and transport, and establishes a schedule for phasing out the availability of line sharing.
In May 1997, the FCC released an order establishing a significantly expanded Federal universal service subsidy regime. For example, the FCC established new subsidies for telecommunications and information services provided to qualifying schools and libraries and for services provided to rural health care providers. The FCC also expanded the Federal subsidies for local exchange telephone service provided to low-income consumers. Providers of interstate telecommunications service, such as us, as
well as certain other entities, must pay for these programs. Our share of these Federal subsidy funds are based on our share of certain defined telecommunications end-user revenues. To offset this expense, we currently charge our customers a surcharge on all interstate usage, subject to periodic adjustment. The FCC and a Federal-state joint board also are continuing to examine and revise various aspects of universal service. We cannot predict the effect that further regulatory or judicial revision of the universal service regime will have on our business, financial condition or results of operations.
The Telecommunications Act of 1996 permitted the regional Bell operating companies to enter the out-of-region long distance market immediately upon its enactment. Further, provisions of the Telecommunications Act of 1996 permit a regional Bell operating company to enter the long distance market in its traditional service area if it satisfies several procedural and substantive requirements in those states in which it seeks long distance relief. The FCC has approved applications to provide long distance services in all states.
In accordance with authority granted by the FCC, we resell the international telecommunications services of other common carriers between the United States and international points.
In October 1996, the FCC adopted an order eliminating the requirement that non-dominant interstate carriers such as us maintain tariffs on file with the FCC for domestic interstate and international end user services, and prohibiting the use of such tariffs. In June 1997, the FCC issued another order, which allows non-dominant carriers, such as us, to offer interstate access services without the filing of tariffs. Accordingly, non-dominant interstate and international service providers are no longer able to rely on the filing of tariffs with the FCC as a means of providing notice to end user customers of prices, terms, and conditions under which they offer their domestic interstate interexchange and international services. The obligation to provide non-discriminatory, just and reasonable prices remains unchanged under the Communications Act of 1934. While tariffs provided a means of providing notice of prices, terms and conditions, we rely primarily on our sales force and direct marketing to provide such information to our customers.
To the extent we provide interexchange telecommunications service, we are required to pay access charges to ILECs and other CLECs when we use the facilities of those companies to originate or terminate interexchange calls. Also, as a CLEC, we provide access services to other interexchange service providers. The interstate access charges of ILECs are subject to extensive regulation by the FCC, while those of CLECs are subject to a lesser degree of FCC regulation. In several orders adopted in recent years, the FCC has made major changes in the structure of access charges. Although these orders do not apply directly to CLECs, ILEC reductions in switched access charges places some downward pressure on CLECs to reduce their own switched access charges.
In August 1999, the FCC adopted an order granting price cap local exchange carriers additional pricing flexibility, implementing certain access charge reforms, and seeking comment on others. The order provides certain immediate regulatory relief to price cap carriers and sets a framework of “triggers” to provide these companies with greater flexibility to set interstate access rates as competition increases. The FCC has granted pricing flexibility applications for switched access services in a number of cities. Additional petitions for pricing flexibility are presently pending.
On May 21, 2001, the FCC’s new rules governing CLEC interstate access charges became effective. The rules establish an initial maximum rate of 2.5 cents per minute for interstate access charges for the first year. In the second year, the rate was reduced to 1.8 cents per minute. In the third year, the rate was further reduced to 1.2 cents per minute. At the end of the third year, the benchmark rate will be reduced to the level of the ILEC. This rate will be established in the first half of 2004. A CLEC may not file tariffs for above benchmark rates unless the ILEC in whose territory it operates charges a higher rate, in which case the CLEC may charge the higher ILEC rate or the rate it had tariffed in the previous six months, if lower than ILEC’s rate. A CLEC may charge a rate higher than the benchmark if the long distance carrier, through negotiations, agrees to such a higher rate.
In addition, the FCC only allowed a CLEC to charge the benchmark rates in those areas in which the CLEC was actually serving customers on May 21, 2001. In new service areas, the CLEC may only tariff rates as high as the ILEC. In the same order, the FCC determined that a long distance carrier’s refusal to serve customers of a CLEC that tariffs the FCC’s benchmark rates would generally violate the long distance carrier’s duty as a common carrier to provide service on a reasonable basis. The manner in which the FCC continues to implement its approach to lowering access charge levels could have a material effect on our ability to compete in providing interstate access services. Several petitions for reconsideration of the FCC’s order were filed with the FCC, as well as appeals to the U.S. Court of Appeals for the District of Columbia Circuit. The Court granted the FCC’s request to hold the appeals in abeyance until the FCC decides the motions for reconsideration.
In February 1999, the FCC issued a declaratory ruling on the issue of inter-carrier compensation for calls bound to Internet service providers. The FCC ruled that the calls are jurisdictionally mixed, but largely interstate calls. The FCC, however, determined that this issue did not resolve the question of whether inter-carrier reciprocal compensation is owed for such calls under existing interconnection agreements. The FCC noted a number of factors that would allow the state public utilities commissions to continue to require the payment of reciprocal compensation. In March 2000, the U.S. Court of Appeals for the District of Columbia Circuit vacated the FCC’s declaratory ruling and remanded the matter to the FCC. The Court determined that the FCC has not provided a reasoned basis for treating calls to Internet service providers differently from other local calls.
On April 27, 2001, the FCC released its Order on Remand regarding intercarrier compensation for Internet service provider-bound traffic. The FCC asserted exclusive jurisdiction over Internet service provider-bound traffic and established a new interim intercarrier compensation regime for Internet service provider-bound traffic with capped rates above a fixed traffic exchange ratio. Traffic in excess of a ratio of 3:1 (terminating minutes to originating minutes) is presumed to be ISP-bound traffic, and is to be compensated at rates that decrease from $.0015 to $.0007, or the applicable state-approved rate if lower, over three years. Traffic below the 3:1 threshold is to be compensated at the rates in existing and future interconnection agreements. Traffic above the 3:1 ratio is also subject to a growth ceiling with traffic in excess of the growth ceiling subject to “bill and keep,” an arrangement in which the originating carrier pays no compensation to the terminating carrier to complete calls. In addition, when a competitive carrier begins to provide service in a state it has not previously served, all traffic in excess of the 3:1 ratio is subject to bill-and-keep arrangements. In exchange for this reduction in reciprocal compensation obligations to CLECs, the ILECs must offer to exchange all traffic subject to Section 251 (b) (5) of the Telecommunications Act of 1996, as well as Internet service provider-bound traffic, at the Federal capped rates. It is not possible to estimate the full impact of the FCC Order at this time because the Federal regime does not alter existing contracts except to the extent that they incorporate changes of Federal law, and because adoption of the Federal regime is within the discretion of the ILEC exchanging traffic with CLECs on a state-by-state basis. In the event an ILEC determines not to adopt the Federal regime, the ILEC must pay the same rate for Internet service provider-bound traffic as for calls subject to reciprocal compensation. On May 3, 2002, the U.S. Court of Appeals for the District of Columbia Circuit (Court) issued its decision in which it found that the FCC had failed to provide an adequate legal basis for its decision. The Court remanded the decision back to the FCC. In the interim the Court allowed the FCC’s interim compensation regime to remain in place. We cannot predict the impact of the FCC’s and the Court’s ruling on existing state decisions, the outcome of pending appeals or future litigation on this issue.
In December 1996, the FCC initiated a Notice of Inquiry regarding whether to impose regulations or surcharges upon providers of Internet access and information services (the “Internet NOI”). The Internet NOI sought public comment upon whether to impose or continue to forebear from regulation of Internet and other packet-switched network service providers. The Internet NOI specifically identifies Internet telephony as a subject for FCC consideration. On April 10, 1998, the FCC issued a Report to Congress on its implementation of the universal service provisions of the 1996 Act. In the Report, the
FCC indicated that it would examine the question of whether certain forms of “phone-to-phone Internet Protocol telephony” are information services or telecommunications services. It noted that the FCC did not have an adequate record on which to make any definitive pronouncements on that issue at this time, but that the record the FCC had reviewed suggests that certain forms of phone-to-phone Internet Protocol telephony appear to have similar functionality to non-Internet Protocol telecommunications services and lack the characteristics that would render them information services. If the FCC were to determine that certain Internet Protocol telephony services are subject to FCC regulations as telecommunications services, the FCC noted it may find it reasonable that the ISPs pay access charges and make universal service contributions similar to non-Internet Protocol based telecommunications service providers. The FCC also noted that other forms of Internet Protocol telephony appear to be information services.
On October 18, 2002, AT&T Corporation filed a petition for declaratory ruling with the FCC with respect to phone-to-phone Internet Protocol telephony. The petition requested that the FCC affirm that such services are exempt from the access charges applicable to circuit switched interexchange calls and that it is lawful to provide such service through local end user services. It is unclear when the FCC might rule on the question presented. Several related petitions before the FCC raise the issue of the appropriate regulatory treatment of Voice over IP telephony. The FCC, on March 10, 2004, adopted a Notice of Proposed Rulemaking which will address a variety of issues concerning the regulatory treatment of VoIP telephony. At the same time, the FCC ruled on a petition which dealt with a VoIP service that never used the public switched network, was offered free to members of the service, and did not involve the transport of the calls. The FCC determined the service was not a telecommunications service under the Act. The Company cannot predict the outcome of these proceedings or other FCC or state proceedings that may affect the Company’s operations or impose additional requirements, regulations or charges upon the Company’s provision of Internet access and related Internet Protocol-based telephony services.
In November 1999, the FCC also adopted a new order requiring ILECs to provide line sharing, which allows CLECs to offer data services over the same lines that a consumer uses for voice services without the CLEC having to offer voice services. These rules were appealed and were reversed by the Court. In the FCC’s Triennial Review Order, the FCC established a three-year transition period during which line sharing would be restricted and then prohibited. That order is the subject of a petition for reconsideration and appeals to the U.S. Court of Appeals for the District of Columbia Circuit.
The FCC and many state public utilities commissions have implemented rules to prevent unauthorized changes in a customer’s pre-subscribed local and long distance carrier services (a practice commonly known as “slamming.”) Pursuant to the FCC’s slamming rules, a carrier found to have slammed a customer is subject to substantial fines. In addition, the FCC’s slamming rules allow state public utilities commissions to elect to administer and enforce the FCC’s slamming rules. These slamming liability rules substantially increase a carrier’s possible liability for unauthorized carrier changes, and may substantially increase a carrier’s administrative costs in connection with alleged unauthorized carrier changes. The Communications Assistance for Law Enforcement Act (CALEA) provides rules to ensure that law enforcement agencies would be able to properly conduct authorized electronic surveillance of digital and wireless telecommunication services. CALEA requires telecommunications carriers to modify their equipment, facilities, and services used to provide telecommunications services to ensure that they are able to comply with authorized surveillance requirements. The Company’s switches are CALEA compliant.
State Regulation: General Framework
State regulatory agencies have regulatory jurisdiction when Pac-West facilities and services are used to provide intrastate services. A significant portion of our current traffic is classified as intrastate and therefore subject to state regulation. To provide intrastate services, we generally must obtain a certificate of public convenience and necessity from the state regulatory agency and comply with state
requirements for telecommunications utilities, including state tariffing requirements. We currently have such certificates to provide local exchange and intrastate toll service in California, Nevada, Washington, Oregon and Arizona. Most states in which we operate also require us to seek approval for any transfers of control.
The implementation of the Telecommunications Act of 1996 is subject to numerous state rulemaking proceedings on these issues. Thus, it is difficult to predict how quickly full competition for local services, including local dial tone, will be introduced. Furthermore, the Telecommunications Act of 1996 provides that state public utilities commissions have significant roles in determining the content of interconnection agreements, including the responsibility to conduct the mandatory arbitration proceedings called for by the Telecommunications Act of 1996. The actions of the state public utilities commissions are subject to the Telecommunications Act of 1996 and, in several respects, the FCC’s interpretations thereof.
California Regulatory Proceedings and Judicial Appeals
On March 29, 2002, SBC-California filed with the CPUC a petition for arbitration with respect to unresolved issues in negotiations of a new interconnection agreement with us, which would replace our then-existing agreement which continued in effect until replaced pursuant to its terms. On May 8, 2003, the CPUC issued its final decision, which requires us to pay SBC-California certain transport charges when SBC-California carries a category of telephone calls referred to as “VNXX Calls” from its customers to certain customers of ours not physically located in the same local calling area as the calling party. We have determined that we could extend the geographic scope of our network to avoid such charges. However, in recognition of the complexity of this determination and the time required to enact such a modification, the CPUC has deferred the effectiveness of these new transport charges until February 2004 to provide the Company time to modify its network. Such network modifications would cause additional costs on both an an-going and one-time basis. The agreement also authorizes the Company to charge tandem switching and transport where appropriate. The CPUC decision approved the continued payment of reciprocal compensation for all local calls, including those to ISP customers of the company, which was voluntarily agreed to by the parties.
SBC-California notified the Company of its election to implement the FCC’s interim rate plan for ISP-bounds calls beginning August 1, 2003. The Company has disputed SBC’s implementation of the FCC plan, and on October 14, 2003 SBC-California filed a Complaint with the CPUC seeking resolution of this issue. The Company has opposed the relief sought by SBC and asserted several counter claims against SBC related to its performance under the new agreement. The matter is currently pending before an administrative law judge at the CPUC.
On June 12, 2002, Verizon California (Verizon) filed a Petition for Arbitration with the CPUC with respect to unresolved issues in negotiations of a new ICA with the Company, that would replace the then-existing agreement, the terms and conditions of which continued in effect until replaced pursuant to an order of the CPUC. On May 22, 2003, the CPUC issued its decision establishing the provisions of the agreement which resulted from the arbitration. The new three-year agreement establishes the rules under which the Company and Verizon can interconnect their networks to allow for the exchange of traffic and the recovery of costs associated with exchanging such traffic. In addition, like the SBC agreement, it includes a new transport charge applicable to VNXX Calls and makes the reciprocal compensation rates established by the FCC Plan effective upon the commencement of the term of the new agreement. The terms of the agreement also incent the Company to modify its existing network in order to avoid these transport charges. However, in recognition of the complexity of this determination and the time required to enact such a modification, the CPUC has deferred the effectiveness of these new transport charges until January of 2004 to provide the Company time to modify its network. Such network modifications would cause additional costs on both an an-going and one-time basis. The agreement also authorizes the Company to charge tandem switching and transport where appropriate.
We expect that reciprocal compensation will continue to represent a significant portion of our revenues in the future although, based on current market conditions, we expect the per minute reciprocal compensation rate will continue to decline from historic rates under interconnection agreements in the future. Furthermore, the policies of the CPUC and other regulatory bodies are subject to change with respect to issues which affect the economic structure of interconnection agreements is other ways, and these issues can differ from time to time.
Regulatory Legal Proceedings
In July 2003 Verizon appealed the arbitration decision of the CPUC to Federal District Court, arguing among other things that the FCC Plan reciprocal compensation rates, which are contained in the new agreement but lower than the comparable rates in the agreement being replaced, should have been made retroactive. The Company has opposed the relief sought by Verizon, and has challenged the legality of the new transport charges imposed on VNXX traffic. It is not possible to determine the outcome of this proceeding at this time.
Nevada Regulatory Proceedings and Judicial Appeals
In September 1999, Nevada Bell filed suit in U.S. Federal District Court in Reno to overturn a Public Utilities Commission of Nevada decision requiring Nevada Bell to pay the Company reciprocal compensation for terminating traffic to Internet service providers. We negotiated an interconnection agreement, but were unable to agree on the issue of reciprocal compensation. In 1999, a commissioner from the Public Utilities Commission of Nevada serving as arbitrator of that dispute (pursuant to the Telecommunications Act of 1996’s arbitration provisions for interconnection agreements) ruled that Nevada Bell did not have to pay Pac-West reciprocal compensation for this traffic. The full Public Utilities Commission of Nevada overruled that decision and ordered Nevada Bell to pay such compensation under the Pac-West interconnection agreement. On March 21, 2001, in ruling on cross-motions for summary judgment, the district court vacated the Public Utilities Commission of Nevada decision and remanded the matter to the Public Utilities Commission of Nevada with instructions to redo its analysis regarding reciprocal compensation. We have appealed this decision to the United States Court of Appeals for the Ninth Circuit. The appeal has been stayed to allow the parties time to conduct settlement negotiations. With the court’s consent, the parties have agreed to extend the stay.
Local Regulation
Our network is subject to numerous local regulations such as building codes and licensing requirements. Such regulations vary on a city-by-city and county-by-county basis. To the extent we decide in the future to install our own fiber optic transmission facilities, we will need to obtain rights-of-way over private and publicly owned land and pole attachment authorizations. There can be no assurance that such rights-of-way or authorizations will be available to us on economically reasonable or advantageous terms. We could also be subject to unexpected franchise requirements and be required to pay license or franchise fees based on a percentage of gross revenues or some other formula.
Employees
As of December 31, 2003, we had 372 employees. We believe that our future success will depend on our continued ability to attract and retain highly skilled and qualified employees. None of our employees are currently represented by a collective bargaining agreement. We also believe that we enjoy good relationships with our employees.
Available Information
Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities
Exchange Act of 1934, as amended, are available free of charge on our Investor Relations web site at www.pacwest.com as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. The information posted on our web site is not part of this Annual Report.
Risk Factors
Except for the historical information contained herein, this report contains forward-looking statements, subject to uncertainties and risks, and as a result, our actual results may differ materially from those discussed in this report. These uncertainties and risks include, among other things, the uncertainties and risks identified below. You should be aware, however, that the uncertainties and risks described below are not the only uncertainties and risks we are facing or will face in the future. Additional uncertainties and risks not presently known to us or that we currently believe to be immaterial may also adversely affect our business.
We have a substantial amount of indebtedness and are highly leveraged
As of December 31, 2003, our long-term debt totaled $54.7 million. We may also incur additional indebtedness in the future to expand and develop our current business and services, make strategic acquisitions and enter new markets. Our substantial indebtedness could, among other things:
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increase our vulnerability to general adverse economic and industry conditions;
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limit our ability to fund future working capital, capital expenditures, marketing costs and other general corporate requirements;
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require us to dedicate a substantial portion of our cash flows from operations to payments on our indebtedness, thereby reducing the availability of our cash flows to fund working capital, capital expenditures, marketing efforts and other general corporate purposes;
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limit our flexibility in planning for or reacting to changes in our business and the industry in which we operate;
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place us at a competitive disadvantage compared to our less leveraged competitors; and
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limit our ability to borrow additional funds.
We may not be able to generate sufficient cash to service our indebtedness.
Failure to generate cash in the future either from operations or from additional financing will adversely affect our ability to make payments on and to refinance our indebtedness and to fund capital expenditures and marketing efforts. Our ability to generate cash from operations will be particularly dependent on our ability to expand our business and manage our growth, provide competitive services, comply with applicable governmental regulations, negotiate favorable agreements and to maintain or lower our current expenditure rate. In addition, we may need to refinance all or a portion of our indebtedness on or before maturity. We may not be able to refinance this indebtedness on commercially reasonable terms or at all.
A substantial portion of our total revenue is from reciprocal compensation payments, which are subject to regulatory and legal uncertainty.
A substantial portion of our revenues is derived from reciprocal compensation payments by ILECs with which we have interconnection agreements. Our entitlement to reciprocal compensation payments results from terminating on our network, local calls that originate on another carrier’s network. We believe that under the Telecommunications Act of 1996, other ILECs should have to compensate us when their customers place calls to Internet service providers who are our customers. The right of CLECs, such as us, to receive this type of compensation is the subject of continual regulatory and legal
challenges by the ILEC’s. For example, both Verizon and SBC have attempted to adopt the FCC’s Intercarrier ISP Compensation Order (FCC Order). In particular, the FCC Order introduced a series of declining reciprocal compensation pricing tiers for minutes of use, at rates starting below the rates previously negotiated in our interconnection agreements with both carriers. The lowest pricing tier specified by the order went into effect on June 15, 2003, and will remain in effect until such time that a replacement FCC Order may be introduced.
Additionally, the FCC Order introduced artificial annual growth limits on compensable minutes of use subject to reciprocal compensation based on the composition and balance of traffic between carriers. Based on their interpretations of the growth cap formula, Verizon commenced withholding reciprocal compensation payments to us during July 2003 for the remainder of 2003, and SBC commenced withholding in December 2003. ILECs that withheld reciprocal compensation payments for 2003 based on their interpretation of the FCC Order may also withhold reciprocal compensation payments in 2004 and beyond pending resolution of this issue. Pac-West is disputing these withheld reciprocal compensation revenues and has challenged the legality of the growth caps as well as Verizon’s and SBC’s implementation of the FCC Order. There are no assurances that we will ever receive any disputed past or future reciprocal compensation payments. In addition, other regulatory and legal decisions providing that other carriers do not have to compensate us for these calls could limit our ability to service this group of customers profitably and could have a material adverse effect on us.
A substantial portion of our total revenue is based upon reciprocal compensation rates, which have been declining and are expected to continue to decline.
Reciprocal compensation payments from ILECs accounted for approximately 35.0%, 48.7% and 41.6% of our total revenues for the years ended December 31, 2003, 2002 and 2001 respectively. Reciprocal compensation payments are a function of the number of calls we terminate, the minutes of use associated with such calls and the rates we are compensated at by the ILECs. During 2003, we experienced an average decrease of approximately 46.4% in the rate at which we are compensated at by the ILECs. This was largely lower compensation rates enacted by both SBC’s and Verizon’s adoption of the FCC order. This resulted in the withholding of reciprocal compensation payments by Verizon for the final five months and SBC for the final month in 2003. If this trend is repeated in 2004 it could mean that future reciprocal compensation payments could decline.
We may not have sufficient funds available to expand our business.
We may need to make significant capital expenditures in order to expand and develop our current business and to support new product offerings. We expect to fund these expenditures through existing resources, through internally generated funds, or through future equity and debt financings. If we are unable to raise sufficient funds, we may have to delay or abandon some of our expenditures or plans for future growth. This would result in underutilization of our established infrastructure, reduced profitability and may negatively affect our ability to compete for and satisfy the demands resulting from the growth and expansion of our customer base.
The covenants in the guaranty and security agreement related to the Senior Secured Note could adversely affect the operation of our business.
On December 19, 2003, we entered into a guarantee and security agreement with Deutsche Bank in connection with the issuance of a Senior Secured Note. The guarantee and security agreement grants Deutsche Bank a security interest in substantially all of our assets and contains provisions which limit our management’s discretion by restricting our ability to: incur additional debt; pay dividends and make other distributions and restricted payments; prepay subordinated debt; sell assets; and enter into certain transactions with affiliates. If we fail to comply with the restrictions and covenants of the guaranty and security agreement or any other subsequent financing agreements, a default may occur. This default may
allow the creditors to accelerate the related debt as well as any other debt to which a cross-acceleration or cross-default provision applies.
The loss of key executive officers could negatively impact our business prospects.
We believe that a critical component of our success will be the retention of our key executive officers. Henry R. Carabelli, our President and Chief Executive Officer has significant expertise in the telecommunications industry and has been instrumental in establishing and executing our business plan and strategy. The loss of the services of Mr. Carabelli or our other executive officers, including the following officers could adversely affect our business prospects, financial condition and results of operations:
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H. Ravi Brar, our Chief Financial Officer;
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Todd M. Putnam, our Chief Information Officer;
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Michael B. Hawn, our Vice President Customer Network Services;
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Wayne Bell, our Vice President Marketing and Sales;
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Christine Ruane, our Vice President SME Sales;
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Eric E. Jacobs, our Vice President, General Manager Service Provider Sales;
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Peggy Mc Gaw, our Vice President Finance;
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John F. Sumpter, our Vice President, Regulatory and Human Resources; and
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Robert C. Morrison, our Vice President and General Counsel.
We are dependent on effective billing, customer service and information systems.
Sophisticated back office information and processing systems are vital to our growth and our ability to monitor costs, bill and service customers, initiate, implement and track customer orders and achieve operating efficiencies. Our systems require continuous integration and on-going system development to ensure that they continue to meet our business needs.
We cannot provide assurance that any of our systems will perform as expected because: we may fail to adequately identify all of our information and processing needs; our processing or information systems may fail or be inadequate; the scalability of our systems is unknown; we may not be able to effectively integrate such products or services; we may fail to upgrade systems as necessary; and third party vendors may cancel or fail to renew license agreements that relate to these systems. In addition, there can be no assurance that there would be synergy between the network architectures of our systems should it become necessary to transition data between our systems and other systems.
Our need to comply with extensive government regulation can increase our costs and slow our growth.
Our networks and the provision of telecommunications services are subject to significant regulation at the Federal, state and local levels. Delays in receiving required regulatory approvals or the enactment of new adverse regulation or regulatory requirements may slow our growth and have a material adverse effect upon us. Regulators at both the Federal and state level require us to pay various fees and assessments, file periodic reports, and comply with various rules regarding the contents of our bills, protection of subscriber privacy, service quality and similar matters on an ongoing basis. We cannot provide assurance that the FCC or state commissions will grant required authority or refrain from taking action against us if we are found to have provided services without obtaining the necessary authorizations, or to have violated other requirements of their rules and orders. Regulators or others could
challenge our compliance with applicable rules and orders. Such challenges could cause us to incur substantial legal and administrative expenses.
We are dependent on many vendors and suppliers and their financial difficulties may adversely affect our business.
We depend on many vendors and suppliers to conduct our business. For example, we purchase our network assets from equipment manufacturers and other suppliers and we lease fiber and other circuits from other carriers as well as from companies, which construct these network elements for resale. Many of these third parties have experienced substantial financial difficulties, in some cases leading to bankruptcies and liquidations. The financial difficulties of these companies could have a material adverse affect on our business and prospects.
If we do not interconnect with and maintain efficient working relationships with our primary competitors, the ILECs, our business will be adversely affected.
Many new carriers, including us, have experienced difficulties in working with the ILECs with respect to initiating, interconnecting, and implementing the systems used by these new carriers to order and receive UNEs and wholesale services and locating the new carriers’ equipment in the offices of the ILECs. As a new carrier, we must coordinate with ILECs so that we can provide local service to customers on a timely and competitive basis. The Telecommunications Act of 1996 created incentives for regional Bell operating companies to cooperate with new carriers and permit access to their facilities by denying such companies the ability to provide in-region long distance services until they have satisfied statutory conditions designed to open their local markets to competition.
The regional Bell operating companies have been fined numerous times by both Federal and state authorities for their failure to comply with applicable telecommunications laws and regulations. We do not believe these fines have had any meaningful impact on the anticompetitive practices of many of these companies and in fact believe that these practices are increasing in most of our markets. We attempt to enforce our rights against these incumbent monopolies but often times the remedies are inadequate to change their anticompetitive practices and in any event provide us with little or no recovery of the damages we have suffered as a result of these practices. Moreover, efforts by us to enforce our rights against these companies may further diminish the level of cooperation we receive from them. If we cannot obtain the cooperation of a regional Bell operating company in a region, or a regional Bell operating company otherwise fails to meet our requirements, for example, because of labor shortages, work stoppages or disruption caused by mergers or other organizational changes or terrorist attacks, our ability to offer services in such region on a timely and cost-effective basis will be adversely affected.
Our principal competitors for local services, the ILECs, and potential additional competitors, have advantages that may adversely affect our ability to compete with them.
The telecommunications industry is both highly competitive and dominated by the ILECs who enjoy the benefit of significant market share earned over a time when there was little to no competition in the marketplace. Many of our current and potential competitors in the local market have financial, technical, marketing, personnel and other resources, including brand name recognition, substantially greater than ours, as well as other competitive advantages over us. In each of the markets targeted by us, we compete principally with the ILEC serving that area. These ILECs enjoy advantages that may adversely affect our ability to compete with them. ILECs are established providers of local telephone services to all or virtually all telephone subscribers within their respective service areas. ILECs also have long-standing relationships with Federal and state regulatory authorities. FCC and state administrative decisions and initiatives provide the ILECs with pricing flexibility for their: private lines, which are private, dedicated telecommunications connections between customers; special access services, which are dedicated lines from a customer to a long distance company provided by the local phone company;
and switched access services, which refers to the call connection provided by the local phone company’s switch between a customer’s phone and the long distance company’s switch.
In addition, with respect to competitive access services, such as special access services as opposed to switched access services, the FCC recently granted ILECs increased pricing flexibility and deregulation for such access services after certain competitive levels are reached. If the ILECs are allowed by regulators to offer discounts to large customers through contract tariffs, engage in aggressive volume and term discount pricing practices for their customers, and/or seek to charge competitors excessive fees for interconnection to their networks, competitors such as ourselves could be materially adversely affected. If future regulatory decisions afford the ILECs increased pricing flexibility or other regulatory relief, such decisions could also have a material adverse effect on competitors such as us.
We also face, and expect to continue to face, competition in the local market from other current and potential market entrants, including long distance carriers seeking to enter, reenter or expand entry into the local exchange marketplace such as AT&T Corporation, WorldCom, Inc. and Sprint Corporation, among others, and from other CLECs, resellers, competitive access providers, cable television companies, electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end users. In addition, the development of new technologies could give rise to significant new competitors in the local market. These competitive forces could adversely affect our business.
Some of our competitors have lower cost structures through restructuring activities
Due to the readily available sources of capital during the 1990s, many CLECs and other incumbent carriers included building their own networks, including fiber transport capacity, as a key component of their operating plans. This resulted in an excess of network capacity in many areas throughout the U.S with insufficient traffic volumes to cover the corresponding cost of capital and debt loads that were necessary to build the network infrastructures. Accordingly, some of the companies have not survived or have been forced to restructure, often through bankruptcy. When these companies restructure they generally have new, lower cost structures which often allow them to aggressively price their products and services, effectively driving down the market rates in a way that could adversely affect our business.
A system failure could delay or interrupt our services.
Our operations are dependant upon our ability to support our network infrastructure. Many of our customers are particularly dependent on an uninterrupted supply of services. Any damage or failure that causes interruptions in our operations could result in the loss of these customers and could have a material adverse effect on our business and our financial condition. Because of the nature of the services we supply and the nature of our network, it is not feasible to maintain complete backup systems, and the occurrence of a natural disaster, act of terrorism or other operational disruption or unanticipated problem could cause interruptions in the services we provide. Additionally, the failure of a major supplier to provide the communications capacity we require, or of a major customer to continue buying our goods and services, as a result of a natural disaster, act of terrorism or other operational disruption or any other reason, could cause interruptions in the service we provide and adversely affect our business prospects, financial condition and results of operations.
The Internal Revenue Service (IRS) may propose certain adjustments, in connection with an ongoing audit, which could be material in amount.
Our tax affairs are subject to audit and review by numerous taxing authorities, including the IRS. An IRS audit of our tax returns for 1999, 2000 and 2001 is currently ongoing. The IRS may propose certain adjustments, which could be material in amount, in connection with its audit of these periods. If such adjustments were to be proposed by the IRS, we expect that we would vigorously defend the tax returns as filed. However, there can be no assurance that we will be able to successfully defend our tax
positions. If we were unsuccessful in defending our tax returns as filed, we may be assessed a significant tax liability for one or more of the periods under audit, which could have a material adverse effect on our future financial results.
Telecommunication industry trends could slow or eliminate future growth.
Competition in the communication services market has resulted in the consolidation of companies in our industry, a trend we expect to continue. In order to grow our business and better serve our customers, we continue to consider new business strategies, including potential acquisitions or new business lines. We believe that the statewide footprint of our network, which encompasses all of the major metropolitan areas of California, provides us with a significant competitive advantage that will enable us to successfully compete in the future, but we cannot guarantee that we will be able to sustain continued growth.
The developing practice by the ILECs of bundling services including long distance over their comprehensive networks could make it difficult for us to retain customers or attract new ones. In addition, technology continues to evolve with the corresponding development of new products and services. There is no guarantee we will retain our customers with our existing product and service offerings or with any new products or services we may develop in the future.
Our failure to manage growth could result in increased costs.
We may be unable to manage our growth effectively. This could result in increased costs and delay our introduction of additional services. The development of our business will depend on, among other things, our ability to achieve the following goals in a timely manner, at reasonable costs and on satisfactory terms and conditions:
•
purchase, install and operate equipment;
•
negotiate suitable interconnection agreements with, and
•
arrangements for installing our equipment at the central offices of ILECs on satisfactory terms and conditions;
•
hire and retain qualified personnel;
•
lease suitable access to transport networks; and
•
obtain required government authorizations.
Any significant growth will place a strain on our operational, human and financial resources and will also increase our operating complexity as well as the level of responsibility for both existing and new management personnel. Our ability to manage our growth effectively will depend on the continued development of plans, systems and controls for our operational, financial and management needs and on our ability to expand, train and manage our employee base.
Our services may not achieve sufficient market acceptance to become profitable.
To be successful, we must develop and market services that are widely accepted by businesses at profitable prices. Our success will depend upon the willingness of our target customers to accept us as a high-value independent broadband provider of integrated business communications solutions.
Our failure to achieve or sustain market acceptance at desired pricing levels could impair our ability to achieve profitability or positive cash flow.
Market prices for our services have fallen in response to the competitive pressures we face, a trend which may continue. Accordingly, we cannot predict to what extent we may need to further reduce our prices to remain competitive or whether we will be able to sustain future pricing levels as our
competitors introduce competing services or similar services at lower prices. Our ability to meet price competition may depend on our ability to operate at costs equal to or lower than our competitors or potential competitors. There is a risk that competitors, perceiving us to lack capital resources, may undercut our rates, increase their services or take other actions that could be detrimental to us.
If we are unable to effectively deliver our services to a substantial number of customers, we may experience revenue losses.
We cannot guarantee that our network will be able to connect and manage a substantial number of customers at high transmission speeds. If we cannot achieve and maintain digital transmission speeds that are otherwise available in a particular market, we may lose customers to competitors with higher transmission speeds and we may not be able to attract new customers. Actual transmission speeds on our network will depend on a variety of factors many of which are beyond our control, including the distance an end user is located from a central office, the quality of the telephone lines, the presence of interfering transmissions on nearby lines and other factors.
Our ability to provide certain services to potential customers depends on the quality, physical condition, availability and maintenance of telephone lines within the control of the ILECs. If the telephone lines are not adequate, we may not be able to provide certain services to many of our target customers and our expected revenues will be diminished. In addition, the ILECs may not maintain the telephone lines in a condition that will allow us to implement certain services effectively or may claim they are not of sufficient quality to allow us to fully implement or operate certain services.
We may incur liabilities as a result of our Internet service offerings.
United States law relating to the liability of on-line service providers and Internet service providers for information carried on, disseminated through, or hosted on their systems is currently unsettled. If liability is imposed on Internet service providers, we would likely implement measures to minimize our liability exposure. These measures could require us to expend substantial resources or discontinue some of our product or service offerings. In addition, increased attention to liability issues, as a result of litigation, legislation or legislative proposals could adversely affect the growth and use of Internet services.
Our stock has been extremely volatile.
Our stock has experienced significant price and volume fluctuations, often times due to factors beyond our control. Given that our stock is thinly traded, sales by even a single large stockholder can materially decrease our market price. The market price for our common stock may continue to be subject to wide fluctuations in response to a variety of other factors, including but not limited to the following, some of which are beyond our control: revenues and operating results of our company or other emerging communications companies failing to meet the expectations of securities analysts or investors in any period; failure to successfully implement our business strategy; announcements of operating results and business conditions by our customers and competitors; technological innovations by competitors or in competing technologies; announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; announcements by third parties of significant claims or proceedings against us; investor perception of our industry or our prospects; economic developments in the telecommunications industry or general market conditions; or major geopolitical events such as war, terrorism or political change around the world.
Economic conditions in the State of California may negatively impact our financial results.
The current economic conditions in California may negatively impact our financial results. The state’s economy continues to recover, but at a slower rate than the national average. There has been modest employment growth, but limited growth in wages and salaries. Weak economic conditions
impact spending on telecommunication services. As a result continued weak economic conditions in California could negatively impact near-term financial results.
Consolidation in the telecommunications industry could lead to the creation of stronger competitors.
There has been consolidation in the telecommunications industry with several mergers and acquisitions and this trend may continue. In addition, some telecommunication companies have filed for bankruptcy protection and enjoy court protection from creditors and lower their cost structures. These events could lead to the creation of substantially larger competitors, which may have greater resources and lower cost structures than us.
Item 2.
Item 2.
Properties
We are headquartered in Stockton, California and lease offices and space in a number of locations primarily for sales offices and network equipment installations. As of December 31, 2003, we had 26 premise leases. The table below lists our material active facilities as of December 31, 2003:
We believe that our leased facilities are suitable and adequate to meet our current needs in the markets in which we currently operate. Additional facilities may be required as business in our existing markets grows or facilities may be closed down if they are no longer needed. Each of the leases associated with our material facilities is extendable at our option. Our Stockton, California switching facility lease is extendable for four two-year periods, our Oakland switching facility is extendable for one five year period and all other leases in the table above are extendable for two five-year periods.
Item 3.
Item 3.
Legal Proceedings
On December 6, 2001, a complaint captioned Krim vs Pac-West Telecomm, Inc., et. al., Civil Action No. 01-CV-11217, was filed in United States District Court for the Southern District of New York against the Company, certain executive officers, and various underwriters in connection with our initial public offering. An amended complaint was filed on April 19, 2002. The plaintiffs allege that the Company and its officers failed to disclose alleged allocations of shares of the Company’s common stock in exchange for excessive brokerage commissions or agreements to purchase shares at higher prices in the aftermarket, in violation of Section 11 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. Substantially similar actions have been filed concerning the initial public offerings for more than 300 different issuers, and the cases have been coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. The complaint against the Company seeks unspecified damages on behalf of a purported class of purchasers of its common stock. In October 2002, the executive officers of the Company were dismissed from the action without prejudice by agreement with the plaintiffs which also resulted in tolling of the statute of limitations. The court dismissed the Section 10(b) claim against the Company in 2002.
On July 10, 2003, a committee of the Company’s board of directors conditionally approved a proposed settlement with the plaintiffs in this matter. The settlement would provide, among other things,
a release of the Company and of the individual defendants for the conduct alleged in the action to be wrongful in the plaintiff’s complaint. The Company would agree to undertake other responsibilities under the settlement, including agreeing to assign away, not assert, or release certain potential claims the Company may have against its underwriters. Any direct financial impact of the proposed settlement is expected to be borne by the Company’s insurers. The committee agreed to approve the settlement subject to a number of conditions, including the participation of a substantial number of other issuer defendants in the proposed settlement, the consent of the Company’s insurers to the settlement, and the completion of acceptable final settlement documentation. Furthermore, the settlement is subject to a hearing on fairness and approval by the court overseeing the litigation.
From time to time, the Company is a party to litigation that arises in the ordinary course of business. The Company believes that the resolution of this litigation, and any other litigation the Company may be involved with in the ordinary course of business, will not materially harm its business, financial condition or results of operations.
In addition the Company is also a party to various legal proceedings relating to reciprocal compensation payment and other interconnection agreement issues. These are discussed in more detail in “Business-Regulation” in item 1 to this form 10-K.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
On December 18, 2003 the shareholders approved at a special meeting of the shareholders two proposals related to a financing transaction with Deutsche Bank AG - New York, acting through DB Advisors, LLC (Deutsche Bank), as investment advisor, and a related tender offer, which are more fully described in the definitive proxy statement filed by us with the Securities and Exchange Commission on November 26, 2003.
The first proposal was for the approval of the issuance by us to Deutsche Bank of warrants to purchase up to 26,666,667 shares of common stock, at an exercise price of $1.50 per share and the issuance by us of the common stock issuable upon exercise of such warrants. The total votes cast for this resolution were as follows (in thousands):
The second proposal was to ratify all matters related to the issuance of the warrants and the common stock issuable upon the exercise warrants including, among other things, the proposed financing transaction with Deutsche Bank pursuant to which the warrants are intended to be issued and the tender offer for at least a majority of our outstanding Senior Notes and related consent solicitation. The total votes cast for this resolution were as follows (in thousands):
Item 4A.
Directors and Executive Officers
The table below sets forth certain information as of December 31, 2003 with respect to Pac-West’s current directors and executive officers:
The present principal occupations and recent employment history of each of our executive officers and directors listed above are set forth below.
Executive Officers
Henry R. Carabelli joined Pac-West as President and COO in June 2001. Effective January 1, 2003, Mr. Carabelli became a Director of Pac-West. In July 2003 he also became CEO. Mr. Carabelli has overall responsibility for the operations of the Company. Formerly the COO of ICG, a Colorado-based CLEC, and President of @Link Networks, a broadband service provider, Mr. Carabelli brings over 24 years of telecom experience to Pac-West. He joined ICG in 1996 as Executive Vice President of network operations, and served as COO from 1998 to 1999 with responsibility over network engineering, customer care, sales, and installation. Prior to ICG, Mr. Carabelli spent 19 years in management with Ameritech and Michigan Bell. In 1986, he was chosen for a technology internship program at Bellcore to expand exposure to new broadband technologies. He is also a Director on the San Joaquin Business Council.
H. Ravi Brar joined Pac-West in July 1999 as Vice President of Business Development. He was appointed Vice President of Customer Operations in October 2000, Vice President of Finance and Treasurer in August of 2001, Acting Chief Financial Officer in February of 2002, and Chief Financial Officer in September 2002. Mr. Brar has responsibility for the Company’s financial and accounting operations and evaluating strategic growth opportunities. Prior to joining Pac-West, Mr. Brar was employed with Xerox Corporation from 1991 to 1999, where he held several senior level business
development and financial management positions, including Business Development Manager of Developing Markets Operations in China and Russia, and Area General Manager and Controller of Xerox’s Business Services division in Pittsburgh, PA.
Todd M. Putnam joined Pac-West in October 2003 as Chief Information Officer. Mr. Putnam has responsibility over the Company’s information systems including the Company’s Information Technologies strategic plan and infrastructure, including operating support systems, software development, database administration, information services and security, system integration, internal and external web sites, and supplier partnerships. Prior to joining Pac-West, he completed a consulting assignment with TechNexxus, LLC (a subsidiary of Mintz Levin Cohn Ferris Glovsky and Popeo PC) in Washington D.C. From 1989 to 2002, he was employed with Global Crossing LTD (Frontier Communications, ConferTech International, and T1 Systems), where he was responsible for building, operating, and maintaining the global information systems infrastructure for the entire company. He held a variety of senior level IT positions, including Vice President of Global IS Operations, Vice President of North American Systems and Infrastructure, Vice President of Systems Development, and CIO of the ConferTech division.
Michael B. Hawn joined Pac-West as Vice President of Customer Network Services in August 2001. Mr. Hawn has end-to-end responsibility over service delivery, maintenance, field operations, engineering and reliability. He has over 15 years of telecommunications management experience, including network planning, engineering, service delivery, provisioning, and software development. His former positions include Vice President of National Operations and Vice President of Program Management for @Link Networks, Inc. in Louisville, CO, Vice President of Planning and Engineering for ICG Communications, Inc. in Englewood, CO, and Technical Manager for Lucent Technologies’ Regional Technical Assistance Center (RTAC) in Lisle, IL and Cockeysville, MD.
Wayne Bell joined Pac-West as Vice President of Marketing in August 2001. He assumed additional responsibility as Vice President of Service Provider Markets in February 2003. In October 2003, he also assumed the added responsibility of SME Markets. Mr. Bell has overall responsibility over product management and development, business analysis, corporate communications, channel development and support, service provider sales and customer relations, and small and medium business sales and customer relations. Mr. Bell has over 11 years of telecommunications management experience, including product marketing, product and process development, network planning, engineering, sales, and operations. His former positions include Vice President of Marketing and Channel Development for @Link Networks, Inc. in Louisville, CO and Senior Director of Product and Process Development for ICG Communications, Inc. in Englewood, CO. He also served in a Director capacity in the Program Office for U S WEST Communications, Inc. in Englewood, CO.
Christine Ruane joined Pac-West in January 2000 as a Branch Manager in Napa, California, and was promoted to Regional Manager for Northern California in April 2002. Ms. Ruane has responsibility over the Company’s SME sales channel. In July 2002, she was appointed Vice President of Sales-SME Markets. Prior to joining Pac-West, Ms. Ruane was employed with Ameritel from 1995 to 1999 as Director of Enhanced Network and Agency Services. From 1987 to 1991, Ms. Ruane was employed with R.H. Macy and Co., where she held several executive management positions in sales and human resources.
Eric E. Jacobs joined Pac-West in March 2003 as Senior Director of Service Provider Sales and was promoted to Vice President, General Manager Service Provider Sales in December 2003. Mr. Jacobs has responsibility over the Company’s service provider sales and customer relations, focusing on revenue growth, customer retention, and new customer acquisitions. He has over ten years of sales management experience in the communications industry, including positions as Director of Sales for Metromedia Fiber Network from April 2000 to March 2003 and Manager of Corporate Accounts for Nextel Communications, Inc from August 1998 to April 2000.
Peggy Mc Gaw joined Pac-West in June 2002 as Executive Director of Accounting and Finance and was promoted to Vice President Finance in December 2003. Ms. Mc Gaw has responsibility over accounting, risk management, financial reporting and compliance, and tax and treasury activities. Prior to joining Pac-West she has served as CFO of theDial.com from 1999 to 2002. Prior positions included in her 19 years of finance experience are Vice President of Finance and Acting CFO of Intracel Corporation and Business Assurance Manager for PricewaterhouseCoopers, LLP. Her extensive experience with technology-based companies includes numerous capital raising and M&A transactions. Ms. Mc Gaw is a member of the American Institute of Certified Public Accountants, Financial Executives International and the Forum for Women Entrepreneurs.
John F. Sumpter joined Pac-West as Vice President of Regulatory in July 1999. He assumed additional responsibility as Vice President of Human Resources in January 2003. He is responsible for Pac-West’s relations with government regulatory agencies, regulatory compliance, intercarrier relations, and human resources. Mr. Sumpter has over 30 years of experience in the telecommunications industry. Prior to Pac-West, he was employed with AT&T from 1984 to 1999, where he held several executive level regulatory and marketing positions, including Division Manager of Law and Government Affairs, District Manager of Switched Services Product Management, and District Manager of Marketing. He currently serves as Chairman of the Board of CALTEL, the California Association of Competitive Telecommunications Companies and of CACE, the California Alliance for Consumer Education.
Robert C. Morrison joined Pac-West as Vice President and General Counsel in January 2003. He served on Pac-West’s Board of Directors from 2001 through December 31, 2002. He has served as our Corporate Secretary since February 2001. Mr. Morrison has responsibility over corporate governance, record keeping, documentation and legal administration of contractual relationships, and managing the Company’s relationships with outside law firms. Prior to joining Pac-West, Mr. Morrison was an attorney with Neumiller and Beardslee, P.C. in Stockton, California from 1972 to 2002. He served as Managing Director from 1983 to 1990. In July 2002, he completed a term on the Board of Regents of the University of California. He is a past president of the Greater Stockton Chamber of Commerce, the San Joaquin County Economic Development Association, and the alumni association for UC Davis, and is a former member of the Board of Directors and Executive Committee of the Lassen Volcanic National Park Foundation.
Directors
Wallace W. Griffin was appointed President, CEO, and a Director of Pac-West in September 1998 when an investor group he was part of purchased and recapitalized the Company. In June 2001 he transferred the title of president to Mr. Carabelli and in July 2003 he transferred the title of CEO to Mr. Carabelli. Mr. Griffin has over 40 years experience in telecommunications, cable television, publishing and advertising. Prior to joining Pac-West, Mr. Griffin served as a Group President for a number of Jones International companies from 1994 to 1997, including Jones Lightwave, Ltd., a CLEC, and Jones Education Company, a leader in using technology to deliver education. Concurrently, he was co-owner of a consulting and business development company, Griffin Enterprises, Inc. From 1987 through 1992, he served as the President and CEO of U S West Marketing Resources Group, where he managed the $1 billion publishing, media software and advertising services division. Mr. Griffin currently serves on the Advisory Board for the University of the Pacific Eberhardt School of Business and the Board of Trustees for the University of California, Merced.
A. Gary Ames has served as a Director of Pac-West since July 2000. Mr. Ames served as President and Chief Executive Officer of MediaOne International, a provider of broadband and wireless communications from 1995 until his retirement in June 2000. From 1989 to 1995, he served as President and Chief Executive Officer of U S West Communications, a regional provider of residential and business telephone services, and operator and carrier services. Mr. Ames also serves as a director of Albertsons, Inc., Tektronix, Inc. and iPass, Inc.
David G. Chandler has served as a Director of Pac-West since September 1998. Mr. Chandler is a Managing Director of William Blair Capital Partners, L.L.C., a Chicago-based private equity firm. In addition, Mr. Chandler is a Principal of William Blair & Company where he has been employed since 1987. Prior to joining William Blair & Company, Mr. Chandler was an investment banker with Morgan Stanley & Co. Inc. from 1984 to 1987. Mr. Chandler serves as a director of the following companies: Morton Grove Pharmaceuticals, Inc., Pharma Research Corporation, Engineering Materials Corp., U.S. Education Corporation, The Plastics Group and American Civil Constructors, Inc.
Jerry L. Johnson served as Chairman of Pac-West’s Board of Directors from September 1998 to June 2001. From 1995 until December 2001, Mr. Johnson was employed by Safeguard Scientifics Inc., where he was the Executive Vice President overseeing the partner companies in the E-Communications group. From 1985 to 1995, he worked at U S West in various positions, including Vice President, Network and Technology Services, which included managing U S West’s largest division, and supervising 21,000 management, engineering, technical and clerical employees. From 1983 to 1985, Mr. Johnson was President and CEO of Northwestern Bell Information Technologies.
John K. La Rue founded the Company’s predecessor (also known as Pac-West Telecomm, Inc.) in 1980 and served as its President until September 1998. From September 1998 until July 2001, Mr. La Rue served as Pac-West’s Executive Vice President. Currently, Mr. La Rue is semi-retired and employed on a part-time basis serving as an advisor to Mr. Carabelli, Pac-West’s President and CEO. Mr. La Rue has over 34 years of experience in the telecommunications industry.
Thomas A. Munro has served as a director since April 2003 and has over 22 years of financial and technology experience. In January 2003, he retired from Wireless Facilities, Inc. (Nasdaq: WFII), a global leader in the design, deployment, and management of wireless mobility and broadband wireless networks. He served as CFO from 1997 to 2000, and President from September 2000 until his retirement. Prior to WFI, he was founder and CEO of @Market, a retail sporting goods website. From 1994 to 1995, he served as CFO for Precision Digital Images, Inc. From 1981 to 1994, he was employed with MetLife Capital Corporation, where he served as CFO and a Director on the company’s Board from 1992 to 1994. He holds a bachelor’s degree in business administration and an MBA from the University of Washington and has co-authored two college level text books on computer programming. Mr. Munro also serves as a director of BioFortis, Inc. and Renaissance Golf Group.
Samuel A. Plum has served as a Director of Pac-West since September 1998. Mr. Plum has been a Managing General Partner of the general partner of SCP Private Equity Partners, L.P. since its commencement in August 1996, and was employed by Safeguard Scientifics from 1993 to 1996. From February 1989 to January 1993, Mr. Plum served as President of Charterhouse, Inc. and Charterhouse North American Securities, Inc., the U.S. investment banking and broker-dealer divisions of Charterhouse PLC, a merchant bank located in the United Kingdom. From 1973 to 1989, Mr. Plum served in various capacities at the investment banking divisions of PaineWebber, Inc. and Blyth Eastman Dillon & Co., Inc. Mr. Plum has 22 years of investment banking, mergers and acquisitions, and private equity investment experience. Mr. Plum also serves as a director of Index Stock Photography, Inc., Metallurg Holdings, Inc. and Pentech Financial Services Inc.
Dr. Jagdish N. Sheth has served as a Director of Pac-West since July 1999. Dr. Sheth has also been the Charles H. Kellstadt Professor of Marketing in the Goizueta Business School since 1991 and is the founder of the Center for Relationship Marketing at Emory University. From 1984 to 1991, Dr. Sheth was the Robert E. Brookner Professor of Marketing at the University of Southern California and is the founder of its Center for Telecommunications Management. Dr. Sheth also serves as a director of Norstan, Inc., Wipro Limited and Cryo-Cell, Inc.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity and Related Stockholder Matters
Market Information
The Company’s common stock trades under the symbol “PACW.” The following table represents the quarterly high and low closing sale prices of the Company’s common stock for the years ended December 31, 2003 and 2002 as reported by the Nasdaq Stock Market.
As of March 17, 2004, the number of shareholders of record of the Company’s common stock was 471. On May 28, 2002, our common stock ceased being quoted on the Nasdaq National Market and began being quoted on the Nasdaq SmallCap Market as a result of our failure to comply with the Nasdaq’s minimum bid price requirement. Following our move to the Nasdaq Small Cap Market, we were again notified that we failed to comply with the Nasdaq’s minimum bid requirement. On August 11, 2003, we received notification from the Nasdaq Listing Qualifications Panel that we regained compliance with all requirements for continued listing on the Nasdaq SmallCap Market. Consequently, we currently have no plans to implement the reverse split approved by our shareholders on June 9, 2003.
We have not declared any cash dividends on our common stock during the fiscal years 2003, 2002 and 2001, and do not anticipate declaring or paying any cash dividends in the foreseeable future. We currently intend to retain future earnings, if any, to fund the development and growth of our business. Declaration or payment of future dividends, if any, will be at the discretion of our Board of Directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion. In addition, our ability to pay dividends on the common stock is restricted by the provisions of our outstanding debt agreements.
Securities Issuance Under Equity Compensation Plans
The information required to be set forth herein is included in the section entitled “Securities Issuance Under Equity Compensation Plans” in Item 10 of the Company’s Proxy Statement, which section is incorporated herein by reference.
Recent sales of Unregistered Securities
On December 19, 2003, we sold to Deutsche Bank AG - New York, acting through DB Advisors, LLC, as investment advisor (Deutsche Bank), as investment advisor, in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended, a senior secured note in the principal amount of $40.0 million, which we refer to as the Senior Secured Note, and warrants to purchase up to 26,666,667 shares of our common stock at an exercise price of $1.50 per share. We used the net proceeds of this financing transaction, $40.0 million in cash less certain expenses, to complete a tender offer for $59.0 million in aggregate principal amount of our Senior Notes.
Item 6.
Item 6.
Selected Financial Data
This section presents selected historical financial data of the Company. You should read carefully the consolidated financial statements, related notes thereto, and the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K. The selected data in this section is not intended to replace the consolidated financial statements.
The following table highlights our financial performance for the last five years (in thousands except per share amounts and minutes of use data):
(1)
Restructuring charges relate to our restructuring plan approved and announced in June 2002 and August 2001.
(2)
As a result of our modified business plan, we determined some of our assets were impaired and recorded impairment charges. See Note 4 to the accompanying consolidated financial statements.
(3)
During 2003 and 2002, we repurchased some of our Senior Notes. See Note 8 to the accompanying consolidated financial statements.
Earnings before interest, taxes, depreciation and amortization (EBITDA) for the years ended December 31, 2003, 2002 and 2001 was $35.3 million, $58.9 million and $0.6 million, respectively. EBITDA represents earnings before interest, net; income taxes; depreciation and amortization. Although EBITDA is not a measure of financial performance under generally accepted accounting principles, we believe EBITDA is a common measure used by analysts and investors to evaluate our capacity to meet our obligations. We also use EBITDA as an internal measurement tool and accordingly, we believe that the presentation of EBITDA provides useful and relevant information. The table above reconciles EBITDA to net cash provided by operating activities.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
We encourage you to read the following discussion and analysis in conjunction with the “Selected Consolidated Financial Data” and our consolidated financial statements and related notes, which are included in this Annual Report. Our discussion of results of operations and financial condition includes various forward-looking statements about our markets, the demand for our products and services and our future results. We based these statements on assumptions that we consider reasonable. Actual results may differ materially from those suggested by our forward-looking statements for various reasons, including those discussed under “Risk Factors” and elsewhere.
Introduction
As described more fully under “Business,” we are a high-value, independent broadband provider of integrated communications services within our target markets. Our customers include Internet service providers and enhanced communications service providers, collectively referred to as service providers,
or SPs, and the enterprise market, also referred to as the small and medium sized enterprises, SME business, many of which are communications-intensive users.
Fiscal 2003 was an eventful year for us. While our consolidated revenues for the year ended December 31, 2003 decreased by $29.5 million, or 18.0%, to $134.6 from $164.1 million for the year ended December 31, 2002 largely as a result of decreases in reciprocal compensation payments received from incumbent local exchange carriers, or ILECs, we continue to increase the number of lines in service and minutes of use on our network with total DS-0 lines in service increasing 30.9% to 428,192 as of December 31, 2003 and billable minutes of use up 29.9% to 41.7 billion for the year ended December 31, 2003. In addition, as described more fully below, in December 2003, we sold to Deutsche Bank a senior secured note in the principal amount of $40.0 million and warrants to purchase up to 26,666,667 shares of our common stock at an exercise price of $1.50 per share, and used the proceeds to repurchase a significant portion of our Series B 13.5% Senior Notes due 2009, which we refer to as the Senior Notes, as part of a tender offer.
The following table shows financial performance and noteworthy items (in thousands except per share amounts):
Earnings before interest, taxes, depreciation and amortization (EBITDA) represents earnings before interest expense, net; income taxes; depreciation and amortization. For the years ended December 31, 2003, 2002 and 2001 EBITDA was $35.3 million, $58.9 million and $0.6 million, respectively. Although EBITDA is not a measure of financial performance under generally accepted accounting principles, we believe EBITDA is a common measure used by analysts and investors to evaluate our capacity to meet our obligations. We also use EBITDA as an internal measurement tool and accordingly, we believe that the presentation of EBITDA provides useful and relevant information. The table included in item 6 above reconciles EBITDA to net cash provided by operating activities.
In December 2003, we successfully completed an important financing transaction which permitted us to reduce our debt level and future cash interest expense. In particular, on December 19, 2003, we sold to Deutsche Bank AG - New York, acting through DB Advisors, LLC, as investment advisor, (Deutsche Bank), a Senior Secured Note in the principal amount of $40.0 million, which we refer to as the Senior Secured Note, and warrants to purchase up to 26,666,667 shares of our common stock at an exercise price of $1.50 per share. The guarantee and security agreement grants Deutsche Bank a security interest in substantially all of our assets. We used the net proceeds of this financing transaction, $40.0 million in cash less certain expenses, together with our own cash, to complete a tender offer for $59.0 million in aggregate principal amount of our Senior Notes. In connection with the tender offer, we also solicited consents to effect certain proposed amendments to the indenture governing the Senior Notes. These amendments to the indenture governing the Senior Notes, which are now effective, eliminated most of the indenture’s principal restrictive covenants and amended some other provisions contained in the indenture.
We derive our revenues from monthly recurring charges, usage charges and amortization of initial non-recurring charges. We provide services to both retail and wholesale customers. Monthly recurring
charges include the fees paid by customers for lines in service and additional features on those lines, as well as equipment collocation services. Usage charges consist of fees paid by end users for each call made, fees paid by our intercarrier customers as reciprocal compensation for completion of their customers’ calls through our network, and access charges paid by carriers for long distance traffic terminated on our network. Initial non-recurring charges consist of fees paid by end users for the installation of our service. These payments and related costs up to the amount of revenues are recognized as revenue and expense ratably over the term of the service contracts, which is generally 24 to 36 months. We recognize revenue when there is persuasive evidence of an arrangement, delivery of the product or performance of the service has occurred, the selling price is fixed or determinable and collectibility is reasonably assured.
We also have intercarrier customers who pay us to terminate their originating call traffic on our network. These payments consist of meet point, transit traffic and reciprocal compensation payments, collectively referred to as reciprocal compensation. Reciprocal compensation payments are a function of the number of calls we terminate, the minutes of use associated with such calls and the rates we are compensated at by the ILECs. Reciprocal compensation payments have historically been a significant portion of our revenues but the intercarrier payments are not currently a targeted customer. In particular, reciprocal compensation payments accounted for 35.0%, 48.7% and 41.6% of our total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. As a result, the failure, for any reason, of one or more ILECs from which we ordinarily receive reciprocal compensation payments to make all or a significant portion of such payments would adversely affect our financial results.
Our right to receive reciprocal compensation payments from ILECs, as well as the right of other CLECs to receive such payments is the subject of numerous regulatory and legal challenges. For example, in 2003, Verizon and SBC attempted to adopt the Federal Communications Commission’s, or FCC’s, Intercarrier ISP Compensation Order. The FCC ISP order introduced a series of declining reciprocal compensation pricing tiers for minutes of use, at rates starting below the rates previously negotiated in our interconnection agreements (ICAs) with both carriers. The lowest pricing tier specified by the FCC ISP order was reached on June 15, 2003, will remain in effect until such time that a replacement FCC ISP order may become effective. Additionally, the FCC ISP order introduced artificial annual growth limits on compensable minutes of use subject to reciprocal compensation based on the composition and balance of traffic between carriers. Based on Verizon’s interpretation of the growth cap formula, Verizon commenced withholding of reciprocal compensation payments to us for the final five months and SBC commenced withholding for the final month in 2003. We are disputing these withheld reciprocal compensation payments and have challenged the legality of the growth caps as well as Verizon’s and SBC’s implementation of the FCC ISP order; however, there are no assurances that we will ever receive these withheld reciprocal compensation payments. We expect that SBC and Verizon may also withhold reciprocal compensation payments in 2004 and beyond once we have exceeded their calculation of the growth cap.
In addition, the rates upon which reciprocal compensation payments are determined are generally under downward pressure. For example, on May 16, 2002, the California Public Utilities Commission, or CPUC, implemented an Unbundled Network Element pricing structure for local traffic exchanged with SBC in California. The impact of this pricing structure had a significant negative impact on the reciprocal compensation revenue recognized subsequent to the ruling.
Our tax affairs are subject to audit and review by numerous taxing authorities, including the Internal Revenue Service (IRS). An IRS audit of our tax returns for 1999, 2000 and 2001 is currently ongoing. The IRS may propose certain adjustments, which could be material in amount, in connection with its audit of these periods. If such adjustments were to be proposed by the IRS, we expect that we would vigorously defend the tax returns as filed. However, there can be no assurance that we will be able to successfully defend our tax positions. If we were unsuccessful in defending our tax returns as filed, we
may be assessed a significant tax liability for one or more of the periods under audit, which could have a material adverse effect on our future financial results.
As technology continues to evolve with the corresponding development of new products and services, there is no guarantee we will retain our customers with our existing product and service offerings or with any new products or services we may develop in the future. While the demand for Internet access in our target markets continues to grow, the demand for dial-up Internet access has slowed in recent years. The introduction of broadband and Voice over Internet Protocol (VoIP), could further effect the growth of our existing dial-up access to the Internet and our switched local and long-distance voice products. VoIP utilizes high-speed data networks rather than traditional phone lines to complete calls, offering customers enhanced functionality and potential cost savings over traditional carrier networks. VoIP services are rapidly gaining momentum in the enterprise market as the quality and reliability continue to improve and broadband becomes more affordable. In this regard, in the fourth quarter of 2003 we entered into a joint operating agreement with Sentient Group, Inc. (Sentient) to jointly develop opportunities for the application of VoIP services to the enterprise market, and in the first quarter of 2004 we acquired substantially all of the assets, and assumed certain specified liabilities of Sentient.
Regulatory uncertainty and competition in the communication services market has resulted in the consolidation of CLECs, a trend we expect to continue. In order to grow our business and better serve our customers, we continue to consider new business models and strategies, including potential acquisitions or new business lines. We believe that the statewide footprint of our network, which encompasses all of the major metropolitan areas of California, provides us with a significant competitive advantage that will enable us to successfully compete in the future, but we cannot guarantee that we will be able to sustain continued growth.
Results of Operations
The following table summarizes the results of operations as a percentage of our revenues for the years ended December 31, 2003, 2002 and 2001. Income (loss) from operations for 2003, 2002 and 2001 includes restructuring and impairment charges totaling $0.1 million, $25.2 million and $25.6 million, respectively.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
The significant revenue components and operational metrics of the Company for the years ended December 31, 2003 and 2002 are as follows:
Consolidated revenues for the year ended December 31, 2003 decreased by $29.5 million, or 18.0%, to $134.6 million from $164.1 million for the year ended December 31, 2002. The decrease in revenues was mainly the result of a $32.8 million decrease in reciprocal compensation, due principally to withholding of reciprocal compensation payments to us by Verizon for the final five months and SBC for the final month in 2003, and negotiated settlements of previously withheld reciprocal compensation payments in 2003 of $5.7 million compared to $20.6 million in 2002. This decrease was partially offset by a $7.9 million increase in recurring charges and installation charges billed directly to SP and SME business customers due to the increase growth in total lines in service in 2003 over 2002 and an increase in billable minutes of use during the same period.
The total DS-0 equivalent lines in service (lines) increased 30.9% to 428,192 as of December 31, 2003 from 327,021 lines as of December 31, 2002 due to our continued success at attracting new customers and retaining existing customers. Billable minutes of use were 41.7 billion for the year ended December 31, 2003, up 29.9% from 32.1 billion billed minutes during 2002 due to both the increased number of lines in service and higher average traffic volume per line on a year over year basis. Of these minutes, 40.9 billion and 31.4 billion were subject to reciprocal compensation in 2003 and 2002, respectively.
The following table describes the main components of our reciprocal compensation revenues for the years ended December 31, 2003 and 2002 (in thousands excepts minutes of use):
Reciprocal compensation decreased by $32.8 million or 41.1% to $47.1 million from $79.9 million in 2002. The main reason for the decrease was:
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a decrease of $14.9 million in amounts received as a result of the settlement of disputes related to prior withholdings of reciprocal compensation payments in 2003;
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withholdings of reciprocal compensation payments in 2003 by Verizon for the final five months and SBC for the final month based on Federal rate caps; partially offset by
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an increase of 30.1% in minutes of use subject to reciprocal compensation payments.
Direct billings to SP customers increased during the year ended December 31, 2003 from the same period in 2002 by $3.5 million, or 8.4%, to $45.0 million from $41.5 million during the year ended December 31, 2002. While lines in service to this market increased to 363,164 lines at December 31, 2003 from 272,636 lines in service at December 31, 2002, an increase in lines of 90,528, or 33.2%, revenue per line decreased in response to on-going competitive pressure on pricing.
Direct billings to SME business customers increased in the year ended December 31, 2003 from the same period in 2002 by $4.4 million, or 34.1%, to $17.3 million from $12.9 million during the same period in 2002. This increase was primarily due to introduction of new services for SME customers in 2003 combined with an increase in lines in service to 65,028 lines at the year ended December 31, 2003 from 54,385 lines in service at December 31, 2002, an increase of 10,643, or 19.6%, partially offset by lower rates offered to our new and renewing customers in 2003 in response to increased market pricing pressures.
Outbound local and long distance revenues, including 800, 888, and 877 numbers and travel card calls, decreased during the year ended December 31, 2003 by $0.5 million or 3.8% to $12.7 million from $13.2 million during the year ended December 31, 2002. The decline in revenue from 2002 to 2003 was principally due to the highly competitive nature of this market.
The $3.3 million, or 37.1%, decrease in dedicated transport revenues to $5.6 million during the year ended December 31, 2003 from $8.9 million during the same period in 2002 primarily relates to reduced service levels. Switched access revenues decreased in the year ended December 31, 2003 from the same period in 2002 by $1.2 million, or 16.7%, to $6.0 million from $7.2 million in the year ended December 31, 2002. This decrease was mainly due to payments received in 2002 that were previously withheld.
Our significant costs and expenses for the years ended December 31, are as follows:
Our consolidated network expenses for the year ended December 31, 2003 decreased by $17.2 million, or 32.1%, to $36.3 million from $53.5 million for the corresponding period in 2002. The decrease in expense is primarily the result of negotiated supplier credits recorded and improved network utilization in the year ended December 31, 2003, and decisions made in 2002 to discontinue certain low-margin products and services, specifically products and services related to COAM equipment and DSL. Although we continue to look for ways to optimize our network, we cannot guarantee that our network expenses will continue to decline in the future as we experience growth in network operations associated with a higher level of telecommunications activity.
Our consolidated selling, general and administrative expenses for the year ended December 31, 2003 decreased $0.9 million, or 1.5%, to $59.2 million from $60.1 million for the same period in 2002.
The decrease is primarily the result of decreases in bad debt expense of $0.8 million, resulting from improved quality in our customer base and collection activities. The reserve for bad debts requires management’s judgment and is based on customer specific indicators, as well as historical trending, industry norms and recognition of current market indicators about general economic conditions. Reserve for bad debt was $1.6 million and $1.7 million at December 31, 2003 and 2002, respectively. Selling, general and administrative expenses were 44.0% and 36.6% of revenues for the year ended December 31, 2003 and 2002, respectively. Selling, general and administrative expenses as a percentage of revenues increased in 2003 mainly due to the decrease in 2003 revenues as discussed above.
Estimates and assumptions are used in setting depreciable lives. Assumptions are based on internal studies of use, industry data on average asset lives, recognition of technological advancements and understanding of business strategy. Our consolidated depreciation and amortization expense for the year ended December 31, 2003 increased $3.6 million to $44.0 million, from $40.4 million for the same period in 2002. The increase in depreciation and amortization expense is primarily due to the change in estimated useful lives of certain assets, which we made in January 2003, and a higher fixed asset depreciable base in 2003. This change reduced the useful life for phone equipment provided to customers and computer hardware from 5 years to 3 years and extended the useful life of some leasehold improvements from 10 years to up to 20 years. These changes were made to more closely match our accounting treatment to the expected lives of these assets. As a result of the change, we incurred a charge in 2003 which increased depreciation expense for the year ended December 31, 2003 by $1.6 million.
Restructuring charges were $0.1 million for the year ended December 31, 2003 compared to $8.6 million in the year ended December 31, 2002. A summary of the restructuring expenses and the associated remaining liability which is included in other accrued liabilities in the our consolidated balance sheet as of December 31, 2003 and 2002 consist of the following (in thousands):
We did not approve a new restructuring plan in 2003. During 2003, we recorded additional restructuring charges of $0.2 million relating to office space in San Diego, California. Due to the specialized nature of this facility and current economic conditions we no longer anticipate finding a
tenant for the remaining available space. The amount of the reserve recorded is equal to the monthly lease payment of the unoccupied space multiplied by the remaining months on the lease. In addition, during 2003, we reversed $0.1 million of previously recorded restructuring charges relating to professional fees that were anticipated but not incurred. The final cash payment to be recorded against the restructuring reserve is currently expected to occur in March of 2010.
Loss from operations for the year ended December 31, 2003 was $5.0 million compared to a loss from operations of $15.1 million for the year ended December 31, 2002. In addition to the factors discussed in the preceding paragraphs no asset impairment charges were recorded in year ended December 31, 2003 compared to asset impairment charges of $16.6 million in year ended December 31, 2002.
Our consolidated interest expense, net for the year ended December 31, 2003 decreased $2.8 million, or 17.7%, to $13.0 million from $15.8 million for the same period ended 2002. Interest expense is net of interest income. Interest expense over these two periods is primarily related to our Senior Notes issued on January 29, 1999, including amortization of related deferred financing costs associated with the offering over a period of ten years. The decrease in interest expense, net during 2003 was primarily due to reduced interest expense of $3.9 million consistent with lower average debt outstanding, due to the repurchase of approximately $54.9 million principal amount of Senior Notes during 2002, offset by reduced interest income of $1.1 million.
Our effective income tax rates for the years ended December 31, 2003 and 2002 reflect the applicable Federal and state statutory income tax rates. For the years ended December 31, 2003 and 2002, our effective income tax rate was 29.9% and 26.7%, respectively.
Net loss for the year ended December 31, 2003 was $15.2 million compared to net income of $2.0 million in the year ended December 31, 2002. This was principally due the factors discussed in the preceding paragraphs, and a gain on the repurchase of bonds of $3.7 million in the year ended December 31, 2003 compared to a gain on the repurchase of bonds of $33.8 million in the year ended December 31, 2002;
Year Ended December 31, 2002 Compared to Year Ended December 31,
The significant revenue components and operational metrics for the years ended December 31, are as follows (in millions except lines and minutes of use):
Consolidated revenues for the year ended December 31, 2002 increased by $14.1 million, or 9.4%, to $164.1 million from $150.0 million for the year ended December 31, 2001. The increase in revenues is
primarily the result of an increase of $17.5 million in reciprocal compensation payments, which includes $20.6 million of previously withheld reciprocal compensation billings in negotiated settlements during 2002. In addition, there was an increase of $4.2 million in recurring charges and installation charges billed directly to SP and SME business customers and an increase of $1.5 million in switched access revenues resulting from increased line growth and usage. These increases were partially offset by a decrease of $6.8 million in product and service revenues related to exiting the COAM business, a decrease of $1.2 million in local and long distance usage revenues and a decrease of $0.9 million in dedicated transport services due primarily to declining market rates During 2002, we also experienced a decrease of approximately 57.6% in the reciprocal compensation rate at which we are compensated at by the ILECs.
The total lines in service increased 39.0% to 327,021 as of December 31, 2002 from 235,244 lines as of December 31, 2001. Billable minutes of use were 32.1 billion for the year ended December 31, 2002, up 20.7% from 26.6 billion billed minutes during 2001. The Company has also segregated SME lines into on-network and off-network components as related to the Company’s decision to exit a number of off-network lines of business in 2002.
The number of inbound local minutes subject to reciprocal compensation revenues in accordance with interconnection agreements were 31.4 billion and 26.0 billion for the years ended December 31, 2002 and 2001, respectively, while the year over year increase of 5.4 billion billable minutes of use from 2001 to 2002 represented a 20.8% increase. However, the favorable increase in inbound local minutes was offset by the 57.6% decline in the reciprocal compensation rate over the course of the year. Net of the effect of the previously withheld reciprocal compensation payments of $20.6 million during the year ended December 31, 2002, reciprocal compensation revenues decreased $3.1 million from 2001 to $59.3 million compared to $62.4 million for the year ended December 31, 2001. Total reciprocal compensation revenue, inclusive of settlement amounts, for the year ended December 31, 2002 was $79.9 million.
Direct billings to SP customers increased during the year ended December 31, 2002 from the same period in 2001 by $2.2 million, or 5.6% to $41.5 million from $39.3 million during the year ended December 31, 2001. This change was due to the increase in lines in service to this market from 193,266 lines at December 31, 2001 to 272,636 lines in service at December 31, 2002. The revenue effect of the 41.1% increase in lines in service was partially offset by the drop in DSL revenue when the Company exited the DSL market during the second quarter of 2002.
Direct billings to SME business customers increased during the year ended December 31, 2002 from the same period in 2001 by $2.0 million, or 18.3% to $12.9 million from $10.9 million during the year ended December 31, 2001. This change was due to the increase in lines in service from 41,978 lines at December 31, 2001 to 54,385 lines in service at December 31, 2002. The revenue effect of the 29.6% increase in lines in service was partially offset by a drop in the residential resale revenue when the Company exited the residential market during the second quarter of 2002.
Outbound local and long distance revenues, including 800, 888, and 877 numbers and travel card calls, decreased during the year ended December 31, 2002 from the same period in 2001 by $1.2 million or 8.3% to $13.2 million from $14.4 million during the year ended December 31, 2001. Although total minutes billed to customers increased between periods, the average rate per minute charged to customers declined in part to a change in the mix between local and long distance calls made by customers changed during these periods. During the year ended December 31, 2002, approximately 44.8% of minutes billed to customers were charges for local minutes compared to approximately 43.6% in the same period ended 2001. The revenue effect was also impacted when the Company made business decisions to exit certain lines of business such as residential, certain 800 numbers and the suspension of service in states outside the Company’s network footprint.
The $0.9 million, or 9.2%, decrease in dedicated transport revenues to $8.9 million during the year ended December 31, 2002 from $9.8 million during the year ended December 31, 2001 primarily relates to decreases in the number of SP customers who collocate at our SuperPOPs.
As a result of comprehensive product reviews intended to identify opportunities to improve profitability undertaken in connection with the development of the restructuring plan, we decided to exit certain low-margin businesses in 2001 such as COAM equipment, residential resale and DSL and concentrate efforts in developing next generation offerings. This decision contributed to decreased revenues from product and service offerings of $6.7 million, or 93.1%, for the year ended 2002 compared to the same period ended 2001.
The significant costs and expenses of the Company for the years ended December 31, are as follows:
Our consolidated network expenses for the year ended December 31, 2002 decreased $3.8 million, or 6.6% to $53.5 million from $57.3 million for the year ended December 31, 2001. Although we continue to experience an increase in network operations associated with a higher level of minutes of use passing through our network, our network expenses declined from the prior year as a result of discontinuing certain low-margin products and services, our business decision to shut down certain of our switch locations during 2001 and improve capital utilization.
Our consolidated selling, general and administrative expenses for the year ended December 31, 2002 decreased $6.5 million, or 9.8%, to $60.1 million from $66.6 million for the year ended December 31, 2001. In first two quarters of 2001 we incurred significant selling and marketing costs in connection with our anticipated efforts to expand our operations and establish ourselves in new markets before the decision was made to implement the 2001 restructuring plan, which provided for, among other things, a workforce reduction. Our headcount remained fairly stable throughout 2002 with 414 employees as of December 31, 2002 compared to 407 employees at December 31, 2001. During the fourth quarter of 2001 we completed a work force reduction of approximately 200 employees as part of our 2001 restructuring plan. As anticipated, the workforce reduction resulted in payroll savings of approximately $5.4 million for the year ended December 31, 2002 compared to the year ended December 31, 2001. Selling, general and administrative expenses for the year ended December 31, 2001 also include approximately $1.1 million of provision for doubtful accounts compared to $3.2 million for the year ended December 31, 2001, a decrease of $2.1 million. The reserve for bad debts requires management’s judgment and is based on customer specific indicators, as well as historical trending, industry norms and recognition of current market indicators about general economic conditions. During 2001 we experienced an unusually high level of delinquencies and bankruptcies in our customer base. This was primarily due to our mix of customers, which included among others residential, paging and COAM. We exited these product lines during 2001 and early 2002 due in part to the high level of delinquencies experienced in 2001 on these product lines. In addition, our SP customer base contracted as the smaller, less financially stable customers were forced to restructure, or failed to survive. Our overall SP lines in service and SP revenues were not directly affected by this contraction as our larger SP customers absorbed many of the smaller SP customers end user base. Partially offsetting these costs savings, however, were additional legal expenses incurred in connection with efforts to defend our position on various reciprocal compensation proceedings and additional maintenance and property tax expense incurred on purchases of equipment between the years. Selling, general and administrative expenses were 36.6% and 44.4% of revenues for the years ended December 31, 2002 and 2001 respectively.
Estimates and assumptions are used in setting depreciable lives. Assumptions are based on internal studies of use, industry data on average asset lives, recognition of technological advancements and understanding of business strategy. Our consolidated depreciation and amortization expense for the year ended December 31, 2002 increased $6.2 million to $40.4 million from $34.2 million for the year ended December 31, 2001. Depreciation and amortization as a percentage of revenues increased to 24.6% for the year ended December 31, 2002 from 22.8% from the year ended December 31, 2001. The increase in depreciation and amortization expense was primarily due to additional depreciation expense incurred related to significant capital purchases between years. During the year ended December 2002 the Company purchased an additional $19.6 million of property and equipment.
Restructuring charges were $8.6 million for the year ended December 31, 2002 compared to $8.8 million in the year ended December 31, 2001. A summary of the restructuring expenses and the associated remaining liability which is included in other accrued liabilities in the our consolidated balance sheet as of December 31, 2002 and 2001 consist of the following (in thousands):
In June 2002, management approved a restructuring plan that contained additional business initiatives to those approved and announced in August 2001. The 2002 restructuring plan was approved in response to:
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further weakening of the economy;
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additional competitive pressure from competitors who had reorganized and lowered their cost structure;
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overcapacity in our industry; and
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lower demand from customers for our products and services.
Among other initiatives, the 2002 restructuring plan provided for the closure of our switch facility in Colorado. In connection with this closing, we recorded a $9.3 million restructuring charge in the second quarter of 2002. Of this amount, $3.3 million related to the write-off of the net book value of leasehold improvements and equipment which could not be redeployed to other locations and, in management’s
best estimate, had a fair market value of zero; $2.8 million related to circuit commitment obligations; and $3.2 million related to future rent payments due for the abandoned premise in Colorado which will be paid over the lease term, which ends in fiscal year 2010. In order to estimate rent expense related to this premise, and those premises discussed in the following paragraph, the Company made certain assumptions including; (1) the time period over which the premises would remain vacant, (2) sublease terms, and (3) estimated sublease rents. In the case of the Colorado switching facility and the Utah switching facility described in the following paragraph, no sublease income was estimated due to the specialized nature of these facilities and current economic conditions. Accordingly, the Company believed the net book value of the leasehold improvements for the facilities had a fair market value of zero.
In the third quarter of 2002, we recorded an additional restructuring charge of $21,000, net representing the net difference between the amount estimated and the actual net book value of impaired leasehold improvements. In the fourth quarter of 2002, we reduced our restructuring accrual for future rent payments for the Colorado switch facility by $0.2 million as we had to use the facility longer than anticipated due to a delay in transferring one of our customers to another carrier. This lease expires in March 2010.
In the fourth quarter of 2002, we negotiated and paid an early termination penalty to satisfy all future rent payments due for our switch facility in Utah. Accordingly, we reversed previous charges of $0.5 million to bring the accrual for this facility to zero.
In August 2001, in response to a weakening economy and increasing competitive pressure resulting from lower than expected demand for telecommunications services and overcapacity in our industry, we shifted our strategy to margin improvement, cost containment and cash conservation rather than top-line growth we approved and announced a restructuring plan. Among the initiatives included in the restructuring plan was the suspension of our expansion plans in certain states, exiting of certain lower margin products and services, including residential resale and customer owned and maintained (COAM) equipment, and undertaking certain cost reduction initiatives. In addition to restructuring certain product offerings, the restructuring initiatives included closing the switch facility in Utah, consolidation of six sales offices, and a workforce reduction of approximately 200 employees. As a result of these restructuring initiatives, we recorded an $8.8 million restructuring charge in the third quarter of 2001, of which $5.0 million was related to the write-off of leasehold improvements and other equipment in Utah, which could not be redeployed to other locations. Amounts expensed totaling $2.4 million relate to future rent payments due (net of estimated sublease payments) for abandoned premises, primarily in Utah and San Diego, to be paid over the respective lease terms. The workforce reduction was completed during the fourth quarter, with all severance payments being made as of December 31, 2001.
Our consolidated interest expense for the year ended December 31, 2002 decreased $2.5 million to $17.4 million from $19.9 million for the year ended December 31, 2001. Interest expense is net of capitalized interest. Interest expense over these two years is primarily related to the $150 million Senior Notes issued on January 29, 1999, including amortization of related deferred financing costs associated with the offering over a period of ten years. As a result of purchasing from holders of our Senior Notes an aggregate of approximately $54.9 million principal amount of Senior Notes during 2002, interest expense on our Senior Notes declined between the years. However, these interest savings were partially offset by a reduction of capitalized interest of $1.0 million and $1.7 million for the twelve months ended December 31, 2002 and 20001 respectively.
Loss from operations was $15.1 million for the year ended December 31, 2002 compared to $33.7 million for the year ended December 31, 2001. In addition to the factors discussed in the preceding paragraphs we recorded asset impairment charges of $16.6 million in the year ended December 31, 2002 compared to asset impairment charges of $16.8 million in year ended December 31, 2001.
Our consolidated interest income for the year ended December 31, 2002 decreased $2.6 million to $1.6 million from $4.2 million for the year ended December 31, 2001. This decrease is primarily related to lower cash balances between the years. Interest income includes realized gains and losses on investments.
The Company’s effective income tax rates reflect the applicable Federal and state statutory income tax rates. For the years ended December 31, 2002 and 2001, the Company’s effective income tax rate was 26.7% and 29.5%, respectively.
Net income for the year ended December 31, 2002 was $2.0 million compared to net loss of $34.8 million in the year ended December 31, 2001. This was because of the factors discussed in the preceding paragraphs and a gain on the repurchase of bonds of $33.8 million in the year ended December 31, 2002 compared to no equivalent loss in the year ended December 31, 2001.
Quarterly Operating and Statistical Data
The following table sets forth unaudited operating and statistical data for each of the specified quarters of 2003 and 2002. The operating and statistical data for any quarter are not necessarily indicative of results for any future period.
(1)
The decline in ports equipped from September 30, 2002 to December 31, 2002 is a result of ports in transit from our Denver switch facility to our Oakland switch facility.
Liquidity and Capital Resources
Sources and use of cash. At December 31, 2003 cash and short term investments decreased $22.6 million to $34.7 million from $57.3 million at December 31, 2002. The primary cause of the decrease was:
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repayment of Senior Notes of $59.0 million in December 2003;
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financing costs of $5.2 million related to our efforts to reduce debt; offset by
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Senior Secured Note proceeds of $40.0 million.
Net cash provided by operating activities was $18.4 million for the year ended December 31, 2003 as compared to net cash provided by operating activities of $44.6 million for the same period ended in 2002. Net cash provided by operating activities for the periods ended December 31, 2003 and 2002 includes $0.1 million and $5.2 million, respectively of restructuring charges. Some of the main reasons for the decline in net cash provided by operating activities in 2003 from 2002 were as follows:
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withholdings of reciprocal compensation payments by Verizon for the final five months and SBC for the final month of 2003 based on their interpretation of growth rate caps;
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a decrease of $14.9 million in amounts received as a result of the settlement of disputes related to reciprocal compensation payments withheld from prior periods; and
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a loss on redemption of debt of $3.7 million in 2003 compared to a gain in 2002 of $33.8 million.
Net cash provided by investing activities was $23.7 million for the year ended December 31, 2003 compared to a net cash used in investing activities of $30.2 million for the same period ended in 2002. During the year ended December 31, 2003 we sold $29.4 million of short-term investments, to help fund the repurchase of the Senior Notes, as compared to $10.8 million of purchases of short-term investments during the year ended December 31, 2002. Purchases of property and equipment decreased to $5.7 million during the year ended December 31, 2003 as compared to $19.6 million during the same period in 2002 as we were able to re-deploy existing or under-utilized equipment rather than purchase new equipment to meet our operating needs.
Net cash used in financing activities was $35.5 million for the year ended December 31, 2003 compared to $50.4 million for the same period ended 2002. This was mainly due to cash used to repurchase our Senior Notes of $59.0 million in 2003 and $20.7 million in 2002, partially offset by $40.0 million of cash provided by the issuance of Senior Secured Notes in December 2003.
Cash requirements. The telecommunications service business is capital intensive. Our operations have required substantial capital investment for the design, acquisition, construction and implementation of our network. With the recent advancements in switch technology, we are currently investigating our options for the deployment of our first next generation network switch, which represents the latest technological improvements in switch capacity and configuration, sometime during 2004. In addition we completed a modem replacement program in the first quarter of 2004 which we expect will provide us with increased operational efficiencies. We continue to seek further ways to enhance our infrastructure in 2004 and beyond. These projects and our business plan, as currently contemplated, anticipates capital expenditures, excluding acquisitions, of approximately $12 million for 2004. However, the actual cost of capital expenditures during 2004 will depend on a variety of factors. Accordingly, our actual capital requirements may exceed, or fall below, the amounts described above.
During the normal course of business, we may enter into agreements with some suppliers, which allow these suppliers to have equipment or inventory available for purchase based upon criteria as defined by us. As of December 31, 2003, we did not have any material future purchase commitments to purchase equipment from any of our vendors.
Debt outstanding. At December 31, long-term debt and capital lease obligations consist of the following (in thousands):
The Senior Secured Note in the principal amount of $40.0 million carries an interest rate of LIBOR plus 0.5% (1.7% at December 31, 2003), and matures in December 2006. The maturity date of the Senior Secured Note will be automatically extended to coincide with any extension of the expiration date of the warrants, which is extendable for up to an additional 18 months at the option of Deutsche Bank. Under the terms of the guaranty and security agreement related to the Senior Secured Note, we granted Deutsche Bank a security interest in substantially all of our assets and agreed to certain
covenants including limitations on our ability to incur additional indebtedness, incur liens, sell assets and pay dividends.
The Senior Notes in the principal amount of approximately $36.1 million bear interest at 13.5% per annum payable in semiannual installments, with all principal due in full on February 1, 2009. In conjunction with the December 2003 tender offer for Senior Notes we also solicited consents to effect certain proposed amendments to the indenture governing the Senior Notes. These amendments to the indenture governing the Senior Notes, which are now effective, eliminated most of the indenture’s principal restrictive covenants and amended certain other provisions contained in the indenture.
In addition, we are currently considering various alternatives to replace our senior credit facility which expired in 2002. However, there can be no assurance we will be successful in obtaining additional capital sources at rates and terms acceptable to us.
Future uses and sources of cash. Our principal sources of funds for 2004 are anticipated to be current cash and short-term investment balances and cash flows from operating activities. We may also obtain lease or additional lines of credit in 2004. There can be no assurance that additional lines of credit or leases will be entered into at interest rates that are acceptable. We believe that these funds will provide us with sufficient liquidity and capital resources for us to fund our business plan for the next 12 months. No assurance can be given, however, that this will be the case. We discuss our material contractual obligations under “Contractual obligations” below. As currently contemplated, we expect to fund, among other things:
•
interest payments of approximately $5 million assuming an interest rate of 2% on our Senior Secured Note and our expected election to defer quarterly interest payments;
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anticipated capital expenditures of approximately $12 million; and
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capital lease payments (including interest) of approximately $3 million.
The foregoing statements do not take into account (i) acquisitions, which, if made, are expected to be funded through a combination of cash and equity (ii) the repurchase of any of our remaining outstanding Senior Notes or (iii) any potential payments made in respect of adjustments which may arise from our ongoing tax audits. Depending upon our rate of growth and profitability, among other things, we may require additional equity or debt financing to meet our working capital requirements or capital needs. There can be no assurance that additional financing will be available when required, or, if available, will be on terms satisfactory to us. Key factors which could affect our liquidity include:
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future demand of our services;
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financial stability of our customers;
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outcomes of regulatory proceedings involving reciprocal compensation;
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capital expenditures;
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our debt payments;
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capital lease repayments; and
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interest expense on debt.
The guaranty and security agreement related to the Senior Secured Note contains various covenants, which among other things restrict our ability to borrow future amounts, early repay future borrowings and restrict our ability to pay dividends or repurchase our common stock. Our Senior Notes indenture contained financial and other covenants and events of default. However in connection with the cash tender offer and consent solicitation we obtained the consent of the majority of our holders of our Senior Notes to amend certain provisions of the indenture governing such Senior Notes. The amendments eliminated substantially all of the restrictive covenants and certain events of default and
related provisions contained in the indenture. We received the consent of noteholders holding a majority of the outstanding principal amount of Senior Notes, and entered into a supplemental incorporating the amendments.
Contractual Obligations
Our significant contractual obligations at December 31, 2003 are as follows (in thousands):
(1)
The Senior Secured Note matures in December 2006 and has been included in due from 1-3 years. This note can be extended for 18 months at the option of Deutsche Bank. The carrying value of the note included in liabilities in our balance sheet was approximately $18.4 million at December 31, 2003 as further described in Note 8 in the accompanying consolidated financial statements.
Off balance sheet arrangements
At December 31, 2003, 2002, and 2001, we did not have any other relationships with unconsolidated entities or financial partnerships, including entities often referred to as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Therefore, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we were engaged in such relationships.
Inflation
We do not believe that inflation has had any material effect on our business over the past three years.
Application of Critical Accounting Policies
Critical Accounting Policies. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that effect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities, and reported amounts of revenues and expenses for the reporting period. We consider the following accounting policies to be critical policies due to the estimation processes involved in each:
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revenue recognition;
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provision for doubtful accounts receivable;
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estimated settlement of disputed billings; and
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impairment of long-lived assets.
By their nature, these judgments are subject to an inherent degree of uncertainty. Thus, actual results could differ from estimates made and these differences could be material.
Revenue Recognition. We recognize revenue when:
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there is pervasive evidence of an arrangement;
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delivery of the product or performance of the service has occurred;
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the selling price is fixed and determined; and
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collectibility is reasonably assured.
Non-refundable up-front payments received for installation services and related costs up to the amount of installation revenues, are recognized as revenue and expense ratably over the term of the service contracts, generally 24 to 36 months. Any costs in excess of recognized revenues are expensed in the current period. As of December 31, 2003 and 2002, $1.1 million and $1.3 million, respectively, of installation payments received were deferred and are included in deferred revenues, and $0.7 million and $0.9 million, respectively, of associated costs were deferred and are included in other assets, respectively, in the accompanying consolidated balance sheets.
We recognize revenues from the sale of telecommunications products upon installation, or if no installation is required, upon shipment, which is concurrent with the transfer of legal title. Revenues from service access agreements are recognized as the service is provided, except for reciprocal compensation generated by calls placed to ISPs connected through our network. Our right to receive this type of compensation is the subject of numerous regulatory and legal challenges. Until this issue is ultimately resolved, we will continue to recognize reciprocal compensation as revenue when the price becomes fixed and determinable and collectibility is reasonably assured.
Some ILECs with which we have interconnection agreements had withheld payments from amounts billed by us under their agreements. The process of collection of reciprocal compensation can be complex and subject to interpretation of regulations and laws. This can lead to the requirement for negotiated settlements between us and the ILEC where we agree to accept a portion of what we believe is owed to us. These settlements generally reflect the mutual agreements of both parties that exist at the date of the settlement. Settlements were entered into with ILECs whereby the ILECs paid us an aggregate of $5.7 million in 2003 and $20.6 million in 2002. The settlements were included in revenues.
Provision for doubtful accounts receivable. Provisions for allowances for doubtful accounts receivable are estimated based upon:
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historical collection experience;
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customer delinquencies and bankruptcies;
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information provided by our customers;
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observance of trends in the industry; and
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other current economic conditions.
At December 31, 2003 our provision for doubtful accounts receivable was $1.6 million, which represented approximately 17.8% of accounts receivable. If an additional 1% of our gross accounts receivable were deemed to be uncollectible at December 31, 2003, our provision for doubtful accounts and provision for bad debt expense would increase by approximately $0.9 million. If this information does not properly reflect future collections, our accounts receivable balance could be subject to change.
Accruals for disputed billings. During the ordinary course of business, we may be billed for carrier traffic that management believes we are not responsible for. Accordingly, we will dispute with the appropriate vendor and withhold payment until the matter is resolved. Our current disputes are primarily related to incorrect facility rates or incorrect billing elements we believe we are being charged. Management regularly reviews and monitors all disputed items and, based on industry experience, records an accrual that represents what we estimate that we owe on the disputed billings. Although we
continue to actively try and expedite resolutions, often times the state Public Utilities Commission must become involved to arbitrate such agreements. This process is often not timely and resolutions often subject to appeal. As of December 31, 2003, the Company has accrued approximately $1.8 million, representing approximately 37.5% of the gross amount of disputes in negotiation at this time. If resolutions to items in negotiation are favorable or unfavorable to management’s estimations, our reserve for disputed items may be subject to change.
Long-lived assets. In 2002, we adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” We evaluate our long-lived assets if events or changes in circumstances indicate that the carrying amount of such assets may not be fully recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the potential future income expected to be generated by the asset. If we consider an asset to be impaired, it is written down to its estimated fair market value. This is assessed based on factors specific to the type of asset. In assessing the recoverability of these assets, we must make assumptions regarding, among other things, estimated future cash flows to determine the fair value of the respective assets. If these estimates and the related assumptions change in the future, we may be required to record additional impairment charges for these assets in the future.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
The SEC’s rule related to market risk disclosure requires that we describe and quantify our potential losses from market risk sensitive instruments attributable to reasonably possible market changes. Market risk sensitive instruments include all financial or commodity instruments and other financial instruments that are sensitive to future changes in interest rates, currency exchange rates, commodity prices or other market factors. We are not exposed to market risks from changes in foreign currency exchange rates or commodity prices. We do not hold derivative financial instruments nor do we hold securities for trading or speculative purposes. At December 31, 2003, we had an outstanding $40.0 million principal amount of Senior Secured Notes payable. These notes are at a rate of LIBOR plus 0.5%, which was 1.7% at December 31, 2003. A hypothetical 1% point increase in short-term interest rates would reduce the annualized income before tax by approximately $0.4 million as a result of higher interest expense.
Additionally, we are exposed to changes in interest rates on our investments in cash equivalents and short-term investments. Substantially all of our investments are in cash equivalents with original maturities of less than three months. Currently this reduces our exposure to long-term interest rate changes. A hypothetical 1% decrease in short-term interest rates would reduce the annualized pretax interest income on our $34.7 million cash and cash equivalents at December 31, 2003 by approximately $0.3 million.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Our consolidated financial statements required by Item 8, together with the notes thereto and the report thereon of the independent public accountants dated February 13, 2004, are set forth on pages through of this Form 10-K. The consolidated financial statement schedule listed under Item 14(a)2 is set forth on page of this Form 10-K and should be read in conjunction with our consolidated financial statements.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
On June 4 2002, we dismissed our independent auditors, Arthur Andersen LLP (Arthur Andersen), and engaged KPMG LLP (KPMG) as our new independent auditors for the fiscal year ending December 31, 2002. Our board of directors authorized the dismissal of Arthur Andersen and the engagement of KPMG.
Arthur Andersen provided auditing services to us since 1996. During this time, which specifically includes the fiscal year ended December 31, 2001, and the subsequent interim period through June 4, 2002, there were no disagreements between Arthur Andersen and us on any matter of accounting principals or practices, financial statement disclosure, or auditors scope or procedure, which disagreements, if not resolved to Arthur Andersen’s satisfaction, would have caused them to make reference to the subject matter of the disagreement in connection with its reports. Furthermore, there were no reportable events described under Item 304(a)(1)(v) of Regulation S-K.
The audit reports issued by Arthur Andersen on our consolidated financial statements as of and for the year ended December 2001 did not contain an adverse opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.
During the fiscal year ended December 31, 2001, and the subsequent interim period through June 4, 2002, we did not consult with KPMG regarding any of the matters or events set forth in Item 304(a)(2)(i) and (ii) of Regulation S-K.
Item 9A.
Item 9A.
Controls and Procedures
Within 90 days prior to the filing of this Report, we carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-14(c) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), in accordance with Rule 13a-15 of the Exchange Act. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer, together with the other members of management participating in the evaluation, concluded that we are in compliance with the requirements of Rule 13a-15(a) of the Exchange Act and that our disclosure controls and procedures are effective.
There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the date of our evaluation of our disclosure controls and procedures. It should be recognized that the design of any system of controls is based upon certain assumptions about the scope of the tasks to be performed and the environment in which the tasks are to be performed. As such, our internal controls provide us with a reasonable assurance of achieving their intended effect.
PART III
Items 10, 11, 12, 13 and 14.
Information concerning Executive Officers of the Company is included in this Annual Report in Item 4A under the caption “Executive Officers of the Registrant.” Information required by Items 10, 11, 12, 13, and 14 of Part III of this Annual Report on Form 10-K is incorporated by reference from Pac-West Telecomm, Inc.’s Proxy Statement, to be delivered to its shareholders in connection with its Annual Meeting of Shareholders to be held June 16, 2004, which will be filed with the Securities Exchange Commission, pursuant to Regulation 14A, not later than 120 days after the end of the fiscal year, all of which information is hereby incorporated by reference, in and made part of, this Annual Report on Form 10-K.
PART IV
Item 15.
Exhibits, Financial Statement Schedule and Reports on Form 8-K
(a)(1) Financial Statements
The consolidated financial statements of Pac-West Telecomm, Inc. and its subsidiaries for the year ended December 31, 2003, together with the Report of Independent Public Accountants, are set forth on Pages through of this annual report on Form 10-K. The supplemental financial information listed and appearing hereafter should be read in conjunction with the consolidated financial statements included in the Form 10-K.
(2) Financial Statement Schedules
The following are included in Part IV of this annual report on Form 10-K for each of the years ended December 31, 2003, 2002 and 2001 as applicable:
Schedule II - Valuation and Qualifying Accounts
Financial statement schedules not included in this Form 10-K have been omitted either because they are not applicable or because the required information is shown in the consolidated financial statements or notes thereto, included in this annual report on Form 10-K.
(3) Exhibits
The exhibits are filed herewith pursuant to Item 601 of Regulation S-K.
*
Newly filed with this report
+
Management contract or compensatory plan or arrangement
(a) Reports on Form 8-K
On December 22, 2003, we furnished pursuant to Item 9 of Form 8-K a copy of our press release issued on December 19, 2003, and related exhibits containing the announcement of the Settlement of Cash Tender Offer and Closing of Financing Transaction With Deutsche Bank.
On December 19, 2003, we furnished pursuant to Item 9 of Form 8-K a copy of our press release issued on December 18, 2003, containing the announcement the expiration of Cash Tender Offer and Shareholder Approval of Certain Proposals Related to the Previously Announced Financing Transaction with Deutsche Bank.
On November 26, 2003, we furnished pursuant to Item 9 of Form 8-K a copy of our press release issued on November 25, 2003, containing the announcement that the expiration of the early premium deadline for tendering Senior Notes.
On November 18, 2003, we furnished pursuant to Item 9 of Form 8-K a copy of our press release issued on November 17, 2003, announcing that we had extended the early tender premium deadline and expiration time to repurchase our Senior Notes.
On November 17, 2003, we furnished pursuant to Item 9 of Form 8-K a copy of our press release issued on November 14, 2003, announcing that we had extended the early tender premium deadline and expiration time to repurchase our Senior Notes.
On November 14, 2003, we furnished pursuant to Item 9 of Form 8-K a copy of our press release issued on November 13, 2003, announcing that we had extended the early tender premium deadline and expiration time to repurchase our Senior Notes.
On October 30, 2003, we furnished pursuant to Item 9 of Form 8-K a copy of our press release issued on October 30, 2003, announcing that we had offered to repurchase up to $74.0 million of our outstanding Senior Notes.
On October 30, 2003, we furnished pursuant to Item 12