PAETEC Holding 10-K 2010
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2009
For the transition period from to
Commission file number: 000-52486
PAETEC HOLDING CORP.
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code:
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
The aggregate market value of the registrants common equity held by non-affiliates of the registrant at June 30, 2009, which was the last business day of the registrants most recently completed second fiscal quarter, was approximately $288.4 million based on the closing price of the common stock as reported on the NASDAQ Global Select Market on such date.
The number of shares of the registrants common stock outstanding on March 5, 2010 was 145,556,387.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following documents are incorporated by reference in this Form 10-K as indicated herein:
TABLE OF CONTENTS
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words may, will, anticipate, estimate, expect, intend, plan, continue and similar expressions as they relate to us or our management are intended to identify these forward-looking statements. All statements by us regarding our expected financial position, liquidity, revenues, cash flows and other operating results, business strategy, financing plans, forecasted trends related to the markets in which we operate, legal proceedings and similar matters are forward-looking statements. Our expectations expressed or implied in these forward-looking statements may not turn out to be correct. Our results could be materially different from our expectations because of various risks, including the risks discussed in this report under BusinessRegulation and Risk Factors.
We have derived some of the information contained in this report concerning the markets and industry in which we operate from publicly available information and from industry sources. Although we believe that this publicly available information and the information provided by these industry sources are reliable, we have not independently verified the accuracy of any of this information.
Unless we indicate otherwise, we have rounded dollar amounts over $1 million to the nearest hundred thousand dollars and dollar amounts less than $1 million to the nearest thousand dollars.
Unless we indicate otherwise, references in this report to we, us, our, PAETEC Holding and PAETEC mean PAETEC Holding Corp. and PAETEC Corp. and its subsidiaries for all periods before the completion of the merger with US LEC Corp., or US LEC, on February 28, 2007. For the period beginning on March 1, 2007 through February 8, 2008, such references refer to PAETEC Holding Corp. and its subsidiaries, including US LEC and its subsidiaries. On February 8, 2008, PAETEC completed its acquisition by merger of McLeodUSA Incorporated, or McLeodUSA. For the period beginning on February 9, 2008, such references refer to PAETEC Holding Corp. and its subsidiaries, including US LEC and McLeodUSA and their respective subsidiaries.
PAETEC is a competitive communications services and solutions provider guided by the principle that delivering superior customer service is the key to competing successfully with other communications services providers. PAETECs primary business is providing large, medium-sized and, to a lesser extent, small business end-user customers in metropolitan areas with a package of integrated communications services that encompasses data services, including broadband Internet access services and virtual private network services, and voice services, including local telephone services and domestic and international long distance services. As of March 1, 2010, PAETEC Holding had in service 234,116 digital T1 transmission lines, which represented the equivalent of 5,618,784 access lines, for approximately 44,000 business customers in a service area encompassing 84 of the top 100 metropolitan statistical areas.
PAETEC Holding was incorporated in Delaware in August 2006, and its predecessor, PAETEC Corp., was incorporated in Delaware in 1998. PAETEC Holding is a holding company that conducts its operations through wholly-owned subsidiaries. PAETEC Holdings principal executive offices are located at One PAETEC Plaza, 600 Willowbrook Office Park, Fairport, New York 14450, and our telephone number at that address is (585) 340-2500.
We maintain a corporate Internet web site at www.paetec.com. We make available free of charge through our web site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, as soon as reasonably practicable after we electronically file or furnish the reports with the SEC. The contents of our web site are not a part of this report. The SEC maintains an Internet web site at www.sec.gov that contains reports and other information regarding PAETEC Holding.
PAETEC provides a range of data and voice services on a retail basis to large, medium-sized and, to a lesser extent, small end-user business customers. PAETEC complements its offering of these network services with sales to its retail customers of integrated solutions, including software applications, network integration services, managed and other services, energy services and communications equipment. PAETEC also offers a range of data and voice carrier services on a wholesale basis to other communications companies and to larger-scale purchasers of network capacity. PAETECs retail sales and marketing initiatives focus on bundling its
network services and integrated solutions for sale to its core business and institutional customers. PAETEC believes this bundling adds value for its customers and increases its share of its customers expenditures on communications services.
As of March 1, 2010, PAETEC delivered its communications services in 48 states and the District of Columbia, had broadband network and facilities spanning approximately 20,080 local route miles, operated 122 switching facilities that provide traditional voice and Internet Protocol, or IP, capabilities, and had more than 5,951,654 access line equivalents in service, including plain old telephone service, or POTS, lines relating to the provision of basic telephone services supplying standard line telephones, telephone lines and access to the public switched network.
Although PAETEC has an existing base of residential customers and it expects to continue to support that base, PAETEC does not actively market residential services to new customers. PAETECs provision of residential services is not a material part of its business.
PAETEC has designed its network, developed its back office systems and trained its employees and sales agents to support a broad line of services. PAETEC believes that its ability to bundle a package of value-added communications services enables it to build customer loyalty, increase the penetration of its existing markets and facilitate its entry into additional markets.
PAETEC offers a range of network services and solutions to its retail end-user customers, encompassing both data services, including broadband Internet access services and virtual private network services, and voice services, including local telephone services and domestic and international long distance services. PAETEC also provides other services that relate to its core business, such as service management tools that permit its customers to prioritize their IP applications, as well as data backup and recovery applications, data center collocation services and web hosting services. PAETECs strategy has been to expand these service offerings over time and to complement them with a variety of integrated solutions that it also offers on a retail basis. PAETEC derived approximately 80% of its total revenue for 2009 from its network services.
Internet Connectivity and Other Networking Services. PAETEC offers its customers the following broadband Internet connectivity and other networking services:
Local Telephone Services. PAETECs local telephone service offering provides basic local dial tone service, as well as additional services, such as directory assistance, call forwarding and call hunting. PAETEC is certified to offer local telephone services in 48 states and the District of Columbia.
Long Distance Services. PAETEC offers a range of switched and dedicated long distance services to customers connected to its network. These include services that originate and terminate within the same local transport area and in different local transport areas, international services, 1+ outbound services and inbound toll-free services. PAETEC also offers ancillary long distance services, such as audio and web conferencing services. In those instances where PAETEC is not able to connect a customer to its network, the company resells the long distance services of other communications carriers. PAETEC generally sells its long distance services as part of a bundle that includes one or more of its local services offerings, its other network service offerings and/or its integrated solutions offerings.
Access Services. In addition to services it provides to its retail end-user customers, PAETEC offers switched and dedicated access services that other communications providers use when they originate or terminate long distance calls to or from PAETECs retail end -user customers. PAETEC also provides access services to other local exchange carriers when it terminates local calls made by the customers of other local carriers.
Related Services. PAETEC offers its customers in some regions the following additional services that relate to its core business:
PAETEC supplements the network services and integrated solutions it provides to end users on a retail basis with its wholesale offering of voice and data carrier services to other communications providers and to larger-scale purchasers of network capacity. PAETECs carrier services customers include communications companies that resell PAETECs local and long distance services, interactive voice response providers, Voice over Internet Protocol, or VoIP, providers, other competitive carriers such as PAETEC that were formed as a result of the Telecommunications Act of 1996, wireless service providers, web services providers and Internet service providers. PAETEC derived approximately 16% of its total revenue for 2009 from its carrier services.
PAETEC offers the following services to some or all of its carrier customers:
The majority of PAETECs carrier services revenue is generated from terminating and originating communications traffic to and from end-user customers on the PAETEC network that is sent to and from these end users by other communications companies. PAETEC historically has generated the majority of these revenues by terminating and originating traditional long distance services. PAETEC provides its regional customers, through the companys centralized network equipment centers, with the flexibility to extend their coverage areas without extending their operational centers or investing in additional personnel.
As part of its package of retail solutions offerings, PAETEC offers a variety of customized services that help customers build and operate their own data and voice networks. Sales of these offerings can follow or often result in subsequent sales of one or more of PAETECs network services. These customized services enhance customer retention and frequently represent a decisive factor for customers that choose PAETEC over its competitors for the provision of network services. PAETEC derived approximately 4% of its total revenue for 2009 from its integrated solutions.
Applications Services. PAETECs Pinnacle software product provides customers with many of the network management and cost allocation capabilities of a telecommunications carrier. Customers using PAETECs software are able to perform rate inquiries, initiate trouble ticketing, track work orders and perform other tasks associated with maintaining a large scale internal telecommunications network. In addition, Pinnacle software customers can track and allocate the costs of voice, data and other communications charges at the individual, departmental and general ledger levels. PAETECs target market segment for the Pinnacle software products includes institutions with large internal telecommunications networks, such as Fortune 1,000 companies, universities and government agencies.
Network Design and Implementation. PAETEC offers design, installation and maintenance services for networks, including local and wide area networks, located on the customers premises.
Customer Premise Equipment Sales, Installation and Leasing. PAETEC sells and installs equipment located on its customers premises. This equipment, including products from Avaya and Cisco, historically has included private branch exchanges, local area networks and servers and routers. Through its Allworx Corp., or Allworx, subsidiary, PAETEC develops and sells complete phone and network systems and provides software and digital hardware engineering services specifically designed to benefit small and medium-sized businesses. In addition, to complement its own work force, PAETEC establishes relationships with local equipment installation companies to sell and install equipment that PAETEC does not sell directly. PAETEC also facilitates the network
integration efforts of select customers through its Equipment for Services program. This program helps customers secure financing from third parties to lease the telecommunications equipment. PAETEC includes the equipment lease charges due to the third party on the customers regular invoices for the communications services they purchase from PAETEC and remits the associated equipment lease payment collected from the customer to the third-party financing company.
Managed Services. PAETEC provides billing and customer care services for the telecommunications resale programs of universities. As part of these services, PAETEC manages the provision of high-speed communications services, including high-speed Internet access and enhanced voice and video services, at universities and private student housing complexes.
PAETECs Network Architecture and Deployment
Overview. PAETEC has developed, installed and continues to invest in a flexible network that facilitates delivery of its voice and data services. To deploy its network, PAETEC employs:
This network deployment strategy has allowed PAETEC to enter new markets relatively rapidly and to offer its customers flexible technological solutions tailored to their specific needs. PAETEC believes that this network deployment strategy also will facilitate the companys adoption and delivery of new technologies.
Last Mile. PAETEC primarily connects its customers to its network by leasing special access digital T1 transmission lines. PAETEC supplements its use of special access lines with unbundled network element, or UNE, high capacity loops, or UNE digital T1 transmission lines, which we refer to as UNE digital T1. Both types of access lines provide a dedicated connection between customer locations and PAETEC switches. PAETEC has obtained almost all of these leased digital transmission lines from the major incumbent local exchange carriers such as AT&T Inc., Verizon Communications, Qwest Corporation and CenturyTel, Inc. (which, after its acquisition of Embarq Corporation, refers to itself as CenturyLink). Each last mile connection provides PAETEC customers with up to 1.5 Megabits per second, or Mb/s, of network capacity, over which PAETEC can provide network services. PAETEC also has relationships with providers to supply alternative types of last mile connectivity to certain locations. PAETECs strategy traditionally has been to form relationships with multiple providers of last mile access to locations where alternative last mile facilities are available to improve service reliability through alternative network paths and to lower its costs through competitive procurement. PAETEC is able to provide direct access to a limited number of buildings using its own last mile facilities. These PAETEC-owned facilities are capable of providing up to 1 gigabit Ethernet managed services to the customers located in those buildings, as well as services via digital system cross-connect frame, or DSX, and very high capacity optical carrier, or OC-n, lines. PAETEC also can provide direct wireless last mile access using a variety of speeds over wireless spectrum at the DS-x, OC-x, or Ethernet levels of 10, 100 or 1,000 Mb/s.
Packet Technology. PAETECs network infrastructure and operations support systems enable it to control the types of services that it offers, how these services are packaged and how they are integrated to serve customers. Through its installation of IP routers at its switch sites, PAETEC has broadly deployed packet-based technology across its service area as it migrates from traditional circuit-switching technology. Circuit switch-based systems, which historically have dominated the public telephone network, establish a dedicated channel for each communication, such as a telephone call for voice or fax, maintain the channel for the duration of the call, and disconnect the channel at the conclusion of the call. Packet-switched systems format the information to be transmitted into a series of shorter digital messages called packets. Each packet consists of a portion of the complete message plus the addressing information to identify the destination and return address. Unlike circuit-
switching, packet-switching does not require a single dedicated channel between communication points. This type of communication between sender and receiver is considered connectionless, rather than circuit-based. Traffic over the Internet, which is a connectionless network, uses packet-switching technology. We believe a transition to combining the delivery of PAETEC data and voice services over a converged packet-based network enables us to streamline the delivery of core communications services to our customer base in a more flexible manner than circuit-switching technology has permitted, to deliver a new generation of product offerings, and to leverage our network assets more effectively and efficiently.
Network Infrastructure and Backbone Network. PAETECs network backbone enables it to offer high-quality Internet access and VPN services. This backbone consists of high-capacity fiber optic facilities that allow PAETEC to transport traffic between points on its network. PAETEC has obtained a large fiber-based backbone that reaches portions of 27 states. As of March 1, 2010, PAETECs fiber backbone network spanned approximately 14,160 intercity and 5,920 metropolitan local route miles and encompassed approximately 1,041,100 intercity backbone fiber miles and 563,840 fiber miles of metropolitan local fiber optic cable. PAETEC primarily leases fiber backbone facilities between locations where it does not operate its fiber network. The packet-switching portion of PAETECs backbone is based on Internet Protocol, which is a broadly deployed standards-based protocol that allows unrelated computer networks to exchange data and is the technological basis of the Internet. IP technology has enabled PAETEC to accelerate network traffic flow and has made it easier and less costly for PAETEC to manage its network. This technology generally makes more of the network capacity available for revenue-generating customer traffic. PAETECs backbone network is intended to provide a network switching presence closer to the customer to reduce access mileage and switching costs, and to allow the company to expand its network rapidly to meet customer demand. The regional design also is intended to enhance service reliability and allow PAETEC to improve quality and performance.
Collocations. PAETEC has approximately 603 collocations, enabling it to access lower cost special access digital T1 lines and UNE digital T1 lines from within the central offices of regional Bell operating companies, or RBOCs, to connect to customer locations in local service areas using shorter access loops. In addition, PAETEC can serve outlying areas of its markets where it does not have collocations by using enhanced extended loops, or EELs, or special access T1 lines to connect more remote customer locations to its network.
As of March 1, 2010, PAETEC provided service in 84 of the top 100 metropolitan statistical areas and operated 122 switches.
Sales and Marketing
Network Services Sales Strategy. PAETEC targets large, medium-sized and, to a lesser extent, small business customers that it believes can benefit from the companys value-added services. PAETEC pursues a decentralized sales strategy, which affords its sales representatives substantial flexibility to negotiate the pricing and other terms of its customer agreements, subject to meeting specified revenue and profitability requirements. For this strategy to succeed, PAETEC must be able to attract, train, motivate and retain skilled sales professionals. PAETEC seeks to recruit sales representatives with experience working for other communications providers, telecommunications equipment manufacturers and network systems integrators in the companys existing and target markets. PAETEC then augments that experience with an internal training program and software tools that provide its sales representatives with the information they need to negotiate profitable customer contracts.
Sales of network services in each of the markets in which PAETEC provides such services is led by PAETECs President of National Sales and Service, who is responsible for the acquisition and retention of all network services accounts and who reports directly to PAETECs Chief Executive Officer. Network sales teams
are divided into four regions, with a regional sales president responsible for managing all direct sales, agent sales, account development, network design and service engineering in the assigned region. Each sales team generally includes branch sales managers, account managers, sales representatives, sales engineers and field technicians. PAETECs sales teams use a variety of methods to qualify leads and schedule initial appointments, including developing relationships with local industry associations and obtaining customer referrals. PAETEC believes this regionalized sales structure allows the company to maintain personalized customer service across its national operations.
PAETECs sales representatives generally make the initial customer contacts and sales. After the initial sale, PAETEC provides follow-up support and the sale of additional services, based on the size of the customer account, either through an account manager assigned to the customer or as part of the customer service organization. PAETEC also provides the local sales offices with technical resources to support the sales force and to coordinate switching the customer to PAETEC service. PAETECs service agreements with new customers generally have a fixed period initial term (currently averaging approximately 35 months) and a specified volume commitment, which volume commitment is typically measured on a monthly basis. The service agreement may be terminated by the customer at any time following a specified notice period and upon payment of a termination fee. Following expiration of the initial term, PAETEC seeks to enter into a new term agreement with the customer. If a new agreement is not reached, the initial agreement will continue either on a term or monthly basis. Some of PAETECs integrated solutions agreements have initial terms of up to five years.
For each prospective customer, PAETECs network services sales force uses proprietary software tools to allow the sales force to create a customized solution for the customer and to conduct profitability and pricing analysis for use in preparing proposals. This procedure serves to ensure that PAETEC maintains its focus on obtaining customers that meet internal profitability standards, while illustrating the potential benefits that a customer may realize by using a broader bundle of services. The focus of the software tool is to allow PAETECs network services sales representatives maximum flexibility in pricing individual services so long as each bundled sale is profitable. In this way, PAETECs sales representatives can customize their sales approach, using the companys proprietary software, to the unique requirements and price sensitivities of each customer. PAETEC believes that this pricing flexibility provides its sales force with a competitive advantage over the sales efforts of many other telecommunications carriers. In addition, PAETEC believes this tailored approach to service pricing allows the company to position itself as a flexible and responsive service provider at the initial point of contact with customers.
Network Services Sales Force. As of March 1, 2010, over 1,100 of PAETECs employees were dedicated to developing and supporting its direct sales and marketing activities. As of the same date, PAETEC maintained a total of 74 sales offices in 35 states and the District of Columbia. Each sales office is generally staffed with at least one sales manager, who has primary responsibility for the results of that office. PAETEC uses its sales offices not only to target businesses and other customers operating within its markets, but also to solicit and service national accounts. To increase operating efficiency, some of its sales offices support the sales teams for multiple markets.
PAETEC requires each new member of its direct sales force to participate in an initial in-house training program, which includes seminars, on-the-job training and direct one-on-one supervision by experienced sales personnel. PAETEC also requires members of its direct sales force to participate in an ongoing training program designed to enhance their knowledge of the communications industry, the companys services and the needs of its targeted customers. PAETEC seeks to motivate its direct sales force with a total compensation program that includes base salary, a cash commissions plan, and eligibility to participate in PAETECs long-term equity plan. The PAETEC sales commission program is primarily designed to reward the addition of new profitable customers and the sale of additional products and services to existing customers. The commission program also includes an element for some sales personnel that is designed to promote account retention and minimize customer turnover.
The efforts of PAETECs direct sales force are complemented by marketing activities conducted by independent sales agents. PAETEC seeks to select sales agencies that are well known to medium-sized and large businesses and institutions in their markets, and trains its sales agents on how to retain and develop the customer accounts they introduce to the company. For 2009, customers referred to PAETEC by its sales agents generated approximately 33% of the companys network services revenue. As of March 1, 2010, approximately 100 of its employees were dedicated to developing and supporting its agent program.
Carrier Services Sales Strategy. Carrier services sales in each of the markets in which PAETEC provides such services are led by PAETECs President of Wholesale Services, who is responsible for the acquisition and retention of all carrier services accounts and who reports directly to PAETECs Chief Executive Officer. Initial sales are made through national account managers located in various sales offices throughout the companys markets. Sales support is provided through carrier sales account managers and sales engineers. As of March 1, 2010, approximately 70 of PAETECs employees were dedicated to developing and supporting its carrier sales organization.
Customer Service. PAETEC believes that customer service has become a critical element in attracting and retaining customers in the communications industry. PAETEC has designed its customer service strategy to allow it to meet its customer needs rapidly and efficiently. PAETEC operates customer service centers in Cedar Rapids, Iowa and in Rochester, New York and also outsources some support functions with respect to residential and small business customers to a third-party service provider. Functions handled by the customer service operations include billing questions, order inquiries and changes to services. PAETEC operates network operations centers, or NOCs, in Rochester, New York, Cedar Rapids, Iowa and Charlotte, North Carolina to support its customers nationwide. The NOCs are staffed by skilled technicians who complete a certification program to advance through four levels of proficiency. The network operations center staff evaluates any out-of-service condition and directs remedial action to be implemented by PAETECs technical personnel or, where appropriate, its equipment vendors or external service providers. In addition, the network operations center staff maintains contact with the customer and prepares reports documenting the service issue and any corrective action taken. All alarm monitoring is performed centrally by the staff operating from a network monitoring center in Cedar Rapids.
Marketing. In its markets, PAETEC seeks to position the company as the high-quality alternative for communications services by offering network reliability, increased customer support and a broad spectrum of communications services at competitive prices. PAETEC intends to continue to build its reputation and brand identity by working closely with its customers to develop services tailored to the customers particular needs. PAETEC implements targeted promotional efforts that emphasize the breadth of its communications solutions and its ability to deliver a cost-effective integrated services package to its target customer base.
Customer Concentration. No single customer, or group of related customers, represented 10% or more of our total operating revenues for 2009, 2008 or 2007.
Back Office Systems
PAETEC believes that its information systems and procedures for operations support and other back office systems enable it to price its services competitively, to meet the needs of its customers and to interface with other carriers. PAETEC has consolidated the operational support systems for all its non-McLeodUSA operations with Oracle Metasolv Software, thus facilitating more efficient order entry, provisioning and order work flow management. The company is continuing its integration efforts to consolidate the operational support systems for McLeodUSAs operations with those for PAETEC. PAETEC also is consolidating the non-McLeodUSA billing systems, with the goal of having all billing activities for the PAETEC and US LEC businesses operating from the Revchain billing platform by the end of the second quarter of 2010. PAETEC plans to consolidate the PAETEC and McLeodUSA billing operations after completion of the US LEC billing system consolidation.
PAETEC has developed a common sales tool that uses a combination of Oracles E-business suite and customized internal software. All network services sales personnel submit prospects and sales forecasts as well as generate customer proposals and contracts through this system. This sales tool enables PAETEC to have real-time, single source data on sales performance across the country. PAETEC continues to invest in the development of one common customer portal, PAETEC Online, and has implemented numerous customer self-service functions available via the Internet.
To supplement its internal growth, PAETEC has pursued a targeted acquisition strategy that has sought acquisition candidates that fulfill one or more of the following objectives:
PAETEC continues to seek acquisition candidates that will add customers and cash flow to its existing network services business or that will enhance its operating efficiencies by lowering access costs through the acquisition of fiber-based assets. In accordance with this strategy, PAETEC focuses its acquisition efforts on other competitive carriers, on local and long distance providers, on enhanced service providers, on network integrators and on equipment solutions providers. From time to time, PAETEC may consider selective acquisitions of those types of businesses that PAETEC believes will enhance its package of service offerings, increase its customer base and bring experienced back office, technical and customer service personnel to the company.
Following a comprehensive review of its organizational structure, PAETEC completed in March 2010 a reorganization involving some of PAETEC Holding Corp.s direct and indirect wholly-owned subsidiaries that was designed to achieve various administrative and tax efficiencies. Following the reorganization, all but two of PAETEC Holding Corp.s subsidiaries are wholly owned, directly or indirectly, by PAETEC Corp., which in turn remains a direct, wholly-owned subsidiary of PAETEC Holding Corp.
The telecommunications industry is highly competitive. PAETEC competes primarily on the basis of a flexible product solution, availability, reliability, variety, price and quality of its service offerings and on the quality of its customer service. PAETECs competitors in the provision of local and long distance, Internet connectivity, and related network services include:
Incumbent Carriers. PAETEC believes that its primary competition in each of its markets will continue to be the incumbent carriers, which are the large telephone companies, such as AT&T, Qwest and Verizon, that
historically provided local telephone service before the Telecommunications Act of 1996. Today, these companies offer a comprehensive package of local, long distance and Internet services to their customers in direct competition with PAETEC. AT&T and Verizon, which also have wireless affiliates, are also investing to upgrade their networks, which will enhance their ability to offer a range of services and compete with PAETEC.
Incumbent carriers generally have long-standing relationships with their customers, have resources substantially greater than PAETECs and have the potential to subsidize competitive services with revenue from a variety of other businesses. The mergers between AT&T and SBC Communications, Inc., between Verizon and MCI, Inc., and between AT&T and BellSouth Corporation have provided these carriers with significant operating efficiencies and substantial marketing, financial and technical resources. The Communications Act of 1934, as amended, which we refer to as the Communications Act, and past decisions by the Federal Communications Commission, or FCC, and state regulatory commissions have established extensive obligations on the incumbent carriers to allow non-incumbent carriers such as PAETEC to interconnect with the facilities of the incumbent carriers and to obtain critical network elements, such as digital T1 transmission lines, from those carriers. The scope of such obligations, however, has been narrowed by recent court decisions and regulatory changes. These developments, which have resulted in increased pricing flexibility and relaxed regulatory oversight for incumbent carriers, may have a negative impact on PAETECs business opportunities and competitive position.
FCC decisions and policy initiatives have provided incumbent carriers with increased pricing flexibility for their private line, special access and switched access services. These FCC decisions and initiatives provide that, when an incumbent carrier demonstrates that competitors have made specified competitive inroads in providing a specified federally-regulated service in a geographic area, the incumbent carrier in that area may offer discounts to large customers through contract tariffs, engage in aggressive volume and term discount pricing practices for its customers, or otherwise free itself of regulatory constraints. Regulators in some states have adopted or are considering similar forms of deregulation. These actions could have a material adverse effect on the ability of competitive carriers, including PAETEC, to compete with the incumbent carriers.
The ability of AT&T to increase its rates for some special access services is constrained until July 1, 2010 as a result of conditions that were imposed by the FCC when AT&T merged with BellSouth. AT&T has filed tariff changes to reinstate higher special access prices once the conditions expire. It is not clear what effect, if any, efforts at broader deregulation involving AT&T, Verizon and other incumbent carriers will have on the prices these carriers are able to charge for special access services or to lease portions of their networks to competitive carriers such as PAETEC.
Other Types of Companies. Other current and prospective competitors in the local and long distance voice and data markets include the following:
Cable Television Companies. Cable television companies such as Cablevision Systems Corp., Comcast Corporation, Cox Communications Inc. and Time Warner Cable Inc. have continued to deploy telecommunications and broadband Internet access services aggressively to customers on a broad scale to primarily residential and small business customers. These companies initially deployed telecommunications services using circuit-switched facilities, but, increasingly, these companies are using VoIP applications and other technologies to provide voice services in a less costly, more efficient manner. In addition, some of these
companies, including Time Warner, Cox and Comcast, have announced plans to resell wireless services, which potentially could lead to the creation of new bundled competitive service offerings that incorporate multimedia components of cable television and wireless broadband Internet access services at competitive rates. Some of these companies recently have acquired a financial interest in spectrum capable of accommodating advanced mobile wireless services. Such a development also could result in additional competitive offerings.
Internet Service Providers. Advances in digital transmission technologies have created opportunities for the transmission of voice and data services over the Internet. Broadband Internet service providers such as AT&T, Qwest, Verizon and the largest cable television companies are exploiting their market position as incumbent providers of telecommunications or cable television services to promote their broadband Internet services and related voice and data applications. If successful, these plans will increase the number of competitive providers of broadband service, which could place additional downward pressure on prices for such service.
VoIP Providers. PAETEC expects to face increasing competition from companies offering long distance data and voice services using VoIP. The emergence of these companies could present a competitive threat, principally because the regulatory classification of VoIP remains unclear. Providers of VoIP services may be able to avoid significant costs such as the payment of switched access intercarrier compensation fees, if these regulatory classification issues are resolved in favor of VoIP providers. Such a resolution could impede PAETECs ability to compete against these providers on the basis of price.
Wireless Service Providers. National carriers such as AT&T Mobility, Sprint Nextel, T-Mobile USA and Verizon Wireless, as well as smaller regional companies, provide voice services that increasingly are viewed by consumers as competitive with wireline telecommunications offerings. Robust growth in wireless usage has caused a decline in the volume of voice traffic carried by PAETEC and other wireline carriers. Cable television companies and other companies have entered into arrangements to resell or re-brand wireless services. Technological advances have allowed wireless service providers to add data transmission, Internet access services and next-generation services, such as mobile multimedia products. Recent spectrum auctions and other regulatory changes have afforded wireless service providers access to substantial additional spectrum resources that can be used for deployment of high-speed broadband wireless services. New wireless service providers could include Microsoft Corporation and Google Inc. using unlicensed white space spectrum, which is unused wireless spectrum between broadcast television channels. Additional spectrum auctions in the next few years may accelerate the deployment of wireless high-speed broadband networks and offerings. In addition, the introduction of fixed wireless applications has facilitated the creation of companies that are in the process of installing equipment and building networks that may offer the same types of services that PAETEC offers or intends to offer. A commercially successful deployment of WiMax technology, for example, would facilitate the development of similar broadband access services on a fixed and mobile basis. Some wireless service providers have long-standing relationships with customers and financial, technical, marketing and other resources substantially greater than PAETECs.
In the last few years, consolidation within the wireless industry has resulted in significant growth for the largest wireless providers. Wireless Holdings, Inc. and Sprint Nextel, together with a group of cable television operators and information technology companies, recently made major investments in Clearwire Corp. Continued consolidation within the wireless industry could further enhance the economies of scale that would improve the competitiveness of wireless service providers in the telecommunications market.
PAETEC expects that new competitors, including large computer hardware, software, media and other technology and telecommunications companies, will enter the tailored, value-added network services market, resulting in even greater competition. Some telecommunications companies and online services providers are currently offering broadband Internet access services, or have announced plans to expand these services and other network services. Other companies, including Time Warner, also have obtained or expanded their broadband Internet access products and services as a result of acquisitions. Still others, such as Google, are developing new technologies and applications, the effect of which PAETEC cannot determine at this time. These
developments may permit PAETECs competitors to devote greater resources to the marketing of existing competitive products and services and the creation of new competitive products and services. In addition, the ability of some of PAETECs competitors to bundle other services and products with outsourced corporate networking services or Internet access services could place it at a competitive disadvantage.
Industry Consolidation. Consolidation of telecommunications providers has occurred with relative frequency over recent years and is expected to continue to create larger, better situated competitors that may put PAETEC at a competitive disadvantage. For example, the mergers between AT&T and SBC, between MCI and Verizon, and between AT&T and BellSouth increased the strength of those combined companies in the local, long distance, data and wireless markets. These mergers also decreased the competitive alternatives available to PAETEC for various network elements and services. Many other incumbent and non-incumbent carriers also are expanding their facilities-based and non-facilities-based offerings in the long distance and data markets. Other competitive carriers already have established full service local operations in some of PAETECs current and target markets. Many competitive carriers and independent long distance service providers have been struggling financially, but PAETEC cannot accurately predict which of these carriers will be able to compete effectively against it over time. Recent consolidation activities involving telecommunications providers also have begun to blur the line between different types of competitors in a manner that may also make it more difficult for PAETEC to compete. In February 2010, Windstream Corporation, a mid-sized incumbent local exchange carrier acquired NuVox, Inc., a competitive local carrier that has competed with PAETEC in a variety of markets in the southeast. In December 2009, Comcast, one of the largest cable companies providing telecommunications services, announced a transaction to acquire the NBC Universal businesses, pending approval of the FCC and U.S. Department of Justice. PAETEC cannot accurately predict all of the changes that the marketplace for telecommunications services may continue to experience as a result of this consolidation trend.
PAETECs services are subject to varying degrees of federal, state and local regulation. The following summary of regulatory developments and legislation does not purport to describe all current and proposed federal, state and local regulations, administrative rulemakings and legislation affecting PAETEC. Federal and state legislation and regulations governing telecommunications and related services are the subject of ongoing judicial proceedings, rulemakings and legislative initiatives that could change, in varying degrees, the manner in which the communications industry operates.
Under the Communications Act, as amended, the rules of the FCC, and comparable state laws and regulations, PAETEC and other competitive carriers are required to provide service upon reasonable request and to interconnect their networks with the networks of other carriers, and are subject to other regulatory obligations, some of which are described below. The FCC exercises jurisdiction over PAETECs facilities and services to the extent they are used to provide, originate or terminate interstate or international communications services offered to the public. State regulatory commissions regulate the same facilities and services to the extent they are used to originate or terminate intrastate communications services offered to the public. In addition, as a result of the passage of the Telecommunications Act of 1996, state and federal regulators share responsibility for implementing and enforcing rules to allow new companies to compete with the local phone companies that historically have operated as monopolies.
Existing federal and state regulations are subject to amendment by federal and state administrative agencies, judicial proceedings, and legislative action that could affect, in varying degrees, the manner in which PAETEC operates. Bills intended to amend the Communications Act are introduced in Congress from time to time and their effect on PAETEC and the communications industry cannot always be predicted. Proposed legislation, if enacted, could have a significant effect on PAETECs business, particularly if the legislation impairs PAETECs ability to interconnect with incumbent carrier networks, lease portions of other carriers networks or resell their services at reasonable prices, or lease elements of networks of the incumbent local exchange carriers under acceptable rates, terms and conditions. PAETEC cannot predict the outcome of any ongoing legislative initiatives
or administrative or judicial proceedings or their potential impact upon the communications and information technology industries generally or upon PAETEC specifically. PAETEC is also subject to a variety of local regulations in each of the geographic markets in which it operates.
PAETEC is regulated by the FCC as a non-dominant carrier subject to minimal regulation under the Communications Act. Both the Communications Act and the FCCs rules and policies implementing the Act generally favor entry into local and other telecommunications markets by new competitors, such as PAETEC, and seek to prevent anti-competitive practices by incumbent carriers.
Licenses and Authorizations. The FCC requires all telecommunications service providers, including non-dominant carriers such as PAETEC, to maintain authorizations to provide or resell domestic long distance and international services. The FCC generally has the power to modify or terminate a carriers authority to provide domestic long distance or international services for failure to comply with federal laws or FCC regulations and may impose fines or other penalties for violations. In addition, the FCC maintains jurisdiction to act upon complaints filed against any telecommunications service provider for failure to comply with statutory or regulatory obligations.
Tariffs and Retail Pricing Requirements. Under the Communications Act, PAETEC is subject to the general requirement that its charges, practices and classifications for communications services must be just and reasonable, and that it refrain from engaging in any unjust or unreasonable discrimination with respect to its charges, practices or classifications. The FCC must grant its approval before any change in control of any carrier providing interstate or international services, or of any entity controlling such a carrier, and before the assignment of any authorizations held by such a carrier.
The FCC no longer requires non-dominant carriers to file tariffs with respect to long distance access and does not permit tariffing of domestic long distance or international services. Instead, the FCC requires carriers to post their interstate end user and international long distance rates and terms and conditions of service on the Internet and otherwise make the rates, terms and conditions for these services available to their customers. As a result, PAETECs non-tariffed interstate service offerings may no longer be subject to the filed rate doctrine, which provides that the terms of the filed tariff control all contractual disputes between a carrier and its customers. The deregulatory scheme could expose PAETEC to legal liabilities and costs, because the company may no longer be able to rely on this doctrine to settle disputes with retail customers. PAETEC currently enters into contracts with customers and notifies its customers when rates are adjusted or services are added or removed. PAETEC also no longer may rely on the tariff filings of its competitors to determine the extent to which PAETECs products and services are competitively priced.
Measures Designed to Speed Competitive Entry. The Communications Act imposes a variety of duties on local telephone service providers, including PAETEC, to promote competition in the provision of local telephone services. These duties include requirements to:
Incumbent carriers also are subject to additional duties that facilitate local market entry by competitive carriers such as PAETEC. For example, incumbent carriers must:
Interconnection Agreements. Incumbent carriers are required to negotiate statewide interconnection agreements in good faith with competitive carriers such as PAETEC that set forth the terms for, among other items, interconnection, collocation, intercarrier compensation, access to unbundled network elements and reselling an incumbent carriers services. If the negotiating carriers cannot reach agreement within a prescribed time, either carrier may request binding arbitration of the disputed issues by a state regulatory commission. In addition, carriers are permitted to adopt in their entirety an existing state commission-approved interconnection agreement between an incumbent carrier and another carrier in the same state. PAETEC has interconnection agreements with incumbent carriers in 47 states and the District of Columbia which encompass all local exchange markets in which PAETEC currently offers local services. Each statewide interconnection agreement with an incumbent carrier allows PAETEC to enter other local exchanges served by that same incumbent in that state. Each interconnection agreement must be approved by the applicable state regulatory agency before becoming effective. Although parties may negotiate prices contained in the interconnection agreement, such statewide agreements typically incorporate prices for interconnection, collocation, intercarrier compensation and UNEs that have been established by the state regulatory agency in generic proceedings for that a incumbent carrier using the FCCs approved pricing methodology. When an interconnection agreement does not resolve a particular operational issue, PAETEC and the incumbent carrier seek resolution of those issues through informal and formal dispute processes, including commercial negotiations or arbitration.
Interconnection agreements typically have terms of three years, although the parties may mutually agree to extend or amend such agreements. If PAETEC cannot negotiate new interconnection agreements or renew its existing interconnection agreements in each state on acceptable terms, PAETEC may invoke its ability to seek binding arbitration before state regulatory agencies. The arbitration process conducted on a state-by-state basis can be costly and time-consuming, and the results of an arbitration may be unfavorable to PAETEC. If PAETEC is not able to renegotiate or enter into interconnection agreements on acceptable terms, or if it is subject to unfavorable arbitration decisions, PAETECs cost of doing business could increase and its ability to compete could be impeded. Moreover, PAETECs interconnection agreements with companies other than incumbent local exchange carriers (such as wireless and VoIP providers and other competitive carriers) are not subject to the statutory arbitration mechanism, making it potentially more difficult to reach any agreement on terms PAETEC views as acceptable.
The mergers between SBC and AT&T, between Verizon and MCI, and between AT&T and BellSouth have significantly affected the availability of acceptable interconnection agreements that competitive carriers such as PAETEC can opt into without incurring the expense of lengthy negotiation and arbitration with an incumbent carrier in each state. Before their respective mergers with SBC and Verizon, AT&T and MCI dedicated significant internal and external resources to negotiate and arbitrate interconnection agreements that many competitive carriers opted into or used as model agreements. These resources and the resulting model agreements are no longer available as a result of consolidation among carriers, and it is likely that competitive carriers such as PAETEC will be required to invest more resources than in the past to secure acceptable interconnection agreements.
In March 2007, Qwest provided notice to PAETEC that Qwest was terminating all current interconnection agreements with PAETECs McLeodUSA operating subsidiary. The termination notice began a negotiation
period for new interconnection agreements for the twelve Qwest states in which PAETEC interconnects with Qwest on a facilities-basis. As a result of a mediation process, Qwest and PAETEC agreed that the statutory timetable for starting arbitration of unresolved issues will be delayed until Qwest provides PAETEC its entire proposed agreement. The companies will continue to operate under the existing state agreements until such time as new agreements are executed. If PAETEC cannot successfully negotiate new agreements with Qwest for each state or find existing interconnection agreements that Qwest has with other competitive carriers that meet PAETECs network and operating requirements and that it can opt into, PAETEC will be required to arbitrate all unresolved issues before each state commission in the Qwest region. If, after arbitrating these issues, PAETEC cannot secure interconnection with Qwest on reasonable terms, PAETEC may not be able to offer on a profitable basis the services to its customers that it provides today.
Intercarrier Compensation. Interconnected carriers exchange communications traffic, and they must establish the compensation arrangements for the use of their respective networks in carrying that traffic for each other. Long distance carriers compensate local exchange carriers for the origination and termination of long distance traffic through the payment of switched or dedicated access charges. Facilities-based telecommunications providers, including wireless carriers, charge other facilities-based telecommunications providers to terminate local traffic on the terminating providers network. These charges are known as reciprocal compensation. The FCC has established rules governing how much PAETEC may charge for interstate switched access and reciprocal compensation, including rules that apply to traffic bound for Internet service providers.
Universal Service. The FCC has established a federal universal service subsidy regime known as the Universal Service Fund, which provides subsidies for the provision of telecommunications and information services to rural and other high-cost areas and for discounted communications services to schools and libraries. Providers of interstate telecommunications services such as PAETEC must pay assessments that fund these subsidies. The FCC currently is assessing Universal Service Fund contribution payments based on a percentage of each telecommunications providers projected interstate and international telecommunications revenue. Carriers are permitted to pass through a specified percentage of their Universal Service Fund contribution assessment to their customers in a manner consistent with FCC billing regulations.
The FCCs November 2008 further notice of proposed rulemaking proposed to base Universal Service Fund assessments on the number of telephone numbers that a telecommunications carrier actively provides to residential customers and a connections-based contribution methodology for business customers, rather than on a percentage of collected interstate revenues. The objective behind the new proposal is to capture Universal Service Fund revenues from the expanding number of new service providers using different technologies to offer communications services. The FCC also is exploring whether to limit the number of recipients of Universal Service Fund proceeds in a specified geographic region and whether to select these recipients through a reverse auction process, in which the company willing to serve the region using the least amount of Universal Service Fund proceeds would be selected as the proceeds recipient. The FCC also is considering expanding the use of the federal universal service to fund deployment of broadband services to areas that currently do not have or have limited access to high speed broadband services. These and other proposals pending before the FCC related to Universal Service Fund reform are expected to generate considerable debate and their outcome is not predictable. In addition, various states maintain, or are in the process of implementing, their own universal service programs.
Customer Proprietary Network Information. Federal regulations protect the privacy of some subscriber data that telecommunications carriers such as PAETEC acquire in the course of providing their services. This information is referred to as Customer Proprietary Network Information, or CPNI, and includes information related to the quantity, technological configuration, type, destination and the amount of use of a communications service. PAETEC must file a verified certification of compliance by March 1 of each year that affirms the existence of training and other sales and marketing processes designed to prevent improper use and unauthorized release of CPNI. A violation of these and related CPNI requirements by PAETEC could subject our company to significant fines or other regulatory penalties.
Network Element Rules. The FCCs current unbundling rules identify some competitive conditions in terms of business line counts and fiber-based collocators at a wire center level that, if such competitive conditions are found to exist, eliminate an RBOCs obligation to offer competitive carriers access to unbundled network elements such as UNE digital T1 or DS3 loops or high capacity transport, as well as combinations of those elements under federal and state price regulations. Under the current unbundling rules, PAETEC is no longer able to obtain UNE digital T1 loops at regulated prices in 56 wire centers serving areas where PAETEC has previously used UNE digital T1 loops. Incumbent carriers are permitted to charge just and reasonable rates for network elements in these wire centers and make them available on a deregulated commercial basis. Incumbent carriers also are permitted to designate in the future additional wire centers in which they believe competitive conditions should entitle the RBOC to limit the availability of UNE digital T1 loops, high capacity transport or both, and to make these services available only on a commercial basis.
Pending FCC Proceedings. PAETEC faces substantial uncertainties stemming from ongoing FCC proceedings related to the implementation of the statutory requirements discussed above, as well as ongoing judicial review of various FCC decisions, both of which could result in significant changes to these regulatory obligations. PAETEC cannot predict the outcome of ongoing administrative or judicial proceedings or their potential impact upon the company. The following examples illustrate the types of ongoing rule changes that could affect PAETECs business:
Special Access Regulatory Regime
PAETEC relies to a considerable extent on special access lines as the last mile facility to reach its customer locations. As a result, the price of special access lines must be available at a rate that allows PAETEC to price its retail offerings to meet its gross margin expectations while remaining competitively priced in the retail market. Incremental increases in prices of special access lines will exert pressure on PAETECs gross margins. Since special access lines are not subject to the unbundling requirements of the Communications Act, the prices for special access lines have not been directly affected by the FCCs modification of network unbundling rules. To the extent, however, that the availability of UNE digital T1 lines may have served as a restraint on the prices charged for special access lines, PAETEC could face increased prices for special access lines given the limited alternative means of last mile access in some central offices resulting from application of the current unbundling rules. In 2005, the FCC opened an inquiry into whether and how to reform its special access rules. In November 2009, the FCC asked interested parties to respond to several questions regarding the appropriate analytical framework for resolution of issues in its longstanding special access proposed rulemaking proceeding. Interested parties filed initial comments in January 2010 and reply comments were filed in February 2010. At this time, PAETEC cannot predict when the FCC will issue a decision regarding special access prices or how any such decision will affect its business.
As a result of the mergers of AT&T with SBC, Verizon with MCI, and AT&T with BellSouth, the number of providers of competitive access services has diminished. The FCC and the Department of Justice placed conditions on AT&Ts merger with SBC and Verizons merger with MCI to constrain the ability of AT&T and Verizon to raise prices on their wholesale special access and equivalent retail services. These regulatory pricing constraints expired in May 2008 with respect to the AT&T-SBC merger and July 2008 with respect to the Verizon-MCI merger. The FCC also placed conditions on AT&Ts merger with BellSouth to restrict similarly the ability of AT&T to raise prices on its wholesale special access and equivalent retail services for existing customers and, in some regions, to reduce its prices for these services under specified circumstances. The additional restrictions apply only to AT&T in the former SBC and BellSouth regions and will remain effective until July 1, 2010. After the expiration of their respective merger conditions, AT&T and Verizon are free to realign charges for special access services in line with current commercial rates. Because a substantial portion of PAETECs services are generated through the use of special access lines purchased from AT&T and Verizon, a significant increase in the price for special access could materially increase PAETECs cost of services.
A proceeding was initiated at the FCC in 2003 to examine the current rules governing the methodology by which state regulatory authorities set wholesale prices for UNEs, including UNE digital T1 loops, and for collocation, interconnection and intercarrier compensation provided by incumbent carriers to competitive carriers. If the FCC adopts significant changes to the pricing methodology, incumbent carriers could seek approval from state regulatory commissions to increase their prices for a variety of wholesale services required by PAETEC to provide service to its customers. Such an event could raise the cost of doing business for competitive carriers such as PAETEC. We cannot predict whether the FCC will change its pricing rules, or, if it does so, the extent to which state regulatory commissions will permit incumbent carriers to increase their UNE prices.
Qwest and Verizon Dominant Carrier Forbearance Proceedings
In December 2005, the FCC granted, in part, a petition for forbearance filed by Qwest seeking relief from specified dominant carrier regulations, including some unbundling obligations related to high capacity loops and transport, in those portions of the Omaha metropolitan statistical area where facilities-based competition had allegedly increased significantly. The FCCs dominant carrier regulations require Qwest, in part, to offer UNEs and also serve as a check on dominant carrier pricing for other wholesale services, such as special access lines, that PAETEC seeks to purchase at commercially acceptable prices. Upon being granted relief by the FCC, Qwest has substantially increased the prices for the network elements that PAETEC uses to provide services in nine central offices in the Omaha metropolitan statistical area, or MSA. In July 2007, PAETEC asked the FCC to reconsider its 2005 decision. In its request, PAETEC asserted that the FCCs prediction that Qwest would offer commercial replacements of network elements at just and reasonable prices has been shown to be inaccurate. PAETEC renewed its request to have the FCC revisit the grant of forbearance in Omaha in a letter PAETEC filed in December 2009. The matter remains pending before the FCC.
In January 2007, Qwest filed additional petitions for relief from dominant carrier regulation in the metropolitan statistical areas of Denver, Minneapolis-St. Paul, Phoenix and Seattle. In July 2008, the FCC denied the Qwest petitions using the same basis that it used in December 2007 to deny Verizons request for relief from its unbundling obligations for the MSAs of Boston, New York, Philadelphia, Pittsburgh, Providence and Virginia Beach. In January 2008, Verizon sought review of the FCCs decision before a federal court of appeals. In February 2008, Verizon re-filed petitions for relief from dominant carrier regulation for the State of Rhode Island and Virginia Beach. In July 2008, Qwest sought appellate review in the U.S. Court of Appeals for the District of Columbia Circuit of the FCCs decision to deny forbearance in the four MSAs. In March 2009, Qwest re-filed its petition seeking forbearance in the Phoenix MSA. In late May 2009, Verizon withdrew its re-filed applications for Virginia Beach and Rhode Island several days before the FCC was required to rule on the petitions. In June 2009, a federal court of appeals remanded the FCCs decision rejecting Verizons original six-city forbearance petitions and directed the FCC to explain further why it did not consider potential competition in its analysis of the petitions. After the appellate courts remand of the Verizon six-city appeal, the FCC voluntarily asked the court also to remand Qwests appeal of its four-city petitions to concurrently reconsider all forbearance rulings in light of the courts remand. The FCC currently has pending before it the remand proceedings related to the original Verizon six-city and Qwest four-city petitions, and the Qwest re-filing of its Phoenix forbearance petition. If a court or the FCC upholds or grants any forbearance or similar petitions filed by incumbent carriers in the future affecting markets in which PAETEC operates, PAETECs ability to purchase wholesale network services from these carriers at cost-based prices that would allow PAETEC to achieve its target profit margins in those markets could be materially adversely affected. The grant of these petitions also would enable incumbent carriers to compete with their competitors, including PAETEC, more aggressively on price in the affected markets.
The FCC currently is reviewing the compensation arrangements between all carriers for the use of their respective networks. The pending proceeding, which was initiated in 2001, could significantly alter the manner in which carriers, including carriers that use different service platforms such as wireless, cable and VoIP, are compensated for the origination and termination of communications traffic and the rates local exchange carriers charge for these access services. The proceeding could also significantly alter the manner in which facilities- based local carriers charge other carriers, such as VoIP providers and wireless providers, for the origination and termination of local communications traffic. The FCCs review of these matters will not only re-examine the rules governing the way carriers charge one another, which is referred to as intercarrier compensation, but also the potential effect that changes to the intercarrier compensation regime could have on various federal subsidy programs such as the Universal Service Fund, on the nations legacy carrier network infrastructure, and on consumers retail rates.
As a non-dominant carrier, PAETEC generally is not subject to price or rate of return regulation at the federal level, nor is it required to obtain express FCC authorization for the installation or operation of its domestic network facilities. In 2001, however, the FCC established a benchmark rate policy that, under most circumstances, precludes competitive carriers, such as PAETEC, from charging interexchange carriers for interstate switched access services at rates that are higher than the rates that incumbent carriers may charge for comparable services. The FCC has also imposed restrictions on the rates that carriers may charge other carriers for traffic terminated to Internet service providers.
In May 2004, the FCC announced that where a competitive local exchange carrier does not directly serve an end user, the competitive carriers interstate access charges may not exceed the rate charged by the local incumbent regional Bell company for the same service. Disputes between PAETEC and other carriers have arisen from time to time with respect to intercarrier compensation, and most have been resolved in due course. In general, the FCC benchmark rate policy may prevent PAETEC from raising its access charges with respect to the provision of some carrier services and its reciprocal compensation rates substantially above specified levels. Current FCC policies and regulations also have helped to maintain or reduce the rates that PAETECs competitors may charge PAETEC for similar wholesale carrier services.
Multiple proposals to reform the entire intercarrier compensation regime have been submitted to the FCC by various industry groups since the proceeding was initiated. In July 2004, several carriers led by AT&T proposed a comprehensive proposal, known commonly as the Missoula Plan, which was anticipated to be the blueprint for nationwide intercarrier compensation reform. The Missoula plan was never adopted after several rounds of comments. In August 2008, AT&T submitted a new proposal for comprehensive reform of intercarrier compensation in which the FCC would establish a unified termination rate for all communications traffic, including traditional long distance, local, wireless and VoIP service. Verizon submitted a more limited proposal in September 2008 that incorporated key provisions of the Missoula Plan. In November 2008, the FCC issued an order that supplied a new legal justification for the rules governing rates that terminating carriers may charge other carriers for traffic terminated to Internet service providers. The FCC also issued a notice of further rulemaking in which it requested comments by the end of 2008 on two comparable proposals to reform intercarrier compensation and one proposal to reform Universal Service Fund contributions. If intercarrier compensation and Universal Service Fund reforms are adopted by the FCC, these reforms could have a substantial effect on PAETECs access revenues, network capital expenditures and costs of sales.
The FCC separately has initiated a rulemaking to examine allegations that some carriers are collaborating to artificially increase levels of terminating access traffic. In October 2007, the FCC released a notice of proposed rulemaking soliciting comments on issues relating to existing federal rules regarding the tariffing practices of local exchange carriers for traffic-sensitive switched access charges. The FCC sought comment on whether those practices ensure that interstate switched access rates remain just and reasonable under some provisions of the Communications Act. In response to allegations made by interexchange carriers against some local exchange
carriers, the FCC also solicited comment on whether services those local exchange carriers provide to chat lines, conference bridges or other high volume traffic termination customers result in an over-collection of access charges or violate the Communications Act. In November 2009, the FCC ruled that a rural local exchange carrier was not entitled to bill switched access charges for terminating long distance calls to a free conference calling service hosted by that local exchange carrier. Although the FCC proceedings to date have been initiated as a result of practices engaged in by small, rural local exchange carriers that are subject to more stringent regulation than PAETEC, a decision by the FCC that limits the ability of carriers to use some federal for their interstate exchange access services, to set rates for those services and to engage in revenue sharing arrangements with their end-user customers may have a material impact on PAETECs access revenues.
Another proposal has been submitted regarding phantom traffic that also could materially affect intercarrier compensation. This proposal would require every originating carrier to identify in its signaling information the calling partys telephone number and every intermediate carrier to transmit that information in its signaling without alteration, so that the appropriate form and level of intercarrier compensation can be calculated and assessed. The proposal also would require that in the absence of a mutual agreement between carriers to the contrary, most calls would be classified for purposes of intercarrier compensation based on the area code and exchange prefix of the calling and called parties. This proposal, if adopted, could result in the application of terminating interstate switched access charges on VoIP traffic originated on a broadband connection. PAETEC cannot predict the effect, if any, resulting from the implementation of this proposal or other pending intercarrier compensation reform proposals. Significant changes to the current rules governing the intercarrier compensation regime could, however, have a material adverse effect on PAETECs ability to bill and collect reciprocal compensation and access fees.
In addition to failing thus far to enact prospective reform of intercarrier compensation, the FCC has repeatedly declined requests to declare whether under existing law interstate interexchange traffic that originates in IP format and terminates in circuit-switched or time-division multiplexing format is subject to higher switched access charges or lower reciprocal compensation rates. As a result, individual courts and state regulatory commissions have been addressing the issue in the context of individual collection disputes, with inconsistent results. In one such case, a federal district court ruled in February 2010 that PAETEC could not collect switched access charges from another provider for VoIP-originated traffic.
IP-Enabled Services Proceeding
The FCC has held that cable modem services offered by cable television companies and broadband Internet services offered by incumbent local exchange carriers should be classified as information services and not telecommunications services subject to regulation under Title II of the Communications Act. The regulatory classification of various other IP-based services, however, is currently unclear. In March 2004, the FCC issued a notice of proposed rulemaking seeking comment on how it might categorize various types of IP-based services, for example, by distinguishing IP services that interconnect to the public switched telephone network, or PSTN, or classifying those that are used as a true substitute for traditional telephone service. Although the FCC has yet to reach a conclusion on many of the key issues presented in this proceeding, it has issued a series of orders holding that VoIP services that interconnect with the PSTN are to be subject to a number of regulatory requirements, including rules relating to Universal Service Fund contributions, disabilities access, number portability, privacy of customer proprietary network information, E-911, and others. If the FCC classifies some IP-based services that traverse the last mile or local loop as information services, the ability of competitive carriers such as PAETEC to lease as UNEs the facilities on which these services rely could be impeded.
Numerous FCC decisions issued over the last several years reflect a deregulatory position with regard to broadband service offerings. For instance, in March 2006, the FCC granted the forbearance petition of Verizon exempting Verizons stand-alone broadband services, such as asynchronous transfer mode and frame relay services, as well as other packet-switched services, from regulation under Title II of the Communications Act, which requires that such services be provided on a common carrier basis. Subsequently, in October 2007, the
FCC issued orders granting similar but more limited broadband forbearance relief to AT&T, Citizens, CenturyLink and Qwest. The FCC agreed to treat the existing packet-switched broadband telecommunications services and existing optical transmission services of these carriers as non-dominant and no longer subject to some regulatory requirements. In December 2007, the U.S. Court of Appeals for the District of Columbia Circuit ruled that Verizon had obtained a grant of forbearance on the basis of FCC inaction, pursuant to a provision in the Communications Act that such petitions will be deemed granted if the FCC does not address them within a specified time period. Because the relief was secured on a deemed granted basis, the scope of the impact on PAETEC and the telecommunications industry is not yet clear. The FCC separately has held that some IP-based offerings are to be classified as telecommunications services and remain subject to the regulatory framework established under Title II, including the payment of access charges. The covered IP-based offerings are those that use ordinary customer premises equipment with no enhanced functionality, that originate and terminate on the PSTN, and that undergo no net protocol conversion and provide no enhanced functionality to end users due to the providers use of IP technology. These and other recent decisions by the FCC together demonstrate that the regulatory classification of many IP-based services remains unclear.
Broadband Network Management and Net Neutrality Policies. In August 2005, the FCC adopted a policy statement that outlined four principles intended to preserve and promote the open and interconnected nature of the public Internet. The FCC explained at the time that these net neutrality principles are subject to reasonable network management. In January 2008, the FCC sought comment on petitions filed by a number of parties seeking clarification on what conduct constitutes reasonable network management and whether the practice of degrading certain peer-to-peer network traffic is unreasonable or violates the net neutrality principles. In August 2008, the FCC characterized these net neutrality principles as binding and enforceable and stated that network operators have the burden to prove that their network management techniques are reasonable. In that order, the FCC imposed sanctions on a cable broadband Internet access provider for managing its network by blocking or degrading some Internet transmissions and applications in a way that the FCC found to be unreasonably discriminatory. This FCC decision is on appeal and although the outcome cannot be predicted with certainty, members of the court of appeals panel presiding at oral argument openly questioned the FCCs authority to impose regulations on a deregulated cable broadband Internet access provider. In October 2009, the FCC issued a notice of proposed rulemaking in which it proposed adoption of rules that would require open Internet access subject to a carriers reasonable traffic management needs. Initial comments were filed in December 2009 by more than 200 interested parties, and reply comments are scheduled to be filed in March 2010. It is difficult to predict a final outcome of the proposed rulemaking and the implications for PAETEC.
Expanding Network Access Options. In November 2009, PAETEC and other competitive carriers asked the FCC to initiate a rulemaking to adopt a regulatory structure governing network elements known as 271 Checklist elements. Under the Telecommunications Act of 1996, Bell operating companies are required to make some network elements, such as access loops, transport and local switching, available to competitive local exchange companies at just and reasonable prices in exchange for regaining the ability to offer long distance and information services in their respective local exchange markets, which the RBOCs had been prohibited from offering in their respective local exchanges since 1984. Beginning in 2005, multiple federal appellate courts have determined that state utility agencies do not have authority to regulate the 271 Checklist network element pricing, and that only the FCC has authority to set prices for these network elements. In response to the rulemaking petition, the FCC asked interested parties to comment on the proposed rules. In December 2009, another petition was filed asking the FCC to require RBOCs to provide competitive providers access to bitstreams on fiber facilities serving small business locations. The FCC had previously eliminated the RBOC obligation to provide unbundled access to fiber and hybrid loop facilities. The FCC has asked interested parties to comment on the proposal. PAETEC cannot predict whether the FCC will proceed with action on either proposal at this time.
Other Provisions. Telecommunications carriers such as PAETEC are subject to a variety of miscellaneous regulations that can have cost or operational implications. The regulations, for instance, require the filing of periodic revenue and service quality reports, the provision of services to customers with hearing or speech disabilities and associated funding of telecommunications relay services, the capability to associate a physical
address with a calling partys telephone number (E-911), compliance with truth in billing requirements, and cooperation with law enforcement officials engaged in lawful communication intercept or monitoring activities, in addition to regulating telemarketing and slamming, which involves an unauthorized change in a subscribers carrier of choice. Noncompliance with these and other provisions can result in administrative fines and penalties.
PAETEC provides local telephone service and other intrastate telecommunications services that are subject to the jurisdiction of state regulatory commissions.
To provide local and intrastate telecommunications services in a state, PAETEC generally is required to obtain a certificate of public convenience and necessity from the state public utility commission and to comply with applicable state regulations, including, in some states, the requirement to file tariffs setting forth the companys terms and conditions for providing services. Certificates of authority can be conditioned, modified, canceled, terminated or revoked by state regulatory authorities for a carriers failure to comply with state laws or rules, regulations and policies of state regulatory authorities. State utility commissions generally have authority to supervise telecommunications service providers in their states and to enforce state utility laws and regulations. Fines or other penalties also may be imposed for violations. As of March 1, 2010, PAETEC provided local telecommunications services in 46 states and the District of Columbia, and provided intrastate long distance services in 48 states.
State public utility commissions typically require PAETEC to file periodic reports, pay various regulatory fees and assessments, and comply with state regulations governing service quality, billing, consumer protection and other similar issues. State public utility commissions also regulate intercarrier compensation rates between local services providers. Interexchange carriers led by AT&T have urged several state commissions to initiate proceedings to institute generic investigations of switched access rate levels of competitive local exchange carriers such as PAETEC. AT&T, Verizon and Sprint are proposing that state utility agencies should cap such switched access rates at levels charged by RBOCs in the state for the same intrastate access services, or at existing interstate rate levels. AT&T and other interexchange carriers also are pursuing state legislation that seeks to impose caps on intrastate switched access rates charged by competitive carriers such as PAETEC. PAETEC cannot predict the outcome of these state agency investigations into intrastate access rates or legislative initiatives that may arise from time to time. PAETECs retail rates for enterprise customers are not subject to any price regulation in any of its current or planned markets. Because complying with state regulations can be costly and burdensome, the imposition of new regulations in a particular state may adversely affect the profitability of PAETECs services in that state.
Some of the states in which PAETEC operates require public utility commission approval before the transfer of a carriers authority to operate within the state, the transfer of its assets to a new entity, or a change in the control of an entity that controls a carrier operating within the state. Some states also regulate a carriers issuance of securities, incurrence of debt, guarantees or pledges of security in support of such debt. These requirements can delay and increase the cost we incur to complete various financing transactions, including future stock or debt offerings, the sale of part or all of our regulated business, or the acquisition of assets and other entities to be used in our regulated business.
PAETECs network is subject to numerous local regulations such as building codes, municipal franchise requirements and licensing. Such regulations vary on a city-by-city and county-by-county basis and can affect the companys provision of both network services and carrier services, as well as, where applicable, video services. In some of the areas where PAETEC provides service, it may be subject to municipal franchise requirements and may be required to pay license or franchise fees based on a percentage of gross revenue or other formula. It is possible that some municipalities that do not currently impose fees could seek to impose fees in the future, and
that, following the expiration of existing franchises, they could increase fee levels. In many markets, the traditional local telephone companies do not pay rights-of-way fees or pay fees that are substantially less than those paid by PAETEC. In some markets, PAETECs McLeodUSA operating subsidiary is objecting to or challenging various fees as improper under state or federal law. The outcome of these challenges cannot be predicted.
PAETECs ability to compete depends in part upon its proprietary rights in its technology and business procedures and systems. PAETEC relies on a combination of contractual restrictions and copyright, trademark and trade secret laws to establish and protect these proprietary rights. It is the companys policy to require employees, consultants and, if warranted based on the service to be provided, vendors to execute confidentiality agreements upon the commencement of their relationships with PAETEC. These agreements provide that confidential information developed or made known during the course of a relationship with PAETEC must be kept confidential and not disclosed to third parties except in specific circumstances.
The U.S. Patent and Trademark Office has granted PAETEC federal registrations for some of PAETECs trademarks. Federal registration of trademarks is effective for as long as PAETEC continues to use the trademarks and renew its registrations. PAETEC does not generally register any of its copyrights with the U.S. Copyright Office, but relies on the protection afforded to such copyrights by the U.S. Copyright Act. That law provides protection to authors of original works, whether published or unpublished and whether registered or unregistered.
As of March 1, 2010, PAETEC had approximately 3,630 full-time employees. None of its employees are covered by collective bargaining contracts. PAETEC considers its relationships with its employees to be good.
Executive Officers and Directors
The table below presents information about our executive officers and directors as of March 5, 2010:
Our executive officers serve at the pleasure of the board of directors.
Arunas A. Chesonis has served as Chairman of the Board, President and Chief Executive Officer of PAETEC Holding since August 2006. Mr. Chesonis has served as Chairman of the Board, President and Chief Executive Officer of PAETEC Corp., of which he was the founder, since its formation in May 1998 and as Chairman of the Board, President and Chief Executive Officer of its principal operating subsidiary, PaeTec Communications, Inc., since July 1998. Mr. Chesonis was appointed as President of ACC Corp., an international telecommunications company in Rochester, New York, in February 1994 and was elected to its board of directors in October 1994. Mr. Chesonis joined ACC in May 1987 as Vice President of Operations for the U.S. business unit and was named President of ACC Long Distance Corp. in January 1989. Mr. Chesonis also served as President of ACCs Canadian operations and Managing Director of ACCs U.K. enterprise. Before he joined ACC, Mr. Chesonis held several positions within Rochester Telephone Corporation, now known as Frontier Communications Corporation, a subsidiary of Citizens Communications Company.
Keith M. Wilson has served as a director and as Executive Vice President and Chief Financial Officer of PAETEC Holding since August 2006. Mr. Wilson has served as Executive Vice President and Chief Financial Officer of PAETEC Corp. and PaeTec Communications, Inc. since January 2001, and as a director of PAETEC Corp. since March 2006. From June 1999 until January 2001, Mr. Wilson served as Vice President and head of the Telecommunications Finance Group at Union Bank of California, where he focused on sourcing and providing capital for telecommunications services companies in the wireline, wireless and data services markets. From March 1998 until May 1999, Mr. Wilson was a Vice President of Merchant Banking and head of Syndicated Finance for First Dominion Capital, based in New York. Mr. Wilson also held positions with NationsBank from September 1996 until March 1998, Bank of Boston and Fleet Bank.
Edward J. Butler, Jr. has served as Executive Vice President and President and Chief Executive Officer of PAETECs energy businesses since March 2, 2010. Prior to assuming this position, Mr. Butler served as Executive Vice President and Chief Operating Officer of PAETEC Holding since February 2007. Mr. Butler served as the Chief Operating Officer of PaeTec Communications since January 2006, and before that he served as Co-Chief Operating Officer beginning in September 2003. Mr. Butler joined PaeTec Communications as a member of the founding officer team in 1998 in the role of President-Wholesale Markets and, in May 2002, his role was expanded to President-Wholesale Markets/Network Services. He possesses more than 20 years of experience in the telecommunications industry. Before joining PAETEC, Mr. Butler served ACC Corp. for more than a decade in a number of executive and managerial positions.
Mario DeRiggi has served as Executive Vice President and President, National Sales and Service since January 2009. Prior to his current role, he has held positions of increasing responsibility in the areas of sales and account development since joining PAETEC in May 1999 as Vice President and General Manager, including as Senior Vice President, Sales; Executive Vice President, Sales; and President, East Region. In his capacity as Executive Vice President and President, National Sales and Service, Mr. DeRiggi is responsible for managing all of PAETECs direct sales, agent sales, account development, sales support, and customer service operations. Prior to joining PAETEC Mr. DeRiggi had over ten years experience in the telecommunications industry, holding positions at Allnet Communications, AT&T, Winstar Communications, and Cablevision Lightpath.
Robert D. Moore, Jr. has served as the Executive Vice President and Chief Information Officer of PAETEC Holding since December 2009. Before assuming his current position, Mr. Moore served as the Senior Vice President and Chief Information Officer of PAETEC Holding since February 2007, and in that position with PaeTec Communications since December 2005. Before assuming these positions with PAETEC Holding and PaeTec Communications, Mr. Moore served as Senior Vice President-Information Technology from August 2004 and, beginning in 1998, in various other roles with PaeTec Communications. In his capacity as Senior Vice President and Chief Information Officer, Mr. Moore has been responsible for overseeing operating support systems, systems operations and engineering, and applications development and deployment. Mr. Moore possesses more than 16 years of experience in the telecommunications industry and was employed by ACC Corp. before joining PaeTec Communications.
Mary K. OConnell has served as Senior Vice President, General Counsel and Secretary of PAETEC Holding since November 2008. Ms. OConnell joined PaeTec Communications in September 2001 as Director and Senior Corporate Counsel and held various positions of increasing responsibility prior to her appointment as General Counsel, including service as PAETECs Corporate Compliance Officer and Vice President and Senior Corporate Counsel. Before joining PAETEC, Ms. OConnell was in private practice at the law firms of Morrison & Foerster, LLP and Levine, Blaszak, Block & Boothby, LLP in Washington, D.C. and Phillips, Lytle LLP in Rochester, New York. Ms. OConnells experience before joining PAETEC included work in the areas of commercial law, telecommunications, corporate legal matters, and regulatory affairs.
Algimantas K. Chesonis has served as Senior Vice President, Chief Accounting Officer and Controller of PAETEC Holding since March 2007. Mr. Chesonis has served as Senior Vice President and Controller of PAETEC Corp. and PaeTec Communications since August 2004. Mr. Chesonis served as Vice President of Finance and Controller of PaeTec Communications from July 1998 to August 2004. In his capacity as Senior Vice President and Controller, Mr. Chesonis has been responsible for all aspects of accounting and financial reporting. Mr. Chesonis previously served as Director of Public Reporting for US Foodservice and Audit Manager for the international accounting firm of PriceWaterhouse, LLP. Mr. Chesonis is the brother of Arunas Chesonis.
Laurie L. Zaucha has served as the Senior Vice President of Human Resources of PAETEC Holding since November 2007. Before joining PAETEC, Ms. Zaucha spent more than four years at Bausch & Lomb Incorporated, a manufacturer of eye health products, most recently as Vice President, Global Compensation and Benefits. Ms. Zaucha also held positions with Footstar, Inc. and Starbucks Coffee Co.
Richard T. Aab has served as Vice Chairman of the Board of PAETEC Holding since February 2007. Mr. Aab co-founded US LEC Corp. in June 1996 and served as its Chairman of the Board from June 1996 to February 2007, when US LEC completed its combination by merger with PAETEC Corp. In 1982, Mr. Aab co-founded ACC Corp. Between 1982 and 1997, he held various positions with ACC, including Chairman of the Board, Chief Executive Officer, President and director. Also during that period, he served as Chairman and director of ACCs international subsidiaries in Canada, ACC TelEnterprises, Ltd., and the United Kingdom, ACC Long Distance UK Ltd. Mr. Aab is a member of the boards of trustees of the University of Rochester, the University of Rochester Medical Center and Rochester Institute of Technology, and is a director of several privately-held corporate businesses, including E-chx, Inc., a nationwide payroll processing company, for which he serves as Chairman. From May 2007 to May 2008, Mr. Aab served on the board of directors of Medifast, Inc.
Shelley Diamond was appointed to the PAETEC Holding board of directors on March 6, 2009. She has served since 2007 as the Managing Director of the New York office of Young and Rubicam, an advertising agency. In this role, she leads the day-to-day operations of the agency, formulating and implementing strategic direction, attracting talent, expanding the offices new media and digital capabilities, and cultivating new business from both existing and new clients. Ms. Diamond has served in various roles at Young and Rubicam since 1991, and before assuming her current position had been Director of Client Services since 2001. Before joining Young and Rubicam, she held various positions at Ted Bates Advertising, at Grey Advertising and at Foote Cone and Belding, an advertising agency.
H. Russell Frisby, Jr. has served as a director of PAETEC Holding since February 2007 and as a director of PAETEC Corp. since January 2007. Mr. Frisby is a partner in the Energy and Telecommunications Group of Stinson Morrison Hecker LLP, , a law firm. Mr. Frisbys legal practice focuses on regulatory and corporate matters affecting entities in the communications, energy and technology areas, and for over 20 years he has represented clients in a wide variety of proceedings before the FCC, state utility commissions and federal courts. Before joining Stinson Morrison Hecker, Mr. Frisby was a partner with the law firms Fleischman and Harding LLP and Kirkpatrick & Lockhart Nicholson Graham LLP. From February 1998 to March 2005, Mr. Frisby was the President, Chief Executive Officer and Acting Chief Legal Officer of the Competitive Telecommunications Association (CompTel). Before his service in that position, he served as Chairman of the Maryland Public Service Commission.
Tansukh V. Ganatra has served as a director of PAETEC Holding since February 2007. Mr. Ganatra co-founded US LEC in June 1996, served as a director of US LEC from June 1996 to February 2007 and served as interim Chief Executive Officer of US LEC from November 2006 to February 2007. He served as Chief Executive Officer and Vice Chairman of the board of directors of US LEC from July 1999 until his retirement in December 2001. Mr. Ganatra also served as President and Chief Operating Officer of US LEC from June 1996 until July 1999. From 1987 to 1997, Mr. Ganatra held various positions with ACC Corp., including service as its President and Chief Operating Officer. Before joining ACC, Mr. Ganatra held various positions during a 19-year career with Rochester Telephone Corporation, now known as Frontier Communications Corporation, a subsidiary of Citizens Communications Company, culminating with the position of Director of Network Engineering.
Michael C. Mac Donald has served as a director of PAETEC Holding since February 2007. Mr. Mac Donald served as a director of US LEC from April 2003 to February 2007. Before his retirement on December 31, 2009, Mr. Mac Donald held various sales and marketing positions with Xerox Corporation, a provider of document management technology and services, beginning in 1977. These positions included President of Xerox Marketing Operations and, most recently prior to his retirement, Senior Vice President, Operational Effectiveness. Mr. Mac Donald is a director of Medifast, Inc. and of the Jimmy V Foundation.
William R. McDermott has served as a director of PAETEC Holding since February 2007 and as a director of PAETEC Corp. since March 2004. Mr. McDermott is the co- Chief Executive Officer of SAP AG, a provider of business software solutions headquartered in Walldorf, Germany. In this capacity, and also as a member of the Executive Board of SAP, he oversees SAPs strategic business activities relating to sales, all customer operations and ecosystem activities. Before joining SAP, Mr. McDermott served as the Executive Vice President, Worldwide Sales & Operations of Siebel Systems, a business software provider, as President of Gartner, Inc., a provider of research and analysis on the information technology industry, and on the boards of directors of two subsidiaries of Xerox Corporation. Mr. McDermott is also a director of Under Armour, Inc. and Ansys, Inc.
Alex Stadler has served as a director of PAETEC Holding since June 2008. Mr. Stadler previously served on the board of directors of McLeodUSA from January 2006 until its acquisition by PAETEC Holding on February 8, 2008. From 1999 until 2002, he served as Chief Executive Officer of Riodata NV, a data services carrier specializing in private network and Internet access and connectivity for medium-sized companies. A wholly-owned subsidiary of Riodata NV filed for bankruptcy protection under the laws of Germany during the time that Mr. Stadler served as an officer for its controlling shareholder. Before joining Riodata NV, Mr. Stadler served as Chief Operating Officer of Otelo Communications, a competitive local exchange carrier, and as Chief Executive Officer of RWE Telliance AG, a German telecommunications company. Mr. Stadler joined GTE Corporation in 1977, and from 1985 to 1996 served in a variety of senior management positions at GTEs cellular and telephone subsidiaries and as GTEs head of mergers and acquisitions. Since 2002, Mr. Stadler has pursued private interests. Mr. Stadler started his career as an Economist at the Reserve Bank of Rhodesia.
Mark Zupan has served as a director of PAETEC Holding since February 2007 and as a director of PAETEC Corp. since May 2006. Mr. Zupan is dean of the William E. Simon Graduate School of Business Administration at the University of Rochester, a position which he has held on a full-time basis since January 1, 2004. Mr. Zupan previously served as dean and professor of economics at the University of Arizonas Eller College of Management from 1997 to 2003. Before his appointment at the University of Arizona, Mr. Zupan taught at the University of Southern Californias Marshall School of Business, where he also served as associate dean of master degree programs. He was a teaching fellow in Harvard Universitys Department of Economics while pursuing his doctoral studies at the Massachusetts Institute of Technology, and has been a visiting faculty member at the Amos Tuck School of Business Administration at Dartmouth College. Mr. Zupan is also a director of Constellation Brands, Inc and served from 2003 to 2005 as a director of StockerYale, Inc.
PAETECs business, operating results, financial condition and prospects are subject to a variety of significant risks, many of which are beyond PAETECs control. The following is a description of some of the important risk factors that may cause PAETECs actual results in future periods to differ substantially from those the company currently expects or seeks.
Deterioration in the global economy has had, and may continue to have, a negative impact on PAETECs business.
PAETEC believes that the financial and economic pressures faced by its business customers in the current environment of diminished consumer spending, corporate downsizing and tightened credit have had, and may continue to have, an adverse effect on billable minutes of use and on customer attrition rates, and have resulted in and may continue to result in increased customer demands for price reductions in connection with contract renewals.
PAETEC relies on other carriers to provide it with critical parts of its network under a regulatory framework that may change.
PAETEC must interconnect and lease from incumbent carriers last mile special access digital T1 transmission lines and UNE digital T1 transmission lines and other elements to connect substantially all of its end-user customers to its network. To obtain these lines and, accordingly, to provide voice and data services, PAETEC depends on existing laws and regulations that require incumbent local exchange carriers to lease these special access digital T1s, UNE T1s and other network elements to competitive carriers. Regulatory developments may reduce the extent to which incumbent carriers are required to lease these network facilities to PAETEC or may permit incumbent carriers to increase the prices they charge for such lines or impose unacceptable terms and conditions. Changes in law or regulation could limit or terminate PAETECs affordable access to the network components it needs to provide voice and data services.
If PAETEC cannot continue to interconnect with and obtain key network elements and special access services from some of its primary competitors on acceptable terms, it may not be able to offer its local voice and data services on a profitable basis, if at all.
PAETEC will not be able to provide its voice and data services on a profitable basis, if at all, unless it is able to continue to interconnect with and obtain key network elements and special access service from some of PAETECs primary competitors on acceptable terms. To offer local voice and data services in a market, PAETEC must connect its network with the network of the incumbent carrier in that market. This relationship is governed by interconnection agreements between the incumbent carrier and PAETEC that are based on provisions of the Telecommunications Act of 1996 obligating incumbent carriers to interconnect with competitive carriers and provide them with access to various elements of the incumbents network. Access to last mile special access digital T1 transmission lines is governed by each incumbent local exchange carriers special access tariffs. These tariffs can be changed and the prices for the services increased. Interconnection agreements can be terminated or expire and thereby require renegotiation and renewal. Current FCC rules permit regional Bell operating companies to retire unilaterally without any regulatory oversight last mile copper loop facilities that we use to reach our customers. As incumbents replace copper facilities with fiber loop facilities that the FCC has declared are not subject to unbundling obligations, the incumbent carriers may be able to eliminate our access to last mile facilities that we require to serve our customers. Several competitive local exchange carriers, including PAETEC, have petitioned the FCC to change the rules governing copper loop retirement to protect our access to these last mile facilities. The FCC has not yet made any decision on the petition. Additional changes in law or regulation that limit our ability to use key network elements of the incumbent carrier may have an adverse impact on our ability to serve end user customers. If PAETEC is not able to renegotiate or enter into new interconnection agreements on terms that are acceptable to it, or obtain special access services on competitive terms, or if there is a change in law or regulation that limits or narrows the obligation of the incumbent carrier to provide network access to competitive carriers, PAETECs cost of doing business could increase and its ability to compete could be impeded.
Revised FCC policy or rules governing intercarrier compensation could have a material adverse effect on PAETECs operating results.
Adoption of significant changes in policy or rules governing intercarrier compensation by the FCC and the time frame over which changes are to be implemented could have a material adverse effect on PAETECs collection and payment of reciprocal compensation and access fees. Intercarrier compensation, including exchange access and reciprocal compensation, currently is the subject of several ongoing investigations and proceedings before the FCC that are intended to reform the way in which carriers and service providers pay other carriers and providers for the use of their respective networks. There is no clear consensus as to when or how the rules governing intercarrier compensation will be reformed. Whether and how intercarrier compensation reform will affect PAETEC and other carriers therefore remains unclear, but such reform could have a negative impact on PAETECs business and operating results.
Existing law governing intercarrier compensation is unclear in some respects, and regulatory or judicial decisions resolving the uncertainties could have a material adverse effect on PAETECs operating results.
In areas where current law is unclear and subject to dispute, including the proper intercarrier compensation treatment applied to long distance traffic that begins in IP format and terminates on the public switched telephone network, or vice versa, decisions by the FCC, state commissions, or courts could resolve the uncertainty in ways that could adversely affect PAETECs operations.
PAETECs business is subject to a variety of risks based on its dependence on regulations that continue to change.
Most of the network services and carrier services that PAETEC provides are subject to regulation and may be adversely affected by regulatory developments at the federal, state and local levels. The regulations, for example, can affect the types of services PAETEC may offer, the rates PAETEC is permitted to charge for its services and for the use of its network by other carriers, the manner in which PAETEC may bill its customers and the rates PAETEC must pay others for their services and for the use of their networks. In addition, the regulations may impose specific operational or compliance requirements related to the protection of customer proprietary network information, capability to associate a physical address with a calling partys telephone number, referred to as E-911, or cooperation with law enforcement officials engaged in lawful communication intercept or monitoring activities. All of these requirements may reduce the revenue PAETEC generates from its operating activities or increase its operating costs. Federal and state regulations also determine the level of contribution payments PAETEC must make to the federal Universal Service Fund and other federal and state telecommunications subsidy programs, as well as the terms under which it may use any rights of way necessary for the operation of its business. If PAETEC fails to comply with applicable regulations, or if the regulations change in a manner adverse to PAETEC, its business and operating results may suffer.
If PAETEC is required to reduce the prices it charges for some or all of its network services, PAETECs profitability may be negatively affected and its ability to continue to generate positive cash flows from operations may be diminished.
PAETEC may be required to reduce the prices it charges for some or all of its network services for the following reasons, which could adversely affect its profit margins and its ability to generate positive cash flows from operations:
Industry consolidation and realignment may increase PAETECs costs.
Before their respective mergers, AT&T and MCI offered some network services and elements in competition with the incumbent carriers, including high-speed circuits (DS1 and DS3 and OCN), interoffice transport and last mile access loops to some premises. The mergers between AT&T and SBC and between AT&T and BellSouth have increased the cost of the high-speed circuits that PAETEC leases to connect its customers to PAETECs switching equipment. The merger between MCI and Verizon could also increase the cost of similar high-speed circuits in the Verizon region by reducing the number of providers that offer those high-speed circuits. PAETEC also may incur increased circuit costs in portions of the Qwest region, where these large incumbents may not have a significant presence. Such a development could decrease the competitive pressure on other carriers to maintain low rates for these circuits. The expansion of operations of medium-sized incumbent carriers into markets served by PAETEC, either through merger or the sale of exchanges by a regional Bell operating company to a smaller incumbent carrier, may negatively affect PAETECs operations if the non-RBOC incumbent carrier has less sophisticated systems and more costly terms for interconnection and access to last mile facilities.
If PAETEC is unable to manage its business effectively, PAETECs prospects for profitable operations will be harmed.
To achieve and sustain operating profitability, PAETEC is required to generate revenue growth, control expenses and otherwise manage its business efficiently. This places significant demands on PAETECs management and other employees, its operational and financial systems, and its internal controls and procedures. If PAETEC fails to manage PAETECs operations effectively, PAETEC may experience higher costs of operations, a decline in service quality, the loss of customers, and other limitations that would adversely affect PAETECs prospects for profitable operations.
If PAETEC does not compete effectively in the highly competitive market for network services, it could lose customers and revenue and may face more difficulties as it expands in existing markets and enters new markets.
The telecommunications industry is highly competitive, particularly with the advent of new technologies replacing traditional public switched telecommunications networks in favor of services transmitted over the Internet. This increased level of competition could diminish PAETECs market share and affect PAETECs ability to expand PAETECs business. PAETEC will compete with current and potential market entrants, including:
Many of the competitors identified above have significantly greater market presence, engineering and marketing capabilities, and financial, technological and personnel resources than PAETEC. Additionally, some of these competitors are currently subject to substantially less regulation than competitive and incumbent carriers and claim to be exempt from a number of taxes and regulatory charges that PAETEC is required to pay. As a result, compared to PAETEC, the companys competitors may be able to develop and expand their network infrastructures and services offerings more efficiently or more quickly, adapt more swiftly to new or emerging technologies and changes in customer requirements, take advantage of acquisitions and other opportunities more readily, and devote greater resources to the marketing and sale of their products and services. Further, they may succeed in developing and expanding their communications and network infrastructures more quickly than PAETEC.
PAETEC faces price competition in the market for network services and, as a result, may not be able to sustain operating profitability, maintain adequate market share or achieve significant revenue growth.
The demand for PAETECs services may not exist at prices that will enable it to maintain adequate market share or achieve significant revenue growth. In response to competition from incumbent carriers, and providers using new technologies, including VoIP, competitive carriers like PAETEC have reduced the prices they charge for their network services in recent years. Moreover, in light of the mergers between AT&T and SBC, between MCI and Verizon, and between AT&T and BellSouth, PAETEC faces price and service competition with respect to its network services from these incumbents, which are the largest incumbent carriers in the United States, as well as from other large established telephone companies that are the dominant competitors in all of PAETECs service areas. PAETEC expects to continue experiencing an overall increase in downward pricing pressures, particularly with respect to its network services, due to competition, volume-based pricing and other factors. PAETECs ability to reduce its prices may be limited by its reliance on some of its principal competitors to provide key network elements that PAETEC needs to provide network services. In addition, if regulatory authorities were to prohibit PAETEC from including specified types of additional charges on bills for network services to offset expenses that PAETEC may incur, PAETEC could be required to increase its base prices for network services above competitive levels.
An inability to market and develop additional services may adversely affect PAETECs ability to retain existing customers or attract new customers.
PAETEC offers data, Internet, VoIP, local, long distance and other telecommunications services. To address the future needs of PAETECs customers, PAETEC will need to market and develop additional services. PAETEC may not be able to continue to provide the range of telecommunications services that PAETECs customers need or seek. PAETEC may lose some of its customers or be unable to attract new customers if it cannot offer these services.
Changes in technology, service offerings and customer preferences could affect PAETECs ability to compete in the marketplace for telecommunications and information services.
PAETEC faces rapid and significant changes in technology. PAETECs ability to retain existing customers and attract new customers will be impaired if PAETEC is unable to deliver new technologies and services that have significant customer acceptance, to adopt those new technologies and offer those new services in a timely and effective manner, and to compete successfully against other service providers that introduce the same or similar new technologies and offer substantially similar new services. The telecommunications industry has changed significantly over the past several years and is continuing to evolve rapidly. Emerging technologies and services, such as VoIP applications, broadband services and advanced wireless offerings, are altering the economic conditions under which the telecommunications and information services industry operates. New technologies also could lead to the development of new, more convenient and cost-effective services. In addition, the preferences and requirements of customers are rapidly changing. For example, telecommunications customers are increasingly using wireless forms of communication, such as handheld Internet-access devices and mobile phones. The use of wireless communications has resulted in a decline in the volume of voice traffic carried by traditional wireline telecommunications networks and likely has resulted in a decrease in the average minutes of use generated by customers of wireline communications services providers, including PAETEC. We expect this trend to continue.
The development and offering of new services in response to new technologies or consumer demands may require PAETEC to increase its capital expenditures significantly. In addition, new technologies may be protected by patents or other intellectual property laws and therefore may be available only to PAETECs competitors and not to PAETEC.
PAETEC may not be able to compete effectively if it is unable to install additional network equipment or to convert its network to more advanced technology.
PAETECs long-term business strategy may require it to convert its existing network to a network using more advanced technology. PAETEC may not have or be able to raise the significant capital that a conversion may require, or be able to complete the installation of additional network equipment and the conversion to more advanced technology in a timely manner, at a commercially reasonable cost or at all. PAETEC also may face technological problems that cannot be resolved. If PAETEC is unable successfully to install or operate new network equipment or to convert its network to a network using more advanced technology, PAETEC may not be able to compete effectively, and PAETECs results of operations could be adversely affected.
If PAETEC does not successfully implement its acquisition strategy, its acquisition of other businesses could harm PAETECs results of operations and financial condition.
As part of PAETECs growth strategy, PAETEC seeks to supplement internal expansion through targeted acquisitions. PAETEC is subject to various risks in connection with any acquisitions or series of acquisitions, including the risks that PAETEC:
Even if acquired companies eventually contribute to an improvement in PAETECs operating results or financial condition, the acquisitions may adversely affect PAETECs operating results and financial condition in the short term. PAETECs operating results may decrease as a result of transaction-related expenses PAETEC records for the period in which it completes an acquisition. PAETECs operating results may be further reduced by the higher operating and administrative expenses PAETEC may incur in the periods immediately following an acquisition as PAETEC seeks to integrate the acquired business into its operations.
Any significant impairment of PAETECs goodwill would lead to a decrease in PAETECs assets and a reduction in its net operating performance.
At December 31, 2009, PAETEC had goodwill of approximately $300.6 million, which constituted approximately 20.6% of PAETECs total assets at that date. If PAETEC makes changes in its business strategy or if market or other conditions adversely affect its business operations, PAETEC may be forced to record an impairment charge, which would lead to a decrease in the companys assets and reduction in net operating performance. For 2008, PAETEC recorded a goodwill impairment charge of $355.0 million. PAETEC tests goodwill for impairment annually or whenever events or changes in circumstances indicate an impairment may have occurred. If the testing performed indicates that impairment has occurred, PAETEC is required to record an impairment change for the difference between the carrying value of the goodwill and the implied fair value of the goodwill in the period in which the determination is made. The testing of goodwill for impairment requires PAETEC to make significant estimates about the future performance and cash flows of the company, as well as other assumptions. These estimates can be affected by numerous factors, including changes in economic, industry or market conditions, changes in underlying business operations, future reporting unit operating performance, existing or new product market acceptance, changes in competition, or changes in technologies. Any changes in key assumptions, or actual performance compared with those assumptions, about PAETECs business and its future prospects or other assumptions could affect the fair value of one or more reporting units, resulting in an impairment charge.
Adverse developments in the credit and capital markets may negatively affect PAETECs ability to raise additional capital.
Adverse conditions in the debt security and syndicated loan markets, which have significantly reduced the availability of corporate credit, are continuing to affect the global financial system and equity markets. PAETECs ability to access the debt and equity markets may be restricted at a time when it would like, or need, to access such markets, which could have an adverse effect on PAETECs flexibility to react to changing economic and business conditions. The disruptions in the financial markets have had, and may continue to have, an adverse effect on the market value of PAETECs common stock, which could make it more difficult or costly for the company to raise capital through an offering of its equity securities.
PAETECs significant level of debt and interest payment obligations may limit its ability to compete.
As of March 1, 2010, PAETEC had a total of $950 million in aggregate principal amount of senior indebtedness outstanding, which consisted of $650 million principal amount of PAETECs 8 7/8% senior secured notes due 2017 and $300 million principal amount of PAETECs 9.5% senior notes due 2015.
This substantial level of indebtedness may have important consequences. For example, it may:
Covenants under PAETECs debt agreements may restrict its future operations.
PAETECs senior secured credit facilities and senior notes indenture impose operating and financial restrictions that limit PAETECs discretion on some business matters, which could make it more difficult for PAETEC to expand, finance its operations and engage in other business activities that may be in its interest. These restrictions include compliance with or maintenance of a maximum leverage ratio under PAETECs credit facilities, and will limit the ability of PAETEC and its subsidiaries to:
PAETEC may incur indebtedness in addition to the foregoing indebtedness. Any additional indebtedness it may incur in the future may subject PAETEC to similar or even more restrictive conditions.
If PAETEC is unable to raise additional capital, its ability to expand its business and to meet its obligations will be limited.
The development and expansion of PAETECs network will require substantial capital investment. If PAETEC chooses to accelerate the expansion of its business, PAETEC will require additional capital. PAETEC also may require additional capital to fund payments of its indebtedness as an increasing amount of such indebtedness becomes due and payable. If PAETEC cannot successfully obtain additional equity or debt financing for necessary purposes on acceptable terms, PAETEC could be at a competitive disadvantage relative to competitors with significant capital or the ability to raise significant capital for expansion. The terms of any financing PAETEC does obtain may be burdensome to PAETEC.
PAETECs operating performance will suffer if it is not offered competitive rates for the access services PAETEC needs to provide its long distance services.
PAETEC depends on other telecommunications companies to originate and terminate a significant portion of the long distance traffic initiated by its network services customers. Access charges historically have made up a significant percentage of the overall cost associated with the provision of long distance service by PAETEC. If the volume of long distance traffic PAETEC carries remains substantial, its operating performance will suffer if it is not offered these access services at rates that are substantially equivalent to the rates charged to its competitors or that otherwise do not enable it to have profitable pricing of its long distance services.
Regulatory initiatives may continue to reduce the rates PAETEC is permitted to charge for some services that it provides to long distance and competing local exchange carriers.
The rates that PAETEC charges long distance service providers for originating or terminating interstate and intrastate calls initiated by their customers to customers served by its network, and for transferring calls by
PAETECs customers onto the long distance carriers network, cannot exceed the rates established by federal and, in some cases, state regulatory authorities. There are several pending FCC and state regulatory proceedings addressing these rates and state legislative proposals that would mandate reductions in competitive carrier rates for these services. The outcome of these proceedings and legislative initiatives could result in a material reduction in the rates PAETEC may charge interexchange carriers for originating and terminating long distance traffic. Mandated reductions in switched access rates for all carriers also could adversely affect operating margins and revenues of PAETECs carrier services business, as PAETECs wholesale termination and origination services may not be offered at significantly lower cost than the reduced switched access rates. Similarly, the rates PAETEC may charge to local carriers to terminate local calls made by their customers to PAETECs customers are governed by state regulatory authorities and agreements between the local carriers and PAETEC. In the future, federal or state regulatory authorities may institute proceedings that could have the effect of reducing the rates PAETEC may charge local service providers for terminating local traffic. Such reductions in originating and terminating rates could have a material adverse effect on PAETECs business and cash flow.
If PAETEC does not continue to attract and retain qualified personnel and independent sales agents or retain its key management, PAETEC may not be able to execute its business plan.
PAETEC faces competition for qualified personnel, including management, technical and sales personnel. PAETEC also relies on a large number of independent sales agents to market and sell PAETECs services. If PAETEC is unable to attract and retain experienced and motivated personnel, including a large and effective direct sales force, a substantial number of independent sales agents, and qualified information technology and other back office personnel, PAETEC may not be able to obtain new customers or effectively service existing customers, or sell sufficient amounts of service to execute PAETECs business plan. Additionally, the loss of key management personnel could impair PAETECs ability to implement its acquisition integration plan and execute its business strategy, which could hinder PAETECs ability to sustain profitable operations.
Failure to obtain and maintain necessary permits and rights-of-way could interfere with PAETECs network infrastructure and operations.
To obtain and maintain rights-of-way and similar rights and easements needed to install, operate and maintain fiber optic cable and its other network elements, PAETEC must negotiate and manage agreements with state highway authorities, local governments, transit authorities, local telephone companies and other utilities, railroads, long distance carriers and other parties. The failure to obtain or maintain any rights-of-way could interfere with PAETECs operations, interfere with its network infrastructure and its use of that infrastructure and adversely affect PAETECs business. For example, if PAETEC loses access to a right-of-way, it may need to spend significant sums to remove and relocate its facilities.
PAETEC and other industry participants are frequently involved in disputes over issues that, if decided adversely to PAETEC, could harm PAETECs financial and operational prospects.
PAETEC anticipates that it will continue to be subject to risks associated with the resolution of various disputes, lawsuits, arbitrations and proceedings affecting PAETECs business. The deregulation of the telecommunications industry, the implementation of the Telecommunications Act of 1996, the evolution of telecommunications infrastructure from time-division multiplexing to Internet Protocol, and the distress of many carriers in the telecommunications industry as a result of continued competitive factors and financial pressures have resulted in the involvement of numerous industry participants, including PAETEC, in disputes, lawsuits, proceedings and arbitrations before state and federal regulatory commissions, private arbitration organizations such as the American Arbitration Association, and courts over many issues that will be important to PAETECs financial and operational success. These issues include the interpretation and enforcement of existing interconnection agreements and tariffs, the terms of new interconnection agreements, operating performance obligations, intercarrier compensation, treatment of different categories of traffic (for example, traffic originated or terminated on wireless or VoIP), the jurisdiction of traffic for intercarrier compensation purposes, the
wholesale services and facilities available to PAETEC, the prices PAETEC will pay for those services and facilities, and the regulatory treatment of new technologies and services.
PAETECs business could suffer if third parties successfully claim that PAETEC has infringed their intellectual property rights.
The dependence of the telecommunications industry on proprietary technology has resulted in increasingly frequent litigation based on allegations of the infringement of patents and other intellectual property. PAETEC may be subject to litigation to defend against claimed infringement of the rights of others or to determine the scope and validity of the proprietary rights of others. Regardless of its merits, any intellectual property litigation could be time-consuming and costly and could divert managements time and attention from PAETECs business operations.
If PAETEC is unable to maintain or enhance its back office information systems, PAETEC may not be able to increase its revenue as planned or to compete effectively.
Sophisticated back office information systems are vital to PAETECs revenue growth and PAETECs ability to monitor costs, bill customers, initiate, implement and track customer orders, and achieve operating efficiencies. To increase revenue, PAETEC must select products and services offered by third-party vendors and efficiently integrate those products and services into PAETECs existing back office operations. PAETEC may not successfully implement these products, services and systems on a timely basis, and PAETECs systems may fail to perform as the company expects. A failure or delay in the expected performance of PAETECs back office systems, or a failure or delay in effectively integrating the back office systems of acquired companies with PAETECs back office systems, could slow the pace of PAETECs expected revenue growth or harm PAETECs competitiveness by adversely affecting PAETECs service quality, which could lead to a loss of existing customers or a failure to attract and retain new customers.
Network failures or system breaches could cause delays or adversely affect PAETECs service quality, which may cause it to lose customers and revenue.
In operating its network, PAETEC must maintain connections for, and manage, a large number of customers and a large quantity of traffic at high speeds. Any failure or perceived failure to achieve or maintain high-speed data transmission could significantly reduce demand for PAETECs services and adversely affect PAETECs operating results. PAETEC has experienced outages, such as temporary switch outages, that have prevented PAETEC from providing uninterrupted services to some of its customers. Outages such as these have resulted in lost revenue and could cause PAETEC to lose customers. In the future, PAETEC may experience similar or more severe outages or other network failures or breaches.
Computer viruses, break-ins, human error, natural disasters and other problems also may disrupt PAETECs network. The network security and stability measures PAETEC implements may be circumvented in the future or otherwise fail to prevent the disruption of PAETECs services. The costs and resources required to eliminate computer viruses and other security problems may result in interruptions, delays or cessation of services to PAETECs customers, which could result in a decrease in demand, decrease PAETECs revenue and slow PAETECs planned expansion.
If PAETECs network or other ground facilities are damaged by natural catastrophes or terrorism, PAETECs ability to provide services may be interrupted and the quality of PAETECs services may be adversely affected.
A major earthquake, hurricane, tornado, fire, terrorist attack on the United States, or other catastrophic event could damage PAETECs network, network operations centers, central offices or corporate headquarters. Such an event could interrupt PAETECs services, adversely affect service quality and harm PAETECs business.
PAETEC does not have replacement or redundant facilities that it can use to provide alternative means of service to all customers or under every circumstance in the event of a catastrophic event. Any damage to PAETECs network could result in degradation of PAETECs service for some customers and could result in complete loss of service in affected areas.
Future sales of PAETECs common stock in the public market could lower the price of PAETEC common stock and impair PAETECs ability to raise funds in future securities offerings.
Future sales of a substantial number of shares of PAETEC common stock in the public market, or the perception that such sales could occur, could adversely affect the prevailing market price of PAETEC common stock and could make it more difficult for PAETEC to raise funds through a public offering of its equity securities. PAETEC stockholders with rights under existing registration rights agreements will have the benefit, subject to limitations and qualifications, to registration rights with respect to their PAETEC common stock that would permit the sale of such common stock in the public market.
If PAETEC fails to maintain proper and effective internal control over financial reporting or fails to implement any required changes, PAETECs ability to produce accurate financial statements could be impaired, which could increase its operating costs and adversely affect its ability to operate its business.
PAETEC is required to provide annual management assessments of the effectiveness of its internal control over financial reporting and to provide reports by PAETECs independent registered public accounting firm addressing the effectiveness of internal control over financial reporting. Ensuring that PAETEC has adequate internal control over financial reporting so that PAETEC can produce accurate financial statements on a timely basis is a costly and time-consuming effort. Implementing any required changes to PAETECs internal controls may require modifications to PAETECs existing accounting systems or the engagement of additional accounting personnel. Any failure to maintain adequate internal controls, or the inability to produce accurate financial statements on a timely basis, could increase PAETECs operating costs and impair PAETECs ability to operate its business.
PAETEC owns and leases several sales offices, switch sites, collocation sites, and other facilities across its nationwide service area. PAETECs corporate headquarters and one of its network operations centers are located in Fairport, New York. The shared facility consists of approximately 100,000 square feet of office space and is occupied under a 20-year lease expiring in April 2021. For information about the leased facilities, see Note 11 to the consolidated financial statements appearing elsewhere in this report.
PAETEC intends to lease additional sales offices and network equipment sites as it expands. PAETEC believes that necessary space will be available on a commercially reasonable basis to accommodate its anticipated growth.
All owned properties secure PAETECs obligations under its senior secured indebtedness, which as of March 1, 2010 totaled $650.0 million in aggregate principal amount outstanding. For information about PAETECs indebtedness, see Note 5 to the consolidated financial statements appearing elsewhere in this report.
For additional information about PAETECs properties, see BusinessPAETECs BusinessPAETECs Network Architecture and Deployment.
Proceeding Involving Iowa Department of Revenue
Certain operating subsidiaries of McLeodUSA have protested and appealed various sales and use tax assessments levied by the Iowa Department of Revenue, or IDOR, with respect to the purchase of certain equipment from 1996 through 2005. These assessments, including estimated interest and penalties, originally totaled approximately $16.5 million. PAETEC entered into settlement agreements with the IDOR in April 2009 and January 2010 as described in Note 11 to the consolidated financial statements appearing elsewhere in this report, resolving a substantial portion of the disputed assessments. PAETEC recognized a $7.2 million benefit recorded as a sales and use tax settlement in its consolidated statements of operations and comprehensive (loss) income during the year ended December 31, 2009 as a result of the agreements.
Proceeding Involving Alcatel-Lucent
In October 2008, PaeTec Communications, Inc. filed a claim in the Supreme Court for the State of New York, County of Monroe, against Lucent Technologies, Inc., Alcatel USA Marketing, Inc. and Alcatel-Lucent, which we refer to collectively as Alcatel-Lucent, for reimbursement of costs and fees in connection with the patent infringement case brought against PAETEC by Sprint Communications Company L.P., or Sprint. The Sprint action was settled in May 2009 and is further described in Note 11 to the consolidated financial statements appearing elsewhere in this report. PAETECs claim against Alcatel-Lucent alleges that because the Sprint claims arose from the use by PAETEC of Alcatel-Lucent equipment, Alcatel-Lucent has an obligation to defend and indemnify PAETEC pursuant to the contract terms under which it sold the equipment to PAETEC. In response, Alcatel-Lucent has denied the claim and counter-claimed against PAETEC for allegedly unpaid switch software licensing charges, and associated late fees. PAETEC believes that it has meritorious defenses against these counter-claims.
From time to time, PAETEC is subject to other legal proceedings in the normal course of its operations. See BusinessRegulation for information about some of these proceedings.
Market For Common Stock
PAETECs common stock is listed on the Global Select Market of The NASDAQ Stock Market LLC and is traded under the trading symbol PAET. The following tables set forth, for the periods indicated, the high and low sales prices per share of PAETEC common stock as reported by the NASDAQ Global Select Market.
As of March 1, 2010, PAETEC had approximately 475 holders of record of its common stock.
PAETEC has not declared or paid cash dividends on its common stock. Future declaration and payment of cash dividends, if any, on PAETECs common stock are within the discretion of PAETECs board of directors and will be determined in light of factors deemed relevant by the board of directors, including PAETECs earnings, operations, capital requirements and financial condition and restrictions in its financing agreements. Under its credit facilities agreement and notes indentures, PAETEC may pay cash dividends on its common stock in excess of specified amounts only if it is not otherwise in default and meets specified requirements relating to levels of its cash flows, total and secured indebtedness, interest obligations and other financial measures.
The following performance graph compares the cumulative total return on PAETECs common stock on a year-end basis from March 31, 2007, the last day of the month in which trading of PAETECs common stock began on the NASDAQ Global Select Market, through December 31, 2009, with the total return over the same period on the NASDAQ Composite Index and the NASDAQ Telecommunications Index. The graph assumes that the value of the investment was $100 on March 31, 2007, and that all dividends and other distributions were reinvested.
Comparison of Cumulative Total Return
Among PAETECs Common Stock, the NASDAQ Composite Index
and the NASDAQ Telecommunications Index
The performance graph will not be deemed to be incorporated by reference by means of any general statement incorporating by reference this Form 10-K into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that PAETEC specifically incorporates such information by reference, and shall not otherwise be deemed filed under such Acts.
Issuer Purchases of Equity Securities
The following table provides information about PAETECs purchases of its common stock during the fourth quarter of 2009:
The selected consolidated statements of operations data, consolidated balance sheet data, other financial data and operating data reflect the financial results of PAETEC Corp., as predecessor to PAETEC Holding Corp., and PAETEC Corp.s wholly-owned subsidiaries. After February 28, 2007, the date of completion of the merger transaction with US LEC Corp., or US LEC, the accompanying selected data include the accounts of PAETEC Holding Corp. and its wholly-owned subsidiaries, including PAETEC Corp. and PAETEC Corp.s wholly-owned subsidiaries and US LEC and US LECs wholly-owned subsidiaries. After February 8, 2008, the date of completion of the merger transaction with McLeodUSA, the accompanying selected data include the foregoing accounts as well as the accounts of McLeodUSA and McLeodUSAs wholly-owned subsidiaries.
The following tables show the selected consolidated statements of operations data, consolidated balance sheet data, other financial data and operating data of PAETEC Corp. as of and for each of the years ended December 31, 2005 and 2006, and of PAETEC Holding as of and for the years ended December 31, 2007, 2008 and 2009. The selected consolidated statements of operations data and other financial data for the years ended December 31, 2009, 2008 and 2007 and the selected consolidated balance sheet data as of December 31, 2009 and 2008 are derived from PAETECs audited consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, appearing elsewhere in this report. The selected consolidated statements of operations data and other financial data for the years ended December 31, 2006 and 2005 and the selected consolidated balance sheet data as of December 31, 2007, 2006 and 2005 are derived from PAETECs audited consolidated financial statements prepared in accordance with GAAP, which are not included in this report. PAETECs historical results are not necessarily indicative of its results for any future period.
You should read the data set forth below together with PAETECs consolidated financial statements and the related notes and Managements Discussion and Analysis of Financial Condition and Results of Operations, and the other financial information appearing elsewhere in this report.
You should read the following managements discussion and analysis together with the consolidated financial statements and related notes and the other financial information that appear elsewhere in this report.
PAETEC is a competitive communications services and solutions provider guided by the principle that delivering superior customer service is the key to competing successfully with other communications services providers. PAETECs primary business is providing large, medium-sized and, to a lesser extent, small business end-user customers in metropolitan areas with a package of integrated communications services that encompasses data services, including broadband Internet access services and virtual private network services, and voice services, including local telephone services and domestic and international long distance services. PAETEC Holding had approximately 3,630 employess as of March 1, 2010. As of the same date, PAETEC Holding had in service 234,116 digital T1 transmission lines, which represented the equivalent of 5,618,784 access lines, for approximately 44,000 business customers in a service area encompassing 84 of the top 100 metropolitan statistical areas.
To supplement its internal growth, PAETEC has pursued an acquisition strategy that has sought acquisition candidates that fulfill one or more of the following objectives:
To fund its expansion through acquisitions, which began in February 2007 with the US LEC merger and included the acquisition of McLeodUSA in February 2008, PAETEC has increased its borrowings under a variety of debt arrangements. In connection with its acquisition of US LEC in 2007, PAETEC obtained $850 million principal amount of new senior secured credit facilities on February 28, 2007 and applied the proceeds of the facilities primarily to refinance or retire substantially all of the indebtedness of the two companies and to repurchase US LECs outstanding preferred stock. In July 2007, PAETEC amended its senior secured credit facilities and prepaid $300 million principal amount of borrowings under those facilities with the proceeds of an offering of $300 principal amount of its 9.5% senior notes due 2015 and cash on hand. In January 2008, PAETEC obtained $100 million principal amount of additional term loans under an incremental facility extended pursuant to its existing credit facilities agreement and applied a portion of the borrowings under that facility toward the redemption of all of McLeodUSAs outstanding senior secured notes in connection with PAETECs acquisition of McLeodUSA.
In October 2008, in consideration of, among other matters, the adverse conditions in the credit markets and uncertainties concerning the timetable for a recovery of those markets, PAETEC obtained $50 million principal amount of revolving loans by a drawdown under its existing revolving credit facility. PAETEC used the proceeds of the revolving loans for capital expenditures, working capital and other general corporate purposes. During 2009, PAETEC paid down $20.0 million in aggregate principal amount of loans outstanding under the revolving credit facility.
In June 2009, to strengthen its financial position, PAETEC prepaid $330.5 million principal amount of borrowings under its senior secured credit facilities with the proceeds of an offering of $350 million principal amount of its 8 7/8% senior secured notes due 2017 and cash on hand. In January 2010, PAETEC prepaid the remaining $270.2 million principal amount of borrowings under its senior secured credit facilities with the proceeds of an additional offering of $300 million principal amount of its 8 7/8% senior secured notes due 2017. As a result of the two offerings, PAETEC eliminated its outstanding borrowings under its senior secured credit facilities and extended its debt maturities to 2015 and 2017 with limited impact to its cash flow generation capabilities.
Trends Affecting Our Business
General Economic Slowdown. Adverse conditions in the economy, which have significantly reduced the availability of corporate credit, are continuing to affect the global financial system and equity markets. These conditions and other factors have contributed to a slowdown of business activity across a broad range of industries. PAETEC believes that the financial and economic pressures faced by its business customers in this environment of diminished consumer spending, corporate downsizing and tightened credit have had, and may continue to have, an adverse effect on billable minutes of use and on customer attrition rates, and have resulted in and may continue to result in increased customer demands for price reductions in connection with contract renewals. In addition, as a result of the current conditions, PAETECs ability to access further the debt and equity markets may be restricted at a time when it would like, or need, to access such markets, which could have an adverse effect on PAETECs flexibility to react to changing economic and business conditions. The disruptions in the financial markets have had, and may continue to have, an adverse effect on the market value of PAETECs common stock, which could make it more difficult or costly for the company to raise capital through an offering of its equity securities.
Shifting Patterns of Use and Convergence of Technology. As telecommunications customers increasingly use wireless forms of communication, such as hand-held Internet access devices and cell phones, the volume of traffic carried by traditional wireline telecommunications networks has declined and is expected to continue to decline. Although PAETEC believes this trend is most pronounced in the residential marketplace, wireless substitution also has had an adverse effect on the wireline usage patterns of the medium-sized and large businesses and institutions PAETEC targets. PAETEC believes that wireless substitution has led to a decrease in the average minutes of use generated by its customers. To date, PAETEC has been able partially to offset this loss of revenue from existing customers through sales of services to new customers. PAETEC believes that the transition to wireless-based forms of communication will continue in the foreseeable future. PAETEC seeks to respond to this trend by offering service levels and product packages that are not currently available using wireless alternatives.
Voice and data traffic historically have traveled over telecommunications networks using incompatible transmission formats. This means that a telecommunications transmission circuit had to be designated to carry either data traffic or voice traffic. As a result, excess capacity on a voice circuit could not be made available to reduce demand on a data circuit. VoIP technology, which allows voice and data traffic to travel interchangeably over the same network, enables more efficient use of the telecommunications networks. Because PAETEC leases the majority of its transmission capacity, this increased efficiency has the potential to reduce significantly PAETECs cost of providing services to its customers. PAETEC continues to install equipment and transition its network to take advantage of these new technologies. PAETEC believes that, in operating a network using both traditional voice and newer VoIP technology, it is one of the leading competitive carriers in pursuing the benefits of technological convergence.
The combination of shifting patterns of use and increasing convergence of voice and data traffic could make it harder for PAETEC to sustain and improve its operating margins over the next several years. PAETEC believes that the challenges these trends may present will be offset in part by the efficiencies of operating a data network to which it will increasingly transition its traditional voice services.
Recent Growth of PAETEC. PAETEC primarily targets large, medium-sized and, to a lesser extent, small business end-user customers in providing a package of integrated communications services. Over the course of its recent merger transactions, PAETEC has acquired some customers and products that would not be considered consistent with PAETECs traditional operating focus. As PAETEC looks to increase its operating leverage, management anticipates that the company may choose not to enhance offerings to some customers or renew some customer relationships. Such actions may impact the rate of our future revenue growth compared to historical trends.
Competition; Evolving Regulatory Environment; Industry Consolidation. The telecommunications industry has remained highly competitive in an environment marked by increased deregulation. Market forces and changes in government regulations have required, and may continue to require, PAETEC to reduce rates for some of the services it provides. These trends may reduce PAETECs historical rate of revenue growth and continue to exert pressure on its operating margins. PAETEC believes that the relatively long-term nature of its agreements with customers of its network services, which as of March 1, 2010 have an average initial term of 35 months, should reduce the likelihood that it will experience significant, rapid decreases in the rates it charge for its services.
Mergers involving the RBOCs and deregulatory activity favoring RBOCs at both federal and state levels over the past several years have made it more difficult to compete against these larger, financially stronger competitors. Additional regulatory changes that would permit incumbent carriers to materially increase rates charged for accessing last mile connections or reduce PAETECs rates for certain network services could make it more difficult for our company to remain competitive.
PAETECs industry has experienced a significant amount of consolidation in recent periods. Merger and acquisition transactions have created more significant competitors for PAETEC and have reduced the number of vendors from which PAETEC may purchase network elements it leverages to operate its business. PAETEC expects this trend to continue in the near future. To compete more effectively in its industry, PAETEC plans to continue pursuing its historical acquisition strategy to increase its operating leverage, achieve economies of scale and broaden its name recognition.
Financial Difficulties Faced by Many Competitive Communications Carriers. Over the last seven years, many competitive communications services providers have experienced financial difficulties. These difficulties have led to the general perception that the competitive carrier sector of PAETECs industry is marred by instability and financial weakness. This perception makes it harder for PAETEC to gain new customers, raise additional capital and negotiate with vendors. PAETEC has addressed this perception by maintaining cash balances that are generally in excess of its current needs and by limiting its growth activities so that its short-term cash flow is not impaired.
PAETEC derives revenue from sales of its network services, carrier services and integrated solutions services. PAETEC derives most of its revenue from monthly recurring fees and usage-based fees that are generated principally by sales of its network services.
Monthly recurring fees include the fees paid by PAETECs customers for lines in service and additional features on those lines. PAETEC primarily bills monthly recurring fees in advance.
Usage-based fees consist of fees paid by PAETECs network services customers for each call made, fees paid by the incumbent carriers in PAETECs markets as reciprocal compensation when PAETEC terminates local calls made by their customers, and access fees paid by other carriers for long distance calls PAETEC originates or terminates for those carriers.
The monthly recurring fees and usage-based fees generated by sales of PAETECs network services to end users and carrier services to any customer tend to be relatively consistent from month to month, subject to changes in the calling patterns of the customers business. These fees generally are based on the number of digital T1 transmission lines used by the customer. Because PAETEC believes that the cumulative number of digital T1 transmission lines in service provides accurate information with respect to its revenue prospects, the company uses data with respect to the cumulative number of digital T1 transmission lines PAETEC has in service from period to period to assist it in evaluating revenue trends related to its network services and carrier services businesses.
Network Services. PAETEC delivers integrated communications services, including data and Internet services, local services and long distance services, to end users on a retail basis, which the company refers to as its network services. PAETECs core network services are those that generate revenue from retail enterprise customers to which PAETEC delivers such integrated communications services on primarily Tl or larger access lines, which excludes access fee and reciprocal compensation fee revenue related to network services and revenue from the companys non-core plain old telephone service, or POTS, operations. POTS operations involve the provision of basic telephone services supplying standard single line telephones, telephone lines and access to the public switched network.
PAETECs network services revenue consists primarily of monthly recurring fees and usage-based fees. In addition to usage-based fees invoiced directly to the end-user customers, usage-based fees for PAETECs network services include the interstate and intrastate access fees the company receives from other communications providers when it originates or terminates long-distance calls for those other providers to or from PAETECs network services customers, and the reciprocal compensation fees PAETEC receives from some other local carriers when it terminates non-toll calls originated by customers of other carriers. PAETEC recognizes revenue during the period in which the revenue is earned. PAETECs network services also generate non-recurring service activation and installation fee revenues, which it receives upon initiation of service. PAETEC defers recognition of these revenues and amortizes them over the average customer life.
Carrier Services. PAETEC generates revenue from wholesale sales of communications services to other communications businesses, which the company refers to as its carrier services. PAETECs core carrier services are those that generate revenue from other communications providers, which excludes access fee and reciprocal compensation fee revenue related to carrier services and revenue from the companys non-core POTS operations.
PAETECs carrier services revenue consists primarily of monthly recurring fees and usage-based fees. Usage-based fees for PAETECs carrier services consist primarily of the interstate and intrastate access fees the company receives from other communications providers when it originates or terminates long distance calls for those other providers to or from PAETECs carrier services customers, and the reciprocal compensation fees PAETEC receives from some other local carriers when it terminates to its carrier services customers local calls made by customers of other local carriers.
Access Fee and Reciprocal Compensation Revenue Generated by Network Services and Carrier Services. PAETEC generates access fees when PAETECs switching facilities provide a connection between a long distance carrier and an end user. In accordance with a May 2004 order by the FCC, PAETEC has designed its interstate access rates to equal the interstate access rates charged by the competing incumbent carrier for functionally equivalent access services, including all applicable fixed and traffic-sensitive charges. In the May 2004 order, the FCC announced a new rule that limits the interstate access fees competitive carriers like PAETEC are able to collect from a long distance carrier in situations where the competitive carriers do not provide service directly to the end user. This rule specifically targeted traffic that competitive carriers handle for wireless carriers and provided that competitive carriers could charge no more than incumbent carriers for these services.
State regulatory commissions historically have regulated the intrastate access rates imposed by incumbent carriers, but many states had subjected the intrastate access rates of competitive carriers to significantly less regulation. Some states in PAETECs geographic markets also require a competitive carrier to mirror the intrastate access rates of the incumbent carrier in that state or interstate rate levels. In 2008, California and Virginia adopted requirements requiring competitive carriers progressively to reduce their intrastate access rates over a limited period. In 2009, Massachusetts required competitive local exchange carriers to mirror the intrastate access rates of the incumbent local exchange carrier effective as of June 2010 unless a competitive local exchange carrier could justify higher cost-based access rates. Also in 2009, Michigan adopted legislation requiring competitive carriers to reduce intrastate rates to interstate rate levels over the next five years. In January 2010, New Jersey ordered all local exchange carriers, including competitive carriers, to transition to interstate rate levels over 36 months. Other state regulatory commissions have begun proceedings to investigate intrastate access rates of competitive carriers. Those proceedings may result in a change to the intrastate rates PAETEC assesses long distance carriers for use of the companys in-state networks. Further, if enacted, legislation pending in some states would require state agencies to order reductions in competitive carrier access charges.
Both the FCC and state regulatory commissions continue to review rules regarding the compensation local carriers pay to other local carriers for termination of local telephone calls as reciprocal compensation. Rates and terms for reciprocal compensation are based on agreements between PAETEC and other local carriers and are supported by federal and state regulatory and judicial rulings. The company is engaged in continuing discussions with large incumbent carriers, among others, to perpetuate its contractual arrangements for reciprocal compensation in relevant service territories. PAETEC has agreements in place with an increasing number of other local providers, including Qwest in its region, that require such termination services to be provided on a bill and keep basis in which neither carrier charges the other for terminating local calls.
All forms of intercarrier compensation, including exchange access and reciprocal compensation, currently are the subject of a generic proceeding at the FCC designed to reform the way carriers and providers pay other carriers and providers for use of their respective networks.
Integrated Solutions. PAETEC derives revenue from sales to retail end-user customers of telecommunications equipment and software and related services, which the company refers to as its integrated solutions.
A portion of PAETECs integrated solutions revenue consists of fees its customers pay for equipment and for PAETECs system design and installation services. PAETEC recognizes revenue for equipment sales and system design and installation services upon delivery and acceptance of the underlying equipment.
PAETEC derives an additional component of its integrated solutions revenue by selling and supporting its proprietary telecommunications software. PAETEC recognizes revenue related to software sales upon delivery of the software. Support fees include fees for maintenance of PAETECs telecommunications software and fees for training the end user in the proper use of that software. PAETEC recognizes maintenance fees on a pro rata basis over the length of the underlying maintenance contract and training fees after it fulfills the training obligation.
Cost of Sales
PAETEC provides its network services and carrier services by using electronic network components that it owns and telephone and data transmission lines that it leases from other telecommunications carriers. PAETECs cost of sales for these services consists primarily of leased transport charges and usage costs for local and long distance calls. PAETECs leased transport charges are the payments it makes to lease the telephone and data transmission lines, which the company uses to connect its customers to its network and to connect its network to the networks of other carriers. Usage costs for local and long distance are the costs that PAETEC incurs for calls made by its customers. Cost of sales for PAETECs integrated solutions includes the costs it incurs in designing systems and purchasing and installing equipment.
Selling, General and Administrative Expenses
PAETECs selling, general and administrative expenses include selling and marketing, customer service, billing, corporate administration, engineering personnel and other personnel costs.
PAETEC assesses the carrying value of its goodwill annually or as events or circumstances change. In accordance with its impairment assessment process, PAETEC recorded a non-cash impairment charge of $340.0 million in the third quarter of 2008 based on a preliminary assessment in that quarter, and recorded an additional non-cash charge of $15.0 million in the fourth quarter of 2008 based on the finalization of that preliminary assessment. The goodwill impairment charges were attributable to weaker economic conditions in PAETECs markets. For more information about PAETECs impairment review policies, see Critical Accounting Policies below. There was no change in goodwill during the year ended December 31, 2009.
Depreciation and Amortization
Depreciation and amortization include depreciation of PAETECs telecommunications network and equipment, computer hardware and purchased software, office equipment, furniture and fixtures, and buildings, as well as amortization of intangible assets.
Debt Extinguishment and Related Costs
PAETECs debt extinguishment and related costs include expenses related to the repayment of outstanding term loans under PAETECs senior secured credit facilities, costs incurred related to the reduction of the notional amount of its swap agreement in effect as of June 30, 2009, and the reclassification into earnings of derivative losses previously reported in accumulated other comprehensive loss, due to the discontinuation of hedge accounting treatment of PAETECs swap agreement in effect as of December 31, 2009.
Interest expense includes interest due on borrowings under PAETECs senior secured credit facilities, the 9.5% senior notes due 2015 and the 8 7/8% senior secured notes due 2017, amortization of debt issuance costs, debt discounts, and interest due on PAETECs capital lease obligations and other debt.
Other Income, Net
Other income, net includes non-monetary gains on the exchange of reciprocal indefeasible rights of use, or IRUs, investment income, and other financing income.
Accounting for Income Taxes
PAETEC recognizes deferred income tax assets and liabilities for the expected future tax consequences of transactions and events. Under this method, PAETEC determines deferred income tax assets and liabilities based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which it expects the differences to reverse. If necessary, PAETEC reduces deferred income tax assets by a valuation allowance to an amount that it determines is more likely than not to be recoverable. PAETEC makes significant estimates and assumptions about future taxable income and future tax consequences to determine the amount of the valuation allowance.
PAETECs employees participate in a variety of equity incentive plans. Stock-based compensation expense for all stock-based compensation awards is based on the grant date fair value estimated in accordance with the
Financial Accounting Standards Board, or FASB, ASC Topic 718, CompensationStock Compensation. PAETEC recognizes these compensation costs, net of an estimated forfeiture rate, ratably over the requisite service period of the award.
Adjusted EBITDA Presentation
Adjusted EBITDA, as defined by PAETEC for the periods presented in this managements discussion and analysis, represents net (loss) income before depreciation and amortization, interest expense, provision for (benefit from) income taxes, stock-based compensation, sales and use tax settlement, impairment charge, integration and separation costs, gain on non-monetary transaction, debt extinguishment and related costs, leveraged recapitalization related costs, and change in fair value of Series A convertible redeemable preferred stock conversion right. PAETECs adjusted EBITDA is not a measure of financial performance under GAAP. This non-GAAP financial measure is used by PAETECs management, together with financial measurements prepared in accordance with GAAP such as net (loss) income and revenue, to assess PAETECs historical and prospective operating performance.
Management uses adjusted EBITDA to enhance its understanding of PAETECs core operating performance, which represents managements views concerning PAETECs performance in the ordinary, ongoing and customary course of its operations. Management historically has found it helpful, and believes that investors have found it helpful, to consider an operating measure that excludes expenses, such as integration and separation costs, debt extinguishment and related costs, and impairment charges, relating to transactions not reflective of PAETECs core operations. In the future, the company expects that it may again report adjusted EBITDA excluding the items discussed below and may incur expenses similar to the excluded items discussed below. Accordingly, the exclusion of these and other similar items in PAETECs non-GAAP presentation should not be interpreted as implying that these items are non-recurring, infrequent or unusual. Management believes that, for the reasons discussed below, PAETECs use of a supplemental financial measure which excludes these expenses facilitates an assessment of PAETECs fundamental operating trends and addresses concerns of management and of PAETECs investors that these expenses may obscure such underlying trends. Management notes that each of these expenses is presented in PAETECs financial statements and discussed in the managements discussion and analysis section of PAETECs reports filed with the Securities and Exchange Commission, so that investors have complete information about the expenses.
The information about PAETECs core operating performance provided by this financial measure is used by management for a variety of purposes. Management regularly communicates its adjusted EBITDA results to its board of directors and discusses with the board managements interpretation of such results. Management also compares the companys adjusted EBITDA performance against internal targets as a key factor in determining cash bonus compensation for executives and other employees, largely because management feels that this measure is indicative of the how the fundamental business is performing and is being managed. In addition, PAETECs management uses adjusted EBITDA to evaluate PAETECs performance relative to that of its competitors. This financial measure permits a comparative assessment of PAETECs operating performance relative to the companys performance based on its GAAP results, while isolating the effects of certain items that vary from period to period without any correlation to core operating performance or that vary widely among similar companies.
Management believes that adjusted EBITDA is a particularly useful comparative measure within PAETECs industry. The communications industry has experienced recent trends of increased merger and acquisition activity and financial restructurings. These activities have led to significant charges to earnings, such as those resulting from integration costs and debt restructurings, and to significant variations among companies with respect to capital structures and cost of capital (which affect interest expense) and differences in taxation and book depreciation of facilities and equipment (which affect relative depreciation expense), including significant differences in the depreciable lives of similar assets among various companies. Adjusted EBITDA facilitates company-to-company comparisons in the communications industry by eliminating some of the foregoing
variations. Management believes that because of the variety of equity awards used by companies, the varying methodologies for determining both stock-based compensation and stock-based compensation expense among companies and from period to period, and the subjective assumptions involved in those determinations, excluding stock-based compensation from adjusted EBITDA enhances company-to-company comparisons over multiple fiscal periods. By permitting investors to review both the GAAP and non-GAAP measures, PAETEC and its peers that customarily use similar non-GAAP measures facilitate an enhanced understanding of historical financial results and enable investors to make more meaningful company-to-company comparisons.
PAETEC also provides information relating to its adjusted EBITDA so that analysts, investors and other interested persons have the same data that management uses to assess PAETECs core operating performance. Management believes that adjusted EBITDA should be viewed only as a supplement to the GAAP financial information. Management also believes, however, that providing this information in addition to, and together with, GAAP financial information permits the foregoing persons to obtain a better understanding of PAETECs core operating performance and to evaluate the efficacy of the methodology and information used by management to evaluate and measure such performance on a standalone and a comparative basis.
PAETECs adjusted EBITDA may not be directly comparable to similarly titled measures reported by other companies due to differences in accounting policies and items excluded or included in the adjustments, which limits its usefulness as a comparative measure. In addition, adjusted EBITDA has other limitations as an analytical financial measure. These limitations include the following:
PAETECs management compensates for these limitations by relying primarily on PAETECs GAAP results to evaluate its operating performance and by considering independently the economic effects of the foregoing items that are or are not reflected in adjusted EBITDA. Management also compensates for these limitations by providing GAAP-based disclosures concerning the excluded items in its financial disclosures. As a result of these limitations, however, adjusted EBITDA should not be considered as an alternative to net (loss) income, as calculated in accordance with GAAP, as a measure of operating performance, or as an alternative to any other GAAP measure of operating performance.
Results of Operations
The following table presents selected operating data for the fiscal years ended December 31, 2009, 2008 and 2007. The comparison of PAETECs operating results for 2009 to PAETECs operating results for 2008 is materially affected by the acquisition by PAETEC Holding Corp. of McLeodUSA on February 8, 2008. McLeodUSAs operating results are included in PAETECs operating results beginning on February 9, 2008. In
addition, the following comparison of PAETECs operating results for 2008 to PAETECs operating results for 2007 is materially affected by both the acquisition of McLeodUSA and by the combination of PAETEC Corp. and US LEC on February 28, 2007. As a result of the US LEC merger, US LECs operating results are included in PAETECs results for 2007 beginning on March 1, 2007. Because of the significance of both merger transactions, PAETECs operating results for 2009, 2008 and 2007 are not directly comparable. PAETECs operating results for those years were as follows (dollars in thousands):
(footnotes continued on following page)
2009 Compared With 2008
Revenue. Total revenue increased $9.8 million, or 0.6%, to $1,580.2 million for 2009 from $1,570.4 million for 2008, principally due to a 12.9% increase in PAETECs data revenue and the inclusion of McLeodUSAs results for the full 2009 period. Of total revenue for 2009, revenue from network services, carrier services and integrated solutions accounted for 79.6%, 16.5% and 3.9%, respectively, compared to 78.8%, 17.3% and 3.9%, respectively, for 2008.
Revenue from network services increased $20.8 million, or 1.7%, to $1,258.5 million for 2009 from $1,237.7 million for 2008. For 2009, revenue from monthly recurring fees and usage-based fees accounted for 72.3% and 26.6%, respectively, of revenue from network services, compared to 71.6% and 27.8%, respectively, of such revenue for 2008. Revenue from core network services accounted for 72.3% of total revenue for 2009, compared to 70.5% for 2008. Revenue from core network services increased $34.3 million, or 3.1%, to $1,141.8 million for 2009 from $1,107.5 million for 2008. The increase in core network services revenue primarily resulted from a 13.0% increase in PAETECs data revenue generated by increased sales of its Dynamic IP and MPLS VPN products, the inclusion of McLeodUSAs results for the full 2009 period, and an increase in the number of digital T1 transmission lines in service. Growth of the network services business was affected by lower billable minutes of use, increased pricing pressure, and continued customer attrition, particularly in the non-strategic POTS portion of the business obtained as part of the McLeodUSA acquisition.
Revenue from carrier services decreased $11.3 million, or 4.1%, to $260.0 million for 2009 from $271.3 million for 2008. Revenue from core carrier services accounted for 11.9% of total revenue for 2009, compared to 11.6% for 2008. The decrease in carrier services revenue primarily resulted from a decrease in access fee revenue and reciprocal compensation. For 2009, revenue from monthly recurring fees and usage-based fees accounted for 47.2% and 43.4%, respectively, of revenue from carrier services, compared to 42.0% and 49.9%, respectively, of such revenue for 2008. The increase in monthly recurring fees as a percentage of total carrier services revenue was primarily attributable to the inclusion of McLeodUSAs results for the full 2009 period, as monthly recurring fees historically have represented a higher percentage of total carrier services revenue of McLeodUSAs business than of PAETECs business.
Access fee revenue and reciprocal compensation included in network services revenue and access fee revenue and reciprocal compensation included in carrier services revenue together accounted for 8.0% of total revenue for 2009, compared to 8.6% for 2008. Reciprocal compensation revenue included in network services revenue and reciprocal compensation revenue included in carrier services revenue together accounted for 1.2% of total revenue for 2009, compared to 1.6% for 2008. Access fee revenue as a percentage of network services
usage-based fees increased to 19.3% for 2009 from 17.7% for 2008, while reciprocal compensation as a percentage of network services usage-based fees increased slightly to 2.1% for 2009 from 2.0% for 2008. Network access fee revenue grew primarily due to the inclusion of McLeodUSAs results for the full 2009 period. Access fee revenue as a percentage of carrier services usage-based fees increased to 37.5% for 2009 from 37.1% for 2008. Reciprocal compensation as a percentage of carrier services usage-based fees decreased to 11.2% for 2009 from 13.2% for 2008. The decrease in reciprocal compensation as a percentage of carrier services usage-based fees was principally attributable to a shift in product mix toward IP-based services and other services that do not generate as much or any reciprocal compensation for PAETEC. PAETEC believes that the decrease also reflected in part adverse economic conditions in PAETECs markets that have contributed to usage-related pressure experienced by the carrier services business. The carrier services business also experienced a loss of some wireless customers, which PAETEC believes is primarily due to continuing consolidation in the wireless communications industry.
Revenue from integrated solutions services increased $0.2 million, or 0.4%, to $61.7 million for 2009 from $61.4 million for 2008. The increase in revenue generated by the integrated solutions business, which has a longer revenue cycle causing irregular trends on a quarterly basis, was attributable to growth in equipment sales.
Cost of Sales. Cost of sales increased slightly to $782.4 million for 2009 from $781.3 million for 2008, primarily due to the inclusion of McLeodUSAs results for the full 2009 period.
Leased transport charges increased to $610.6 million, or 78.0% of cost of sales, for 2009 from $583.4 million, or 74.7% of cost of sales, for 2008, primarily due to the inclusion of McLeodUSAs results for the full 2009 period.
Usage costs for local and long distance calls decreased to $131.0 million, or 16.7% of cost of sales, for 2009 from $153.2 million, or 19.6% of cost of sales, for 2008. The decrease was attributable in part to a decline in the average usage rates PAETEC is charged by network providers, as well as to a decline in minutes of use.
Cost of sales as a percentage of total revenue decreased slightly from 49.8% for 2008 to 49.5% for 2009.
Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased to $559.5 million for 2009 from $572.2 million for 2008. The decrease was primarily due to a decline in salaries, wages and benefits and a decrease in sales and marketing expenses. The decrease was partially offset by the inclusion of McLeodUSAs results for the full 2009 period, which resulted in an increase in facilities expense to support the companys more extensive network infrastructure after the McLeodUSA acquisition. Selling, general and administrative expenses as a percentage of total revenue decreased to 35.4% for 2009 from 36.4% for 2008.
Sales and Use Tax Settlement. PAETEC recognized a $7.2 million benefit recorded as a sales and use tax settlement in the accompanying consolidated statements of operations and comprehensive (loss) income during the year ended December 31, 2009 as a result of settlement agreements entered into with the Iowa Department of Revenue. These assessments, including estimated interest and penalties, originally amounted to approximately $16.5 million. PAETEC entered into settlement agreements with the Iowa Department of Revenue in April 2009 and January 2010, resolving a substantial portion of the disputed assessments. See Legal Proceedings for more information.
Depreciation and Amortization. Depreciation and amortization expense increased to $184.6 million for 2009 from $174.3 million for 2008, largely due to the inclusion of McLeodUSAs results for the full 2009 period.
Debt Extinguishment and Related Costs. During 2009, PAETEC recognized a total of $17.9 million of debt extinguishment and related costs. In connection with the June 2009 issuance of its 8 7/8% senior secured notes due 2017, PAETEC recognized $10.3 million of debt extinguishment and related costs, which reflected the elimination of $5.8 million of debt issuance costs and unamortized debt discount related to the repayment of
approximately $330.5 million of outstanding term loans under the companys existing senior secured credit facilities and $4.5 million of costs incurred related to the reduction of the notional amount of its swap agreement in effect as of June 30, 2009 from $400.0 million to $265.0 million. PAETEC recognized another $7.5 million of debt extinguishment and related costs in connection with the December 2009 reclassification into earnings of derivative losses previously reported in accumulated other comprehensive loss , due to the discontinuation of hedge accounting treatment of PAETECs swap agreement in effect as of December 31, 2009.
Interest Expense. PAETECs average outstanding debt balances increased to $933.2 million for 2009 from $878.2 million for 2008, primarily as a result of the $50.0 million principal amount of loans PAETEC obtained in October 2008 under its revolving credit facility and also as a result of PAETECs issuance in June 2009 of its senior secured notes and application of the note proceeds to repay outstanding credit facility term loans. Interest expense increased slightly to $74.1 million for 2009 from $73.7 million for 2008, as the effect of higher debt levels and PAETECs issuance in June 2009 of its senior secured notes was offset by a decline in the weighted average annual borrowing rates under PAETECs credit facilities and its notes to 7.6% for 2009 from 7.8% for 2008.
Income Taxes. PAETEC recorded a tax benefit of $1.4 million for the year ended December 31, 2009, which represented an effective tax rate of 4.5%. The difference between the statutory rate and PAETECs effective tax rate for the tax year ended December 31, 2009 was primarily attributable to a $7.0 million tax charge to establish the valuation allowance on net operating losses generated in the current year, and the effect of non-deductible stock-based compensation.
PAETEC recorded a tax provision of $89.8 million for 2008, which represented an effective tax rate of (22)%. The difference between the statutory rate and PAETECs effective tax rate for the tax year ended December 31, 2008 was primarily attributable to a $355.0 million non-deductible goodwill impairment charge, a $104.3 million tax charge to establish a valuation allowance, and the effect of non-deductible stock-based compensation.
Deferred income tax assets or liabilities reflect temporary differences between amounts of assets and liabilities, including net operating loss, or NOL, carryforwards, for financial and tax reporting. Such amounts are adjusted as appropriate to reflect changes in the tax rates expected to be in effect when the temporary differences reverse. A valuation allowance is established for any deferred income tax asset for which realization is uncertain.
PAETEC considers all available positive and negative evidence, including future reversals of existing temporary differences, projected future taxable income and recent financial operations, to determine whether, based on the weight of that evidence, a valuation allowance is needed for some portion or all of a net deferred income tax asset. Judgment is used in considering the relative impact of negative and positive evidence. In arriving at these judgments, the weight given to the potential effect of negative and positive evidence is commensurate with the extent to which such evidence can be objectively verified. In evaluating the objective evidence provided by historical results, PAETEC considered the past three years of combined results on a pro forma basis that included the results of McLeodUSA and of US LEC beginning on January 1, 2007.
Based on an assessment of the available positive and negative evidence, including the historical pro forma combined results, PAETEC determined that there are uncertainties relative to its ability to utilize the net deferred tax assets. In recognition of these uncertainties, PAETEC has provided a valuation allowance of $367.9 million on the net deferred income tax assets as of December 31, 2009. A valuation allowance of $368.2 million existed on the net deferred income tax assets as of December 31, 2008, resulting in a net decrease of $0.3 million in the year ended December 31, 2009, of which $7.0 million represents a charge to income tax expense and the offsetting $7.3 million decrease to equity. PAETEC will continue to evaluate the need for a valuation allowance in the future and if it is determined that its deferred tax assets are realizable, an adjustment to the valuation allowance will be reflected.
Upon the January 1, 2009 adoption of ASC 805, Business Combinations, changes in deferred tax asset valuation allowances and income tax uncertainties after an acquisition date generally will affect income tax expense, including charges and uncertainties associated with acquisitions that closed prior to the effective date of ASC 805.
As of December 31, 2009, PAETEC had federal NOL carryforwards of approximately $962.7 million, including approximately $300.0 million of NOL carryforwards acquired as part of the February 8, 2008 merger with McLeod. PAETEC has recorded a deferred income tax asset of approximately $381.4 million reflecting the benefit of federal and state loss carryforwards. If unused, the NOL carryforwards would expire on various dates from 2016 through 2029. In recognition of the uncertainties relative to the utilization of the federal NOLs, a full valuation allowance has been recorded.
Included in the NOL carryforward deferred tax asset above is approximately $44.4 million of deferred tax assets attributable to state NOLs. Management believes that it is more likely than not that the benefit from certain state NOL carryforwards will not be realized prior to their expiration. In recognition of this uncertainty, PAETEC has provided a valuation allowance of $43.8 million on the deferred tax assets related to the state NOL carryforwards.
As a result of the realization requirements of ASC 718, CompensationStock Compensation, PAETECs deferred tax assets at December 31, 2009 do not include approximately $89.7 million of excess tax benefits from employee stock option exercises that are a component of PAETECs NOL carryforwards. Equity will be increased by approximately $31.4 million if and when such deferred tax assets are ultimately realized for federal income tax purposes. PAETEC uses ordering pursuant ASC 740, Income Taxes, for purposes of determining when excess tax benefits have been realized.
ASC 740 also provides guidance to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing a minimum recognition threshold, which income tax positions must achieve before being recognized in the financial statements. ASC 740 requires expanded annual disclosures, including a rollforward of the beginning and ending aggregate unrecognized tax benefits as well as specific information related to tax uncertainties for which it is reasonably possible the amount of unrecognized tax benefit will significantly increase or decrease within twelve months. The amount of unrecognized tax benefits from uncertain tax positions, including interest, at December 31, 2009 was $0.6 million, the majority of which, if recognized, would affect the effective tax rate.
2008 Compared With 2007
Revenue. Total revenue increased $529.4 million, or 50.9%, to $1,570.4 million for 2008 from $1,041.0 million for 2007, principally because of the inclusion of McLeodUSAs results for the majority of 2008. Of total revenue for 2008, revenue from network services, carrier services and integrated solutions services accounted for 78.8%, 17.3% and 3.9%, respectively, compared to 82.2%, 13.9% and 3.9%, respectively, for 2007.
Revenue from network services increased $381.8 million, or 44.6%, to $1,237.7 million for 2008 from $855.8 million for 2007. For 2008, revenue from monthly recurring fees and usage-based fees accounted for 71.6% and 27.8%, respectively, of revenue from network services, compared to 66.6% and 31.2%, respectively, of such revenue for 2007. The increase in network services revenue primarily resulted from an increase in the number of digital T1 transmission lines in service from 119,987 lines as of December 31, 2007 to 215,768 lines as of December 31, 2008, of which McLeodUSA accounted for 82,109 lines, as well as from increased revenue from application services and network security products. Growth of the network services business was constrained by fewer than expected billable minutes of use, increased pricing pressure, and an increase in customer attrition rates.
Revenue from carrier services increased $126.4 million, or 87.2%, to $271.3 million for 2008 from $144.9 million for 2007. The increase in carrier services revenue primarily resulted from an increase in the number of digital T1 transmission lines in service, as well as growth of new integrated T1 services and multi-site VPN sales. For 2008, revenue from monthly recurring fees and usage-based fees accounted for 42.0% and 49.9%, respectively, of revenue from carrier services, compared to 30.3% and 68.8%, respectively, of such revenue for 2007. The increase in monthly recurring fees as a percentage of total carrier services revenue was primarily attributable to the inclusion of McLeodUSAs results for a majority of 2008, as monthly recurring fees historically have represented a higher percentage of total carrier services revenue of McLeodUSAs business than of PAETECs business.
Access fee revenue represented 37.1% of carrier services usage-based fees for 2008 and 45.3% of carrier services usage-based fees for 2007. Reciprocal compensation constituted 13.2% of carrier services usage-based fees for 2008 and 16.4% of carrier services usage-based fees for 2007. The decrease in access fees and reciprocal compensation as a percentage of carrier services usage-based fees was principally attributable to a shift in product mix toward IP-based and other services that do not generate as much or any access fee revenue or reciprocal compensation for PAETEC. PAETEC believes that the decrease also reflected in part adverse economic conditions in PAETECs markets that have contributed to usage-related pressure experienced by the carrier services business. The carrier services business also experienced a loss of some wireless customers, which PAETEC believes is primarily due to consolidation in the wireless communications industry.
Revenue from integrated solutions services increased $21.2 million, or 52.6%, to $61.4 million for 2008 from $40.3 million for 2007. The increase in revenue generated by the integrated solutions business, which has a longer revenue cycle causing irregular trends on a quarterly basis, is partly attributable to PAETECs acquisition of Allworx Corp. during the fourth quarter of 2007. The operations of Allworx Corp. contributed $10.7 million to integrated solutions revenue for 2008.
Cost of Sales. Cost of sales increased to $781.3 million for 2008 from $491.7 million for 2007, in part because of the inclusion of McLeodUSAs results for a majority of 2008. In each period, cost of sales consisted primarily of leased transport charges and usage costs for local and long distance calls.
Leased transport charges increased to $494.3 million, or 63.3% of cost of sales, for 2008 from $363.2 million, or 73.9% of cost of sales, for 2007. The decrease as a percentage of cost of sales was primarily attributable to the inclusion of McLeodUSAs results, which reflect charges based on a broader facilities-based owned network, for the majority of 2008.
Usage costs for local and long distance calls increased to $153.2 million, or 19.6% of cost of sales, for 2008 from $101.8 million, or 20.7% of cost of sales, for 2007. The increase was partially offset by a decrease in the average usage rates PAETEC is charged by network providers.
Cost of sales as a percentage of total revenue increased from 47.2% for 2007 to 49.8% for 2008. This increase was primarily attributable to the inclusion of the results of US LEC and Allworx Corp. for the full 2008 period and the inclusion of McLeodUSAs results for a majority of 2008. Cost of sales as a percentage of revenue historically has been higher for the acquired companies than for PAETEC. The increase in cost of sales also reflected the costs associated with an increase in equipment sales, an upgrade in PAETECs Southeast data network, and an increase in lower margin wholesale traffic.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased to $572.2 million for 2008 from $373.7 million for 2007. The increase was primarily attributable to PAETECs acquisition of McLeodUSA. The acquisition contributed to an increase in salaries, wages, commissions and benefits of $101.7 million, of which $98.0 million was due to an increase in the total number of employees from approximately 2,400 at December 31, 2007 to approximately 3,700 at December 31, 2008, and $7.1 million was due to an increase in sales commissions paid to PAETECs sales force for their contribution to the increase in total revenue. An increase in facilities expense necessary to support the broader network infrastructure after the
McLeodUSA acquisition also contributed to the total increase in selling, general and administrative expenses. Selling, general and administrative expenses as a percentage of total revenue increased to 36.4% for 2008 from 35.9% for 2007.
Impairment Charge. As discussed above under Overview, PAETEC determined that goodwill was impaired and recorded a non-cash charge of $340.0 million in the third quarter of 2008 based on a preliminary assessment. In the fourth quarter of 2008, management finalized the assessment and recorded an additional non-cash charge of $15.0 million.
Integration and Separation Costs. PAETEC recorded $12.1 million of integration and separation costs in 2008. In connection with the McLeodUSA merger, PAETEC incurred integration costs of approximately $6.7 million in 2008, primarily related to costs associated with employee separations. PAETEC also incurred approximately $5.4 million of separation costs as a result of the involuntary employee separations announced in the fourth quarter of 2008.
Depreciation and Amortization. Depreciation and amortization expense increased to $174.3 million for 2008 from $75.2 million for 2007. The increase was primarily attributable to increased depreciation expense resulting from an increase of $461.7 million in gross property and equipment since December 31, 2007, largely as a result of property and equipment obtained in the acquisition of McLeodUSA and as part of PAETECs network deployment and maintenance. The increase was also partly attributable to the write-up of intangible assets associated with the US LEC, McLeodUSA, and Allworx Corp. acquisitions. The increase in depreciation and amortization expense was offset in part as PAETEC ceased to record depreciation on some of its older equipment that had reached the end of its useful life.
Interest Expense. Interest expense increased to $73.7 million for 2008 from $68.4 million for 2007, due to the higher average outstanding debt balances during 2008 that resulted from the $300 million principal amount of 9.5% senior notes PAETEC issued in July 2007, the $100 million incremental term loan facility PAETEC obtained in January 2008, and the $50.0 million principal amount of revolving loans PAETEC obtained in October 2008. The average outstanding debt balances were $878.2 million for 2008 and $729.8 million for 2007. As of December 31, 2008 and 2007, borrowing rates under the senior secured credit facilities and the 9.5% senior notes averaged 7.8% and 8.4%, respectively.
Income Taxes. PAETEC recorded a tax provision of $89.8 million for 2008, which represented an effective tax rate of (22)%. The difference between the statutory rate and PAETECs effective tax rate for the tax year ended December 31, 2008 was primarily attributable to the $355.0 million non-deductible goodwill impairment charge discussed above, a $104.3 million tax charge to establish the valuation allowance described below, and the effect of non-deductible stock-based compensation.
Based on an assessment of the available positive and negative evidence, including the historical pro forma combined results, PAETEC determined that there are uncertainties relative to its ability to utilize the net deferred tax assets. In recognition of these uncertainties, PAETEC provided a valuation allowance of $368.2 million on the net deferred income tax assets as of December 31, 2008. A valuation allowance of $20.3 million existed on the net deferred income tax assets as of December 31, 2007, resulting in an increase of $347.9 million in 2008, of which $104.3 million represents a charge to income tax expense and $243.6 million represents a charge to goodwill or equity as it relates primarily to purchase accounting for the McLeodUSA acquisition. If PAETEC were to determine that it could realize its deferred tax assets in the future in excess of their net recorded amount, it would make an adjustment to the valuation allowance.
PAETEC acquired approximately $3.8 billion of NOLs pursuant to the McLeodUSA acquisition. Section 382 of the Internal Revenue Code of 1986, or IRC Section 382, places annual limitations on the use of some tax attributes such as net operating losses and tax credit carryovers in existence at the time of an ownership change. As a result of the acquisition, McLeodUSA experienced an ownership change within the meaning of IRC Section 382. PAETEC has determined that the acquired NOLs will be subject to substantial limitations under IRC Section 382 as a result of the ownership change.
As of December 31, 2008, PAETEC had a deferred tax asset for federal NOL carryforwards of approximately $856.9 million, including the approximately $300.0 million of NOL carryforwards acquired as part of the McLeodUSA acquisition. PAETEC recorded a deferred income tax asset of approximately $339.6 million that reflected the benefit of federal and state loss carryforwards as of December 31, 2008.
Included in the NOL carryforward deferred tax asset above is approximately $39.7 million of deferred tax assets attributable to state NOLs. Approximately $15.4 million of this deferred tax asset relates to NOLs acquired pursuant to the McLeodUSA acquisition. Management believes that it is more likely than not that the benefit from some state NOL carryforwards will not be realized before their expiration. In recognition of this risk, as of December 31, 2008 PAETEC provided a valuation allowance of $39.0 million on the deferred tax assets related to the state NOL carryforwards.
As a result of some realization requirements of ASC 718, PAETECs deferred tax assets at December 31, 2008 do not include approximately $86.8 million of excess tax benefits from employee stock option exercises that are a component of the companys NOL carryovers.
On January 1, 2007, PAETEC adopted the provisions of ASC 740 relating to uncertain tax positions, and recorded a reduction of retained earnings of $0.2 million effective January 1, 2007. The amount of unrecognized tax benefits from uncertain tax positions at December 31, 2008 was $0.4 million, the majority of which, if recognized, would affect the effective tax rate.
Critical Accounting Policies
PAETECs consolidated financial statements are prepared in accordance with generally accepted accounting principles, which require PAETEC to make estimates and assumptions. Of PAETECs significant accounting policies described in Note 2 to the audited consolidated financial statements appearing elsewhere in this report, PAETEC believes that the following policies may involve a higher degree of judgment and complexity.
Revenue Recognition. PAETEC generates recurring operating revenue pursuant to contracts with PAETECs customers and non-recurring revenue pursuant to non-recurring agreements. PAETEC recognizes revenue in accordance with generally accepted accounting principles, which require satisfaction of the following four basic criteria before revenue can be recognized:
PAETEC bases its determination of the third and fourth criteria above on the companys judgment regarding the fixed nature of the fee it has charged for the services rendered and products delivered, and the prospects that those fees will be collected. If changes in conditions should cause it to determine that these criteria likely will not be met for some future transactions, revenue recognized for any reporting period could be materially adversely affected.
Management makes estimates of future customer credits through the analysis of historical trends and known events. The provisions for revenue adjustments are recorded as a reduction of revenue when incurred. Since any revenue allowances are recorded as an offset to revenue, any future increases or decreases in the allowances will positively or negatively affect revenue by the same amount.
Network Services and Carrier Services Revenue. PAETEC derives revenue primarily from its sale of communications services. PAETECs service revenue consists principally of usage fees and monthly recurring fees.
Usage fees consist of fees paid by PAETECs customers for each call made, fees paid by the incumbent carriers in PAETECs markets as reciprocal compensation when the company terminates non-toll calls originated by their customers, and access fees paid by carriers for long distance calls that PAETEC originates and terminates. PAETEC recognizes revenue related to usage fees when the service is provided. PAETEC bills usage fees in arrears and uses estimates to recognize revenue for unbilled usage fees. PAETECs ability to generate reciprocal compensation revenue and access revenue is subject to numerous regulatory and legal proceedings. Until these proceedings are ultimately resolved, PAETECs policy is to recognize reciprocal compensation and access revenue only when it concludes that its realization of that revenue is reasonably assured.
Monthly recurring fees include the fees paid by PAETECs customers for lines in service and additional features on those lines. Monthly recurring fees are paid by PAETECs end-user customers and are billed in advance. PAETEC recognizes this revenue during the period in which it is earned.
PAETEC has arrangements where it recognizes revenue in accordance with ASC 605-20, Revenue Recognition Services, which requires some non-recurring service activation and installation fee revenues that are payable in advance of the provision of services to be deferred over the average customer life. In accordance with those guidelines, PAETEC defers service activation and installation fee revenues and related costs and amortizes them over the average customer life, which is primarily three years.
The revenue from indefeasible rights to use fiber optic telecommunications network facilities is recognized over the term of the related lease unless it qualifies as a sales type lease, for which revenue is recognized at the time the sale criteria in ASC 605-976, Real EstateRetail Land, are met. Base annual revenue for telecommunications network maintenance is recognized on a straight-line basis over the term of the contract. Additional services provided under these contracts are recognized as the services are performed.
Integrated Solutions Revenue. PAETEC also derives revenue from sales of telecommunications equipment and software. Equipment revenue consists of fees PAETECs customers pay for equipment and for PAETECs system design and installation services. PAETEC recognizes equipment revenue upon delivery and acceptance of the equipment. PAETEC derives software revenue through selling and supporting its proprietary telecommunications software. PAETEC recognizes revenue related to software sales upon delivery and acceptance of the software in accordance with ASC 605-985, Software. Support fees include fees for maintenance of PAETECs telecommunications software and fees for training the end user in the proper use of PAETECs telecommunications software. PAETEC recognizes maintenance fees pro rata over the length of the underlying maintenance contract. PAETEC recognizes training fees after the training obligation has been fulfilled.
Allowance for Doubtful Accounts. To determine its allowance for bad debts, PAETEC uses estimates based on the companys historical collection experience, its assessment of current industry and economic trends, customer concentrations and its credit policies. As of December 31, 2009, PAETEC had reserved for $11.9 million of bad debts.
PAETEC has reserved for expected bad debt losses based on the factors referred to above, and believes that its reserves are adequate. It is possible, however, that the sufficiency of PAETECs estimates could become materially inadequate as the composition of PAETECs receivables changes over time. PAETEC continually reviews and refines the estimation process to take account of these changes, but from time to time the company may need to adjust its estimate to reflect actual experience.
Cost of Sales. Costs of sales are composed primarily of network costs, which are costs incurred for leased transport charges and for transmission of voice and data services over other carriers networks. These costs consist of both fixed payments and variable amounts based on actual usage and negotiated or regulated contract rates. PAETEC expenses network costs as incurred. These costs include PAETECs estimate of charges for which it has not yet received bills, and are based upon the estimated number of transmission lines and facilities
PAETEC has in service and its estimated minutes of use based on internal reports. Once PAETEC receives an invoice from a carrier, the company begins a process of reconciling that carriers invoice to PAETECs internal reports. Once the reconciliation is complete, PAETEC follows contractual terms to dispute any erroneous billing and, ultimately, agrees with the carrier on the final amount due. In some cases, this reconciliation process can take several months to complete. PAETEC may make subsequent adjustments to its estimates after it receives bills for the actual costs it incurs, but PAETEC generally does not expect that these adjustments will be material to its operating results. Accordingly, PAETECs accrual for network costs includes estimates for which the reconciliation of the carriers invoices to PAETECs internal reports has not been completed. Because of the significance of access costs, the complexity of the systems that capture accrual information, and the quantity of negotiated and regulated rates, PAETEC believes that the estimation of network cost accruals is a critical accounting policy. As of December 31, 2009 and 2008, PAETEC had $27.8 million and $20.6 million, respectively, of disputed network invoices and approximately $8.1 million and $5.8 million, respectively, of recorded reserves related to disputed balances recorded in accounts payable on the consolidated balance sheets.
Impairment of Long-Lived Assets and Finite-Lived Intangible Assets. It is PAETECs policy to review its long-lived assets for possible impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. Factors the company considers important, and which could trigger an impairment review, include the following:
PAETEC determines whether the carrying value of its long-lived assets, including property and equipment, and finite-lived intangible assets may not be recoverable based upon the existence of one or more of the foregoing or other indicators of impairment. PAETEC determines if impairment exists relating to long-lived assets by comparing future undiscounted cash flows to the assets carrying value. If the carrying value is greater than the undiscounted cash flows, PAETEC measures the impairment as the amount by which the carrying value of the assets exceeds the fair value of the assets. Because of the significance of long-lived assets and finite lived intangible assets and the judgments and estimates that go into the fair value analysis, PAETEC believes that its policies regarding impairment are critical.
Goodwill and Indefinite-Lived Intangible Assets. In accordance with the provisions of ASC 350, Goodwill and Other Intangible Assets, PAETEC does not amortize goodwill or other acquired intangible assets with indefinite useful lives. PAETEC has identified four reporting units as defined in ASC 350. There were no changes in allocation of reporting unit goodwill during 2009, 2008 or 2007. As of December 31, 2009 and 2008, PAETEC had $300.6 million of goodwill, with the telecommunications reporting unit accounting for approximately 99% of the goodwill. As of December 31, 2009 and 2008, PAETEC had $2.4 million of intangible assets with indefinite lives.
Goodwill is assessed for impairment at least annually using a two-step impairment test. Step one of the test is used to identify whether or not impairment may exist. In step one, PAETEC compares the fair value of each individual reporting unit with its carrying amount. PAETEC estimates the fair value of its reporting units based on the income approach, using a discounted projection of future cash flows, supported with a market-based valuation. The income approach is dependent on a number of critical management assumptions, including estimates of future cash flows that take into account assumed growth rates, price increases, profitability margins, capital expenditures, benefits of recent acquisitions and expected synergies, and an appropriate discount rate. PAETECs estimates of discounted cash flows may differ from actual cash flows due to, among other factors, economic conditions, changes to PAETECs business model or changes in operating performance. Significant
differences between these estimates and actual cash flows could materially affect PAETECs future financial results. If a reporting units carrying amount exceeds its fair value, impairment may exist. Step two of the impairment test must then be performed to measure the amount of impairment, if any. Goodwill impairment potentially exists when the implied fair value of a reporting units goodwill is less than its carrying value. ASC 350 requires PAETEC to determine the implied fair value of goodwill in the same manner as if PAETEC had acquired those reporting units. Specifically, PAETEC allocates the fair value of the reporting unit to the assets, including any unrecognized intangible assets, and liabilities of that reporting unit, in a hypothetical calculation that yields the implied fair value of the goodwill. If the carrying amount of the reporting units goodwill is greater than the implied fair value of its goodwill, an impairment loss must be recognized for the excess.
PAETEC assesses the carrying value of its goodwill during the third quarter of each fiscal year. The annual assessment of the carrying value of PAETECs reporting units undertaken with respect to 2009, 2008 and 2007 indicated that goodwill was not impaired as of July 1, 2009, 2008 and 2007, respectively.
In accordance with ASC 350, goodwill of a reporting unit will also be tested for impairment between annual tests if a triggering event occurs, as defined by ASC 350, that could potentially reduce the fair value of the reporting unit below its carrying value. During the third quarter of 2008, PAETEC experienced a significant decline in market capitalization as a result of a decrease in the market price of its common stock as reported on the NASDAQ Global Select Market. The decline in market capitalization occurred after PAETECs announcement in August 2008 that its operating results for the second quarter of 2008 would be lower than expected. Some factors contributing to this performance below expectations included less robust billable minutes of use, an increase in customer attrition rates, and continued pricing pressures resulting from competitive product offerings and customer demands for price reductions in connection with contract renewals. PAETEC determined that these factors combined with the overall general decline in the economy and financial markets were an indicator that a goodwill impairment test was required pursuant to ASC 350. As a result, PAETEC completed step one of the impairment process and concluded that the fair values of some of its reporting units were less than the carrying values. For those reporting units whose fair values were less than the carrying values, PAETEC conducted step two of the impairment process and determined that the fair value of each reporting units goodwill was less than the carrying value and concluded that goodwill was impaired. PAETEC recorded a non-cash goodwill impairment charge of $340.0 million in the third quarter of 2008 based on a preliminary assessment. In the fourth quarter of 2008, management finalized the assessment in connection with the preparation of the companys audited financial statements and recorded an additional non-cash charge of $15.0 million. Approximately 95% of the goodwill impairment charge was attributed to the telecommunications reporting unit.
During the fourth quarter of 2008, PAETECs market capitalization declined further as a result of a decrease in the market price of its common stock as reported on the NASDAQ Global Select Market from the market price at September 30, 2008. PAETEC determined that the continued decline in market capitalization and the continuation of the factors that were identified during the third quarter of 2008 were an indicator that a goodwill impairment test was again required pursuant to ASC 350 for the fourth quarter of 2008. As a result, PAETEC completed step one of the impairment process and concluded that the fair values of its reporting units exceeded the carrying values and therefore recorded no impairment.
The changes in the carrying value of goodwill from January 1, 2008 through December 31, 2009 were as follows (in thousands):
There was no change in goodwill during the twelve months ended December 31, 2009.
Share-Based Payment. Employees of PAETEC participate in various equity incentive plans. In accordance with ASC 718, CompensationStock Compensation, PAETEC measures the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. PAETEC recognizes these compensation costs ratably over the period during which an employee is required to provide service in exchange for the award. The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model that uses assumptions regarding expected volatilities based on historical experience. The expected term of options granted is derived from the vesting period of the award, as well as exercisability of the award, and represents the period of time that options granted are expected to be outstanding. The risk-free rate is calculated using the U.S. Treasury yield curve, and is based on the expected term of the option. PAETEC uses historical data to estimate forfeitures.
The assumptions used in calculating the fair value of share-based payment awards represent managements best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and PAETEC uses different assumptions, its stock-based compensation expense could be materially different in the future. In addition, PAETEC is required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If PAETECs actual forfeiture rate is materially different from its estimate, the stock-based compensation expense could be significantly different from the amount recorded by PAETEC in the current period.
Income Taxes. PAETEC accounts for income taxes in accordance with ASC 740, Income Taxes. The asset and liability approach underlying ASC 740 requires the recognition of deferred income tax liabilities and assets for the expected future tax consequences of temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Management provides valuation allowances against the net deferred income tax asset for amounts that are not considered more likely than not to be realized. PAETEC must make significant estimates and assumptions about future taxable income and future tax consequences when determining the amount of the valuation allowance.
PAETEC considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed for some portion or all of a net deferred income tax asset. PAETEC uses judgment in considering the relative impact of negative and positive evidence. In arriving at these judgments, the weight given to the potential effect of negative and positive evidence is commensurate with the extent to which such evidence can be objectively verified.
Purchase Accounting. PAETEC accounts for the purchase of a business by allocating the purchase price to the assets acquired and the liabilities assumed in the transaction at their respective estimated fair values. The most difficult estimations of individual fair values are those involving long-lived assets, such as property and equipment and intangible assets. PAETEC uses available information to make these fair value determinations and, when necessary, engages an independent valuation specialist to assist in the fair value determination of the acquired long-lived assets. Because of the inherent subjectivity associated with estimating the fair value of long-lived assets, PAETEC believes that the recording of assets and liabilities acquired in conjunction with the acquisition of a business is a critical accounting policy.
Derivatives. ASC 815, Derivatives and Hedging, allows the gains and losses of a derivative to offset related results on the hedged item in the consolidated statements of operations and comprehensive income, and requires PAETEC formally to document, designate and assess the effectiveness of transactions that receive hedge accounting.
Derivatives are recognized on the consolidated balance sheet at fair value. PAETECs freestanding derivative instruments are designated as hedges at inception and evaluated for effectiveness at least quarterly throughout the hedge period. These derivatives are designated as hedges of the variability of cash flows to be
received or paid related to a recognized asset or liability (cash flow hedge). The effective portion of the derivatives gain or loss is initially reported as a component of comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.
PAETEC formally documents all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as cash flow hedges to specific assets and liabilities on the balance sheet.
PAETEC discontinues hedge accounting prospectively when it determines that the derivative is no longer effective in offsetting changes in cash flows of a hedged item, the derivative or hedged item expires or is sold, terminated, or exercised, or management determines that it is no longer appropriate to designate the derivative as a hedge instrument.
Legal and Contingency Reserves. PAETEC accounts for legal and other contingencies in accordance with ASC 450, Contingencies. Loss contingencies are accrued by a charge to income if both of the following conditions are met: information before issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements; and the amount of the loss can be reasonably estimated.
The foregoing list of critical accounting policies is not intended to be a comprehensive list of all of PAETECs accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States of America, with no need for PAETEC to judge their application. There are also areas in which PAETECs judgment in selecting any available alternative would not produce a materially different result. In addition to reviewing the foregoing list, PAETEC encourages you to review carefully the notes to its audited consolidated financial statements appearing elsewhere in this report, where you will find a more comprehensive description of the companys accounting policies and additional disclosures that are required by generally accepted accounting principles.
Liquidity and Capital Resources
PAETEC finances its operations and growth primarily with cash flow from operations, borrowings under credit facilities, issuances of debt securities, operating leases and normal trade credit terms. To fund its recent expansion through significant acquisitions, beginning in February 2007 with the US LEC merger and including the acquisition of McLeodUSA in February 2008, PAETEC has increased its borrowings under a variety of debt arrangements.
Sources and Uses of Cash. PAETECs cash flows for 2009, 2008 and 2007 were as follows (in thousands):
Cash flows from operating activities for 2009 were consistent with those for 2008, with a $33.3 million increase in net income adjusted for non-cash items being offset by a $33.3 million decrease in working capital. The $39.0 million increase in cash flows from operating activities for 2008 over 2007 was primarily attributable to a $26.1 million increase in net income adjusted for non-cash items and a $12.9 million increase in working capital.
PAETECs investing activities for 2009 consisted primarily of activities related to the purchase and installation of property and equipment. PAETECs investing activities for 2008 consisted primarily of activities related to the McLeodUSA merger and the purchase and installation of property and equipment. PAETECs investing activities for 2007 consisted primarily of activities related to the US LEC merger, the acquisition of Allworx Corp., and the purchase and installation of property and equipment.
Net cash used in financing activities of $44.1 million for 2009 was primarily related to the repayment of $330.5 million principal amount of borrowings under PAETECs senior secured credit facilities with the proceeds of an offering of $350 million principal amount of its 8 7/8% senior secured notes due 2017, which we refer to as the 8 7/8% senior secured notes, the payment of debt issuance costs incurred in connection with PAETECs issuance and sale of the 8 7/8% senior secured notes, and the repayment of $20.0 million in aggregate principal amount of loans outstanding under PAETECs revolving credit facility. Net cash provided by financing activities for 2008 of $127.8 million was primarily related to $100 million of borrowings incurred under PAETECs incremental term loan facility, a portion of which was applied toward the redemption of McLeodUSAs outstanding senior secured notes in connection with the McLeodUSA acquisition and $50.0 million of borrowings under PAETECs revolving credit facility. Net cash provided by financing activities for 2007 was $290.3 million and primarily reflected PAETECs borrowings of $1.1 billion to finance the US LEC merger, the effect of which was offset in part by the early retirement of US LECs debt.
Contractual Obligations and Commitments. PAETEC has various contractual obligations and commercial commitments. PAETEC does not have off-balance sheet financing arrangements other than its letters of credit and operating leases. As of December 31, 2009, PAETEC was party to letters of credit totaling $7.3 million. PAETEC does not expect any material losses from their resolution since performance under these letters of credit is not likely to be required.
The following table sets forth PAETECs future contractual obligations and commercial commitments as of December 31, 2009:
The long-term debt obligations in the table above reflect the senior credit facilities and note issues outstanding at December 31, 2009 and do not reflect the issuance of additional 8 7/8% senior secured notes in January 2010 and the application of the proceeds of that sale except as described below. On January 12, 2010, PAETEC issued and sold $300.0 million in aggregate principal amount of its 8 7 /8% senior secured notes pursuant to an indenture dated as of June 29, 2009, as supplemented as of January 12, 2010, under which PAETEC had issued $350.0 million in aggregate principal amount of its 8 7/8% senior secured notes on June 29, 2009. PAETEC applied a portion of the proceeds from the January 2010 sale of the 8 7/8% senior secured notes to repay $240.2 million in aggregate principal amount of term loans and $30.0 million in aggregate principal of revolving loans outstanding under its senior secured credit facilities. As a result of the issuance of the additional 8 7/8% senior secured notes in January 2010 and in accordance with ASC Topic 470, Debt, PAETEC has presented $270.2 million of aggregate principal amount outstanding under its senior secured credit facilities as maturing in 2017 in the table above as of December 31, 2009.
The long-term debt obligations in the table above also do not include scheduled interest payments on PAETECs variable-rate senior secured credit facilities outstanding at December 31, 2009, which are generally based on the London interbank offered rate, or LIBOR, and fixed-rate senior notes. Based upon the issuance of the 8 7/8% senior secured notes on January 12, 2010 and the associated repayment of the balances outstanding under the variable-rate senior secured credit facilities, PAETEC projects interest payments to be $90.9 million for each of the fiscal years 2010 through 2014, and $160.8 million thereafter.
Indebtedness. At December 31, 2009, PAETEC had approximately $926.1 million of total indebtedness, net of unamortized discount of $12.8 million, which had an overall weighted average annual interest rate of 7.7%, including debt discount and excluding deferred financing costs. Of this total indebtedness, an aggregate principal amount of $350.0 million was outstanding under the companys 8 7/8 % senior secured notes, an aggregate principal amount of $300.0 million was outstanding under the companys 9.5% senior notes due 2015, an aggregate principal amount of $240.2 million was outstanding under the companys senior secured credit facility term loans, and an aggregate principal amount of $30.0 million was outstanding under the companys revolving credit facility.
On June 29, 2009, PAETEC issued and sold $350.0 million in aggregate principal amount of its 8 7/8% senior secured notes at an offering price of 96.549% of their principal amount, in an offering not subject to the registration requirements of the Securities Act of 1933. PAETEC applied the proceeds of the offering, together with cash on hand, to repay approximately $330.5 million principal amount of outstanding term loans under PAETECs existing senior secured credit facilities and to pay related fees and expenses. The 8 7/ 8% senior secured notes issued in this offering accrue interest at a rate of 8.875% per year from June 29, 2009. Interest is payable semi-annually in cash in arrears on June 30 and December 31 of each year, commencing on December 31, 2009. The 8 7/8 % senior secured notes will mature on June 30, 2017.
In April 2009, PAETEC paid an additional $5.6 million of principal on its credit facility term loans as a result of excess cash flows generated during its 2008 fiscal year as calculated under the terms of its credit agreement. On each of September 30, 2009 and December 17, 2009, PAETEC paid $10.0 million in principal amount of loans outstanding under its revolving credit facility.
Under the terms of the total leverage ratio covenant contained in PAETECs credit agreement, PAETECs ratio of consolidated debt (defined for purposes of the credit agreement as total consolidated debt less cash and cash equivalents in excess of $20.0 million) to consolidated adjusted EBITDA (as defined for purposes of the credit agreement) as of any measurement date may not exceed 5.00:1.00. PAETEC was in compliance with this financial covenant as of December 31, 2009.
As described above, on January 12, 2010, PAETEC Holding issued and sold an additional $300.0 million in aggregate principal amount of its 8 7/8% senior secured notes. Accordingly, immediately following the issuance and sale in January 2010 of the 8 7/8% senior secured notes, the company had $650.0 million in aggregate principal amount of the 8 7/8% senior secured notes outstanding. PAETEC Holding applied a portion of the proceeds from the January 2010 sale of the 8 7/8% senior secured notes to repay the $240.2 million in aggregate principal amount of term loans and $30.0 million in aggregate principal of revolving loans outstanding under its senior secured credit facilities at December 31, 2009.
See Note 5 and Note 15 to PAETECs consolidated financial statements appearing elsewhere in this report for additional information regarding the companys indebtedness.
Operating Lease Obligations. PAETEC has entered into various non-cancelable operating lease agreements, with expiration dates through 2021, for office space and equipment. Some of these leases have free or escalating rent payment provisions. PAETEC recognizes rent expense under these leases on a straight-line basis. The company began occupying its current corporate headquarters in January 2001 under a 20-year lease agreement. PAETEC expects that its annual rental payments under the lease will increase to approximately $2.0 million for the last ten years of the lease term. PAETECs rental payments under the lease were $1.8 million for 2009.
Purchase Obligations. PAETECs purchase obligations as of December 31, 2009 represent non-cancelable contractual obligations for equipment and services and minimum commitments under data and voice contracts with certain carriers.
Other Long-Term Liabilities. Included in PAETECs long-term liabilities as of December 31, 2009, for which the company anticipates no payments to be required during the periods presented or thereafter, are deferred revenues, tax contingency reserve and deferred rent credits.
Stock Repurchase Program. During the year ended December 31, 2009, PAETEC Holdings board of directors authorized the repurchase of up to $25.0 million of PAETEC Holdings outstanding common stock through December 31, 2010, subject to conditions. PAETEC Holding may repurchase shares from time to time, at its discretion, on the open market or in private transactions. The repurchase program does not obligate PAETEC Holding to repurchase any specific number of shares and may be modified or discontinued at any time. PAETEC Holdings previous stock repurchase program expired in August 2009.
During 2009, PAETEC Holding repurchased, at fair value and on the open market, a total of 923,100 shares of its common stock at a total cost of approximately $1.6 million under PAETECs previous stock repurchase program and another 1,028,200 shares of its common stock at a total cost of approximately $3.9 million under the newly authorized stock repurchase program. In total, for the year ended December 31, 2009, PAETEC Holding repurchased, at fair value and on the open market, 1,951,300 shares of its common stock at a total cost of approximately $5.5 million. In connection with the repurchases, PAETEC Holding paid commissions totaling less than $0.1 million.
Capital and Cash Requirements. PAETEC expects that it will continue to require significant capital expenditures to maintain and enhance its network and services and to generate planned revenue growth. PAETEC made capital expenditures, principally for the purchase of communications equipment, of approximately $121.5 million in 2009. PAETEC expects to fund all of its 2010 capital expenditures from cash on hand and cash flow from operations. PAETEC plans to make such capital expenditures primarily for the following purposes:
The actual amount and timing of PAETECs capital requirements may differ materially from its estimates as a result of regulatory, technological and competitive developments in the companys industry. As of December 31, 2009, PAETEC had entered into agreements with vendors to purchase approximately $19.3 million of equipment and services, of which PAETEC expects $15.9 million to be delivered and payable in 2010, $2.2 million in 2011 and $1.2 million in 2012.
PAETEC may seek to purchase some of its outstanding 9.5% senior notes due 2015 and/or some of its outstanding 8 7/8% senior secured notes for cash in open market transactions, privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions and the discount, if any, at which the notes may be purchased, PAETECs liquidity requirements, contractual restrictions and other factors. The amounts involved in any such purchases may be material.
PAETEC believes that cash on hand and cash flow from operations will provide sufficient cash to enable the company to fund its planned capital expenditures, make scheduled principal and interest payments on its debt, meet its other cash requirements, and maintain compliance with the terms of its financing agreements for at least the next 12 months. After the foregoing period, PAETEC may require additional capital for network enhancements to provide increased capacity to meet expected increased demand for its services. The amount and
timing of these additional network enhancements, if any, will depend on the anticipated demand for services, the availability of funds and other factors. The actual amount and timing of PAETECs future capital requirements may differ materially from the companys estimates depending on the demand for its services and new market developments and opportunities, and on other factors, including those described in Part I, Item 1A. Risk Factors in this report. If PAETECs plans or assumptions change or prove to be inaccurate, the foregoing sources of funds may prove to be insufficient. In addition, if PAETEC seeks to acquire other businesses or to accelerate the expansion of its business, it may be required to seek additional capital. Additional sources may include equity and debt financing and other financing arrangements, such as vendor financing. In addition, if PAETEC believes it can obtain additional debt financing on advantageous terms, PAETEC may seek such financing at any time, to the extent that market conditions and other factors permit it to do so. The debt financing PAETEC may seek could be in the form of additional term loans under its senior secured credit facilities or additional debt securities having substantially the same terms as, or different terms from, PAETECs outstanding senior notes and senior secured notes. Any inability of PAETEC to generate the sufficient funds that it may require or to obtain such funds under reasonable terms could limit its ability to increase its revenue or to operate profitably. PAETECs ability to raise any required funds is subject to restrictions imposed by covenants contained in its existing debt agreements and could be negatively affected by a continuation of adverse conditions in the credit and capital markets.
Recently Issued Accounting Standards
In June 2009, the FASB issued Statement of Financial Accounting Standards, or SFAS, No. 167, Amendments to FASB Interpretation No. 46(R), currently codified as ASC Topic 810, Consolidation. This statement is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entitys purpose and design and a companys ability to direct the activities of the entity that most significantly impact the entitys economic performance. The statement is effective on January 1, 2010 for companies reporting on a calendar year basis. PAETEC is currently evaluating the impact of SFAS No. 167 on its financial statements.
In October 2009, the FASB issued Accounting Standards Update, or ASU, 2009-13, Revenue Recognition (Topic 605). This ASU provides amendments to the criteria in ASC 605-25 for separating consideration in multiple-deliverable revenue arrangements. It establishes a hierarchy of selling prices to determine the selling price of each specific deliverable which includes vendor-specific objective evidence (if available), third-party evidence (if vendor-specific evidence is not available), or estimated selling price if neither of the first two are available. This ASU also eliminates the residual method for allocating revenue between the elements of an arrangement and requires that arrangement consideration be allocated at the inception of the arrangement. Finally, this ASU expands the disclosure requirements regarding a vendors multiple-deliverable revenue arrangements. This ASU is effective for fiscal years beginning on or after June 15, 2010. PAETEC is currently evaluating the impact of this ASU on its financial statements.
In October 2009, the FASB issued ASU 2009-14, Certain Revenue Arrangements that include Software Elements. This ASU amends accounting and reporting guidance under ASC 605-985 to exclude from its scope all tangible products containing both software and non-software components that function together to deliver the products essential functionality. ASU 2009-14 will be effective for fiscal years beginning on or after June 15, 2010. PAETEC is currently evaluating the impact of this ASU on its financial statements.
PAETEC is exposed to market risks in the normal course of business. PAETEC manages the sensitivity of its results of operations to these risks by maintaining an investment portfolio consisting primarily of short-term, interest-bearing securities and by entering into long-term debt obligations with appropriate pricing and terms. PAETEC does not hold or issue derivative, derivative commodity or other financial instruments for trading
purposes, although at December 31, 2009 the company held some derivative financial instruments to manage its exposure to fluctuations in interest rates. PAETEC does not have any material foreign currency exposure.
PAETECs major market risk exposure is to changing interest rates associated with borrowings the company used to fund the expansion of its business and to support its acquisition activities. The interest rates that PAETEC is able to obtain on this debt financing depend on market conditions.
PAETECs policy is to manage interest rates through a combination of fixed-rate debt and the use of interest rate swap contracts to manage the companys exposure to fluctuations in interest rates on its variable-rate debt. As of December 31, 2009, $270.2 million of PAETECs long-term debt consisted of variable-rate instruments that accrue interest at floating rates. As of the same date, through an interest rate swap contract, PAETEC had capped its interest rate exposure through June 30, 2011 at a rate of 2.85% on $265.0 million of floating-rate debt. A change of one percentage point in the interest rates applicable to PAETECs $265.0 million of variable-rate debt subject to an interest rate swap contract as of December 31, 2009 would result in a fluctuation of approximately $2.7 million in the companys annual interest expense in the absence of the interest rate swap contracts. All foregoing variable-rate debt was repaid in January 2010 with the proceeds of the offering of $300 million principal amount of PAETECs 8 7/8% senior secured notes, as described in Note 5 and Note 15 to the audited consolidated financial statements appearing elsewhere in this report.
Our consolidated financial statements listed in Item 15 are filed as part of this report on pages F-2 through F-42 and are incorporated by reference in this Item 8.
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chairman, President and Chief Executive Officer, who is our principal executive officer, and our Executive Vice President and Chief Financial Officer, who is our principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15 under the Securities Exchange Act of 1934, as amended, as of December 31, 2009. Based upon that evaluation, our Chairman, President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of December 31, 2009.
Changes in Internal Control over Financial Reporting
During the fourth fiscal quarter of 2009, there have been no changes in our internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.
Managements Annual Report on Internal Control Over Financial Reporting
The management of PAETEC Holding Corp. (the Company) is responsible for establishing and maintaining an adequate system of internal control over financial reporting. This system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the accounting principles generally accepted in the United States of America.
The Companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding the prevention or timely detection of unauthorized acquisition, use, or disposition of the Companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, a system of internal control over financial reporting can provide only reasonable assurance and may not prevent or detect misstatements. Further, because of changes in conditions, effectiveness of internal control over financial reporting may vary over time. The Companys system contains self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Management conducted an evaluation of the effectiveness of the system of internal control over financial reporting based on the framework in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commissions (the COSO Framework). Based on this evaluation, management concluded that the Companys system of internal control over financial reporting was effective as of December 31, 2009, based on the COSO Framework.
Deloitte & Touche LLP, an independent registered public accounting firm, has audited the effectiveness of the Companys internal control over financial reporting, as stated in its report which is included in Item 8 of this annual report.
In March 2010, H. Russell Frisby, Jr., a member of PAETECs board of directors, entered into a sales plan pursuant to Rule 10b5-1 under the Securities Exchange Act of 1934. Rule 10b5-1(c) permits stockholders to adopt written pre-arranged stock trading plans subject to specified restrictions. Under such plans, stockholders can spread stock trades out over an extended period of time to minimize the market effect, can gradually diversify their investment portfolios and can avoid concerns about the timing of transactions.
The sales plan entered into by Mr. Frisby provides for his sale of up to 6,666 shares of PAETEC Holdings common stock from time to time from April 2010 through April 2011. Any sales will be made based on share amounts and other conditions specified in the plan.
See Executive Officers and Directors in Part I, Item 1 of this report for information about our executive officers, which is incorporated by reference in this Item 10. Other information required by this Item 10 is incorporated herein by reference to our definitive proxy statement for our 2010 annual meeting of stockholders, referred to as the 2010 proxy statement, which we will file with the SEC on or before 120 days after our 2009 fiscal year-end, and which appears in the 2010 proxy statement under the captions Election of Directors (Proposal 1) and Section 16(a) Beneficial Ownership Reporting Compliance.
We have adopted a code of ethics applicable to our chief executive officer and other senior financial officers, who include our principal financial officer, principal accounting officer or controller, and persons performing similar functions. The code of ethics, which we refer to as our Code of Conduct, is available on our web site, at www.paetec.com, by clicking on Investors and then on Corporate Governance. To the extent required by SEC rules, we intend to disclose any amendments to this code and any waiver of a provision of the code for the benefit of our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, on our web site within four business days following any such amendment or waiver, or within any other period that may be required under SEC rules from time to time.
Information required by this Item 11 is incorporated herein by reference to the 2010 proxy statement, including the information in the 2010 proxy statement appearing under the captions Election of Directors (Proposal 1)Compensation of Directors, Executive Compensation, Compensation Committee Interlocks and Insider Participation, Compensation Committee Report and Compensation Discussion and Analysis.
Information required by this Item 12 is incorporated herein by reference to the 2010 proxy statement, including the information in the 2010 proxy statement appearing under the caption Security Ownership.
Equity Compensation Plan Information
The following table presents information as of December 31, 2009 with respect to shares of our common stock that were issuable under awards granted pursuant to PAETECs equity compensation plans, along with the weighted average exercise price of outstanding awards and the number of shares of common stock remaining available for issuance in connection with future grants.
The following compensation plans were adopted without the approval of PAETEC Corp.s stockholders:
PAETEC Corp. Executive Incentive Plan. The board of directors of PAETEC Corp., PAETEC Holdings predecessor company, approved the PAETEC Corp. Executive Incentive Plan on June 7, 2006 in connection with PAETEC Corp.s June 2006 leveraged recapitalization. The Executive Incentive Plan provided for the issuance of restricted stock units for a total of 4,000,000 shares of PAETEC Corp. common stock (or 6,492,000 shares of PAETEC Holding common stock after adjusting for the US LEC merger), substantially all of which were issued to senior executives in connection with the leveraged recapitalization. As of December 31, 2009, and as adjusted for the US LEC merger, restricted stock units for 324,600 shares of PAETEC Holding common stock were outstanding under the Executive Incentive Plan. No additional awards will be made pursuant to the Executive Incentive Plan.
PAETEC Corp. Non-Qualified Stock Option Agreement. As part of its acquisition of Campuslink Communications Systems, Inc. in September 1999, PAETEC Corp. issued an option to purchase 10,000 shares of PAETEC Corp. common stock (or 16,230 shares of PAETEC Holding common stock after adjusting for the US LEC merger) to James A. Kofalt, who served as the chairman of the board of directors of Campuslink Communications Systems and was appointed to the board of directors of PAETEC Corp. in connection with the transaction. The option vested in September 2000 with respect to all of the shares subject to the award. As of December 31, 2009, and as adjusted for the US LEC merger, options to purchase 16,230 shares of PAETEC Holding common stock were outstanding under the award.
Agent Incentive Plans. PAETEC has granted to its independent sales agents warrants to purchase shares of PAETEC Holding common stock pursuant to two agent incentive plans. Independent sales agents include, in addition to individuals, corporations and other organizations that act as PAETECs sales agents. PAETEC Corp. and its wholly-owned subsidiary, PaeTec Communications, Inc., adopted the PaeTec Communications, Inc. Agent Incentive Plan under which PaeTec Communications granted warrants to purchase up to a total of 395,666 shares of PAETEC Corp. common stock (or 642,142 shares of PAETEC Holding common stock after adjusting for the US LEC merger). Warrants issued under this plan generally vest in five equal annual installments beginning on the date of grant, subject to the warrant holders achievement of specified performance objectives. As of December 31, 2009, and as adjusted for the US LEC merger, warrants to purchase 383,825 shares of PAETEC Holding common stock were outstanding under this plan. No additional grants will be made under this plan. In August 2009, PAETEC Holding Corp. adopted the PAETEC Holding Corp. 2009 Agent Incentive Plan under which PAETEC Holding Corp. granted warrants to purchase up to a total of 600,000 shares of PAETEC Holding Corp. common stock. Warrants issued under this plan generally vest upon the warrant holders achievement and maintenance of specified revenue levels. As of December 31, 2009, warrants to purchase 600,000 shares of PAETEC Holding common stock were outstanding under this plan. All of the warrants issued under the agent incentive plans are exercisable for ten years from the date of grant.
For additional information about the foregoing compensation plans, see Note 8 to the consolidated financial statements appearing elsewhere in this report.
Information required by this Item 13 is incorporated herein by reference to the 2010 proxy statement, including the information in the 2010 proxy statement appearing under the captions Election of Directors (Proposal 1) and Transactions With Related Persons.
Information required by this Item 14 is incorporated herein by reference to the 2010 proxy statement, including the information in the 2010 proxy statement appearing under the caption Independent Registered Public Accounting Firm.
(a)(1) The following consolidated financial statements of PAETEC Holding Corp. appear on pages F-2 through F-42 of this report and are incorporated by reference in Part II, Item 8:
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets:
PAETEC Holding Corp.as of December 31, 2009 and 2008
Consolidated Statements of Operations and Comprehensive Income:
PAETEC Holding Corp.for the years ended December 31, 2009, 2008 and 2007
Consolidated Statements of Redeemable Preferred Stock and Stockholders Equity (Deficit):
PAETEC Holding Corp.for the years ended December 31, 2009, 2008 and 2007
Consolidated Statements of Cash Flows:
PAETEC Holding Corp.for the years ended December 31, 2009, 2008 and 2007
Notes to Consolidated Financial Statements
(a)(2) The following financial statement schedule is filed as part of this report and is set forth on page F-43:
Schedule IIValuation and Qualifying Accounts
All other schedules for which provision is made in the applicable accounting regulations of the SEC either have been included in the consolidated financial statements of PAETEC or the notes thereto, are not required under the related instructions or are inapplicable, and therefore have been omitted.
(a)(3) The following exhibits are either filed with this Form 10-K or are incorporated herein by reference. Our Securities Exchange Act file number is 000-52486.
Index to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
PAETEC Holding Corp.
Fairport, New York
We have audited the internal control over financial reporting of PAETEC Holding Corp. and subsidiaries (the Company) as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Managements Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed by, or under the supervision of, the companys principal executive and principal financial officers, or persons performing similar functions, and effected by the companys board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2009 of the Company and our report dated March 12, 2010 expressed and unqualified opinion on those financial statements and financial statement schedule and included an explanatory paragraph relating to the acquisition of McLeodUSA Incorporated on February 8, 2008 and the merger with US LEC Corp. on February 28, 2007.
/s/ DELOITTE & TOUCHE LLP
Rochester, New York
March 12, 2010
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
PAETEC Holding Corp.
Fairport, New York
We have audited the accompanying consolidated balance sheets of PAETEC Holding Corp. and subsidiaries (the Company) as of December 31, 2009 and December 31, 2008, and the related consolidated statements of operations and comprehensive (loss) income, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the consolidated financial statement schedule listed in the Index at Item15(a)(2), These financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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, such consolidated financial statements present fairly in all material respects, the financial position of PAETEC Holding Corp. and subsidiaries as of December 31, 2009 and December 31, 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Companys internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 12, 2010 expressed an unqualified opinion on the Companys internal control over financial reporting.
As discussed in Note 1 to the consolidated financial statements, the Company acquired McLeodUSA Incorporated on February 8, 2008, and the Company merged with US LEC Corp. on February 28, 2007.
/s/ DELOITTE & TOUCHE LLP
Rochester, New York
March 12, 2010
Consolidated Balance Sheets
December 31, 2009 and 2008
(Amounts in Thousands, Except Share and Per Share Amounts)
See notes to consolidated financial statements.
Consolidated Statements of Operations and Comprehensive (Loss) Income
Years Ended December 31, 2009, 2008 and 2007
(Amounts in Thousands, Except Share and Per Share Amounts)
See notes to consolidated financial statements.
Consolidated Statements of Stockholders Equity
Years Ended December 31, 2009, 2008 and 2007
(Amounts in Thousands, Except Share Amounts)