ITEM 1. BUSINESS
OVERVIEW
We provide broadband wireless Internet and wireless subscription television services using radio spectrum licensed by the FCC in the 2.1 GHz and 2.5 GHz bands, primarily in medium and small markets across Texas, Oklahoma and the Midwestern United States. We own the basic trading area ("BTA") authorization, or otherwise license or lease MDS, MMDS and ITFS spectrum, in 93 markets covering an estimated 8.4 million total households. On average, we own or lease approximately 130 MHz of spectrum per market. We often refer to our frequencies collectively in this report as "MMDS."
CONVERSION OF WIRELESS CABLE BUSINESS
Historically, we have used our spectrum to provide wireless subscription television services, commonly referred to as "wireless cable." However, as part of our long-term plan to shift the use of our spectrum from wireless cable to broadband Internet and other advanced wireless services, we are in the process of converting substantially all of our wireless cable subscribers to programming provided by DIRECTV, Inc. ("DIRECTV"), Pegasus Satellite Television, Inc. ("Pegasus") and an affiliate of Time Warner Cable ("Time Warner Cable").
In exchange for each wireless cable subscriber converted, we receive a conversion payment and, in the case of subscribers converted to DIRECTV and Pegasus, an equipment subsidy, installation payment and residual royalty. As a result of the conversion of our wireless cable subscribers, revenues and cash generated from our wireless cable business will decline substantially in 2003 as our wireless cable subscribers convert or otherwise disconnect their service. Except for a nominal residual royalty payment and recognition of deferred revenues related to cash received at the time of conversion, we do not expect our existing wireless cable subscriber base to generate material revenues or cash flows for the Company after 2003. Although we intend to continue to reduce expenditures associated with our wireless cable business, the ongoing costs of maintaining our FCC spectrum licenses and leases, as well as other corporate overhead, will exceed recurring revenues as we implement this conversion program. At February 28, 2003, we had converted a total of approximately 19,800 wireless cable customers to programming provided by DIRECTV, Pegasus and Time Warner Cable. Since August 2002, as part of our conversion plan we have terminated wireless cable service in 14 markets, and consolidated operations in 14 additional markets. We continue to provide wireless cable services in a total of 43 markets. We expect to close and consolidate operations in additional wireless cable markets through 2003 as we implement the conversion program and clear our spectrum for advanced broadband wireless services.
In addition to the conversion of our wireless cable subscribers discussed above, we have marketed and sold DIRECTV digital broadcast satellite programming as a commissioned sales agent for DIRECTV since 1998. Under an agreement with DIRECTV entered into in February 2001, we receive up front and residual commissions for DIRECTV subscriptions that we sell. We also receive certain equipment subsidies from DIRECTV-approved equipment providers. If we do not meet certain subscriber benchmarks during any calendar year of our agreement with DIRECTV, residual commissions will be reduced for future years. As part of the downsizing of our wireless cable sales, marketing and technical resources, we expect the residual commissions to be reduced, and we do not expect to generate material revenues or cash flows from this DIRECTV resale business beyond 2003.
At February 28, 2003, we had approximately 13,600 wireless cable customers, including approximately 13,200 customers who subscribed only to programming service provided over our MMDS spectrum, and 400 "combo" subscribers who subscribed to both our MMDS programming service and to DIRECTV programming service sold by us. In addition, at February 28, 2003, there were approximately 18,000 customers
who received only DIRECTV programming sold by us. We already have received up front commissions for the "DIRECTV only" and "combo" subscribers; therefore, we are not eligible for additional conversion payments under our agreements with DIRECTV and Pegasus for these subscribers. Our business strategy contemplates a decline in wireless cable subscribers, DIRECTV subscribers, revenues and cash flows in 2003 and beyond, as we allocate most of our resources to maintain our spectrum assets and develop our broadband wireless Internet access and other advanced wireless services.
BUSINESS STRATEGY
Our long-term business strategy is to provide fixed, portable and, ultimately, mobile broadband wireless Internet access and other information services using our high-capacity MMDS radio spectrum in medium and small markets. We often refer to these services throughout this report as "broadband wireless" services. Our expected range of services includes high-speed Internet connectivity that is integrated with wireless Local Area Networks for businesses and Home Area Networks for residential users to distribute broadband services throughout a customer's business and home. We currently provide high-speed wireless Internet access service to approximately 420 accounts in Austin and Sherman-Denison, Texas. These accounts primarily are medium-sized and small businesses, small offices/home offices ("SOHOs") and telecommuters. Our current service offerings include Internet access from 128 Kbps to 1.54 Mbps, or up to 50 times faster than service provided over standard dial-up telephone lines. Through two national independent contractors, we also provide value-added services such as e-mail, Web hosting and design, and domain name service.
We believe we are well positioned to bring advanced wireless services to our medium and small markets, due to the relatively large amount of spectrum (approximately 130 MHz per market) that we hold, and the lack of affordable broadband alternatives in many of our markets. We currently are focused on validating the most efficient technical platform from which to deliver our wireless services. Commercial deployment of second generation ("2G") MMDS technology has increased substantially over the last six months. MMDS equipment providers have announced deployments of 2G systems in both the U.S. and internationally. We expect 2G technology to allow us to deliver broadband wireless service that (1) does not require a direct line-of-sight from our base stations to many customers' premises, (2) is suited for portable and nomadic devices such as lap-top computers and personal digital assistants, or PDAs, and (3) allows customers to "plug and play," or install and upgrade their customer premises equipment themselves.
During the first half of this year, we expect to complete our evaluation of 2G technical platforms, and will seek to raise $15 million -- $20 million in new capital. We expect to use this capital for maintenance of existing strategic spectrum resources, operating expenses and to fund deployment of a 2G MMDS Internet system in up to two markets. We have retained Houlihan Lokey Howard & Zukin ("Houlihan Lokey") as our financial advisor in connection with this potential financing. We also may seek additional capital if we consummate any significant acquisitions or strategic alliances, or determine that market conditions are appropriate for such financing. There can be no assurance that financing will be available on acceptable terms or in a timely manner, if at all. See Item 7, "MD&A -- Liquidity and Capital Resources" in this report.
At February 28, 2003, we had approximately $4.7 million of unrestricted cash and cash equivalents. As set forth in note 1(b) to the consolidated financial statements, the consolidated financial statements contained in this report have been prepared on a "going concern" basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. In conjunction with their 2002 year end audit, our independent accountants have issued an audit opinion with respect to our 2002 consolidated financial statements which includes an explanatory paragraph describing conditions that raise substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. We expect that cash on hand of $4.7 million at February 28, 2003, and cash generated from our operations, with no additional financing, will be sufficient to fund operations in the normal course of business at least through the second quarter of 2003. See Item 7, "MD&A -- Liquidity and Capital Resources" in this report.
CORPORATE INFORMATION
Nucentrix was incorporated under the laws of the State of Delaware in October 1993. Our executive offices are located at 4120 International Parkway, Suite 2000, Carrollton, Texas 75007, and our telephone number is (972) 662-4000.
MMDS LICENSES AND LEASES
We hold the licenses granted by the FCC for approximately 85% of our MDS and MMDS channels. We lease from third-party license holders the rights to (1) the remaining 15% of our MDS and MMDS channels and (2) all of our ITFS channels, which generally comprise 20 of the 33 channels available in each market. All MDS and MMDS licenses expire in either 2006 or 2011. Approximately 60% of our MDS/MMDS licenses are for BTA channels that expire in 2006; the other 40% are "incumbent" channels that expire in May 2011. ITFS licenses generally have a term of 10 years. All licenses are subject to renewal by the FCC as described in "Government Regulation." Although FCC custom and practice establish a presumption of granting renewals of licenses, the presumption requires that the licensee substantially comply with its regulatory obligations during the license period, including construction obligations.
Each of our spectrum leases typically covers four ITFS channels or one to four MDS/MMDS channels. The initial terms of our leases for ITFS spectrum typically expire five to ten years after the license grant date, but in any event may not exceed 15 years. The initial terms of the leases for MDS/MMDS spectrum typically expire five to 10 years from the lease execution date. The average remaining terms of most of our current ITFS and MDS/MMDS spectrum leases, including all renewal terms, is approximately 10 years. Substantially all of our ITFS spectrum leases contain a right of first refusal, which allows us the right to match any offer for use of the spectrum for a period of time after termination of the lease (generally one year). We believe that substantially all of our MDS/MMDS spectrum leases allow for flexible use of the spectrum, including for two-way data transmission. Approximately 75% of our ITFS spectrum leases in our top 40 projected Internet markets conform to the FCC's rules for flexible, two-way use of this spectrum. We believe that another 10% of these ITFS channel leases, although entered into before the issuance of the two- way rules, would be "grandfathered" under the FCC's rules and authorized for flexible, two-way use of the spectrum.
We also hold authorizations for 90 BTAs in which we have the exclusive right to apply for and develop available MDS and MMDS frequencies, subject to our lease of MDS/MMDS channels in 10 BTAs and portions of four other BTAs to CS Wireless Systems, Inc. ("CS Wireless"), a subsidiary of WorldCom, Inc. ("WorldCom"). Additionally, current FCC regulations generally require these BTAs to be built out by August 2003. See "Government Regulation -- BTA Auction and Service Requirements" in this report. As of February 28, 2003, we believe all of the BTAs that we hold and consider important to our long-term business strategy would be considered built out under current FCC rules, except for 19 BTAs. However, we believe we have sufficient MMDS or ITFS spectrum leased in approximately one-half of these remaining 19 BTAs to launch a 2G Internet system. The rules proposal submitted to the FCC for the 2.5 GHz band and discussed below requests the FCC to suspend the BTA build-out requirements while the proceedings to consider new rules for the 2.5 GHz band are pending.
RULES PROPOSAL FOR 2.5 GHZ BAND
In September 2001, the FCC allocated the 2.5 GHz band for flexible use, making this band available for advanced fixed, portable and mobile services, including mobile third generation, or "3G," wireless systems. However, new technical and licensing rules are necessary in order to accommodate the provision of portable and mobile 2G broadband wireless services. In October 2002, a coalition of MMDS and ITFS operators and licensees submitted a proposal to the FCC to replace the existing regulations for the 2.5 GHz band with new rules, including a new nationwide bandplan and geographic service areas that would accommodate deployment of 2G broadband wireless services. Among other things, the proposal requests the FCC to:
- modify the MMDS/ITFS rules to allow deployment of cellular systems that can operate on fixed, portable and mobile bases,
- establish a new, nationwide bandplan for the 2.5 GHz band that separates high-power operations from two-way cellular operations and eliminates the need for consent from adjacent channel licensees in most instances,
- replace the existing system of multiple, interleaved 6-MHz channels in MMDS/ITFS with substantially contiguous spectrum blocks in a lower (66 MHz), middle (42 MHz) and upper (66 MHz) portion of the 2.5 GHz band,
- replace the site-by-site licensing system for MMDS/ITFS cellular systems with rules modeled on more flexible wireless regulations, allowing licensees to construct and operate facilities within defined geographic service areas,
- establish a market-by-market mechanism for transitioning from the old bandplan to the new one, and
- eliminate certain outdated regulations and conform the MMDS/ITFS rules to current FCC standards for geographically-licensed flexible use services.
The proposal also requests that the FCC suspend BTA build-out requirements, as well as individual station construction and maintenance rules, while the proposed rulemaking is pending. The proposal further requests that current BTA and individual station construction deadlines (e.g., August 2003 for BTAs, 12 months from the date of grant of the authorization for MMDS stations and 18 months from the date of grant of the authorization for ITFS stations) be replaced with a uniform "substantial service" requirement at renewal of the applicable authorization, similar to current rules for Wireless Communications Service ("WCS") spectrum at 2.3 GHz. Under this proposal, a licensee would be required to demonstrate that it is providing substantial service to a specified geographic area in order for the FCC authorization to be renewed. See "Business -- Government Regulation -- BTA Auction and Service Requirements" and "WCS Licenses" in this report.
In October 2002, the FCC issued a public notice seeking comment on the industry rules proposal. In March 2003, the FCC adopted a Notice of Proposed Rulemaking ("NPRM") on the 2.5 GHz band. Among other things, the NPRM requests public comment on operational, technical and procedural rule changes for the 2.5 GHz band, including the industry proposal to reconfigure the 2.5 GHz band. The NPRM also proposes technical rules designed to increase flexibility of licensees in the 2.5 GHz band, including rules governing fixed, portable and mobile operations. See "Business -- Risk Factors -- Changes in the regulatory status of the 2.5 GHz band may delay deployment of 2G broadband systems" in this report.
MARKETS/SPECTRUM HOLDINGS
We estimate that the BTAs and 35-mile protected service areas ("PSAs") in our markets include approximately 8.4 million households. Estimated household information is based on 1990 census bureau data and data from a commercially available 2001 population projection database. The actual number of households that can receive and/or transmit an adequate signal may vary significantly from this estimate based on a number of factors, including transmitter height and power, topography and the proximity of adjacent MMDS systems. In addition, because of smaller cell radiuses typically associated with 2G MMDS technology, it may be uneconomic to construct networks to serve all of the households in our BTAs and PSAs. Therefore, our total addressable market may be significantly less than 8.4 million households.
During the fourth quarter of 2002, we considered the potential effect of the proposed new rules for the 2.5 GHz band, which we believe will accommodate deployment of 2G broadband wireless services using less spectrum than with first generation technology. We also evaluated the strategic importance of spectrum leases in certain of our smaller markets and the associated cost of maintaining these leases. Based on these considerations, we determined not to renew certain spectrum leases, and otherwise informed spectrum lessors in non-strategic markets of our intent to discontinue certain leases. As a result, we have reduced our average spectrum per market from 150 MHz to approximately 130 MHz per market, which we believe is more than sufficient to launch and maintain 2G and future broadband Internet systems in our strategic markets.
The following table provides information as of February 28, 2003, regarding the 93 markets in which we operate a wireless cable or broadband wireless system, own the BTA authorization or hold additional MDS/MMDS/ITFS spectrum rights. Certain of our spectrum rights are subject to pending applications for new channel licenses, modifications to existing channel licenses or special temporary and developmental authorizations, and must be reviewed by the FCC's engineering and legal staff.
- ---------------
+ Operating wireless cable market.
++ Operating broadband wireless market.
(1) Unless otherwise noted, the number of channels available includes channels (a) that are either licensed to us or leased to us from other license holders or (b) for which we or our ITFS lessors have filed applications with the FCC that we expect to be granted in 2003. The number of channels available includes leased ITFS channels that may not currently be available for two-way broadband wireless services.
(2) Eight commercial ITFS channels are subject to pending petitions for reconsideration of the FCC's decision to declare the stations automatically forfeited, which we believe will be granted.
In addition to MDS, MMDS and ITFS spectrum rights owned by Nucentrix, we are a party to an agreement with CS Wireless under which CS Wireless agreed to assign to us 20 MHz of WCS spectrum at 2.3 GHz in 19 markets, primarily in Texas. We currently lease this spectrum under an exclusive lease agreement with CS Wireless. Assignment of the WCS spectrum is subject to FCC approval. In June 2002, WorldCom Broadband Solutions, Inc., an affiliate of CS Wireless and Nucentrix filed an application for FCC consent to the assignment of this spectrum to Nucentrix. The application remains pending.
NETWORKS/SUPPLIERS
Our broadband wireless business is built around a network comprised of many elements. At the core of our network is a broadband wireless platform that controls when, where and how subscribers access our
network and how data is transported over the air between subscriber premises and our services networks (e.g., the Internet for data services, the Public Switched Telephone Network for voice services). This core wireless access system is the focus of our 2G technology validation process.
On either side of this core wireless network are specific computer and communications equipment components that are typically supplied by third party vendors, and are necessary for a complete "end-to-end" system solution. These components are generally commercially available, field proven technologies, such as radio antennas, power amplifiers, point-to-point microwave equipment, routers, gateways, switching equipment and communication servers from vendors such as AML Wireless Systems, Inc., Andrew Corporation, Inc., Cisco Systems, Inc., Hewlett-Packard Company, Juniper Networks, Inc., REMEC, Inc., Sun Microsystems, Inc. and many others.
Next generation, or "2G," technology platforms, are characterized by:
- multi-cellular architectures using smaller cells to improve both the coverage and capacity performance of the network,
- small, relatively inexpensive customer premises equipment ("CPE") that can be located within the residence or place of business, with little or no significant line-of-sight requirement, and typically installed or configured by the customer, and
- nomadic and portable broadband services.
There currently are several vendors manufacturing 2G platforms. These vendors include BeamReach Networks, Inc., IP Wireless, Inc., Navini Networks, Inc., NextNet Wireless, Inc. and Soma Networks, Inc. Each of these vendors has made unique engineering choices in the fundamental design of its system to best position its technology for success. These choices include multiple access method (e.g., CDMA, OFDM), duplexing method (frequency division duplexing and time division duplexing) and the use of advanced access techniques such as adaptive modulation and smart antennas. During the second half of 2002 and first quarter of 2003, several of these vendors began commercial deployment of 2G systems, both domestically and internationally. We expect to complete our evaluation of the commercial viability and business case potential of 2G platforms in the first half of 2003 and, by the end of the first quarter of 2004, deploy up to two 2G broadband wireless systems to validate the business model for more wide-scale deployment after 2003.
COMPETITION
HIGH-SPEED INTERNET COMPETITION
The Internet access market is highly competitive. We face competition from many Internet access and service providers with significantly greater financial resources, well-established brand names and large, existing customer bases. Our competition in this industry includes:
Internet Service Providers ("ISPs"). ISPs provide Internet access to residential and business customers. These companies can:
- provide Internet access over incumbent local exchange carriers' ("ILECs") networks at high speeds,
- offer digital subscriber line ("DSL")-based access using their own DSL services, or DSL services offered by ILECs and others, and
- have significant and sometimes nationwide marketing presences and combine these with strategic or commercial alliances with DSL-based incumbent and competitive carriers. Significant ISPs include AOL Time Warner, Inc. ("AOL"), Microsoft Corporation and EarthLink, Inc.
Incumbent Local Exchange Carriers. ILECs, such as SBC Communications, Inc., Verizon Communications, Inc. and Qwest Communications International, Inc. ("Qwest") have existing metropolitan area networks and circuit-switched local access networks. Incumbent carriers have deployed commercial DSL services in certain areas and are combining their DSL service with their own Internet access services. The
incumbent carriers generally have an established brand name in their service areas and possess sufficient capital to deploy DSL services rapidly.
Interexchange Carriers. Many of the interexchange carriers, such as AT&T Corporation, WorldCom and Sprint, have the capability to support high-speed, end-to-end networking services. These carriers have deployed large scale networks, have large numbers of existing business and residential customers and enjoy strong name recognition. These companies increasingly are bundling their services to include high-speed local access combined with metropolitan and wide area networks, and a full range of Internet services and applications. Other carriers, such as Qwest and Level 3 Communications, Inc., are managing high-capacity, nationwide Internet protocol, or "IP," networks and partnering with ISPs to offer a range of services to businesses and consumers.
Cable Modem Service Providers. Cable modem service providers, like the Time Warner Cable division of AOL, AT&T Broadband Corp., Comcast Corporation and Cox Communications, Inc., among others, currently offer consumers and businesses high-speed Internet access over hybrid fiber coaxial cable networks. Where deployed, these networks provide local access services similar to our services, and in some cases at higher speeds.
Satellite and Other Fixed Wireless Providers. We will face competition from satellite-based systems. Hughes Network Systems, a unit of Hughes Electronics Corporation (through its DirecWay brand), currently offers two-way broadband satellite service. In addition, many local and regional ISPs use unlicensed spectrum to offer terrestrial fixed wireless high-speed Internet access.
Competitive Local Exchange Carriers. We expect competitive local exchange carriers ("CLECs") to offer DSL-based data services. Traditional CLECs, including Allegiance Telecom, Inc., McLeodUSA Incorporated and Birch Telecom, have extensive fiber-based networks in numerous metropolitan areas and are capable of providing voice and high-speed data services to businesses.
3G Wireless. We also expect more competition from 3G wireless providers, as commercial mobile radio service providers begin to deploy 3G services in their spectrum bands. The successful deployment of 3G wireless services could significantly expand the availability of broadband services, especially to consumers that currently are unserved by wireline connections.
Many of these competitors are offering, or may soon offer, and services that will directly compete with some or all of our service offerings. We may not be able to compete effectively, especially against established industry competitors with significantly greater financial resources. We believe the principal competitive factors that we face include:
- transmission speed,
- reliability of service,
- ability to bundle services,
- price performance,
- customer support,
- brand recognition,
- operating experience, and
- capital availability.
For a further discussion of competition in this industry, see "Business -- Risk Factors -- The Internet access market is highly competitive. Because many competitors in our markets are well-established and have resources significantly greater than those available to us, we may not be able to establish a significant number of Internet access customers in our markets" in this report.
GOVERNMENT REGULATION
General. MDS, MMDS and ITFS services are subject to regulation by the FCC under the Communications Act of 1934, as amended ("Communications Act"). The Communications Act authorizes the FCC, among other things, to:
- issue, revoke, modify and renew station licenses,
- approve the assignment and/or transfer of control of such licenses,
- approve the location and technical parameters of MDS, MMDS and ITFS transmission facilities (headends and base stations),
- regulate the type, configuration and operation of equipment used by MDS, MMDS and ITFS systems,
- impose certain equal employment opportunity and other periodic reporting requirements on MDS, MMDS and ITFS operators, and
- review and approve/disapprove certain terms of ITFS spectrum lease agreements.
MDS, MMDS and ITFS Licenses. In our markets, a total of 32 six-MHz channels and one four-MHz channel are available in the MDS, MMDS and ITFS frequency bands. The FCC can license the 13 MDS and MMDS channels directly to commercial entities for full-time operation without service restrictions. Except in limited circumstances, the FCC generally can license 20 ITFS channels only to qualified non-profit educational organizations. When using analog transmissions, each of the ITFS channels must broadcast programming for educational purposes a minimum of 20 hours per week. The remaining air time on ITFS channels may be leased for commercial use, without further programming restrictions except that the ITFS license holder, at its option, must be entitled to recapture up to an additional 20 hours of air time per channel per week for educational programming. When using digital transmissions, an ITFS licensee must reserve 5% of the capacity of each 6 MHz channel for immediate ITFS use upon request. There is no additional recapture requirement for an ITFS licensee when using digital transmissions.
The FCC established MDS/MMDS spectrum in 1974 with the allocation of two channels (MDS-1 and MDS-2/2A). In 1983, the FCC reallocated a total of eight ITFS channels to MMDS to satisfy a growing demand for the delivery of video entertainment programming to subscribers and to provide competition to hardwire cable television systems. Simultaneous with this reallocation of spectrum, the FCC amended its rules for the remaining ITFS channels to permit ITFS licensees, subject to their meeting certain educational programming requirements, to lease excess capacity to commercial MMDS service providers. ITFS channels originally had been allocated solely for educational purposes.
In 1985, the FCC established a lottery procedure for awarding MDS and MMDS station licenses. In 1990, the FCC shifted to a one-day cut-off period application process, under which all mutually exclusive MDS and MMDS licenses were issued on essentially a first-come, first-served basis. In 1995, the FCC adopted rules under which MDS and MMDS applications for new stations would be subject to a competitive bidding process, or spectrum auction. The FCC generally considers applications to be mutually exclusive if the grant of one application would effectively preclude the grant of one or more of the other applications due to interference that cannot be avoided through cooperation of the parties. Using the competitive bidding process, in 1996 the FCC auctioned off one authorization for each of the 493 BTAs. Each BTA authorization holder is permitted to apply for, and following FCC grant, to construct facilities to provide services over any unlicensed MDS or MMDS channel within the BTA, and has preferred rights to the available ITFS frequencies within the BTA, subject to the superior rights of any qualified ITFS applicant. The MDS and MMDS licenses issued or applied for before the BTA auction are commonly referred to as "incumbent" MDS/MMDS licenses, while the MDS and MMDS station authorizations issued pursuant to BTA ownership are commonly referred to as "BTA" MDS/MMDS licenses.
The application and licensing process for ITFS stations is different from those for MDS and MMDS stations. In 1995, the FCC adopted a national filing window system. Under this system the FCC accepts applications for licenses for new ITFS stations or major changes to existing ITFS licenses only if they are filed
within specific windows, typically five days, set by the FCC. Applications filed in a particular window are subject only to competing proposals filed in that same window. Where two or more applications are filed within the same window and are predicted to cause each other harmful electrical interference, licenses are awarded by the FCC pursuant to a comparative selection process.
Generally, in the case of MDS, MMDS and ITFS stations, the FCC issues the station licensee a conditional license, allowing construction of the station to commence. The station may be constructed and operated only in accordance with the parameters set forth in the license. Transmission generally must begin within one year of grant of the conditional license in the case of incumbent MDS/MMDS licenses, 18 months in the case of ITFS licenses and by August 2003 for BTA MDS/MMDS licenses. As discussed above under "Rules Proposal for 2.5 GHz Band," the industry proposal for new rules in the 2.5 GHz band requests that that the FCC suspend the build-out requirements for BTAs and individual stations while the proposed rulemaking is pending, and replace existing construction deadlines with a "substantial service" requirement at renewal. If this or a similar proposal is not adopted and construction deadlines for a license are not met, then (1) the FCC may revoke the license or (2) in the case of the BTA licenses, reduce the license service area if less than two-thirds of the population of the BTA service area is capable of being reached by a station signal by the expiration of the seven-year BTA build-out period. Although FCC rules permit parties to request extensions of channel construction deadlines, the FCC is not required to grant extensions. We believe that we have satisfied all construction deadlines relating to our licensed stations except for those licenses for which the deadline has not yet passed or for which we have received an extension.
MDS, MMDS and ITFS licenses generally have terms of 10 years. All BTA MDS/MMDS licenses expire on March 28, 2006. All incumbent MDS/MMDS licenses expire on May 1, 2011. Licenses may be renewed through applications filed with the FCC within a certain period before expiration of the license term, and petitions to deny applications for renewal may be filed by other parties during certain periods following the filing of such applications. The FCC may revoke or cancel licenses for violations of the Communications Act or the FCC's rules and policies, whether or not related to the license under review. Alien ownership exceeding prescribed levels and conviction of certain criminal offenses may also render a licensee or applicant unqualified to hold a license. Although FCC custom and practice establish a presumption granting renewals of licenses, the presumption requires that the licensee substantially comply with its regulatory obligations during the license period.
FCC rules generally prohibit the sale for profit of an MDS or MMDS conditional license or of a controlling interest in the conditional license holder before construction of the station or, in certain instances, prior to the completion of one year of operation. However, access to channels may be obtained during these prohibited periods through the leasing of an MDS or MMDS license holder's channel capacity. The granting of options to purchase a controlling interest in a licensee or an option to purchase a license is also permitted during these prohibited periods. During the lifetime of any such lease or option agreement, the licensee must remain in control of its FCC license to avoid violating FCC transfer-of-control rules. Our lease agreements with license holders typically require the license holders, at our expense, to use their best efforts, in cooperation with us, to make various required filings with the FCC in connection with the maintenance and renewal of licenses. We believe this reduces the likelihood that the FCC will revoke, cancel or fail to renew a license.
BTA Auction and Service Requirements. In 1996, the FCC concluded its first auction of available commercial MMDS spectrum in the 493 BTAs. Under the FCC's rules, certain qualified small business auction winners, called "designated entities," were permitted to pay off winning bids in installment payments. The winner of a BTA has the exclusive right to apply for and develop the available MDS and MMDS frequencies in the BTA, subject to certain specified interference criteria that protect incumbent MDS and MMDS stations. Incumbent licensees also must protect the BTA licensees from system interference caused by modifications to incumbent stations, including power increases or base station relocations.
BTA auction winners currently have a "build-out" period through August 2003. During the build-out period, a BTA holder can initiate or expand service within its BTA without competition from other MDS/ MMDS spectrum applicants except in those areas and on those channels for which there is an incumbent
MDS/MMDS licensee. After the build-out period, a BTA holder can retain its authorization for an entire BTA if its signal is capable of covering at least two-thirds of the population within its BTA service area, excluding those who are located within the protected service areas of incumbent MDS/MMDS stations licensed to others. As discussed above, the industry proposal for new rules in the 2.5 GHz band requests that the FCC suspend the build-out requirements for BTAs while the proposed rulemaking is pending, and replace current BTA build-out requirements with a "substantial service" requirement at renewal. If this or a similar proposal is not adopted, and the BTA holder fails to meet the coverage requirement after the build-out period, then the BTA license for the portion of the BTA that is not capable of being served will be subject to forfeiture. The FCC's rules allow BTAs to be partitioned and BTA licensees are permitted to contract with other entities to allow them to file applications with the FCC for available spectrum within the partitioned area. We expect the FCC to renew BTA licenses after the expiration of their 10-year term if the authorization holder satisfies the coverage requirement and is in compliance with the Communications Act and the FCC's rules.
BTAs. We hold authorizations for 90 BTAs acquired in the 1996 auction.Failure to remit installment payments in a timely manner or to meet the build-out deadlines could result in the forfeiture of some or all of the BTA authorizations that we hold. We believe that we have satisfied the applicable financial and coverage requirements, or that the FCC will suspend, extend or otherwise modify the build-out requirement, to allow us to retain substantially all our BTA authorizations in which we intend to operate. If the FCC does not suspend, extend or otherwise modify the August 2003 build-out requirement, we believe all of the BTAs that we hold and consider strategic to our long-term business strategy would be considered built out under current FCC rules, except for 19 BTAs. However, we believe we have sufficient MMDS or ITFS spectrum leased in approximately one-half of these remaining 19 BTAs to launch a 2G Internet system.
In October 1997, we entered into a lease and purchase option agreement with CS Wireless for BTA channels in 10 BTAs and portions of four additional BTAs already licensed to us. Under this agreement, CS Wireless has agreed to reimburse us for all amounts paid to the FCC for the BTAs leased to CS Wireless. The agreement also provides CS Wireless the option to purchase the leased BTA channels. In July 2002, CS Wireless, along with its indirect parent WorldCom, Inc., filed for protection under Chapter 11 of the U.S. Bankruptcy Code. CS Wireless has reimbursed the Company for substantially all post-petition amounts owed to us. Approximately $87,000 in prepetition amounts related to BTA reimbursements remain unpaid. If CS Wireless assumes the BTA Agreement in its Chapter 11 proceeding, it will be required to pay all prepetition amounts owed to the Company.
WCS Licenses. In February 1997, the FCC reallocated and assigned the use of the frequencies at 2305-2320 MHz and 2345-2360 MHz to WCS. WCS licensees are permitted to provide fixed, mobile and radio location services throughout their 2.3 GHz band. In addition, satellite digital audio radio service ("SDARS") may be provided on all frequencies in the band except for those at 2305-2310 MHz. WCS licenses, which generally are awarded by the FCC through competitive bidding, have terms of 10 years. Although the licenses carry with them a "renewal expectancy," each WCS licensee is subject to certain "substantial service" requirements that must be met during the initial license term. "Substantial service" is defined by the FCC as "service which is sound, favorable, and substantially above the level of mediocre service which just might minimally warrant renewal." Failure by a licensee to meet this requirement may result in a forfeiture of its license. We lease 20 MHz of WCS spectrum in 19 markets from CS Wireless, which spectrum is subject to an application for assignment to Nucentrix that is pending at the FCC. Some SDARS providers have proposed to deploy an extensive network of land-based repeaters that, if authorized by the FCC, could create interference that substantially impairs the use of WCS spectrum for two-way Internet, data and other services.
Transmission. The FCC also regulates transmitter locations and signal strengths. The operation of an MDS, MMDS and ITFS system typically requires the co-location of a commercially viable amount of spectrum operating under common technical characteristics. To co-locate spectrum, an applicant must demonstrate that its proposed signal does not violate interference standards in the FCC-protected area of previously-authorized MDS, MMDS and ITFS stations. An MDS and MMDS license holder generally is protected from interference from another MDS or MMDS operator within a 35-mile radius of the base station called a "protected service area." An ITFS license holder generally is entitled to protection from electrical
interference to all of its receive sites. In addition, an ITFS station is entitled to a 35-mile protected service area (1) during the use of the station's excess channel capacity by an MMDS operator if it has requested and received a protected service area from the FCC or (2) from all MDS, MMDS and ITFS station licensees that implement two-way digital operations.
Two-Way Authorization. In September 1998, the FCC amended its rules to allow for the use of MMDS spectrum for two-way digital services, including high-speed Internet, data, voice and video services. As amended, these rules are referred to as the "two-way rules." The two-way rules are intended to provide licensees and operators in the MDS, MMDS and ITFS spectrum with the technical and operational flexibility to add various digital two-way services to their current offerings. The two-way rules permit the use of MDS, MMDS and ITFS frequencies for both downstream and response transmissions. Two-way service is provided through the use of "response" stations, such as at the customer's premises, and response station "hubs," or base stations, which serve as collection points for response transmissions. The two-way rules also permit a cellular system design using a "signal booster station," or additional transmission site not located at the base station, which is used either to originate or relay signals to customers and also serve as a response station hub for those customers.
Under the two-way rules, all MDS, MMDS and ITFS spectrum generally can be used for upstream or downstream communications. All spectrum will continue to be subject to the FCC's interference protection requirements and existing or future spectrum capacity lease agreements. In addition, MDS, MMDS and ITFS operators that operate digital two-way communications systems are permitted, subject to certain limitations, to "shift" required ITFS educational programming to any MDS, MMDS or ITFS channel within the same operating system, "load" ITFS programming onto less than the total number of channels licensed to a particular ITFS licensee or "swap" their spectrum for other spectrum in the same market. However, channel swaps represent changes in licensees and require the filing of applications with the FCC and receipt of FCC approval.
Flexible Use Authorization. In September 2001, after a period of study of almost one year to identify additional spectrum for 3G wireless services, the FCC decided not to relocate incumbent license holders and operators in the 2.5 GHz band, such as the Company, to other frequency bands. In connection with this decision, the FCC also added a flexible use allocation to the 2.5 GHz band, making this band available for advanced mobile services, including 3G wireless systems. In October 2002, a coalition of MMDS and ITFS operators and licensees submitted a proposal to the FCC to replace the existing regulations for the 2.5 GHz band with new rules, including a new nationwide bandplan and geographic service areas that would accommodate deployment of 2G broadband wireless services. The same month, the FCC issued a public notice seeking comment on the proposal and, in March 2003, the FCC adopted a NPRM proposing technical rules for fixed, portable and mobile operations in the 2.5 GHz band. See "Business -- Rules Proposal for 2.5 GHz Band" in this report.
Regulation of Internet Service Providers. Congress has passed a number of laws that concern the Internet, including the Digital Millennium Copyright Act, the Children's Online Privacy Protection Act, the Children's Online Protection Act and the Protection of Children from Sexual Predators Act of 1998. A number of states and foreign countries have enacted or proposed similar legislation. Generally, these laws provide liability limitations for Internet service providers that do not knowingly engage in unlawful activity. We do not anticipate that compliance with these laws will have an adverse impact on us. However, we may be required to implement operating guidelines to comply with the laws and could be subject to liability if we fail to implement appropriate guidelines or otherwise violate any of these new laws.
Aside from the use of spectrum, the FCC has held that Internet access services are "information services" not subject to FCC regulation. Nevertheless, the FCC has held that Internet dial-up traffic is interstate traffic subject to FCC jurisdiction. The U.S. Court of Appeals for the D.C. Circuit has remanded that decision for the second time, and the FCC has not yet addressed the most recent remand. There can, therefore, be no certainty that the providing of Internet access services will continue to be free from FCC regulation.
Regulation of Telecommunications Services. If we begin providing wireless telecommunications services or voice over IP services, we may be subject to a variety of FCC and state regulation of our interstate and intrastate telecommunications services, respectively. Although the FCC currently does not consider voice over IP services to be telecommunications services, and thus does not regulate them as such, this position could change. Moreover, the regulatory status of voice over IP is unsettled at the state level, and a number of states have indicated that they will assert or attempt to assert regulatory jurisdiction over at least some voice over IP services. If we begin providing voice over IP, we may be subject to regulation in some states but not in others.
The Cable Act. On October 5, 1992, Congress passed the Cable Television Consumer Protection and Competition Act of 1992 (the "Cable Act"). Pursuant to the Cable Act, effective October 6, 1993, commercial broadcasters may require cable operators and other multichannel video service providers to obtain their consent before retransmitting their signals. The FCC has exempted wireless cable providers from the retransmission consent rules if the receive-site antenna is either owned by the subscriber or within the subscriber's control and available for purchase by the subscriber upon the termination of service. In all other cases, wireless cable providers must obtain consent to retransmit broadcast signals. We believe that we have obtained or requested substantially all consents required to retransmit local broadcast signals in our wireless cable markets. We cannot assure you that existing consents will be maintained or renewed or that we will be able to obtain any additional necessary consents on terms satisfactory to us, if at all. Unlike hardwire cable systems, wireless cable systems are not required under the Cable Act and the FCC's "must carry" rules to retransmit a specified number of local commercial and non-commercial television or qualified low power television signals.
Copyright. Under the Federal copyright laws, permission from the copyright holder generally must be secured before certain video programs may be retransmitted. Under Section 111 of the Copyright Act of 1976, certain "cable systems," including wireless cable providers, are entitled to engage in the secondary transmission of broadcast programming without the prior permission of the holders of copyrights in the programming if a compulsory copyright license is secured. Such a license may be obtained upon the filing of certain reports and the payment of certain fees set by copyright arbitration royalty panels. We believe we have obtained all compulsory copyright licenses required for each of our wireless cable markets.
Other Regulations. As a lessee of antenna structure space, we indirectly (through contractual commitments) may be subject to Federal Aviation Administration regulation and FCC registration for the construction, maintenance and lighting of transmission towers and by certain local zoning regulations affecting construction of towers and other facilities. Federal environmental regulations, state and local environmental land use regulations and zoning regulations also may apply.
SPECTRUM ALLOCATION PROCEEDINGS FOR ADVANCED WIRELESS SERVICES
We currently use spectrum at 2150-2160 MHz for upstream transmissions in our two existing broadband wireless systems. In November 2002, the FCC issued a Second Report and Order (the "Order") that allocated one 45-MHz frequency band at each of 1710-1755 MHz and 2110-2155 MHz for fixed and mobile advanced wireless services, including 3G services. Under the Order, our licenses and operations in the 2.1 GHz band would be relocated. In February 2003, the FCC released a Notice of Proposed Rulemaking (the "Subsequent NPRM") to consider possible relocation spectrum and procedures for MDS operations in the 2.1 GHz band. However, in February 2003, the Wireless Communications Association International, Inc. ("WCA"), the principal trade association for the MMDS industry, filed a Petition for Reconsideration of the Order ("WCA Petition"). The WCA Petition seeks reconsideration of the Order because, among other reasons, the Order purports to relocate 2.1 GHz licenses, many of which were purchased under the FCC's BTA auction in 1996, without identifying proposed comparable replacement spectrum or relocation reimbursement procedures.
In July 2002, prior to the issuance of the Order and the Subsequent NPRM, the Company and the other major holders of MDS spectrum in the United States (BellSouth Corporation, Sprint Corporation and WorldCom), along with WCA, filed a proposal for a compromise solution with the FCC. The proposal provides that the holders of MDS spectrum at 2.1 GHz would agree to relocate to spectrum at
1916 MHz and 1990-1996 MHz, with the costs of relocation to be borne by the winners of the 1.7/2.1 GHz band auction. Among other parties, Nextel Communications, Inc. ("Nextel") has opposed this proposal, and has requested that the FCC provide Nextel with replacement spectrum at 1.9 GHz in connection with the possible realignment of public safety operations in the 800 MHz band.
We are not able to predict whether the FCC will reconsider the Order or accept our proposal, nor can we determine at this time the impact that relocation to another band would have on our operations. Relocation of our 2.1 GHz licenses and operations to another frequency band could require new or additional equipment, raise operating costs, delay the provision of service or render service uneconomic in certain areas.
TRADEMARKS
We own common law trademark rights in and have United States trademark registrations on the trademarks NUCENTRIX BROADBAND NETWORKS, NUCENTRIX, CYBERWAVE, HEARTLAND CABLE TELEVISION and in the stylized mark HEARTLAND. We consider these intellectual property rights important to our business.
EMPLOYEES
As of February 28, 2003, we had approximately 100 employees. None of our employees is subject to a collective bargaining agreement. We have experienced no work stoppages and believe that we generally have good relations with our employees. We also use the services of independent contractors in our wireless cable systems.
REORGANIZATION
On December 4, 1998, we filed a voluntary, prenegotiated Plan of Reorganization (the "Plan") and disclosure statement under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of Delaware (In re Heartland Wireless Communications, Inc., Case No. 98-2692 (JJF)). We filed the Plan with the prepetition agreement from the holders of more than 70% in principal amount of our $115 million 13% senior notes and $125 million 14% senior notes to support the Plan. On March 15, 1999, the Bankruptcy Court confirmed our Plan, which became effective on April 1, 1999 (the "Effective Date"). As of the Effective Date we changed our name from Heartland Wireless Communications, Inc. ("Heartland"), to Nucentrix Broadband Networks, Inc. We also adopted Fresh Start Reporting as of the Effective Date. See "MD&A -- Effects of Reorganization" in this report.
As of the Effective Date:
- all previously issued and outstanding common stock, options granted under our stock option plans, warrants and any other equity interests in Nucentrix were canceled,
- holders of our senior notes received 9,700,000 shares of newly issued common stock, and
- holders of $40.2 million of convertible subordinated notes received 300,000 shares of newly issued common stock and warrants to purchase 825,000 shares of common stock at an exercise price of $27.63 per share, subject to downward adjustment in the event of a sale or merger of the Company.
Under the Plan we also were obligated to issue warrants to acquire an additional 275,000 shares of common stock at an exercise price of $27.63 per share, subject to downward adjustment in the event of a sale or merger of the Company. These warrants were allocated pro rata to holders of Heartland common stock, and substantially all of these warrants were issued in 2002.
TRANSACTIONS
In February 2003, we sold seven MDS/MMDS channels in Seminole, Texas to a rural telephone cooperative for approximately $100,000. We estimate that the channels include approximately 9,000 households in their coverage area.
In February 2003, we partitioned and sold our BTA rights in two counties in Eastern New Mexico from our Amarillo, Texas BTA to a rural telephone cooperative for $88,000. We estimate that the partitioned portion of the BTA includes approximately 8,000 households in its coverage area, and that up to 13 MDS/MMDS channels should be available for licensing.
In September 2002, in connection with a market interference agreement entered into in 1996, we entered into an agreement to assign our Brownwood and San Angelo, Texas BTAs and 21 BTA channels (12 in Brownwood and nine in San Angelo) to a rural telephone cooperative for $210,000, net of BTA debt. We estimate that the unencumbered portion of the BTAs includes approximately 32,000 households in its coverage area. This transaction is subject to FCC approval.
SEGMENT INFORMATION
Based on the criteria outlined in SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information," Nucentrix is comprised of two reportable segments: (1) wireless cable and (2) broadband wireless. See note 1(s) of the notes to consolidated financial statements included in Item 8 of this report. Although revenues from our broadband wireless segment were immaterial in 2002, 2001 and 2000, financial data regarding each of our segments is contained in note 16 of the notes to consolidated financial statements included in Item 8 hereof, which is incorporated herein by reference.
RISK FACTORS
Our business operations and the implementation of our long-term business strategy are subject to significant risks inherent in our business, including, without limitation, the risks and uncertainties described below. The occurrence of any one or more of the risks or uncertainties described below could have a material adverse effect on our financial condition, results of operations and cash flows. Additionally, further discussion of these risk factors and other risks may be found in Item 7, "MD&A" and elsewhere in this Item 1.
WE MAY NOT BE ABLE TO OBTAIN THE ADDITIONAL FINANCING NECESSARY TO IMPLEMENT OUR LONG-TERM BUSINESS STRATEGY ON SATISFACTORY TERMS AND CONDITIONS.
To implement our long-term business strategy, we will need additional capital for capital expenditures, operating expenses, system development costs and acquisition costs, including debt that may be assumed in future acquisitions. We plan to finance these activities by debt or equity financings, secured or unsecured credit facilities, vendor financing, sales of assets, joint ventures or other arrangements. We cannot assure you that we will be able to obtain the financing we will need to fund the implementation of our long-term business strategy on satisfactory terms and conditions, if at all. If we incur additional debt, we may have to dedicate a substantial portion of our cash flow from operations to the payment of principal and interest, which may cause us to be more vulnerable to competitive pressures and economic downturns. Our failure to obtain additional financing in a timely manner and on acceptable terms would adversely affect our ability to continue as a going concern and may require us to delay, reduce or eliminate the launch of new high-speed Internet access systems or sell some or a substantial portion of our assets.
WE ARE PURSUING A NEW BUSINESS THAT WE HAVE NOT PREVIOUSLY OPERATED ON A LARGE SCALE. WE MAY NOT BE ABLE TO SUCCESSFULLY IMPLEMENT OUR LONG-TERM BUSINESS STRATEGY OR REVERSE OUR HISTORY OF LOSSES.
We historically have used our radio spectrum to provide wireless cable services and incurred substantial operating and net losses from these operations. The principal focus of our long-term business strategy currently is to transition the use of our MDS, MMDS and ITFS spectrum to fixed, portable and mobile broadband wireless services, such as high-speed Internet access. We have launched commercial high-speed Internet access service in only two of our markets, and the revenues that we have received in these two initial markets are immaterial to date (approximately 1.4% of consolidated revenues in 2002). When we determine to deploy additional markets, we intend to increase our capital expenditures to develop and launch broadband wireless services in additional markets, and we expect operating expenses from our broadband wireless operations to exceed revenues from those operations until our customer base increases. As a result, we anticipate that our
net and operating losses will continue until we successfully implement our business strategy. We cannot assure you that we can develop, market and expand our broadband wireless services in the two initial markets or any additional markets to the extent necessary to successfully compete in the broadband services industry.
WE EXPECT THAT OPEN TECHNOLOGY STANDARDS AMONG MMDS EQUIPMENT MANUFACTURERS WILL LOWER EQUIPMENT AND OTHER COSTS FOR SERVICE PROVIDERS. THERE IS NO ASSURANCE THAT THESE STANDARDS WILL EVOLVE.
We believe that open, or non-proprietary, manufacturing standards ultimately are necessary in 2G MMDS technology to lower infrastructure and customer premise equipment costs, and allow for interoperability and flexibility for service providers. Although there are discussions among various vendors to develop open standards in this area, there is no assurance that these standards will evolve in the near future or at all. The failure of these standards to evolve could result in higher operating costs and unacceptable operating margins.
THE INTERNET ACCESS MARKET IS HIGHLY COMPETITIVE. BECAUSE MANY COMPETITORS IN OUR MARKETS ARE WELL-ESTABLISHED AND HAVE RESOURCES SIGNIFICANTLY GREATER THAN THOSE AVAILABLE TO US, WE MAY NOT BE ABLE TO ESTABLISH A SIGNIFICANT NUMBER OF INTERNET ACCESS CUSTOMERS IN OUR MARKETS.
As we enter the high-speed Internet access business, we will be forced to compete with numerous service providers, including the following:
- other ISPs which have developed high-speed access capabilities such as DSL along with their existing services,
- ILECs which are providing DSL-based services in addition to their existing wide area, metropolitan and local area networks,
- interexchange carriers, which are expanding their networks to support high-speed local access, including DSL-based services and a full range of Internet services and applications,
- cable modem service providers offering high-speed access services to consumers and businesses,
- satellite and other fixed wireless data service providers, which have deployed or are developing broadband two-way data and voice services,
- CLECs, which are offering high-speed data and other services, and
- 3G wireless providers, which are expected to offer broadband mobile wireless services and capabilities.
Many of our competitors are well-established and have larger and better developed networks and systems, longer-standing relationships with customers and suppliers, greater name recognition and significantly greater financial, technical and marketing resources than we have. Many of these companies can subsidize competing services with revenues from other services and have ready access to capital markets. As competition increases in the high-speed Internet access market, we anticipate intensified downward pricing pressure for our services. If we are unable to compete effectively it will adversely affect our ability to successfully implement our business strategy.
WE CANNOT PREDICT WHETHER WE WILL BE SUCCESSFUL IN IMPLEMENTING OUR LONG-TERM BUSINESS STRATEGY BECAUSE IT INCLUDES OPERATIONS THAT HAVE NOT BEEN WIDELY DEPLOYED ON A COMMERCIAL BASIS. OUR FAILURE TO ACHIEVE OR SUSTAIN MARKET ACCEPTANCE COULD IMPAIR OUR ABILITY TO ACHIEVE PROFITABILITY.
Our primary business strategy of providing broadband wireless services over MMDS spectrum has not been widely deployed on a commercial basis. The success of our long-term business strategy depends on our ability to develop and market our high-speed Internet access service at profitable rates. We will face a number of difficulties and uncertainties generally associated with new businesses, such as:
- lack of consumer acceptance,
- difficulty in obtaining financing,
- competition from providers using more traditional and commercially proven sources for these services,
- advances in competing technologies, and
- changes in laws and regulations.
We have launched commercial high-speed Internet access service in only two of our existing markets, and we cannot assure you that businesses and consumers will accept our service as a commercially viable alternative to other means of Internet access.
WE ARE SUBJECT TO EXTENSIVE FEDERAL LAWS, RULES AND REGULATIONS. THE LAWS, RULES AND REGULATIONS TO WHICH WE ARE SUBJECT COULD CHANGE AT ANY TIME IN AN UNPREDICTABLE MANNER.
Our continued ability to acquire, lease and maintain MDS, MMDS and ITFS spectrum, which is vital to our operations, is subject to extensive regulation. These regulations directly affect the breadth of services we are able to offer, as well as the rates, terms and conditions of those services. We also are affected indirectly by other governmental regulations of companies that offer competing services. Regulations and their application are subject to continual change as a result of new legislation, regulations adopted from time to time by regulatory authorities and judicial interpretation of these laws and regulations. We are not able to predict the extent to which any change in the regulatory environment could affect our business. We cannot assure you that changes in legislation, regulations and interpretations would not have a significant adverse impact on our ability to implement our business strategy.
Aside from the use of spectrum, the FCC has held that Internet access services are "information services" not subject to FCC regulation. Nevertheless, the FCC has held that the Internet dial-up traffic is interstate traffic subject to FCC jurisdiction. The U.S. Court of Appeals for the D.C. Circuit has remanded that decision for the second time, and the FCC has not yet addressed the most recent remand. There can, therefore, be no certainty that the providing of Internet access services will continue to be free from FCC regulation. Moreover, if we begin providing wireless telecommunications services or voice over IP services, we will be subject to FCC and state regulation of our interstate and intrastate telecommunications services, respectively, and may be subject to regulation of our voice over IP services.
CHANGES IN THE REGULATORY STATUS OF THE 2.5 GHZ BAND MAY DELAY DEPLOYMENT OF 2G BROADBAND SYSTEMS.
Use of the 2.5 GHz band for 2G fixed, portable and mobile services will require an extensive rulemaking proceeding at the FCC to adopt technical, operating and licensing rules in this band. The failure to finalize interference rules in the 2.5 GHz band on a timely basis could delay, limit or prevent the launch of fixed, portable or mobile services in this band.
WE COULD BE REQUIRED TO RELOCATE EXISTING AND FUTURE OPERATIONS IN THE 2.1 GHZ BAND TO ACCOMMODATE 3G MOBILE SYSTEMS.
We currently use the 2.1 GHz band in our two existing broadband wireless networks. In November 2002, the FCC issued an Order that allocated one 45-MHz frequency band at each of 1710-1755 MHz and 2110-2155 MHz for fixed and mobile advanced wireless services, including 3G services. Under the Order, our licenses and operations in the 2.1 GHz band would be relocated. In February 2003, the FCC released a subsequent Notice of Proposed Rulemaking to consider possible relocation spectrum and procedures for MDS operations in the 2.1 GHz band. However, in February 2003, WCA filed a Petition for Reconsideration of the Order. We are not able to predict with certainty whether the FCC will reconsider the Order, nor can we determine at this time the impact that relocation would have on our operations; however, relocation of operations to another frequency band could require new or additional equipment, raise operating costs, delay the provision of service or render service uneconomic in certain areas.
WE DEPEND ON FCC-REGULATED LICENSES AND SPECTRUM LEASES. THE FAILURE TO MAINTAIN SPECTRUM RIGHTS IN VARIOUS MARKETS COULD ADVERSELY AFFECT OUR ABILITY TO TIMELY IMPLEMENT OUR BUSINESS STRATEGY.
We depend upon licenses granted to us by the FCC and leases with other FCC license holders for access to spectrum capacity necessary to operate our Internet business. These licenses are subject to renewal as determined by the FCC. FCC licenses also specify construction deadlines by which channel transmissions must begin, which, if not met, would permit the FCC to revoke the license. We cannot assure you that:
- the FCC will renew our licenses as their initial terms expire,
- our spectrum lessors will continue to hold valid licenses for their spectrum,
- we will be able to renew our spectrum leases on terms acceptable to us, or
- the FCC will grant requests for extensions of construction deadlines.
The failure to maintain FCC licenses and spectrum leases will reduce the spectrum available for our use. If we fail to maintain sufficient FCC licenses or spectrum leases in markets where we operate or in which we intend to launch two-way Internet access service, then the resulting reduction in spectrum capacity could have a material adverse effect on our ability to:
- serve our existing Internet access customer base,
- serve increasing customer demand for high-speed Internet access service, and
- add services such as voice over IP or wireless telecommunications services.
We cannot assure you that we will be able to obtain replacement spectrum or other acceptable alternatives in a market if we lose an FCC license or spectrum lease in that market.
OUR BASIC TRADING AREA, OR "BTA," AUTHORIZATIONS ARE SUBJECT TO FORFEITURE IF WE DEFAULT ON OUR PURCHASE PRICE PAYMENTS OR FAIL TO MEET CERTAIN SERVICE REQUIREMENTS. THE COSTS OF THE BUILD-OUT TO SATISFY OUR BTA SERVICE REQUIREMENTS COULD BE MATERIAL.
We acquired authorizations for over 90 BTAs in August 1996 at a total cost of approximately $19.8 million. As of February 28, 2003, $8.4 million in principal amount of this debt remained payable quarterly through August 2006. Each BTA is subject to an individual installment note. If we fail to make one or more scheduled installment payments on a BTA note after any applicable grace period, that BTA authorization may be forfeited to the FCC.
To retain a BTA authorization, we must provide a required level of service in the BTA by August 2003. We will satisfy the service requirement for a BTA under current FCC regulations if we construct MDS and MMDS stations capable of providing a signal to at least two-thirds of the BTA population outside of the service areas of other MDS and MMDS operators within our BTAs. The industry proposal for new rules for the 2.5 GHz band requests that the FCC suspend BTA build-out requirements while a proposed rulemaking is pending, and replace those requirements with a uniform "substantial service" requirement at renewal of the BTA authorizations in 2006. If the FCC does not adopt this or a similar proposal, then a BTA authorization for the portion of the BTA that is not capable of being served may be subject to forfeiture. Constructing MDS and MMDS channels capable of providing service to the required population in unconstructed BTAs could require substantial capital expenditures.
THE CONVERSION OF OUR EXISTING WIRELESS CABLE SUBSCRIBERS WILL REQUIRE US TO MARKET, SELL AND INSTALL DIRECTV PROGRAMMING SERVICES TO EXISTING SUBSCRIBERS WHO CHOOSE TO ACCEPT THE CONVERSION OFFER. WE DO NOT EXPECT OUR EXISTING WIRELESS CABLE SUBSCRIBER BASE TO GENERATE MATERIAL REVENUES OR CASH FLOWS FOR THE COMPANY BEYOND 2003.
Our sales agency agreements with DIRECTV and Pegasus require us to market, sell and install DIRECTV programming packages to our existing wireless cable subscribers, except for approximately 5,700 subscribers in Central Texas, to whom Time Warner Cable has agreed to market, sell and install a conversion
offer. The failure of the Company or Time Warner Cable to effectively market, sell or install conversion offers, or poor subscriber response to the conversion program, will reduce the amounts payable by DIRECTV, Pegasus and Time Warner Cable to us for converted subscribers. Except for a nominal residual royalty and recognition of deferred revenue related to cash received at the time of conversion, we do not expect our existing wireless cable subscriber base to generate material revenues or cash flows for the Company beyond 2003. Although we intend to reduce expenditures associated with our wireless cable business, ongoing costs of maintaining our strategic FCC spectrum licenses and leases, as well as other corporate overhead, will exceed revenues as we implement the conversion program.
WE DEPEND ON KEY PERSONNEL. IF WE LOSE OUR CHIEF EXECUTIVE OFFICER OR CERTAIN OTHER MEMBERS OF SENIOR MANAGEMENT, OUR ABILITY TO IMPLEMENT OUR LONG-TERM BUSINESS STRATEGY COULD BE ADVERSELY AFFECTED.
Our future success largely depends on the expertise of Carroll D. McHenry, our Chief Executive Officer, President and Chairman of the Board, and certain other members of senior management. We have employment agreements with Mr. McHenry and other members of senior management, but do not maintain a key person life insurance policy on the life of Mr. McHenry or other members of senior management.
BUILDING AND TOWER OWNERS CONTROL ACCESS TO CERTAIN STRATEGIC ANTENNA SITES.
We will be required to obtain rights from building and tower owners to install our antennas and other equipment to provide service to our customers. We cannot assure you that we will be able to obtain, at costs or on terms acceptable to us, the rights necessary to expand our services as planned.
OUR INDUSTRY IS SUBJECT TO RAPID TECHNOLOGY CHANGES.
The high-speed Internet access industry is subject to rapid technological change, frequent new service introductions and evolving industry standards. We believe that our future success will depend largely on our ability to anticipate or adapt to these changes and to offer, on a timely basis, services that meet evolving standards. We cannot predict the extent to which competitors using existing or currently undeployed methods of delivery of Internet access services will compete with our services. We cannot assure you that:
- existing, proposed or undeveloped technologies will not render our broadband wireless systems less profitable or less viable,
- we will have the resources to acquire new technologies or to introduce new services that could compete with future technologies, or
- we will be successful in responding to technological changes in a timely and cost effective manner.
WE MAY BE LIABLE FOR INFORMATION SENT THROUGH OUR NETWORK.
The law relating to the liability of Internet access providers for information carried on, stored on or disseminated through their network is unsettled. A number of private lawsuits seeking to impose liability upon Internet access providers currently are pending or have been adjudicated. In addition, legislation has been enacted and new legislation has been proposed at both the federal and state levels as well as in foreign countries that imposes or would impose liability for the transmission of or prohibits the transmission of certain types of information on the Internet, including sexually explicit and gambling information. While no one has ever asserted a claim against us relating to this issue, someone may assert a claim of that type in the future and may be successful in imposing liability on us. Although we carry Internet liability insurance, it may not be adequate to compensate claimants or may not cover us if we become liable for information carried on or disseminated through our networks.
WE HAVE A LARGE PORTION OF OUR COMMON STOCK HELD BY A SMALL NUMBER OF OUR STOCKHOLDERS. THIS CONCENTRATION OF OWNERSHIP CAN AFFECT STOCKHOLDER VOTES AND CAUSE OUR STOCK PRICE TO BE VOLATILE IN THE PUBLIC TRADING MARKET.
A large portion of our common stock is held by a small number of stockholders. As a result, these stockholders are able to influence the outcome of stockholder votes on various matters, including the election of directors and extraordinary corporate transactions including business combinations. In addition, the occurrence of sales of a large number of shares of our common stock, or the perception that these sales could occur, may affect our stock price and could impair our ability to obtain capital through an offering of equity securities. Furthermore, the current ratios of ownership of our common stock reduces the public float and liquidity of our common stock which can in turn affect the market price of our common stock.
ITEM 2.
ITEM 2. PROPERTIES
We currently lease approximately 21,000 square feet of office space for our executive offices in Carrollton, Texas. We also lease approximately 9,600 square feet of space for telemarketing, customer care operations and training facilities in Denison, Texas. We believe that the facilities described above are leased at fair market value and are adequate for the foreseeable future.
The principal physical assets of our operating systems consist of satellite signal reception equipment, radio transmitters and transmission antennas and customer premises equipment. We lease space or have options to lease space for our broadband wireless operations on about 100 communications towers. The leases and options have terms from one to 15 years.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Settlement of Late Fee and Other Lawsuits. From time to time we have been a party to several purported class action lawsuits alleging that we overcharged our customers for administrative late fees, and that we breached various state consumer lease and credit laws and federal privacy and notice statutes. As of the date of filing of our last Quarterly Report on Form 10-Q, four of these lawsuits remained pending:
- Garcia, et al. v. Heartland Wireless Communications, Inc. d/b/a Heartland Cable Television (98-05-8388-CV), filed in May 1998 in the 79th Judicial District Court in Brooks County, Texas (dismissed and appealed),
- John Nolen, Jr., et al. v. Nucentrix Broadband Networks, Inc. (DC-00-155), filed in May 2000 in the 229th Judicial District Court in Duval County, Texas,
- Nolen, et al. v. Nucentrix Broadband Networks, Inc., et al. (L-00CV134), filed in October 2000 in U.S. District Court for the Southern District of Texas, Laredo Division (dismissed and appealed), and
- Perez, et al. v. Nucentrix Broadband Networks, Inc. (01-141-D), filed in March 2001 in the 105th Judicial District Court in Kleberg County, Texas.
In December 2002, the U.S. Supreme Court denied the plaintiff's application for writ of certiorari in the federal Nolen lawsuit. In addition, in December 2002 we removed the state court cases in Nolen and Perez to federal court.
In January 2003, we entered into a Settlement Agreement with all named plaintiffs in the lawsuits listed above, as well as all named plaintiffs in prior similar lawsuits, settling all claims brought by these plaintiffs in such matters.
Other. We are involved in routine legal and regulatory proceedings incident to our business. We do not believe that any other pending legal or regulatory matter will have a material adverse effect on our consolidated financial condition, results of operations or cash flows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended December 31, 2002.
Our annual meeting of stockholders for 2003 is scheduled for May 13, 2003. This date has changed by more than 30 days from the June 28 date of our 2002 annual meeting of stockholders. Therefore, in accordance with the Exchange Act, the dates originally disclosed in our proxy statement for the 2002 annual meeting by which stockholder proposals for the 2003 annual meeting must be delivered to Nucentrix for purposes of Rule 14a-8 and Rule 14a-4(c) of the Exchange Act have been changed to April 2, 2003, as described below.
To qualify for inclusion in the proxy statement and form of proxy for our 2003 annual meeting of stockholders, under Rule 14a-8 of the Exchange Act we must receive a proposal intended by a stockholder for presentation at that meeting at our principal executive offices on or before April 2, 2003. Under Rule 14a-4(c) of the Exchange Act, the Board of Directors may exercise discretionary voting authority under proxies solicited by it on any matter properly presented by a stockholder at our 2003 annual meeting that the stockholder does not seek to have included in our proxy statement under Rule 14a-8 of the Exchange Act if, except as described in the following sentence, the proxy statement discloses the nature of the matter and how the Board of Directors intends to exercise its discretion to vote on such matter. If we first receive notice of such matter after April 2, 2003, the Board of Directors may exercise discretionary voting authority on any matter as permitted under Rule 14a-4(c)(2), without including any discussion of the matter in the proxy statement for the 2003 annual meeting. We reserve the right to reject, rule out of order or take other appropriate action on any proposal that does not comply with the requirements described above and other applicable requirements.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Common Stock. Our common stock is traded on The Nasdaq Stock Market under the symbol "NCNX." The following sets forth the high and low sale prices of our common stock as reported on The Nasdaq Stock Market for the last two fiscal years.
The closing sale price of our common stock on March 14, 2003, was $2.05 per share. The number of record holders of common stock as of March 14, 2003, was 17.
Equity Compensation Plan Information. The following table provides information regarding all equity compensation plans as of December 31, 2002, that provide for the award of securities or grant of options,
warrants or rights to purchase securities of Nucentrix to employees or any other person. We do not have any equity compensation plans that have not been approved by our stockholders.
DIVIDENDS
We have not paid any cash dividends on our common stock, and do not intend to pay cash dividends in the foreseeable future. Our Board of Directors may reexamine our dividend policy from time to time. However, if we raise capital in the future through financings, the terms of these financings may restrict or prohibit us from paying any dividends on our common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents summary historical financial and other data for Nucentrix. As a result of the application of Fresh Start Reporting in connection with the Plan, financial information as of December 31, 2002, 2001, 2000 and 1999, and for the years ended December 31, 2002, 2001 and 2000, and the period from the Effective Date to December 31, 1999 (the "Successor Period"), is presented on a different basis than the financial information as of December 31, 1998, and for the year ended December 31, 1998, and for the period from January 1, 1999, to the Effective Date (collectively, the "Predecessor Period"). See Item 1, "Business -- Reorganization" in this report. The selected historical financial data presented below as of and for each of the years in the five year period ended December 31, 2002, is derived from the audited consolidated financial statements of Nucentrix. Historically, we have used our spectrum primarily to deliver wireless cable services. In 2002, we began to convert our wireless cable subscriber base to clear our spectrum to provide broadband wireless Internet, data and other services. Therefore, our historical results are not necessarily indicative of our future results as we pursue our business strategy as described in Item 1, "Business -- Overview." You should read the financial data below together with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and with Nucentrix's consolidated financial statements, including the notes thereto, included elsewhere in this report.
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(1) In the fourth quarter of 2002, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, we wrote down systems and equipment, and license and leased license investments (spectrum licenses and leases), to estimated fair value, which resulted in a non-cash impairment charge of $4.8 million. In the fourth quarter of 2001, in accordance with SFAS No. 121 (which has been superseded by SFAS No. 144), we also wrote down systems and equipment, and license and leased license investments to estimated fair value, which resulted in a non-cash impairment charge of $14.1 million. See Item 7, "MD&A -- Results of Operations for the Three Years Ended December 31, 2002 -- Impairment of Long-Lived Assets," and note 3 to the consolidated financial statements included in this report. In the second and third quarters of 1998, we wrote down license and leased license investments, systems and equipment and other long-lived assets to estimated fair value, which resulted in a non-cash impairment charge of $105.8 million.
(2) We filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code on December 4, 1998. Our Plan was confirmed on March 15, 1999, and became effective on April 1, 1999. Accordingly, we have reclassified our prior senior and subordinated notes, which were subject to compromise in the reorganization, to "Liabilities Subject to Compromise" at December 31, 1998. Expenses related to our reorganization, such as professional fees and administrative expenses, were classified as "Reorganization costs." See note 2 to the consolidated financial statements included in this report.
(3) Loss per basic and diluted common share for each period presented has been calculated using the provisions of SFAS No. 128, "Earnings per Share." Earnings per share information has not been presented for the Predecessor Period because Nucentrix was recapitalized on the Effective Date, in connection with the Plan, and accordingly, per share amounts are not comparable between the
Predecessor Period and the Successor Period. See note 2 to the consolidated financial statements included in this report.
(4) "EBITDA," or earnings before interest, taxes, depreciation and amortization, for 2002 and 2001 includes non-cash charges for impairment of long-lived assets of $4.8 million and $14.1 million, respectively. EBITDA is widely used by analysts, investors and other interested parties as a measure of operating results in the Internet, cable television and telecommunications industries, due to the significant initial capital investment typically required by companies in these industries. EBITDA is also a widely accepted financial indicator of a company's ability to incur and service indebtedness. EBITDA is not a financial measure determined by generally accepted accounting principles ("GAAP") and should not be considered as an alternative to net income or net loss as a measure of operating results or to cash flows as a measure of funds available for discretionary or other liquidity purposes. EBITDA may not be comparably calculated from one company to another.
A reconciliation of EBITDA to net income (loss) is as follows:
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
General. We provide broadband wireless Internet and wireless subscription television services using radio spectrum licensed by the FCC in the 2.1 GHz and 2.5 GHz bands, primarily in medium and small markets across Texas, Oklahoma and the Midwestern United States. We own the BTA authorization, or otherwise license or lease MDS, MMDS and ITFS spectrum, in 93 markets covering an estimated 8.4 million total households. On average, we own or lease approximately 130 MHz of spectrum per market. Our long-term business strategy is to provide fixed, portable and, ultimately, mobile broadband Internet access and other information services using our high-capacity MMDS radio spectrum in medium and small markets. See Item 1, "Business -- Overview" in this report.
Historically, we have used our spectrum to provide wireless subscription television services, commonly referred to as "wireless cable." We presently have wireless cable transmission facilities constructed and
operating in 43 markets in seven states. At February 28, 2003, we had approximately 13,600 wireless cable customers, including approximately 13,200 customers who subscribed only to programming service provided over our MMDS spectrum, and 400 "combo" subscribers who subscribed to both our MMDS programming service and to DIRECTV programming service sold by us. In addition, at February 28, 2003, there were approximately 18,000 customers who received only DIRECTV programming sold by us. In March 2002, as part of our long-term plan to clear our spectrum for broadband Internet and other advanced wireless services, we announced the signing of agreements with DIRECTV, Pegasus and Time Warner Cable to convert substantially all of our wireless cable subscribers to programming provided by these entities. See Item 1, "Business -- Conversion of Wireless Cable Business" in this report.
Revenues. Our revenues currently consist primarily of monthly fees paid by wireless cable subscribers for basic programming, premium programming, equipment rental and other miscellaneous fees and revenues from our agency relationship with DIRECTV (which include revenues from the conversion program discussed in Item 1, "Business," in this report). Revenues also include fees generated from Internet operations in Austin and Sherman-Denison, Texas. Unless the context requires otherwise, all references to "subscribers" or "systems" are to our wireless cable subscribers and systems because revenues and subscribers from our Internet business were immaterial in 2002 (approximately 1.4% of consolidated revenues), 2001 (approximately 1% of consolidated revenues) and 2000 (less than 1% of consolidated revenues).
Subscription revenues from wireless cable subscribers and continuing monthly service fees from DIRECTV for each DIRECTV customer generated are recognized as service is provided. If the Company does not meet minimum subscriber benchmarks each year, the DIRECTV continuing monthly service fee will be reduced.
Effective January 1, 2001, wireless cable and DIRECTV installation revenue, and revenue received from our agency relationship with DIRECTV (except for continuing monthly service fees, which are recognized as received), is recognized to the extent of direct selling costs incurred, and the remainder is deferred and amortized to income over the expected subscriber relationship period. For recognition of wireless cable installation revenue, this period was three years in 2001 and one year in 2002. For recognition of DIRECTV installation and agency revenue, this period was three years in 2001 and 2002. A chargeback reserve is recorded for all DIRECTV contingencies. Prior to 2001, wireless cable installation revenue was offset against the nonrecoverable portion of installation costs, with the excess cost capitalized and amortized to depreciation expense over the expected subscriber relationship period of three years. Prior to 2001, DIRECTV installation revenue (cash received directly from the customer in conjunction with the sale) was offset against direct incremental costs, with the resulting amount recorded as a net asset. This asset, referred to as "subscriber acquisition costs," was amortized as a component of Selling, General and Administrative expense in proportion to the revenues projected to be generated over the expected subscriber relationship period. Revenue from our agency relationship with DIRECTV (other than monthly service fees) was recognized as the contingencies related to each revenue component were resolved. A chargeback reserve was not recorded for canceled subscribers. The Company revised the application of its SFAS No. 51 accounting for wireless cable installation and DIRECTV revenues prospectively, effective January 1, 2001, as discussed above. See "MD&A -- Revised Application of Accounting Policy in 2001" in this report.
System Operations Expenses. System operations expenses include channel lease payments, wireless cable programming costs, labor, and overhead, and costs related to service calls and disconnects, transmitter site and tower rentals, and certain repairs and maintenance expenditures. Programming costs, with the exception of minimum payments, channel lease payments, and repairs and maintenance, are variable expenses based on the number of subscribers.
Selling, General and Administrative ("SG&A") Expenses. SG&A expenses include office and administrative costs of operating our 43 wireless cable and two Internet markets, as well as sales and marketing and bad debt expenses related to these operations and corporate costs directly and indirectly allocated to these operations. In addition, the direct incremental costs incurred in generating a customer relationship with DIRECTV, comprised of material, equipment and labor, are recorded as an asset. This asset, referred to as "subscriber acquisition costs," is amortized as a component of SG&A expense over the expected subscriber
relationship period of three years. Prior to 2001, the direct incremental cost was offset by DIRECTV installation revenue, with only the resulting excess cost recorded as subscriber acquisition costs and amortized as a component of SG&A expense in proportion to revenues projected to be generated over the expected subscriber relationship period. The Company revised the application of its SFAS No. 51 accounting for DIRECTV installation revenue prospectively, effective January 1, 2001, as discussed above. See Item 7, "MD&A -- Revised Application of Accounting Policy in 2001" in this report.
Depreciation and Amortization Expense. Depreciation and amortization expense includes depreciation of systems and equipment and capitalized installation costs, and amortization of license and leased license investment. Our policy is to capitalize the direct costs of wireless cable installations. These direct costs include reception materials and equipment on subscriber premises and installation labor. These direct costs are capitalized as systems and equipment in the accompanying consolidated balance sheets, and are amortized over the useful life of the asset (currently 12 months) for the recoverable portion and the estimated average subscription term (currently 12 months) for the nonrecoverable portion of such costs. Prior to January 1, 2002, the recoverable portion of such costs was amortized over an estimated useful life of five years, and the nonrecoverable portion was amortized over an estimated average subscription term of three years. The nonrecoverable portion of the cost of a wireless cable installation becomes fully depreciated upon disconnection of the subscriber. Prior to 2001, the Company capitalized only the excess of nonrecoverable costs of wireless cable installations over installation revenue. The Company revised the application of its SFAS No. 51 accounting for wireless cable nonrecoverable installation costs prospectively, effective January 1, 2001, as discussed above. See "MD&A -- Revised Application of Accounting Policy in 2001" in this report.
EBITDA. EBITDA, or earnings before interest, taxes, depreciation and amortization, for 2002 and 2001 includes non-cash charges for impairment of long-lived assets of $4.8 million and $14.1 million, respectively. EBITDA is widely used by analysts, investors and other interested parties as a measure of operating results in the Internet, cable television and telecommunication industries due to the significant initial capital investment typically required by companies in these industries. EBITDA is also widely accepted as a financial indicator of a company's ability to incur and service indebtedness. EBITDA is not a financial measure determined by GAAP and should not be considered an alternative to net income or net loss as a measure of operating results or to cash flows as a measure of funds available for discretionary or other liquidity purposes. EBITDA may not be comparably calculated from one company to another. See note (4) to the Selected Financial Data contained in Item 6 of this report, for a reconciliation of the differences between our EBITDA and net loss.
RESULTS OF OPERATIONS FOR THE THREE YEARS ENDED DECEMBER 31, 2002
The following table summarizes the operating results for the years ended December 31, 2002, 2001 and 2000:
Revenues. Our revenues were $35.2 million in 2002, $49.8 million in 2001 and $61.0 million in 2000 representing a 29% decrease from 2001 to 2002, and an 18% decrease from 2000 to 2001. The average number of wireless cable subscribers for the year ended December 31, 2002, was 60,600 compared to 94,000 and 121,000 for the years ended December 31, 2001 and 2000, respectively. In addition, during the years ended December 31, 2002, 2001 and 2000, we had 20,300, 23,000 and 16,500 average subscribers, respectively, who received only DIRECTV programming sold by us. Beginning in January 2000, we did not include these customers in our reported wireless cable subscriber base but we do receive certain agency revenue from DIRECTV related to these accounts, as well as equipment lease payments from a portion of these customers. We also do not include these customers or their related revenues in our calculation of recurring average revenue per subscriber.
The decline in revenues from 2001 to 2002 and from 2000 to 2001 was primarily due to fewer total wireless cable subscribers resulting from:
- the closing in 2002 of 14 of our wireless cable systems (see Item 1, "Business -- Conversion of Wireless Cable Business" in this report),
- decreased sales and marketing as we continued to shift our principal business focus from wireless cable to broadband wireless services,
- price increases for our wireless cable service in the first and third quarters of 2001 which resulted in increased disconnects by video subscribers in 2001, and
- the suspension, in seven markets in March 2000, of our offer of video programming provided solely over MMDS frequencies in anticipation of transitioning this spectrum to Internet services.
In addition, in 2001 the Company adjusted the fair value of its liabilities at Fresh Start by $2.5 million, and correspondingly reduced revenues that had been deferred and recognized since Fresh Start. Also, in connection with its revised application of SFAS No. 51 in 2001, the Company established a $2.2 million chargeback reserve for canceled subscribers. These two changes resulted in a reduction in total revenues in 2001 of $4.7 million. See "MD&A -- Revised Application of Accounting Policy in 2001" in this report.
This decline was partially offset by a revision in policy for recognizing wireless cable and DIRECTV installation revenue and revenue received from our agency relationship with DIRECTV (except for continuing
monthly service fees, which are recognized as received). Prior to 2001, wireless cable installation revenue was offset against the nonrecoverable portion of installation costs, with the excess cost capitalized and amortized to depreciation expense over the expected subscriber relationship period. Prior to 2001, DIRECTV installation revenue (cash received directly from the customer in conjunction with the sale) was offset against direct incremental costs, with the resulting amount recorded as a net asset and amortized to SG&A in proportion to the revenues projected to be generated over the expected subscriber relationship period. Beginning in 2001, these revenues are now recognized to the extent of direct selling costs incurred, and the remainder is deferred and amortized to income over the expected subscriber relationship period of three years. This resulted in $3.4 million of additional revenues in 2001.
Average monthly recurring revenue per subscriber was $38.18, $37.06 and $35.44 for the years ended December 31, 2002, 2001 and 2000, respectively. The increase over these periods is due to overall higher priced packages being purchased by our subscribers, including increased purchases of premium programming and price increases for wireless cable services.
We expect to convert the remainder of our wireless cable subscriber base to satellite programming provided by DIRECTV and Pegasus, and cable programming provided by Time Warner Cable, in 2003. Except for a nominal residual royalty and recognition of deferred revenue related to cash received at the time of conversion, we do not expect our existing wireless cable subscriber base to continue to generate material revenues or cash flows for the Company beyond 2003. See Item 1, "Business -- Conversion of Wireless Cable Business" in this report. We expect to recognize revenues associated with the conversion of subscribers to DIRECTV and Pegasus to the extent of direct selling costs incurred, and the remainder to be deferred and amortized to income over the expected subscriber relationship period of three years. A chargeback reserve will be recorded for all DIRECTV contingencies. We do not expect the decline in revenues to be offset materially by an increase in revenues from our Internet business in 2003, as we plan to deploy no more than two 2G Internet systems before the end of the first quarter of 2004. See Item 1, "Business -- Business Strategy" in this report.
System Operations Expense. System operations expense was $20.5 million in 2002, $25.7 million in 2001 and $28.4 million in 2000. As a percentage of revenues, system operations expense was 58% in 2002, 52% in 2001 and 47% in 2000. The decrease in system operations expense over the periods presented was primarily due to lower programming expense as a result of fewer subscribers. System operations expense as a percent of revenue increased in all three years due to lower overall revenues and higher costs under certain spectrum leases that were renegotiated in preparation for providing broadband wireless services, and due to the fixed portion of technical labor in certain wireless cable markets which has been reduced to minimum levels with the decline in subscribers. We expect system operations expense to decrease further in 2003 in connection with the conversion of our wireless cable subscriber base. See Item 1, "Business -- Conversion of Wireless Cable Business" in this report.
SG&A Expense. SG&A expense was $21.0 million in 2002, $25.5 million in 2001 and $32.8 million in 2000. As a percent of revenues, SG&A expense was 60% in 2002, 51% in 2001 and 54% in 2000. SG&A expense decreased annually from 2000 through 2002 due to savings from the consolidation of certain offices and management in our wireless cable markets, lower wireless cable marketing expenses, and a reduction in start-up and general and administrative costs, principally incurred in the first quarter of 2001, related to our broadband wireless business. SG&A expense as a percent of revenues increased from 2001 to 2002 primarily because of lower overall revenues and the fixed portion of SG&A expenses related to the conversion of our wireless cable subscribers. The reduction in overall SG&A was partially offset by increased costs related to the development of our broadband wireless business and related personnel and infrastructure at the end of 2000 and the beginning of 2001, and business and corporate overhead allocable to our broadband wireless operations in 2000 and the beginning of 2001. Broadband wireless SG&A decreased from 2001 to 2002, primarily due to a reduction in force and related cost savings caused by a delay in availability of a 2G technology platform. We expect overall SG&A expenses to continue to decline in 2003 as wireless cable television field offices are closed and related administrative costs are reduced.
Depreciation and Amortization. Depreciation and amortization expense was $20.6 million in 2002, $25.7 million in 2001 and $27.3 million in 2000. The decrease in depreciation and amortization expense from 2000 to 2002 is principally due to the aging of customer equipment in our wireless cable and DIRECTV businesses, much of which is fully depreciated and, to a lesser extent, the sale of used equipment during the three years. Depreciation and amortization also decreased due to a $14.1 million impairment charge in the fourth quarter of 2001 to write down systems and equipment and license and leased license investment to estimated fair value. These decreases were partially offset by increased depreciation as a result of the Company changing its estimated useful life for systems and equipment relating to its wireless cable operations from 3-10 years to one year effective January 1, 2002. We expect depreciation and amortization to decrease in 2003 as wireless cable assets are fully depreciated, and wireless cable market operations are closed upon conversion of our wireless cable subscriber base as discussed above.
Impairment of Long-Lived Assets. The Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," effective January 1, 2002. In the fourth quarter of 2002, we reviewed our systems and equipment, and license and leased license investment assets (spectrum licenses and leases) for impairment in accordance with the requirements of SFAS No. 144. In our review, we considered, among other factors, (i) the uncertainties of raising capital for our long-term business plan, (ii) the strategic importance of spectrum licenses and leases in smaller or less-densely populated markets, and the likelihood of deployment of 2G Internet systems in such markets within the next three years, (iii) a declining demand for analog MMDS video equipment in the resale market and (iv) the reduction in personnel in our wireless cable business, which affects our ability to retrieve and resell wireless cable CPE. In analyzing our spectrum licenses and leases, we retained the services of a third party to perform a fair market valuation.
In the fourth quarter of 2001, we reviewed our systems and equipment, and license and leased license investment assets for impairment in accordance with the requirements of SFAS No. 121, which has been superseded by SFAS No. 144. Events and circumstances that we considered in this review included (i) the expected conversion of substantially all of our wireless cable subscribers to satellite and cable programming provided by other companies, (ii) the need to continue evaluating the development of technology for MMDS service which likely would delay deployment of new Internet markets beyond 2002, and (iii) the uncertainties associated with raising capital required to implement our long-term business plan. In determining whether an impairment was required for systems and equipment, we examined the future cash flows expected to be generated from these assets and the amount that we estimated could be realized for these assets in an orderly disposition, if required. In analyzing our license and leased license investment assets, we retained the services of a third party to provide a fair market valuation.
As a result of our review and the third party valuation, we determined that non-cash impairment charges of $4.8 million and $14.1 million were required in 2002 and 2001, respectively, to write down systems and equipment and license and leased license investments to estimated fair value, as follows:
Although the third party market valuation of our aggregate license and leased license investment assets was substantially in excess of our aggregate carrying cost, as required by SFAS No. 144 in 2002 and SFAS No. 121 in 2001, we examined these assets on an individual market basis and determined that the carrying value related to 20 markets in 2002 and ten markets in 2001 should be written down in the total amounts of $2.4 million and $9.4 million, respectively.
Our estimates of future gross revenues and operating cash flows, the remaining estimated lives of long-lived assets, or both could be reduced in the future due to changes in, among other things, technology, government regulation, available financing or competition. As a result, the carrying amounts of long-lived assets could be reduced by additional amounts which would be material to the Company's financial condition and results of operations.
Operating Loss. We generated operating losses of $31.7 million ($26.8 million excluding the impairment of long-lived assets) in 2002, $41.2 million ($27.1 million excluding the impairment of long-lived assets) in 2001 and $27.5 million in 2000. The slight improvement in operating losses from 2001 to 2002 (excluding impairment of long-lived assets) resulted from lower depreciation and amortization expense discussed above, partially offset by lower revenues from our wireless cable business. The slight improvement in operating losses (excluding the impairment of long-lived assets) from 2000 to 2001 resulted from lower programming expense, decreased marketing costs and other SG&A savings discussed above, and lower depreciation and amortization expense. Compared to 2002, we expect operating losses in 2003 to increase as our revenue from wireless cable subscribers continues to decrease and we allocate most of our resources to maintain our spectrum assets and develop our broadband and other wireless services.
EBITDA. EBITDA was a negative $11.1 million for the year ended December 31, 2002, a negative $15.5 million for the year ended December 31, 2001 and a negative $202,000 for the year ended December 31, 2000. The decrease in EBITDA from 2000 to 2002 was primarily due to non-cash charges for impairment of long-lived assets in 2002 and 2001 of $4.8 million and $14.1 million, respectively, decreased wireless cable revenues resulting from fewer subscribers as we continued to shift our principal focus to developing our broadband wireless services, and from start-up and SG&A costs related to our broadband wireless operations. Excluding the non-cash impairment charges we incurred in 2002, we expect negative EBITDA to increase materially in 2003, as we complete the conversion of our wireless cable subscribers and clear our spectrum for our broadband wireless business. See note (4) to the Selected Financial Data contained in Item 6 of this report, for a reconciliation of the differences between our EBITDA and net loss.
Interest Income. Interest income was $318,000 in 2002, $984,000 in 2001 and $2.0 million in 2000. The decrease in interest income from 2000 to 2002 was due to declining earnings on smaller unrestricted cash balances. Average interest rates were 2.7% in 2002, 4.8% in 2001 and 6.3% in 2000.
Interest Expense. Interest expense was $1.1 million in 2002, $1.2 million in 2001 and $1.4 million in 2000. Interest expense decreased from 2000 to 2002 due to lower principal balances on our BTA debt and capital leases. Interest rates on our capital lease obligations in 2002 were an average of 14.9%. The interest rate on other notes payable in 2002 was 9.5%.
Other income (expense). Other income in 2002 includes $600,000 in gain recognized on the conversion of our wireless cable subscribers to programming provided by Time Warner Cable, as well as the recognition of a deferred gain on the sale and leaseback of 34 of our towers during 1999 and 2000. Other income in 2001 included the recognition of the deferred gain on the sale and leaseback of the towers, as well as a $100,000 gain from the sale of our equity interest in a Mexican MMDS company. During the first and third quarters of 2000, we received $3.8 million and $723,000, respectively, in exchange for our equity interest in Wireless One, Inc. ("Wireless One"). The entire amount was recognized as other income, as our investment balance had been reduced to zero. Other income during 2000 also included the recognition of the deferred gain on the tower sale and leaseback described above.
Income Tax Benefit. Federal income tax law related to reorganizations generally requires that the amount of income from discharge of indebtedness that occurs in connection with a Chapter 11 bankruptcy be used to reduce federal tax attributes. Generally, the reduction is applied to reduce net operating loss carryforwards, followed by other tax attributes including the basis of certain assets and the tax basis of subsidiary stock ("Tax Attribute Reduction"). An election exists to reduce the basis of depreciable assets first, which can be favorable under certain circumstances. Management elected to apply the required reduction first to tax basis in depreciable assets, and then to net operating loss carryforwards. The amount of reduction in depreciable assets was approximately $56 million. The amount of reduction in net operating loss carryforwards was approximately $118 million, leaving approximately $222 million in remaining net operating loss carryforwards at December 31, 2000. Net operating loss carryforwards at December 31, 2002, were $269 million, and expire in years 2013 through 2021. See note 11 of the consolidated financial statements included in Item 8 of this report. No income tax benefit was recorded for the years ended December 31, 2002, 2001 and 2000.
Net Loss. We have recorded net losses since our inception. Our net loss was $31.4 million ($26.5 million excluding the non-cash impairment of long-lived assets) in 2002, $40.9 million in 2001 ($26.8 million excluding the non-cash impairment of long-lived assets) and $22.1 million in 2000. Excluding the gain of $4.8 million in 2000 discussed below, net loss in 2000 was $26.9 million. The net loss from 2000 to 2002 was primarily impacted by the following:
- lower wireless cable revenue and programming costs related to fewer subscribers,
- the impact of revising the application of SFAS No. 51 in 2001,
- cost savings from consolidation of certain market offices and management,
- decreased subscription television marketing expenses,
- the impairment of long-lived assets in 2001 and 2002, and
- a gain of $4.8 million during 2000 on the exchange of our equity interest in Wireless One.
Loss per share for the year ended December 31, 2002 was $3.01 ($2.55 excluding the non-cash impairment of long-lived assets), compared to $3.95 ($2.59 excluding the non-cash impairment of long-lived assets) per share in 2001 and $2.17 in 2000. Compared to 2002, we expect our net loss in 2003 to increase as our wireless cable market operations are closed upon conversion of our wireless cable subscriber base.
BALANCE SHEET AS OF DECEMBER 31, 2002, COMPARED TO THE BALANCE SHEET AS OF DECEMBER 31, 2001
Material changes to balance sheet accounts from 2001 to 2002 were as follows:
- The decrease in cash and cash equivalents resulted primarily from use of cash for system operations, including spectrum maintenance, and from net loss caused by declining revenues from our wireless cable business and other factors discussed above under "Net Loss".
- The decrease in restricted assets resulted from the transfer of restricted cash to operating cash upon cancellation of letters of credit to certain vendors.
- The decrease in subscriber receivables resulted primarily from a decrease of approximately 60,000 average wireless cable subscribers.
- The decrease in systems and equipment, and license and leased license investment was primarily due to the impairment of long-lived assets, a decrease in the estimated useful life for wireless cable equipment and depreciation and amortization for 2002.
- The increase in net other assets resulted from an increase in subscriber acquisition costs, which are the direct incremental costs incurred in generating a customer relationship with DIRECTV. These costs include material, equipment and labor and are recorded as a net asset and amortized as a component of SG&A expense over the expected subscriber relationship period of three years. This asset increased in 2002 due to more conversions of subscribers to DIRECTV.
- The increase in accounts payable and accrued liabilities is primarily due to an increase in deferred revenue from converting subscribers to DIRECTV and Pegasus, as discussed above, and accrued spectrum lease payments. This increase was partially offset by lower accrued programming and lower accrued compensation and benefits. Installation revenue and revenue received from our agency relationship with these providers is recognized to the extent of direct selling costs incurred, and the remainder is deferred and amortized to income over the expected subscriber relationship period of three years. This increase was slightly offset by a decrease in accrued programming due to fewer wireless cable subscribers and a decrease in accrued compensation due to fewer employees.
- The increase in other long-term liabilities is primarily due to an increase in the long-term portion of deferred revenue related to subscriber conversions discussed above.
LIQUIDITY AND CAPITAL RESOURCES
The broadband wireless business is capital-intensive. Since inception, we have spent funds to lease or otherwise acquire MMDS spectrum rights in various markets and operating systems, to construct wireless cable operating systems and two Internet systems, and to finance initial system operating losses. Our primary sources of capital have been subscription fees, debt financing, the sale of common stock and the sale of MMDS spectrum rights that were not essential to our business strategy. The approval by the FCC of the use of MMDS spectrum for advanced communications services and the FCC's flexible use authorization will allow us to use our spectrum to provide fixed, portable and, ultimately, mobile broadband wireless services such as high-speed Internet access services and voice over IP.
The growth of our business by using our spectrum to provide fixed, portable or mobile broadband Internet service will require substantial capital expenditures. We expect that 2G MMDS technology will provide improved coverage capabilities by addressing line-of-sight limitations that exist in first generation equipment, and will allow customers to install and upgrade customer premises equipment themselves. We believe these improvements will allow us to reduce subscriber-related costs and operating expenses; however, the development and launch of broadband wireless MMDS networks will be capital intensive, and additional capital will be required to implement our long-term strategy of providing advanced wireless services in medium and small markets.
We estimate that a launch of a 2G broadband wireless system providing high-speed Internet access in a typical market will involve an initial capital expenditure of approximately $1.5 million to $1.7 million for network equipment, depending upon the system design and type and sophistication of the equipment. In addition, we estimate that the acquisition and installation of each new Internet subscriber will cost between $400 and $900 depending upon the type of customer. This includes charges for equipment, labor and direct commissions. This may be offset partially by installation and other up-front fees. Other launch costs include the cost of securing adequate space for marketing and operational facilities, as well as costs related to employees. As a result of these costs, operating losses are likely to be incurred by an Internet system during the start-up period.
Cash used in operations was $6.4 million during the year ended December 31, 2002, compared to $2.9 million during the year ended December 31, 2001. Cash used in operations during 2002 resulted primarily from our net loss of $31.4 million, offset by depreciation and amortization of $20.1 million, non-cash impairment charges of $4.8 million and payment of accrued property taxes and other liabilities. Cash used in operations during 2001 was primarily due to increased subscriber acquisition costs related to our DIRECTV agency relationship, and severance payments related to a reduction in force in the first quarter and to pay accrued property taxes and other liabilities. Cash used in operations of $1.9 million during 2000 included our net loss of $22.1 million, offset by depreciation and amortization of $27.3 million and by higher revenue received from our agency relationship with DIRECTV due to higher installs in 2000.
Cash used in investing activities principally relates to the acquisition and installation of subscriber equipment, the upgrade of transmission equipment in certain markets, and the acquisition of MMDS spectrum rights, offset by the sale of MMDS spectrum rights that are not a part of our strategic plan. Cash provided by investing activities during the year ended December 31, 2002 was $271,000, compared to cash used in investing activities of $1.8 million in 2001 and $4.6 million in 2000. The improvement in cash provided by investing activities is due to substantially lower spending for the acquisition and installation of subscriber premise equipment in the current year as we began converting our wireless cable subscribers to programming provided by DIRECTV, Pegasus and Time Warner Cable. Cash used in investing activities during 2001 included expenditures for engineering, legal, site acquisition and other costs related to the acquisition of MMDS spectrum rights. Cash used in investing activities in 2000 of $4.6 million included expenditures related to our applications for two-way licenses, partially offset by $4.5 million from the exchange of our equity interest in Wireless One and approximately $780,000 from the sale-leaseback of our communications towers.
Cash used in financing activities during 2002 was $1.8 million, compared to $2.0 million during 2001 and $285,000 during 2000. Cash used in financing activities during 2002 and 2001 included payments on our BTA debt and capital lease obligations related to the sale and leaseback of our 34 communications towers. Cash
used in financing activities during 2000 also included principal payments on our BTA debt and capital lease obligations. This was partially offset by $1.5 million in cash proceeds received from the exercise of employee stock options.
At February 28, 2003, we had approximately $4.7 million of unrestricted cash and cash equivalents. As set forth in note 1(b) to the consolidated financial statements, the consolidated financial statements contained in this report have been prepared on a "going concern" basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. In conjunction with their 2002 year end audit, our independent accountants have issued an audit opinion with respect to our 2002 consolidated financial statements which includes an explanatory paragraph describing conditions that raise substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. We expect that cash on hand of $4.7 million at February 28, 2003, and cash generated from our operations, with no additional financing, will be sufficient to fund operations in the normal course of business at least through the second quarter of 2003.
As discussed in Item 1, "Business -- Business Strategy," during the first half of 2003 we will seek to raise $15 million -- $20 million for maintenance of existing strategic spectrum resources, operating expenses and to fund the deployment of up to two 2G Internet systems. We have retained Houlihan Lokey as our financial advisor in connection with this potential financing. We also may seek to raise additional capital if we consummate any significant acquisitions or strategic alliances, or determine that market conditions are appropriate for such financing. Options for raising capital include the sale of debt or equity securities, borrowings under secured or unsecured loan arrangements, including vendor equipment financing, and sales of assets. There can be no assurance that financing will be available on acceptable terms or in a timely manner, if at all.
EFFECTS OF REORGANIZATION
Our company and certain of our subsidiaries file a consolidated federal income tax return. Subsidiaries in which we own less than 80% of the voting stock will file separate federal income tax returns. We have had no material state or federal income tax expense since inception. As of December 31, 1999, and before taking into consideration the effects of the reorganization, we had approximately $366.8 million in net operating losses for U.S. federal income tax purposes, expiring in years 2013 through 2019. We estimate that approximately $38 million of the above losses relate to various acquisitions and as such are subject to certain limitations.
We adopted Fresh Start Reporting on the April 1, 1999, Effective Date of our Plan in accordance with SOP 90-7. Fresh Start Reporting resulted in a new reporting entity with assets and liabilities adjusted to fair value and beginning retained earnings set to zero. Liabilities subject to compromise also were adjusted to zero in the debt discharge portion of the Fresh Start Reporting entry. In addition, on the Effective Date our outstanding common stock was canceled and newly issued shares of common stock and warrants were distributed to certain creditors in satisfaction of their claims against us. In connection with the debt discharge, we recorded an extraordinary gain of approximately $174 million.
Federal income tax law generally requires that the amount of income from discharge of indebtedness that occurs in connection with a Chapter 11 bankruptcy be used to reduce federal tax attributes. Generally, the reduction is applied to reduce net operating loss carryforwards, followed by other tax attributes including the basis of certain assets and the tax basis of subsidiary stock. An election exists to reduce the basis of depreciable assets first, which can be favorable under certain circumstances. Management has elected to apply the required reduction first to tax basis in depreciable assets, and then to net operating loss carryforwards. The amount of reduction in the tax basis of depreciable assets was approximately $56 million, leaving approximately $183 million in remaining basis in depreciable assets. The amount of reduction in net operating loss carryforwards was approximately $118 million, leaving approximately $222 million in remaining net operating loss carryforwards at December 31, 2000. Net operating loss carryforwards at December 31, 2002, were $269 million, and expire in years 2013 through 2021. See note 11 of the consolidated financial statements included in Item 8 of this report.
In addition to the permanent Tax Attribute Reduction, we also must limit the annual deduction of pre-bankruptcy net operating losses and "built-in deductions" to an amount no greater than the fair market value of Nucentrix immediately after the reorganization, multiplied by the long-term tax exempt rate. The annual limitation applicable to our pre-bankruptcy net operating losses and "built-in" deductions currently is estimated to be approximately $7.3 million.
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require the Company to make estimates and assumptions. The Company's significant accounting policies and methods used in the preparation of the consolidated financial statements are discussed in note 1 of the notes to consolidated financial statements included in Item 8 of this report. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity.
Revenues currently consist primarily of monthly fees paid by wireless cable subscribers for basic programming, premium programming, equipment rental, and other miscellaneous fees, and revenues from our agency relationship with DIRECTV (which include revenues from the conversion program discussed in Item 1, "Business" of this report). Revenues also include fees generated from Internet operations in Austin and Sherman-Denison, Texas. Unless the context requires otherwise, all references to "subscribers" or "systems" are to wireless cable subscribers and systems because revenues and subscribers from Internet business were immaterial in 2002 (approximately 1.4% of consolidated revenues).
Subscription revenues from wireless cable subscribers and continuing monthly service fees from DIRECTV for each DIRECTV customer generated are recognized as service is provided. If the Company does not meet minimum subscriber benchmarks each year, the DIRECTV continuing monthly service fee will be reduced.
Effective January 1, 2001, wireless cable and DIRECTV installation revenue, and revenue received from our agency relationship with DIRECTV (except for continuing monthly service fees, which are recognized as received), is recognized to the extent of direct selling costs incurred, and the remainder is deferred and amortized to income over the expected subscriber relationship period. For recognition of wireless cable installation revenue, this period was three years in 2001 and one year in 2002. For recognition of DIRECTV installation and agency revenue, this period was three years in 2001 and 2002. A chargeback reserve is recorded for all DIRECTV contingencies. Prior to 2001, wireless cable installation revenue was offset against the nonrecoverable portion of installation costs, with the excess cost capitalized and amortized to depreciation expense over the expected subscriber relationship period of three years. Prior to 2001, DIRECTV installation revenues (cash received directly from the customer in conjunction with the sale) were offset against direct incremental costs, with the resulting amount recorded as a net asset. This asset, referred to as "subscriber acquisition costs," was amortized as a component of SG&A expense in proportion to the revenues projected to be generated over the expected subscriber relationship period. Revenue from our agency relationship with DIRECTV (other than monthly service fees) was recognized as the contingencies related to each revenue component were resolved. A chargeback reserve was not recorded for canceled subscribers. The Company revised the application of its SFAS No. 51 accounting for wireless cable installation and DIRECTV revenues prospectively, effective January 1, 2001, as discussed above. See Item 7, "MD&A -- Revised Application of Accounting Policy in 2001" in this report.
The direct costs of wireless cable installations include reception materials and equipment on subscriber premises and installation labor, which are amortized over the useful life of the asset (presently 12 months) for the recoverable portion and the estimated average subscription term (presently 12 months) for the nonrecoverable portion of such costs. Prior to January 1, 2002, the recoverable portion of such costs was amortized over an estimated useful life of five years, and the nonrecoverable portion was amortized over an estimated average subscription term of three years. The nonrecoverable portion of the cost of a subscriber installation becomes fully depreciated upon disconnection of the subscriber. Prior to 2001, the Company capitalized only the excess of non-recoverable costs of wireless cable installations over installation revenues.
The Company revised the application of its SFAS No. 51 accounting for wireless cable non-recoverable installation costs prospectively, effective January 1, 2001, to discontinue the netting of installation fees against nonrecoverable costs of subscriber installations. See Item 7, "MD&A -- Revised Application of Accounting Policy in 2001" in this report.
Our revenue recognition for wireless cable and DIRECTV installation revenue, and amortization of the recoverable portion of direct costs of wireless cable installations, is based on assumptions regarding our expected subscriber term. The expected subscriber terms of 12 months for wireless cable and three years for DIRECTV currently used for these purposes is based on historic subscriber churn rates and the expected remaining terms of our wireless cable subscribers. Effective January 1, 2002, we reduced our estimate of the expected subscriber terms of wireless cable subscribers from three years to 12 months, as we plan to convert substantially all of these subscribers to satellite and cable programming in 2003. See "Business -- Conversion of Wireless Cable Business" in this report. The reduced estimate did not have a material effect on revenues in our consolidated financial statements. If a different subscriber term was used, the revenue amounts reported could be materially different than amounts reported in this report, and if the subscriber term changes in future years, the revenue amounts reported in future years may not be comparable to the years reported in this report.
The direct incremental costs incurred in generating a customer relationship with DIRECTV, comprised of material, equipment and labor, are recorded as an asset. This asset, referred to as "subscriber acquisition costs," is amortized as a component of SG&A expense over the expected subscriber relationship period of three years.
Our long-term operating assets, which include headend and base station equipment, are recorded at cost and amortized on a straight-line basis over the estimated useful lives. Our licenses and leased license investments, which include our FCC licenses and spectrum leases, are amortized from the inception of service in each market. In accordance with SFAS No. 144, we review our long-lived assets and certain intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the net asset exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. In the fourth quarters of 2002 and 2001, we wrote down our license and leased license investments and systems and equipment by $4.8 million and $14.1 million, respectively. See Item 7, "MD&A -- Results of Operations for the Three Years Ended December 31, 2002 -- Impairment of Long-Lived Assets" and note 3 of the consolidated financial statements included in Item 8 of this report. Effective January 1, 2002, we reduced the estimated remaining useful life of our systems and equipment for wireless cable operating systems from 3-10 years to one year and the estimated remaining useful life of our license and leased license investment from 12.5-15 years to 10 years. These changes increased net loss for the year ended December 31, 2002, by $3.5 million, or $0.33 per share. See note 13 of the consolidated financial statements included in Item 8 of this report.
REVISED APPLICATION OF ACCOUNTING POLICY IN 2001
The Company revised its application of SFAS No. 51, Financial Reporting by Cable Television Companies ("SFAS No. 51"), for its wireless cable service and DIRECTV programming service during the fourth quarter of 2001, retroactively effective to the beginning of 2001. Prior to this revision:
- wireless cable installation revenue was offset against the nonrecoverable portion of installation costs, with the excess cost capitalized and amortized to depreciation expense over the expected subscriber relationship period of three years,
- the excess nonrecoverable costs of a wireless cable installation over installation revenue were capitalized and amortized to depreciation expense over the expected subscriber relationship period of three years,
- DIRECTV installation revenue was offset against direct incremental costs, with the resulting amount recorded as a net asset,
- this asset, referred to as "subscriber acquisition costs," was amortized as a component of SG&A expense in proportion to the revenues projected to be generated over the expected subscriber relationship period, and
- revenue from our agency relationship with DIRECTV (other than monthly service fees) was recognized as the contingencies related to each revenue component were resolved; a chargeback reserve was not recorded for canceled subscribers.
The revised application of SFAS No. 51 resulted in the following changes to the Company's accounting practices:
- wireless cable and DIRECTV installation revenue, and revenue received from our agency relationship with DIRECTV (except for continuing monthly service fees, which are recognized as received), is recognized to the extent of direct selling costs incurred, the remainder is deferred and amortized to income over the expected subscriber relationship period and a chargeback reserve is recorded for all DIRECTV contingencies (for recognition of wireless cable installation revenue, the expected subscriber relationship period was three years in 2001 and one year in 2002; for recognition of DIRECTV installation and agency revenue, this period was three years in 2001 and 2002), and
- direct incremental costs incurred in generating a customer relationship with DIRECTV, comprised of material, equipment and labor, is recorded as an asset and amortized as a component of SG&A expense over the expected subscriber relationship period of three years.
Since the revised application of SFAS No. 51 was retroactively effective to the beginning of 2001, financial information for the first three quarters of 2001 was revised. The revised application of SFAS No. 51 resulted in $3.2 million of additional revenue in the first three quarters of 2001. Also, in connection with its revised application of SFAS No. 51 in 2001, the Company reduced revenues to establish a $2.2 million chargeback reserve for canceled subscribers. In addition, in 2001 the Company adjusted the fair value of its liabilities at Fresh Start and correspondingly reduced revenues that had been deferred and recognized since Fresh Start for a net reduction in revenues in the first three quarters of $2.2 million. Other miscellaneous adjustments reduced revenues in the first three quarters a total of approximately $200,000. For periods prior to 2001, neither the revised application of SFAS No. 51 nor the other changes discussed above had a material impact on the Company's consolidated financial statements.
COMMITMENTS AND CONTINGENCIES
We have a programming arrangement with World Satellite Network, Inc. ("WSNet"), under which we pay WSNet to obtain and manage certain of the video programming that we deliver to our wireless cable subscribers, including making payments for such programming directly to programming providers such as Disney, ESPN and HBO. In October 2002, WSNet filed for protection under Chapter 11 of the U.S. Bankruptcy Code and, in February 2003, WSNet announced that it would discontinue operations at the end of that month. We now pay programmers directly for the monthly programming that we continue to deliver to our remaining wireless cable subscribers. However, for programming delivered in September 2002, we paid WSNet approximately $550,000. WSNet did not remit this amount to the various programmers from whom we received programming. In February 2003, WSNet notified us that it intended to reject its agreement with us in its Chapter 11 proceedings. We are continuing to evaluate our rights and potential obligations with respect to WSNet and the programmers. We ultimately may be liable for payment of some or all of this amount to one or more programmers. We believe we have a claim against WSNet or its creditors for such amount. While it is not feasible to predict or determine the final outcome of this matter or to estimate the amounts or potential range of loss, we do not believe that an adverse outcome in this matter would have a material adverse effect on our consolidated financial condition, results of operations or cash flows.
CONTRACTUAL OBLIGATIONS
The Company's contractual obligations include long-term debt (primarily related to BTA installment notes), capital lease obligations (primarily related to tower leases), operating leases (primarily related to spectrum leases), and other long-term obligations (purchase installments for spectrum license acquisitions and settlement payments), as summarized below.
PAYMENTS DUE BY YEAR
In July 2002 we began negotiations with spectrum lessors to defer a portion of our monthly spectrum lease payments until we launched commercial two-way Internet services in the applicable market. As of February 28, 2003, we had renegotiated over 120 spectrum leases. All deferred spectrum lease obligations are included in the Contractual Obligations table above. We are continuing to expense all spectrum lease payments on a straight-line basis in our consolidated statements of operations. In addition, the consolidated balance sheets in this report include a current liability of approximately $850,000 for accrued spectrum lease payments as of December 31, 2002.
OFF-BALANCE SHEET ARRANGEMENTS
The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
RECENTLY ISSUED ACCOUNTING PRINCIPLES
Statement of Financial Accounting Standards No. 144. Effective January 1, 2002, we adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which addresses financial accounting and reporting for the impairment or disposal of long-lived assets, and supersedes SFAS No. 121.
Statement of Financial Accounting Standards No. 148. In December 2002, FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure -- an amendment of FASB Statement No. 123." This statement amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for fiscal years ending after December 15, 2002. We have adopted the disclosure requirements of SFAS No. 148 and the adoption of this standard had no material effect on our financial condition, cash flows or results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
We are not exposed to market risk from changes in marketable securities.
We are not exposed to material future earnings or cash flow fluctuations from changes in interest rates on long-term debt since 100% of our long-term debt is at a fixed rate as of December 31, 2002. The fair value of our long-term debt at December 31, 2002, is estimated to be $9.1 million based on the overall rate of the long-term debt of 9.5% and an overall maturity of five years compared to terms and rates currently available in long-term financing markets. To date, we have not entered into any derivative financial instruments to manage interest rate risk and are not currently evaluating the future use of any such financial instruments.
We do not currently have any exposure to foreign currency transaction gains or losses. All business transactions are in U.S. dollars.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information called for by this item is included on pages through of this annual report on Form 10-K, which information is incorporated herein by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The information called for by this item previously has been reported by the registrant on Form 8-K and, therefore, is not included in this report.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The response to this item will be included in our Proxy Statement for our Annual Meeting of Stockholders to be held May 13, 2003, and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The response to this item will be included in our Proxy Statement for our Annual Meeting of Stockholders to be held May 13, 2003, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The response to this item required by item 201(d) of Regulation S-K is incorporated herein by reference to the information contained in "Equity Compensation Plan Information," in Part II, Item 5 of this report. The balance of the response to this item will be included in our Proxy Statement for our Annual Meeting of Stockholders to be held May 13, 2003, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The response to this item will be included in our Proxy Statement for our Annual Meeting of Stockholders to be held May 13, 2003, and is incorporated herein by reference.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
Within 90 days prior to the filing date of this report, we carried out an evaluation, under the supervision and with the participation of our principal executive officer/principal financial officer and other senior management, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer/principal financial officer concluded that our disclosure controls and procedures are effective in ensuring that material information is timely communicated to
appropriate management personnel, including the principal executive officer/principal financial officer, to enable such personnel to evaluate information and determine the information required to be included in our periodic SEC reports. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. In addition, we reviewed our internal controls, and there have been no significant changes in our internal controls or in other factors that could significantly affect those controls subsequent to the date of their last evaluation.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements. The following financial statements are filed as part of this Form 10-K:
2. Financial Statement Schedules. The following financial statement schedule is filed as part of this Form 10-K:
All other schedules are omitted because they are not applicable or not required or because the required information is included in the financial statements or notes thereto.
3. Exhibits. Reference is made to the Index to Exhibits immediately following Schedule II on page S-1 of this report for a list of all exhibits filed as a part of this report.
(b) Reports on Form 8-K
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
NUCENTRIX BROADBAND NETWORKS, INC.
By: /s/ CARROLL D. MCHENRY ------------------------------------ Carroll D. McHenry Chairman of the Board, President and Chief Executive Officer, Acting Chief Financial Officer (Principal Executive Officer and Principal Financial Officer)
Date: March 25, 2003
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in capacities and on the dates indicated.
CERTIFICATIONS
I, Carroll D. McHenry, certify that:
1. I have reviewed this annual report on Form 10-K of Nucentrix Broadband Networks, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to me by others within those entities, particularly during the period in which this annual report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
(c) presented in this annual report my conclusions about the effectiveness of the disclosure controls and procedures based on my evaluation as of the Evaluation Date;
5. I have disclosed, based on my most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of my most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
/s/ CARROLL D. MCHENRY -------------------------------------- Carroll D. McHenry Chairman of the Board, President and Chief Executive Officer, Acting Chief Financial Officer (Principal Executive Officer and Principal Financial Officer)
Date: March 25, 2003
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of Nucentrix Broadband Networks, Inc.
We have audited the accompanying consolidated balance sheet of Nucentrix Broadband Networks, Inc. and subsidiaries as of December 31, 2002 and the related consolidated statements of operations, stockholders' equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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 audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nucentrix Broadband Networks, Inc. and subsidiaries as of December 31, 2002 and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related 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.
The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in note 1(b) to the consolidated financial statements, the Company's recurring losses from operations and the resulting dependence upon access to additional financing and the Company's current negative working capital position raise substantial doubt about its ability to continue as a going concern. Management's plans with regard to these matters are also discussed in note 1(b). The consolidated financial statements and financial statement schedule do not include any adjustments that might result from the outcome of this uncertainty.
KBA GROUP LLP
Dallas, Texas February 21, 2003
Independent Auditors' Report
The Board of Directors Nucentrix Broadband Networks, Inc.
We have audited the accompanying consolidated balance sheet of Nucentrix Broadband Networks, Inc. and subsidiaries as of December 31, 2001 and the related consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 2001 and 2000. In connection with our audits of the consolidated financial statements, we also have audited the accompanying financial statement schedule. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nucentrix Broadband Networks, Inc. and subsidiaries as of December 31, 2001, and the results of their operations and their cash flows for the years ended December 31, 2001 and 2000, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related 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.
The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in note 1(b) to the consolidated financial statements, the Company's recurring losses from operations and the resulting dependence upon access to additional financing raise substantial doubt about its ability to continue as a going concern. Management's plans with regard to these matters are also discussed in note 1(b). The consolidated financial statements and financial statement schedule do not include any adjustments that might result from the outcome of this uncertainty.
KPMG LLP
Dallas, Texas April 4, 2002
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes to consolidated financial statements.
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (TABLES IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(1) GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) DESCRIPTION OF BUSINESS
Nucentrix Broadband Networks, Inc. ("Nucentrix" or the "Company") provides broadband wireless Internet and wireless subscription television services using radio spectrum licensed by the Federal Communications Commission ("FCC") in the 2.1 gigahertz ("GHz") and 2.5 GHz bands, primarily in medium and small markets across Texas, Oklahoma and the Midwestern United States. The Company owns the basic trading area ("BTA") authorization, or otherwise licenses or leases spectrum, in 93 markets. On average, the Company owns or leases 130 MHz of spectrum per market. This spectrum commonly is referred to as Multichannel Multipoint Distribution Service, or "MMDS," and Instructional Television Fixed Service, or "ITFS." The Company currently provides high-speed wireless Internet access service in two markets, primarily to medium-sized and small businesses, small offices/home offices and telecommuters. Nucentrix also provides wireless subscription television service, commonly referred to as "wireless cable," in 43 markets.
In March 2002, as part of the Company's long-term plan to focus on the use of its spectrum for broadband Internet and other advanced wireless services, the Company announced the signing of agreements with DIRECTV, Inc. ("DIRECTV"), Pegasus Satellite Television, Inc. ("Pegasus") and an affiliate of Time Warner Cable ("Time Warner Cable") to convert substantially all of the Company's wireless cable subscribers to programming provided by these entities. The Company expects to complete the conversion of its wireless cable business in 2003. Except for a nominal residual royalty payment and recognition of deferred revenue related to cash received at the time of conversion, the Company does not expect its existing wireless cable subscriber base to generate material revenues or cash flows for the Company beyond 2003. Substantially all revenues reported in the Company's consolidated financial statements for the years ended December 31, 2002, 2001 and 2000, are related to the Company's wireless cable business.
(b) GOING CONCERN AND LIQUIDITY
Nucentrix's consolidated financial statements have been presented on a going concern basis which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.
The Company incurred operating losses of $31.7 million, $41.2 million and $27.5 million for the years ended December 31, 2002, 2001 and 2000, respectively. The growth of the Company's business by using its spectrum to provide fixed, portable or mobile broadband Internet service using second generation, or "2G," MMDS technology will require substantial investment in capital expenditures, and additional capital will be required to implement the Company's long-term strategy of providing advanced wireless services in medium and small markets.
At February 28, 2003, the Company had approximately $4.7 million (unaudited) of unrestricted cash and cash equivalents. The Company expects that cash on hand and cash generated from its operations, with no additional financing, will be sufficient to fund operations in the normal course of business at least through the second quarter of 2003.
During the next six months the Company will seek to raise $15 million -$20 million for maintenance of existing strategic spectrum resources, operating expenses and to fund the deployment of up to two 2G Internet systems. The Company has retained a financial advisor in connection with this potential financing. The Company also may seek to raise additional capital if it consummates any significant acquisitions or strategic alliances, or determines that market conditions are appropriate for such financing. Options for raising capital include the sale of debt or equity securities, borrowings under secured or unsecured loan arrangements, including vendor equipment financing, and sales of assets. There can be no assurance that financing will be available on acceptable terms or in a timely manner, if at all.
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The consolidated financial statements do not include any adjustments that might result from the outcome of the uncertainties discussed above.
(c) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Nucentrix and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
(d) CASH AND CASH EQUIVALENTS
Nucentrix considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. Cash and cash equivalents consist of money market funds, overnight repurchase agreements and other investment securities.
(e) RESTRICTED ASSETS
At December 31, 2001, restricted assets consisted of bank certificates of deposit with an original maturity of less than one year. These investments were considered held to maturity and were stated at amortized cost which approximated fair value. The Company had pledged these certificates of deposit as letters of credit for capital leases with remaining terms of less than one year. As of December 31, 2002 these certificates of deposit and underlying letters of credit had expired and the funds were transferred to unrestricted cash.
(f) IMPAIRMENT OF LONG-LIVED ASSETS
The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 144 "Accounting for the Impairment or Disposal or Long-Lived Assets," effective January 1, 2002. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets to be Disposed of." Both of these standards require that long-lived assets and certain intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the net asset exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
(g) SYSTEMS AND EQUIPMENT
Systems and equipment are recorded at cost and principally include the cost of transmission equipment as well as direct costs of subscriber installations (see note 4). Upon installation, depreciation and amortization of systems and equipment is recorded on a straight-line basis over the estimated useful lives, from one to 16 years during the years ended December 31, 2001 and 2000. Effective January 1, 2002, the Company revised its estimate of the remaining useful life of its systems and equipment to between one and four years.
The direct costs of wireless cable subscriber installations include reception materials and equipment on subscriber premises and installation labor, which are amortized over the useful life of the asset (presently 12 months) for the recoverable portion and the estimated average subscription term (presently 12 months) for the nonrecoverable portion of such costs. Prior to January 1, 2002, the recoverable portion of such costs was amortized over an estimated useful life of five years, and the nonrecoverable portion was amortized over an estimated average subscription term of three years. The nonrecoverable portion of the cost of a wireless cable installation becomes fully depreciated upon disconnection of the subscriber. Prior to 2001, the Company capitalized only the excess of nonrecoverable costs of subscriber installations over installation revenues. The Company revised its accounting for wireless cable nonrecoverable installation costs prospectively, effective
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January 1, 2001, to discontinue the netting of installation revenues against nonrecoverable costs of subscriber installations.
In the fourth quarter of 2002, Nucentrix wrote down the value of its systems and equipment to fair market value (estimated by management), in accordance with SFAS No. 144 (see note 3). In the fourth quarter of 2001, Nucentrix also wrote down the value of its systems and equipment to fair market value (estimated by management), in accordance with SFAS No. 121 (see note 3). The Company's remaining systems and equipment will be amortized over the estimated remaining useful life of one to four years.
(h) LICENSE AND LEASED LICENSE INVESTMENT
License and leased license investment includes costs incurred to acquire and/or develop MMDS and ITFS spectrum rights and are amortized on a straight-line basis over 15 years beginning with inception of service in each market since the Effective Date and 12.5 years for those markets that existed at the Effective Date (see note 2).
In the fourth quarter of 2002, Nucentrix wrote down the value of its license and leased license investment assets to estimated fair market value in accordance with SFAS No. 144 (see note 3). In the fourth quarter of 2001, Nucentrix also wrote down the value of its license and leased license investment assets to estimated fair market value in accordance with SFAS No. 121 (see note 3). The re-valued license and leased license investment assets are being amortized over the average remaining life of 10 years.
(i) REVENUE RECOGNITION
Revenues currently consist primarily of monthly fees paid by wireless cable subscribers for basic programming, premium programming, equipment rental and other miscellaneous fees and revenues from the Company's agency relationship with DIRECTV (which include revenues from the conversion of wireless cable subscribers). Revenues also include fees generated from Internet operations in Austin and Sherman-Denison, Texas. Unless the context requires otherwise, all references to "subscribers" or "systems" are to wireless cable subscribers and systems because revenues from the Company's Internet business were approximately 1.4% of consolidated revenues in 2002.
Subscription revenues from wireless cable subscribers and continuing monthly service fees from DIRECTV for each DIRECTV customer generated are recognized as service is provided. If the Company does not meet minimum subscriber benchmarks each year, the DIRECTV continuing service fee will be reduced.
Effective January 1, 2001, wireless cable and DIRECTV installation revenue and revenue received from the Company's agency relationship with DIRECTV (except for continuing monthly service fees, which are recognized as received), is recognized to the extent of direct selling costs incurred, and the remainder is deferred and amortized to income over the expected subscriber relationship period. For recognition of wireless cable installation revenue, this period was three years in 2001 and one year in 2002. For recognition of DIRECTV installation and agency revenue, this period was three years in 2001 and 2002. A chargeback reserve is recorded for all DIRECTV contingencies. Prior to 2001, wireless cable installation revenue was offset against the nonrecoverable portion of installation costs, with the excess cost capitalized and amortized to depreciation expense over the expected subscriber relationship period of three years. Prior to 2001, DIRECTV installation revenue (cash received directly from the customer in conjunction with the sale) was offset against direct incremental costs, with the resulting amount recorded as a net asset. This asset, referred to as "subscriber acquisition costs," was amortized as a component of selling, general and administrative ("SG&A") expense in proportion to the revenues projected to be generated over the expected subscriber relationship period. Revenue from the agency relationship with DIRECTV (other than monthly service fees) was recognized, as the contingencies related to each revenue component were resolved. A chargeback reserve
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was not recorded for canceled subscribers. The Company revised its accounting for wireless cable installation and DIRECTV revenues prospectively, effective January 1, 2001, as discussed above.
(j) INCOME TAXES
Nucentrix utilizes the asset and liability method for accounting for deferred income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Based on this policy, deferred tax assets net of deferred tax liabilities have been fully reserved.
(k) NET LOSS PER COMMON SHARE -- BASIC AND DILUTED
The Company has presented basic and diluted loss per share, computed on the basis of the weighted average number of common shares outstanding during the period. Outstanding options to purchase 530,000 and 796,100 shares of common stock at December 31, 2002 and 2001, respectively, and outstanding warrants to purchase 1,099,635 and 825,000 shares of common stock at December 31, 2002 and 2001, respectively, were not included in the computation of diluted loss per share because their effects are antidilutive.
(l) USE OF ESTIMATES
Preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
(m) CONCENTRATIONS OF CREDIT RISK AND ACCOUNTS RECEIVABLE
Nucentrix's subscribers and the related accounts receivable are primarily wireless cable subscribers. Nucentrix establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific subscribers, historical trends and other information.
(n) SUBSCRIBER ACQUISITION COSTS
Subscriber acquisition costs consist of the direct incremental costs incurred in generating a customer relationship with DIRECTV (materials, equipment and labor). These costs are amortized as a component of SG&A expense over the expected customer term of three years.
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(o) OTHER ASSETS
Other assets are comprised primarily of purchased software.
(p) RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform to the current year presentation.
(q) STOCK-BASED COMPENSATION
The Company accounts for its stock-based employee compensation plan using the intrinsic value-based method prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25") and related interpretations. As such, compensation expense is recorded on the date of grant to the extent the current market price of the underlying stock exceeds the exercise price. Nucentrix recorded a net credit to compensation expense of $237,000 in 2002 and a charge to compensation expense of $251,000 in 2001 related to the issuance of stock options. The credit recorded in 2002 arose in connection with the reversal of compensation charges for options that were forfeited. Had Nucentrix determined compensation based on the fair value at the grant date for its stock options under SFAS No. 123, "Accounting for Stock-Based Compensation" as amended by SFAS No. 148, net loss and loss per share would have been increased as indicated below:
Compensation cost is reflected over the options' vesting period of five to seven years.
(r) COMPREHENSIVE INCOME
Comprehensive income includes net income and other comprehensive income which is generally comprised of changes in the fair value of available-for-sale marketable securities, foreign currency translation adjustments and adjustments to recognize additional minimum pension liabilities. For all periods presented, comprehensive income (loss) and net income (loss) are the same amount.
(s) SEGMENT REPORTING
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," requires that public companies report operating segments based upon how management allocates resources and assesses
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performance. Based on the criteria outlined in SFAS No. 131, Nucentrix is comprised of two reportable segments: (i) wireless cable, and (ii) broadband wireless (see note 16).
(t) RECENTLY ISSUED ACCOUNTING PRINCIPLES
Statement of Financial Accounting Standards No. 144. Effective January 1, 2002, the Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which addresses financial accounting and reporting for impairment or disposal of long-lived assets, and supersedes SFAS No. 121.
Statement of Financial Accounting Standards No. 148. In December 2002, FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123." This statement amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for fiscal years ending after December 15, 2002. The Company has adopted the disclosure requirements of SFAS No. 148 and the adoption of this standard had no material effect on its financial condition, cash flows or results of operations.
(2) REORGANIZATION
On December 4, 1998, the Company filed a voluntary, prenegotiated Plan of Reorganization (the "Plan") under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of Delaware. On March 15, 1999, the Bankruptcy Court confirmed the Plan, which became effective on April 1, 1999 (the "Effective Date").
(3) IMPAIRMENT OF LONG-LIVED ASSETS
In the fourth quarter of 2002, the Company reviewed its systems and equipment, and license and leased license investment assets (spectrum licenses and leases) for impairment in accordance with the requirements of SFAS No. 144. In this review, the following factors were considered, among others, (i) the uncertainties of raising capital for the Company's long-term business plan, (ii) the strategic importance of spectrum licenses and leases in smaller or less-densely populated markets, and the likelihood of deployment of 2G Internet systems in such markets within the next three years, (iii) a declining demand for analog MMDS video equipment in the resale market, and (iv) the reduction in personnel in the Company's wireless cable business, which affects its ability to retrieve and resell wireless cable customer premises equipment. In analyzing its licensed and leased license investment assets, spectrum licenses and leases, the Company retained the services of a third party to perform a fair market valuation.
In the fourth quarter of 2001, the Company reviewed its systems and equipment, and license and leased license investment assets for impairment in accordance with the requirements of SFAS No. 121, which was replaced by SFAS No. 144. Events and circumstances that the Company considered in this review included (i) the expected conversion of substantially all of our wireless cable subscribers to satellite and cable programming provided by other companies, (ii) the need to continue evaluating the development of technology for MMDS service which likely would delay deployment of new Internet markets beyond 2002, and (iii) the uncertainties associated with raising capital required to implement the Company's long-term business plan. In determining whether an impairment was required for systems and equipment, the Company examined the future cash flows expected to be generated from these assets and the amount that it estimated could be realized for these assets in an orderly disposition, if required. In analyzing its license and leased
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license investment assets, the Company retained the services of a third party to provide a fair market valuation.
As a result of the Company's analysis and the third party valuation, the Company determined that non-cash impairment charges of $4,843,000 and $14,100,000 were required in 2002 and 2001, respectively, to write down systems and equipment and license and leased license investments to estimated fair value, as follows:
Although the third party market valuation of the Company's aggregate license and leased license investment assets was substantially in excess of its aggregate carrying cost, as required by SFAS No. 144 in 2002 and SFAS No. 121 in 2001, the Company examined these assets on an individual market basis and determined that the carrying value related to 20 markets in 2002 and 10 markets in 2001 should be written down in the total amounts of $2,425,000 and $9,369,000, respectively.
The Company's estimates of future gross revenues and operating cash flows, the remaining estimated lives of long-lived assets, or both could be reduced in the future due to changes in, among other things, technology, government regulation, available financing or competition. As a result, the carrying amounts of long-lived assets could be reduced by additional amounts which would be material to the Company's financial position and results of operations.
(4) SYSTEMS AND EQUIPMENT
Systems and equipment consists of the following at December 31, 2002 and 2001:
See note 3 for discussion of systems and equipment write-down in the fourth quarters of 2002 and 2001.
In the fourth quarter of 1999, Nucentrix sold 30 of its communication towers to SBA Towers, Inc. ("SBA Towers") for approximately $6.2 million in a transaction accounted for as a sale-leaseback (see note 7). This transaction resulted in a deferred gain of approximately $3.8 million. The sale of four additional tower sites was closed in the second and third quarters of 2000 for approximately $830,000, resulting in a deferred gain of approximately $450,000. During the years ended December 31, 2002, 2001 and 2000, $417,000, $417,000 and $400,000, respectively, of the total $4.2 million gain was recognized as other income. The remaining deferred gain is included in other long-term liabilities (long-term portion) and accrued liabilities (current portion) on the accompanying consolidated balance sheet as of December 31, 2002.
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During the fourth quarter of 2002, Nucentrix retired the portion of its subscriber premises equipment which was no longer in service due to the decrease in the Company's wireless cable business. The net carrying value of this equipment had been reduced to zero through depreciation and as a portion of the impairment charge of $2,418,000 in 2002 (see note 3).
(5) FCC LICENSES AND OPERATING LEASES
License and leased license investment consists primarily of costs incurred in connection with the Company's acquisition and development of FCC spectrum rights. Spectrum rights represent the right to use capacity on spectrum operated under a license received from the FCC or leased from the licensee. These assets are recorded at cost and amortized using the straight-line method over the assets' estimated useful lives. Accumulated amortization on license and leased license investment was $26.9 million and $22.1 million at December 31, 2002 and 2001, respectively. Additions to license and leased license investment of $161,000 and $5.2 million during 2002 and 2001, respectively, consisted of engineering and other costs related to the preparation and filing of applications with the FCC for two-way use of the Company's spectrum, as well as the cost to acquire new licenses in several markets. See note 3 for discussion of license and leased license investment write-down in the fourth quarters of 2002 and 2001.
Nucentrix depends on leases with third parties for some of its spectrum rights. FCC licenses generally must be renewed every 10 years. All licenses are subject to renewal by the FCC. Although FCC custom and practice establish a presumption of granting renewals of licenses, the presumption requires that the licensee substantially comply with its regulatory obligations during the license period.
Spectrum lease agreements generally require payments based on the greater of specified minimums or amounts based upon subscriber levels or revenues. Spectrum lease payments generally begin upon the completion of construction of transmission equipment and facilities and upon approval for operation under FCC rules. For certain leases, payments begin upon grant of the spectrum rights. Spectrum lease expense was $3.7 million, $3.6 million and $3.5 million for the years ended December 31, 2002, 2001 and 2000, respectively.
Nucentrix also has other operating leases for office space, vehicles, equipment, and transmission tower space. Rent expense incurred in connection with these leases was $2.6 million, $2.8 million and $2.6 million for the years ended December 31, 2002, 2001 and 2000, respectively.
Future minimum lease payments due under noncancellable leases at December 31, 2002, are as follows:
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(6) ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
Accounts payable and accrued liabilities consists of the following at December 31, 2002 and 2001:
(7) LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Long-term debt and capital lease obligations at December 31, 2002 and 2001, consists of the following:
In December 1999, Nucentrix entered into capital lease agreements with SBA Towers to lease back space on 34 towers that Nucentrix sold to SBA Towers in 1999 and 2000 (see note 4). A lease obligation of $2.2 million was recorded in connection with the lease of 30 of the towers as of December 31, 1999, and an additional obligation of $294,000 was recorded when the sale of the four remaining towers closed during 2000. These capital lease obligations have an initial term of 10 years, with three (3) five-year renewal options.
Other notes payable at December 31, 2002 and 2001, relate to the acquisition of BTAs from the FCC. The notes payable to the FCC bear interest at 9.5%, payable quarterly over ten years beginning November 1996. Quarterly principal payments (currently $475,000) are payable over the remaining eight years beginning November 1998. The notes payable to the FCC are secured by the underlying BTA authorizations issued by the FCC.
In October 1997, Nucentrix and CS Wireless Systems, Inc. ("CS Wireless") entered into a lease and purchase option agreement ("BTA Agreement") for certain spectrum rights associated with 10 BTAs and portions of four additional BTAs (collectively, the "Leased BTAs") awarded to Nucentrix at a total cost of approximately $5.2 million. Under the BTA Agreement, CS Wireless reimburses Nucentrix for principal and interest paid to the FCC for the Leased BTAs. As of December 31, 2002 and 2001, the amount of FCC debt related to the Leased BTAs totaled $1.5 million (net of current portion of $519,000) and $2.0 million (net of current portion of $400,000), and CS Wireless' obligation to the Company has been recorded as a receivable. In July 2002, CS Wireless, along with its indirect parent WorldCom, Inc., filed for protection under Chapter 11 of the U.S. Bankruptcy Code. CS Wireless has reimbursed the Company for substantially all post-petition amounts owed to the Company under the BTA Agreement. Approximately $87,000 in prepetition
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amounts related to BTA reimbursements remains unpaid. If CS Wireless assumes the BTA Agreement in its Chapter 11 proceeding, it will be required to pay all prepetition amounts due and owing to the Company.
Aggregate maturities of long-term debt and capital lease obligations as of December 31, 2002, for the five years ending December 31, 2007, are as follows: 2003 -- $2.8 million; 2004 -- $2.3 million; 2005 -- $2.6 million; 2006 -- $2.2 million; and 2007 and thereafter -- $1.4 million.
(8) OTHER LONG-TERM LIABILITIES
Other long-term liabilities at December 31, 2002 and 2001, consists of the following:
(9) ACQUISITIONS/DISPOSITIONS
Fayetteville and Fort Smith, Arkansas Acquisition. In April 2001, the Company completed the purchase of certain of the MMDS spectrum licenses, leases and related assets of Smithco of Ft. Smith, Inc. and Smithco Investments of West Memphis, Inc., in Fort Smith, Arkansas in exchange for the issuance of approximately 153,000 shares of common stock of the Company, valued at $4.2 million as of the date of filing of the Company's Form 10-Q for the first quarter of 2001, in which the Company initially announced this transaction. The 153,000 shares of common stock includes up to approximately 16,000 shares issuable over two years. In addition, the Company entered into new MDS spectrum leases for three channels (18 MHz) in Fort Smith and new ITFS spectrum leases for 20 channels (120 MHz) in each of Fort Smith and Fayetteville, Arkansas. The Company also assumed a lease and purchase agreement for four MMDS channels (24 MHz) in Fort Smith that provides for the payment of $337,000 in cash through September 2002.
Exchange of Equity Interest in Wireless One, Inc. In January 2000, the Company exchanged 2,911,725 shares of common stock in Wireless One, Inc. ("Wireless One") for approximately $3.8 million, pursuant to Wireless One's plan of reorganization under Chapter 11 of the Bankruptcy Code. In July 2000, an additional 547,783 shares of common stock in Wireless One was exchanged for approximately $700,000. After these transactions, Nucentrix retained no equity interest in Wireless One. Losses recorded in prior years for Wireless One had reduced the carrying amount of the Company's investment to zero. Accordingly, the proceeds have been classified as a gain on sale of assets and included in other income in the consolidated statement of operations for the year ended December 31, 2000.
(10) STOCKHOLDERS' EQUITY
(A) STOCK OPTIONS
The Company's First Amended and Restated 1999 Share Incentive Plan provides for the grant of options to purchase a maximum of 1,300,000 shares of common stock of the Company. Options vest according to schedules set by the Compensation Committee of the Board of Directors.
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A summary of option activity during 2000, 2001 and 2002 follows:
The following table summarizes information about stock options outstanding at December 31, 2002:
At December 31, 2001, the number of options exercisable and the weighted average exercise prices of those options were 391,474 and $13.22, respectively.
The per share weighted average fair values of stock options granted during fiscal years 2002, 2001 and 2000, estimated on the dates of grant using the Black-Scholes option pricing model, were as follows:
The following weighted-average assumptions for stock options granted during fiscal years 2002, 2001 and 2000 were used:
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(B) WARRANTS
On April 1, 1999, under the terms of the Plan, holders of convertible subordinated notes received warrants ("Initial Warrants") to purchase 825,000 shares of common stock at an exercise price of $27.63 per share, subject to downward adjustment in the event of a sale or merger of the Company. These warrants expire in October 2007. In June 2002, upon resolution of certain litigation claims, the Company issued additional warrants ("Additional Warrants") to purchase 274,635 shares. The terms of the Additional Warrants are the same as the Initial Warrants. The Initial Warrants and Additional Warrants represent substantially all of the warrants that the Company is required to issue under the Plan.
(11) INCOME TAXES
Income tax expense (benefit) for the years ended December 31, 2002, 2001 and 2000, differed from the amount computed by applying the U.S. federal income tax rate of 35% to income (loss) before income taxes as a result of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001, are presented below:
The net changes in the total valuation allowance for the years ended December 31, 2002, 2001 and 2000 were increases (decreases) of $1.7 million, $17.5 million and ($62.4) million, respectively. In assessing the
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realizability of deferred tax assets, Nucentrix considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on the generation of future taxable income during the periods in which the temporary differences become deductible. Nucentrix considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon these considerations, Nucentrix has fully reserved all deferred tax assets to the extent that such assets exceed deferred tax liabilities.
As a result of the cancellation of debt in connection with the Company's reorganization in 1999, federal tax law requires that the amount of income from discharge of indebtedness that occurs in connection with a Chapter 11 bankruptcy be used to permanently reduce federal tax attributes. These reductions may be applied to one or more tax items, including but not limited to pre-bankruptcy net operating loss carryforwards, the tax basis of certain assets and the tax basis of subsidiary stock. Management has elected to apply the required reduction first to tax basis in depreciable assets, and then to net operating loss carryforwards. The amount of reduction in the tax basis of depreciable assets was approximately $56 million. The amount of reduction in net operating loss carryforwards was approximately $118 million, leaving approximately $222 million in remaining net operating loss carryforwards at December 31, 2000. The net operating loss carryforwards at December 31, 2002 are $269 million and expire in years 2013 through 2021. Nucentrix estimates that approximately $31 million of the carryforwards at December 31, 2002 relate to various acquisitions and are subject to certain limitations.
In addition to the permanent Tax Attribute Reduction, the Company also must limit the annual deduction of pre-bankruptcy net operating losses and "built-in deductions" to an amount no greater than the fair market value of the Company immediately after the restructuring, multiplied by the long-term tax exempt rate. This annual limitation is currently estimated to be approximately $7.3 million.
(12) BENEFIT PLAN
The Company sponsors a 401(k) savings plan in which substantially all employees are eligible to participate upon completion of six months of service. The plan is subject to the provisions of the Employee Retirement Income Security Act of 1974, as amended. The plan permits eligible employees to contribute up to 20% of their compensation, subject to the annual maximum allowed by the Internal Revenue Service. The Company may make discretionary matching contributions to the plan. The Company began making discretionary matching contributions to the plan for the 2001 plan year on April 1, 2001, and contributed $139,000 and $113,000 during the years ended December 31, 2002 and 2001, respectively. The Company made no discretionary matching contributions during the year ended December 31, 2000.
(13) CHANGE IN ACCOUNTING ESTIMATE
Effective January 1, 2002, the Company changed its estimated useful life on systems and equipment for its wireless cable operations (subscriber premises equipment, installation costs, transmission equipment and systems construction costs) from 3-10 years to one year, and its estimated useful life of license and leased license investment from 12.5-15 years to 10 years. These changes increased net loss for the year ended December 31, 2002, by $3.5 million or $0.33 per share. The changes were made to better reflect the remaining estimated useful life of systems and equipment and license and leased license investment, and more accurately match depreciation and amortization expense with the future estimated cash flows generated by these assets. The Company expects decreasing future cash flows generated by its wireless cable systems and equipment as a result of the conversion of the Company's wireless cable subscribers discussed in note 1(a) and (b), above.
(14) COMMITMENTS AND CONTINGENCIES
WSNet. The Company has a programming arrangement with World Satellite Network, Inc. ("WSNet"), under which the Company pays WSNet to obtain and manage certain of the video programming
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
that the Company delivers to its wireless cable subscribers, including making payments for such programming directly to programming providers such as Disney, ESPN and HBO. In October 2002, WSNet filed for protection under Chapter 11 of the U.S. Bankruptcy Code and, in February 2003, announced that it would cease operations at the end of that month. The Company now pays programmers directly for the monthly programming that the Company continues to deliver to its remaining wireless cable subscribers. However, for programming delivered for September 2002, the Company paid WSNet approximately $550,000. WSNet has not remitted this amount to the various programmers from whom the Company received programming. In February 2003, WSNet notified the Company that it intended to reject its agreement with the Company in its Chapter 11 proceeding. The Company is continuing to evaluate its rights and potential obligations with respect to WSNet and the programmers. The Company ultimately may be liable for payment of some or all of this amount to one or more programmers. The Company believes it has a claim against WSNet or its creditors for such amount. While it is not feasible to predict or determine the final outcome of this matter or to estimate the amounts or potential range of loss, the Company do not believe that an adverse outcome in this matter would have a material adverse effect on our consolidated financial condition, results of operations or cash flows.
Settlement of Securities Litigation. Nucentrix and certain of its former officers and directors were co-defendants in securities litigation styled Coates, et al. v. Heartland Wireless Communications, Inc., et al. (3-98-CV-0452-D) and Thompson, et al. v. David E. Webb, et al. (98-371-D), originally filed in February 1998 and July 1998, respectively. In 2001, the parties in the Coates and Thompson lawsuits executed settlement agreements for the respective lawsuits. In January 2002, the court in Thompson approved the settlement and entered a Final Judgment and Order of Dismissal with prejudice in this matter. In March 2002, the Court of Appeals in Coates dismissed the appeal pursuant to the settlement agreement entered into in that lawsuit. All amounts payable by the defendants in the settlement of both the Coates and Thompson lawsuits were covered by the proceeds from the Company's primary directors and officers liability insurance policy. Accordingly, this settlement did not have a material adverse effect on the consolidated financial condition, results of operations or cash flows of the Company.
Settlement of Other Litigation. From time to time the Company has been a party to purported class action lawsuits alleging that the Company overcharged its customers for administrative late fees, and that the Company breached various state consumer lease and credit laws and federal privacy and notice statutes. These lawsuits included the following:
- Garcia, et al. v. Heartland Wireless Communications, Inc. d/b/a Heartland Cable Television (98-05-8388-CV), filed in May 1998 in the 79th Judicial District Court in Brooks County, Texas (dismissed and appealed),
- John Nolen, Jr., et al. v. Nucentrix Broadband Networks, Inc. (DC-00-155), filed in May 2000 in the 229th Judicial District Court in Duval County, Texas,
- Nolen, et al. v. Nucentrix Broadband Networks, Inc., et al. (L-00CV134), filed in October 2000 in U.S. District Court for the Southern District of Texas, Laredo Division (dismissed),
- Perez, et al. v. Nucentrix Broadband Networks, Inc. (01-141-D), filed in March 2001 in the 105th Judicial District Court in Kleberg County, Texas,
- Garcia v. Heartland Wireless Communications, Inc. (01-04-10449CV), filed in April 2001 in the 79th Judicial District Court in Brooks County, Texas (dismissed and appealed),
- Torres v. Nucentrix Broadband Networks, Inc. (01-61022-1), filed in September 2001 in County Court at Law No. 1 in Nueces County, Texas,
- Santellana v. Nucentrix Broadband Networks, Inc. (S-01-6109-CV-B), filed in November 2001 and pending in the 156th Judicial District Court in San Patricio County, Texas (dismissed),
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- Ysasi and Garcia v. Nucentrix Broadband Networks, Inc., DIRECTV, Inc., et al. (C-02-001), filed in January 2002 in U.S. District Court for the Southern District of Texas, Corpus Christi Division (dismissed), and
- Santellana v. Nucentrix Broadband Networks, Inc. and DIRECTV, Inc. (C-02-079), filed in February 2002 and pending in U.S. District Court for the Southern District of Texas, Corpus Christi Division (dismissed).
In January 2003, the Company entered into a Settlement Agreement with all named plaintiffs in the lawsuits listed above, as well as all named plaintiffs in prior similar lawsuits, settling all claims brought by these plaintiffs in such matters. This settlement did not have a material adverse effect on the consolidated financial condition, results of operations or cash flows of the Company
Dismissal of State Court Action. In September 2002, the U.S. District Court for the District of Delaware affirmed the U.S. Bankruptcy Court's dismissal of the plaintiffs' claims that the Company had undervalued the enterprise value in the chapter 11 proceeding of its predecessor, Heartland Wireless Communications, Inc., in Hunt Capital Group, L.L.C., et al., v. Carroll D. McHenry, et al., Case No. OJ-2000-534. Plaintiffs did not appeal the District Court's decision.
General. The Company is a party to other legal and regulatory proceedings, a majority of which are incidental to its business. In the opinion of management, and after consideration for amounts recorded in the accompanying consolidated financial statements, the ultimate effects of such other matters are not expected to have a material adverse effect on the consolidated financial condition, results of operations or cash flows of the Company.
(15) FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and estimated fair value of Nucentrix's financial instruments at December 31, 2002 and 2001. The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties.
The fair value of cash and cash equivalents, accounts receivable and accounts payable approximate the carrying amounts of these assets and liabilities because of the short maturity of these instruments.
The carrying value of bank certificates of deposit approximates fair value since the term of the underlying deposits is short-term at the reporting date. The carrying amount of the lease receivable approximates fair value since the interest rate (9.5% at December 31, 2002) equates to the market rate of interest. The fair value of the long-term debt is based on management's estimates derived from current rates offered for similar borrowings.
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(16) SEGMENT REPORTING
Based on the criteria outlined in SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information," Nucentrix is comprised of two reportable segments: (i) wireless cable and (ii) broadband wireless.
A reconciliation from the segment information to net loss for the years ended December 31, 2002, 2001 and 2000, is as follows:
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Total expenditures for additions to long-lived assets during the years ended December 31, 2002, 2001 and 2000, are as follows:
Total assets as of December 31, 2002, 2001 and 2000, are as follows:
(A) Revenues from the wireless cable segment's agency relationship with DIRECTV represent approximately $4.1 million, $2.1 million and $6.3 million of the Company's consolidated revenue for the years ended December 31, 2002, 2001 and 2000, respectively.
(B) Intersegment revenue (expense) represents a charge from the IP-based services segment to the wireless cable services segment for the use of shared assets. The "other" category includes corporate expenses, other income and assets not considered part of the two reportable segments.
(C) The Company measures segment profit or loss, as reviewed by the Company's "chief operating decision maker" (as defined in SFAS No. 131), as operating loss before depreciation and amortization.
(17) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following tables present unaudited financial data of Nucentrix for each quarter of 2002 and 2001.
SCHEDULE II
NUCENTRIX BROADBAND NETWORKS, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
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(a) Accounts written off.
(b) Recognized as a component of deferred tax assets.
S-1
INDEX TO EXHIBITS
Exhibits followed by an (*) constitute management contracts or compensatory plans or arrangements.
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+ Filed herewith.