Item 1. Business
The terms “the Company,” “Pac-West,” “we,” “our,” “us,” and similar terms as used in this Form 10-K, refer to Pac-West Telecomm, Inc.
Our Company
We were incorporated in May 1996 in the State of California. Our predecessor (also known as Pac-West Telecomm, Inc.), which transferred its telephone division to our Company effective September 30, 1996, began offering long distance service in 1982, and local service in 1996, in California. We are an independent provider of integrated communication solutions that enable communication providers to use our network and services as an alternative to building and maintaining their own network. Our customers currently include Internet service providers (ISP), Voice over Internet Protocol (VoIP) providers, other enhanced communication service providers (ESPs) and other direct providers of communication services to business or residential end-users, collectively referred to as service providers (SPs).
We announced in October 2005 the first phase of a planned national expansion, which is expected to begin in early 2006. Under our expansion plan, we intend to offer our full suite of VoIP and Internet access enabling services in 36 major metropolitan markets, covering more than 50% of the U.S. population. We are positioning ourselves as a key player in the SP space with a focus on expansion through enabling others to become communication service providers. This planned expansion is designed to provide a nationwide, single source platform that seamlessly bridges circuit-switching and packet-switching targeted at VoIP providers, wireless broadband providers, ISPs, carriers and other Next Generation service providers. We are in the business of enabling any company to become a custom phone company. In addition, this planned expansion is anticipated to increase our market share of dial-up Internet services. While we expect that the majority of dial-up Internet service will migrate to broadband over time, it is a large target market and we remain focused on serving the needs of our customers.
We announced in January 2006 a strategic alliance with VeriSign, Inc. to provide services that enable communications providers to offer converged IP, voice and data communications. The alliance contemplates that VeriSign will facilitate us with back office and database services including Calling Party Name, Local Number Portability, E911 related database updating, SS7 and provisioning services. Further it is expected that we will contribute voice and data network services such as trunking, switching, E911 selective router trunking and IP transport. Our strategic alliance with VeriSign is expected to enhance our national expansion plans and strategy of being a single source for converged solutions offered by VoIP, wireless, broadband and other service providers, allowing both companies to drive adoption of next-generation applications.
We built and are expanding our facilities-based network to capitalize on the significant growth in Internet usage and in the related demand for local telephone service by SPs. We believe the statewide footprint of our network, which encompasses all of the major metropolitan areas of California, and the planned national expansion, provides us with a competitive advantage over incumbent local exchange carriers (ILECs), and competitive local exchange carriers (CLECs). Our existing network in California, Arizona, Nevada, Oregon, Utah and Washington, enable SPs to provide their end-users with access to the Internet, and other data and voice services, such as VoIP, through a local call. We believe the breadth of our product offerings, such as the expansion of our VoiceSource product suite, during 2005, and the structure of our network enables us to generate high network utilization.
In connection with our transition to a business model based upon enabling other communication service providers, on March 11, 2005, we sold substantially all of our enterprise customer base to U.S. TelePacific Corp. (TelePacific) while retaining our associated network assets. Under the terms of this transaction, TelePacific acquired certain assets, such as property and equipment with a net book value of approximately $3.0 million and other assets of approximately $0.6 million, and assumed certain liabilities of approximately $0.7 million, in exchange for $27.0 million in cash. As a result, we recorded a gain of $24.0 million from this sale during the first quarter of 2005. Subsequent to the first quarter of 2005, we recorded a net gain of
$0.1 million for adjustments associated with this sale and an amendment to the Asset Purchase Agreement (APA) as discussed below.
In addition, on March 11, 2005, we entered into a Transition Service Agreement (TSA) with TelePacific that, among other things, obligates us to provide certain transition services to TelePacific at our estimated cost for a one-year period subject to extension for two additional three-month periods. The estimated costs to be reimbursed to us include network related and administrative support services which are provided exclusively to TelePacific and were capped at $10.5 million. In accordance with the TSA, TelePacific received a $2.0 million credit against the total amount to be billed that occurred during the second quarter of 2005. Due to the inseparability of our network, the absence of identifiable shared costs, and as no network assets were sold to TelePacific, we determined the assets sold did not constitute discontinued operations. During the third quarter of 2005, we entered into an amendment with TelePacific to resolve certain disputed matters arising out of the APA and to amend and modify the TSA. The TSA amendment included, among other things, a credit to TelePacific of up to $0.5 million during the fourth quarter of 2005 against future transition service costs to be reimbursed to us, and the elimination of the $10.5 million cap. During January 2006, TelePacific exercised their first option to extend the transition period for an additional three months. This will extend the TSA transition period to June 12, 2006.
Markets
We believe increased demand for access to the Internet, the desire for one-stop integrated communication services by SPs and end-users and new communications technologies such as VoIP continue to present significant growth opportunities for us.
Traditional dial-up access to the Internet, although a mature technology, remains a large target market for us. Major segments of this market may experience migration to broadband access technologies where available and competitively priced. While we remain focused on serving the needs of our customers who provide dial-up access to their end-users, with the evolution of new technologies, many new Internet protocol (IP) applications are now available, such as VoIP, which have presented us with new product development and sales opportunities. We are developing and overlaying new products and services that take advantage of these new technologies to further increase the utilization of our network.
In 2004, we launched PSTN On Ramp as the first in a series of offerings that enables the rapid delivery of next generation services. PSTN On Ramp provides SPs and other communication companies, such as VoIP providers, local telephone numbers and call origination and termination by interconnecting through our network to the PSTN. In 2005 we launched the full VoiceSource suite of products, which includes PSTN On Ramp, PSTN On Ramp with Networks Database Services (NDS) and Driver’s Seat, and Intelligent Foreign Exchange (IFEX). VoiceSource provides a single source for the key components required to deliver IP-based local phone service, including local telephone numbers, access to the PSTN, and the ability to update end-user information in industry databases such as E911 and directory listing services so these providers do not have to invest in extensive internal infrastructure and systems.
With the sale of our enterprise customer base to TelePacific in March 2005, we no longer focus our efforts on directly serving the enterprise market, but rather on serving communication providers, who in turn may serve the enterprise market. Communication providers such as SPs, cable television companies, wireless carriers and other organizations, which desire access to the PSTN for their enterprise and residential end-users, are able to use our network. This enables communication providers to avoid the cost of building and maintaining their own network to meet their end-user needs. We believe that we provide a more comprehensive and cost-effective alternative to using the ILECs’ networks. In addition, we believe that this approach to serving the enterprise market is more efficient for us than serving the enterprise market directly.
Network
We built our facilities-based network to capitalize on the significant growth in demand for Internet access and data and voice communications in addition to the increasing demands of enterprise businesses for customized, integrated communications services. We use a “smart-build” strategy, building and owning
intelligent components of our network while leasing circuits, services and bandwidth from other carriers. We believe that this strategy provides us with significant cost and time-to -market advantages over competitors that own both their switches and access networks. By owning our switches, we can configure our network to provide high performance, high reliability and cost-effective solutions for our customers’ needs. By leasing our transport lines, we can reduce up-front capital expenditures, rapidly respond to increased demand, and provide low-cost redundancy. In addition to leasing our transport lines, we have an Indefeasible Right of Use (IRU) agreement, which expires in 2020 with a purchase option for dedicated fiber optics circuits of OC-48 capacity connecting the major metropolitan areas within California, which are high volume markets for us.
Our ubiquitous network in California enables SPs to provide their enterprise and residential customers with access to Internet, paging and other data and voice services from almost any point in the state through a local call. In this way, our customers can achieve statewide coverage with significantly lower capital and operating expenses. We currently aggregate and concentrate all of our network traffic into our high volume switching sites, called SuperPOPs. Our switching sites offer SPs highly reliable, tandem switching and the option to build lower cost networks by collocating equipment at our switching sites rather than in each local access and transport area (LATA) from which they can originate and terminate local, long distance and international calls. Our network includes digital connections in all LATAs in California as well as in key LATAs in Nevada, Washington, Oregon and Arizona. In addition, our interconnection arrangements and statewide leased transport network allow SPs to obtain coverage throughout the West Coast at local calling rates, which reduces switching and transmission costs.
We believe that our network’s broad market coverage results in:
| • | high volume of communications traffic both originating and terminating on our network, which supports strong operating margins; | |
| • | enhanced reliability at competitive prices; | |
| • | the ability to leverage our investment in high capacity switching equipment and electronics; and | |
| • | the opportunity for our network to provide backhaul carriage for other telecommunications service providers, such as long distance and wireless carriers. |
As of December 31, 2005, we had an installed capacity of more than 1 million ports.
Switching Platform. We currently own and operate eleven Alcatel digital tandem switches in or near Los Angeles (three switches), Oakland (three switches) and Stockton (two switches), California with one switch each in Las Vegas, Nevada, Phoenix, Arizona and Seattle, Washington, and one Tekelec 9000 Digital Switching System tandem/end office (Next Gen Switch) in Los Angeles. An additional Tekelec 9000 switch was delivered in early 2006 to our new switch location in New York for evaluation. Under terms of the field trial agreement with Tekelec, we have 90 days to evaluate the switch performance and the option to purchase the switch at the end of the evaluation period. Our intent is to purchase this switch subsequent to the evaluation period. Although the Alcatel switches we use are no longer in production, on-going maintenance and support for our switches is still provided to us by Alcatel. Our tandem switches have high call carrying capacity and multiple path call routing capabilities. Tandem switches are ideally suited for handling the high call volumes and long duration times involved in serving SP customers. Our switching platforms combined with the intelligence of our customized call processing software and adjunct processors enable us to:
| • | deploy features and functions quickly throughout our entire network; | |
| • | expand switch and transport capacity in a cost-effective, demand-based manner; and | |
| • | our Next Gen Switch supports leading edge products and interfaces, such as Session Initiation Protocol (SIP). |
Transmission Capacity. We currently lease our transmission facilities from inter-exchange carriers, ILECs and CLECs. We generally seek to lease fiber optic transmission facilities from multiple sources in each of our markets. In addition, as discussed above, we have purchased long-term rights of use and operate a high capacity fiber IRU connecting the major metropolitan areas within California.
Interconnection. We have established interconnection agreements (ICAs) with certain ILECs. The Telecommunications Act of 1996 requires ILECs to enter into ICAs with CLECs and other competitors and requires state Public Utilities Commissions (PUCs) to arbitrate such agreements if the parties cannot reach agreement. The ICAs govern, among other items, intercarrier compensation agreements for the exchange of local and local toll calls between the parties. We are in the process of extending our ICAs and entering into new ICAs in connection with the national expansion plan. We presently have interconnection agreements with:
| • | Pacific Bell Telephone Co., d/b/a AT&T California (AT&T); | |
| • | Verizon California, Inc. (Verizon); | |
| • | Citizens Telecommunication Company of California, Inc.; | |
| • | SureWest Telephone in California; | |
| • | Central Telephone Company (d/b/a Sprint of Nevada); | |
| • | Cox California Telcom, LLC; | |
| • | Mpower Communications Corp. in California; | |
| • | AT&T Wireless Services, Inc. in California; | |
| • | Nevada Bell Telephone Co., d/b/a AT&T Nevada; | |
| • | U.S. West Communications, Inc. (Qwest) in Washington, Oregon, and Utah; | |
| • | Qwest Corporation in Colorado and Idaho; | |
| • | GTE Northwest, Inc. (Verizon) in Washington and Oregon; | |
| • | U.S. West Communications, Inc. (Qwest) in Arizona; | |
| • | Sprint Spectrum L.P (network-wide); | |
| • | BellSouth Telecommunications, Inc. in Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina, and Tennessee; | |
| • | Verizon Florida, Inc. in Florida; | |
| • | Southwestern Bell Telephone, L.P. d/b/a AT&T Kansas in Kansas; | |
| • | Verizon Maryland, Inc. in Maryland; | |
| • | Verizon New Jersey, Inc. in New Jersey; | |
| • | Verizon New York, Inc. in New York; | |
| • | Verizon Pennsylvania, Inc., and Verizon North, Inc., in Pennsylvania; | |
| • | Verizon Rhode Island, Inc. in Rhode Island; | |
| • | Southwestern Bell Telephone, L.P. d/b/a AT&T Texas in Texas; | |
| • | Verizon Washington DC, Inc. for the District of Columbia; and | |
| • | Wisconsin Bell, Inc. d/b/a AT&T Wisconsin and Verizon North, Inc. in Wisconsin |
As described below under “— Significant Relationships,” we derive a significant portion of our revenues from intercarrier compensation payments under ICAs. In addition, as described below under “— Regulation,” intercarrier compensation payments and the terms of the ICAs are regularly the subject of disputes among the parties to such agreements.
Strategy
We have positioned ourselves as a high-value, independent provider of integrated communications solutions that enable SPs to use our network and services as an alternative to building and maintaining their own network. We believe that providing superior levels of customer service and network reliability with a competitive cost structure is key to continuing to attract and retain customers. In addition, we are committed to reducing our expenses and offering value-added support services that enable our customers to be more successful in serving their end-users. Our goal is to build on our momentum by pursuing the following initiatives:
Continue to emphasize superior customer service. Our goal is to fully understand our customer needs and to be recognized as the industry leader for customer service. We believe our focus on superior customer service on a company-wide basis provides us with the ability to sustain high levels of customer loyalty and allows us to achieve benchmark industry levels of customer retention and contract renewal. We have internally branded this level of service as “Five Star.”
Grow the SP base through sales and services. We are a leading provider of dial-up Internet access in our target markets. In California, for example, we believe we provide our SP customers with the underlying infrastructure utilized by over 20% of the state’s dial-up Internet subscribers. While the demand for Internet access in our target markets continues to grow, migration to broadband Internet access where available and competitively priced has resulted in a slowing of dial-up Internet access in recent years. In spite of this market environment, we have continued to achieve growth in minutes of use primarily due to what we believe is our superior value proposition created by our coverage and service reliability. We anticipate opportunities to serve existing and new SP customers across our footprint, particularly in connection with our planned national expansion. Furthermore, in order to inspire loyalty and to increase usage across our network, we provided new service options to assist our SP customers with identifying operational improvements. These new options provide new revenue opportunities for our SP customers to sell to their retail customers.
Enable our customers to serve their end-users. We believe our customers need technologically advanced communications systems along with high quality bundled local, long distance, data and other enhanced services and/or innovative new services such as VoIP to meet the growing demand for advanced communication services by their end-users. We believe our expertise in designing and implementing network infrastructure and support services allow our customers to avoid the cost of building and maintaining their own network to meet their end-user needs. Federal Communications Commission (FCC) annual reports indicate that the ILECs have a dominant share of the market in most telecommunication markets in California. We believe that we provide a more comprehensive and cost-effective alternative to using the ILECs’ networks. We intend to continue our efforts to become an enabler of integrated communications services so our customers may provide innovative and competitive offerings to their end-users.
Develop or acquire the next market opportunity. We are constantly exploring methods of entering new markets and providing new services. An example, is our VoiceSource suite of products, which provides a single source for the key components required to deliver IP-based local phone service, including local telephone numbers, access to the PSTN, and the ability to update end-user information in industry databases such as 911 and directory listing so these providers do not have to invest in extensive internal infrastructure and systems. As we roll out our national expansion plan we plan to offer products such as managed modems, IFEX and PSTN On Ramp.
Upgrade our infrastructure. We have built one of the most comprehensive and reliable networks in California. We carry over 120 million minutes of voice and data traffic per day and an estimated 20% of the dial-up Internet traffic in California. Through our SP customers, millions of people rely on us every day to access the Internet and other voice and data services through a local dial-up number. Network reliability is critical to our customers. In December 2004, we deployed our first Next Gen Switch. This marked the beginning of Pac-West’s planned multi-year transition to a packet-based switching platform. In early 2006, we received a Tekelec 9000 switch in New York for evaluation, which is scheduled to be purchased in early 2006. This second Next Gen Switch is designed to provide functionality across our expanded nationwide footprint. In addition to cost savings, capacity expansion and the ability to deliver new services with Class 4/5
functionality, the Next Gen Switch supports a “cap-and-grow” model, enabling us to quickly and easily add capacity as needed. We continue to seek further ways to enhance our infrastructure during 2006 and beyond.
Products and Services
Our products and services are designed to appeal to targeted telecommunications needs of SPs. The following is a summary of certain of our key products and service offerings to our SP customers:
Dial Access Services. Provides incoming call access lines, modems, routers, and authentication services. This product provides SP customers with a non-capital intensive means of quickly establishing local points of presence throughout our coverage area. This service can be delivered through a fixed monthly recurring charge, or as a pay as you go, usage based model. As a service option, we provide customer facing reporting tools that allow our customers to effectively manage their traffic patterns that traverse our network.
Collocation. Collocation enables our customers to install their equipment in any or all of our switch facilities and interconnect directly to our central office switching, transport and data equipment. Collocated equipment is protected by the same cooling power back-up and security systems protecting our switches. An SP’s ability to collocate equipment at a limited number of sites, rather than in each LATA, reduces their capital expenditures and maintenance requirements. We receive monthly rental revenue from the SP for the space and power used.
High-Volume Multi-Rate Center Local Service. This service offers our customers the ability to establish local points of presence (POPs) throughout our network with minimal capital investment, which dramatically expands their coverage; while at the same time reduces their overall costs.
VoiceSource. In 2005, we began to offer our full VoiceSource suite of products, which includes PSTN On Ramp, PSTN On Ramp with NDS and Driver’s Seat, and IFEX, to provide a single source for the key components required to deliver IP-based local phone service, including local telephone numbers, access to the PSTN, and the ability to update end-user information in industry databases such as E911 and directory listing services without investing in extensive internal infrastructure and systems.
| • | PSTN On Ramp. In 2004, we launched PSTN On Ramp as the first service in a series of offerings that will enable the rapid delivery of next generation services. These services expand our service offerings to the existing customer base, as well as reach new customer segments. Targeted at sub segments of the ESP market, this offering attracts carriers and providers of enhanced services such as unified messaging, calling cards, conferencing, Fax over IP, and VoIP. PSTN On Ramp provides local telephone numbers and call origination and termination between these service providers and the PSTN through cost effective interconnection to our network. PSTN On Ramp is a component of VoiceSource. | |
| • | IFEX. In 2005, we launched IFEX. IFEX is targeted at communications providers, such as calling card companies, IP-based service providers, and other enhanced service providers looking to originate and terminate high volumes of traffic in our Western U.S. footprint. IFEX enables these customers to quickly and cost- effectively reach new Western US markets by establishing a local presence in multiple foreign exchange areas, and delivering calls to and from customers served by those exchanges. IFEX is a component of VoiceSource. | |
| • | PSTN On Ramp with NDS and Driver’s Seat. Provides the three key components needed to deliver IP-based local phone service including PSTN On Ramp, the ability to update industry databases such as E911, Number Portability, 411/directory listing, caller name and line information, toll-free routing and the ability to manage these from an online portal. |
We no longer offer the following services as a result of the sale of our enterprise customer base to TelePacific:
Direct Digital Telephone Service (DDTS). This service was an integrated solution for enterprise businesses consisting of system design, equipment installation and maintenance combined with voice and data communications services. For a monthly fee, we offered feature-rich digital telephone sets bundled together
with local and long distance services, Centrex-type direct inward dialing, voice mail and maintenance. Additionally, our Data Advantage and Data Advantage Internet services were commonly added to this bundled service.
Facilities Based Dial Tone (FBDT). This service was marketed toward enterprise businesses that already own their phone system. For a monthly fee, we provided these customers with an integrated solution of voice and data services, typically consisting of local and long distance services, data transport and Internet access services.
Integrated Access Service (IAS). This service was targeted at enterprise businesses that currently had analog telephone service, such as a key system or Centrex service. IAS offered these customers a cost-effective solution for receiving integrated voice and Internet services over a single T-1. Based upon customer demand we had upgraded the ability for customers to interconnect multiple small and large offices into private data networks.
Sales and Marketing
Sales. We have an experienced direct sales force, focusing on consultative sales practices within the SP markets. Through their telecommunication backgrounds, they each have a strong sales foundation within our existing and target markets. We continue to attract and retain highly qualified salespeople by offering them an opportunity to work with an experienced management team in an entrepreneurial environment and to participate in the potential economic rewards made available through a results-oriented compensation program that emphasizes sales commissions. With the support of our account managers, our sales teams are able to focus their efforts on the revenue growth and retention of our customers.
Marketing. We seek to position ourselves as a provider of superior customer service and a high-value independent broadband provider of integrated business communications solutions within our target markets by offering a high level of network reliability, superior customer service on a company wide basis, which we have branded as “Five Star” and bundled solutions for competitive value. We have built and intend to continue to build our reputation and brand identity by working closely with our customers to help them grow their businesses and develop services tailored to their particular needs.
Customer and Technical Service. We believe that our ability to consistently deliver superior customer and technical service is a key factor in acquiring new customers and maximizing retention of existing customers. We have developed a customer service strategy designed to effectively meet the service requirements of our target customers. A dedicated account manager is provided to each strategic account. The assigned account managers for these customer provides the first line of customer service by identifying and resolving any customer concerns through real time problem identification and resolution. Our experienced engineers also support our account managers and technical staff and are available to meet customer requests as needed.
Customers
We focus on providing integrated communications services to SPs, many of which are communications-intensive users. SP customers offer Internet access, unified messaging platforms, pre-paid platforms, fax mail services, voice mail services and VoIP to their end-users. The characteristics of this market segment offer us the potential to increase our billed minutes of use and improve the utilization of our network resources.
SP revenues do not include intercarrier compensation. Intercarrier compensation consists of revenues earned by terminating calls on our network sent to us by other telecommunication carriers and long distance services, dedicated transport services and transit traffic. Intercarrier compensation payments are a function of the number of calls we process, the minutes of use associated with such calls and the rates at which the associated carriers compensate us. As described below under “— Significant Relationships,” intercarrier compensation payments have historically been a significant portion of our revenues.
Financial Information about Industry Segments
We operate in a single industry segment, telecommunications services. Based on criteria established by Statement of Financial Accounting Standards (SFAS) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” we have determined that we have one reportable operating segment. While our chief decision-maker monitors the revenue streams of various services, the revenue streams share many expenses such as leased transport charges and circuits. In addition, operations are managed and financial performance is evaluated based upon the delivery of multiple services over common networks and facilities. This allows us to leverage our costs in an effort to maximize return. As a result, the revenue streams share almost all of the various operating expenses. Because we believe that any allocation of the expenses to multiple revenue streams would be impractical and arbitrary, we do not currently make such allocations internally. Our chief decision-maker does, however, monitor revenue streams at a more detailed level than those depicted in our consolidated financial statements.
Seasonality
There is no significant seasonality to any of our products or services although some of our customers do experience some seasonality in their business and related demand for telecommunications services. However, we believe that the seasonality effects of the businesses of individual customers do not have a significant impact on our consolidated revenues.
Significant Relationships
Intercarrier compensation payments from ILECs accounted for 40.4%, 32.1%, and 35.0% of our total revenues for the years ended December 31, 2005, 2004, and 2003, respectively. Intercarrier compensation payments recorded as revenue in 2005 include payments received for settlements in connection with disputes over previously withheld intercarrier compensation payments, which amounted to $2.2 million, or 2.4%, of our total 2005 revenue. The revenues from these ILECs are the result of ICAs we have entered into with them that provide for the transport and termination of local telecommunication traffic. Intercarrier compensation payments are currently an important source of revenue for us, and as a result, the failure, for any reason, of one or more ILECs from which we receive intercarrier compensation payments to make all or a significant portion of such payments in the future could adversely affect our financial condition. Intercarrier compensation payments are a function of the number of calls we terminate, the minutes of use associated with such calls and the rates at which we are compensated by ILECs. Further details relating to the regulatory issues associated with intercarrier compensation are further discussed in “— Regulation” below.
Revenues from our three largest customers provided the following percentage of total revenues for the years ended December 31, 2005, 2004 and 2003.
| 2005 | 2004 | 2003 | ||||||||||
|
AT&T
|
24.8 | % | 21.1 | % | 21.8 | % | ||||||
|
Verizon
|
9.2 | % | 3.9 | % | 10.6 | % | ||||||
|
Qwest
|
17.2 | % | 17.6 | % | 17.1 | % |
No other entities accounted for more than 10% of our total revenues for these periods.
AT&T, previously known as SBC, from whom we receive the largest amount of intercarrier compensation, is also our largest source of operating costs, accounting for 45.2%, 40.3% and 37.3% of our network expenses for the years ended December 31, 2005, 2004 and 2003, respectively.
Competition
The telecommunications industry is both highly price competitive and dominated by the ILECs who enjoy the benefit of significant market share earned over a time when there was no possibility of competition in the marketplace. Recently announced mergers and acquisitions and regulatory actions are factors tending to increase ILEC market influence. In this environment, we believe that the principal competitive factors
differentiating our business from other vendors will be customer service, network reliability, billing accuracy, pricing levels and policies, and, a unique range of products and service offerings tailored to customer needs and rapidly changing market conditions. Our ability to compete effectively will depend upon our continued ability to rapidly respond to changing market requirements by delivery of high quality, value added, services at prices which are in accordance with accepted market rates. We believe that our ability to provide exceptional customer service in tandem with our unique western U.S. footprint and our planned national expansion will differentiate us in the marketplace. Many of our current and potential competitors have financial, personnel, and other resources, including brand name recognition, substantially greater than ours as well as other competitive advantages over us. Although we must be in a position to reduce our prices, if necessary, to meet rate reductions by our competitors, any such reductions could adversely affect us.
Incumbent Local Exchange Carriers. We compete with the ILECs serving each of the markets we target, such as AT&T and Verizon in California, and Qwest Communications International Inc. (Qwest) in Arizona, Oregon, and Washington. In addition, we expect that we will compete with ILECs in each of the markets we enter as part of our planned national expansion. Some ILECs in our territory, including Verizon and AT&T in California, and Qwest in Washington, are offering Internet access services to their local telephone customers. We believe ILECs will attempt to further entrench their market share by capitalizing on their strong regional brand names and through the use of extensive advertising campaigns, targeted primarily to the residential and enterprise segment. For more information regarding our relationships with ILECs, please refer to discussion below in “— Regulation.”
In particular, the ILECs have:
| • | long-standing relationships with their customers; | |
| • | financial, technical and marketing resources substantially greater than ours; | |
| • | the potential to subsidize competitive services with revenues from a variety of businesses; | |
| • | long-standing relationships with regulatory authorities at the Federal and state levels; and | |
| • | currently benefit from certain existing regulations and regulated subsidies that favor the ILECs over their competitors in certain respects. |
While regulatory initiatives, which allow CLECs to interconnect with ILEC facilities, provide us with increased business opportunities, such interconnection opportunities have been, and likely will continue to be, accompanied by increased pricing flexibility for, and relaxation of regulatory oversight of the ILECs.
Competitive Access Carriers/ Competitive Local Exchange Carriers/ Other Market Entrants. We also face, and expect to continue to face, competition from other current and potential market entrants, including CLECS, cable television companies, electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end users. In addition, a renewed trend toward consolidation as a result of mergers, acquisitions and strategic alliances in the telecommunications industry could also affect the level of competition we face. Examples of consolidation that may put us at a greater competitive disadvantage include the following recent or pending type of consolidations:
| • | Mpower Holding Corporation and ICG Communications customer base | |
| • | XO Communications and Allegiance Telecom | |
| • | SBC Communications, Inc. and AT&T Corporation | |
| • | AT&T Inc. and BellSouth Corporation | |
| • | Verizon Communications Inc. and MCI, Inc. | |
| • | Cingular Wireless and AT&T Wireless | |
| • | Level 3 Communications, Inc. and Sprint Corporation’s wholesale dial Internet access business |
| • | Level 3 and WilTel | |
| • | Level 3 and Progress Telecom |
The Telecommunications Act of 1996 imposes certain regulatory requirements on all local exchange carriers, including competitors such as ourselves, while granting the FCC expanded authority to reduce the level of regulation applicable to any or all telecommunications carriers, including ILECs. The manner in which these provisions of the Telecommunications Act of 1996 are interpreted, implemented and enforced could have a material adverse effect on our ability to successfully compete against ILECs and other telecommunications service providers. The Telecommunications Act of 1996 is subject to review by the FCC at any time and could change in the near future. Due to the readily available sources of capital during the 1990s, many CLECs and other incumbent carriers built their own networks, including fiber transport capacity, as a key component of their operating plans. This resulted in an excess of network capacity in many areas throughout the U.S. with insufficient traffic volumes to cover the corresponding cost of capital and debt loads that were necessary to build the network infrastructures. Accordingly, some of the companies have not survived or have been forced to reorganize, often through bankruptcy. When these companies reorganize they generally have new, lower cost structures, which often allow them to aggressively price their products, and services, effectively driving down market rates.
Competition from International Telecommunications Providers. Under the World Trade Organization agreement on basic telecommunications services, the United States and 68 other members of the World Trade Organization committed themselves to opening their respective telecommunications markets to foreign ownership and/or to adopting regulatory measures to protect competitors against anticompetitive behavior by dominant telecommunications companies, effective in some cases as early as January 1998. There can be no assurance that the pro-competitive effects of the World Trade Organization agreement will not have a material adverse effect on our business, financial condition and results of operations or that members of the World Trade Organization will implement the terms of the World Trade Organization agreement.
Regulation
The following summary of regulatory developments and legislation does not purport to describe all present and proposed Federal, state and local regulations and legislation affecting the telecommunications industry or Pac-West, all of which are available in the public record. Other existing Federal and state legislation and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals, which could change, in varying degrees, the manner in which this industry operates. Neither the outcome of these proceedings, nor their impact upon the telecommunications industry or Pac-West, can be predicted at this time. This section also includes a brief description of regulatory and tariff issues pertaining to the operation of our business, which is subject to varying degrees of Federal, state and local regulation.
Federal Regulation
The FCC regulates interstate and international telecommunications services. We provide service on a common carrier basis. The FCC imposes certain regulations on common carriers such as the regional Bell operating companies that have some degree of market power. The FCC imposes less regulation on common carriers without market power including, to date, CLECs. Among other obligations, common carriers are generally subject to nondiscrimination requirements, as well as certain service reporting requirements. The FCC also requires common carriers to receive authorization to construct and operate telecommunications facilities, and to provide or resell telecommunications services, between the United States and international points.
To the extent we provide interexchange telecommunications service, we are required to pay access charges to ILECs and CLECs when we use the facilities of those companies to originate or terminate interexchange calls. Also, we provide access services to other interexchange service providers. The interstate access charges of ILECs are subject to extensive regulation by the FCC, while those of CLECs are subject to a lesser degree of FCC regulation.
The manner in which the FCC continues to implement its approach to lowering access charge levels could have a material effect on our ability to compete in providing interstate access services.
On April 27, 2001, the FCC released its Order on Remand regarding intercarrier compensation for Internet service provider-bound traffic. The FCC asserted exclusive jurisdiction over Internet service provider-bound traffic and established an interim intercarrier compensation regime for “presumed” Internet service provider-bound traffic with capped rates above a fixed traffic exchange ratio. Traffic in excess of a ratio of 3:1 (terminating minutes to originating minutes) is presumed to be ISP-bound traffic, and is to be compensated at a rate of $.0007, or the applicable state-approved rate if lower. Traffic below the 3:1 threshold is to be compensated at the rates in existing and future interconnection agreements. Traffic above the 3:1 ratio was also subject to a growth ceiling with traffic in excess of the growth ceiling subject to “bill and keep,” an arrangement in which the originating carrier pays no compensation to the terminating carrier to complete calls. On May 3, 2002, the U.S. Court of Appeals for the District of Columbia Circuit (Court) issued a decision in which it found that the FCC had failed to provide an adequate legal basis for its decision. The Court remanded the decision back to the FCC. In the interim the Court allowed the FCC’s interim compensation regime to remain in place. The FCC stopped enforcing the aforementioned growth ceiling in October 2004. We cannot predict the impact of the FCC’s and the Court’s ruling on existing state decisions, the outcome of pending appeals or future litigation on this issue.
The FCC, on March 10, 2004, adopted a Notice of Proposed Rulemaking, which will address a variety of issues concerning the regulatory treatment of VoIP telephony. At the same time, the FCC ruled on a petition that dealt with a VoIP service that never used the PSTN, was offered free to members of the service, and did not involve the transport of the calls. The FCC determined the service was not a telecommunications service under the Act. We cannot predict the outcome of these proceedings or other FCC or state proceedings that may affect our operations or impose additional requirements, regulations or charges upon our provision of Internet access and related Internet Protocol-based telephony services.
The FCC and many state public utilities commissions have implemented rules to prevent unauthorized changes in a customer’s pre-subscribed local and long distance carrier services (a practice commonly known as “slamming.”) Pursuant to the FCC’s slamming rules, a carrier found to have slammed a customer is subject to substantial fines. In addition, the FCC’s slamming rules allow state public utilities commissions to elect to administer and enforce the FCC’s slamming rules. These slamming liability rules substantially increase a carrier’s possible liability for unauthorized carrier changes, and may substantially increase a carrier’s administrative costs in connection with alleged unauthorized carrier changes. The Communications Assistance for Law Enforcement Act (CALEA) provides rules to ensure that law enforcement agencies would be able to properly conduct authorized electronic surveillance of digital and wireless telecommunication services. CALEA requires telecommunications carriers to modify their equipment, facilities, and services used to provide telecommunications services to ensure that they are able to comply with authorized surveillance requirements. Our switches are CALEA compliant.
State Regulation: General Framework
State regulatory agencies have regulatory jurisdiction when Pac-West facilities and services are used to provide intrastate services. A significant portion of our current traffic is classified as intrastate and therefore subject to state regulation. To provide intrastate services, we generally must obtain a certificate of public convenience and necessity from the state regulatory agency and comply with state requirements for telecommunications utilities, including state tariffing requirements. We currently have such certificates in the following 35 states, although we do not currently operate in all 35 states: Alabama, Arizona, California, Colorado, District of Columbia, Delaware, Florida, Georgia, Idaho, Illinois, Indiana, Kansas, Kentucky, Louisiana, Massachusetts, Maryland, Michigan, Missouri, Mississippi, North Carolina, New Jersey, New Mexico, Nevada, New York, Ohio, Oregon, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Utah, Washington, Wisconsin and Virginia (as Pac-West Telecomm of Virginia, Inc. dba Pac-West Telecomm, Inc.). We are currently pending approval in Minnesota.
The implementation of the Telecommunications Act of 1996 is subject to numerous state rulemaking proceedings on these issues. Thus, it is difficult to predict if full competition for local services, including local dial tone, will develop. Furthermore, the Telecommunications Act of 1996 provides that state public utilities commissions have significant roles in determining the content of interconnection agreements, including the responsibility to conduct the mandatory arbitration proceedings called for by the Telecommunications Act of 1996. The actions of the state public utilities commissions are subject to the Telecommunications Act of 1996 and, in several respects, the FCC’s interpretations thereof.
California Regulatory Proceedings and Judicial Appeals
On October 20, 2004, we filed a formal complaint with the California Public Utilities Commission (“CPUC”) against AT&T. In the complaint proceeding, we alleged that AT&T owed us over $7.0 million for traffic terminated by us on behalf of AT&T, plus late payment fees. On September 19, 2005, the presiding hearing officer released a decision granting our complaint in all regards, except for our claim for late payment fees. On October 19, 2005, AT&T filed an appeal with the CPUC, claiming the decision was in error. We filed a simultaneous appeal with the CPUC, asking for approval of late payment fees. The CPUC has not established a schedule for resolving the appeals, affecting the timing, and potentially the collectibility of these amounts.
SBC-California, now AT&T, notified us of its election to implement the FCC’s interim rate plan for ISP-bounds calls beginning August 1, 2003. We disputed SBC’s implementation of the FCC plan, and on October 14, 2003 SBC-California filed a Complaint with the CPUC seeking resolution of this issue. Pac-West and SBC reached settlement of these disputes in July 2004.
On June 12, 2002, Verizon California (Verizon) filed a Petition for Arbitration with the CPUC with respect to unresolved issues in negotiations of a new ICA with us, that would replace the prior agreement, the terms and conditions of which continued in effect until replaced pursuant to an order of the CPUC. On May 22, 2003, the CPUC issued its decision establishing the provisions of the agreement, which resulted from the arbitration. The new three-year agreement establishes the rules under which Pac-West and Verizon can interconnect their networks to allow for the exchange of traffic and the recovery of costs associated with exchanging such traffic. In addition, like the SBC agreement, it includes a new transport charge applicable to a category of telephone calls referred to as “VNXX Calls” and makes the intercarrier compensation rates established by the FCC Plan effective upon the commencement of the term of the new agreement. The terms of the agreement also provide us with incentive to modify our existing network in order to avoid these transport charges. Such modifications have been completed. We expect that intercarrier compensation will continue to represent a significant portion of our revenues in the future although, based on current market conditions, we expect the per minute intercarrier compensation rate will continue to decline from historic rates under interconnection agreements in the future. Furthermore, the policies of the CPUC and other regulatory bodies are subject to change with respect to issues, which affect the economic structure of interconnection agreements in other ways, and these issues can differ from time to time.
Regulatory Legal Proceedings
In July 2003, Verizon appealed the arbitration decision of the CPUC to Federal District Court, arguing among other things that the FCC Plan intercarrier compensation rates, which are contained in the new agreement but are lower than the comparable rates in the agreement being replaced, should have been made retroactive. We have opposed the relief sought by Verizon, and have challenged the legality of the new transport charges imposed on VNXX traffic. It is not possible to determine the outcome of this proceeding at this time.
Nevada Regulatory Proceedings and Judicial Appeals
In September 1999, Nevada Bell filed suit in U.S. Federal District Court in Reno to overturn a Public Utilities Commission of Nevada decision requiring Nevada Bell to pay us intercarrier compensation for terminating traffic to Internet service providers. On March 21, 2001, in ruling on cross-motions for summary
judgment, the district court vacated the Public Utilities Commission of Nevada decision and remanded the matter to the Public Utilities Commission of Nevada with instructions to redo its analysis regarding intercarrier compensation. We appealed this decision to the United States Court of Appeals for the Ninth Circuit. The Ninth Circuit upheld the district court and the matter has been remanded to the Public Utilities Commission of Nevada. It is not possible to determine the outcome of this proceeding at this time.
Local Regulation
Our network is subject to numerous local regulations such as building codes and licensing requirements. Such regulations vary on a city-by-city and county-by-county basis. To the extent we decide in the future to install our own fiber optic transmission facilities, we will need to obtain rights-of -way over private and publicly owned land and pole attachment authorizations. There can be no assurance that such rights-of -way or authorizations will be available to us on economically reasonable or advantageous terms. We could also be subject to unexpected franchise requirements and be required to pay license or franchise fees based on a percentage of gross revenues or some other formula.
Employees
As of December 31, 2005, we had 296 employees. We believe that our future success will depend on our continued ability to attract and retain highly skilled and qualified employees. None of our employees are currently represented by a collective bargaining agreement. We also believe that we enjoy good relationships with our employees.
Available Information
Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on our Investor Relations web site at www.pacwest.com as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. The information posted on our web site, www.pacwest.com, is not part of this Annual Report.
Item 1A. Risk Factors
Except for the historical information contained herein, this report contains forward-looking statements, subject to uncertainties and risks, and as a result, our actual results may differ materially from those discussed in this report. These uncertainties and risks include, among other things, the uncertainties and risks identified below. You should be aware; however, that the uncertainties and risks described below are not the only uncertainties and risks we are facing or will face in the future. Additional uncertainties and risks not presently known to us or that we currently believe to be immaterial may also adversely affect our business.
We have a substantial amount of indebtedness and are highly leveraged.
As of December 31, 2005, our long-term debt totaled $43.5 million. We may also incur additional indebtedness in the future to expand and develop our current business and services, make strategic acquisitions and enter new markets. Our substantial indebtedness could, among other things:
| • | increase our vulnerability to general adverse economic and industry conditions; | |
| • | limit our ability to fund future working capital, capital expenditures, marketing costs and other general corporate requirements; | |
| • | require us to dedicate a substantial portion of our cash flows from operations to payments on our indebtedness, thereby reducing the availability of our cash flows to fund working capital, capital expenditures, marketing efforts and other general corporate purposes; |
| • | limit our flexibility in planning for or reacting to changes in our business and the industry in which we operate; | |
| • | place us at a competitive disadvantage compared to our less leveraged competitors; and | |
| • | limit our ability to borrow additional funds. |
On March 11, 2005, we utilized the proceeds from the sale of our enterprise customers to TelePacific, as well as cash on hand, to repay our outstanding $40.0 million Senior Secured Note to Deutsche Bank AG — London (Deutsche Bank), as well as retire the related warrants to purchase up to 26,666,667 shares of our common stock.
We may not be able to generate sufficient cash to service our indebtedness.
Failure to generate cash in the future either from operations or from additional financing will adversely affect our ability to make payments on and to refinance our indebtedness and to fund capital expenditures and marketing efforts. Our ability to generate cash from operations will be particularly dependent on our ability to expand our business and manage our growth, provide competitive services, comply with applicable governmental regulations, negotiate favorable agreements and to maintain or lower our current expenditure rate. In addition, we may need to refinance all or a portion of our indebtedness on or before maturity. We may not be able to refinance this indebtedness on commercially reasonable terms or at all.
Migration to broadband Internet access will affect dial-up Internet access.
Traditional dial-up access to the Internet is a mature technology. Major segments of this market may experience migration to broadband access where available and competitively priced. With the evolution of new technologies many new IP applications are now available, such as VoIP, which may hasten the transition of end-users from dial-up to broadband access. While we remain focused on serving the needs of our customers who provide dial-up access to their end-users, if migration to broadband access occurs faster than we anticipate our revenue streams may be adversely affected.
A substantial portion of our total revenue is from intercarrier compensation payments, which are subject to regulatory and legal uncertainty.
Intercarrier compensation payments from ILECs accounted for approximately 40.3%, 32.1% and 35.0% of our total revenues for the years ended December 31, 2005, 2004 and 2003, respectively. Intercarrier compensation payments are a function of the number of calls we terminate, the minutes of use associated with such calls and the rates at which we are compensated by the ILECs. We believe that under the Telecommunications Act of 1996, other ILECs should have to compensate us when their customers place calls to Internet service providers who are our customers. Our right, to receive this type of compensation is the subject of continual regulatory and legal challenges by the ILECs.
Potential change in the regulation of network neutrality could affect our operations.
Network neutrality is the concept that network operators provide free and non-discriminatory transport on their networks between the endpoints of the Internet. There were principles that were adopted by the FCC to ensure that broadband networks are widely deployed, open, affordable and accessible to all consumers. Congress and federal regulation agencies are reviewing “network neutrality,” which may be resolved in a manner that strengthens or weakens interconnection rights and obligations for carriers, or leaves the existing rules intact. Weaker interconnection rights may make the environment more difficult for CLECs, including Pac-West.
We may not have sufficient funds available to complete our planned national expansion or otherwise expand our product offerings.
We may need to make significant capital expenditures in order to complete our planned national expansion or otherwise expand our product offerings. We expect to fund these expenditures through existing
resources, through internally generated funds, or through future equity and debt financings. If we are unable to raise sufficient funds, we may have to delay or abandon some of our expenditures or plans for future growth. This could result in underutilization of our established infrastructure, reduced profitability and may negatively affect our ability to compete for and satisfy the demands resulting from the growth and expansion of our customer base.
Our failure to develop and timely deliver products and services may impair our ability to achieve sufficient market acceptance to become profitable.
To be successful, we must develop and market products and services that are widely accepted by customers at profitable prices. Our success will depend upon the willingness of our target customers to accept us as a high-value independent provider of integrated communications solutions that are timely delivered to market.
The loss of key executive officers could negatively impact our business prospects.
We believe that a critical component of our success will be the retention of our key executive officers. Henry R. Carabelli, our President and Chief Executive Officer has significant expertise in the telecommunications industry and has been instrumental in establishing and executing our business plan and strategy. The loss of the services of Mr. Carabelli or our other executive officers, including the following officers could adversely affect our business prospects, financial condition and results of operations:
| • | H. Ravi Brar, our Chief Financial Officer and Vice President of Human Resources; | |
| • | Todd M. Putnam, our Chief Information Officer; | |
| • | Michael B. Hawn, our Vice President Customer Network Services; | |
| • | Sarita Fernandes, our Vice President Marketing; | |
| • | Eric E. Jacobs, our Vice President, General Manager Service Provider Sales; | |
| • | Michael L. Sarina, our Vice President Finance; | |
| • | John F. Sumpter, our Vice President Regulatory; | |
| • | Robert C. Morrison, our Vice President and General Counsel; and | |
| • | Reid M. Cox, our Vice President of Business Development and Investor Relations. |
Future success will depend on the ability to attract and retain highly skilled and qualified employees.
Due to the telecommunication being a high tech industry we are subject to high employee turnover.
Our need to comply with extensive government regulation can increase our costs and slow our growth.
Our networks and the provision of telecommunications services are subject to significant regulation at the Federal, state and local levels. Delays in receiving required regulatory approvals or the enactment of new adverse regulation or regulatory requirements might slow our growth and have a material adverse effect upon us. Regulators at both the Federal and state level require us to pay various fees and assessments, file periodic reports, and comply with various rules regarding the contents of our bills, protection of subscriber privacy, service quality and similar matters on an ongoing basis. We cannot provide assurance that the FCC or state commissions will grant required authority or refrain from taking action against us if we are found to have provided services without obtaining the necessary authorizations, or to have violated other requirements of their rules and orders. Regulators or others could challenge our compliance with applicable rules and orders. Such challenges could cause us to incur substantial legal and administrative expenses.
The Sarbanes-Oxley Act of 2002 is expected to be significant in terms of time, resources and costs.
On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law and became some of the most sweeping federal legislation addressing accounting, corporate governance and disclosure issues. The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and imposes significant new requirements for public company governance and disclosure requirements. Some of the provisions of the Sarbanes-Oxley Act became effective immediately while others are still being implemented.
In general, the Sarbanes-Oxley Act mandates important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It establishes new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and creates a new regulatory body to oversee auditors of public companies. It backs these requirements with new SEC enforcement tools, increases criminal penalties for federal mail, wire and securities fraud, and creates new criminal penalties for document and record destruction in connection with federal investigations. It also increases the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.
The economic and operational effects of this new legislation on public companies, including us, will be significant in terms of the time, resources and costs associated with complying with the new law. Because the Sarbanes-Oxley Act, for the most part, applies equally to larger and smaller public companies, we will be presented with additional challenges as a smaller, telecommunications company seeking to compete with larger telecommunications companies in our industry.
In September 2005, the SEC decided to postpone the compliance date for filing internal control reports by companies not designated as accelerated filers. As discussions are continuing regarding the final implementation deadline of Sarbanes-Oxley Act, the ultimate timing, resources and costs to be incurred by the Company are unknown.
We are dependent on many vendors and suppliers and their financial difficulties may adversely affect our business.
We depend on many vendors and suppliers to conduct our business. For example, we purchase our network assets from equipment manufacturers and other suppliers and we lease fiber and other circuits from other carriers as well as from companies, which construct these network elements for resale. Many of these third parties have experienced substantial financial difficulties, in some cases leading to bankruptcies and liquidations. The financial difficulties of these companies could have a material adverse affect on our business and prospects.
Our network expenses could increase if the TelePacific enterprise customer base migration occurs sooner than contemplated in the Transition Service Agreement.
We have certain commitments and agreements with certain vendors associated with our circuits in which our network expenses could increase if the enterprise customers sold to TelePacific move off of our network sooner than what is contemplated in our Transition Service Agreement.
If we do not interconnect with and maintain efficient working relationships with our primary competitors, the ILECs, our business will be adversely affected.
Many carriers, including us, have experienced difficulties in working with the ILECs with respect to initiating, interconnecting, and implementing the systems used by these carriers to order and receive unbundled network elements and wholesale services and locating the new carriers’ equipment in the offices of the ILECs. We must coordinate with ILECs so that we can provide local service to customers on a timely and competitive basis. The Telecommunications Act of 1996 created incentives for regional Bell operating companies to cooperate with new carriers and permit access to their facilities by denying such companies the
ability to provide in-region long distance services until they have satisfied statutory conditions designed to open their local markets to competition.
The regional Bell operating companies have been fined numerous times by both Federal and state authorities for their failure to comply with applicable telecommunications laws and regulations. We do not believe these fines have had any meaningful impact on the anticompetitive practices of many of these companies and in fact believe that these practices are increasing in most of our markets. We attempt to enforce our rights against these incumbent monopolies but often times the remedies are inadequate to change their anticompetitive practices and in any event provide us with little or no recovery of the damages we have suffered as a result of these practices. Moreover, efforts by us to enforce our rights against these companies may further diminish the level of cooperation we receive from them. If we cannot obtain the cooperation of a regional Bell operating company in a region, or a regional Bell operating company otherwise fails to meet our requirements, for example, because of labor shortages, work stoppages or disruption caused by mergers or other organizational changes or terrorist attacks, our ability to offer services in such region on a timely and cost-effective basis will be adversely affected.
Our principal competitors, the ILECs, and potential additional competitors, have advantages that may adversely affect our ability to compete with them.
The telecommunications industry is both highly competitive and dominated by the ILECs who enjoy the benefit of significant market share earned over a time when there was little to no competition in the marketplace. Many of our current and potential competitors in the local market have financial, technical, marketing, personnel and other resources, including brand name recognition, substantially greater than ours, as well as other competitive advantages over us. In each of the markets targeted by us, we compete with the ILEC serving that area. ILECs are established providers of local telephone services to all or virtually all telephone subscribers within their respective service areas. ILECs also have long-standing relationships with Federal and state regulatory authorities. FCC and state administrative decisions and initiatives provide the ILECs with pricing flexibility for their products and services.
We also face, and expect to continue to face, competition from other current and potential market entrants, including CLECS, cable television companies, electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end users. In addition, a renewed trend toward consolidation as a result of mergers, acquisitions and strategic alliances in the telecommunications industry could also affect the level of competition we face. Furthermore, the development of new technologies could give rise to significant new competitors in the local market. These competitive forces could adversely affect our business.
Some of our competitors have lower cost structures through restructuring activities.
Due to the readily available sources of capital during the 1990s, many CLECs and other incumbent carriers included building their own networks, including fiber transport capacity, as a key component of their operating plans. This resulted in an excess of network capacity in many areas throughout the U.S. with insufficient traffic volumes to cover the corresponding cost of capital and debt loads that were necessary to build the network infrastructures. Accordingly, some of the companies have not survived or have been forced to restructure, often through bankruptcy. When these companies restructure they generally have new, lower cost structures, which often allow them to aggressively price their products and services, effectively driving down the market rates in a way that could adversely affect our business.
A system failure could delay or interrupt our services.
Our operations are dependant upon our ability to support our network infrastructure. Many of our customers are particularly dependent on an uninterrupted supply of services. Any damage or failure that causes interruptions in our operations could result in the loss of these customers and could have a material adverse effect on our business and our financial condition. Because of the nature of the services we supply and the nature of our network, it is not feasible to maintain complete backup systems, and the occurrence of a
natural disaster, act of terrorism or other operational disruption or unanticipated problem could cause interruptions in the services we provide. Additionally, the failure of a major supplier to provide the communications capacity we require, or of a major customer to continue buying our goods and services, as a result of a natural disaster, act of terrorism or other operational disruption or any other reason, could cause interruptions in the service we provide and adversely affect our business prospects, financial condition and results of operations.
Telecommunication industry trends could slow or eliminate future growth.
Competition in the communication services market has resulted in the consolidation of companies in our industry, a trend we expect to continue. In order to grow our business and better serve our customers, we continue to consider new business strategies, including potential acquisitions or new business lines. We believe that the statewide footprint of our network, which encompasses all of the major metropolitan areas of California, provides us with a significant competitive advantage that will enable us to successfully compete in the future, but we cannot guarantee that we will be able to sustain continued growth.
The developing practice by the ILECs of bundling services including long distance over their comprehensive networks could make it difficult for us to retain customers or attract new ones. In addition, technology continues to evolve with the corresponding development of new products and services. There is no guarantee we will retain our customers with our existing product and service offerings or with any new products or services we may develop in the future.
Our failure to achieve or sustain market acceptance at desired pricing levels could impair our ability to achieve profitability or positive cash flow.
Market prices for our services face competitive pressures, a trend which may continue. Accordingly, we cannot predict to what extent we may need to further reduce our prices to remain competitive or whether we will be able to sustain future pricing levels as our competitors introduce competing services or similar services at lower prices. Our ability to meet price competition may depend on our ability to operate at costs equal to or lower than our competitors or potential competitors. There is a risk that competitors, perceiving us to lack capital resources, may undercut our rates, increase their services or take other actions that could be detrimental to us.
If we are unable to effectively deliver our services to a substantial number of customers, we may experience revenue losses.
We cannot guarantee that our network will be able to connect and manage a substantial number of customers at high transmission speeds. If we cannot achieve and maintain digital transmission speeds that are otherwise available in a particular market, we may lose customers to competitors with higher transmission speeds and we may not be able to attract new customers. Actual transmission speeds on our network will depend on a variety of factors many of which are beyond our control, including the distance an end user is located from a central office, the quality of the telephone lines, the presence of interfering transmissions on nearby lines and other factors.
Our ability to provide certain services to potential customers depends on the quality, physical condition, availability and maintenance of telephone lines within the control of the ILECs. If the telephone lines are not adequate, we may not be able to provide certain services to many of our target customers and our expected revenues will be diminished. In addition, the ILECs may not maintain the telephone lines in a condition that will allow us to implement certain services effectively or may claim they are not of sufficient quality to allow us to fully implement or operate certain services.
We may incur liabilities as a result of our Internet service offerings.
United States law relating to the liability of on-line service providers and Internet service providers for information carried on, disseminated through, or hosted on their systems is currently unsettled. If liability is imposed on Internet service providers, we would likely implement measures to minimize our liability exposure.
These measures could require us to expend substantial resources or discontinue some of our product or service offerings. In addition, increased attention to liability issues, as a result of litigation, legislation or legislative proposals could adversely affect the growth and use of Internet services.
We are subject to audits with various tax authorities and may incur liabilities as a result.
From time to time, we are subject to audits with various tax authorities that arise during the normal course of business which could result in a liability exposure. During the third quarter of 2005, the Company received two tax assessments arising from audits. Subsequent to the third quarter of 2005, the Company filed appeals against both assessments.
Our stock has been extremely volatile.
Our stock has experienced significant price and volume fluctuations, often times due to factors beyond our control. Given that our stock is thinly traded, sales by even a single large stockholder can materially decrease our market price. The market price for our common stock may continue to be subject to wide fluctuations in response to a variety of other factors, including but not limited to the following, some of which are beyond our control: revenues and operating results of our company or other emerging communications companies failing to meet the expectations of securities analysts or investors in any period; failure to successfully implement our business strategy; announcements of operating results and business conditions by our customers and competitors; technological innovations by competitors or in competing technologies; announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; announcements by third parties of significant claims or proceedings against us; investor perception of our industry or our prospects; economic developments in the telecommunications industry or general market conditions; or major geopolitical events such as war, terrorism or political change around the world.
On September 15, 2005, we received a letter from The Nasdaq Stock Market (“Nasdaq”) notifying us that the bid price of our common stock had closed below the minimum bid price required for continued inclusion on the Nasdaq Capital Market. The letter further notified us that we will be provided 180 calendar days to regain compliance with the minimum bid price requirement. Compliance may be achieved if the bid price per share of our common stock closes at $1.00 per share or greater for a minimum of 10 consecutive business days. However, Nasdaq has the discretion to require a period in excess of 10 business days before determining that the ability to maintain long-term compliance has been demonstrated. The letter from Nasdaq further stated that, if compliance with the minimum bid price requirement cannot be demonstrated, but we otherwise meet the applicable initial listing requirements, we may qualify for an additional 180 day compliance period. On March 15, 2006, we received a letter from Nasdaq notifying us that we had been granted an additional 180-day compliance period.
If we do not regain compliance with Nasdaq’s minimum bid price requirement, our common stock could be delisted from the Nasdaq Capital Market, which could reduce the liquidity of the market for our common stock and increase the volatility of the market price of our common stock. As of March 15, 2006, we had not regained compliance with the Nasdaq’s minimum bid price requirement.
Consolidation in the telecommunications industry could lead to the creation of stronger competitors.
There has been consolidation in the telecommunications industry with several mergers and acquisitions and this trend may continue. In addition, some telecommunication companies have filed for bankruptcy protection and enjoy court protection from creditors and lower their cost structures. These events could lead to the creation of substantially larger competitors, which may have greater resources and lower cost structures than us.
