Item 1. Business
For definitions of certain terms used in this Form 10-K, see "Certain Definitions" beginning on Page 15 hereof.
Overview
Vanguard Cellular Systems, Inc. ("the Company") is an independent operator of cellular telephone systems in the United States with 7.9 million aggregate POPs as of December 31, 1997. The Company serves over 645,000 subscribers located in five "metro-clusters," or contiguous groups of cellular markets, comprised of 29 markets in the Eastern United States, including the Mid-Atlantic and Ohio Valley SuperSystems and the Florida, Carolinas and New England metro-clusters. The Mid-Atlantic SuperSystem, which is contiguous to the New York, Philadelphia and Baltimore/Washington MSAs and the New England metro-cluster, which is contiguous to the Boston MSA, (four of the nation's seven largest MSAs) collectively represent approximately 71% of the Company's operating POPs. The Company's wireless products and services are distributed under the CellularONE(R) brand name, one of the most recognized brand names in the wireless industry.
In March, 1998, the Company entered into an agreement to sell for $160 million in cash its investment in the Myrtle Beach, South Carolina RSA. Additionally, the Company entered into an agreement in February 1998 to sell for $30 million its interest in the Eastern North Carolina Cellular Joint Venture which includes the Wilmington and Jacksonville, NC markets. These transactions, which are expected to close in the third quarter of 1998, are subject to approval by regulatory authorities, including the FCC. The Company is also pursuing various divestiture alternatives related to its Florida Metro-Cluster and other non-core cellular properties in which it owns minority interests.
The Company's markets are located in predominantly suburban and rural areas proximate to major urban areas, which the Company believes affords it several advantages over traditional urban wireless operations, including (i) greater network capacity, (ii) greater roaming revenue opportunities, (iii) lower distribution costs and (iv) higher barriers to entry. Because there are limits to the number of signals that can be transmitted simultaneously in a given area, the Company's less densely populated suburban and rural locations allow for greater frequency reuse, resulting in greater overall network capacity than in high density urban markets. The Company is able to provide high quality voice transmission with reduced instances of blocked or dropped calls. In addition to these network advantages, the Company's metro-clusters enjoy greater roaming revenue opportunities by virtue of their proximity to large urban centers. This benefit is best exemplified in the Mid-Atlantic SuperSystem, which is located in the heavily traveled corridor between New York, Philadelphia and Baltimore/Washington D.C. Roaming revenue requires minimal incremental administrative and marketing expenditures, and the Company believes that it is well positioned to benefit from both cellular roaming and eventual roaming by users of personal communication services ("PCS"). The Company has signed an agreement with AT&T Wireless and Sprint Spectrum to provide roaming services to both companies' PCS customers who roam into the Company's markets with dual frequency phones. The Company also believes that it experiences lower distribution costs due to its internal distribution channels such as direct sales, retail stores and kiosks, which are more economical outside of urban areas. Finally, the Company believes that the lower population density and greater geographic coverage of its suburban and rural metro-clusters act as barriers to entry given the relatively higher per-subscriber costs of building competing wireless systems.
Since its inception until the introduction of PCS, the cellular industry had two entities competing as facilities based carriers in each market. Licensing for PCS broadband spectrum is complete, and the Company is currently competing with PCS operators in six markets and is aware of site acquisition, zoning and construction of infrastructure by other competitive PCS providers in several of its other markets. The Company is preparing for increased competition by building out and converting its cellular telephone systems to digital networks, increasing the quality of coverage in its service areas, offering new features, products and services to its customers and expanding its service areas through selected acquisitions of adjacent and nearby cellular systems. The Company believes its management team's operating experience, developed distribution channels and customer service orientation will be significant components in providing effective competition to these new entrants. In addition, the Company believes its extensive system footprint and the location of its operations in suburban and rural markets provide significant barriers to early competition from PCS competitors.
Business Strategy
The Company's overall goal is to continue to pursue strong growth of subscribers, revenues and EBITDA. The Company intends to achieve this goal through its operating strategy of providing a broad range of high quality integrated wireless communications products and services. Key elements of the Company's strategy include:
o Development of Core Metro-Cluster Service Areas. The Mid-Atlantic SuperSystem, Ohio Valley SuperSystem and New England Metro-Cluster, which the Company considers to be its core metro-cluster service areas, represent 88% of the Company's subscribers and 86% of the Company's POPs at December 31, 1997. The Company plans to continue a strategy of developing and supplementing its core regional metro-clusters to enable it to serve its customers better and to achieve cost efficiencies through economies of scale. By operating in contiguous markets, the Company can provide broad areas of seamless service and achieve economies of scale in marketing and operations as well as cost efficiencies in deploying its network infrastructure. The Company continually evaluates opportunities for acquisitions of new cellular properties in proximate suburban and rural markets that will expand its core metro-clusters. Given the Company's focus on its core metro-cluster service areas, the Company has entered into or is pursuing agreements to divest of its interests in the Florida and Carolinas metro-clusters as well as its minority interests in all other non-core cellular properties.
o Continuous Cellular Network Buildout. The Company continuously improves its systems. In 1994, the Company began a cellular network expansion and upgrade program in order to increase geographic coverage and provide for additional portable usage in the Company's cellular markets. In 1995, 1996 and 1997 combined, the Company added 274 new cell sites and replaced or upgraded 108 others, bringing its total number of cell sites to 458 as of December 31, 1997. The Company plans to add 86 cell sites in 1998 as it continues to enhance its network. The Company believes that its networks have sufficient capacity in its spectrum to serve the Company's growing subscriber base in the near future but plans to implement a gradual transition to digital technology before analog capacity constraints become a significant concern. The Company's networks are currently digital-ready, with dual mode analog/Time Division Multiple Access ("TDMA") digital radio technology already built-in such that individual transmitters may be converted to digital mode with minimal additional investment. See " -- Expansion of Product Offerings" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
o Investment in Brand Identity. The Company's wireless products and services are distributed under the CellularONE(R) brand name, one of the most recognized brand names in the wireless industry. The CellularONE(R) brand name currently is used by cellular systems covering more than 11,000 cities and towns, representing total POPs of over 129 million. The Company has a minority ownership interest in the partnership that owns the CellularONE(R) brand name and that controls the promotion and management of the brand. In addition to benefitting from local advertising by licensees, the CellularONE(R) brand name is advertised on a national basis by the partnership that owns the brand with funding provided by licensing fees.
o Emphasis on Customer Service and Advanced Billing Systems. The Company provides on-line customer support, 24 hours a day, seven days a week. The Company's internally developed, proprietary Flexcell(R) billing and management information system enables the Company to provide quality services to its expanding customer base and affords it access to customer data, which it uses to facilitate its marketing efforts. One such service is Rapid Activation, which enables the Company to complete credit checks, order entry, and subscriber activation within five minutes. See " -- Customer Service."
o Growth of Internal Distribution Channels. The Company distributes its products and services through both its internal distribution network (direct sales force, sales and service centers, and retail stores) and external distribution channels (national retailers, local agents and automotive dealers). The Company is continuing its long-term emphasis on internal distribution channels, particularly its own retail outlets, which the Company believes offer substantial benefits. These benefits include lower cost, higher effectiveness in selling to high margin customers, and a consistent point of customer contact, resulting in greater ongoing satisfaction for both internally and externally generated customers. The Company is therefore building additional retail outlets, as well as upgrading existing outlets. See " -- Marketing and Distribution."
o Expansion of Product Offerings. The Company continues to offer new and innovative products and services in order to increase the value of the basic voice product to the customer and to increase airtime revenues. In addition to enhanced cellular voice service packages, the Company has begun to offer data transmission, and Cellular Digital Packet Data ("CDPD") services are being deployed. The Company has also begun reselling paging and Internet services. With the integration of digital technology, the Company will be able to offer a variety of additional services such as caller identification, short messaging and call encryption.
Markets and Clusters
The following table sets forth as of December 31, 1997, (i) the markets in which the Company owns an interest in a cellular system by region and by cluster, (ii) the Company's ownership percentage of the system, (iii) the total POPs (as derived from 1997 population estimates) and (iv) the Company's POPs based on its ownership percentage.
Company Total Net Ownership POPs POPs --------- ------- ------- Mid-Atlantic SuperSystem: Allentown, PA/NJ ................ 100.00% 713,438 713,438 Wilkes-Barre/Scranton, PA ....... 100.00 653,817 653,817 Harrisburg, PA .................. 100.00 499,402 499,402 Lancaster, PA ................... 100.00 453,348 453,348 York, PA ........................ 100.00 456,861 456,861 Reading, PA ..................... 100.00 353,650 353,650 Williamsport, PA ................ 100.00 118,681 118,681 State College, PA ............... 100.00 131,962 131,962 Wayne, PA (PA-5 RSA) ............ 100.00 84,292 84,292 Chambersburg, PA (PA-10 East RSA) 100.00 141,875 141,875 Mifflin, PA (PA-11 RSA) ......... 100.00 113,933 113,933 Lebanon, PA (PA-12 RSA) ......... 100.00 117,361 117,361 Union, PA (PA-8 RSA) ............ 100.00 408,709 408,709 Altoona, PA ..................... 100.00 131,287 131,287 Binghamton, NY/PA ............... 100.00 293,703 293,703 Elmira, NY ...................... 100.00 92,820 92,820 --------- Subtotal .................... 4,765,139 --------- Ohio Valley SuperSystem: Huntington, WV/KY/OH ............ 100.00 316,929 316,929 Charleston, WV .................. 100.00 254,889 254,889 Parkersburg, WV /OH ............. 100.00 157,364 157,364 Chillecothe, OH (OH-9 RSA) ...... 100.00 248,993 248,993 Athens, OH (OH-10-South RSA) .... 100.00 112,256 112,256 Logan, WV (WV-6 RSA) ............ 100.00 182,128 182,128 Ripley, WV (WV-1 RSA) ........... 100.00 77,008 77,008 --------- Subtotal .................... 1,349,567 --------- New England Metro-cluster: Portland, ME .................... 100.00 288,136 288,136 Portsmouth, NH/ME ............... 100.00 280,193 280,193 Bar Harbor, ME (ME-4 RSA) ....... 100.00 86,052 86,052 Bangor, ME ...................... 5.31 144,777 7,681 Other ........................... 15,558 --------- Subtotal ................... 677,620 --------- Florida Metro-cluster: Pensacola, FL ................... 100.00 390,989 390,989 Fort Walton Beach, FL ........... 100.00 168,283 168,283 Panama City, FL ................. 18.28 146,713 20,184 Columbus, GA .................... 13.69 250,931 34,361 Albany, GA ...................... 10.29 117,662 12,105 Pascagoula, MS .................. 3.99 129,421 5,164 Other ........................... 9,445 --------- Subtotal .................... 640,531 --------- Carolinas Metro-cluster: * Myrtle Beach, SC (SC-5 RSA) ... 100.00 253,351 253,351 * + Wilmington, NC ................ 47.97 211,278 101,345 * + Jacksonville, NC .............. 47.79 144,614 69,112 Petersburg, VA ................ 12.44 129,786 16,141 --------- Subtotal ..................... 439,949 --------- Other Minority Interests .......... 38,664 --------- TOTAL POPs ........................ 7,911,470 =========
- ---------- + Jointly controlled through the Company's 50% ownership of a joint venture. * The Company has entered into agreements to divest of these interests in 1998.
Subscribers
Management believes that the Company generates the majority of its revenue from subscribers who are business users. Historically, the Company's business users were individuals in such professions as construction and real estate who worked extensively from their cars and utilized cellular telephone service to improve productivity. As a result of the growing acceptance of cellular communications and the declining cost of portable and transportable phones, as well as the Company's marketing efforts, the Company is attracting larger numbers of customers who are nonbusiness users and business users now are drawn from a wider range of occupations. Business users normally generate more revenue than nonbusiness consumers. While the Company anticipates increasing nonbusiness consumer acceptance of cellular telephone service, business users are expected to generate the majority of the Company's revenue for the foreseeable future.
The following table sets forth the aggregate number of subscribers in the Company's majority-owned markets at the end of the periods indicated.
Quarter 1995 1996 1997 ------- ------- ------- ------- First ........... 280,000 405,000 540,000 Second .......... 314,000 430,000 580,000 Third ........... 340,000 461,000 610,000 Fourth .......... 381,000 513,000 645,000
The incremental subscriber growth and the rate of incremental subscriber growth in the Company's majority-owned markets is set forth in the following table for the periods indicated.
1995 1996 1997 ------- ------- ------- Incremental Subscriber Growth ....... 136,000 132,000 132,000 Rate of Incremental Subscriber Growth 56% 35% 26%
The following table sets forth the number of subscribers and the penetration percentages in majority-owned markets as of the dates indicated.
- ---------- * Penetration represents total year-end subscribers divided by year-end total POPs in the Company's majority-owned markets.
The decrease in penetration from 1995 to 1996 in the Ohio Valley SuperSystem was due entirely to the acquisition in 1996 of certain markets in which the penetration was significantly lower than the Company's existing markets. The Company expects this region to add subscribers at rates consistent with its other operating regions in the future. The Company believes subscriber growth and increased penetration in 1995, 1996 and 1997 were a product of the growing acceptance of cellular communications and the Company's efforts to capitalize on this increasing acceptance of cellular communications and an expanded distribution network. In addition, 1995 and 1996 subscriber growth was augmented by approximately 9,000 and 5,000, subscribers, respectively, associated with the acquisition of certain cellular markets.
Products and Services
The Company's primary line of business is the provision of cellular telephone services. Customers are offered several pricing options combining different monthly access and usage charges and fees for related services.
The Company provides regional service among its contiguous markets, such as those within the Mid-Atlantic SuperSystem. A customer in these regions can place and receive calls throughout the network without any additional daily fee and often at the same incremental rate per minute as in the customer's home market. In certain adjacent cellular markets not owned by the Company, the
Company offers similar regional pricing options to its subscribers. The Company has entered into agreements with other cellular companies that allow its subscribers to roam in substantially all of the MSAs and RSAs in the country. These agreements allow the Company's subscribers to be pre-registered in cellular systems outside the Company's operating regions and to receive service while they are outside their home systems, typically for a per minute usage charge, and in most cases, an additional daily fee.
The Company has offered and will continue to offer new and innovative products and services in order to increase the value of the basic voice product to the customer and to increase airtime revenues. Recent service additions include enhanced voice mail, which alerts the customer when a message has been left, and single number service, which allows a customer to use the same phone number in several locations. Other recent service additions include call management, which directs incoming calls to a succession of locations until the customer is reached, and voice dialing, which lets the customer make calls by spoken command without having to touch the keypad.
The Company now offers digital data transmission over its existing cellular network, which allows the rapid transfer of data to and from personal computers, personal digital assistants, and other devices. During 1997, the Company completed testing of its TDMA digital voice and features network in conjunction with Northern Telecom. Vanguard was selected to serve as the test site for Northern Telecom's TDMA hardware and software. The tests were successful and led to the introduction of IS-136 TDMA digital voice using the new 13 Kb vocoders (voice encoders) and features in Myrtle Beach, South Carolina and the Southern Pennsylvania region in the fourth quarter of 1997. The remaining markets are expected to offer digital service by the second quarter of 1998.
The digital upgrades will allow the Company to offer a full range of digital services to its customers. Among the new opportunities are full digital voice communication, short message service, caller ID, and paging. Additionally, Cellular Digital Packet Data ("CDPD") and Wireless Intelligent Network ("WIN") services are being deployed. See "--Cellular Technology."
During 1997, other new product offerings included extensive voice-mail and call-tracking options. The Company has begun reselling paging services in its regional metro-clusters. To maintain its access to quality paging for its customers in its Mid-Atlantic SuperSystem, the Company has entered into an agreement to purchase NationPage, a leading regional paging provider in Pennsylvania and New York for approximately $28.5 million. The acquisition of NationPage will minimize future capacity constraints, eliminate variations in reselling prices and margins, and create synergies with the Vanguard sales and network infrastructure. The Company also expanded its product offering into Internet services as a reseller.
During 1998, the Company's transition to digital service will allow the Company to offer a full range of digital services to customers as discussed above. Additionally, the Company intends to offer long distance telephone service on a reselling basis.
Marketing and Distribution
The Company markets its services under the CellularONE(R) brand name, one of the most recognized brand names in the wireless communications industry. In addition to benefiting from local advertising by licensees, the CellularONE(R) brand name is advertised on a national basis by the partnership that owns the brand using the proceeds of licensing fees. The CellularONE(R) brand name currently is used by cellular systems covering more than 11,000 cities and towns with total POPs of more than 129 million. The Company is one of three owners of the CellularONE(R) brand name. The Company currently has an option to increase its ownership interest in the partnership that owns the brand name, at a cost of approximately $6.1 million, to one-third from the 2.5% interest it currently owns. As an owner of the CellularONE(R) name, the Company exercises influence over the promotion and future services offered under the brand. As part of an ongoing strategy to enhance the value of the CellularONE(R) brand, the owners of the brand currently plan to continue to license new carriers to operate under the CellularONE(R) name, both for cellular, as well as for paging, PCS, long distance and for resellers of these services. Where CellularONE(R) is licensed, existing licensees currently have the exclusive right to use the brand name for cellular and other services.
The Company uses multiple distribution channels in each of its service areas to provide effective and extensive marketing of its products and services and to reduce its reliance on any single distribution source. These distribution channels fall into two broad categories: internally developed and controlled channels, and external channels.
The Company is continuing its long-term focus on internal distribution channels as a means to reduce the cost and improve the quality of new subscribers. The Company's retail stores have been a historically low-cost distribution channel.
The Company believes that cellular customers prefer to deal directly with sales representatives employed by the Company. In addition, Company stores provide an ongoing point of contact for service to subscribers regardless of whether the point of purchase was internal or external. The Company plans to expand its base of retail stores and kiosks and upgrade its existing retail outlets. The Company had over 110 retail locations as of December 31, 1997 and intends to add 10 locations in 1998.
The Company's direct sales force consists of approximately 850 sales and administrative employees, who target small-to-medium sized companies, a high-margin area of business. In order to maintain a knowledgeable, customer-oriented sales force, the Company developed and administers its own sales training program designed to educate sales representatives for its markets. The program offers a curriculum that highlights mobile technologies, cellular equipment prospecting, sales techniques, and the customer service process, and the Company believes that, following the program, sales representatives are better able to address existing and potential customers' needs in a professional, knowledgeable and productive manner.
The Company sells and rents cellular telephone equipment to its customers in order to encourage use of its services. The Company continues its practice, typical in the industry, of selling telephones at or below cost in response to competitive pressures. The magnitude of the losses experienced in connection with providing cellular telephone equipment reflects the Company's increased subscriber growth. The Company also offers an equipment rental program that many subscribers have found to be an economical means of acquiring the use of cellular equipment. Under the terms of the rental program, subscribers obtain the use of a cellular telephone for a monthly charge. Although the Company retains ownership of this equipment, subscribers have the option to purchase their cellular telephones at any time during the rental period. The Company often utilizes a promotion under which the first year's rental charge is waived when the subscriber agrees to a one-year service contract.
The Company also utilizes a telemarketing program as part of its sales and customer service efforts. This program is intended to aid the customer by providing sales follow-up and support, and helps the Company in securing additional and better sales referrals, upgrading existing subscribers to higher rate plans and promoting new custom-calling features.
External distribution channels include national retailers such as WalMart, automobile dealers, and local agents and resellers. The Company enters into exclusive short-term contracts with each of its external distribution channels. Rapid growth in the wireless communications business, especially from customers contracted through external channels, reduced the percentage of internally generated customers from 70% in 1992 to 52% in 1995. While the Company benefitted from the increased success of external distribution channels, the Company continues to emphasize internal distribution channels, which it believes result in higher long-term profit margins, and as a result, the percentage of internally generated customers increased to 70% and 75% in 1996 and 1997, respectively.
Customer Service
The Company places a high priority on providing consistently high quality customer service. The central customer service department located in Greensboro, North Carolina, is open 24 hours daily, including weekends and holidays, and is available to handle all types of customer service inquiries. In 1996, the Company opened regional call centers in each of its metro-clusters to handle certain types of customer issues. The benefits of regional call centers include having service delivery as close to the customer as possible to cover specific regional circumstances, being a more significant local employer in the regions and reducing the risk of encountering a lack of experienced customer service employees in the Greensboro, North Carolina area. The central customer service facility continues to provide service as backup and overflow for the regional centers, as primary service provider in certain instances and for the critical evening, night and weekend duty. All customer service personnel are trained in certain key areas such as general mobile telephone technology, available cellular equipment, cellular billing and roaming. The Company believes that this training provides these employees with the requisite knowledge to handle customer inquiries quickly and competently, resulting in greater customer satisfaction. The Company's training program, which was developed and is administered internally, requires employees to demonstrate competency through testing.
The Company has developed a proprietary billing and management information system, Flexcell(R), which it believes provides several service advantages to its customers. Using Flexcell(R), customer service representatives are able to access current billing information quickly in order to respond promptly to customer inquiries. In addition, this system allows for integration of customer-related data from various operations within the Company into a single database. Using this database, service calls are systematically analyzed each month to highlight key customer issues. The customer database also provides the basis for customer satisfaction information. The Company has entered into a contract to provide Flexcell(R) software and support to American Mobile Satellite Corporation, but is not currently marketing Flexcell(R) to third parties in order to ensure that it can meet the needs of the Company and American Mobile Satellite Corporation.
To supplement the Company's customer service operations, Company telemarketers contact customers periodically to determine their satisfaction with the Company's service and to identify problems that can lead to subscriber cancellations. The Company has developed an integrated feature called "Rapid Activation," designed to reduce the time required to activate service for a new customer. Rapid Activation allows the Company to perform a credit check, complete order entry and activate a cellular subscriber in approximately five minutes.
To ensure quality installation for automotive customers and overall customer satisfaction, the Company has established its own installation and repair centers in most of its markets. These CellularONE(R) installation and repair centers provide one-stop shopping for the Company's customers and enable the Company to control installation quality and scheduling and inventory levels. These centers are also authorized to perform warranty repair work for certain cellular telephone manufacturers.
Cellular Telephone Technology
Cellular telephone service is a form of telecommunications capable of delivering high quality, high capacity mobile and portable telephone services. Cellular systems are engineered so that a service area is divided into multiple cells approximately one to five miles in radius. Each cell contains a relatively low power transmitter, a receiver and signaling equipment (the base station). The base station in each cell is connected by microwave or telephone line to the mobile telephone switching office ("MTSO"). The MTSO controls the automatic transfer of calls from cell to cell as a subscriber travels, coordinates calls to and from a mobile unit, allocates calls among the cells within the system, and connects calls to the local landline telephone system or to a long-distance telephone network. Each conversation in a cellular system involves a radio transmission between a subscriber unit and a base station and the transmission of the call between the base station and the MTSO.
The MTSO and base stations periodically monitor the signal strength of calls in progress. The signal strength of the transmission between a subscriber unit and the base station in any cell declines as the unit moves away from the base station. When the signal strength of a call declines to a predetermined level, the MTSO hands off the call in a fraction of a second to the base station of another cell where the transmission strength is greater. If the subscriber unit leaves the service area of the cellular system, the call is disconnected unless an appropriate technical interface has been established with an adjacent system.
The FCC has allocated the cellular telephone systems frequencies in the 800 MHz band of the radio spectrum. Each of the two licenses in a cellular market is assigned 416 frequency pairs. Each conversation on a cellular system occurs on a pair of radio talking paths, thus providing full duplex (i.e., simultaneous two-way) service. Two significant features of cellular telephone systems are: (i) frequency reuse, enabling the simultaneous use of the same frequency in two adequately separated cells, and (ii) call hand-off. A cellular telephone system's frequency reuse and call hand-off features result in efficient use of available frequencies and enable cellular telephone systems to process more simultaneous calls and service more users over a greater area than conventional mobile telephone systems.
A cellular telephone system's capacity can be increased in various ways. Within certain limitations, increasing demand may be met by simply adding available frequency capacity to cells as required or, by using directional antennas, dividing a cell into discrete multiple sectors or coverage areas, thereby facilitating frequency reuse. Furthermore, an area within a system may be served by more than one cell through procedures that utilize available channels in adjacent cells. When all possible channels are in use, further growth can be accomplished through a process known as "cell splitting." Cell splitting entails dividing a single cell into a number of smaller cells serviced by lower-power transmitters, thereby increasing the reuse factor and the number of calls that can be handled in a given area. Digital transmission technologies are expected to provide cellular licensees with additional capacity to handle calls on cellular frequencies.
There are limits to the number of signals that can be transmitted simultaneously in a given area. In highly populated MSAs, the level of demand for mobile and portable service is often large in relation to the existing capacity of most systems. Based on the demographics of its markets, the Company does not anticipate that the provision of mobile and portable service within its networks will require as large a proportion of the systems' capacities as is required in higher density MSAs. Therefore, the Company's systems are expected to have more capacity with which to pursue data applications and other expanded cellular services, which the Company believes may enhance its revenue potential and limit market opportunities for competitive mobile data systems.
All cellular telephones are designed to be compatible with cellular systems in all market areas within the United States so that a cellular telephone may be used wherever a subscriber is located. Changes of cellular telephone numbers or other technical adjustments to mobile units by the manufacturer or local cellular telephone service businesses are generally required to enable the subscriber to change from one cellular service provider to another within a service area. Cellular system operators may provide service to roamers
temporarily located in, or traveling through, their service area. The cellular system providing service to the roamer generally receives 100% of the revenues from such service and such roaming charges are billed to the roamer's local service provider.
The cellular mobile telephone services available to customers and the sources of revenue available to a system operator are similar to those available with standard home and office telephones. For example, cellular systems can offer a variety of features, including call forwarding, call waiting, conference calling, voice message and retrieval, and data transmission. Because cellular systems are fully interconnected with the landline telephone network, subscribers can receive and originate both local and long distance calls from their cellular telephones. The subscribers generally are charged separately for monthly access, air time, toll calls and custom calling features.
Cellular telephone systems operate under interconnection agreements with various local exchange carriers ("LECs") and interexchange (long distance) carriers ("IXCs"). The interconnection agreements establish the manner in which the cellular telephone system integrates with other telecommunications systems. The cellular operator and the local landline telephone Company must cooperate in the interconnection between the cellular and landline telephone systems to permit cellular subscribers to call landline subscribers and vice versa. The technical and financial details of such interconnection arrangements are subject to negotiation and vary from system to system.
There are a number of recent technical developments in the cellular industry. Currently, while most of the MTSOs process information digitally, the radio transmission of cellular telephone calls is done predominantly on an analog basis. Digital technology offers advantages, including improved voice quality, larger system capacity, and perhaps lower incremental costs for additional subscribers. The conversion from analog to digital radio technology is expected to be an industry-wide process that will take a number of years. There are currently two principal digital technologies used by cellular operators in the United States, Time Division Multiple Access ("TDMA") and Code Division Multiple Access ("CDMA"). All leading telecommunications handset manufacturers are producing digital dual-mode phones and preparing for the rollout of TDMA which is presently in commercial service. CDMA is currently operating in a limited number of markets. CDMA technology is expected to increase system capacity significantly relative to that provided by analog systems albeit at a higher unit cost than TDMA.
During 1997, the Company completed testing of its TDMA digital voice and features network in conjunction with Northern Telecom. Vanguard was selected to serve as the test site for North Telecom's TDMA hardware and software. The tests were successful and led to the introduction of IS-136 TDMA digital voice using new 13Kb vocoders (voice encoders) and features in Myrtle Beach, South Carolina and the Southern Pennsylvania region in the fourth quarter of 1997. The remaining markets are expected to offer digital service by the second quarter of 1998. The substantial majority of the cellular equipment currently employed by the Company in its systems is "TDMA ready" and can work in either an analog or digital mode. As a result, the Company should be able to transition from analog to digital mode with minimal expense. At the time of any conversion, the Company's subscribers may not have digital handsets and, as a result, the Company may have to provide such devices to some of its subscribers. If this is necessary the Company will analyze usage patterns to determine the most effective means of distributing these handsets to a small segment of its subscribers who have disproportionately high use. However, one or more of the technologies currently utilized by the Company or implemented in the future may not be preferred by its customers or may become obsolete. If either event occurs, it could result in the Company undergoing a conversion which could involve significant expense. Pending such a conversion, the Company could be at a competitive disadvantage.
Competition
Other Cellular Competition. The cellular telephone business is a regulated duopoly. Until 1994, the FCC provided for only two licenses in each market (although certain markets have been subdivided as a result of voluntary settlements), one to a nonwireline company and one to a wireline company, which is usually the local telephone company or its affiliate. Each licensee has the exclusive grant of a defined frequency band within each market. The Company holds exclusively nonwireline licenses. The primary competition, therefore, for the Company's cellular service in any market has traditionally come from the wireline licensee in that market. Competition is principally on the basis of services and enhancements offered (including the provision of cellular equipment at or below cost), the technical quality of the system, price and the quality and responsiveness of customer service.
In the Company's majority-owned markets, its cellular competitors are affiliates of the following companies:
Market Cellular Competitor ------ ------------------- Allentown, PA/NJ Bell Atlantic Mobile Altoona, PA 360(degree) Communications Company Harrisburg, PA 360(degree) Communications Company Lancaster, PA 360(degree) Communications Company Reading, PA Bell Atlantic Mobile State College, PA 360(degree) Communications Company. Wilkes Barre/Scranton, PA 360(degree) Communications Company Williamsport, PA 360(degree) Communications Company York, PA 360(degree) Communications Company Wayne, PA (PA-5 RSA) 360(degree) Communications Company Union, PA (PA-8 RSA) 360(degree) Communications Company Chambersburg, PA (PA-10 East RSA) 360(degree) Communications Company Mifflin, PA (PA-11 RSA) Bell Atlantic Mobile Lebanon, PA (PA-12 RSA) 360(degree) Communications Company Binghamton, NY/PA Frontier/Bell Atlantic Mobile Elmira, NY Frontier/Bell Atlantic Mobile Charleston, WV 360(degree) Communications Company Huntington, WV/OH/KY 360(degree) Communications Company Parkersburg/Marietta WV/OH 360(degree) Communications Company Jackson, WV (WV-l East RSA) Bell Atlantic Mobile Logan, WV (WV-6 RSA) 360(degree) Communications Company Athens, Ohio (OH-10 RSA) 360(degree) Communications Company Chillicothe, Ohio (OH-9 RSA) U.S. Cellular Corp. Pensacola, FL GTE Mobilnet Fort Walton Beach, FL 360(degree) Communications Company Myrtle Beach, SC (SC-5 RSA) 360(degree) Communications Company Portland, ME Northeast Cellular/U.S. Cellular Corp. Portsmouth, NH/ME Saco River Cellular, Inc./U.S. Cellular Corp. Bar Harbor, ME (ME-4 RSA) U.S. Cellular Corp.
Recently, Alltel announced that it would merge with 360(degree) Communications Company, subject to receipt of regulatory approvals.
Competition from Other Technologies. In addition to competition from the other cellular carrier in each of its markets, the Company faces or will face competition from PCS, Enhanced Specialized Mobile Radio ("ESMR") system operators, and resellers of cellular and other facilities-based services.
Licensing for broadband PCS has been divided by the FCC into 51 Major Trading Areas ("MTAs") and 493 Basic Trading Areas ("BTAs") based upon geographic boundaries described in the 1992 Rand McNally Commercial Atlas & Marketing Guide. Two licensees each will hold 30 MHz of PCS spectrum in each MTA, one licensee will hold 30 MHz of PCS spectrum in each BTA and three licensees will hold 10 MHz of PCS spectrum in each BTA. The FCC's rules limit a cellular licensee to 45 MHz of aggregate spectrum in an area in which the cellular licensee provides cellular services to 10% or more of the population. The FCC's imposed 45 MHz cap for combined PCS/cellular spectrum means that cellular carriers may acquire two 10 MHz PCS licenses now. Cellular licensees are not limited by the two 10 MHz PCS license limitations outside of the areas in which they operate cellular systems.
PCS services include wireless two-way telecommunications for voice, data and other transmissions employing digital micro-cellular technology. PCS operates in the 1850 to 1990 MHz band. PCS requires a network of small, low-powered transceivers placed throughout a neighborhood, business office or office complex, city or metropolitan area. PCS customers communicate using digital devices similar to portable cellular telephones. The Company believes that digital service technology offers similar services on the 800 MHz cellular frequencies.
During all of 1997, the Company competed with a PCS operator in its Myrtle Beach RSA. In addition, during the year, the construction of towers and other wireless infrastructure by other competitive PCS providers occurred in many of the Company's other markets. The Company is currently competing with PCS operators in six of its majority-owned markets. The Company's active PCS competitors are affiliates of the following companies:
Market PCS Competitor ------ -------------- Allentown, PA/NJ Omnipoint Harrisburg, PA Omnipoint Chillicothe, Ohio (OH-9 RSA) Chillicothe Telephone Myrtle Beach, SC (SC-5 RSA) BellSouth/Horry Telephone Portland, ME Sprint Spectrum Portsmouth, NH/ME Sprint Spectrum
The specialized mobile radio ("SMR") industry provides customers, principally business users such as taxicabs and construction firms with two-way radio dispatch services. The FCC has licensed Enhanced SMR ("ESMR") system operators to construct digital mobile communications systems on existing SMR frequencies in many metropolitan areas throughout the United States. ESMR systems are permitted by the FCC to be interconnected to the public switched telephone network and are significantly less expensive to build and operate than other wireless telephone systems. The systems are, however, licensed to operate on substantially fewer channels per system than cellular or PCS systems, and currently lack the ability to expand capacity through frequency re-use by using low-power transmitters and by handing off calls. However, in 1994, the FCC licensed ESMR systems in the 800-MHz bands for wide-area use, thus increasing the potential competition with cellular networks. The FCC has also decided to license SMR spectrum in contiguous blocks via the competitive bidding process. ESMR systems have been built out in most MSAs and some RSAs and offer both traditional dispatch services and cellular like services.
Cellular system licensees are required by FCC policy to provide wholesale cellular service to qualified resellers. A reseller provides cellular service to customers but is not itself an FCC cellular license holder. A reseller typically buys capacity on a cellular telephone network and is assigned a block of cellular telephone numbers from a cellular carrier. The reseller markets provide wireless telephone service through their own distribution channels to the public. In this way, a reseller is not only a customer of the cellular telephone licensee's service, but also competes with the licensee for customers.
The Company intends to explore mutually advantageous relationships with resellers to supplement its existing distribution channels. MCI Communications, Inc. and other large communications companies have begun negotiating resale agreements in certain larger markets throughout the country. The Company believes that it will receive increasing interest from persons interested in reselling the Company's cellular service but there can be no assurance that this will occur or that pursuing any such opportunities will be profitable.
Plans to construct and launch Low Earth Orbit satellites ("LEOs"), such as Motorola's Iridium project, are viewed as a feasible means of providing wireless phone service to remote areas that would otherwise be unattractive to other wireless operators. The service can therefore be viewed as complementary (not competitive with cellular), particularly since LEOs are expected to eventually offer their connection services to wireless operators in their service areas.
In February 1997, the U.S. entered into a World Trade Organization treaty stipulating global telecommunications standards. The agreement requires the U.S. to permit foreign investors to hold indirect ownership of commercial mobile radio services ("CMRS") licenses in the U.S. These changes will permit additional foreign investment and participation in the U.S. wireless marketplace and therefore may enhance competition.
Despite increasing competition from PCS, SMR and other technologies, cellular service is expected to maintain its dominant position in the wireless communications industry in the near future. While the new PCS operators are forcing operators to digitize their networks at a faster pace, cellular operators have a considerable head start relative to future entrants into the wireless communications industry. As a result, competing technologies will have to address the cellular industry's considerable coverage, marketing advantage and other barriers to entry. In the meantime, the cellular industry's increasingly rapid pace of conversion to digital will provide it with the ability to offer expanded services, improved quality and lower pricing to its customer base.
The Company is preparing for the more competitive environment represented by the introduction of PCS and other digitally based communications technologies by building out and enhancing its cellular telephone networks including the conversion of its own networks to digital technology, increasing the quality of coverage in its service areas, expanding its service areas by selected acquisitions of adjacent and nearby cellular systems and by offering new features, products and services to its customers that the Company believes will be competitive with future communications providers that may utilize digital technology. See " -- Products and Services." The Company believes that it can effectively compete by utilizing its experience in developing and operating cellular networks and by virtue of the barriers imposed by its extensive existing system footprint. The Company believes that it has developed strong distribution channels and customer service capabilities overseen by an experienced management team.
The Company will offer roaming services to PCS customers and has already entered into several roaming contracts to do so.
Regulation of Cellular Systems
Federal Regulation. The Company is subject to extensive regulation by the Federal Government as a provider of cellular communications services. Pursuant to the Communications Act of 1934, as amended (the "Communications Act"), the licensing, construction, operation, acquisition and transfer of cellular communications systems in the United States are regulated by the FCC. The FCC has promulgated rules governing the construction and operation of cellular communications systems and licensing and technical standards for the provision of cellular telephone service ("FCC Rules"). For licensing purposes, the United States is divided into 734 discrete geographically defined market areas comprised of 306 MSAs and 428 RSAs.
In each market, the frequencies allocated for cellular telephone use are divided into two equal 25 MHZ blocks and designated as Block A and Block B. Block A licenses were initially reserved for nonwireline entities, such as the Company. Block B licensees were initially reserved for entities affiliated with a wireline telephone company. Under current FCC Rules, a Block A or Block B License may be transferred with FCC approval without restriction as to wireline affiliation, but generally, no entity may own a substantial interest in both block A and Block B in any one MSA or RSA. The FCC may prohibit or impose conditions on sales or transfers of licenses.
Cellular service providers must satisfy a variety of FCC requirements relating to technical and reporting matters. One such requirement is the coordination of proposed frequency usage with adjacent cellular users, permitees and licensees in order to avoid interference between adjacent systems. In addition, the height and power of base station transmitting facilities and the type of signals they emit must fall within specified parameters. The FCC also regulates cellular service resale practices and the terms under which certain ancillary services may be provided through cellular facilities.
The Company also regularly applies for FCC authority to use additional frequencies, to modify the technical parameters of existing licenses, to expand its service territory and to provide new services. The Communications Act requires prior FCC approval for transfers to or from the Company of a controlling interest in any license or construction permit, or any rights thereunder. Although there can be no assurance that any future requests for approval of applications filed will be approved or acted upon in a timely manner by the FCC, the Company has no reason to believe such requests or applications would not be approved or granted in due course.
Initial operating licenses are generally granted for terms of up to 10 years, beginning on the dates of the grant of the initial operating authority and are renewable upon application to the FCC. Licenses may be revoked and license renewal applications denied for cause after appropriate notice and hearing. The FCC generally grants current licensees a license renewal if they have complied with their obligations under the Communications Act during their license terms. A potential challenger would bear a heavy burden to demonstrate that a license should not be renewed if the licensee's performance merits renewal expectancy.
Near the conclusion of the license term, licensees must file applications for renewal of licenses to obtain authority to operate for up to an additional 10-year term. Applications for license renewal may be denied if the FCC determines that the grant of an application would not serve the public interest. In addition, at license renewal time, other parties may file competing applications for authorization. In the event that qualified competitors file, the FCC may be required to hold a hearing to determine whether the incumbent or the competitor will receive the license. In 1993, the FCC adopted specific standards to apply to cellular renewals, concluding that it will award a renewal expectancy to a cellular licensee that meets certain standards of past performance. If the existing licensee receives a renewal expectancy, it is likely that the existing licensee's cellular license will be renewed without a full comparative hearing. To receive a renewal expectancy, a licensee must show that it (i) has provided "substantial" service during its past license term, and (ii) has substantially complied with applicable FCC Rules and policies and the Communications Act. "Substantial" service is defined as service which is sound, favorable and substantially above a level of mediocre service that might only minimally warrant renewal.
In 1994, the Company filed for renewal of one expiring license (for the Allentown-Bethlehem-Easton, PA/NJ MSA) which was originally granted by the FCC in 1985. In 1995, the Company filed for renewal of two expiring licenses (for the Northeast Pennsylvania, PA and Harrisburg, PA MSAs) which were originally granted by the FCC in 1986. In 1997, the Company filed for renewal of eight additional MSA licenses which were originally granted in 1987. All license renewals were granted without challenge. The Company believes that it has met and will continue to meet all requirements necessary to secure renewal of its remaining cellular licenses which are scheduled to expire between 1998 and 2006. However, there can be no assurances that any such licenses will be renewed.
In July 1994, the FCC issued a notice proposing a requirement whereby all cellular carriers would have to provide interexchange carriers with equal access. Currently, only AT&T-affiliated cellular carriers and the cellular affiliates of the Regional Bell Operating Companies ("RBOCs") are required to provide equal access. The FCC also proposed requiring all commercial mobile radio service providers to provide interconnection to other mobile service providers. In April 1995, however, the FCC concluded that it would be premature to adopt such a requirement. The Telecommunications Act of 1996 (the "Telecom Act") provides that a cellular carrier need not provide equal access unless such denial is contrary to the public interest.
The Telecommunications Act of 1996. The Telecom Act makes changes to the Communications Act and the antitrust consent decree applicable to the RBOCs, affecting the cellular industry. This legislation, among other things, affects competition for local telecommunications services, interconnection arrangements for carriers, universal service funding and the provision of interexchange services by the RBOCs' wireless systems.
The Telecom Act requires state public utilities commissions and/or the FCC to implement policies that mandate cost-based reciprocal compensation between cellular carriers and local exchange carriers for interconnection services. The Company believes that implementation of these policies has resulted in a substantial decrease in interconnection expenses incurred by the Company. Pursuant to the requirements of the Act, the Company entered into negotiations with all of the local exchange carriers who provide interexchange service to the Company and its customers. These negotiations have resulted in contracts containing significant decreases in the rates charged by many of the LECs and have also provided for the LEC to pay reciprocal compensation to the Company for calls the Company terminates to its customers. The Company has not yet concluded negotiations with all of these LECs. These contractual arrangements must be reviewed by state public utility commissions within 90 days of submission, or the agreements will become effective automatically.
The Telecom Act also eases the restrictions on provision of interexchange telephone services by wireless carriers affiliated with RBOCs. RBOC-related wireless carriers have interpreted the legislation to permit immediate provision of long distance call delivery for their cellular customers and have begun providing this service.
State and Local Approvals. Congress amended the Communications Act to preempt, as of August 10, 1994, state or local regulation of the entry of, and the rates charged by, any commercial mobile service or any private mobile service, which includes cellular telephone service. The Company is free to establish rates and offer new products and services with a minimum of regulatory requirements. Several of the nine states in which the Company operates still maintain nominal oversight jurisdiction, primarily focusing upon resolution of customer complaints.
The location and construction of cellular transmitter towers and antennas are subject to Federal Aviation Administration ("FAA") regulations and may be subject to Federal, state and local environmental regulation as well as state or local zoning, land use and other regulation. Before a system can be put into commercial operation, the grantee of a construction permit must obtain all necessary zoning and building permit approvals for the cell sites and MTSO locations and must secure state certification and tariff approvals, if required. The time needed to obtain zoning approvals and requisite site permits varies from market to market and state to state. Similarly, variations exist in local zoning processes. There can be no assurance that any state or local regulatory requirements currently applicable to the systems in which the Company's affiliates have an interest will not be changed in the future or that regulatory requirements will not be adopted in those states and localities which currently have none.
Zoning and planning regulation is becoming more restrictive with the addition of PCS carriers which are seeking sites for network construction as well. The industry is seeking relief from local laws which arbitrarily restrict the expansion of cellular networks. The Telecom Act provides potential limited relief by permitting the FCC to preempt states and localities from applying regulations in a manner which has the effect of prohibiting construction and operation of new cell sites. Members of the Vermont Congressional delegation have announced plans to introduce legislation to strip the FCC of the power to preempt states and localities.
The Communications Act prohibits the issuance of a license to, or the holding of a license by, any corporation of which more than 20% of the capital stock is owned of record or voted by non-U.S. citizens or their representatives or by a foreign government or a representative thereof, or by any corporation organized under the laws of a foreign country. The Communications Act also prohibits the issuance of a license to, or the holding of a license by, any corporation directly or indirectly controlled by any other corporation of which more than 25% of the capital stock is owned of record or voted by non-U.S. citizens or their representatives or by a foreign government or representative thereof, or by any corporation organized under the laws of a foreign country. The FCC does however have the power to waive these restrictions in appropriate circumstances and a recent World Trade Organization treaty has had the effect of easing these restrictions further. The FCC has interpreted these restrictions to apply to partnerships and other business entities as well as corporations, subject to certain modifications. Failure to comply with these requirements may result in denial or revocation of licenses.
Other Investments
International Wireless Communications Holdings, Inc. and Foreign Investments. The Company believes that foreign markets offer significant opportunities for wireless communications providers because of the limited availability of traditional landline telephone systems in many countries and the increasing demand for communications services. The Company's strategy is to pursue opportunities in the international arena as they arise without diverting the Company's financial and personnel resources from its primary business. Accordingly, the Company has primarily pursued such opportunities through joint ventures with local entities and others and its investment in International Wireless Communications Holdings, Inc. ("IWC").
As of December 31, 1997, the Company had invested approximately $13.8 million and owned a 36% equity interest in IWC. IWC is a development stage company specializing in securing, building and operating wireless businesses, primarily in Asia and Latin America.
During 1997, the Company loaned $966,000 to IWC under the $7 million Senior Exchangeable Debt Facility in which the Company participated along with Toronto Dominion Capital and certain other IWC shareholders. The Company also received warrants to purchase IWC certain stock valued at $486,000 in connection with the Company's guarantee and funding of certain loans to IWC affiliates Star Digitel Limited and Pakistan Wireless Holdings, Inc., discussed below. In March 1998, the Company made an additional $10 million equity investment in IWC. As the result of equity financing transactions completed by IWC thus far during 1998, the Company's ownership in IWC has been reduced to approximately 29%. See "Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations."
During the first quarter of 1997, the Company entered into a stock purchase agreement to purchase from an unrelated third party 7% of the outstanding shares of Star Digitel Limited ("SDL"), a Hong Kong company whose principal business activities relate to the provision and development of cellular telecommunications services in the People's Republic of China. Pursuant to the stock purchase agreement, the Company's purchase of such shares will occur in two closings, which are subject to the satisfaction of certain conditions, for an aggregate cash consideration of $8.4 million. IWC also acquired and maintains a 40% ownership interest in SDL. Through December 31, 1997, the Company had invested $5.3 million in SDL. In addition, the Company has guaranteed obligations of SDL totaling $14.1 million, which includes guarantees of $7.2 million on behalf of IWC. If the Company must eventually fund these guarantees, the funding will be in the form of loans to SDL. See "Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations."
During 1997 the Company acquired a 12% equity interest in International Wireless Communications Pakistan Ltd. (IWCPL) for $7.0 million. At the same time, IWC's 100% owned subsidiary, Pakistan Wireless Holdings, Inc. (PWH), also acquired a 39% ownership interest in IWCPL, thereby increasing the Company's total direct and indirect ownership interest in IWCPL to approximately 26%. IWCPL owns 51% of the equity in Pakistan Mobile Communications (Pvt.) Ltd., a Pakistan Company that owns and operates the cellular license in Pakistan. Through December 31, 1997, the Company had invested $8.2 million in IWCPL. In addition, the Company has provided debt financing to PWH in the amount of $3 million. See "Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations."
There is no assurance that the Company's international activities will prove successful.
Inter*Act Systems, Incorporated. The Company has invested approximately $10.0 million in Inter*Act Systems, Incorporated ("Inter*Act") common stock for an aggregate ownership interest of approximately 26%. In addition, during 1996 the Company purchased for $12.0 million a total of 18,000 units consisting of $18.0 million principal amount at maturity of 14% Senior Discount Notes Due 2003 and warrants to purchase 132,012 shares of common stock at $.01 per share, subject to certain adjustments. Effective September 30, 1997 and in accordance with the warrant agreement, the shares of common stock eligible to be purchased with the warrants held by the Company increased from 132,012 to 169,722. The shares issuable upon the exercise of these warrants currently represent approximately 2% of Inter*Act's outstanding common stock. In addition, an existing warrant held by the Company was restructured whereby the Company has the right to acquire at any time prior to May 5, 2005 an aggregate of 900,113 shares of common stock for $23.50 per share, which shares presently represent approximately 10% of the outstanding common stock of Inter*Act. Inter*Act is a development stage company that provides consumer product manufacturers and retailers (currently supermarkets) the ability to offer targeted promotions to retail customers at the point of entry of a retail outlet through an interactive multi-media system utilizing ATM-like terminals. In addition to the current ownership held by the Company, certain officers, directors and entities affiliated with certain directors of the Company maintain an additional 27% ownership interest in Inter*Act. See "Item 13. Certain Relationships and Related Transactions" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations".
Geotek Communications, Inc. In 1994, the Company purchased for $30 million from Geotek Communications Inc. ("Geotek") 2.5 million shares of its common stock and options to invest up to $167 million for an aggregate of 10 million additional shares and also entered into a five-year management consulting agreement to provide operational and marketing support to Geotek in exchange for 300,000 shares of Geotek common stock per year. Geotek is a telecommunications Company that is developing a wireless communications network in certain metropolitan markets in the United States based on its FHMA(R) digital technology. Its common stock is traded on the NASDAQ National Market System. In September 1995, the Company purchased for $5.0 million in cash 531,463 shares of convertible preferred stock of Geotek with a stated value of $9.408 per share. The stock options previously granted to the Company by Geotek in 1994 have all expired unexercised and, as a result, the management consulting agreement also expired. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
Employees
As of December 31, 1997, the Company had approximately 2,000 full-time employees, including approximately 850 employees associated with its direct sales force. None of those employees are represented by a labor organization. Management considers its employee relations to be good.
CERTAIN DEFINITIONS
Certain terms used in this report are defined with particular meanings as used herein.
Analog: Transmission method employing a continuous (rather than pulsed or digital) electrical signal that varies in amplitude or frequency in response to changes in sound, light or position.
Bandwidth: (1) Difference between the top and bottom limiting frequencies of a continuous frequency band. (2) Indicates the information-carrying capacity of a channel. FCC-licensed cellular operators have been allocated a continuous 25 MHz bandwidth in the 824-849 MHz band or 869-894 MHz band.
BTA: One of the 493 Basic Trading Areas, which are smaller than MTAs, into which the licensing for broadband PCS has been divided based on the geographic divisions in the 1992 Rand McNally Commercial Atlas & Marketing Guide.
CDMA: Code Division Multiple Access digital technology. Technique that spreads a signal over a frequency band that is larger than the signal to enable the use of a common band by many users and to achieve signal security and privacy.
CDPD: Cellular Digital Packet Data, a new packet data network protocol which offers fast and reliable data transmission without using large amounts of network capacity.
Cell site: The entire infrastructure and radio equipment associated with a cellular transmitting and receiving station, including the land, building, tower, antennas and electrical equipment.
Clusters: A group of contiguous markets, the provision of which facilitates wide areas of uninterrupted cellular service, reduced airtime rates, automatic delivery of inbound calls and simplified dialing patterns.
Communications Act: The Communications Act of 1934, as amended.
Controlled markets: Markets in which the Company's ownership interest is greater than 50% as well as the Wilmington and Jacksonville, North Carolina markets which are jointly controlled by the Company and a subsidiary of GTE Corporation.
CTIA: The Cellular Telecommunications Industry Association.
Digital: Transmission system in which information is transmitted in a series of pulses.
ESMR: Enhanced Specialized Mobile Radio communications services, supplied by converting analog SMR services into an integrated, digital transmission system providing for call hand-off, frequency reuse and wide-call delivery networks.
FAA: The United States Federal Aviation Administration.
FCC: The United States Federal Communications Commission.
FCC Rules: The rules promulgated by the FCC governing the construction and operation of cellular communications systems and licensing and technical standards for the provision of cellular communications service.
IXC: Usually referred to as inter-exchange carriers or long-distance providers. There are many facilities-based IXCs including AT&T, MCI, WorldCom, Sprint and Frontier, as well as competitive access providers that are authorized for IXC services.
LEC: A Company providing local telephone services.
Market: An MSA or RSA.
Metro-cluster: A group of contiguous markets, the provision of which facilitates wide areas of uninterrupted cellular service, reduced airtime rates, automatic delivery of inbound calls and simplified dialing patterns.
MSA: One of the Metropolitan Statistical Areas for which the FCC licensed cellular communications systems.
MTA: One of the 51 Major Trading Areas into which the licensing for broadband PCS has been divided based on the geographic divisions in the 1992 Rand McNally Commercial Atlas & Marketing Guide.
MTSO: A mobile telephone switching office, through which cell sites are connected to the local landline telephone network.
Net POPs: The estimated population with respect to a given service area multiplied by the percentage interest that the Company owns in the entity licensed by the FCC to operate a cellular communications system within that service area.
Nonwireline license: The license for a market initially awarded to a Company or group that was not affiliated with a local landline telephone carrier in such market.
PCS: Personal Communications Services. Emerging technologies providing wireless access to the local and long distance telephone system. Most PCS plans call for low-powered, light weight pocket phones with individual, personal telephone numbers that can be accessed without geographic restriction.
Penetration: Customers divided by POPs in a given area.
POPs: The estimate of the 1997 population of a MSA or RSA, as derived from the 1997 population estimates prepared by Strategic Mapping, Inc.
RBOCs: The Regional Bell Operating Companies.
Reseller: A Company that provides cellular service to customers but does not hold an FCC cellular license or own cellular facilities. A reseller secures blocks of cellular telephone numbers from a licensed carrier and, in turn, sells service through its own distribution network to the public.
RF: Radio frequency.
Roamer: A cellular customer who makes or receives calls when traveling in another cellular company's market using his/her home cellular phone.
Roaming: The ability of cellular customers to make or receive calls when traveling in another cellular company's market. Occurs when a cellular customer leaves the cellular carrier's home area and uses his cellular phone.
Roaming agreement: Agreement entered into with other domestic cellular companies that allow the Company's customers to make or receive calls when traveling in another cellular Company's market.
RSA: One of the Rural Service Areas for which the FCC licensed cellular communications systems.
Service area: An MSA or RSA.
SMR: Specialized Mobile Radio communications services.
TDMA: Time Division Multiple Access digital technology, which designates a time frame for cellular users to transmit within a frequency.
Wireline license: The license for a market initially awarded to a Company or group that was affiliated with a local landline telephone carrier in such market.
Item 2.
Item 2. Properties
The Company owns or leases certain properties in addition to the interests in cellular licenses presently owned by the Company. The Company leases its principal executive offices located in Greensboro, North Carolina, consisting of approximately 128,000 square feet of office space. The Company either owns or leases under long-term contracts 458 cell site locations, eight cellular switch locations and certain office and retail space in its operating cellular markets. Rent expense under operating leases was $12.9 million in 1997.
Item 3.
Item 3. Legal Proceedings
The only legal proceedings pending against the Company or any of its subsidiaries are routine filings with the FCC and state regulatory authorities and customary regulatory proceedings pending in connection with acquisitions and interconnection rates and practices, proceedings concerning the telecommunications industry generally and other proceedings arising in the ordinary course of business which management believes, even if resolved unfavorably to the Company, would not have a materially adverse effect on the company's business.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters that were submitted to a vote of security holders of the Company during the quarter ended December 31, 1997.
Item 4 (a). Executive Officers of the Registrant
The following table sets forth certain information about each of the Company's executive officers:
Name Age Position ---- --- -------- Haynes G. Griffin 51 Chairman of the Board of Directors, Co-Chief Executive Officer Stephen R. Leeolou 42 President, Co-Chief Executive Officer, Director Stuart S. Richardson 51 Vice Chairman of the Board of Directors L. Richardson Preyer, Jr. 50 Vice Chairman of the Board of Directors, Executive Vice President, Treasurer Stephen L. Holcombe 41 Executive Vice President, Chief Financial Officer Richard C. Rowlenson 48 Executive Vice President, General Counsel Timothy G. Biltz 39 Executive Vice President, Marketing and Customer Service, President of U.S. Wireless Operations S. Tony Gore, III 51 Executive Vice President -- Acquisitions and Corporate Development Dennis B. Francis 46 Executive Vice President -- Technical Services
Haynes G. Griffin is a co-founder of the Company and has been a director since 1985 and was elected Chairman of the Board of Directors in November, 1996. Mr. Griffin is Co-Chief Executive Officer and served as Chief Executive Officer from the Company's inception until November, 1996. Mr. Griffin is Chairman of the Board of International Wireless Communications Holdings, Inc. and is a member of the Boards of Directors of Lexington Global Asset Managers, Inc., Inter*Act Systems, Inc. and Geotek Communications, Inc. Mr. Griffin currently serves on the United States Advisory Council on the National Information Infrastructure. He is a past Chairman of the Cellular Telecommunications Industry Association.
Stephen R. Leeolou is President and Co-Chief Executive Officer, a director and a co-founder of the Company. Prior to becoming President in November 1996, Mr. Leeolou served as Executive Vice President, Chief Operating Officer and Secretary and a director of the Company. Mr. Leeolou is the Chairman of the Board of Inter*Act Systems, Inc. and is a director and former Chairman of the Board of International Wireless Communications, Inc. Prior to joining the Company, from 1983 to 1984, Mr. Leeolou was President and Secretary of Caro-Cell Communications, Inc., and from 1978 to 1983 was a television news anchorman with three successive network-affiliated stations.
Stuart S. Richardson has been a director since 1985 and was elected Chairman of the Board of Directors in 1986 and currently serves as Vice Chairman of the Board of Directors. Since 1995, Mr. Richardson has been Chairman of the Board of Lexington Global Asset Managers, Inc., a diversified financial services holding company. From 1985 to 1995, Mr. Richardson was an executive of Piedmont Management Company, Inc., formerly the parent corporation of Lexington Global Asset Managers, Inc., and served as its Vice Chairman from 1986 to 1995. Mr. Richardson also serves as a director of Chartwell Reinsurance Co. and Inter*Act Systems, Inc. and is the former Chairman of the Board of Richardson-Vicks, Inc. Mr. Richardson's second cousin, L. Richardson Preyer, Jr., and Mr. Preyer's father, L. Richardson Preyer, Sr., are also directors.
L. Richardson Preyer, Jr. is Vice Chairman of the Board, Executive Vice President, Treasurer and a co-founder of the Company. Mr. Preyer serves as Administrative Trustee of Piedmont Associates and Southeastern Associates, investment partnerships, and is a director of Inter*Act Systems, Inc.
Stephen L. Holcombe is Executive Vice President and Chief Financial Officer of the Company. From 1978 to 1985, Mr. Holcombe served in various positions with KPMG Peat Marwick and was a senior audit manager when he left to join the Company in 1985. Mr. Holcombe is a member of the North Carolina Association of Certified Public Accountants.
Richard C. Rowlenson is Executive Vice President and General Counsel of the Company. From 1975 until joining the Company in 1987, Mr. Rowlenson was engaged in the practice of communications law in Washington, D.C. Mr. Rowlenson is a member of the Federal Communications Bar Association.
Timothy G. Biltz joined the Company as Vice President -- Marketing and Customer Service in August 1989 and was promoted to Senior Vice President in November 1990 and Executive Vice President in November 1996. Prior to joining the Company, Mr. Biltz was Regional Manager for Providence Journal Cellular Management Services, Inc. in Raleigh, N.C. from 1987 to 1989, and was responsible for the development of regional marketing and operations programs for several markets.
S. Tony Gore, III is Executive Vice President of Acquisitions and Corporate Development. He is presently a task force member of the North Carolina International Commission on Economic Development. Prior to joining the Company in 1985, Mr. Gore was Chief Executive Officer of Atlantic Coast Entertainment Systems, Inc.
Dennis B. Francis joined the Company as Director of Technical Services in September 1992 and was promoted to Vice President in 1993, Senior Vice President in 1995 and Executive Vice President in November 1996. Prior to joining the Company, Mr. Francis was with Southwestern Bell Mobile Systems for nine years, most recently as Vice President of Network Operations for the Washington/Baltimore cellular system.
PART II
Item 5.
Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters
Price Range of Common Stock
1997 1996 --------------- --------------- High Low High Low ------ ------ ------ ------ First Quarter .................. $16.25 $11.13 $23.50 $18.00 Second Quarter ................. 14.50 9.25 24.66 20.00 Third Quarter .................. 16.00 13.38 23.75 17.50 Fourth Quarter ................. 16.94 11.38 19.38 14.25
The high and low bid prices are as reported by the NASDAQ National Market System. These price quotations reflect inter-dealer prices, without mark-down or commissions, and may not necessarily represent actual transactions. On March 1, 1998, there were approximately 889 shareholders of record.
As discussed in Note 4 to the Consolidated Financial Statements in Item 8 and Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7, the covenants under the Company's long-term credit facility and its Senior Debentures due 2006 limit the payment of cash dividends on common stock. The Company has not paid any cash dividends on its common stock since its inception and does not anticipate paying dividends in the foreseeable future.
Item 6.
Item 6. Selected Consolidated Financial Data
- ---------- (a) In 1994, in order to conform to industry practice, the Company reclassified certain pass-through items previously recognized as service revenue to offset the related cost of service expenses. These reclassified items relate to charges associated with the Company's subscribers roaming into adjacent cellular markets. Appropriate reclassifications have been made in each period presented.
(b) Effective January 1, 1994, the Company changed its depreciation expense period for approximately 30% of its property and equipment from seven years to a 10 to 20 year schedule. The effect of this change was to reduce depreciation for the year ended December 31, 1994 by $4.5 million.
(c) The Company owns 3.3 million shares of Geotek Common Stock. In 1997, this investment was written down to $5.0 million, based on the year-end stock price of $1.53 per share, as quoted on the NASDAQ National Market System.
(d) Certain amounts in the periods prior to 1997 have been reclassified to conform to the 1997 presentation.
(e) In 1997 and 1996, the Company recognized a deferred income tax benefit of $42.7 million and $5.0 million, respectively, net of current income tax expense of $0 and $891,000, respectively. In prior years, the Company made the determination that it was uncertain that its net
deferred income tax assets would be realized. See Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following is a discussion and analysis of the historical financial condition and results of operations of the Company and factors affecting the Company's financial resources. This discussion should be read in conjunction with the Company's consolidated financial statements, including the notes thereto.
Years Ended December 31, 1997 and 1996
Service revenue in 1997 rose 24% to $349.6 million from $282.7 million in 1996. This increase was primarily the result of a 132,000 or 26% increase in the number of subscribers in majority-owned markets to approximately 645,000 in 1997, as compared to approximately 513,000 in 1996. Penetration, computed as a percentage of the Company's subscribers to total POPs in majority owned cellular markets, increased to 8.5% in 1997 from 6.8% in 1996. The increase in subscribers is the result of the growing acceptance of cellular communications and the Company's efforts to capitalize on this increasing acceptance through an expanded sales and distribution network. Churn, the monthly rate of customer deactivations expressed as a percentage of the subscriber base, remained constant between years at 2.2%.
Service revenue attributable to the Company's own subscribers (local revenue) increased 26% during 1997 to $297.5 million as compared to $236.1 million in 1996. Average monthly local revenue per subscriber declined 5% to $43 in 1997 compared to $45 in the prior year. This decline was primarily due to the continued pattern of increased incremental penetration into the segment of consumers who generally use their cellular phones less frequently. Service revenue generated by nonsubscribers roaming into the Company's markets increased 12% to $52.1 million in 1997 as compared to $46.6 million in the prior year. This increase was the result of increased usage partially offset by continued reductions in daily access and usage rates. The reduced rates affect the Company as both a provider and a purchaser of roaming services. Local revenue combined with roaming revenue resulted in overall average monthly revenue per subscriber for the year of $50, a decline of 7% from $54 in the prior year.
Cost of service as a percentage of service revenue decreased to 10% during 1997 from 11% during 1996. The Company expects cost of service as a percentage of service revenue to remain stable in the foreseeable future.
General and administrative expenses increased 26% or $20.9 million during 1997 as compared to 1996. General and administrative expenses as a percentage of service revenue increased from 28% to 29% in 1997. This increase is due primarily to compensation expense resulting from increases in the Company's employee base, generally in the areas of technical services, customer operations and new product development. General and administrative expenses as a percentage of service revenue are expected to stabilize and then decline slowly as the Company adds more subscribers without commensurate increases in general and administrative overhead and experiences higher utilization of the Company's existing personnel and systems.
Marketing and selling expenses increased 21% to $75.8 million during 1997, compared to $62.4 million in 1996. As a percentage of service revenue, these expenses remained constant at 22% in both years. During 1997, marketing and selling expenses including the net loss on cellular equipment ("Combined Marketing and Selling Expenses") increased to $92.7 million from $72.6 million in 1996. Combined Marketing and Selling Expenses per gross subscriber addition increased to $330 in 1997 from $301 in 1996 as a result of increased advertising and fixed costs for new stores that were opened in 1997. While the Company has benefited from the increased success of external distribution channels, the Company continues to emphasize internal distribution channels, which it believes will result in higher long-term profit margins.
Depreciation and amortization expenses increased $25.2 million or 52% during 1997 as compared to 1996. Property and equipment placed in service in 1997 of approximately $121.7 million, which included $22.0 million of cellular telephones held for rental that have relatively short depreciable lives, together with property and equipment placed in service in 1996 of $130.8 million, which had its first complete year of depreciation in 1997, accounted for substantially all of this increase.
Interest expense increased $11.1 million or 24% during 1997. This increase primarily resulted from an increase in average borrowings of approximately $137.0 million. Interest rates remained fairly constant between years.
Net losses from unconsolidated investments increased by $4.0 million. This increase resulted primarily from higher operating, amortization and interest expenses incurred by Inter*Act Systems, Incorporated ("Inter*Act") offset somewhat by the suspension of the Company's recognition of losses attributable to its equity method investments in International Wireless Communications Holdings, Inc. ("IWC"). The Company continues to recognize its share of the income and losses of its equity method investments in Inter*Act, Eastern North Carolina Cellular Joint Venture (ENCCJV), Star Digitel Limited ("SDL") and International Wireless Communications Pakistan, Ltd. ("IWCPL"). See "Liquidity and Capital Resources."
During 1997, the Geotek Communications, Inc. ("Geotek") common stock price, as quoted on the NASDAQ National Market System, declined from $7.13 per share at December 31, 1996 to $1.53 per share at December 31, 1997. Based on Geotek's historical performance, including the significant current year decline in the market value of Geotek's common stock, the Company's management made the determination that the decline in Geotek's common stock price during 1997 was other than temporary. Accordingly, the Company recognized an unrealized holding loss of $32.8 million in the 1997 consolidated statement of operations in recording the Company's investment in Geotek common stock at its market value at December 31, 1997. This treatment is in accordance with the guidance provided by Statement of Financial Accounting Standards ("SFAS") No. 115. Previously, unrealized holding losses related to the investment in Geotek common stock were recorded as a component of stockholders' equity in accordance with SFAS No. 115.
The Company recognized a deferred income tax benefit of $42.7 million in 1997 and a deferred income tax benefit of $5.0 million, net of current income tax expense of $891,000 in 1996. The Company has entered into agreements to sell its investment in the Myrtle Beach, South Carolina RSA as well as its interest in the ENCCJV. See "Liquidity and Capital Resources." These sales transactions are expected to generate substantial capital gains which will utilize an equivalent amount of the Company's accumulated net operating loss carryforwards. Based on these anticipated gains, management has assessed that it is more likely than not that a significant portion of the Company's deferred income tax assets are realizable, and, accordingly, the Company has recognized a total of $52.6 million of net deferred income tax assets as of December 31, 1997. Prior to 1996, the Company made the assessment that realization of its net deferred income tax assets was uncertain due primarily to its history of operating losses. See "Liquidity and Capital Resources -- Income Taxes."
The Company reported a net loss of $10.0 million or $0.25 basic net loss per common share for 1997 as compared to net income of $6.5 million or $0.16 basic net income per common share for 1996. This $16.5 million decline in net income is due primarily to the recognition of the unrealized holding loss on the Geotek investment and increases in depreciation and interest expense and losses from unconsolidated investments from the prior year, partially offset by the increase in the deferred income tax benefit as compared to the prior year.
Years Ended December 31, 1996 and 1995
Service revenue in 1996 rose 30% to $282.7 million from $217.4 million in 1995. This increase was primarily the result of a 132,000 or 35% increase in the number of subscribers in majority-owned markets to approximately 513,000 in 1996, including 5,000 added as a result of acquisitions, as compared to approximately 381,000 in 1995. Penetration, computed as a percentage of the Company's subscribers to total POPs in majority owned cellular markets, increased to 6.8% in 1996 from 5.3% in 1995. The increase in subscribers was the result of the growing acceptance of cellular communications and the Company's efforts to capitalize on this increasing acceptance through an expanded sales and distribution network. This increase was offset slightly by an increase in "churn" in 1996 to 2.2% from 2.1% in the same period in 1995 due to economic concerns felt by certain segments of the Company's subscriber base and by increased price competition at lower end rate plans. Churn is the monthly rate of customer deactivations expressed as a percentage of the subscriber base.
Service revenue attributable to the Company's own subscribers (local revenue) increased 34% during 1996 to $236.1 million as compared to $175.9 million in 1995. Average monthly local revenue per subscriber declined 4% to $45 in 1996 compared to $47 in the prior year. This decline was primarily due to the continued pattern of increased incremental penetration into the segment of consumers who generally use their cellular phones less frequently. Service revenue generated by nonsubscribers roaming into the Company's markets increased 12% to $46.6 million in 1996 as compared to $41.5 million in the prior year. This increase was the result of increased usage and was partially offset by continued reductions in daily access and usage rates which is occurring in the industry with increasing frequency. The reduced rates affected the Company both as a provider and purchaser of roaming services. The revenue from the Company's customers combined with roaming revenue resulted in overall average monthly revenue per subscriber for the year of $54, a decline of 7% from $58 in the prior year.
Cellular telephone equipment revenue decreased $527,000 or 3.4% to $15.1 million in 1996 as compared to 1995. Cost of cellular telephone equipment decreased 1% to $25.4 million during the same period. Net loss on cellular equipment was $10.3 million, an increase of 3% from $10.0 million net loss on cellular equipment experienced in 1995. The Company continues to sell telephones at or below cost for marketing purposes in response to competitive pressures and also continues the availability of its rental program.
Cost of service as a percentage of service revenue decreased to 11% during 1996 from 12% during 1995 primarily as a result of the Company's continuing effort to reduce the charges associated with roamer fraud. The Company estimates that charges associated with roamer fraud included in cost of service decreased from approximately 4% of service revenue in the fourth quarter of 1995 to approximately 1% during 1996. Cellular fraud is expected to be a significant industry issue for the foreseeable future.
General and administrative expenses increased 32% or $19.5 million during 1996 as compared to 1995, but as a percentage of service revenue remained constant at approximately 28% during both years. This increase is due primarily to compensation expense resulting from increases in the Company's employee base.
Marketing and selling expenses increased 14% to $62.4 million during 1996, compared to $54.9 million in 1995. As a percentage of service revenue, these expenses decreased from 25% in 1995 to 22% in 1996. During 1996, marketing and selling expenses including the net loss on cellular equipment ("Combined Marketing and Selling Expenses") increased to $72.6 million from $64.9 million in 1995. Combined Marketing and Selling Expenses per gross subscriber addition (excluding subscribers gained through acquisitions) decreased to $301 in 1996 from $327 in 1995. The decline in the gross subscriber costs was primarily a result of lower sales commissions paid for activations through internal distribution channels.
Depreciation and amortization expenses increased $12.5 million or 34% during 1996 as compared to 1995. Property and equipment placed in service in 1996 of approximately $130.8 million together with property and equipment placed in service in 1995 of $129.9 million, which had its first complete year of depreciation in 1996, accounted for substantially all of this increase.
Interest expense increased $7.9 million or 21% during 1996. This increase primarily resulted from an increase in average borrowings of approximately $110.6 million, and an increase in interest rates on $200 million of borrowings represented by the Debentures, offset slightly by a decrease in average interest rates charged.
Net losses from unconsolidated investments increased by $11.6 million. This increase resulted primarily from higher operating, amortization and interest expenses incurred by Inter*Act and IWC as a result of expanding operations which were made possible by high yield debt financings completed during the third quarter of 1996 by each company aggregating approximately $200 million. Due to the increased losses by IWC the Company has recognized an amount of losses equal to its investment in IWC and accordingly has suspended recognition of losses on IWC as of December 31, 1996 until such time that equity method income is available to offset the Company's share of IWC's future losses or the Company makes further investments in IWC. See "Liquidity and Capital Resources."
In 1996, the Company recognized a deferred income tax benefit of $5.0 million, net of current income tax expense of $891,000. Management concluded at December 31, 1996 that it was "more likely than not" that $5.0 million of the Company's net deferred income tax assets will be realized. This assessment considered the Company's historical operating trends, current forecasts and certain other factors. Prior to 1996, the Company made the assessment that realization of its net deferred income tax assets was uncertain due primarily to its history of operating losses. See "Liquidity and Capital Resources -- Income Taxes."
The Company reported net income of $6.4 million or $0.16 basic net income per common share for 1996 as compared to a net loss of $7.0 million or $0.17 basic net loss per common share for 1995. This $13.4 million positive change in net income was due primarily to the rate of revenue growth exceeding the rate of growth in related operating expenses and due to the recognition of a $4.1 million net income tax benefit in 1996.
Liquidity and Capital Resources
The Company requires capital to acquire, construct, operate and expand its cellular systems. The Company also explores, on an ongoing basis, possible acquisitions of cellular systems and properties as well as other investment opportunities, some of which may involve significant expenditures or commitments. In addition, although the initial buildout of its cellular system is complete, the Company will continue to construct additional cell sites and purchase cellular equipment to increase capacity as subscribers are added and usage increases, to expand geographic coverage, to provide for increased portable usage and to upgrade its cellular system for digital conversion and the implementation of new services. In 1997, the Company spent approximately $17.8 million primarily in connection with acquisitions of investments and loans to unconsolidated affiliates and approximately $121.7 million on total capital expenditures. In 1996, the Company spent approximately $38.8 million and exchanged certain cellular assets in connection with acquisitions and spent $130.8 million on total capital expenditures.
The specific capital requirements of the Company will depend primarily on the timing and size of any additional acquisitions and other investments as well as property and equipment needs. EBITDA has been a growing source of internal funding in recent years, and although the Company anticipates that in 1999 EBITDA will be sufficient to cover property and equipment and debt service requirements, the Company does not expect EBITDA to grow sufficiently to meet both its property and equipment and debt service requirements during 1998. The Company has met its capital requirements primarily through bank financing, issuance of public debentures, private issuances of its Class A Common Stock and internally generated funds and the Company intends to continue to use external financing sources in the future. Subsequent to December 31, 1997, the Company entered into agreements to sell its investment in the Myrtle Beach, South Carolina RSA for approximately $160 million in cash and its interest in the ENCCJV for approximately $30 million in cash. The transactions, which are expected to close in the third quarter of 1998, are subject to approval
by regulatory authorities, including the FCC. The Company is also pursuing opportunities to sell its Pensacola and Fort Walton Beach, FL markets as well as minority interests in other non-core cellular properties. The proceeds from these sales will be used to pay down the Company's existing debt.
EBITDA does not represent and should not be considered as an alternative to net income or operating income as determined by generally accepted accounting principles. It should not be considered in isolation from other measures of performance according to such principles, including operating results and cash flows. EBITDA increased to $123.1 million in 1997 from $102.6 million in 1996 and net cash provided by operating activities as shown on the Statement of Cash Flows decreased to $46.1 million in 1997 from $60.4 million in 1996 primarily due to a change in billing procedures during the second quarter of 1997. Historically, the Company billed subscriber access fees in advance. To reduce customer confusion upon receipt of the first bill and to remain competitive, the Company changed its billing policy and now bills access fees in arrears. This change had no impact on the Company's revenue recognition, bud did affect the in-flow of cash from bill payments. Net cash provided by operating activities in 1997 reflects an $11.1 million increase in interest expense and an increase in working capital items of $22.8 million. Investing activities, primarily purchases of property and equipment and acquisitions of investments, used net cash of $154.9 million and $152.9 million in 1997 and 1996, respectively. Financing activities provided net cash of $100.0 million and $95.6 million in 1997 and 1996, respectively.
Financing Agreements. At December 31, 1997 the Company's long-term debt consisted primarily of a $675 million credit facility (the "Credit Facility") with various lenders led by The Toronto-Dominion Bank and The Bank of New York and $200 million of 9 3/8% Senior Debentures due 2006 (the "Debentures"). The Credit Facility consists of a $325 million term loan ("Term Loan") and a $350 million revolving loan ("Revolving Loan"). As of the end of 1997, $569.0 million had been borrowed under the Credit Facility. The Term Loan and the Revolving Loan bore interest at a rate equal to the Company's choice of the Prime Rate (as defined) or Eurodollar Rate (as defined) plus an applicable margin based upon a leverage ratio for the most recent fiscal quarter. As of December 31, 1997, the applicable margins on the borrowings were 0.125% and 1.375% per annum for the Prime Rate and Eurodollar Rate, respectively.
On April 10, 1996, the Company issued $200 million aggregate principal amount of 9-3/8% Senior Debentures due 2006 through an underwritten public offering. The Credit Facility requires the structural subordination of the Debentures by making a subsidiary the primary obligor of the Credit Facility and all liabilities of the Company (other than the Debentures) and the owner of all stock and partnership interests of the Company's operating subsidiaries. The net proceeds of the sale of the Debentures were approximately $194.8 million.
The Debentures mature in 2006 and are redeemable at the Company's option, in whole or in part, at any time on or after April 15, 2001. There are no mandatory sinking fund payments for the Debentures. Interest is payable semi-annually. Upon a Change of Control Triggering Event (as defined in the Indenture for the Debentures), the Company will be required to make an offer to purchase the Debentures at a purchase price equal to 101% of the principal amount thereof plus accrued and unpaid interest, if any, to the date of purchase.
In February 1998, the Company completed the closing of an amendment to the Credit Facility, increasing the facility to $1.0 billion pursuant to the Third Amended and Restated Facility A Loan Agreement (Facility A Loan) and the Facility B Loan Agreement (Facility B Loan) (collectively, the 1998 Loan Agreements) with various lenders led by The Toronto-Dominion Bank, The Bank of New York and NationsBank of Texas, N.A.
The Facility A and Facility B Loans are available to provide the Company with additional financial and operating flexibility and to enable it to pursue business opportunities that may arise in the future. The Facility A Loan consists of a $750 million senior secured reducing revolving credit facility which allows for the issuance of up to $25 million of standby letters of credit. The Facility B Loan consists of a $250 million 364-day revolving credit facility which may be extended for an additional 364-day period upon the approval of the lenders or converted to a term loan according to the terms and subject to certain conditions of the Facility B Loan Agreement.
Borrowings under the Facility A and Facility B Loans bear interest at a rate equal to the Company's choice of the Prime Rate or Eurodollar Rate plus an applicable margin based upon a leverage ratio for the most recent fiscal quarter. The ranges for this applicable margin are 0.0% to 0.25% for the Prime Rate and 0.5% to 1.5% for the Eurodollar Rate. Based upon the leverage ratio, the applicable margins for the first quarter of 1998 are 0.00% and 1.25% for the Prime Rate and Eurodollar Rate, respectively.
The outstanding amount of the Facility A Loan as of September 30, 2000 is to be repaid in increasing quarterly installments commencing on September 30, 2000 and terminating at the maturity date of December 31, 2005. The quarterly installment payments begin at 2.5% of the outstanding principal amount at September 30, 2000 and gradually increase to 6.875% of the outstanding
principal amount. The maturity date for borrowings under the Facility B Loan is February 18, 1999. However, at the Borrower's request and the Lenders' approval, as set forth in the Facility B Loan Agreement, the maturity date of the Facility B Loan may be extended to February 16, 2000. Under the terms and subject to certain conditions of the Facility B Loan Agreement, the Company has the option to convert the borrowings outstanding under the Facility B Loan as of the Facility B maturity date to a term loan maturing on December 31, 2005. Upon conversion to a term loan, the principal balance of the Facility B Loan outstanding on September 30, 2000 shall be repaid in quarterly installments commencing on September 30, 2000 and terminating at the maturity date of December 31, 2005. The quarterly repayments begin at 2.5% of the outstanding principal amount at September 30, 2000 and gradually increase to 6.875% of the outstanding principal amount.
Among other restrictions, the 1998 Loan Agreements limit the payment of cash dividends, the use of borrowings and the creation of additional long-term indebtedness and require the maintenance of certain financial ratios. The requirements of the 1998 Loan Agreements were established in relation to the Company's projected capital needs, projected results of operations and cash flow. These requirements were generally designed to require continued improvement in the Company's operating performance such that EBITDA would be sufficient to continue servicing the debt as repayments are required. The Indenture for the Debentures contains limitations on, among other things, (i) the incurrence of additional indebtedness, (ii) the payment of dividends and other distributions with respect to the capital stock of the Company, (iii) the incurrence of certain liens, (iv) the ability of the Company to allow restrictions on distributions by subsidiaries, (v) asset sales, (vi) transactions with affiliates and (vii) certain consolidations, mergers and transfers of assets. The Company is currently in compliance with all requirements of the 1998 Loan Agreements and the Indenture.
Borrowings under the 1998 Loan Agreements are secured by the stock of Vanguard Cellular Financial Corp. and Vanguard Cellular Operating Corp., direct or indirect wholly owned subsidiaries of the Company. The Debentures are unsecured obligations of the Company.
Investments in Cellular Entities. The Company explores, on an ongoing basis, possible acquisitions of additional cellular systems and licenses. The Company currently has no agreements in principle regarding any such cellular acquisition. The Company also explores possible acquisition of companies that will facilitate new service offerings to its customer base, such as paging and Internet access. The Company has entered into an agreement to purchase NationPage, a leading regional paging provider in Pennsylvania and New York, for approximately $28.5 million. The NationPage acquisition will minimize future paging service capacity constraints and will be financed through borrowings under the 1998 Loan Agreements.
Other Investments. As of December 31, 1997, the Company had invested $13.8 million in IWC and owned approximately 36% of the outstanding stock of IWC. IWC is a development stage company specializing in securing, building and operating wireless businesses, primarily in Asia and Latin America.
During 1997, the Company loaned $966,000 to IWC under the $7 million Senior Exchangeable Debt Facility in which the Company participated as a lender along with Toronto Dominion Capital and other IWC shareholders. The Company also received warrants to purchase IWC common stock valued at $486,000 in connection with the Company's guarantee and funding of certain loans to SDL and Pakistan Wireless Holdings, Inc. (PWH), discussed below. The Company recorded losses of $1.5 million during 1997 related to these additional investments in IWC.
IWC's existing and new projects are in the network buildout phase. Accordingly, the losses of IWC are expected to grow significantly in future years. The Company records its proportionate share of these losses under the equity method of accounting. During 1995 and 1996, the Company recognized on the equity method an amount of losses from IWC that is equal to the Company's equity investment in IWC. As a result, the Company has suspended the recognition of losses attributable to IWC until such time that equity method income is available to offset the Company's share of IWC's future losses or the Company makes further investments in IWC.
In March 1998, the Company made an additional $10 million equity investment in IWC. Accordingly, the Company will recognize losses equal to the amount of this additional equity investment during the first quarter of 1998. As the result of equity financing transactions completed by IWC during the first quarter of 1998, the Company's ownership in IWC has been reduced to approximately 29%.
During the first quarter of 1997, the Company entered into a stock purchase agreement to purchase from an unrelated third party 7% of the outstanding shares of SDL, a Hong Kong company whose principal business activities relate to the provision and development of cellular telecommunications services in the People's Republic of China. Pursuant to the stock purchase agreement, the Company's purchase of such shares will occur in two closings, which are subject to the satisfaction of certain conditions, for an aggregate cash consideration of $8.4 million. IWC also recently acquired and maintains a 40% ownership interest in SDL. Through
December 31, 1997, the Company had invested $5.3 million in SDL. The Company expects to fund its remaining $3.1 million in July 1998. In addition, the Company has guaranteed obligations of SDL totaling $14.1 million, which includes guarantees of $7.2 million on behalf of IWC. If the Company must eventually fund these guarantees, the funding will be in the form of loans to SDL.
During 1997, the Company acquired a 12% equity interest in IWCPL for $7.0 million. At the same time, IWC's 100% owned subsidiary, PWH, also acquired a 39% equity interest in IWCPL, thereby increasing the Company's total direct and indirect ownership interest in IWCPL to approximately 26%. IWCPL owns 51% of the equity in Pakistan Mobile Communications (Pvt) Ltd., a Pakistan company that owns and operates the cellular license in Pakistan. Through December 31, 1997, the Company had invested $8.2 million in IWCPL. In addition, the Company has provided debt financing to PWH in the amount of $3 million.
As of December 31, 1997, the Company had invested $10.0 million in Inter*Act for an ownership interest of approximately 26% of Inter*Act's outstanding common stock and $12.0 million in Inter*Act notes and warrants. Inter*Act is a development stage company that provides consumer products manufacturers and retailers (currently supermarkets) the ability to offer targeted promotions to retail customers at the point of entry of a retail outlet through an interactive multi-media system utilizing ATM-like terminals.
Inter*Act has incurred net losses since its inception. Inter*Act received approximately $91 million in net proceeds in 1996 from the sale of senior discount notes and warrants which are being used to accelerate the roll-out of its systems in retail supermarkets and, as a result, the net losses incurred by Inter*Act are expected to grow significantly in future years. The Company records its proportionate share of these losses under the equity method of accounting. The Company's equity and warrant investments in Inter*Act were reduced to zero through the recognition of equity method losses during 1997. However, the Company will continue to recognize equity method losses related to its investment in the notes until such investment is reduced to zero.
Both Inter*Act and IWC are currently seeking long-term financing. Although the Company may continue to support IWC and Inter*Act through bridge financing until more permanent financing can be obtained, the Company does not anticipate making any further significant long-term investments.
The Company owns 3.3 million shares of common stock of Geotek. As of December 31, 1997, this investment had been written down to $5.0 million, based on the year-end stock price of $1.53 per share, as quoted on the NASDAQ National Market System.
Capital Expenditures. As of December 31, 1997, the Company had $500.0 million of property and equipment in service. The Company historically has incurred capital expenditures primarily based upon capacity needs in its existing markets resulting from continued subscriber growth. In order to increase geographic coverage and provide for additional portable usage the Company intends to increase the number of sites and add additional capacity to existing sites as it has done over the past few years. As a result of this accelerated network buildout and the continued growth of the Company's subscriber base, capital expenditures were $121.7 million during 1997. During 1998, the Company plans to continue this accelerated buildout. Capital expenditures for 1998 are estimated to be approximately $100.0 million and are expected to be funded primarily through internally generated funds and borrowings under the 1998 Loan Agreements. Approximately $75.0 million of those capital expenditures will be for cellular and paging network equipment, and the remainder will be primarily for rental telephones and computer equipment.
Stock Repurchases. The Company's Board of Directors has authorized the repurchase of up to 7,500,000 shares of its Class A Common Stock from time to time in open market or other transactions. During 1997 and 1996, the Company repurchased 2,810,000 and 255,000 shares, respectively, at an average price per share of approximately $13.00 in 1997 and $17.00 in 1996. At March 26, 1998, the Company had repurchased 1,080,000 shares thus far in 1998 at an average price per share of approximately $17.00.
Income Taxes. The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109--"Accounting for Income Taxes." This standard requires, among other things, the recognition of future tax benefits, measured by enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and to tax NOLs, to the extent that realization of such benefits is more likely than not. Prior to 1996, the Company incurred significant financial reporting and tax losses primarily as a result of substantial depreciation, amortization and interest expenses associated with acquiring and developing its cellular markets and substantial marketing and other operating costs associated with building its subscriber base. Although substantial net deferred income tax assets were generated, these assets and the associated income were not recognized for financial reporting purposes and a valuation allowance equal to the unrecognized asset was established. Management's assessment was that the Company's historical operating results did not make future profitability certain enough for it to recognize any part of the asset and related income.
Historically, the Company's strategy has been to enhance shareholder value by investing in growth initiatives. These efforts have resulted in steadily increasing levels of subscribers, revenues and EBITDA; however, these initiatives in the form of market acquisitions, capital expenditures, and expansion of the Company's sales and marketing and customer service functions have resulted in significant interest, depreciation, amortization and marketing costs. In addition, the Company has explored strategic investment opportunities in international telecommunications ventures and alternative lines of business, all of which are in the early development stages and are generating significant losses to the Company. As a result, although the Company achieved profitability in 1996 for financial reporting purposes, the continued costs of its investment strategy prevented the Company from generating profitable financial results in 1997.
During the fourth quarter of 1997, management revised its strategy from one of growth and expansion to enhancing shareholder value through profitable operations in its core cellular properties in Pennsylvania, West Virginia and New England. This revised strategy incorporates dispositions of non-core properties over the course of the next several years. As part of this Board-approved strategy, in the first quarter of 1998, the Company entered into agreements to dispose of its cellular properties in the Carolinas Metro-cluster, which include the Myrtle Beach, South Carolina RSA and ownership interest in the ENCCJV. Additionally, the Company has begun active efforts to dispose of its operations in Western Florida and anticipates reaching an agreement with a potential buyer during 1998. Based on negotiated sales prices for the Myrtle Beach cellular market and its ownership interests in ENCCJV, the Company expects to generate capital gains approximating $140 million in 1998. Additionally, the Company's anticipated sales price, based on recent transactions in the cellular industry and the two transactions discussed above, for the disposition of its Western Florida markets, is expected to generate a substantial capital gain.
The gains to be generated on these transactions will utilize an equivalent amount of the Company's accumulated NOLs. Based on these anticipated gains, management has assessed that it is more likely than not that a significant portion of the Company's deferred income tax assets are realizable. Accordingly, the Company has recognized a total of $52.6 million of net deferred income tax assets as of December 31, 1997. Of the amount recognized, $42.7 million was recognized as a deferred income tax benefit in 1997, $5.0 million was recognized as a deferred income tax benefit in 1996 and $4.9 million related to acquired NOLs was recognized through a reduction in investments in domestic cellular entities in 1997.
A valuation allowance remains on certain deferred income tax assets due to uncertainties as to when and whether these assets will be realized in the future. To the extent that the income tax benefit of these amounts is realized in future years, the benefit will be recorded as a direct addition to shareholders' equity as these assets relate to additional income tax deductions arising from restricted stock bonuses, stock options and stock purchase warrants.
The transactions discussed above which will create the taxable income upon which management based its deferred income tax asset recognition decisions have been approved by the Company's Board of Directors and are represented by definitive agreements among the parties to the transactions; however, ultimate consummation of these transactions is dependent on the parties reaching final agreement on terms and financing and the Company obtaining standard regulatory approvals. There can be no assurance that these transactions will be consummated.
For Federal income tax reporting purposes, the Company had net operating loss carryforwards of approximately $323 million at December 31, 1997. These losses may be used to reduce future taxable income, if any, and expire through 2012. The primary differences between the accumulated deficit for financial reporting purposes and the income tax loss carryforwards relate to the differences in the treatment of certain deferred cellular license acquisition costs, certain gains on dispositions of cellular interests, partnership losses, depreciation methods, estimated useful lives and compensation earned under stock compensation plans. These carryforwards may be subject to annual limitation in the future in accordance with the Tax Reform Act of 1986 and the ability to use these carryforwards could be significantly impacted by a future "change in control" of the Company. The limitations, if any, arising from such future "change in control" cannot be known at this time. See Note 6 to the Company's Consolidated Financial Statements for further information regarding the Company's income tax status.
General. Although no assurance can be given that such will be the case, the Company believes that its internally generated funds and available borrowing capacity under the 1998 Loan Agreements will be sufficient during the next several years to complete its planned network expansion, to fund debt service, to provide flexibility, to repurchase shares, to pursue acquisitions and other business opportunities that might arise in the future, and to meet working capital and general corporate needs. The Company also may issue additional shares of Class A Common Stock.
The Year 2000 Issues
Many existing computer programs use only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the Year 2000. The Year 2000 issue affects virtually all companies and organizations.
The Company's cellular operations are heavily dependent on computer applications. System failures caused by Year 2000 issues could have a material adverse impact on the Company. The Company has begun efforts to assess its Year 2000 compliance issues. However, the assessment is not yet complete and a detailed plan for addressing Year 2000 issues has not been finalized. Until the assessment is completed, management is unable to determine the magnitude of effort and cost that will be required to bring the Company's computer systems into compliance. The Company expects to complete its overall Year 2000 assessment and any required remediation prior to any anticipated impact on its operations.
Inflation
The Company believes that inflation affects its business no more than it generally affects other similar businesses.
"Safe Harbor" Statement under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended:
Except for the historical information presented, the matters disclosed in this report include forward-looking statements. These statements represent the Company's judgment on the future and are subject to risks and uncertainties that could cause actual results to differ materially. Such factors include, without limitation: (i) the substantial leverage of the Company which may adversely affect the Company's ability to finance its future operations, to compete effectively against better capitalized competitors and to withstand downturns in its business or the economy generally; (ii) a change in economic conditions in the markets served by the Company which could affect demand for cellular services; (iii) greater than anticipated competition from PCS and ESMR companies that provide services and features in addition to those currently provided by cellular companies, and the risk that the Company will not be able to provide such services and features or that it will not be able to do so on a timely or profitable basis; (iv) technological developments that make the Company's existing analog networks and planned digital networks uncompetitive or obsolete such as the risk that the Company's choice of Time Division Multiple Access ("TDMA") as its digital technology leaves it at a competitive disadvantage if other digital technologies, including Code Division Multiple Access ("CDMA"), ultimately provide substantial advantages over TDMA or analog technology and competitive pressures force the Company to implement CDMA or another digital technology at substantially increased cost; and (v) higher than anticipated costs due to unauthorized use of its networks and the development and implementation of measures to curtail such fraudulent use; and (vi) greater than anticipated losses attributable to its equity interests in other companies.
Item 8.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements and notes to consolidated financial statements of the Registrant and its subsidiaries are included in this Form 10-K following the Index to Financial Statements and Schedules. In addition, Financial Statements of the Registrant's 50% or less owned significant subsidiaries are included.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information with respect to directors appearing under the heading, "Election of Directors" in the Registrant's proxy statement for the Annual Meeting of Shareholders to be held May 19, 1998, is incorporated herein by reference. Other information with respect to executive officers is contained in Part I -- Item 4 (a) Executive Officers of the Registrant.
Item 11.
Item 11. Executive Compensation
Information with respect to executive compensation appearing under the heading "Executive Compensation" in the Registrant's proxy statement for the Annual Meeting of Shareholders to be held May 19, 1998, is incorporated herein by reference.
Item 12.
Item 12. Securities Ownership of Certain Beneficial Owners and Management
Information with respect to securities ownership of certain beneficial owners and management appearing under the headings "Voting Securities Outstanding" and "Security Ownership of Management" in the Registrant's proxy statement for the Annual Meeting of Shareholders to be held May 19, 1998, is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
Information with respect to certain transactions appearing under the heading "Certain Transactions" in the Registrant's proxy statement for the Annual Meeting of Shareholders to be held May 19, 1998, is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a)(1) and (2) Financial Statements and Financial Statement Schedules. The financial statements and supplemental schedules listed in the accompanying Index to Financial Statements and Schedules are filed as a part of this report.
(a)(3) Exhibits. Exhibits to this report are listed in the accompanying Index to Exhibits.
(b) Reports on Form 8-K. There were no reports filed on Form 8-K during the fourth quarter of 1997.
SIGNATURES
Pursuant to the requirements of the Section 13 and 15(d) of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
VANGUARD CELLULAR SYSTEMS, INC.
By: /s/ HAYNES G. GRIFFIN ------------------------------ Haynes G. Griffin Chairman of the Board of Directors and Co-Chief Executive Officer
Date: March 31, 1998
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
/s/ HAYNES G. GRIFFIN Chairman of the Board of March 31, 1998 - -------------------------------- Directors, Co-Executive Haynes G. Griffin Officer
/s/ STEPHEN R. LEEOLOU President, Co-Chief Executive March 31, 1998 - -------------------------------- Officer, Director Stephen R. Leeolou
/s/ Stuart S. Richardson Vice Chairman of the Board March 31, 1998 - -------------------------------- of Directors Stuart S. Richardson
/s/ L. RICHARDSON PREYER, JR. Vice Chairman of the Board March 31, 1998 - -------------------------------- of Directors L. Richardson Preyer, Jr.
/s/ STEPHEN L. HOLCOMBE Chief Financial Officer March 31, 1998 ------------------------------- (Principal accounting Stephen L. Holcombe and principal financial officer)
/s/ F. COOPER BRANTLEY Director March 31, 1998 - -------------------------------- F. Cooper Brantley
/s/ DORIS R. BRAY Director March 31, 1998 - -------------------------------- Doris R. Bray
/s/ ROBERT M. DEMICHELE Director March 31, 1998 - -------------------------------- Robert M. DeMichele
/s/ L. RICHARDSON PREYER, SR. Director March 31, 1998 - -------------------------------- L. Richardson Preyer, Sr.
/s/ ROBERT A. SILVERBERG Director March 31, 1998 - -------------------------------- Robert A. Silverberg
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Page ----
Vanguard Cellular Systems, Inc. and Subsidiaries Consolidated Balance Sheets, December 31, 1997 and 1996 ............. Consolidated Statements of Operations for the Years ended December 31, 1997, 1996 and 1995 ........................................... Consolidated Statements of Changes in Shareholders' Equity for the Years ended December 31, 1997, 1996 and 1995 ...................... Consolidated Statements of Cash Flows for the Years ended December 31, 1997, 1996 and 1995 ........................................... Notes to Consolidated Financial Statements .......................... Report of Independent Public Accountants ............................ Schedule I -- Condensed Financial Information of the Registrant ..... Schedule II -- Valuation and Qualifying Accounts .................... Financial Statements of Certain Significant 50% or less Owned Subsidiaries ......................................................... *
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
- -------- *Financial statements for Pt Rajasa Hazanah Perkasa, a foreign business, will be filed by June 30, 1998 as permitted by Rule 3-09.
------------------------
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollar amounts in thousands)
The accompanying notes to consolidated financial statements are an integral part of these balance sheets.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands, except per share data)
The accompanying notes to consolidated financial statements are an integral part of these statements.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollar amounts in thousands)
The accompanying notes to consolidated financial statements are an integral part of these statements.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollar amounts in thousands)
The accompanying notes to consolidated financial statements are an integral part of these statements.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 -- ORGANIZATION
Vanguard Cellular Systems, Inc. ("Vanguard") (a North Carolina corporation) through its only direct subsidiary, Vanguard Cellular Financial Corp. ("VCFC"), is a provider of cellular telephone service to various markets in the eastern United States. The majority of Vanguard's operations are conducted in the Mid-Atlantic SuperSystem covering areas of Pennsylvania, New York and New Jersey. The primary activities of Vanguard, VCFC, its wholly owned subsidiaries and its majority owned cellular entities (collectively referred to as the Company) include acquiring interests in entities that have been granted nonwireline Federal Communications Commission ("FCC") permits to construct or authorizations to operate cellular telephone systems, and constructing and operating cellular telephone systems.
All of the Company's cellular entities operate under the trade name of CellularONE(R), which is the trade name many nonwireline carriers have adopted to provide uniformity throughout the industry. The trade name is owned by a partnership in which the Company holds a minority ownership interest.
Vanguard is a holding company which is the 100% shareholder of VCFC. This organization was created to structurally subordinate Vanguard's $200 million in Senior Debentures to VCFC's Credit Facility. (See Note 4 -- Long-Term Financing Arrangements.)
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of Vanguard, VCFC, its wholly owned subsidiaries and the entities in which it has a majority ownership interest. Investments in which the Company exercises significant influence but does not exercise control through majority ownership have been accounted for using the equity method of accounting. Investments in which the Company does not exercise significant influence or control through majority ownership have been accounted for using the cost method of accounting. All significant intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of these consolidated financial statements and footnote disclosures required the use of certain estimates by management in determining the Company's financial position and results of operations. Actual results could differ from those estimates.
Cellular Telephone Inventories
Inventories, consisting primarily of cellular telephones held for resale, are valued at the lower of first-in, first-out (FIFO) cost or market.
Investments
Investments in Domestic Cellular Entities -- Investments in domestic cellular entities consist of the costs incurred to acquire FCC licenses or interests in entities that have been awarded FCC licenses to provide cellular service net of the Company's share of the fair value of the net assets acquired, payments of other acquisition related expenses and capital contributions to unconsolidated cellular entities. The Company's investments in consolidated cellular entities are being amortized over forty years. Exchanges of minority ownership interests in cellular entities are recorded based on the fair value of the ownership interests acquired.
Investments in Other Entities -- Investments in other entities consist of the Company's investments in International Wireless Communications Holdings, Inc. ("IWC"), Star Digitel Limited ("SDL"), International Wireless Communications Pakistan Ltd. ("IWCPL"), Inter*Act Systems, Incorporated ("Inter*Act") and Geotek Communications, Inc. ("Geotek"). The investments in IWC, SDL, IWCPL and Inter*Act are recorded using the equity method. The investment in Geotek common stock is considered to be "available for sale" under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, the Company's investment in the marketable common stock of Geotek is recorded at its fair value and the investment in other securities of Geotek is recorded at cost.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES -- Continued
The Company recognizes its pro rata share of the net income or losses generated by the unconsolidated cellular and noncellular entities carried on the equity method of accounting in its consolidated statements of operations.
Property and Equipment
Property and equipment are recorded at cost. Depreciation is calculated on a straight-line basis for financial reporting purposes over the following estimated useful lives:
Buildings ............................................. 20 years Cellular telephones held for rental ................... 3 years Cellular telephone systems ............................ 7-20 years Office furniture and equipment ........................ 3-10 years
At December 31, 1997 and 1996, construction in progress was composed primarily of the cost of uncompleted additions to the Company's cellular telephone systems in majority owned cellular markets. The Company capitalized interest costs of $1.3 million in 1997, 1996 and 1995, as part of the cost of cellular telephone systems.
Maintenance, repairs and minor renewals are charged to operations as incurred. Gains or losses at the time of disposition of property and equipment are reflected in the statements of operations currently.
Cellular telephones are rented to certain customers generally with a contract for a minimum length of service. Such customers have the option to purchase the cellular telephone at any time during the term of the agreement.
Long-Lived Assets
In accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", the Company reviews for the impairment of long-lived assets and certain identifiable intangibles whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Under SFAS No. 121, an impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. No such impairment losses have been identified by the Company.
Other Assets
Other assets consist of the following at December 31, 1997 and 1996 (in thousands):
1997 1996 -------- -------- Deferred financing costs $ 16,016 $ 16,016 Acquired customer bases 8,190 8,190 Interest rate cap agreements 1,569 413 Other 1,967 1,691 -------- --------- 27,742 26,310 Accumulated amortization (10,701) (6,965) -------- -------- $ 17,041 $ 19,345 ======== ========
Deferred financing costs are being amortized over the period of the related agreements. Amortization of $2.0 million, $1.6 million and $1.3 million has been included in interest expense in each of the accompanying December 31, 1997, 1996 and 1995 consolidated statements of operations, respectively. The acquired customer bases relate to the acquisitions of the Logan, WV (WV-6) RSA in August 1996, the Union, PA (PA-8) RSA in January 1995, and the Binghamton, NY and Elmira, NY MSAs in December 1994. The customer bases are being amortized over a four-year period and, accordingly, amortization of $2.1 million, $1.8 million and
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES -- Continued
$1.7 million has been included in the accompanying December 31, 1997, 1996 and 1995 consolidated statements of operations, respectively. The Company maintains certain interest rate cap agreements with certain major financial institutions. These costs are being amortized over the lives of the agreements, and accordingly, amortization of $243,000, $242,000 and $323,000 has been included in interest expense in the accompanying December 31, 1997, 1996 and 1995 consolidated statements of operations, respectively.
Revenue Recognition
Service revenue is recognized at the time cellular services are provided and service fees related to prebilled services are not recognized until earned. Cellular telephone equipment revenues consist primarily of sales of cellular telephones to subscribers and are recognized at the time equipment is delivered to the subscriber.
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes", which requires the use of the "asset and liability method" of accounting for income taxes. Accordingly, deferred income tax assets and liabilities are determined based on the difference between the financial statement and income tax bases of assets and liabilities, using enacted income tax rates in effect for the year in which the differences are expected to reverse.
Derivative Financial Instruments
Derivative financial instruments in the form of interest rate cap and swap agreements are used by the Company in the management of its interest rate exposures. Interest rate swap agreements modify the interest characteristics of a portion of the Company's debt. Amounts paid or received under interest rate swap agreements are accrued as interest rates change and are recognized over the life of the swap agreements as an adjustment to interest expense. The related receivable from, or amounts payable to the counter-parties are included in accounts receivable or accounts payable and accrued expenses. Interest rate caps are used to lock in a maximum rate if rates rise, but enable the Company to otherwise pay lower market rates. The costs of interest rate cap agreements are included in interest expense ratably over the lives of the agreements. Payments to be received as a result of the cap agreements are accrued as a reduction of interest expense. The unamortized costs of the cap agreements are included in other assets. The Company does not hold or issue financial instruments for trading purposes.
Net Income (Loss) per Common Share
Basic net income (loss) per common share is computed based upon the weighted average number of common shares outstanding during the year. Diluted net income per common share for 1996 reflects the potential dilution that could occur if the Company's outstanding options to issue common stock were exercised and converted into common shares that then shared in the earnings of the Company. Diluted net income (loss) per common share is computed in accordance with the guidance provided by SFAS No. 128, "Earnings Per Share". The calculation of diluted net loss per common share for 1997 and 1995 does not include the effect of outstanding stock options, as their effect would be antidilutive.
Outstanding options to purchase 2,314,750 common shares with exercise prices ranging from $21.50 to $25.13 were not included in the 1996 calculation of diluted net income per common share because the options' exercise prices were greater than the average market price of the common shares. Options to purchase 3,903,102 and 4,870,802 shares at a weighted average exercise price of $18.96 and $7.11 were outstanding as of December 31, 1995 and 1997, respectively, but were not included in the computation of diluted net loss per common share because the effect would be antidilutive.
Statements of Cash Flows
Additional required disclosures of noncash investing and financing activities for the years ended December 31, 1997, 1996 and 1995 are as follows:
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 2 -- SIGNIFICANT ACCOUNTING AND REPORTING POLICIES -- Continued
The Company acquired ownership interests in certain cellular entities and other investments for cash and noncash consideration, as follows (in thousands):
Reclassification
Certain amounts in the 1996 and 1995 financial statements have been reclassified to conform to the 1997 presentation.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS
Investments consist of the following as of December 31, 1997 and 1996 (in thousands):
1997 1996 --------- --------- Investments in domestic cellular entities: Consolidated entities: License cost ................................... $ 297,142 $ 300,780 Accumulated amortization ....................... (43,696) (36,113) --------- --------- 253,446 264,667 --------- --------- Entities carried on the equity method: Cost ........................................... 10,193 10,193 Accumulated share of earnings .................. 1,960 2,056 --------- --------- 12,153 12,249 --------- --------- Entities carried on the cost method ............... 9,592 9,993 --------- --------- 275,191 286,909 --------- --------- Investments in other entities: Entities carried on the equity method: Investment in equity securities ................ 40,794 26,924 Investment in debentures, net of discount of $6,449 and $8,389........................... 11,551 9,611 Loans .......................................... 4,045 -- Accumulated share of losses .................... (33,842) (18,239) --------- --------- 22,548 18,296 --------- --------- Investments carried as "available for sale": Cost ........................................... 37,736 37,736 Net unrealized holding losses .................. (32,757) (14,570) --------- --------- 4,979 23,166 --------- --------- Other investments, at cost ........................ 5,000 5,000 --------- --------- 32,527 46,462 --------- --------- $ 307,718 $ 333,371 ========= =========
Investments in Domestic Cellular Entities
The Company's significant activity relating to its investments in domestic cellular entities is discussed below.
Consolidated Entities
In January 1995, the Company purchased the Union, PA (PA-8) RSA for a cash price of $51.3 million. The PA-8 RSA lies in the center of the Company's Mid-Atlantic SuperSystem and is an operational cellular system. Pro forma consolidated results of operations, are as follows (in thousands, except per share data):
Year ended December 31, ------------------------ 1995 1994 ----------- ----------- Revenue .................................... $ 236,578 $ 173,735 Net loss before extraodinary item .......... (7,254) (18,155) Net loss ................................... (7,254) (26,557) Net loss per common share: Basic ................................... (0.18) (0.69) Diluted ................................. (0.18) (0.69)
In December 1995, the Company completed the acquisition of the remaining 13.24% ownership interests in the Harrisburg, PA MSA in exchange for ownership interests in cellular markets outside its regional metro-clusters and $2.9 million in cash.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
In August 1996, the Company acquired the Logan, WV RSA ("WV-6 RSA") for a cash purchase price of $16.7 million. The WV-6 RSA is contiguous to the Company's West Virginia markets and its operations are managed as part of its West Virginia metro-cluster.
Pro forma results of operations, as if the acquisition of the WV-6 RSA had occurred January 1, 1995 are as follows (in thousands, except per share data):
Year Ended December 31, -------------------------- 1996 1995 --------- ---------
Revenue ................................. $ 304,196 $ 239,412 Net income (loss) ....................... 4,774 (8,790) Net income (loss) per common share: Basic ................................ 0.12 (0.21) Diluted .............................. 0.11 (0.21)
In the third quarter of 1996, the Company acquired the remaining portions of the State College, PA and Williamsport, PA MSAs and the PA-10 East RSA in exchange for $2.8 million in cash. These markets are now 100% owned by the Company.
In October 1996, the Company exchanged certain cellular properties for four cellular markets contiguous to its Ohio Valley SuperSystem. In this transaction, the Company received four markets, OH-9 RSA, OH-10 RSA (excluding Perry and Hocking counties), Parkersburg-Marietta, WV-OH MSA, and the remaining county in the WV-1 RSA, in exchange for the Company's Orange County, NY cellular market and ownership interests in several minority owned cellular markets. The Company surrendered 324,000 POPs in Orange County and 76,000 POPs in minority owned markets, and added 542,000 POPs to the Ohio Valley SuperSystem. This transaction was treated principally as an exchange of similar productive assets and, therefore, the cellular markets received have been recorded at the historical cost of the Orange County, NY cellular market, increased for the fair value of the additional minority ownership interests given up.
In March 1998, the Company entered into an agreement to sell for $160 million in cash its investment in the Myrtle Beach, SC RSA. This transaction is expected to close in the third quarter of 1998. Additionally, the Company is pursuing various alternatives for divesting of its Florida metro-cluster and other non-core cellular properties in which it owns minority interests.
The Company also explores, on an ongoing basis, possible acquisitions of companies that will facilitate new service offerings to its customers, such as paging and Internet access. The Company entered into an agreement in December, 1997 to purchase NationPage, a leading regional paging provider in Pennsylvania and New York, for approximately $28.5 million in cash.
Cellular Entities on the Equity Method
The Company holds a 50% investment in a joint venture known as Eastern North Carolina Cellular Joint Venture ("ENCCJV"), created to acquire, own and operate various cellular markets located primarily in eastern North Carolina. The underlying net assets of the joint venture consist principally of its investment in the FCC licenses in the Wilmington, NC and Jacksonville, NC MSA cellular markets. The Company recognized $(95,000), $1.9 million, and $284,000 as its proportionate share of the ENCCJV earnings (losses) during the years ended December 31, 1997, 1996 and 1995, respectively.
In February 1998, the Company entered into an agreement to sell for $30 million in cash its ownership interest in the ENCCJV. This transaction is expected to close in the third quarter of 1998.
Cellular Entities on the Cost Method
The investment balance of approximately $9.6 million at December 31, 1997 represents the Company's investment in approximately 28 cellular markets with ownership interests ranging from 0.27% to 13.76%. The Company holds these ownership interests for investment purposes.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
Noncellular Investments
International Wireless Communications Holdings, Inc. and Foreign Investments
At December 31, 1997, the Company owned approximately 36% of the outstanding stock of IWC and had invested an aggregate of $13.8 million. IWC is a development stage company specializing in securing, building and operating wireless businesses, primarily in Asia and Latin America.
During 1996, IWC completed the sale of 14% Senior Secured Discount Notes due 2001, which have been exchanged for identical notes registered with the Securities and Exchange Commission ("SEC"), and warrants to purchase shares of IWC common stock. IWC received approximately $100 million in net proceeds from this financing which was used to fund existing projects and the exploration of other opportunities. As existing and new projects are in the network buildout phase, the losses of IWC are expected to grow significantly in future years. The Company records its proportionate share of these losses under the equity method of accounting. During 1995 and 1996, the Company recognized an amount of losses on the equity method from IWC that is equal to the Company's equity investment in IWC. As a result, the Company has suspended the recognition of losses attributable to IWC until such time that the equity method income is available to offset the Company's share of IWC's future losses or the Company makes further investments in IWC.
During 1997, the Company loaned $966,000 to IWC under the $7 million Senior Exchangeable Debt Facility in which the Company participated as a lender with Toronto Dominion Capital and other IWC shareholders. The Company also received warrants to purchase IWC common stock valued at $486,000 in connection with the Company's guarantee and funding of certain loans to SDL and Pakistan Wireless Holdings, Inc., as discussed below. As these transactions are subject to the equity method, the Company recorded losses of $1.5 million during 1997 related to these additional investments in IWC. Total equity method losses recorded by the Company in 1996 and 1995 were $11.5 million and $2.3 million, respectively.
In March 1998, the Company made an additional $10.0 million equity investment in IWC. Accordingly, the Company will recognize losses equal to the amount of this additional equity investment during the first quarter of 1998. As a result of equity financing transactions completed by IWC thus far during 1998, the Company's ownership in IWC has been reduced to approximately 29%.
During the first quarter of 1997, the Company entered into a stock purchase agreement to purchase from an unrelated third party 7% of the outstanding shares of SDL, a Hong Kong company whose principal business activities relate to the provision and development of cellular telecommunications services in the People's Republic of China. Pursuant to the stock purchase agreement, the Company's purchase of such shares will occur in two closings, which are subject to the satisfaction of certain conditions, for an aggregate cash consideration of $8.4 million. IWC also acquired and maintains a 40% ownership interest in SDL. Through December 31, 1997, the Company has invested $5.3 million in SDL and expects to fund its remaining $3.1 million in July 1998. The Company accounts for its investment using the equity method of accounting, and recognized equity method losses of $629,000 during 1997. In addition, the Company has guaranteed obligations of SDL totaling $14.1 million, which includes guarantees of $7.2 million on behalf of IWC. If the Company must eventually fund these guarantees, the funding will be in the form of loans to SDL.
During 1997, the Company acquired a 12% equity interest in IWCPL for $7.0 million. At the same time, IWC's 100% owned subsidiary, Pakistan Wireless Holdings, Inc. (PWH), also acquired a 39% equity interest in IWCPL, thereby increasing the Company's total direct and indirect ownership interest in IWCPL to approximately 26%. IWCPL owns 51% of the equity in Pakistan Mobile Communications (Pvt) Ltd., a Pakistan company that owns and operates the cellular license in Pakistan. Through December 31, 1997, the Company has invested $8.2 million in IWCPL. Through a loan facility arranged by PWH with the Company and Toronto Dominion Capital, the Company loaned to PWH $3 million during 1997. The proceeds of the loan facility were used by PWH to fund its equity investment in IWCPL. The loan facility is secured by all assets of
PWH, and loans under the facility have a term of 5 years. The Company records its proportionate share of the losses of IWCPL under the equity method of accounting, and recognized equity method losses of $246,000 in 1997, accordingly.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
Inter*Act Systems, Incorporated.
As of December 31, 1997, the Company had invested $10.0 million in Inter*Act for an ownership interest of approximately 26%. Inter*Act is a development stage company that provides consumer product manufacturers and retailers (currently supermarkets) the ability to offer targeted promotions to retail customers at the point of entry of a retail outlet through an interactive multi-media system utilizing ATM-like terminals.
During 1996, Inter*Act completed the sale of 142,000 units ("Units") of 14% Senior Discount Notes due 2003, which have been exchanged for identical notes registered with the SEC and warrants to purchase shares of common stock at $.01 per share. The Company purchased for $12.0 million a total of 18,000 Units consisting of $18.0 million principal amount at maturity of these 14% Senior Discount Notes and warrants to purchase 132,012 shares of common stock. At issuance, the Company allocated, based upon the estimated fair values, $8.9 million and $3.1 million to the debentures and warrants purchased by the Company, respectively. Effective September 30, 1997 and in accordance with the warrant agreement, the shares of common stock eligible to be purchased with the warrants held by the Company increased from 132,012 to 169,722. The shares issuable upon the exercise of these warrants currently represent approximately 2% of Inter*Act's outstanding common stock. In addition, an existing warrant held by the Company was restructured whereby the Company has the right to acquire at any time prior to May 5, 2005 an aggregate of 900,113 shares of common stock for $23.50 per share, which shares presently represent approximately 10% of the outstanding common stock of Inter*Act.
Inter*Act has incurred net losses since its inception. Inter*Act received approximately $91 million in net proceeds from the above financing which are being used to accelerate the roll-out of its systems in retail supermarkets and, as a result, the net losses incurred by Inter*Act are expected to grow significantly in future years. The Company records its proportionate share of these losses under the equity method of accounting. The Company's equity and warrant investment was reduced to zero through the recognition of equity method losses during 1997. However, Vanguard will continue to recognize equity method losses related to its investment in bonds until such investment is reduced to zero.
In addition to the current ownership held by the Company certain officers, directors and entities affiliated with certain directors of the Company maintain an additional 27% ownership interest in Inter*Act.
Total equity method losses related to Inter*Act were $11.0 million, $4.2 million and $257,000 during 1997, 1996 and 1995, respectively.
Geotek Communications, Inc.
In 1994, the Company purchased from Geotek 2.5 million shares of Geotek common stock for $30 million and received a series of options to purchase additional shares and entered into a management consulting agreement to provide operational and marketing support in exchange for 300,000 shares of Geotek common stock per year. Geotek is a telecommunications company that is developing a wireless communications network using its FHMA(R) digital technology. Under the management agreement, the Company earned and recorded as revenue approximately 201,370 shares with an aggregate value of $2.1 million in 1996, and approximately 300,000 shares with an aggregate value of $2.4 million in 1995. The stock options previously granted to the Company by Geotek in 1994 have all expired unexercised. The expiration of the options also resulted in the termination of the management agreement. The Company currently owns less than 5% of Geotek's outstanding common stock.
The investment in Geotek common shares is accounted for as "available for sale" pursuant to SFAS No. 115. As such, the investment is recorded at its market value, and a net unrealized holding loss of $14.6 million was recorded as a component of shareholders' equity as of December 31, 1996. During 1997, the Geotek common stock price, as quoted on the NASDAQ National Market System, declined from $7.13 per share at December 31, 1996 to $1.53 per share at December 31, 1997. Based on Geotek's historical performance, including the significant current year decline in the market value of Geotek's common stock, the Company's management made the determination that the decline in Geotek's common stock price during 1997 was
other than temporary and, accordingly, recognized an unrealized holding loss of $32.8 million in the accompanying 1997 consolidated statement of operations to record the Company's investment in Geotek common stock at its market value at December 31, 1997. In September 1995, the Company purchased, for $5.0 million in cash, 531,463 shares of convertible preferred stock of Geotek with a stated value of $9.408 per share. The preferred stock investment is accounted for at cost and is included in Other Equity Investments.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 3 - INVESTMENTS -- Continued
in the above table.
Financial Information of Equity Method Investees
Combined financial position and operating results of the Company's equity method investees, ENCCJV, IWC, Inter*Act, SDL and IWCPL, as well as certain significant investees of IWC, for the last three years are as follows (in thousands):
1997 (1) 1996 (2) 1995 (3) --------- --------- ---------
Current assets ....................... $108,774 $ 161,974 $ 30,040 Non-current assets ................... 445,925 237,507 119,528 Current liabilities .................. 249,354 48,397 19,318 Non-current liabilities .............. 311,747 254,073 2,701 Redeemable convertible preferred stock 209,412 103,021 98,845 Minority interest .................... 11,624 7,360 335 Revenues ............................. 40,544 29,583 14,050 Gross profit ......................... 8,697 2,769 10,418 Loss from operations ................. (229,651) (54,386) (12,787) Net loss ............................. (319,708) (71,730) (15,081)
- --------
Information for each investee is summarized from the available financial information for each entity and is presented only for the years in which the Company maintained an investment.
(1) Includes information for ENCCJV, Inter*Act, IWC, SDL, IWCPL and certain of IWC's investees for which the Company's attributable indirect ownership was determined to be significant. (2) Includes information for ENCCJV, Inter*Act, IWC and certain of IWC's investees for which the Company's attributable indirect ownership was determined to be significant. (3) Includes information for ENCCJV, IWC and Inter*Act.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS
At December 31, 1997 the Company's long-term financing arrangements consist primarily of a $675 million Credit Facility with various lenders led by The Toronto-Dominion Bank and The Bank of New York, and $200 million of Senior Debentures due 2006. The Credit Facility is senior to the Senior Debentures through the use of structured subordination whereby Vanguard is the borrower on the Senior Debentures and VCFC, Vanguard's only direct subsidiary, is the primary obligor on the Credit Facility. As discussed below, the Company's Credit Facility was refinanced subsequent to December 31, 1997.
Long-term debt consists of the following as of December 31, 1997 and 1996 (in thousands):
1997 1996 -------- -------- Debt of VCFC: Borrowings under the Credit Facility: Term Loan ......................................... $325,000 $325,000 Revolving Loan .................................... 244,000 105,000 Other Long-Term Debt ................................. 130 137 -------- -------- 569,130 430,137 Debt of Vanguard: Senior Debentures due 2006, net of unamortized discount of $163 and $183 ............ 199,837 199,817 -------- -------- $768,967 $629,954 ======== ========
Credit Facility of VCFC
The Credit Facility consisted of a $325 million "Term Loan" and a "Revolving Loan". As of December 31, 1997, $244 million had been borrowed under the Revolving Loan. The Term Loan and the Revolving Loan bear interest at a rate equal to the Company's choice of the Prime Rate or Eurodollar Rate plus an applicable margin based upon a leverage ratio for the most recent fiscal quarter. At December 31, 1997, the applicable margins on the borrowings were 0.125% and 1.375% per annum for the Prime Rate and Eurodollar Rate, respectively. At December 31, 1997, the Company's effective interest rate on its outstanding borrowings was 7.26%.
In February 1998, the Company completed the closing of an amendment to the Credit Facility, increasing the facility to $1.0 billion pursuant to the Third Amended and Restated Facility A Loan Agreement (Facility A Loan) and the Facility B Loan Agreement (Facility B Loan) (collectively, the 1998 Loan Agreements), with various lenders led by The Toronto-Dominion Bank, The Bank of New York and NationsBank of Texas, N.A.
The Facility A and Facility B Loans are available to provide the Company with additional financial and operating flexibility and enable it to pursue business opportunities that may arise in the future. The Facility A Loan consists of a $750 million senior secured reducing revolving credit facility which allows for the issuance of up to $25 million of standby letters of credit. The Facility B Loan consists of a $250 million 364-day revolving credit facility which may be extended for an additional 364-day period upon the approval of the lenders or converted to a term loan according to the terms and subject to certain conditions of the Facility B Loan Agreement.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS -- Continued
Borrowings under the Facility A and Facility B Loans bear interest at a rate equal to the Company's choice of the Prime Rate or Eurodollar Rate plus an applicable margin based upon a leverage ratio for the most recent fiscal quarter. The ranges for this applicable margin are 0.0% to 0.25% for the Prime Rate and 0.5% to 1.5% for the Eurodollar Rate. Based on the leverage ratio, computed as the ratio of Total Debt (as defined) to Adjusted Cash Flow (as defined), as of December 31, 1997, the Company's applicable margins on borrowings under the Facility A and Facility B Loans are 0.00% and 1.25% per annum for the first quarter of 1998 for the Prime Rate and Eurodollar Rate, respectively. Upon the occurrence of an event of default as defined in the 1998 Loan Agreements, the applicable margin added to both the Eurodollar Rate and the Prime Rate becomes 2.0%.
The outstanding amount of the Facility A Loan as of September 30, 2000 is to be repaid in increasing quarterly installments commencing on September 30, 2000 and terminating at the maturity date of December 31, 2005. The quarterly installment payments begin at 2.5% of the outstanding principal amount at September 30, 2000 and gradually increase to 6.875% of the outstanding principal amount. The maturity date for borrowings under the Facility B Loan is February 18, 1999. However, at the Borrower's request and the Lenders' approval, as set forth in the Facility B Loan Agreement, the maturity date of the Facility B Loan may be extended to February 16, 2000. Under the terms and subject to certain conditions of the Facility B Loan Agreement, the Company has the option to convert the borrowings outstanding under the Facility B Loan as of the Facility B maturity date to a term loan maturing on December 31, 2005. Upon conversion to a term loan, the principal balance of the Facility B Loan outstanding on September 30, 2000 shall be repaid in quarterly installments commencing on September 30, 2000 and terminating at the maturity date of December 31, 2005. The quarterly repayments begin at 2.5% of the outstanding principal amount at September 30, 2000 and gradually increase to 6.875% of the outstanding principal amount.
The outstanding commitment under the Facility A Loan is reduced and the outstanding borrowings under the Facility B term loan, if converted, are due quarterly as follows:
Percentage of Outstanding Loans ----------------- 1998........................................................... -- 1999........................................................... -- 2000........................................................... 5.0 2001........................................................... 15.0 2002........................................................... 15.0 2003........................................................... 17.5 2004........................................................... 20.0 2005........................................................... 27.5 ---- 100.0% =====
Upon closing of the 1998 Loan Agreements, the Company paid fees of approximately $4.0 million to the lenders. These fees and other costs incurred in the refinancing will be recorded as a long-term asset in 1998 and amortized over the lives of the agreements. Remaining unamortized deferred financing costs of $6.8 million at December 31, 1997 related to the 1994 Credit Facility will be expensed in 1998. The Company must pay to the lenders a commitment fee equal to either 0.375% or 0.25% of the aggregate unborrowed balance of the available Facility A commitment and 0.2% or 0.15% of the aggregate unborrowed balance of the Facility B commitment during the terms of the loans based upon the Leverage Ratio for the most recent fiscal quarter.
Borrowings under the 1998 Loan Agreements are secured by the stock of VCFC and Vanguard Cellular Operating Corp., direct or indirect wholly owned subsidiaries of the Company. Among other restrictions, the 1998 Loan Agreements and the 1994 Credit Facility limit the payment of cash dividends, limit the use of borrowings, limit the creation of additional long-term indebtedness and require the maintenance of certain financial ratios. The requirements of the 1998 Loan Agreements were established in relation to projected capital needs and projected results of operations and cash flow. These requirements generally were designed to require continued improvement in operating performance such that its cash flow would be sufficient to continue servicing the debt as repayments are required. As of December 31, 1997, VCFC is in compliance with all loan covenants.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS
Senior Debentures of Vanguard
On April 10, 1996, Vanguard issued $200 million aggregate principal amount of 9 3/8% Senior Debentures due 2006 (the "Debentures") through an underwritten public offering. The Debentures were issued at a price to the public of 99.901 for a yield of 9.384%. The net proceeds from the sale of the Debentures of approximately $194.8 million were used to reduce borrowings under the Revolving Loan portion of the Credit Facility and pay approximately $844,000 of expenses in connection with an amendment to the Credit Facility. The Credit Facility was amended to permit issuance of the Debentures and to require the structural subordination of the Debentures by making VCFC the primary obligor of the Credit Facility and all liabilities of the Company (other than the Debentures) and the owner of all stock and partnership interests of the Company's operating subsidiaries. The Debentures mature in 2006 and are redeemable at the Company's option, in whole or in part, at any time on or after April 15, 2001. There are no mandatory sinking fund payments for the Debentures. Interest is payable semi-annually. Upon a Change of Control Triggering Event (as defined in the Indenture for the Debentures), the Company will be required to make an offer to purchase the Debentures at a purchase price equal to 101% of the principal amount thereof plus accrued and unpaid interest, if any, to the date of purchase.
The Debentures require that the Company limit, among other things, the incurrence of additional indebtedness, the payment of dividends or the repurchase of Capital Stock, certain distributions and transfers, and certain asset sales.
The future maturities of the principal amount outstanding of all long-term financing arrangements at December 31, 1997 are as follows (in thousands):
1998.......................................................... $ 0 1999.......................................................... 0 2000.......................................................... 28,580 2001.......................................................... 85,350 2002.......................................................... 85,350 Thereafter.................................................... 569,687 ------- $768,967 ========
Interest Rate Protection Agreements
The Company maintains interest rate swaps and interest rate caps which provide protection against interest rate risk. At December 31, 1997 and 1996, the Company had interest rate cap agreements in place covering a notional amount of $500 million and $100 million, respectively. The interest rate cap agreements provide protection to the extent that LIBOR exceeds the strike level through the expiration date as follows (in thousands):
The total cost of the interest rate cap agreements in place at December 31, 1997 of $1.6 million has been recorded in other assets in the accompanying 1997 consolidated balance sheet and is being amortized over the lives of the agreements as a component of interest expense. The total cost of interest rate cap agreements in place at December 31, 1996 of $413,000 has been fully amortized as of December 31, 1997.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 4 -- LONG-TERM FINANCING ARRANGEMENTS -- Continued
Additionally, at December 31, 1997 the Company maintains interest rate swap agreements that fix the LIBOR interest rate at 6.10% on a notional amount of $50 million through October 1998. At December 31, 1996, the Company had interest rate swap agreements outstanding that fixed the LIBOR interest at 6.01% on a notional amount of $50 million through July 1997. Under these swap agreements, the Company benefits if LIBOR interest rates increase above the fixed rates and incurs additional interest expense if rates remain below the fixed rates. Any amounts received or paid under these agreements are reflected as interest expense over the period covered.
On December 9, 1996, the Company entered into two 10 year reverse interest rate swaps with notional amounts totaling $75 million. The reverse swaps effectively convert $75 million of the Debentures into floating rate debt with interest payable at the six month LIBOR rate plus 3.1%. Simultaneous with this transaction, the Company purchased an interest rate cap that limits the total interest on the $75 million to 10% for the first three years should interest rates rise. The Company's average effective interest rate under these agreements during 1997 was 8.93%, or 0.45% below the coupon rate for the Debentures. Additionally, during the first quarter of 1997, the Company entered into two 9 year reverse interest rate swaps with notional amounts totaling $25 million. The reverse swaps effectively convert $25 million of the Debentures into floating rate debt with interest payable at the six-month LIBOR rate plus 2.61%. Simultaneously with this transaction, the Company purchased an interest rate cap that limits the total interest rate on the $25 million to 10% for the first three years of the 9 year agreement. The Company's average effective interest rate under those agreements during 1997 was 8.57%, which is 0.81% below the coupon rate for the Debentures.
The effect of interest rate protection agreements on the operating results of the Company was to increase interest expense by $16,000, $464,000, and $82,000, in 1997, 1996 and 1995, respectively.
Subsequent to December 31, 1997 the Company entered into two additional interest rate swap agreements covering a notional amount of $100 million that fix LIBOR at 5.62% and have an expiration date of January 2003.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Note 5 -- COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases office space, furniture, equipment, vehicles and land under noncancelable operating leases expiring through 2019. As of December 31, 1997, the future minimum rental payments under these lease agreements having an initial or remaining term in excess of one year were as follows (in thousands):
1998 ............................................................ $ 10,941 1999 ............................................................ 10,371 2000 ............................................................ 9,745 2001 ............................................................ 9,076 2002 ............................................................ 8,410 Thereafter ...................................................... 89,440 --------- $ 137,983 =========
Rent expense under operating leases was $12.9 million, $9.3 million and $6.6 million for the years ended December 31, 1997, 1996 and 1995, respectively.
Construction and Capital Commitments
Capital expenditures for 1998 are estimated to be approximately $100.0 million for the Company, and are expected to be funded primarily with internally generated funds.
Note 6 -- INCOME TAXES
Deferred income taxes are provided for the temporary differences between the financial reporting and income tax basis of the Company's assets and liabilities. The components of net deferred income taxes as of December 31, 1997 and 1996 were as follows (in thousands):
1997 1996 --------- --------- Deferred income tax assets: Net operating loss carryforwards ......... $ 122,926 $ 125,135 Alternative minimum tax credits .......... 891 891 Other liabilities and reserves ........... 6,280 3,660 Valuation allowance ...................... (31,439) (74,208) --------- --------- Total deferred income tax assets .... 98,658 55,478 --------- --------- Deferred income tax liabilities: Investments and other intangibles ........ (45,630) (49,823) Property and equipment ................... (442) (655) --------- --------- Total deferred income tax liabilities (46,072) (50,478) --------- --------- Net deferred income taxes .................. $ 52,586 $ 5,000 ========= =========
Prior to 1996, the Company incurred significant financial reporting and tax losses primarily as a result of substantial depreciation, amortization and interest expenses associated with acquiring and developing its cellular markets and substantial marketing and other operating costs associated with building its subscriber base. Although substantial net deferred income tax assets were generated during these periods, a valuation allowance was established because in management's assessment the historical operating results made it uncertain whether the net deferred income tax assets would be realized.
As of December 31, 1997, the Company has cumulative net deferred income tax assets totaling approximately $84.0 million. The net deferred income tax asset is composed of $130.1 million of gross deferred income tax assets and $46.1 million of gross deferred income tax liabilities. The gross deferred income tax assets consist primarily of the income tax effect of Federal net operating loss
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 6 -- INCOME TAXES -- Continued
carryforwards of approximately $323 million, at December 31, 1997. These losses may be used to reduce future taxable income and expire periodically through 2012. Gross deferred income tax assets also include timing differences related to reserves and accruals, basis differences in property and equipment, cumulative losses on unconsolidated investments and the cumulative unrealized holding loss on the Company's investment in Geotek. Deferred income tax liabilities consist primarily of basis differences in cellular licenses and the excess of income tax depreciation over book depreciation.
Included in the Federal NOL carryforward are additional income tax deductions arising from restricted stock bonuses, stock options and stock purchase warrants. To the extent the income tax benefit of these amounts is realized in future years, the benefit will be recorded as a direct addition to shareholders' equity. Prior to 1997, net deferred income tax assets also included assets related to the net unrealized holding loss on the investment in Geotek. This unrealized loss had been recorded as a reduction in shareholders' equity. During 1997, the Company recognized the unrealized loss through earnings.
Historically, the Company's strategy has been to enhance shareholder value by investing in growth initiatives. These efforts have resulted in steadily increasing levels of subscribers, revenues and EBITDA; however, these initiatives in the form of market acquisitions, capital expenditures, and expansion of the Company's sales and marketing and customer service functions have resulted in significant interest, depreciation, amortization and marketing costs. In addition, the Company has explored strategic investment opportunities in international telecommunications ventures and alternative lines of business, all of which are in the early development stages and are generating significant losses to the Company. As a result, although the Company achieved profitability in 1996 for financial reporting purposes, the continued costs of its investment strategy prevented the Company from generating profitable financial results in 1997.
During the fourth quarter of 1997, management revised its strategy from one of growth and expansion to enhancing shareholder value through profitable operations in its core cellular properties in Pennsylvania, West Virginia and New England. This revised strategy incorporates dispositions of non-core properties over the course of the next several years. As part of this Board-approved strategy, in the first quarter of 1998, the Company entered into agreements to dispose of its cellular properties in the Carolinas Metro-cluster, which include the Myrtle Beach, South Carolina RSA and ownership interest in the ENCCJV. Additionally, the Company has begun active efforts to dispose of its operations in Western Florida and anticipates reaching an agreement with a potential buyer during 1998. Based on negotiated sales prices for the Myrtle Beach cellular market and its ownership interests in ENCCJV, the Company expects to generate capital gains approximating $140 million in 1998. Additionally, the Company's anticipated sales price, based on recent transactions in the cellular industry and the two transactions discussed above, for the disposition of Western Florida markets, is expected to generate a substantial capital gain.
The gains to be generated on these transactions will utilize an equivalent amount of the Company's accumulated NOLs. Based on these anticipated gains, management has assessed that it is more likely than not that a significant portion of the Company's deferred income tax assets are realizable. Accordingly, the Company has recognized a total of $52.6 million of net deferred income tax assets as of December 31, 1997. Of the amount recognized, $42.7 million was recognized as a deferred income tax benefit in 1997, $5.0 million was recognized as a deferred income tax benefit in 1996 and $4.9 million related to acquired NOLs was recognized through a reduction in investments in domestic cellular entities in 1997.
A valuation allowance remains on certain deferred income tax assets due to uncertainties as to when and whether these assets will be realized in the future. To the extent that the income tax benefit of these amounts is realized in future years, the benefit will be recorded as a direct addition to shareholders' equity as these assets relate to additional income tax deductions arising from restricted stock bonuses, stock options and stock purchase warrants.
The transactions discussed above, which will create the taxable income upon which management based its deferred income tax asset recognition decisions, have been approved by the Company's Board of Directors and are represented by definitive agreements among the parties to the transactions; however, ultimate consummation of these transactions is dependent on the parties
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 6 -- INCOME TAXES -- Continued
reaching final agreement on terms and financing and the Company obtaining required lender approval and standard regulatory approvals. There can be no assurance that these transactions will be consummated.
The Company's 1996 income tax benefit of $4.1 million includes a current provision of $891,000 for Federal alternative minimum taxes offset by the deferred income tax benefit discussed above. In 1995, the Company reported no Federal income tax provision because of the reported losses for financial reporting and income tax purposes. State income tax planning strategies have been implemented such that no state income tax provision has been required for any period.
A reconciliation between income taxes computed at the statutory Federal rate of 35% and the reported income tax benefit is as follows (in thousands):
December 31, -------------------------------- 1997 1996 1995 -------- -------- --------
Amount at statutory Federal rate ..... $(18,454) $ 808 $ (2,454) Net benefit of tax planning strategies 0 (6,616) (9,877) Change in valuation allowance ........ (32,805) (638) 9,552 Other ................................ 8,559 2,337 2,779 -------- -------- -------- Income tax benefit ................... $(42,700) $ (4,109) $ -- ======== ======== ========
In 1996 and 1995, the Company executed certain tax planning strategies that had the effect of increasing the total net deferred income tax assets. These transactions generally resulted in the current utilization of net operating loss carryforwards in exchange for the creation of income tax basis that will be deductible in future periods.
The net unrealized holding losses on the investment in Geotek and the additional income tax deductions arising from the exercise of stock options created additional net deferred income tax assets of $10.4 million in 1995. The 1996 change in the unrealized holding loss reduced net deferred income tax assets by $818,000. The valuation allowance was adjusted in these years to fully offset these changes in the net deferred income tax asset.
The primary differences between the accumulated deficit for financial reporting purposes and the income tax loss carryforwards relate to the differences in the treatment of certain deferred cellular license acquisition costs, certain gains on dispositions of cellular interests, partnership losses, depreciation methods, estimated useful lives and compensation earned under the stock compensation plan. These carryforwards may be subject to annual limitation in the future in accordance with the Tax Reform Act of 1986 and the ability to use these carryforwards could be significantly impacted by a future "change of control" of the Company. The limitations, if any, arising from such future "change in control" cannot be known at this time.
Note 7 -- CAPITAL STOCK
Acquisition of Cellular Interests
The Company has registered 4,500,000 shares of its Class A common stock and 3,000,000 shares of its Class B common stock. The shares may be offered in connection with the acquisition of entities which have received or may receive an authorization or license from the FCC to provide cellular service. Through December 31, 1997, 2,707,957 of these registered shares of Class A common stock have been issued in conjunction with the acquisition of certain cellular markets.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 7 -- CAPITAL STOCK -- Continued
Stock Compensation Plans
During 1994, the Board adopted the 1994 Long-Term Incentive Plan (the 1994 Plan). In May 1997, an additional 3,000,000 shares of the Company's Class A Common Stock were authorized for grant under the 1994 Plan. Under the provisions of the 1994 Plan, the Company may now grant up to 6,000,000 shares of the Company's Class A common stock to officers, directors and key employees in the form of nonqualified stock options, incentive stock options, stock appreciation rights, unrestricted stock, restricted stock and performance shares. All stock options must require exercise prices of not less than the fair market value of the Company's Class A common stock on the date of the grant, except that certain incentive stock options must require exercise prices of not less than 110% of fair market value of the Company's Class A common stock on the date of the grant. Options granted under the 1994 Plan may not have a term greater than ten years from the date of grant and are not transferable except upon death. As of December 31, 1997, 3,334,690 shares were available for future grants.
Upon adoption of the 1994 Plan, the Company's previously adopted stock option and stock compensation plans were terminated. Options granted and outstanding under these previous plans are still exercisable, but no further grants may be made under these plans.
Restricted Stock Bonuses
During 1987, the Board granted restricted stock bonuses for a total of 3,469,554 shares of Class A common stock (i) to three key officers for 1,077,768 shares each and (ii) to a director and a key employee for an aggregate of 236,250 shares. In the event of a change in control of the Company prior to December 31, 1998, the participants will be reimbursed for certain individual income tax payments, as defined, on the shares vesting after February 1991. As of December 31, 1997, all of the shares have vested.
Stock Options
Under the terms of the Company's previous and current stock compensation plans, the Board has granted incentive stock options and nonqualified stock options requiring exercise prices approximating the fair market value of the Company's Class A common stock on the date of the grant.
In January 1997, the Board of Directors authorized the cancellation of certain options with higher exercise prices and the issuance of fewer options at a lower exercise price. Options for 2,299,750 shares with exercise prices ranging from $21.50 to $25.125 were canceled and new options for 1,980,575 shares with an exercise price of $15.69 were issued. The exercise price for all of these new options reflected the fair market value at the time of issuance. In April 1997, the Board of Directors authorized the amendment of certain options, nearly all of which were these newly issued options approved in January 1997, to lower the exercise price to $10.00, the fair market value at that time.
Stock option activity under the plans was as follows:
Number of Shares Weighted Average Under Option Exercise Price ---------------- ---------------- Balance, January 1, 1995 .......... 3,777,117 $14.57 Granted ........................... 907,500 25.12 Exercised ......................... (760,765) 4.36 Forfeited ......................... (20,750) 19.06 --------- Balance, December 31, 1995 ....... 3,903,102 18.96 --------- Granted ........................... 1,331,925 18.40 Exercised ......................... (27,190) 16.56 Forfeited ......................... (6,450) 24.57 --------- Balance, December 31, 1996 ........ 5,201,387 18.82 --------- Granted ........................... 2,012,075 10.02 Exercised ......................... (17,470) 3.32 Forfeited ......................... (24,940) 14.91 Canceled ......................... (2,300,250) 22.95 --------- Balance, December 31, 1997 ........ 4,870,802 13.31 ==========
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 7 -- CAPITAL STOCK -- Continued
Of the total options outstanding at December 31, 1997, 4,278,796 have an exercise price in the range of $10.00 and $15.75 with a weighted-average exercise price of $12.60 and a weighted-average contractual life of 7.4 years. Of the 4,278,796 options, 1,986,758 are exercisable at December 31, 1997. Of the total outstanding options at December 31, 1997, 582,006 have an exercise price in the range of $17.17 and $19.25 with a weighted-average exercise price of $18.50 and a weighted-average contractual life of 5.2 years, and 495,124 of those options are exercisable at December 31, 1997. The remaining 10,000 options have an exercise price of $22.38 and an 8.4 years remaining contractual life. All of those options are exercisable at December 31, 1997.
In October 1995, SFAS No. 123, "Accounting for Stock-Based Compensation" was issued. SFAS No. 123 is effective for fiscal years beginning after December 15, 1995. SFAS No. 123 encourages companies to adopt the fair value method for compensation expense recognition related to employee stock options. Existing accounting requirements of Accounting Principles Board Opinion No. 25 ("APB No. 25") use the intrinsic value method in determining compensation expense which represents the excess of the market price of the stock over the exercise price on the measurement date. The Company elected to remain under the APB No. 25 rules for stock options, and is required to provide pro forma disclosures of what net income and earnings per share would have been had the Company adopted the new fair value method for recognition purposes. The following information is presented as if the Company had adopted SFAS No. 123 and restated its results (in thousands, except per share data):
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Note 10 -- QUARTERLY INFORMATION (UNAUDITED; IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
The income from operations amounts reported above for the first three quarters of 1997 differ from the amounts previously reported in the Company's 1997 Form 10-Q Quarterly Reports due to the reclassification of certain expenses from Other, net to Depreciation and amortization. Income from operations amounts previously reported in the Company's 1997 Form 10-Q Quarterly Reports were as follows (in thousands):
First quarter .......... $11,082 Second quarter......... 15,293 Third quarter.......... 19,919
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Vanguard Cellular Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Vanguard Cellular Systems, Inc. (a North Carolina corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements and schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Vanguard Cellular Systems, Inc. and subsidiaries as of December 31, 1997 and 1996 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to consolidated financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN, LLP
Greensboro, North Carolina, February 18, 1998.
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT CONDENSED PARENT COMPANY BALANCE SHEETS (Dollar amounts in thousands)
December 31, December 31, 1997 1996 ----------- ------------ ASSETS Cash ................................................ $ 1,110 $ 586 Prepaid expenses .................................... 6 -- Investments ......................................... 198,542 230,970 Other Assets, net of accumulated amortization of $1,050 and $450 .................. 4,951 5,552 --------- --------- Total assets ................................. $ 204,609 $ 237,108 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Accrued interest .................................... $ 3,862 $ 3,840 Long-Term Debt, net of discount of $163 and $183 .... 199,837 199,817 --------- --------- Total liabilities ............................ 203,699 203,657 --------- --------- Shareholders' Equity: Preferred stock -- $.01 par value, 1,000,000 shares authorized, no shares issued ........... -- -- Common stock, Class A -- $.01 par value, 250,000,000 shares authorized, 38,307,623 and 41,084,522 shares issued and outstanding ....... 383 411 Common stock, Class B -- $.01 par value, 30,000,000 shares authorized, no shares issued ............ -- -- Additional capital in excess of par value ......... 221,624 237,640 Net unrealized holding loss ....................... -- (14,570) Accumulated deficit ............................... (221,097) (190,030) --------- --------- Total shareholders' equity ................... 910 33,451 --------- --------- Total liabilities and shareholders' equity ... $ 204,609 $ 237,108 ========= =========
The accompanying notes to condensed parent company financial statements are an integral part of these balance sheets.
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT CONDENSED PARENT COMPANY STATEMENTS OF OPERATIONS (Dollar amounts in thousands)
For the years ended December 31, --------------------------------- 1997 1996 1995 -------- -------- -------- General and administrative expense ......... $ (73) $ -- $ -- Interest expense ........................... (19,025) (13,940) -- Equity in earnings (losses) of Vanguard Cellular Financial Corp. ............. 9,071 20,389 (7,013) -------- -------- -------- Net income (loss) .......................... $(10,027) $ 6,449 $ (7,013) ======== ======== ========
The accompanying notes to condensed parent company financial statements are an integral part of these statements.
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS (Dollar amounts in thousands)
The accompanying notes to condensed parent company financial statements are an integral part of these statements.
VANGUARD CELLULAR SYSTEMS, INC.
SCHEDULE I -- CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT NOTES TO CONDENSED FINANCIAL STATEMENTS
1. PRESENTATION
These condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information presented not misleading.
2. ORGANIZATION
Vanguard Cellular Systems, Inc. ("Vanguard") is a holding company which is the 100% shareholder of Vanguard Cellular Financial Corp. ("VCFC"). This organization was created in April 1996 to structurally subordinate Vanguard's $200 million in Senior Debentures to VCFC's Credit Facility. Prior to that time, operations of the Company were conducted by Vanguard. For purposes of this condensed financial information, the reorganization has been treated in a manner similar to a pooling-of-interests. As a result, this condensed financial information has been prepared as if Vanguard were a holding company in all periods.
3. LONG-TERM DEBT
On April 10, 1996, Vanguard issued $200 million aggregate principal amount of 9 3/8% Senior Debentures due 2006 (the "Debentures") through an underwritten public offering. The Debentures were issued at a price to the public of 99.901 for a yield of 9.384%. The net proceeds from the sale of the Debentures of approximately $194.8 million were contributed to VCFC primarily to reduce borrowings under the VCFC Credit Facility and were used by Vanguard to pay other expenses. The VCFC Credit Facility was amended to permit issuance of the Debentures and require the structural subordination of the Debentures by making VCFC the primary obligor of the Credit Facility and all liabilities of Vanguard (other than the Debentures) and the owner of all stock and partnership interests of Vanguard's operating subsidiaries. The Debentures mature in 2006 and are redeemable at Vanguard's option, in whole or in part, at any time on or after April 15, 2001. There are no mandatory sinking fund payments for the Debentures. Interest is payable semi-annually. Upon a Change of Control Triggering Event (as defined in the Indenture for the Debentures), Vanguard will be required to make an offer to purchase the Debentures at a purchase price equal to 101% of the principal amount thereof plus accrued and unpaid interest, if any, to the date of purchase. The Debentures require that Vanguard and its subsidiaries limit, among other things, the incurrence of additional indebtedness, the payments of dividends or the repurchase of Capital Stock, certain distributions and transfers, and certain asset sales.
4. SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR ADDITIONAL DISCLOSURES.
VANGUARD CELLULAR SYSTEMS, INC. AND SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 and 1997 (Dollar amounts in thousands)
- ---------- (1) Accounts written off during the period. (2) Represents allowance for doubtful accounts for entities acquired during the period.
Eastern North Carolina Cellular Joint Venture And Subsidiaries
Consolidated Financial Statements as of December 31, 1997 and 1996 Together With Auditors' Report
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Eastern North Carolina Cellular Joint Venture:
We have audited the accompanying consolidated balance sheets of EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE (a Delaware partnership) AND SUBSIDIARIES as of December 31, 1997 and 1996, and the related consolidated statements of operations, changes in partners' capital, and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Eastern North Carolina Cellular Joint Venture and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles.
Atlanta, Georgia March 27, 1998
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1997 AND 1996
(In Thousands)
ASSETS 1997 1996 - --------------------------------------------------------- ------- -------
CURRENT ASSETS: Cash $ 2 $ 2 Accounts receivable--trade, net of allowance for doubtful accounts of $229 and $199 in 1997 and 1996, respectively 1,842 2,424 Inventories 46 484 Deferred income tax assets 75 92 Other current assets 248 277 ------- ------- Total current assets 2,213 3,279 ------- ------- PROPERTY AND EQUIPMENT, at cost: Land 393 393 Buildings and towers 6,186 5,623 Equipment 15,458 13,596 Furniture and fixtures 188 188 Assets under construction 42 771 ------- ------- 22,267 20,571 Less accumulated depreciation 7,913 6,052 ------- ------- Net property and equipment 14,354 14,519 ------- ------- OTHER ASSETS, net: FCC license, net of accumulated amortization of $7,951 and $6,884 in 1997 and 1996, respectively 34,735 35,802 Other 4 4 ------- ------- Total other assets, net 34,739 35,806 ------- ------- Total assets $51,306 $53,604 ======= =======
LIABILITIES AND PARTNERS' CAPITAL -------
CURRENT LIABILITIES: Accounts payable--construction and trade 606 439 Accounts payable--affiliates 71 314 Due to managing partner 2,199 5,119 Federal income taxes payable 341 188 Accrued software license fee 300 -- Other accrued liabilities 540 565 ------- ------- Total current liabilities 4,057 6,625 ------- -------
LONG-TERM OBLIGATIONS: Postretirement benefit obligation 70 69 Deferred income tax liabilities 1,182 893 ------- ------- Total long-term obligations 1,252 962 ------- -------
MINORITY INTERESTS 481 435 ------- -------
PARTNERS' CAPITAL 45,516 45,582 ------- ------- Total liabilities and partners' capital $51,306 $53,604 ======= =======
The accompanying notes are an integral part of these consolidated balance sheets.
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(In Thousands)
1997 1996 1995 -------- -------- --------
REVENUES: Service $ 13,842 $ 15,023 $ 12,975 Equipment 559 605 583 Other 460 604 382 -------- -------- -------- Total revenues 14,861 16,232 13,940 -------- -------- -------- OPERATING EXPENSES: Sales and marketing 5,476 3,857 4,484 Cost of equipment 1,598 1,966 1,797 Operations support 1,114 1,785 1,380 Network 3,502 2,771 2,014 General and administrative 1,259 1,857 1,437 Amortization 1,067 1,067 1,067 -------- -------- -------- Total operating expenses 14,016 13,303 12,179 -------- -------- -------- OPERATING INCOME 845 2,929 1,761
INTEREST EXPENSE, NET (149) (235) (180) -------- -------- --------
NET INCOME BEFORE INCOME TAXES AND MINORITY INTERESTS 696 2,694 1,581
MINORITY INTERESTS (46) (100) (80) -------- -------- -------- NET INCOME BEFORE INCOME TAXES 650 2,594 1,501
PROVISION FOR INCOME TAXES (716) (1,386) (785) -------- -------- -------- NET (LOSS) INCOME $ (66) $ 1,208 $ 716 ======== ======== ========
The accompanying notes are an integral part of these consolidated statements.
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERS' CAPITAL
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(In Thousands)
The accompanying notes are an integral part of these consolidated statements.
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(In Thousands)
The accompanying notes are an integral part of these consolidated statements.
EASTERN NORTH CAROLINA CELLULAR JOINT VENTURE
AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997 AND 1996
1. ORGANIZATION AND MANAGEMENT
Eastern North Carolina Cellular Joint Venture (the "Joint Venture") was formed on July 10, 1990 and operates in accordance with the provisions of the Delaware Revised Uniform Limited Partnership Act. The Joint Venture provides cellular telephone services for the Jacksonville and Wilmington, North Carolina Metropolitan Statistical Areas ("MSAs").
The partners and their respective ownership percentages as of December 31, 1997 were as follows:
Managing General Partner: GTE Mobilnet of Eastern North Carolina Incorporated 50% General Partner: North Carolina Cellular Holding Corp. 50%
Effective September 27, 1996, Vanguard Cellular Systems, Inc. assigned its interest in the Joint Venture to a subsidiary, North Carolina Cellular Holding Corp.
Effective January 22, 1996, W&J Metronet, Inc. changed its name to GTE Mobilnet of Eastern North Carolina Incorporated.
The Joint Venture's ownership interest in the Wilmington, North Carolina MSA was 95.9% as of December 31, 1997 and 1996. The Joint Venture's ownership interest in the Jacksonville, North Carolina MSA was 95.6% as of December 31, 1997 and 1996.
The managing partner is responsible for managing and operating the Joint Venture. The partners make capital contributions to, share in the operating results of and receive distributions from the Joint Venture in accordance with their respective ownership percentage.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The Joint Venture prepares its financial statements in accordance with generally accepted accounting principles which require that management make estimates and assumptions that affect reported amounts. Actual results could differ from these estimates.
Certain prior year amounts have been reclassified to conform to the current year presentation.
Principles of Consolidation
The accompanying financial statements include the accounts of the Joint Venture and its majority-owned corporations and partnerships. All significant intercompany balances and transactions have been eliminated in consolidation.
Revenue Recognition
The Joint Venture earns service revenues primarily by providing access to the cellular network (access revenue) and for usage of the cellular network (airtime and toll revenues). Access revenues are recognized when earned. Airtime (including roaming) and toll revenues are recognized when the services are rendered. Other service revenues are recognized after services are performed and include activation and custom calling feature revenues. Equipment sales are recognized upon delivery of the equipment to the customer. Other revenues include landline call termination revenues and paging revenues, which are recognized when services are rendered.
In 1996 and 1995, the Joint Venture also earned revenue by leasing its switch to an affiliate. In September 1996, the affiliate discontinued its switch sharing agreement with the Joint Venture. These revenues were based on a charge per port and are included in other revenues in the accompanying statements of operations. Refer to Note 4 for additional discussion of affiliated transactions.
Operating Expenses
Operating expenses include expenses incurred directly by the Joint Venture, as well as an allocation of area administrative expenses and other costs incurred by the managing partner or its affiliates. Refer to Note 4 for additional discussion of allocated and affiliated expenses.
Customer Acquisition Costs
The Joint Venture defers certain customer acquisition costs for approximately two weeks and recognizes these costs when the associated revenue stream begins. These deferred costs were $85 thousand and $169 thousand at December 31, 1997 and 1996, respectively, and are included in other current assets in the accompanying balance sheets.
Advertising Costs
The Joint Venture expenses the cost of advertising as incurred. Advertising expense was $701 thousand, $375 thousand and $413 thousand for 1997, 1996 and 1995, respectively, and is included as a component of sales and marketing expense in the accompanying statements of operations.
Interest Expense, Net
The statements of operations reflect total interest expense, net of interest expense capitalized during construction and interest income as follows (in thousands):
1997 1996 1995 ----- ----- -----
Interest expense $(394) $(311) $(299) Interest capitalized 4 40 115 Interest income 241 36 4 ----- ----- ----- Interest expense, net $(149) $(235) $(180) ===== ===== =====
Interest expense and income include charges to the Joint Venture and its subsidiaries for funds advanced by the managing partner and credits to the Joint Venture and its subsidiaries for funds advanced to the managing partner. The interest rate on funds advanced to or from the Joint Venture is equivalent to the managing partner's incremental borrowing rate, which fluctuated between 5.44% and 5.80% in 1997, 5.44% and 6.07% in 1996 and 5.98% and 6.26% in 1995.
Income Taxes
A provision for income taxes is recorded on the subsidiary corporations of the Joint Venture relating to income of these corporations. The consolidated financial statements also include certain partnerships for which, according to the Internal Revenue Code and applicable state statutes, income and expenses are not separately taxable to the partnerships, but rather accrue directly to the partners. Accordingly, no provision for income taxes is made for such entities.
Deferred income taxes are recorded using enacted tax law and rates for the years in which the taxes are expected to be paid. Deferred income taxes are provided for items when there is a temporary difference in recording such items for financial reporting and income tax reporting.
Inventories
Inventories include cellular telephones, pagers and accessories held for sale and are valued at the lower of cost or market. Cost is determined using the specific identification method. Inventories are net of reserves for obsolescence.
Property and Equipment
Property and equipment are recorded at cost. The Joint Venture records depreciation using the straight-line method over the estimated useful lives of the assets, which are primarily twenty years for buildings and towers, seven to ten years for cell and switching equipment and three to five years for furniture and fixtures and other equipment. When property is retired, the cost of the property and the related accumulated depreciation are removed from the balance sheet and any gain or loss on the transaction is included in income.
Assets under construction represent costs incurred for the construction of cell sites and include, if applicable, capitalized interest. When these assets are placed in service, the costs are recorded to the appropriate property and equipment accounts and depreciation begins. Depreciation expense for the years ended December 31, 1997, 1996 and 1995 was $1,927 thousand, $1,596 thousand and $1,028 thousand.
Other Assets, Net
Other assets, net, consist primarily of deferred cellular license costs, which represent the fair value of the cellular market ownership interest contributed to the Joint Venture by the partners, which is being amortized over forty years.
Long-Lived Assets
The Joint Venture periodically reviews the values assigned to long-lived assets, such as cellular license costs and property and equipment, to determine whether any impairments exist that are other than temporary. Management believes that the long-lived assets in the accompanying balance sheets are appropriately valued.
Credit Risk
The Joint Venture's accounts receivable subject the Joint Venture to credit risk, as collateral is generally not required. The Joint Venture's risk of loss is limited due to advance billings to certain customers for services and the ability to terminate access on delinquent accounts. The concentration of credit risk is mitigated by the large number of customers comprising the customer base. The carrying amount of the Joint Venture's receivables approximates their fair value.
Sources of Supplies
The Joint Venture relies on local telephone companies and other companies to provide certain communication services. Although management feels alternative telecommunications facilities could be found in a timely manner, any disruption of these services could potentially have an adverse effect on operating results.
Although the Joint Venture attempts to maintain multiple vendors for each required product, its inventory and equipment, which are important components of its operations, are each currently acquired from only a few sources. If the suppliers are unable to meet the Joint Venture's needs as it builds out its network infrastructure and sells service and equipment, delays and increased costs in the expansion of the Joint Venture's network infrastructure or losses of potential customers could result, which would adversely affect operating results.
3. COMMITMENTS AND CONTINGENCIES
Leases
The Joint Venture leases office space and network sites under long-term operating leases. These leases have options for renewal with provisions for increased rent upon renewal. Rent expense for the years ended December 31, 1997, 1996 and 1995 was $355 thousand, $288 thousand and $190 thousand, respectively, and is included in sales and marketing costs, operation support costs, network costs and general and administrative costs in the accompanying statements of operations.
As of December 31, 1997, future minimum lease payments under noncancelable operating leases with initial or remaining periods in excess of one year were as follows (in thousands):
1998 $ 276 1999 270 2000 266 2001 161 2002 110 Subsequent years 272 -------- Total $ 1,355 ========
Contingencies
In July 1997, a class action lawsuit was filed on behalf of all former and present GTE cellular subscribers nationwide. The plaintiffs claim that GTE committed fraud by its practice of charging for airtime in full minute increments. The complaint alleges violations of federal RICO laws, fraud, and violation of Florida's Unfair and Deceptive Trade Practices Act. The plaintiffs seek to maintain the suit as class action and request compensatory damages, treble damages, injunctive relief, costs and attorneys' fees.
The ultimate outcome of the preceding litigation cannot be determined at the present time. Accordingly, no provision for any liability that might result from this matter has been made in the accompanying financial statements.
The Joint Venture and managing partner face exposure from actual and potential claims and legal proceedings arising in the normal course of business. As of December 31, 1997, the managing partner is not aware of any other asserted or pending litigation or claims that could potentially have a material adverse effect on the Joint Venture's financial position or results of operations.
4. RELATED-PARTY TRANSACTIONS
All transactions of the Joint Venture are authorized by the managing partner. Many management and administrative services are performed by an affiliated service corporation (the "Service Corporation") and GTE Wireless Incorporated. Services provided to the Joint Venture include support in major functional areas, such as accounting, information and cash management, human resources, legal, marketing,
technology planning, billing and customer care. In accordance with a management agreement, only certain area costs that are attributable to these support functions are included in sales and marketing costs, operation support costs, network costs and general and administrative costs. Costs allocated to the Joint Venture for these services were $1,076 thousand, $1,534 thousand and $1,254 thousand in 1997, 1996 and 1995, respectively.
Amounts paid by the Joint Venture to the Service Corporation for inventory purchases, net of transfers, amounted to $1,160 thousand, $1,497 thousand and $1,463 thousand in 1997, 1996 and 1995, respectively.
The managing partner either advances funds to or borrows funds from the Joint Venture and its subsidiaries. Funds advanced to the Joint Venture are used to cover construction and working capital requirements. The advances and borrowings are netted and are reflected in due to managing partner in the accompanying balance sheets. Interest is calculated on this balance as described in Note 2.
Prior to September 1996, the Joint Venture recorded revenue from an affiliate for use of its switch. This revenue amounted to $209 thousand and $254 thousand in 1996 and 1995, respectively.
The Joint Venture makes payments to an affiliate of the managing partner for construction of cell sites and other system property. The amounts capitalized were $376 thousand and $371 thousand in 1997 and 1996, respectively, and are included in assets under construction and other property and equipment.
The Joint Venture purchases roamer administration, advertising and other operating services from affiliates whose business is the provision of such services. The managing partner believes the cost of these services to the Joint Venture of $414 thousand, $145 thousand and $154 thousand in 1997, 1996 and 1995, respectively, was equivalent to the cost charged by the affiliates to any of their customers.
5. INCOME TAXES
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes as well as tax credit and loss carryforwards. The significant components of the Joint Venture's deferred tax assets and liabilities at December 31, 1997 and 1996 were as follows (in thousands):
1997 1996 ------ ------
Deferred tax assets: Loss carryforwards $ 270 $ 414 AMT credit carryforwards 844 667 Provision for bad debts 63 85 Postretirement and other benefits 30 29 Other 176 37 ------ ------ Total deferred tax assets 1,383 1,232 Deferred tax liabilities: Accelerated depreciation 2,490 2,033 ------ ------ Net deferred tax liabilities 1,107 801 Deferred tax asset--current 75 92 ------ ------ Deferred tax liability--noncurrent $1,182 $ 893 ====== ======
The federal net operating loss carryforwards expire from 2003 to 2009 unless utilized. All state net operating loss carryforwards were utilized as of December 31, 1997. The alternative minimum tax ("AMT") credit carryforwards do not expire. Based on recent operating results, no valuation allowance has been recorded as of December 31, 1997. Although realization is not assured, management believes it is more likely than not that the related deferred tax assets will be realized through future taxable earnings.
The provision for income taxes consists of the following (in thousands):
1997 1996 1995 ------- ------- -------
Current taxes $ 410 $ 866 $ 771 Deferred taxes 306 686 379 Reversal of valuation allowance -- (166) (365) ------- ------- ------- Provision for income taxes $ 716 $ 1,386 $ 785 ======= ======= =======
A reconciliation of the income tax provision computed at the statutory tax rate to the Joint Venture's effective tax rate is as follows for the years ended December 31, 1997, 1996 and 1995:
1997 1996 1995 ----- ----- -----
Income tax provision at the statutory rate 35.0% 35.0% 35.0% FCC license amortization 57.4 14.4 24.9 State income taxes, net of U.S. federal benefit 13.8 8.1 5.0 Minority interests 4.6 2.2 2.1 Other taxes -- -- 4.8 Other, net (0.6) 0.1 4.8 Reduction in valuation allowance -- (6.4) (24.3) ----- ----- ----- Provision for income tax 110.2% 53.4% 52.3% ===== ===== =====
6. SUBSEQUENT EVENT
In March 1998, North Carolina Cellular Holding Corp. entered into an agreement with United States Cellular to sell its interest in the cellular operations of the Wilmington and Jacksonville, North Carolina MSAs.
Inter*Act
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To INTER*ACT SYSTEMS, INCORPORATED:
We have audited the accompanying consolidated balance sheets of Inter*Act Systems, Incorporated (a North Carolina corporation) and Subsidiaries as of December 31, 1997 and December 31, 1996, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal years ended September 28, 1996 and September 30, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Inter*Act Systems, Incorporated and Subsidiaries as of December 31, 1997 and December 31, 1996, and the results of their operations and their cash flows for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal years ended September 28, 1996 and September 30, 1995, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
New York, New York March 17, 1998
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated statements.
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated statements.
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated statements.
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
The accompanying notes are an integral part of these consolidated statements.
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
1. BUSINESS DESCRIPTION
Inter*Act Systems, Incorporated (the 'Company') is one of the nation's largest in-store operators of customer-interactive electronic marketing systems. The Company's patented technologies enable consumer products manufacturers ('Manufacturers') and supermarket retailers ('Retailers') to offer shopper-specific purchase incentives and messages to customers moments before shopping begins. The Company's proprietary system, called the Inter*Act Loyalty Network'tm' ('ILN'), utilizes patented, multimedia touch-screen terminals, or Smart Kiosks'tm', located in the entrance area of retail grocery stores. These terminals are connected to each store's point-of-sale scanning system which allows the electronic promotions to be immediately redeemed at the check-out. This fully automated process virtually eliminates misredemption and fraud associated with paper coupons, estimated by industry sources to cost manufacturers hundreds of millions of dollars per year.
Certain factors could affect Inter*Act's actual future financial results. These factors include: (i) the Company's limited operating history, significant losses, accumulated deficit and expected future losses, (ii) the dependence of the Company on its ability to establish, maintain and expand relationships with manufacturers to promote brands on the ILN and the uncertainty of market acceptance for the ILN, (iii) the uncertainty as to whether the Company will be able to manage its growth effectively, (iv) the early stage of the Company's products and services and technical and other problems that the Company has experienced and may experience, (v) risks related to the Company's substantial leverage and debt service obligations, (vi) the Company's dependence on third parties such as those who manufacture ILN terminals, (vii) the intensely competitive nature of the consumer product and promotional industry and (viii) risks that the Company's rights related to patents, proprietary information and trademarks may not adequately protect its business, and (ix) the possible inability of new management to perform their respective roles and the possible conflicts of interest of the Company's directors, officers and principal shareholders in certain transactions with the Company.
From inception to December 31, 1997, the Company has had minimal revenues, incurred recurring losses and experienced negative operating cash flow and there is no assurance that the product the Company has developed will achieve success in the marketplace. The Company intends to raise additional equity or debt capital to fund its ongoing 1998 and 1999 expansion plans. In addition, the Company has received several multi-year equipment leasing proposals from equipment manufacturers for future purchases of ILN equipment. There is no assurance that such additional capital or equipment financing can be obtained. In the event that such additional financing is not obtained, the Company believes that existing cash and cash equivalents, along with reduced or delayed operating and capital expenditures, will be sufficient to meet the Company's operating requirements into the first quarter of 1999.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The financial statements include the consolidated accounts of the Company and its wholly and majority-owned subsidiaries: Network Licensing, Inc. ('NLI'), Inter*Act International Holdings, Inc. ('Inter*Act International'), Inter*Act Holdings, Ltd., ('Inter*Act Holdings') and Inter*Act U.K. Ltd. ('Inter*Act U.K.'). Inter*Act International, Inter*Act Holdings and Inter*Act U.K. were incorporated during 1997. All intercompany accounts and transactions have been eliminated in consolidation.
FISCAL YEAR
On February 13, 1997, the Company elected to change its fiscal year end from the last Saturday in September to December 31, effective December 31, 1996. The Company's 1996 and 1995 fiscal years
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
ended on the Saturday closest to September 30. The financial statements for fiscal 1996 and 1995 each contain activity for fifty-two weeks.
REVENUE RECOGNITION
The Company recognizes revenue as electronic discounts are redeemed at store cash registers. Manufacturers pay a fee to the Company for each redemption. The fee is composed of 1) a retailer processing fee, 2) a redemption fee and 3) the face value of the coupon. The Company, in turn, passes through both the retailer processing fee, which is included in direct operating expenses, and the face value of the coupon to the Retailer, while retaining the redemption fee. The Company records as net sales the redemption fee and the retailer processing fee paid by the Manufacturers. Certain Manufacturers pay the Company in advance for a portion of anticipated redemptions, and these amounts are recorded as deferred revenue until earned through redemptions.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents, which at December 31, 1997 and December 31, 1996 were primarily comprised of money market funds and overnight repurchase agreements, are stated at cost, which approximates market value. Highly liquid investments with original maturities of three months or less are considered cash equivalents.
RECEIVABLES, NET
Accounts receivable included in current assets are stated net of allowances for doubtful accounts of approximately $30,000 and $10,000 at December 31, 1997 and at December 31, 1996, respectively. The Company recorded approximately $30,000 and $10,000 for bad debt expense for the year ended December 31, 1997 and the three month period ended December 31, 1996, respectively. The Company did not record an allowance for doubtful accounts or bad debt expense for the fiscal years ended September 28, 1996 or September 30, 1995.
PROPERTY, PLANT AND EQUIPMENT
Depreciation is generally provided on the straight-line method for financial reporting purposes over the estimated useful lives of the underlying assets. Machinery and equipment are depreciated over a period ranging from 3 to 5 years and leasehold improvements are amortized using the straight-line method over the term of the lease or the estimated useful life of the improvements, whichever is shorter. In-store machinery and equipment are depreciated over five years. Repairs and maintenance are charged to expense as incurred.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs incurred by the Company are included in selling, general and administrative expenses. Such costs for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal years ended September 28, 1996 and September 30, 1995 were $646,000, $121,000, $800,000 and $623,000, respectively.
BOND ISSUANCE COSTS
Bond issuance costs incurred by the Company are costs associated with a private placement offering of 14% Senior Discount Notes during fiscal 1996 (the 'Private Placement') (See Note 6) and are being amortized over seven years using the effective interest rate method. Accumulated
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
amortization was $633,000 and $169,000 at December 31, 1997 and at December 31, 1996, respectively. The Company recorded amortization expense on the bond issuance costs of $464,000, $102,000 and $67,000 for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal year ended September 28, 1996, respectively.
PATENTS, LICENSES AND TRADEMARKS
Acquisition costs for patents, licenses and trademarks and legal fees incurred for the improvement and protection of the Company's patents, licenses and trademarks have been deferred and are being amortized over fifteen years or the remaining life of the patent, license or trademark, whichever is less, using the straight-line method. Accumulated amortization was $95,000 and $34,000 at December 31, 1997 and December 31, 1996, respectively. The Company recorded amortization expense of $131,000, $10,000, $22,000 and $2,000 for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal years ended September 28, 1996 and September 30, 1995, respectively.
FOREIGN CURRENCY TRANSLATION
Assets and liabilities of foreign entities have been translated using the exchange rates in effect at the balance sheet dates. Results of operations of foreign entities are translated using the average exchange rates prevailing throughout the period. Local currencies are considered functional currencies of the Company's foreign operating entities. Translation effects are accumulated as part of the cumulative foreign translation adjustment in equity. Gains and losses from foreign currency transactions are included in net loss for the period. The Company did not incur material foreign exchange gains or losses during any period presented. The Company has not entered into any derivative transactions to hedge foreign currency exposure.
LONG-LIVED ASSETS
Statement of Financial Accounting Standards ('SFAS') No. 121, 'Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,' requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset in question may not be recoverable. The adoption of SFAS No. 121 in the three-month period ended December 31, 1996 did not have a material effect on the Company's results of operations, cash flows or financial position.
INCOME TAXES
The Company accounts for income taxes in accordance with SFAS No. 109, 'Accounting for Income Taxes.' SFAS No. 109 requires an asset and liability approach for financial reporting for income taxes. It also requires the company to adjust its deferred tax balances in the period of enactment for the effect of enacted changes in tax rates and to provide a valuation allowance against such deferred tax assets that are not, more likely than not, to be realized.
STOCK-BASED COMPENSATION
During the three month period ended December 31, 1996, the Company adopted the provisions of SFAS No. 123, 'Accounting for Stock-Based Compensation,' by continuing to apply the provisions of Accounting Principles Board ('APB') Opinion No. 25, 'Accounting for Stock Issued to Employees,' while providing the required pro forma disclosures as if the fair value method had been applied. (See Note 13)
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
NET LOSS PER SHARE
Effective December 31, 1997, the Company adopted SFAS No. 128, 'Earnings Per Share.' (See Note 9.) In accordance with SFAS No. 128, net loss per common share amounts ('basic EPS') were computed by dividing net loss by the weighted average number of common shares outstanding and contingently issuable shares (which satisfy certain conditions) and excluded any potential dilution. Net loss per common share amounts -- assuming dilution ('diluted EPS') were computed by reflecting potential dilution from the exercise of stock options and warrants. SFAS No. 128 requires the presentation of both basic EPS and diluted EPS on the face of the income statement. Net loss per share amounts for the same prior-year periods have been restated to conform with the provisions of SFAS No. 128; however, the result of that restatement was not material. In all periods presented, the impact of stock options and warrants was anti-dilutive.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets (specifically with respect to the lives of in-store machinery and equipment) and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
RECLASSIFICATIONS
Certain prior year financial statement amounts have been reclassified to conform with the current year presentation.
3. PROPERTY, PLANT AND EQUIPMENT, NET
Property, plant and equipment consisted of the following (in thousands):
Depreciation expense was approximately $3.8 million, $456,000, $786,000 and $180,000 for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal years ended September 28, 1996 and September 30, 1995, respectively.
4. LEASES
The Company leases office facilities and equipment under various operating lease agreements expiring through year 2002. Future minimum lease payments under noncancelable operating leases at December 31, 1997 were as follows:
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
Rent expense of $383,000, $57,000, $222,000 and $219,000 was recognized for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal years ended September 28, 1996 and September 30, 1995, respectively, and is included in selling, general and administrative expenses.
5. RELATED PARTY TRANSACTIONS
On April 14, 1993, the Company entered into an agreement with Clearing Systems, Inc. ('CSI'), a Delaware corporation, whereby approximately 817,000 shares of the Company's common stock were exchanged for certain assets, consisting primarily of acquired technology and research and development, at the then estimated fair market value of $612,000, and assumption of certain liabilities of CSI. The agreement provided that CSI would consult on matters pertaining to the Company's technology, vendor relations, customer contacts and strategic planning and be paid a fee when, and if, the Company installed 50 ILN terminals or achieved $1,000,000 in revenues. During December 1995, in anticipation of the Company's limited cash resources, the parties amended the consulting agreement to provide that CSI would receive a $375,000 note, convertible into shares of the Company's common stock at a rate of $5.50 per share and bearing interest at the rate of 8.5% per annum, in satisfaction of the amounts due under the consulting agreement. The Company has paid $138,500 of the note and the remaining portion of $236,500 is due December 28, 1998. The entire consulting fee of $375,000 was recorded as an expense during the fiscal year ended September 28, 1996.
The Company is party to various agreements with Vanguard Cellular Financial Corp. (together with its subsidiaries, 'Vanguard'). As of December 31, 1997, Vanguard has beneficial ownership of approximately 3.1 million shares of common stock of the Company and holds 18,000 units issued in the Private Placement (See Note 6). Stephen R. Leeolou, Chairman and Chief Executive Officer of the Company, is also co-founder and Co-Chief Executive Officer of Vanguard.
On June 17, 1996, the Company entered into a management consulting agreement with Vanguard for a period of two years. Under the agreement, Vanguard will assist the Company in developing accounting, human resources, information management, legal compliance, sales training, research and development, business development and operations procedures, systems and programs. For services rendered under the agreement, the Company issued 10,000 shares of its common stock upon execution of the agreement and issued 10,000 shares in June 1997. In addition, the Company will reimburse Vanguard for any expenses incurred in the course of providing consulting services. This agreement terminated the previous consulting agreements dated January 30, 1996, the Company had with Vanguard. Under the January 30, 1996 agreement, Vanguard was to provide one of its executive employees to serve in the role of Chief Operating Officer (the 'COO') of the Company and to provide other consulting services as necessary. All expenses, including related compensation expenses of such individuals based on time rendered on the Company's activities, would be paid by the Company. This agreement was terminated upon execution of the management consulting agreement with Vanguard on June 17, 1996. The Company has paid Vanguard under such consulting agreements, approximately
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
$218,000, $42,000 and $29,000 during the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal year ended September 28, 1996, respectively.
In May 1995, the Company issued 400,000 shares of common stock to Vanguard at a Purchase price of $5.00 per share. In connection with this issuance, Vanguard also received a warrant (the 'Vanguard Warrant') to purchase up to an additional 400,000 shares of the Company's common stock at the agreed-upon fair market value of such stock at the time of exercise. This warrant agreement contains an anti-dilution clause which provides for adjustments to the number of shares eligible to be purchased to maintain the number of shares at approximately 10.3% of the Company's outstanding common stock. The warrant expires on the earlier of (i) May 5, 2005 or (ii) the consummation of an initial public offering by the Company. The terms of the Vanguard Warrant were restructured immediately prior to the consummation of the private placement transaction (see Note 7) to provide that Vanguard has the right to buy 900,113 shares at any time before May 5, 2005 at $23.50 per share, which was, in the opinion of management, the fair market value of the related common stock at the date of restructuring. The restructured Vanguard Warrant also provides that Vanguard may pay the exercise price either in cash or, if the fair market value of the common stock at the time of exercise is greater than the exercise price, by surrendering any unexercised portion of the Vanguard Warrant and receiving the number of shares equal to (i) the excess of fair market value per share at the time of exercise over the exercise price per share multiplied by (ii) the number of shares surrendered.
On May 5, 1995, the Company entered into a Registration Rights Agreement with Vanguard relating to certain warrants and shares of common stock of the Company owned by Vanguard. The agreement provides that Vanguard may at any time after six months from the date the first registration statement filed by the Company under the Securities Act of 1933 becomes effective, request the Company to effect the registration of certain securities held by Vanguard as expeditiously as may be practicable. However, the Company is entitled to decline such request, if, in the Company's judgment, such demand registration would not be in the Company's best interest. The Company may only decline such request once and will only be effective for a three-month period. In addition, the agreement allows Vanguard certain piggyback registration rights on any security offerings the Company may undertake, provided, however, the Company's underwriter determines, in their sole discretion, such shares will not jeopardize the success of the proposed offering by the Company. The agreement terminates the earlier of five years from date of the Company's first registration statement becomes effective or such time as Vanguard may sell its securities pursuant to Rule 144 under the Securities Act.
6. LONG-TERM DEBT
Long-term debt consisted of the following:
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(1) In August 1996, the Company, through the Private Placement, issued 142,000 units, each consisting of a 14% senior discount note due 2003 (collectively, the 'Notes') with a principal amount at maturity of $1,000 and a warrant to purchase 7.334 shares (adjusting to 9.429 shares at September 30, 1997 if the Company did not complete a qualified initial public offering of common stock by that date) of common stock of the Company at $.01 per share. The gross proceeds of $94.8
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
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million were allocated by the Company to the value of the warrants of approximately $24.5 million and to the discounted notes of approximately $70.2 million. Expenses of the offering of approximately $3.8 million were capitalized as bond issuance costs and are being amortized over the remaining term of the Notes. The Company did not complete a qualified initial public offering of common stock by September 30, 1997; therefore, the Company recorded additional common stock purchase warrants of $3.0 million reflecting the valuation of an additional 297,490 shares, or 2.095 shares issuable per warrant.
No cash interest will be payable on the Notes prior to February 1, 2000. The Notes will accrue cash interest at a rate of 14% per annum, commencing on August 1, 1999, payable semi-annually on February 1 and August 1 of each year commencing on February 1, 2000. The debt discount related to the difference between the face value of the notes ($142 million) and the proceeds of the Private Placement ($94.8 million) is being accreted over the period to August 1, 1999. The debt discount related to the portion of the Private Placement allocated to the value of the warrants ($27.4 million, $24.5 million and $24.5 million at December 31, 1997, December 31, 1996 and September 30, 1996, respectively) is being accreted over the full term of the Notes to August 1, 2003. Interest expense on the notes, including the accretion of debt discount and amortization of issuance costs, is being recognized at a constant rate of interest over the life of the Notes. Discount accretion of $17.5 million, $4.1 million and $2.6 million and amortization of bond issuance costs of approximately $464,000, $102,000 and $67,000 have been recognized as interest expense during the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal year ended September 28, 1996, respectively. If additional funds are raised through debt financing, such financing will increase the financial leverage of the Company and earnings would be reduced by the associated interest expense. There is no assurance that the Company will be able to meet its financial obligations under the Notes or other commitments.
7. COMMON STOCK
During the year ended December 31, 1997, the Company issued 60,000 shares of Common Stock, 50,000 shares for partial consideration in the acquisition of a patent and 10,000 shares issued pursuant to the management service agreement the Company has with Vanguard. (See Note 5) The issuance of such shares was recorded at $10.00 per share, which management believes approximates the fair market value of the shares on date of issuance.
During the fiscal year ended September 28, 1996, the Company issued approximately 3,738,000 shares of Common Stock of which approximately 3,418,000 shares were issued at a purchase price of $5.50 per share and approximately 320,000 were issued at a purchase price of $5.00 per share. Approximately 3,319,000 shares were issued as part of a private offering of common stock at a purchase price of $5.50 per share. In connection with this offering, purchasers of $250,000 or more of common stock received warrants to purchase a number of shares of common stock equal to 5% of the shares purchased in the offering and purchasers of $1,000,000 or more of common stock received warrants to purchase a number of shares of common stock equal to 10% of the shares purchased in the offering. The exercise price of all warrants issued or sold in connection with this offering will equal the sales price of the next $2 million of common stock issued and sold by the Company. Purchasers of common stock in this offering who were also purchasers of common stock in certain earlier offerings were also offered warrants (at a purchase price of $.01 per warrant share) to purchase common stock. Approximately 323,216 warrants were issued under this offering and expire on December 31, 2000. Also during the year ended September 30, 1996, 10,000 shares of common stock were issued pursuant to the management service agreement the Company has with Vanguard at the then estimated fair market value of $5.50 per share. In addition, the Company converted approximately $2.1 million in debt, notes payable and related accrued interest due to stockholders into 409,000 shares of common stock. Notes
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
payable to stockholders of $1.6 million bearing interest at 8.5%, maturing on February 1, 1998 were converted into approximately 320,000 shares of common stock at a conversion price of $5.00 per share. Fifty percent of accrued interest on such notes payable were converted into approximately 13,000 shares at a conversion price of $5.50 per share, the remaining fifty percent of accrued interest was paid in cash. Other notes payable to stockholders with a principal amount of approximately $371,000 and related accrued interest of approximately $47,000 were converted into approximately 76,000 shares of common stock at $5.50 per share.
During the fiscal year ended September 30, 1995, the Company issued 1,032,000 shares of common stock. Vanguard, through a subsidiary, purchased 400,000 shares of common stock of the Company at a purchase price of $5.00 per share. In connection with such investment, Vanguard received a warrant to purchase up to an additional 10.27% of the common stock of the Company at an exercise price equal to the fair market value of the common stock at the time of the exercise (the 'Vanguard Warrant'). The Vanguard Warrant was exercisable at any time prior to the earlier of an underwritten initial public offering or May 5, 2005. The Vanguard Warrant was restructured immediately prior to consummation of the Private Placement to provide that Vanguard has the right to buy 900,113 shares at any time before May 5, 2005 at $23.50 per share. The restructured Vanguard Warrant also provides that Vanguard may pay the exercise price either in cash or, if the fair market value of the common stock at the time of exercise is greater than the exercise price, by surrendering any unexercised portion of the Vanguard Warrant and receiving the number of shares equal to (i) the excess of fair market value per share at the time of exercise over the exercise price per share multiplied by (ii) the number of shares surrendered.
Of the remaining 632,000 shares issued during the fiscal year ended September 30, 1995, approximately 607,000 shares were issued at $5.00 per share and approximately 25,000 shares were issued at $5.50 per share.
On September 30, 1994, a stockholder agreed to forfeit 10,000 shares of the Company's common stock for failure to fulfill an obligation to invest additional capital in the Company. The forfeiture did not reduce the amount of the stockholder's financial investment in the Company at that time, but did reduce the number of shares issued to this individual. These shares were subsequently reissued to two other individuals at $5.00 per share. In December 1994, the same stockholder agreed to forfeit an additional 18,000 shares of the Company's common stock for failure to fulfill an obligation to invest additional capital in the Company. Upon this forfeiture, the investor's equity in the Company was reduced in the total amount of $140,000, representing the value of 28,000 shares of common stock at $5.00 per share. The original forfeiture of 10,000 shares and subsequent reissuance of the same 10,000 shares at $5.00 per share was recorded during the fiscal year ended September 30, 1994. The additional forfeiture of 18,000 shares and the entire value of the September 1994 and December 1994 forfeitures of $140,000 was recorded during the fiscal year ended September 30, 1995.
8. COMMON STOCK PURCHASE WARRANTS
In addition to the Vanguard Warrant to purchase 900,113 shares and the warrants to purchase an aggregate of 323,216 shares issued in the private offering described in Note 7, the Company has issued and outstanding other warrants described below. In August 1996, the Company, through the Private Placement, issued 142,000 units, each consisting of a 14% senior discount note due 2003 (collectively, the 'Notes') with a principal amount at maturity of $1,000 and a warrant to purchase 7.334 shares (adjusting to 9.429 shares at September 30, 1997 if the Company did not complete a qualified initial public offering of common stock by that date) of common stock of the Company at $.01 per share. The Company did not complete a qualified public offering of common stock by September 30, 1997, therefore, the Company recorded additional common stock purchase warrants of $3.0 million reflecting the valuation of an additional 297,490 shares, or 2.095 shares issuable per warrant. These warrants shall be exercisable on or after the earliest to occur of (i) August 1, 2000, (ii) a change of control, (iii) (a) 90
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
days after the closing of an initial public offering or (b) upon the closing of the initial public offering but only in respect of warrants required to be exercised to permit the holders thereof to sell shares in the initial public offering, (iv) a consolidation, merger or purchase of assets involving the Company or any of its subsidiaries that results in the common stock of the Company becoming subject to registration, (v) an extraordinary cash dividend or (vi) the voluntary or involuntary dissolution, liquidation or winding up of the affairs of the Company. The number of shares of the common stock for which a warrant is exercisable is subject to adjustment upon the occurrence of certain events.
Holders of warrants (or common stock issued in respect thereof) will be entitled to include the common stock issued or issuable upon the exercise of the warrants (the 'Underlying Common Stock') in a registration statement whenever the Company or any shareholder proposes to effect a public equity offering with respect to common stock of the Company (other than redeemable stock), except to the extent the managing underwriter for such offering determines that such registration and sale would materially adversely affect the price, timing or distribution of the shares to be sold in such public equity offering. Following the occurrence of an initial public offering, holders of warrants and Underlying Common Stock representing not less than 25% of all the outstanding warrants and Underlying Common Stock, taken together, will have the right, on one occasion, to require the Company to register these securities pursuant to an effective registration statement.
After August 1, 2001, the Company may be required, under certain circumstances, to purchase, at fair market value, the outstanding warrants and underlying common stock issued. Depending on the fair market value at that time, there may be a charge to earnings in connection with the repurchase of warrants and underlying common stock.
Management of the Company believes, based on independent third party valuations, that the value of the Company's common stock at the date of the initial issuance of these warrants was $23.50 per share and, accordingly, allocated $24.5 million of the proceeds of the Private Placement to the value of these warrants based on 142,000 units consisting of warrants to purchase 7.334 shares of common stock per unit with an exercise price of $.01 per share. Effective September 30, 1997, the Company recorded additional Common Stock Purchase Warrants of approximately $3.0 million reflecting the valuation of an additional 297,490 shares, or 2.095 shares issuable per warrant. This aggregate amount is classified between liabilities and stockholders' equity (deficit) in the accompanying consolidated balance sheet as of December 31, 1997. The value of the original warrants and the incremental value of the 2.095 (9.429 less 7.334) warrants issued per unit of the Notes effective September 30, 1997 have, since their issuance, been accounted for as an additional debt discount subject to accretion as described in Note 6.
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
9. NET LOSS PER SHARE
A reconciliation between the net loss and common shares of the basic and diluted EPS computations is as follows:
There were no reconciling items to be reported by the Company in the calculation for basic EPS and diluted EPS for the year ended December 31, 1997, three month period ended December 31, 1996 and the fiscal years ended September 28, 1996 and September 30, 1995. Inclusion of the Company's outstanding common stock purchase warrants and stock options (See Note 13) would have an antidilutive effect on earnings per share and, therefore, they are not included in the calculation of diluted EPS per SFAS No. 128.
10. DEFERRED COMPENSATION
In September 1996, the Company issued options to purchase 48,000 shares of common stock at an exercise price of $7.50 per share under the 1996 Nonqualified Stock Option Plan (See Note 13), which was an exercise price below the then-estimated fair market value of the Company's common stock on the date of grant. Accordingly, the Company has recorded a deferred compensation charge of $768,000, which will be amortized ratably over the five year vesting period of the related options. Accumulated amortization was $198,000, $45,000 and $6,000 at December 31, 1997, December 31, 1996 and September 28, 1996, respectively. Amortization expense of deferred compensation was $153,000, $39,000 and $6,000 for the year ended December 31, 1997, the three month period ended December 31, 1996 and for the fiscal year ended September 28, 1996, respectively.
11. LITIGATION
During the year ended September 28, 1996, a lawsuit was filed and settled against the Company alleging certain patent infringement. The Company expressly denied any wrongdoing and entered into such agreement to avoid lengthy litigation costs. Under the settlement agreement, the Company was required to pay $400,000, and in return, received, among other things, the worldwide, perpetual right to use such patent, dismissal with prejudice and release of all related claims. The cost of the settlement of $400,000 was expensed during the fiscal year ended September 28, 1996.
In February 1996, the Company filed suit against Catalina Marketing Corporation alleging that Catalina has infringed United States Letters Patent No. 4,554,446 (the '446 Patent') under which the Company is licensee. The Company alleges that Catalina is infringing the patent by making, using and offering for sale devices and systems that incorporate and employ inventions covered by the '446 Patent. The Company is seeking an injunction against Catalina to stop further infringement of the patent, treble damages and the costs and expenses incurred in connection with the suit. The complaint has been amended to add additional detail, and Catalina has answered denying the allegations, raising certain
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
affirmative defenses, and seeking declaratory judgment of non-infringement, invalidity or unenforceability of the '446 Patent. In May 1997, Catalina asserted a second counterclaim alleging that the Company is infringing a newly issued Catalina Patent U.S. Patent No. 5,612,868. The Company has answered denying the allegations, raising affirmative defenses and seeking declaratory judgment of non-infringement, invalidity and unenforceability of U.S. Patent No. 5,612,868. Discovery on the claims and counterclaims is proceeding and various motions are pending before the United States District Court in the District of Connecticut. As with any litigation, the ultimate outcome of these actions cannot be predicted. However, the Company intends to assert its claims vigorously.
In January 1998, Catalina Marketing International, Inc. ('Catalina International,' a subsidiary of Catalina) filed suit against the Company alleging that the Company has infringed United States Patent No. 4,674,041 (the '041 Patent') which Catalina International Inc. acquired by assignment in December 1997. Catalina International alleges that the Company is infringing the '041 Patent by making, using and offering for sale devices and systems that incorporate and employ inventions covered by the '041 Patent. Also in February 1998, Catalina International amended its complaint to join as additional parties defendant Thermo Information Solutions, Inc. and Coleman Research Corporation who have manufactured kiosk pursuant to an agreement with the Company. Catalina International seeks injunctive and declaratory relief as well as unspecified money damages against all defendants, and has filed a motion for preliminary injunction against the Company seeking to stop further alleged infringement of the '041 Patent pending trial. Various other motions are pending in the United States District Court in the District of Connecticut, including the Company's motion for a more definite statement. The Company intends to defend against Catalina International's claims vigorously, and to pursue available remedies against Catalina International, which may include the filing of appropriate counterclaims.
12. INCOME TAXES
The components of cumulative deferred tax assets and liabilities were as follows (in thousands):
In accordance with the provisions of Internal Revenue Code Section 382, utilization of the Company's net operating loss carryforwards could be limited in years following a change in the Company's ownership. In general, a change in ownership occurs if a shareholder's (or the combined
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
group of the shareholders each owning less than 5%) ownership increases 50 percentage points over a three year period. This change could occur at the time of an Initial Public Offering. The net operating loss limitation is computed by applying a percentage (approximately 5%, as determined by the Internal Revenue Code) to the value of the Company on the date of the change. The Section 382 limitation limits the use of the net operating loss carryforward as computed on the date of the change in ownership. Net operating losses incurred after the date of the change of ownership are not limited unless another change in ownership occurs. At December 31, 1997 the amount of net operating loss carryforward is approximately $54.4 million. These losses begin to expire in the 2008 tax year.
Creditable foreign taxes paid by the Company or its subsidiaries will be subject to Internal Revenue Code Section 904, Limitation on Foreign Tax Credit, because the Company does not have a Federal Income Tax liability. The Foreign Tax Credit limitation may be carried back two years and forward five years. The Company has the option of deducting these foreign taxes in lieu of the credit. In general, since the Company does not have a federal tax liability, the deduction method will increase the amount of net operating losses which are available to be carried forward fifteen years. As of December 31, 1997 the Company has not paid or accrued foreign taxes.
SFAS No. 109 requires a valuation allowance to be recorded when it is more likely than not that some or all of the deferred tax assets may not be realized. At each of the balance sheet dates, a valuation allowance for the full amount of the net deferred tax asset was recorded. This valuation allowance is recorded due to both the uncertainty of future income and the possible application of Internal Revenue Code Section 382 limitations on the use of the net operating loss carryforwards.
13. STOCK OPTION PLANS
The Company has in place the 1994 Stock Compensation Plan which provides for the issuance of shares of Common Stock to key employees, consultants and directors pursuant to stock options that meet the requirements of Section 422 of the Internal Revenue Code of 1986, as amended (incentive stock options), options that do not meet such requirements (nonqualified stock options) and stock bonuses. All options under the plan must be granted at an exercise price not less than fair market value. Stock bonuses may be in the form of grants of restricted stock. The aggregate number of shares of Common Stock that may be issued pursuant to the plan may not exceed 330,000 shares, subject to adjustment upon occurrence of certain events affecting the Company's capitalization. As of December 31, 1997 an aggregate of 17,900 shares remain available for future grants under the 1994 Stock Compensation Plan.
The Company also has in place the 1996 Nonqualified Stock Option Plan which provides for the issuance of shares of Common Stock to key employees, consultants and directors pursuant to nonqualified stock options. All options must be granted at an exercise price not less than $5.50 per share. The aggregate number of shares of Common Stock that may be issued pursuant to the plan may not exceed 600,000 shares of Common Stock, subject to adjustment upon occurrence of certain events affecting the Company's capitalization. This plan is subject to shareholder approval. As of December 31, 1997 an aggregate of 17,000 shares remain available for future grants under the 1996 Nonqualified Stock Option Plan.
On May 20, 1997, the Company established the 1997 Long-term Incentive Plan ('Long-term Incentive Plan') for the purpose of promoting the long-term financial performance of the Company by providing incentive compensation opportunities to officers, supervisory employees, directors or consultants of the Company or any subsidiary. The plan allows for the Company to grant Stock Options for the purchase of shares of Stock to Grantees under the Plan in such amounts as the Compensation Committee of the Board of Directors, in its sole discretion, determines. The Stock Options granted under the Plan will be designated as either: (i) Incentive Stock Options or (ii) Nonqualified Stock Options. The purchase price for shares acquired pursuant to the exercise, will be determined at the time
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INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
of grant; however, it will not be less than the fair market value of the shares at the time of the grant. The Long-term Incentive Plan also allows the Company to grant Stock Appreciation Rights in any amount, at its sole discretion, either alone or in combination with other Awards granted under the Plan. As of December 31, 1997, 367,900 of 500,000 total available options have been issued under the Long-term Incentive Plan at an exercise price of $10.00 per share. Management believes that these options were granted at fair market value of common stock at the date of grant. No Stock Appreciation Rights were awarded as of December 31, 1997. The awards vest annually over five years from the date of grant with the exception of 63,500 options, which became immediately exercisable.
The Company accounts for these plans under APB Opinion No. 25, under which no compensation cost has been recognized. Had compensation cost for these plans been determined consistent with SFAS No. 123 (See Note 2), the Company's net loss and net loss per share would have been changed to the following pro forma amounts:
Because the SFAS No. 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. A summary of the status of the Company's stock option plans for the year ended December 31, 1997, the three month period ended December 31, 1996 and the fiscal year ended September 28, 1996 is presented in the table and narrative below:
821,100 of the options outstanding at December 31, 1996 have exercise prices between $1.86 and $7.50, with a weighted average exercise price of $5.40 and a weighted average remaining contractual life of 8.2 years. 332,400 of these options are exercisable. The remaining options have exercise prices between $1.86 and $7.50, with a weighted average exercise price of $5.56 and a weighted average remaining contractual life of 6 years. 332,400 of these options are exercisable; their weighted average exercise price is $5.15.
1,259,900 of the options outstanding at December 31, 1997, have exercise prices between $1.86 and 10.00, with a weighted average exercise price of $7.34 and a weighted average remaining contractual life
Inter*Act
INTER*ACT SYSTEMS, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1997, THE THREE MONTH PERIOD ENDED DECEMBER 31, 1996 AND FOR THE FISCAL YEARS ENDED SEPTEMBER 28, 1996 AND SEPTEMBER 30, 1995
of 8.7 years. 571,250 of these options are exercisable. The remaining options have exercise prices between $1.86 and 10.00 with a weighted average price of $8.48 and a weighted average remaining contractual life of 9.1 years. 571,250 of these options are exercisable; their weighted average exercise price is $6.16.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes Option Pricing Model with the following weighted-average assumptions used for grants in the year ended December 31, 1997, the three month period ended December 31, 1996, and the fiscal year ended September 28, 1996 respectively: risk free interest rates of 6.49%, 6.45%, and 6.60%; and expected dividend yields of 0%, expected lives of 5 years, and expected stock volatility of 0 for each respective period.
The foregoing plans are administered by the Compensation and Stock Option Committee of the Board of Directors, which is authorized, subject to the provisions of the plans, to determine to whom and at what time options and bonuses may be granted and the other terms and conditions of the grant.
14. COMMITMENTS AND CONTINGENCIES
COMMITMENTS FOR TECHNOLOGY
The Company is party to several patent licensing agreements relating to its in-store consumer product promotion and couponing business. With respect to one license agreement under which the Company is assignee, the Company is required to pay a royalty of 2% of the gross collected revenues of the Company, to the extent derived from the Company's exploitation of the patent, with such royalty decreasing to 1% of such revenues after $10 million in aggregate royalties have been paid to the licensors. This license agreement requires that certain minimum monthly payments be made to the licensors, and be exceeded within approximately two years, in order to avoid triggering a termination right on the part of the licensors. With respect to another license agreement, the Company is required to pay the licensor a royalty of .8% of the gross collected revenues of the Company to the extent derived from the Company's exploitation of the patent, until such time as the licensor has received the aggregate sum of $600,000 after which no additional royalty payments are required. Under a third agreement, the Company is required to pay the licensor a royalty of 1% of the gross revenues related to the Company's exploitation of the patent subject to certain minimum annual payments, should the Company wish to maintain exclusive rights under such patent. Under these agreements, the Company recorded royalty payments of $398,000, $99,000, $333,000 and $274,000 for the year ended December 31, 1997, the three month period ended December 31, 1996, and for the fiscal years ended September 28, 1996 and September 30, 1995, respectively.
COMMITMENTS FOR FIXED ASSET PURCHASES
On September 9, 1996, the Company sold its manufacturing operations to Coleman Research Corporation ('Coleman') for approximately $2.6 million and entered into an exclusive supply agreement whereby Coleman is to fulfill the Company's anticipated requirements for terminals for the next three years with fixed pricing for the first 5,000 terminals. No material gain or loss was realized in this transaction. As of March 24, 1998, the Company terminated its three-year exclusive terminal supply relationship with Coleman and its subsidiary, Thermo Information Solutions, Inc. ('Thermo') (collectively, the 'Vendors'). As part of this mutual termination agreement, the Company agreed to pay $4.5 million in installments to pay balances on previously purchased ILN equipment, to acquire certain inventory and to obtain early release from the exclusivity provision of the original contract to allow the Company to pursue relationships with new vendors. Of this amount, $4.1 million was charged to operating expense during 1997. The Vendors have agreed to return supplies and terminal parts to the Company, for which approximately $400,000 was reflected in other current assets of the Company as of December 31, 1997. Further, the Vendors will supply the Company with 350 additional kiosks.
INDEX TO EXHIBITS
Sequential Exhibit No. Description Page No. - ----------- ----------- --------
* 3(a) Articles of Incorporation of Registrant as amended through July 25, 1995, filed as Exhibit 1 to the Registrant's Form 8-A/A dated July 25, 1995. * 3(b) Bylaws of Registrant (compilation of July 25, 1995), filed as Exhibit 2 to the Registrant's Form 8-A/A dated July 25, 1995. * 4(a) Specimen Common Stock Certificate, filed as Exhibit 4(a) to the Registrant's Registration Statement on Form S-1 (File No. 33-18067). * 4(b)(1) Amended and Restated Loan Agreement between the Registrant and various lenders led by The Bank of New York and The oronto-Dominion Bank as agents, dated as of December 23, 1994, filed as Exhibit 2(a) to the Registrant's Current Report on Form 8-K dated as of December 23, 1994. * 4(b)(2) Security Agreement between the Registrant and various lenders led by The Bank of New York and The Toronto-Dominion Bank, as Secured Party, dated as of December 23, 1994, filed as Exhibit 2(b) to the Registrant's Current Report on Form 8-K dated as of December 23, 1994. * 4(b)(3) Master Subsidiary Security Agreement between the Registrant, certain of its subsidiaries and various lenders led by The Bank of New York and The Toronto-Dominion Bank, as Secured Party, dated as of December 23, 1994, filed as Exhibit 2(c) to the Registrant's Current Report on Form 8-K dated as of December 23, 1994. * 4(b)(4) Second Amended and Restated Loan Agreement between Vanguard Cellular Operating Corp. and various lenders led by The Bank of New York and The Toronto-Dominion Bank as agents, dated as of April 10, 1996, filed as Exhibit 4(d)(1) to the Registrant's Form 10-Q/A dated March 31, 1996. * 4(b)(5) VCOC Security Agreement between Vanguard Cellular Operating Corp. and various lenders led by The Bank of New York and The Toronto-Dominion Bank as Secured Party, dated as of April 10, 1996, filed as Exhibit 4(d)(2) to the Registrant's Form 10-Q/A dated March 31, 1996. * 4(b)(6) Second Amended and Restated Master Subsidiary Security Agreement between certain subsidiaries of the Registrant and various lenders led by The Bank of New York and The Toronto-Dominion Bank, as Secured Party, dated as of April 10, 1996, filed as Exhibit 4(d)(3) to the Registrant's Form 10-Q/A dated March 31, 1996. * 4(b)(7) Assignment, Bill of Sale and Assumption Agreement by and between Registrant and Vanguard Cellular Financial Corp., dated as of April 10, 1996, filed as Exhibit 4(d)(4) to the Registrant's Form 10-Q/A dated March 31, 1996. * 4(b)(8) Indenture dated as of April 1, 1996 between Registrant and The Bank of New York as Trustee, filed as Exhibit 4(e)(1) to the Registrant's Form 10-Q/A dated March 31, 1996. * 4(b)(9) First Supplemental Indenture, dated as of April 1, 1996 between registrant and The Bank of New York as Trustee, filed as Exhibit 4(e)(2) to the Registrant's Form 10-Q/A dated March 31, 1996. * 4(b)(10) First Amendment to Second Amended and Restated Loan Agreement between Vanguard Operation Corp. and various lenders led by the Bank of New York and The Toronto-Dominion Bank as agents, dated as of July 31, 1996, filed as Exhibit 4(d)(5) to the Registrant's Form 10-Q dated September 30, 1996 and confirmed electronically as Exhibit 4(d)(5) to the Registrant's 10-Q/A dated September 30, 1996. * (11) Second Amendment to Second Amended and Restated Loan Agreement between Vanguard Cellular Operating Corp. and various lenders led by the Bank of New York and The Toronto-Dominion Bank as agents, dated as of October 30, 1996 and confirmed electronically as Exhibit 4(d)(6) to the Registrant's 10-Q/A dated September 30, 1996. * (12) Third Amendment to Second Amended and Restated Loan Agreement between Vanguard Cellular Operating Corp. and various lenders led by the Bank of New York and The Toronto-Dominion Bank as agents, dated as of March 31, 1997 and filed as Exhibit 4(b)(7) to the Registrant's Form 10-Q dated September 30, 1996. * 4(b)(9) First Supplemental Indenture, dated as of April 1, 1996 between Registrant and The Bank of New York as Trustee, filed as Exhibit 4(e)(2) to the Registrant's Form 10-Q/A dated March 31, 1996. * 10(a)(1) Amended and Restated Stock Compensation Plan of the Registrant approved April 22, 1987 by the Shareholders of the Registrant, with forms of stock bonus and stock option agreements attached, filed as Exhibit 10 (a) to the Registrant's Registration Statement, on Form
S-1 (File No. 33-18067). * 10(a)(2) Amendment to Amended and Restated Stock Compensation Plan of the Registrant approved May 2, 1989 by the Shareholders of the Registrant, filed as Exhibit 4(h)(2) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989. * 10(a)(3) Form of Restricted Stock Bonus Agreements dated March 23, 1987 between the Registrant and Stuart S. Richardson, Haynes G. Griffin, L. Richardson Preyer, Jr., Stephen R. Leeolou and Stephen L. Holcombe, and form of amendments dated October 12, 1987 to agreements with Messrs. Richardson, Griffin, Preyer and Leeolou, filed as Exhibit 10(a)(3) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. * 10(a)(4) Form of Restricted Stock Bonus Agreements dated October 12, 1987 between the Registrant and Haynes G. Griffin, Stephen R. Leeolou and L. Richardson Preyer, Jr., filed as Exhibit 10(a)(4) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. * 10(1)(5) Form of Amendment to Restricted Stock Bonus Plan Agreements dated as of March 1, 1990 by and between Haynes G. Griffin, L. Richardson Preyer, Jr., Stephen R. Leeolou, and Stephen L. Holcombe and the Registrant, amending the Restricted Stock Bonus Plan Agreements dated as March 23, 1987, filed as Exhibit 10(a)(5) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(1)(6) Form of Amendment to Restricted Stock Bonus Plan Agreements dated as of March 1, 1990 by and between Haynes G. Griffin, L. Richardson Preyer, Jr. and Stephen R. Leeolou and the Registrant, amending the Restricted Stock Bonus Plan Agreements dated as October 12, 1987, filed as Exhibit 10(a)(6) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(a)(7) Form of Second Amendment to Restricted Stock Bonus Plan Agreements dated February 22, 1991 between the Registrant and Haynes G. Griffin, Stephen R. Leeolou, and L. Richardson Preyer, Jr., amending the Restricted Stockx Bonus Agreements dated October 12, 1987, filed as Exhibit 10(a)(7) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(a)(8) Form of Third Amendment to Restricted Stock Bonus Plan Agreements dated February 22, 1991 between the Registrant and Haynes G. Griffin, Stephen R. Leeolou, L. Richardson Preyer, Jr., and Stephen L. Holcombe, amending the Restricted Stock Bonus Agreements dated March 23, 1987, filed as Exhibit 10(a)(8) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(a)(9) Form of Third Amendment to Restricted Stock Bonus Plan Agreement dated February 22, 1991 between the Registrant and Stuart S. Richardson, amending the Restricted Stock Bonus Plan Agreement dated March 23, 1987, filed as Exhibit 10(a)(9) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(a)(10) Employment Agreement dated March 1, 1995 by and between the Registrant and Haynes G. Griffin, filed as Exhibit 10(a)(10) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. * 10(a)(11) Employment Agreement dated March 1, 1995 by and between the Registrant and L. Richardson Preyer, Jr., filed as Exhibit 10(a)(11) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. * 10(a)(12) Employment Agreement dated March 1, 1995 by and between the Registrant and Stephen R. Leeolou, filed as Exhibit 10(a)(12) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. * 10(a)(13) Executive Officer Long-Term Incentive Compensation Plan adopted October 1, 1990 by the Registrant, filed
as Exhibit 10(a)(13) to the Registrant's Annual Report on Form 10-K to the fiscal year ended December 31, 1990. * 10(a)(14) Form on Nonqualified Option Agreements dated October 12, 1987 between the Registrant and Stephen L. Holcombe, Ralph E. Hiskey, John F. Dille, Jr., Charles T. Hagel, L. Richardson Preyer, Sr. and Robert A. Silverberg, filed as Exhibit 10(a)(5) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. * 10(a)(15) Nonqualified Option Agreements dated October 12, 1987 between the Registrant and Robert M. DeMichele, John F. Dille, Jr., L. Richardson Preyer, Sr., Robert A. Silverberg and Thomas I. Storrs, filed as Exhibit 10(a)(8) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. * 10(a)(16) Form of Incentive Stock Option Agreements dated March 3, 1988 between the Registrant and Stephen L. Holcombe and Richard C. Rowlenson, filed as Exhibit 10(a)(9) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. * 10(a)(17) Form of Incentive Stock Option Agreements dated June 23, 1988 between the Registrant and Charles T. Hagel, Haynes G. Griffin, L. Richardson Preyer, Jr., and Stephen R. Leeolou, filed as Exhibit 10(a)(10) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. 10(a)(18) Amended and restated 1994 Long-Term Incentive Plan, approved by the Registrant's Board of Directors on February 26, 1997. * 10(a)(19) Senior Management Severance Plan of the Registrant adopted March 8, 1995, filed as Exhibit 10(a)(19) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. * 10(a)(20) Form of Severance Agreement for Senior Management Employees of the Registrant, filed as Exhibit 10(a)(20) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. * 10(a)(21) Form of Incentive Stock Agreement dated March 7, 1995 between the Registrant and Haynes G. Griffin, Steven L. Holcombe, Richard C. Rowlenson and Stuart S. Richardson filed as Exhibit 10(a)(21) to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1995. * 10(a)(22) Form of Nonqualified Option Agreement dated March 7, 1995 between the Registrant and Haynes G. Griffin, Stephen R. Leeolou, L. Richardson Preyer, Jr., Stephen L. Holcombe, Richard C. Rowlenson and Stuart S. Richardson, filed as Exhibit 10(a)(22) to the Registrant's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1995. * 10(b))(1) Loan Agreement between the Registrant and various lenders led by The Bank of New York and The Toronto-Dominion Bank as agents, dated as of December 23, 1994, filed as Exhibit 2(a) to the Registrant's Current Report on Form 8-K dated as of December 23, 1994. * 10(b)(2) Security Agreement between the Registrant and various lenders led by The Bank of New York and The Toronto-Dominion Bank, as Secured Party, dated as of December 23, 1994, filed as Exhibit 2(b) to the Registrant's Current Report on Form 8-K dated as of December 23, 1994. * 10(b)(3) Master Subsidiary Security Agreement between the Registrant, certain of its subsidiaries and various lenders led by The Bank of New York and The Toronto-Dominion Bank, as Secured Party, dated as of December 23, 1994 filed as Exhibit 2(c) to the Registrant's Current Report on Form 8-K dated as of December 23, 1994. * 10(d))(1) 1989 Stock Option Plan of the Registrant approved by the Board of Directors of the Registrant on December 21, 1989, and approved by Shareholders at a meeting held on May 10, 1990, filed as Exhibit 10(h)(1) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. * 10(d)(2) Form of Nonqualified Stock Option Agreements dated March 1, 1990 between the Registrant and Haynes G. Griffin, L. Richardson Preyer, Jr., Stephen R. Leeolou, Stephen L. Holcombe and Stuart S. Richardson, filed as Exhibit 10(h)(2) to the Registrant's annual Report on Form 10-K for the fiscal year ended December 31, 1989. * 10(d)(3) Form of Incentive Stock Option Agreement dated March 1, 1990 between the Registrant and Richard C. Rowlenson, filed as Exhibit 10(h)(2) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. * 10(d)(4) Form of Incentive Stock Option Agreement dated July 30, 1990 between the Registrant and Stephen L. Holcombe, Richard C. Rowlenson, Sunir Kochhar and Timothy G. Biltz, filed as Exhibit 10(f)(4) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(d)(5) Stock Option Agreement dated November 28, 1990 between the Registrant and Stuart Smith Richardson, filed as Exhibit 10(f)(5) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(d)(6) Form of Stock Option Agreements dated November 28, 1990 between the Registrant and Haynes G. Griffin, Stephen R. Leeolou, L. Richardson Preyer, Jr. and Stephen L. Holcombe, filed as Exhibit 10(f)(6) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(d)(7) Incentive Stock Option Agreements dated November 28, 1990 between the Registrant and Richard C. Rowlenson, filed as Exhibit 10(f)(7) to the Registrant's December 31, 1990. * 10(e)(1) Joint Venture Agreement by and among W&J Metronet, Inc., Vanguard Cellular Systems of Coastal Carolina, Inc., Providence Journal Telecommunications and the Registrant dated as of January 19, 1990,
filed as Exhibit 10(j) to the Registrant's Registration Statement on Form S-4 (File No. 33-35054). * 10(e)(2) First Amendment and Assumption Agreement dated as of the 28th day of December, 1990 to Joint Venture Agreement by and among W&J Metronet, Inc., Vanguard Cellular Systems of Coastal Carolina, Inc., Providence Journal Telecommunications and the Registrant dated as of January 19, 1990, filed as Exhibit 10(g)(2) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. * 10(f)(1) Stockholders Voting Agreement dated as of February 23, 1994, filed as Exhibit 7 to Amendment 1 of Schedule 13D dated February 23, 1994 with respect to the Common Stock of Geotek Communications, * 10(g)(1) Nonqualified Deferred Compensation Plan with Form of Salary Reduction Agreement filed as Exhibit 10(g(1) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1996. 11 Calculation of diluted net income per share for the years ended December 31, 1997, 1996, and 1995. 22 Subsidiaries of the Registrant. 23 Consent of Arthur Andersen LLP 27 Financial Data Schedule.
- ------- * Incorporated by reference to the statement or report indicated.