-----BEGIN PRIVACY-ENHANCED MESSAGE-----
Proc-Type: 2001,MIC-CLEAR
Originator-Name: webmaster@www.sec.gov
Originator-Key-Asymmetric:
MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen
TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB
MIC-Info: RSA-MD5,RSA,
UTFAQspKGU24bG5pq3kEt2IaW+TNGF54W2M4bdkLDLgzPu9YhYCC9ZEOZCYve01O
BTONL45JEhPo7U4cYXUHsA==
<SEC-DOCUMENT>0000912057-02-012344.txt : 20020415
<SEC-HEADER>0000912057-02-012344.hdr.sgml : 20020415
ACCESSION NUMBER: 0000912057-02-012344
CONFORMED SUBMISSION TYPE: 10-K405
PUBLIC DOCUMENT COUNT: 8
CONFORMED PERIOD OF REPORT: 20011231
FILED AS OF DATE: 20020328
FILER:
COMPANY DATA:
COMPANY CONFORMED NAME: FAIRPOINT COMMUNICATIONS INC
CENTRAL INDEX KEY: 0001062613
STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813]
IRS NUMBER: 133725229
STATE OF INCORPORATION: DE
FISCAL YEAR END: 1231
FILING VALUES:
FORM TYPE: 10-K405
SEC ACT: 1934 Act
SEC FILE NUMBER: 333-56365
FILM NUMBER: 02592331
BUSINESS ADDRESS:
STREET 1: 521 EAST MOREHEAD ST
STREET 2: STE 250
CITY: CHARLOTTE
STATE: NC
ZIP: 28202
BUSINESS PHONE: 7043448150
FORMER COMPANY:
FORMER CONFORMED NAME: MJD COMMUNICATIONS INC
DATE OF NAME CHANGE: 19980527
</SEC-HEADER>
<DOCUMENT>
<TYPE>10-K405
<SEQUENCE>1
<FILENAME>a2074052z10-k405.txt
<DESCRIPTION>10-K405
<TEXT>
<Page>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
(MARK ONE)
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934.
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001.
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 333-56365
FAIRPOINT COMMUNICATIONS, INC.
(Exact Name of Registrant as Specified in Its Charter)
<Table>
<S> <C>
DELAWARE 13-3725229
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
521 EAST MOREHEAD STREET, SUITE 250 28202
CHARLOTTE, NORTH CAROLINA (Zip Code)
(Address of Principal Executive Offices)
</Table>
------------------------
Registrant's Telephone Number, Including Area Code: (704) 344-8150.
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /X/
As of March 22, 2002, the registrant had outstanding 45,850,002 shares of
Class A common stock and 4,269,440 shares of Class C common stock. 1,953,576
shares of Class A common stock were held by non-affiliates and the Company
estimates the market value of such shares, as of March 22, 2002, was
$13.7 million, based upon a fair market value of $7.00 per share. All of the
shares of Class C common stock were held by non-affiliates and the Company
estimates the market value of such shares, as of March 22, 2002, was
approximately $29.9 million, based upon an estimated fair market value of $7.00
per share.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<Page>
FAIRPOINT COMMUNICATIONS, INC. ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
<Table>
<Caption>
ITEM PAGE
NUMBER NUMBER
- --------------------- --------
<C> <S> <C>
Index....................................................... 2
PART I
1. Business.................................................... 3
2. Properties.................................................. 11
3. Legal Proceedings........................................... 11
4. Submission of Matters to a Vote of Security Holders......... 11
PART II
5. Market for Registrant's Common Equity and Related
Stockholder Matters....................................... 12
6. Selected Financial Data..................................... 12
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 14
7A. Quantitative and Qualitative Disclosures about Market
Risk...................................................... 26
8. Independent Auditors' Report and Consolidated Financial
Statements................................................ 28
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 72
PART III
10. Directors and Executive Officers of the Registrant.......... 72
11. Executive Compensation...................................... 74
12. Security Ownership and Beneficial Management................ 77
13. Certain Relationships and Related Transactions.............. 79
PART IV
14. Exhibits, Financial Statement Schedules, and Reports on Form
8K........................................................ 80
Independent Auditors' Report and Schedule................... 81
Signatures.................................................. 83
Exhibit Index............................................... 84
</Table>
2
<Page>
PART I
Except as otherwise required by the context, references in this Annual
Report to the "Company," "FairPoint," "our company," "we," "us," or "our" refer
to the combined business of FairPoint Communications, Inc. and all of its
subsidiaries.
ITEM 1. BUSINESS
OUR BUSINESS
We are a provider of telecommunications services to customers in rural
communities, offering an array of services that include local voice, long
distance, data and Internet. We were incorporated in February 1991 for the
purpose of acquiring and operating traditional telephone companies in rural
markets. Since inception, the Company has acquired 29 such companies, which are
located in 18 states.
All of our traditional telephone company subsidiaries qualify as rural local
exchange carriers or "RLECs" under the Telecommunications Act of 1996 (the
"Telecommunications Act"). RLECs are generally characterized by stable operating
results and strong cash flow margins and primarily operate in a favorable
regulatory environment. In particular, pursuant to existing state and federal
regulations, we are able to charge rates which enable us to recover our
operating and capital costs, plus a reasonable (as determined by the relevant
regulatory authority) rate of return on our invested capital. In addition,
because RLECs primarily serve sparsely populated rural areas and small towns,
competition from competitive local exchange carriers is typically limited due to
the generally unfavorable economics of constructing and operating competitive
systems in such areas. We believe these attractive characteristics of the RLEC
industry, combined with our ability to draw on our existing corporate resources,
create the opportunity to improve our operating results and cash flows.
In early 1998, we launched our competitive local exchange carrier ("CLEC")
enterprise through our wholly owned subsidiary, FairPoint Communications
Solutions Corp. ("FairPoint Solutions"), in an effort to extend our service
offering to markets adjacent to our RLECs. In November 2001, we announced our
plan to discontinue our CLEC operations. For additional information about the
Company's decision to discontinue its CLEC operations, see "Recent
Developments."
BUSINESS STRATEGY
Our business strategy is to be the leading provider of telecommunications
services to the rural communities that we serve. We intend to accomplish this
objective through internal growth and continued growth by acquiring
strategically located RLECs, telecommunications lines and other related assets
located in rural areas which may be sold by the regional Bell operating
companies ("RBOCs"). We believe our success depends upon our ability to leverage
our expertise in the acquisition, integration and operation of RLECs, our
knowledge of our local markets, the strength of our customer relations and the
commitment of our employees. To this end, we have adopted an approach to our
business that is based on the following goals:
- GROW THROUGH STRATEGIC ACQUISITIONS. We have gained substantial experience
in acquiring and integrating 29 RLECs since inception. We intend to
utilize this experience to continue our growth, complement our service
capabilities and increase our customer base by continuing to acquire
strategically located RLECs or RBOC rural assets.
- IMPROVE OPERATING EFFICIENCY AND PROFITABILITY. We have successfully
achieved significant operating efficiencies at our acquired RLECs by
applying our operating, regulatory, marketing, technical and management
expertise and our financial resources. We have focused and will continue
to focus on increasing revenues by introducing innovative marketing
strategies for enhanced and ancillary services and by creating
applications and technologies to meet the growing needs of our
3
<Page>
rural customers. Additionally, we are striving for greater efficiencies by
consolidating various administrative functions and implementing best
practices.
- INCREASE CUSTOMER LOYALTY AND BRAND IDENTITY THROUGH SUPERIOR CUSTOMER
SERVICE. We seek to build long-term relationships with our customers by
offering an array of telecommunications services and ongoing, consistent
customer care. We believe that our service-driven customer relationship
strategy leads to high levels of customer satisfaction and will lead to an
increase in demand for enhanced and ancillary services. Presently, the
penetration rates for such services in our RLEC markets are below industry
levels. We believe this offers an opportunity to increase revenues and
operating margins.
- LEVERAGE OUR MANAGEMENT'S EXPERIENCE. Our senior management team has
substantial experience in the communications industry. Our senior
executives have, on average, 24 years of experience working in a variety
of incumbent local exchange carriers ("ILECs") and/or RLECs. We believe
this experience has been a major factor in our success to date and will
continue to play a critical role in the evolution and execution of our
business strategy.
RECENT DEVELOPMENTS
DISCONTINUED OPERATIONS
In November 2001, we decided to discontinue the CLEC operations of our
wholly owned subsidiary, FairPoint Solutions. This decision was a proactive
response to the deterioration in the capital markets, the general slow-down of
the economy and the slower-than-expected growth in FairPoint Solutions' CLEC
operations.
Prior to our decision to discontinue FairPoint Solutions' CLEC operations,
FairPoint Solutions entered into an agreement on October 19, 2001 to sell
certain of its Northwest assets to Advanced TelCom, Inc. On December 10, 2001,
FairPoint Solutions completed the disposition of these assets in exchange for
$3.4 million in cash, which includes approximately $0.9 million for accounts
receivables. On November 7, 2001, FairPoint Solutions entered into an agreement
to sell certain of its Northeast assets to Choice One Communications Inc. and
certain of Choice One's affiliates. On December 19, 2001, FairPoint Solutions
completed the disposition of these assets for $5.6 million in cash, which
includes approximately $3.5 million for accounts receivables, and 2,500,000
restricted shares of Choice One's common stock. FairPoint Solutions can earn up
to an additional 2,000,000 shares of Choice One restricted common stock based on
the number of access lines converted to Choice One's operating platform
120 days after closing. In connection with these transactions, FairPoint
Solutions is receiving payment for providing certain services to Advanced TelCom
and Choice One to facilitate the successful conversion of customers to their
respective systems and networks. These servicing arrangements are expected to
terminate in or before June 2002.
In addition, FairPoint Solutions has notified its remaining customers in the
Southwest, Southeast, and Mid-Atlantic competitive markets to find alternative
carriers. As a result of the asset sales and notifications described above,
FairPoint Solutions is nearing completion of its operations as a CLEC provider.
FairPoint Solutions will continue to provide wholesale long distance service
and support to our RLEC subsidiaries and other independent local exchange
companies. These services allow such companies to operate their own long
distance communication services and sell such services to their respective
customers. We believe that FairPoint Solutions' ability to provide ongoing
support to independent local exchange companies will provide a source of
increasing revenue and greater profitability (although not material).
4
<Page>
FAIRPOINT SOLUTIONS DEBT FINANCING ACTIVITY
On November 28, 2001, FairPoint Solutions completed a second amendment to
its Amended and Restated Credit Agreement, pursuant to which FairPoint
Solutions' lenders waived certain restrictions with respect to the sale by
FairPoint Solutions of certain of its Northwest assets to Advanced TelCom and
FairPoint Solutions agreed to reduce the aggregate outstanding revolving
commitment to $23.5 million and that after December 31, 2001 it would not be
permitted to borrow any funds under the revolving credit tranche without the
consent of each of its lenders. On December 19, 2001, FairPoint Solutions
completed a third amendment to such Amended and Restated Credit Agreement which
provided for such lenders' consent to the sale of certain of FairPoint
Solutions' Northeast assets to Choice One and for the lenders' forbearance,
until March 31, 2002, from exercising their remedies under the FairPoint
Solutions Amended and Restated Credit Agreement for certain enumerated potential
covenant breaches and potential events of default thereunder.
As of April 1, 2002, FairPoint Solutions will be in default under its
Amended and Restated Credit Agreement as a result of its failure to comply with
certain of the covenants contained therein. In light of such impending default,
FairPoint Solutions' debt has been classified as a net current liability of
discontinued operations in our consolidated financial statements for the year
ended December 31, 2001. The Company has not guaranteed the debt owed to the
lenders under the FairPoint Solutions Amended and Restated Credit Agreement nor
does the Company have any obligation to invest any additional funds in FairPoint
Solutions. Further, our Credit Facility and the indentures governing our senior
subordinated notes contain significant restrictions on the Company's ability to
make investments in FairPoint Solutions. Under a tax sharing agreement, the
Company is obligated to reimburse FairPoint Solutions for any tax benefits it
receives from net operating losses generated by FairPoint Solutions. At
December 31, 2001, the amount payable to FairPoint Solutions under the tax
sharing agreement was approximately $7.6 million.
Upon the occurrence and continuation of an event of default under the
FairPoint Solutions Amended and Restated Credit Agreement, the lenders are
entitled to various rights and remedies, including, but not limited to, the
right to declare all loans and obligations thereunder (which amounted to
approximately $125.8 million as of March 22, 2002) immediately due and payable,
and to enforce all liens and security interests. In addition, as a result of the
occurrence of an event of default under the FairPoint Solutions Amended and
Restated Credit Agreement, FairPoint Solutions will also be in default under its
two interest rate swap agreements. FairPoint Solutions' liability under such
agreements was approximately $3.1 million as of March 22, 2002. If the lenders
or swap counterparty were to enforce their remedies and obtain a final judgment
in excess of $3,000,000 or if FairPoint Solutions either voluntarily filed for
or was involuntarily placed into bankruptcy, then such events would, after the
expiration of any applicable grace periods, cause there to be an event of
default under the Company's Credit Facility and/or the indentures governing the
Company's senior subordinated notes. The FairPoint Solutions lenders do not have
any claim or right to any of the Company's assets or cash flows other than as
required by the tax sharing agreement.
In addition to the foregoing remedies, each lender under the FairPoint
Solutions Amended and Restated Credit Agreement has the option to exchange all
or a portion of the amounts owed to it for shares of the Company's Series A
preferred stock having a liquidation preference equal to the amount of debt
exchanged, such that each $1,000 of debt shall be converted into one share of
the Company's Series A preferred stock. Such Series A preferred stock is
non-voting, except as required by applicable law, and is not convertible into
common stock of the Company. The Series A preferred stock provides for the
payment of dividends at a rate per annum equal to the 10-year Treasury rate on
the date of issue plus 1,200 basis points (which would have been approximately
16.75% as of March 22, 2002). Dividends would be payable either in cash or in
additional shares of Series A preferred stock, at the option of the Company.
Dividends would accrue and be cumulative from the date of issue, and be payable
in arrears. The Company would have the option to redeem the Series A preferred
stock at any
5
<Page>
time. The redemption price would be payable in cash in an amount equal to $1,000
per share plus any accrued but unpaid dividends thereon (the "Preference
Amount"). Under certain circumstances, the Company would be required to pay a
premium of up to 6% of the Preference Amount in connection with the redemption
of the Series A preferred stock. In addition, upon the occurrence of certain
events, such as (i) a merger, consolidation, sale, transfer or disposition of at
least 50% of the assets or business of the Company and its subsidiaries, (ii) a
public offering of the Company's common stock which yields in the aggregate at
least $175.0 million, or (iii) the first anniversary of the maturity of the
Company's senior subordinated notes (which first anniversary will occur in
May 2011), the Company would be required to redeem all outstanding shares of the
Series A preferred stock at a price per share equal to the Preference Amount.
FairPoint Solutions has engaged in continuing discussions with its lenders
regarding a restructuring of its Amended and Restated Credit Agreement.
FairPoint Solutions and its lenders have discussed a restructuring pursuant to
which, among other things, a substantial portion of the outstanding debt under
the Amended and Restated Credit Agreement would be exchanged for shares of the
Company's Series A preferred stock, and the remaining debt would be repaid over
approximately five years after the closing of the restructuring. FairPoint
Solutions believes that, in the event such a restructuring is not agreed upon,
all or substantially all of its lenders would elect to exchange all of their
outstanding debt under the FairPoint Solutions Amended and Restated Credit
Agreement for shares of Series A preferred stock. While FairPoint Solutions can
neither predict nor control which remedies its lenders may pursue, its lenders
have not indicated to FairPoint that they intend to seek a remedy which would
result in the imposition of a judgment against FairPoint Solutions or which
would result in FairPoint Solutions filing for or being placed into bankruptcy,
and forcing FairPoint Solutions into bankruptcy would not enhance the lenders'
claims to the Company's assets or cash flows. There can be no assurance that any
restructuring of the FairPoint Solutions Amended and Restated Credit Agreement
will be agreed upon or that FairPoint Solutions' lenders will not seek a remedy
that would result in the imposition of a judgment against FairPoint Solutions or
in FairPoint Solutions' bankruptcy.
MANAGEMENT
Effective January 1, 2002, Eugene B. Johnson became our Chief Executive
Officer. Mr. Johnson continues to serve as Vice Chairman of the Company's Board
of Directors. Jack H. Thomas retired as the Company's Chief Executive Officer,
effective December 31, 2001. Mr. Thomas continues to serve as Chairman of the
Company's Board of Directors. Effective February 27, 2002, Peter G. Nixon became
our Senior Vice President of Corporate Development.
OUR SERVICES
We design our service offerings to meet the specific needs of our customers.
We offer a comprehensive selection of voice, data and Internet services,
including local voice, long distance, data and Internet services.
VOICE SERVICES
Local Services. Our local services include:
-- basic telephone service
-- caller name and number
identification
-- call waiting
-- call transferring and call forwarding
-- voice mail
-- call hunting
-- teleconferencing
-- video conferencing
6
<Page>
-- cable television service and high speed Internet connectivity
-- store-and-forward fax
-- follow-me numbers
-- three way calling
-- automatic callback
-- call hold
-- DID (direct inward dial)
-- Centrex services
Long Distance Services. We offer intra-state and inter-state long distance
services. International long distance service is available to over 200
countries. These services are available via dedicated and switched access.
Long Distance, Wholesale and Consulting Services. We provide ILECs
end-to-end service and support that allows these customers to operate their own
long distance communications services. We also offer our expertise by providing
sales, marketing and training materials to these companies.
DATA AND INTERNET SERVICES
High Speed Internet Access. We offer Internet access via DSL technology,
dedicated T-1 connections and Internet dial-up. Customers can utilize this
access in combination with customer-owned equipment and software to establish a
presence on the web.
Enhanced Internet Services. Our enhanced Internet services include obtaining
Internet protocol addresses, basic web site design and hosting, domain name
services, content feeds and web-based e-mail services. Our services include
access to 24-hour, 7-day a week customer support.
OUR MARKETS
Our 29 RLECs operate as the incumbent local exchange carrier in each of
their respective markets. Our RLECs serve an average of 12 access lines per
square mile versus the RBOC average of 330 access lines per square mile.
Approximately 78% of these access lines serve residential customers. Our
business customers account for approximately 22% of our access lines. Our
business customers are predominantly agriculture, light manufacturing and
service industries. Approximately 85% of our business customers subscribe to no
more than two access lines.
SALES AND MARKETING
Our marketing strategy emphasizes customer-oriented sales, marketing and
service. Each of our RLECs has a long history in the communities it serves. Our
strategy is to enhance our telecommunications services by offering comprehensive
bundling of services and deploying new technologies to build upon the strong
reputation we enjoy in our markets and to further promote rural economic
development in the rural communities we serve.
INFORMATION TECHNOLOGY AND SUPPORT SYSTEMS
Our approach to billing and OSS systems focuses on implementing
best-of-class applications that allow consistent communication and coordination
throughout our entire organization. Our objective is to improve profitability by
reducing individual company costs through the sharing of best practices,
centralization or standardization of functions and processes, and deployment of
technologies and systems that provide for greater efficiencies and
profitability.
7
<Page>
NETWORK ARCHITECTURE AND TECHNOLOGY
Our RLEC network consists of central office hosts and remote sites with
advanced digital switches, primarily manufactured by Nortel and Siemens,
operating with the most current software. The outside plant consists of
transport and distribution delivery networks connecting our host central office
with remote central offices and ultimately with our customers. As of March 22,
2002, we maintained over 25,000 miles of copper plant and 2,200 miles of fiber
optic plant. We own fiber optic cable, which has been deployed throughout our
current network and is the primary transport technology between our host and
remote central offices and interconnection points with other incumbent carriers.
Our fiber optic transport system is primarily a synchronous optical network
and utilizes asynchronous optical systems for limited local or specialized
applications. Our fiber optic transport system of choice is capable of
supporting increasing customer demand for high bandwidth transport services and
applications due to its 240 gigabyte design and switching capacity. In the
future, this platform will enable direct asynchronous transfer mode, frame relay
and/or Internet protocol insertion into the synchronous optical network or
physical optical layer.
In our RLEC markets, DSL-enabled integrated access technology is being
deployed to provide significant broadband capacity to our customers. As of
December 31, 2001, we had invested approximately $7.1 million and deployed this
technology in 21 of our 29 RLECs, reaching 67 of 123 exchanges within these 21
RLECs.
Rapid and significant changes in technology are expected in the
communications industry. Our future success will depend, in part, on our ability
to anticipate and adapt to technological changes. We believe that our network
architecture enables us to efficiently respond to these technological changes.
REGULATORY ENVIRONMENT
We are subject to regulation by federal, state and local government
agencies. At the federal level, the Federal Communications Commission ("FCC")
generally has jurisdiction over interstate rates, services, access charges and
other interstate telecommunications matters. State telecommunications regulatory
commissions generally exercise jurisdiction over intrastate telecom services,
such as terms and conditions of service. Additionally, municipalities and other
local government agencies may regulate limited aspects of our business, such as
construction permits, rights of way and building codes. The following
description summarizes some of the major regulations affecting our business.
FEDERAL REGULATION
Pursuant to the Communications Act of 1934, as amended, the FCC regulates
the rates and terms for interstate access services, which are an important
source of revenue for our RLEC subsidiaries. The amendments to the
Communications Act contained in the Telecommunications Act dramatically changed
and are expected to continue to change the landscape of the telecommunications
industry. The central aim of the Telecommunications Act was to open local
telecommunications marketplaces to competition while enhancing universal
service. Most significantly, the Telecommunications Act governs the removal of
barriers to market entry into local telephone services, requires ILECs to
interconnect with competitors, establishes procedures pursuant to which ILECs
may provide other services, such as the provision of long distance services by
RBOCs, and imposes on ILECs duties to negotiate in good faith.
Although we are unable to predict the overall impact of the
Telecommunications Act on our business, we expect that it will, along with
subsequent state and federal regulatory rulings and technological changes, lead
to an overall reduction in the level of regulation for the telecommunications
industry. Despite the fact that the majority of our operations continues to be
regulated extensively by
8
<Page>
various state regulatory agencies, often called public service commissions, and
the FCC, we may experience reductions in the level of regulation for some of our
RLECs in the future.
REMOVAL OF ENTRY BARRIERS. Prior to the enactment of the Telecommunications
Act, many states limited the services that could be offered by a company
competing with an incumbent local telephone company. The Telecommunications Act
preempts state and local laws to the extent that they prevent competitive entry
into the provision of any communications service. However, states can modify
conditions of entry into areas served by rural telephone companies where the
state telecommunications regulatory commission has determined that certain
universal service protections must be satisfied. Since the passage of the
Telecommunications Act, we have seen very little increase in the level of
competition in the markets we serve.
INTERCONNECTION WITH LOCAL TELEPHONE COMPANIES AND ACCESS TO OTHER
FACILITIES. In order to create an environment in which local competition is a
practical possibility, the Telecommunications Act imposes a number of access and
interconnection requirements on all local communications providers. All local
carriers must interconnect with other carriers, permit resale of their services,
provide local telephone number portability and dialing parity, provide access to
poles, ducts, conduits, and rights-of-way, and complete calls originated by
competing carriers under reciprocal compensation or mutual termination
arrangements.
Because all of our 29 subsidiaries qualify as RLECs under the
Telecommunications Act, they have an exemption from the incumbent local
telephone company interconnection requirements until they receive a bona fide
request for interconnection and the applicable state telecommunications
regulatory commission lifts the exemption.
ACCESS CHARGES. The FCC regulates the prices that incumbent local telephone
companies charge for the use of their local telephone facilities in originating
or terminating interstate transmissions. The FCC has structured these prices,
also referred to as "access charges" as a combination of flat monthly charges
paid by the end-users and usage sensitive charges paid by long distance
carriers.
The FCC regulates the levels of interstate access charges by imposing price
caps on larger incumbent local telephone companies. These price caps can be
adjusted based on various formulae, such as inflation and productivity, and
otherwise through regulatory proceedings. Smaller incumbents may elect to base
access charges on price caps, but are not required to do so unless they elected
to use price caps in the past or their affiliated incumbent local telephone
companies base their access charges on price caps. Each of our 29 incumbent
local telephone subsidiaries elected not to apply federal price caps. Instead,
our subsidiaries employ rate-of-return regulation for their interstate access
charges.
ILEC SERVICES REGULATION. Our ILEC services segment revenue is subject to
regulation including incentive regulation by the FCC and various state
regulatory agencies. We believe that state lawmakers will continue to review the
statutes governing the level and type of regulation for telecommunications
services. It is expected that over the next few years, legislative and
regulatory actions will provide opportunities to restructure rates, introduce
more flexible incentive regulation programs and possibly reduce the overall
level of regulation. We expect the election of incentive regulation plans and
the expected reduction in the overall level of regulation to allow us to
introduce new services more expeditiously than in the past.
STATE REGULATION
Most states have some form of certification requirement which requires
providers of telecommunications services to obtain authority from the state
telecommunications regulatory commission prior to offering common carrier
services. Our 29 RLECs operate as the incumbent local telephone companies in
each of the eighteen states in which we operate and are certified in those
states to provide local telephone services. State telecommunications regulatory
commissions generally
9
<Page>
regulate the rates incumbent local telephone companies charge for intrastate
services, including rates for intrastate access services paid by providers of
intrastate long distance services. Although the FCC has preempted certain state
regulations pursuant to the Telecommunications Act, states have retained
authority to impose requirements on carriers necessary to preserve universal
service, protect public safety and welfare, ensure quality of service and
protect consumers. For instance, incumbent local telephone companies must file
tariffs setting forth the terms, conditions and prices for their intrastate
services. Under the Telecommunications Act, state telecommunications regulatory
agencies have jurisdiction to arbitrate and review interconnection disputes and
agreements between incumbent local telephone companies and competitive local
telephone companies, in accordance with rules set by the FCC. State regulatory
commissions may also formulate rules regarding taxes and fees imposed on
providers of telecommunications services within their respective states to
support state universal service programs.
LOCAL GOVERNMENT AUTHORIZATIONS
We may be required to obtain from municipal authorities permits for street
opening and construction or operating franchises to install and expand fiber
optic facilities in certain rural communities. We have obtained such municipal
franchises as were required. In some rural areas, we do not need to obtain such
permits or franchises because the subcontractors or electric utilities with
which we have contracts already possess the requisite authorizations to
construct or expand our networks.
COMPETITION
We believe that the Telecommunications Act and other recent actions taken by
the FCC and state regulatory authorities promote competition in the provision of
telecommunications services; however, many of the competitive threats now
confronting the large telephone companies do not currently exist in the RLEC
marketplace. Our RLECs typically experience little competition as the incumbent
carrier because generally the demographic characteristics of rural
telecommunications markets will not support the significant capital investment
required to offer competitive services. For instance, the per minute cost of
operating both telephone switches and interoffice facilities is higher in rural
areas as RLECs typically have fewer, more geographically dispersed customers and
lower calling volumes. Also, the distance from the telephone switch to the
customer is typically longer in rural areas, which results in increased
distribution facilities costs. These relatively high costs tend to discourage
competitors from entering territories serviced by RLECs. As a result, RLECs
generally are not faced with the threat of significant competition. We currently
have no wireline competition in any of our 29 RLEC markets.
We do experience limited competition from wireless technology in certain of
our markets. We do not expect this technology represents a significant threat in
the near term, but as technology and economies of scale improve we may
experience increased competition from this technology. Cable television is
offered in certain of our markets, but has not represented meaningful
competition for our data, DSL or Internet products.
As we attempt to grow through acquisition, we may be subject to competition
for suitable acquisition candidates from other competitors engaged in the
acquisition of RLECs.
EMPLOYEES
As of March 22, 2002, we employed a total of 1,199 full-time employees,
including 132 employees of our RLEC companies represented by four unions. We
believe the state of our relationship with our union and non-union employees is
satisfactory. Within our Company, 26 employees are employed at our corporate
office, 1,006 employees are employed at our RLEC companies and 167 employees are
employed by FairPoint Solutions.
10
<Page>
ITEM 2. PROPERTIES
We own all of the properties material to our business. Our headquarters is
located in Charlotte, North Carolina. We also have administrative offices,
maintenance facilities, rolling stock, central office and remote switching
platforms and transport and distribution network facilities in each of the 18
states in which we operate our RLEC business. Our administrative and maintenance
facilities are generally located in or near the rural communities served by our
RLECs and our central offices are often within the administrative building and
outlying customer service centers. Auxiliary battery or other non-utility power
sources are at each central office to provide uninterrupted service in the event
of an electrical power failure. Transport and distribution network facilities
include fiber optic backbone and copper wire distribution facilities, which
connect customers to remote switch locations or to the central office and to
points of presence or interconnection with the incumbent long distance carrier.
These facilities are located on land pursuant to permits, easements or other
agreements. Our rolling stock includes service vehicles, construction equipment
and other required maintenance equipment.
We believe each of our respective properties is suitable and adequate for
the business conducted therein, is being appropriately used consistent with past
practice and has sufficient capacity for the present intended purposes.
ITEM 3. LEGAL PROCEEDINGS
We currently and from time to time are involved in litigation and regulatory
proceedings incidental to the conduct of our business, but we are not a party to
any lawsuit or proceeding which, in our opinion, is likely to have a material
adverse effect on us.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our security holders during the
fourth quarter of the fiscal year.
11
<Page>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There is no established public market for the common equity of the Company.
Substantially all of the Company's outstanding common equity securities are
owned by Kelso & Company ("Kelso"), Thomas H. Lee Equity Fund IV, L.P. ("THL"),
certain institutional investors and the Company's executive officers and
directors.
As of March 22, 2002, there were approximately 69 record holders of Class A
common stock and 14 record holders of Class C common stock.
There were 5,248,750 options to purchase shares of Class A common stock
outstanding as of March 22, 2002, of which 3,364,466 were fully vested.
There are no shares of common stock that could be sold pursuant to Rule 144
under the Securities Act or, other than pursuant to the Company's registration
rights agreement that we have agreed to register under the Securities Act for
sale by the security holders.
Our ability to pay dividends is governed by restrictive covenants contained
in the indentures governing our publicly held debt as well as restrictive
covenants in our bank lending arrangements. We have never paid cash dividends on
our equity securities and currently have no intention of paying cash dividends
on our equity securities for the foreseeable future.
ITEM 6. SELECTED FINANCIAL DATA
The selected data presented below under the captions "Statement of
Operations Data," "Balance Sheet Data" and "Summary Cash Flow Data" for, and as
of the end of, each of the years in the five-year period ended December 31,
2001, are derived from the consolidated financial statements of FairPoint and
its subsidiaries. The consolidated financial statements as of December 31, 2000
and 2001, and of each of the years in the three-year period ended December 31,
2001 are included elsewhere in this report.
12
<Page>
<Table>
<Caption>
1997 1998 1999 2000 2001
--------- ---------- --------- ---------- ----------
(IN THOUSANDS, EXCEPT RATIO OF EARNINGS TO FIXED CHARGES AND
OPERATING DATA)
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:
Revenues......................................... $ 47,639 $ 91,168 $136,422 $ 195,696 $ 235,213
-------- --------- -------- --------- ---------
Operating expenses:
Network operating costs........................ 14,465 26,696 40,652 55,741 69,133
Selling, general and administrative............ 11,958 23,753 31,866 41,846 48,668
Depreciation and amortization.................. 8,777 20,041 30,885 47,070 56,064
Stock-based compensation....................... -- -- 3,386 12,323 1,337
-------- --------- -------- --------- ---------
Total operating expenses......................... 35,200 70,490 106,789 156,980 175,202
-------- --------- -------- --------- ---------
Income from operations........................... 12,439 20,678 29,633 38,716 60,011
-------- --------- -------- --------- ---------
Interest expense(1).............................. (9,293) (27,170) (50,464) (59,556) (89,187)
Other income, net................................ 1,515 3,096 4,892 13,281 6,260
-------- --------- -------- --------- ---------
Earnings (loss) from continuing operations before
income taxes and extraordinary items........... 4,661 (3,396) (15,939) (7,559) (22,916)
Income tax (expense) benefit..................... (1,876) 409 (2,179) (5,607) (431)
Minority interest in income of subsidiaries...... (62) (80) (100) (3) (2)
-------- --------- -------- --------- ---------
Net earnings (loss) from continuing operations
before extraordinary items..................... 2,723 (3,067) (18,218) (13,169) (23,349)
Discontinued operations.......................... -- (2,412) (10,822) (75,948) (188,251)
Extraordinary items.............................. (3,611) (2,521) -- -- --
-------- --------- -------- --------- ---------
Net loss......................................... $ (888) $ (8,000) $(29,040) $ (89,117) $(211,600)
======== ========= ======== ========= =========
Balance Sheet Data (at period end):
Cash........................................... $ 6,822 $ 13,145 $ 9,269 $ 4,130 $ 3,063
Working capital (deficit)(2)................... 108 9,557 13,880 (37,384) (143,434)
Property, plant and equipment, net............. 61,207 140,838 162,202 277,369 283,280
Total assets................................... 144,613 440,992 489,450 846,699 849,018
Long-term debt, net of current portion........... 126,503 364,610 436,782 751,630 776,279
Net (assets) liabilities from discontinued
operations................................... -- (2,233) (2,384) 37,840 144,114
Redeemable preferred stock..................... 130 -- -- -- --
Total stockholders' equity (deficit)........... (10,939) 9,886 (11,581) 64,378 (149,510)
Other Financial Data:
Adjusted EBITDA(3) from continuing
operations................................... $ 22,669 $ 43,735 $ 68,696 $ 111,387 $ 123,670
Capital expenditures from continuing
operations................................... 8,262 10,917 28,293 50,253 43,701
Ratio of earnings to fixed charges from
continuing operations(4)..................... 1.5x -- -- -- --
Summary Cash Flow Data:
Net cash provided by operating activities of
continuing operations........................ $ 9,839 $ 17,778 $ 25,186 $ 47,372 $ 38,532
Net cash used in investing activities of
continuing operations........................ (38,967) (223,836) (61,233) (285,359) (57,719)
Net cash provided by financing activities of
continuing operations........................ 31,697 217,074 47,480 300,089 101,234
Net cash contributed from continuing operations
to discontinued operations................... -- (4,693) (15,309) (67,241) (83,114)
Operating Data (at period end):
Access lines in service from continuing
operations................................... 48,731 129,649 150,612 236,521 245,306
</Table>
- --------------------------
(1) In 1999, interest expense includes $13.3 million related to the retirement
of warrants of one of our subsidiaries. See note 9 to our consolidated
financial statements. In 2001, interest expense includes $10.7 million
related to the change in the fair value of interest rate swaps and the
reclassification as interest
13
<Page>
expense from the transition adjustment recorded in other comprehensive
income. See note 1 to our consolidated financial statements.
(2) In 2001, the working capital deficit includes $125.8 million related to the
FairPoint Solutions' debt under its credit facility classified as a current
liability. See note 2 to our consolidated financial statements.
(3) Adjusted EBITDA represents net earnings (loss) from continuing operations
plus interest expense, income taxes, depreciation and amortization,
extraordinary items, and non-cash stock-based compensation charges. Adjusted
EBITDA is presented because management believes it provides useful
information regarding our ability to incur and/or service debt. Management
expects that investors may use this data to analyze and compare other
communications companies with us in terms of operating performance, leverage
and liquidity. Adjusted EBITDA is not a measure of financial performance
under generally accepted accounting principles and should not be construed
as a substitute for consolidated net earnings (loss) as a measure of
performance, or for cash flow as a measure of liquidity. Adjusted EBITDA as
calculated by us is not necessarily comparable to similarly captioned
amounts of other companies. The definition in our Indentures governing our
outstanding publicly held debt is designed to determine EBITDA for the
purposes of contractually limiting the amount of debt which we may incur.
Adjusted EBITDA presented in the selected financial data above differs from
the definition of EBITDA in such indentures.
(4) For purposes of determining the ratio of earnings to fixed charges, earnings
are defined as earnings from continuing operations before income taxes,
minority interest, income or loss from equity investments and extraordinary
items, plus distributed income of equity investments, amortization of
capitalized interest, and fixed charges. Fixed charges include interest
expense on indebtedness, capitalized interest and rental expense on
operating leases representing that portion of rental expense deemed to be
attributable to interest. We had a deficiency of $4.2 million,
$15.8 million, $9.4 million and $22.9 million to cover fixed charges in
1998, 1999, 2000 and 2001, respectively.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
We are a provider of telecommunications services to customers in rural
communities, offering an array of services that include local voice, long
distance, data and Internet. We were incorporated in February 1991 for the
purpose of acquiring and operating rural telephone companies in rural markets.
Since inception, the Company has acquired 29 such companies, which are located
in 18 states.
All of our rural telephone company subsidiaries qualify as rural local
exchange carriers or "RLECs" under the Telecommunications Act. RLECs are
generally characterized by stable operating results, and strong cash flow
margins and primarily operate in a favorable regulatory environment. In
particular, pursuant to existing state and federal regulations, we are able to
charge rates which enable us to recover our operating and capital costs, plus a
reasonable (as determined by the relevant regulatory authority) rate of return
on our invested capital. In addition, because RLECs primarily serve sparsely
populated rural areas and small towns, competition from competitive local
exchange carriers is typically limited due to the generally unfavorable
economics of constructing and operating competitive systems in such areas. We
believe these attractive characteristics of the RLEC market, combined with our
ability to draw on our existing corporate resources, create the opportunity to
maintain and improve our operating results and cash flows.
In early 1998, we launched our CLEC enterprise through our wholly owned
subsidiary, FairPoint Solutions, in an effort to extend our service offering to
markets adjacent to our RLECs. In November 2001, we announced our plan to
discontinue our CLEC operations. For additional information about the Company's
decision to discontinue its CLEC operations, see "Recent Developments."
14
<Page>
REVENUES
We derive our revenues from:
- Local calling services. We receive revenues from providing local exchange
telephone services, including monthly recurring charges for basic service,
usage charges for local calls and service charges for special calling
features.
- Network access charges. These revenues consist primarily of charges paid
by long distance companies and other customers for access to our networks
in connection with the origination and/or termination of long distance
telephone calls both to and from our customers. Access charges to long
distance carriers and other customers are based on access rates filed with
the FCC for interstate services and state regulatory agencies for
intrastate services.
- Long distance services. We receive revenues for long distance services to
our retail and wholesale long distance customers.
- Data and Internet services. We receive revenues from monthly recurring
charges for services, including digital subscriber line, special access,
private lines, Internet and other services.
- Other services. We receive revenues from other services, including billing
and collection, directory services and sale and maintenance of customer
premise equipment.
The following summarizes our percentage of revenues from continuing
operations from these sources:
<Table>
<Caption>
% OF REVENUE
YEARS ENDED DECEMBER 31,
---------------------------------------
REVENUE SOURCE 1999 2000 2001
- -------------- ----------- ----------- -----------
<S> <C> <C> <C>
Local calling services...................... 24% 27% 27%
Network access charges...................... 53% 49% 47%
Long Distance services...................... 7% 8% 10%
Data and Internet services.................. 4% 6% 8%
Other services.............................. 12% 10% 8%
</Table>
OPERATING EXPENSES
Our operating expenses are categorized as network operating costs; selling,
general and administrative expenses; depreciation and amortization; and
stock-based compensation.
- Network operating costs include costs incurred in connection with the
operation of our central offices and outside plant facilities and related
operations. In addition to the operational costs of owning and operating
our own facilities, we also purchase long distance services from the
RBOCs, large independent telephone companies and third party long distance
providers.
- Selling, general and administrative expenses consist of expenses relating
to sales and marketing, customer service and administration and corporate
and personnel administration.
- Depreciation and amortization includes depreciation of our communications
network and equipment and amortization of goodwill related to our
acquisitions.
- Stock-based compensation consists of non-cash compensation charges
incurred in connection with the employee stock options of our executive
officers, and shareholder appreciation rights agreements granted to two
executive officers.
15
<Page>
ACQUISITIONS
Our past acquisitions have had a major impact on our operations.
Accordingly, we do not believe that comparing historical results on a
period-by-period basis is meaningful due to the significant number of
acquisitions we have made each year.
- During 2001, we acquired one RLEC and certain assets of additional
telephone exchanges for an aggregate purchase price of $24.2 million,
which included $0.7 million of acquired debt. At the respective dates of
acquisition, these businesses served an aggregate of approximately 5,600
access lines.
- During 2000, we acquired four RLECs for an aggregate purchase price of
$363.1 million, which included $86.9 million of acquired debt. At the
respective dates of acquisition, these companies served an aggregate of
approximately 79,500 access lines.
- During 1999, we acquired seven RLECs for an aggregate purchase price of
$82.7 million, which included $7.4 million of acquired debt. At the
respective dates of acquisition, these companies served an aggregate of
approximately 14,700 access lines.
STOCK-BASED COMPENSATION
In December 2001, we recognized a non-cash compensation charge of
$2.2 million in connection with the modification of employee stock options by
one of our executive officers. This charge is offset by a non-cash compensation
benefit of $0.9 million associated with the reduction in estimated fair market
value of the Stockholder Appreciations Rights Agreements.
In January 2000, we recognized a non-cash compensation charge of
$12.3 million. The charge consisted of compensation expense of $3.8 million
recognized in connection with the modification of employee stock options and the
settlement of employee stock options for cash by one of our principal
shareholders. The compensation expense also included the settlement of a cash
payment obligation between certain of our employee-shareholders and our
principal shareholders under their pre-existing shareholder's agreement for
$8.5 million.
DISCONTINUED OPERATIONS
In November 2001, we decided to discontinue the CLEC operations of FairPoint
Solutions. This decision was a proactive response to the deterioration in the
capital markets, the general slow-down of the economy and the
slower-than-expected growth in FairPoint Solutions' CLEC operations.
Prior to our decision to discontinue FairPoint Solutions' CLEC, FairPoint
Solutions entered into an agreement on October 19, 2001 to sell certain of its
Northwest assets to Advanced TelCom. On December 10, 2001, FairPoint Solutions
completed the disposition of these assets in exchange for $3.4 million in cash,
which includes approximately $0.9 million for accounts receivable. On
November 7, 2001, FairPoint Solutions entered into an agreement to sell certain
of its Northeast assets to Choice One and certain of its affiliates. On
December 19, 2001, FairPoint Solutions completed the disposition of these assets
for $5.6 million in cash, which includes approximately $3.5 million for accounts
receivable and 2,500,000 restricted shares of Choice One's common stock.
FairPoint Solutions can earn up to an additional 2,000,000 shares of Choice One
restricted common stock based on the number of access lines converted to Choice
One's operating platform 120 days after closing. In connection with these
transactions, FairPoint Solutions is receiving payment for providing certain
services to Advanced TelCom and Choice One to facilitate the successful
conversion of customers to their respective systems and networks. These
servicing arrangements are expected to terminate in or before June 2002.
In addition, FairPoint Solutions has notified its remaining customers in the
Southwest, Southeast, and Mid-Atlantic competitive markets to find alternative
carriers. As a result of the asset sales and
16
<Page>
notifications described above, FairPoint Solutions is nearing completion of its
operations as a CLEC provider.
FairPoint Solutions will continue to provide wholesale long distance service
and support to our RLEC subsidiaries and other independent local exchange
companies. These services allow such companies to operate their own long
distance communication services and sell such services to their respective
customers. We believe that FairPoint Solutions' ability to provide ongoing
support to independent local exchange companies will provide a source of
increasing (although not material) revenue and greater (although not material)
profitability.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2001 COMPARED WITH YEAR ENDED DECEMBER 31, 2000
REVENUES. Revenues from continuing operations increased $39.5 million to
$235.2 million in 2001 compared to $195.7 million in 2000. Of this increase,
$2.6 million was attributable to the internal growth of our earlier acquired
RLEC businesses, $1.5 million was attributable to revenues from companies we
acquired in 2001, $29.2 million was attributable to revenues from companies we
acquired in 2000 and $6.2 million was attributable to revenues from our
wholesale long distance company. Local calling services accounted for
$9.9 million of this increase, including an increase of $1.3 million from an
increase in the number of access lines and local services provided in our
earlier acquired RLEC companies, as well as an increase of $0.5 million from the
companies we acquired in 2001 and $8.1 million from companies we acquired in
2000. Network access charges increased $15.0 million, including an increase of
$0.8 million from companies we acquired in 2001 and $15.6 million from companies
we acquired in 2000. Network access charges of our earlier acquired RLEC
telephone companies decreased $1.4 million. Network access charge decreases are
associated with rate cases and access adjustments in Maine, Kansas, Vermont and
Illinois. Long distance services revenues increased $7.9 million, including an
increase of $6.2 million from new long distance wholesale customers, an increase
of $0.9 million from companies acquired in 2001 and 2000 and an increase of
$0.8 million from our RLEC business. Data and Internet services revenues
increased $6.4 million, including an increase of $2.9 million from acquisitions
and an increase of $3.5 million as a result of increased service offerings to
our customers of our earlier acquired RLEC businesses. Other revenues increased
by $0.3 million as other revenue contributed by the companies we acquired in
2001 and 2000 of $2.0 million was offset by a reduction in other revenues of
$1.7 million from our earlier acquired RLEC operations. This decrease is
associated with reductions in billing and collections revenues, non-regulated
telephone services revenues and revenues eliminated due to the sale of cable
operations.
OPERATING EXPENSES OF CONTINUING OPERATIONS
NETWORK OPERATING COSTS. Network operating costs from continuing operations
increased $13.4 million to $69.1 million in 2001 from $55.7 million in 2000. Of
this increase, $1.5 million was attributable to expenses of operation of our
earlier acquired RLECs and $4.6 million was attributable to the growth of our
wholesale long distance company. The companies we acquired in 2001 accounted for
$0.5 million of the increase and the companies we acquired in 2000 account for
$6.8 million of the remaining portion of the increase.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses from continuing operations increased $6.8 million to
$48.7 million in 2001 compared to $41.9 million in 2000. Expenses of our earlier
acquired RLEC companies increased $2.6 million, mainly associated with increased
health insurance costs and legal and consulting expenses incurred in connection
with several rate proceedings. The companies we acquired in 2001 contributed
$0.1 million to the increase and the companies we acquired in 2000 contributed
$4.1 million to the increase.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization from
continuing operations increased $9.0 million to $56.1 million in 2001 from
$47.1 million in 2000. This increase consisted of
17
<Page>
$1.9 million attributable to the increased investment in our communications
network by our RLECs acquired prior to 2000 and $7.1 million related to the
companies we acquired in 2001 and 2000.
STOCK-BASED COMPENSATION. For the year ended December 31, 2001, stock-based
compensation of $(0.9) million was related to the decrease in the estimated
value of fully vested Stock Appreciation Right Agreements between certain
members of our management and our principal stockholders. This is offset by a
$2.2 million non-cash stock-based compensation charge related to a modification
of an employee stock option agreement with an executive officer. The net charge
for the year ended December 31, 2001 was $1.3 million. As discussed above, in
January 2000 we recognized non-cash compensation charges of $12.3 million for
the year ended December 31, 2000.
INCOME FROM OPERATIONS. Income from continuing operations increased
$21.3 million to $60.0 million in 2001 from $38.7 million in 2000. This increase
was primarily attributable to an $11.0 million decrease in stock-based
compensation charges, while $12.1 million was attributable to the companies we
acquired in 2001 and 2000 and $1.6 million was attributable to our wholesale
long distance company. Operating income of our earlier acquired RLECs decreased
$3.4 million as higher expenses (predominately health insurance costs and legal
and consulting expenses) outpaced revenue growth.
OTHER INCOME (EXPENSE). Total other expense from continuing operations
increased $36.6 million to $82.9 million in 2001 from $46.3 million in 2000. The
expense consists primarily of interest expense on long-term debt and a
$7.3 million decrease in net gain on sale of stock and cellular investments for
the year ended December 31, 2001, compared to the year ended December 31, 2000.
INCOME TAX EXPENSE. Income tax expense from continuing operations decreased
$5.2 million to $0.4 million in 2001 from $5.6 million in 2000. The income tax
expense relates primarily to income taxes owed in certain states.
DISCONTINUED OPERATIONS. Losses from discontinued operations for 2001 were
$188.3 million, an increase of $112.4 from a loss of $75.9 million for the
comparable period in 2000. This increase is primarily associated with a loss on
the disposition of the CLEC operations of $95.3 million, which consists of the
net loss on disposition and impairment of assets of $67.2 million and a
provision of $28.1 million for operating losses during the phase-out period. The
loss from the CLEC operations increased $17.1 million to $93.0 million from the
loss of $75.9 million in 2000.
NET LOSS. Our net loss was $211.6 million for 2001, compared to a loss of
$89.1 million for 2000, as a result of the factors discussed above and mainly
associated with the loss from discontinued operations.
YEAR ENDED DECEMBER 31, 2000 COMPARED WITH YEAR ENDED DECEMBER 31, 1999
REVENUES. Revenues from continuing operations increased $59.3 million to
$195.7 million in 2000 from $136.4 million in 1999. This was principally a
result of the acquisitions completed in 2000 and 1999, which contributed
$52.7 million to the increase. Growth in our RLEC businesses acquired prior to
1999 contributed $5.3 million and our wholesale long distance company
contributed $1.3 million to the revenue increase. Local calling services
accounted for $19.5 million of the increase, including $17.7 million from the
companies we acquired in 2000 and 1999 and $1.8 million from growth in our
earlier acquired RLECs. Network access revenue increased $24.6 million, of which
the companies we acquired in 2000 and 1999 contributed $21.0 million. Long
distance services revenues increased $5.6 million, including $3.7 million from
the companies we acquired in 2000 and 1999 and $1.3 million from new long
distance wholesale customers. Data and Internet services increased $6.8 million
and other revenues increased $2.8 million, in each case due mainly to revenues
from companies we acquired in 2000 and 1999.
18
<Page>
OPERATING EXPENSES OF CONTINUING OPERATIONS.
NETWORK OPERATING COSTS. Network operating costs from continuing operations
increased $15.1 million to $55.7 million in 2000 from $40.6 million in 1999. The
increase was mainly attributable to operating expenses associated with the
companies we acquired in 2000 and 1999, which accounted for $14.5 million of the
increase. The remaining increase was primarily associated with the growth of our
wholesale long distance company.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses from continuing operations increased $10.0 million to
$41.9 million in 2000 compared to $31.9 million in 1999. The companies we
acquired in 2000 and 1999 contributed $8.6 million to the increase. Also
contributing to this increase were costs of $1.9 million related to our earlier
acquired RLECs.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization from
continuing operations increased $16.2 million to $47.1 million in 2000 from
$30.9 million in 1999. This increase consisted of $14.7 million related to the
companies we acquired in 2000 and 1999 and $1.5 million due to increased
investment in our communications network by our RLECs.
STOCK-BASED COMPENSATION. As discussed above, in January 2000, we
recognized non-cash compensation charges of $12.3 million. Stock-based
compensation of $3.4 million in 1999 was related to the increase in the
estimated value of fully vested stock appreciation right agreements between
certain members of our management and principal stockholders of the Company.
INCOME FROM OPERATIONS. As a result of the factors described above, income
from continuing operations increased $9.1 million to $38.7 million in 2000 from
$29.6 million in 1999.
OTHER INCOME (EXPENSE). Total other expense from continuing operations
increased $0.7 million to $46.3 million in 2000 from $45.6 million in 1999. The
increase was primarily attributable to an increase in interest expense
associated with the additional debt incurred to complete acquisitions offset by
a $6.6 million net gain on sale of stock and cellular investments for the year
ended December 31, 2000.
INCOME TAX EXPENSE. Income tax expense from continuing operations increased
$3.4 million to $5.6 million in 2000 from $2.2 million in 1999. The income tax
expense relates primarily to income taxes owed in certain states.
DISCONTINUED OPERATIONS. Losses from discontinued operations for 2000 were
$75.9 million, an increase of $65.1 from a loss of $10.8 million for the
comparable period in 1999. The loss increased substantially during 2000 due to
the rapid expansion of our competitive communications operations.
NET LOSS. Our net loss was $89.1 million for 2000, compared to a loss of
$29.0 million for 1999, as a result of the factors discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Our cash flow requirements include general corporate expenditures, capital
expenditures, debt service and acquisitions. We expect that our RLECs' cash flow
from operations and our Credit Facility will fund our capital expenditures,
working capital and debt service requirements for the foreseeable future.
Historically, we have used the proceeds from institutional and bank debt,
private equity offerings, and available cash flow to fund our operations. We may
secure additional funding through the sale of public or private debt and/or
equity securities or enter into another bank credit facility to fund future
acquisitions and operations. If our operating results are below expectations,
there can be no assurance that we will be successful in raising sufficient
additional capital on terms that we consider acceptable, or that our operations
will produce positive cash flow in sufficient amounts to meet our liquidity
19
<Page>
requirements. The failure to raise and generate sufficient funds may require us
to delay or abandon some of our planned acquisitions or expenditures, which
could have a material adverse effect on our growth.
In November 2001, FairPoint Solutions announced its decision to discontinue
its CLEC operations and announced the proposed sale of certain of its
competitive communications assets. In December 2001, FairPoint Solutions
completed these asset sales. FairPoint Solutions expects to substantially
complete the processes of discontinuing its competitive communications business
operations during the first six months of 2002. FairPoint Solutions' cash flow
requirements include general corporate expenditures, expenses related to
discontinued operations and expenses associated with the amendment and
restatement of its credit facility. We expect FairPoint Solutions' cash flow
requirements will be funded from available cash, the liquidation of its
remaining assets, available cash flows from operations and from limited
additional investments permitted under our Credit Facility and the indentures
governing our senior subordinated notes. Our Credit Facility and the indentures
governing our senior subordinated notes contain significant restrictions on the
Company's ability to make investments in FairPoint Solutions. As of March 22,
2002, the Company could have invested up to $34.4 million in FairPoint Solutions
in compliance with such agreements. We believe these sources will be adequate to
fund the complete discontinuation of the competitive communications business.
FairPoint Solutions will continue to provide wholesale long distance service
and support to our RLEC subsidiaries and other independent local exchange
companies, which allows these customers to operate their own long distance
communications services. Historically, this business enterprise has been
profitable and self-funding.
As of April 1, 2002, FairPoint Solutions will be in default under its
Amended and Restated Credit Agreement as a result of its failure to comply with
certain of the covenants contained therein. In light of such impending default,
FairPoint Solutions' debt has been classified as a net current liability of
discontinued operations in our consolidated financial statements for the year
ended December 31, 2001. The Company has not guaranteed the debt owed to the
lenders under the FairPoint Solutions Amended and Restated Credit Agreement nor
does the Company have any obligation to invest any additional funds in FairPoint
Solutions. Further, our Credit Facility and the indentures governing our senior
subordinated notes contain significant restrictions on the Company's ability to
make investments in FairPoint Solutions. Under a tax sharing agreement, the
Company is obligated to reimburse FairPoint Solutions for any tax benefits it
receives from net operating losses generated by FairPoint Solutions. At
December 31, 2001, the amount payable to FairPoint Solutions under the tax
sharing agreement was approximately $7.6 million.
Upon the occurrence and continuation of an event of default under the
FairPoint Solutions Amended and Restated Credit Agreement, the lenders are
entitled to various rights and remedies, including but not limited to the right
to declare all loans and obligations thereunder (which amounted to approximately
$125.8 million as of March 22, 2002) immediately due and payable, and to enforce
all liens and security interests. In addition, as a result of the occurrence of
an event of default under the FairPoint Solutions Amended and Restated Credit
Agreement, FairPoint Solutions will also be in default under its two interest
rate swap agreements. FairPoint Solutions' liability under such agreements was
approximately $3.1 million as of March 22, 2002. If the lenders or swap
counterparty were to enforce their remedies and obtain a final judgment in
excess of $3,000,000 or if FairPoint Solutions either voluntarily filed for or
was involuntarily placed into bankruptcy, then such events would, after the
expiration of any applicable grace periods, cause there to be an event of
default under the Company's Credit Facility and/or the indentures governing the
Company's senior subordinated notes. The FairPoint Solutions lenders do not have
any claim or right to any of the Company's assets or cash flows other than as
required by the tax sharing agreement.
20
<Page>
As an alternative to the foregoing remedies, each lender under the FairPoint
Solutions Amended and Restated Credit Agreement has the option to exchange all
or a portion of the amounts owed to it for shares of the Company's Series A
preferred stock having a liquidation preference equal to the amount of debt
exchanged, such that each $1,000 of debt shall be converted into one share of
the Company's Series A preferred stock. Such Series A preferred stock is
non-voting, except as required by applicable law, and is not convertible into
common stock of the Company. The Series A preferred stock provides for the
payment of dividends at a rate per annum equal to the 10-year Treasury rate on
the date of issue plus 1,200 basis points (which would have been approximately
16.75% as of March 22, 2002). Dividends would be payable either in cash or in
additional shares of Series A preferred stock, at the option of the Company.
Dividends would accrue and be cumulative from the date of issue, and be payable
in arrears. The Company would have the option to redeem the Series A preferred
stock at any time. The redemption price would be payable in cash in an amount
equal to the Preference Amount. Under certain circumstances, the Company would
be required to pay a premium of up to 6% of the Preference Amount in connection
with the redemption of the Series A preferred stock. In addition, upon the
occurrence of certain events, such as (i) a merger, consolidation, sale,
transfer or disposition of at least 50% of the assets or business of the Company
and its subsidiaries, (ii) a public offering of the Company's common stock which
yields in the aggregate at least $175.0 million, or (iii) the first anniversary
of the maturity of the Company's senior subordinated notes (which first
anniversary will occur in May 2011), the Company would be required to redeem all
outstanding shares of the Series A preferred stock at a price per share equal to
the Preference Amount.
FairPoint Solutions has engaged in continuing discussions with its lenders
regarding a restructuring of its Amended and Restated Credit Agreement.
FairPoint Solutions and its lenders have discussed a restructuring pursuant to
which, among other things, a substantial portion of the outstanding debt under
the Amended and Restated Credit Agreement would be exchanged for shares of the
Company's Series A preferred stock, and the remaining debt would be repaid over
approximately five years after the closing of the restructuring. FairPoint
Solutions believes that, in the event such a restructuring is not agreed upon,
all or substantially all of its lenders would elect to exchange all of their
outstanding debt under the FairPoint Solutions Amended and Restated Credit
Agreement for shares of Series A preferred stock. While FairPoint Solutions can
neither predict nor control which remedies its lenders may pursue, its lenders
have not indicated to FairPoint that they intend to seek a remedy which would
result in the imposition of a judgment against FairPoint Solutions or which
would result in FairPoint Solutions filing for or being placed into bankruptcy,
and forcing FairPoint Solutions into bankruptcy would not enhance the lenders'
claims to the Company's assets or cash flows. There can be no assurance that any
restructuring of the FairPoint Solutions Amended and Restated Credit Agreement
will be agreed upon or that FairPoint Solutions' lenders will not seek a remedy
that would result in the imposition of a judgment against FairPoint Solutions or
in FairPoint Solutions' bankruptcy.
CAPITAL EXPENDITURES
Our annual capital expenditures for our RLEC operations have historically
been significant. Our RLECs' capital expenditures are generally for improvements
and for expansions required for growth with any such RLEC's service area.
Occasionally, we are required to make significant capital investments in a
particular year to replace a central switch or to rebuild or upgrade elements or
components of an RLEC's outside plant.
Because existing regulations allow us to recover our operating and capital
costs, plus a reasonable return on our invested capital in regulated telephone
assets, capital expenditures constitute an attractive use of our cash flow. We
have historically generated sufficient cash flow from operations to meet
substantially all of our capital expenditure requirements for our RLEC
operations. For the period from January 1, 2001 to December 31, 2001, our
capital expenditures were $43.7 million for our RLEC
21
<Page>
operations. We expect to finance our future capital expenditures for our RLEC
companies principally from cash flow from operations of these companies.
The discontinuation of our competitive communications business will not
require any significant capital expenditures in 2002.
DEBT FINANCING
We have utilized a variety of debt instruments to fund our business,
including:
OUR CREDIT FACILITY. Our Credit Facility provides for two term facilities,
one with approximately $66.2 million principal amount outstanding as of
December 31, 2001 that matures on June 30, 2006 and the other with the principal
amount of approximately $131.6 million outstanding as of December 31, 2001 that
matures on June 20, 2007. Our Credit Facility also provides for a revolving
facility with a principal amount of $85.0 million that matures on September 30,
2004 and a revolving acquisition facility with a principal amount of
$165.0 million that also matures on September 30, 2004. As of December 31, 2001,
$72.6 million was outstanding on the revolving facility and $86.0 million was
outstanding on the revolving acquisition facility. The Credit Facility requires
that the Company maintain certain financial covenants. As of December 31, 2001,
these financial covenants limited the commitment availability under the
revolving and revolving acquisition facilities to $19.0 million.
SENIOR SUBORDINATED NOTES AND FLOATING RATE NOTES ISSUED IN 1998. We have
outstanding publicly held debt comprised of $125.0 million of aggregate
principal amount of 9 1/2% senior subordinated notes and $75.0 million aggregate
principal amount of floating rate notes. Interest on the senior subordinated
notes and floating rate notes is payable semi-annually in cash on each May 1 and
November 1. Both series of notes mature on May 1, 2008. These notes are general
unsecured obligations, subordinated in right of payment to all existing and
future senior debt and effectively subordinated to all existing and future debt
and other liabilities of our subsidiaries.
SENIOR SUBORDINATED NOTES ISSUED IN 2000. In May 2000, we issued
$200.0 million of aggregate principal amount of 12 1/2% senior subordinated
notes. Interest on these notes is payable semi-annually in cash on May 1 and
November 1 of each year. These notes will mature on May 1, 2010. These notes are
general unsecured obligations and rank equally with all of FairPoint's other
unsecured senior subordinated indebtedness and are subordinated in right of
payment to all of FairPoint's senior indebtedness, whether or not secured, and
effectively subordinated to all existing and future debt and other liabilities
of our subsidiaries.
FAIRPOINT SOLUTIONS CREDIT FACILITY. The FairPoint Solutions Amended and
Restated Credit Agreement originally provided for a $175.0 million term tranche
and a $75.0 million revolving credit tranche. The FairPoint Solutions credit
facility matures on November 9, 2006. Pursuant to an amendment to the Amended
and Restated Credit Agreement, FairPoint Solutions agreed to reduce the term
tranche commitment to $125.0 million. As of December 31, 2001, there was
$111.1 million outstanding under the term tranche and $14.7 million outstanding
under the revolving credit tranche.
On November 28, 2001, FairPoint Solutions completed an amendment to its
Amended and Restated Credit Agreement, pursuant to which FairPoint Solutions'
lenders waived certain restrictions with respect to the sale by FairPoint
Solutions of certain of its Northwest assets to Advanced TelCom and FairPoint
Solutions agreed to reduce the aggregate outstanding revolving commitments to
$23.5 million and that after December 31, 2001 it would not be permitted to
borrow any funds under the revolving credit tranche without the consent of each
of its lenders. On December 19, 2001, FairPoint Solutions completed an amendment
to its Amended and Restated Credit Agreement which provided for the lenders'
consent to the sale of certain of FairPoint Solutions' Northeast assets to
Choice One and for the lenders' forbearance, until March 31, 2002, from
exercising their remedies
22
<Page>
under the Amended and Restated Credit Agreement for certain enumerated potential
covenant breaches and potential events of default thereunder.
As of April 1, 2002, FairPoint Solutions will be in default under its
Amended and Restated Credit Agreement as a result of its failure to comply with
certain of the covenants contained therein. In light of such impending default,
FairPoint Solutions' debt has been classified as a net current liability of
discontinued operations in our consolidated financial statements for the year
ended December 31, 2001. The Company has not guaranteed the debt owed to the
lenders under the FairPoint Solutions Amended and Restated Credit Agreement nor
does the Company have any obligation to invest any additional funds in FairPoint
Solutions. Further, our Credit Facility and the indentures governing our senior
subordinated notes contain significant restrictions on the Company's ability to
make investments in FairPoint Solutions. Under a tax sharing agreement, the
Company is obligated to reimburse FairPoint Solutions for any tax benefits it
receives from net operating losses generated by FairPoint Solutions. At
December 31, 2001, the amount payable to FairPoint Solutions under the tax
sharing agreement was approximately $7.6 million.
Upon the occurrence and continuation of an event of default under the
FairPoint Solutions Amended and Restated Credit Agreement, the lenders are
entitled to various rights and remedies, including but not limited to the right
to declare all loans and obligations thereunder (which amounted to approximately
$125.8 million as of March 22, 2002) immediately due and payable, and to enforce
all liens and security interests. In addition, as a result of the occurrence of
an event of default under the FairPoint Solutions Amended and Restated Credit
Agreement, FairPoint Solutions will also be in default under its two interest
rate swap agreements. FairPoint Solutions' liability under such agreements was
approximately $3.1 million as of March 22, 2002. If the lenders or swap
counterparty were to enforce their remedies and obtain a final judgment in
excess of $3,000,000 or if FairPoint Solutions either voluntarily filed for or
was involuntarily placed into bankruptcy, then such events would, after the
expiration of any applicable grace periods, cause there to be an event of
default under the Company's Credit Facility and/or the indentures governing the
Company's senior subordinated notes. The FairPoint Solutions lenders do not have
any claim or right to any of the Company's assets or cash flows other than as
required by the tax sharing agreement.
As an alternative to the foregoing remedies, each lender under the FairPoint
Solutions Amended and Restated Credit Agreement has the option to exchange all
or a portion of the amounts owed to it for shares of the Company's Series A
preferred stock having a liquidation preference equal to the amount of debt
exchanged, such that each $1,000 of debt shall be converted into one share of
the Company's Series A preferred stock. Such Series A preferred stock is
non-voting, except as required by applicable law, and is not convertible into
common stock of the Company. The Series A preferred stock provides for the
payment of dividends at a rate per annum equal to the 10-year Treasury rate on
the date of issue plus 1,200 basis points (which would have been approximately
16.75% as of March 22, 2002). Dividends would be payable either in cash or in
additional shares of Series A preferred stock, at the option of the Company.
Dividends would accrue and be cumulative from the date of issue, and be payable
in arrears. The Company would have the option to redeem the Series A preferred
stock at any time. The redemption price would be payable in cash in an amount
equal to the Preference Amount. Under certain circumstances, the Company would
be required to pay a premium of up to 6% of the Preference Amount in connection
with the redemption of the Series A preferred stock. In addition, upon the
occurrence of certain events, such as (i) a merger, consolidation, sale,
transfer or disposition of at least 50% of the assets or business of the Company
and its subsidiaries, (ii) a public offering of the Company's common stock which
yields in the aggregate at least $175.0 million, or (iii) the first anniversary
of the maturity of the Company's senior subordinated notes (which first
anniversary will occur in May 2011), the Company would be required to redeem all
outstanding shares of the Series A preferred stock at a price per share equal to
the Preference Amount.
23
<Page>
FairPoint Solutions has engaged in continuing discussions with its lenders
regarding a restructuring of its Amended and Restated Credit Agreement.
FairPoint Solutions and its lenders have discussed a restructuring pursuant to
which, among other things, a substantial portion of the outstanding debt under
the Amended and Restated Credit Agreement would be exchanged for shares of the
Company's Series A preferred stock, and the remaining debt would be repaid over
approximately five years after the closing of the restructuring. FairPoint
Solutions believes that, in the event such a restructuring is not agreed upon,
all or substantially all of its lenders would elect to exchange all of their
outstanding debt under the FairPoint Solutions Amended and Restated Credit
Agreement for shares of Series A preferred stock. While FairPoint Solutions can
neither predict nor control which remedies its lenders may pursue, its lenders
have not indicated to FairPoint that they intend to seek a remedy which would
result in the imposition of a judgment against FairPoint Solutions or which
would result in FairPoint Solutions filing for or being placed into bankruptcy,
and forcing FairPoint Solutions into bankruptcy would not enhance the lenders'
claims to the Company's assets or cash flows. There can be no assurance that any
restructuring of the FairPoint Solutions Amended and Restated Credit Agreement
will be agreed upon or that FairPoint Solutions' lenders will not seek a remedy
that would result in the imposition of a judgment against FairPoint Solutions or
in FairPoint Solutions' bankruptcy.
CASH FLOWS
Net cash provided by operating activities of continuing operations was
$38.5 million, $47.4 million and $25.2 million for the years ended 2001, 2000
and 1999, respectively. Net cash used in investing activities from continuing
operations was $57.7 million, $285.4 million and $61.2 million for the years
ended 2001, 2000 and 1999, respectively. These cash flows primarily reflect
expenditures relating to RLEC acquisitions of $18.9 million, $256.1 million and
$53.9 million in 2001, 2000 and 1999, respectively, and capital expenditures of
$43.7 million, $50.3 million and $28.3 million in 2001, 2000 and 1999,
respectively. Net cash provided by financing activities from continuing
operations was $101.2 million, $300.1 million and $47.5 million for the years
ended 2001, 2000 and 1999, respectively. These cash flows primarily represent
net borrowings of $104.2 million, $150.6 million and $65.1 million in 2001, 2000
and 1999, respectively, and the proceeds from the issuance of common stock of
$158.9 million in 2000. With the exception of the exercise of stock options by
an employee in 2001, there were no common stock issuances in 2001 or 1999. A
majority of the proceeds received from financing activities was used to complete
acquisitions and to provide cash used in the operation of the discontinued
competitive communications operations which was $83.1 million, $67.2 million and
$15.3 million in 2001, 2000 and 1999 respectively.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are as follows:
- Accounting for discontinued and restructured operations;
- Accounting for income taxes; and
- Valuation of long-lived assets, including goodwill.
DISCONTINUED AND RESTRUCTURED OPERATIONS. The discontinuation and
restructuring of FairPoint Solutions CLEC operations required management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities associated with the phase-out period of the discontinued operations
and the accruals associated with the December 2000 and January and June, 2001
restructurings. Management analyzed historical costs, current status of lease
negotiations and projected phase-out cash flows to determine the adequacy of the
accrual of estimated costs to close down FairPoint Solutions' competitive
communications operations. Differences might result in the amount of these
projected assets and liabilities if management were to make different judgments
or utilize
24
<Page>
different estimates. Management does not believe these differences would be
material to the overall amounts of net assets and liabilities resulting from
discontinuing the operations.
ACCOUNTING FOR INCOME TAXES. As part of the process of preparing our
consolidated financial statements we were required to estimate our income taxes.
This process involves estimating our actual current tax exposure and assessing
temporary differences resulting from different treatment of items for tax and
accounting purposes. These differences result in deferred tax assets and
liabilities, which are included within our consolidated balance sheets. We must
then assess the realizability of our deferred tax assets. In performing this
assessment, management considers the scheduled reversal of deferred tax
liabilities, projected future taxable income, and tax planning strategies.
We have approximately $247.3 million in federal and state net operating loss
carryforwards as of December 31, 2001. In order to fully utilize the deferred
tax assets, mainly generated by the net operating losses, the Company will need
to generate future taxable income of approximately $68.6 million prior to the
expiration of the net operating loss carryforwards beginning in 2019 through
2021. Based upon the level of projections for future taxable income over the
periods in which the deferred tax assets are deductible, we believe the Company
will realize the benefits of these deductible differences, net of a valuation
allowance of $76.6 million at December 31, 2001. The amount of the deferred tax
assets considered realizable, however, could be reduced in the near term if
estimates of future taxable income during the carry forward period are reduced.
VALUATION OF LONG-LIVED ASSETS, INCLUDING GOODWILL. We review our
long-lived assets, including goodwill for impairment whenever events or changes
in circumstances indicate that the carrying value may not be recoverable.
Several factors could trigger an impairment review such as (1) significant
under-performance relative to expected historical or projected future operating
results, (2) significant regulatory changes that would impact future operating
revenues, (3) significant negative industry or economic trends and
(4) significant changes in the overall strategy in which we operate our overall
business. Net goodwill was $454.3 million at December 31, 2001.
In 2002, Statement of Financial Accounting Standards (SFAS) No. 142,
GOODWILL AND OTHER INTANGIBLE ASSETS, became effective and as a result, we will
cease to amortize goodwill. We had recorded amortization of approximately
$11.8 million for the year ended December 31, 2001 and would have recorded
approximately the same amount in 2002. In lieu of amortization, we are required
to perform an initial impairment review of our goodwill in 2002 and an annual
impairment review thereafter. We will implement SFAS No. 142 effective
January 1, 2002 and do not anticipate an impairment of goodwill or other
long-lived assets.
NEW ACCOUNTING STANDARDS
In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 141, BUSINESS COMBINATIONS (SFAS No. 141) and SFAS No. 142, GOODWILL AND
OTHER INTANGIBLE ASSETS (SFAS No. 142). SFAS No. 141 requires that the purchase
method of accounting be used for all business combinations initiated after
June 30, 2001, as well as all purchase method business combinations completed
after June 30, 2001. SFAS No. 141 also specifies criteria for the recognition of
intangible assets acquired apart from goodwill. SFAS No. 142 requires that
goodwill and intangible assets with indefinite useful lives, including the
excess cost relating to investments accounted for using the equity method of
accounting (equity method goodwill), no longer be amortized, but instead be
tested for impairment at least annually.
As required by SFAS No. 141, the Company adopted the provisions of SFAS
No. 141 on July 1, 2001 and SFAS No. 142 was adopted on January 1, 2002.
Goodwill acquired in a purchase business combination completed after June 30,
2001, but before SFAS No. 142 is adopted in full, is not amortized, but will
continue to be evaluated for impairment in accordance with the Company's
existing accounting policies for evaluating impairments of long-lived assets.
25
<Page>
Upon adoption of SFAS No. 142, the Company will be required to perform a
transitional impairment test of goodwill and equity method goodwill. In
performing that test, the Company will first identify its reporting units and
determine the carrying value of each reporting unit by assigning the assets and
liabilities, including existing goodwill and intangible assets, to those
reporting units as of the date of adoption. The Company has up to six months
from the date of adoption to determine the fair value of each reporting unit. If
the carrying amount of a reporting unit exceeds its estimated fair value, an
indication of possible impairment exists and the Company is required to perform
a second step to determine the amount of an impairment loss that must be
recognized. The Company will be required to identify the fair value of the
reporting unit's goodwill at the date of adoption by allocating fair value of
the reporting unit to all of the assets (recognized and unrecognized) and
liabilities of the reporting unit, in a manner similar to an initial purchase
price allocation. The amount of the transitional impairment loss for the
reporting unit is determined by comparing the carrying value of the goodwill to
the estimated fair value of goodwill at the date of adoption. The measurement of
the transitional impairment test is required to be completed before the end of
the fiscal year in which SFAS No. 142 is adopted. Transitional impairment
losses, if any, will be recognized as a cumulative effect of a change in
accounting principle in the Company's statement of operations.
As of the date of adoption of SFAS No. 142, the Company will have
unamortized goodwill of approximately $454.3 million and equity method goodwill
of approximately $10.3 million. Amortization expense related to goodwill and
equity method goodwill was approximately $11.8 million and approximately
$0.3 million, respectively, for the year ended December 31, 2001. The Company
does not expect to record any transitional impairment losses as a result of the
implementation of SFAS No. 142.
The FASB issued SFAS No. 143, ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS,
which is effective January 1, 2003. This statement requires, among other things,
the accounting and reporting of legal obligations associated with the retirement
of long-lived assets that result from the acquisition, construction, development
or normal operation of a long-lived asset. The Company has not yet determined
the impact of the adoption of this standard on its financial position, results
of operations and cash flows.
The FASB issued SFAS No. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF
LONG-LIVED ASSETS, which is effective January 1, 2002. This statement addresses
accounting and reporting of all long-lived assets, except goodwill, that are
either held and used or disposed of through sale or other means. The Company
does not expect the implementation of this Statement to impact its financial
position, results from operations or cash flows.
INFLATION
We do not believe inflation has a significant effect on our operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At December 31, 2001, we recorded our marketable available-for-sale equity
securities at a fair value of $8.6 million. These securities have exposure to
price risk. A hypothetical ten percent adverse change in quoted market prices
would decrease the recorded value by approximately $0.9 million. The following
summarizes the realized/unrealized changes in fair value of investments
classified as available-for-sale at December 31, 2001.
We have limited our exposure to material future earnings or cash flow
exposures from changes in interest rates on long-term debt, since approximately
77% of our debt bears interest at fixed rates or effectively at fixed rates
through the use of interest rate swaps. However, our earnings are affected by
changes in interest rates as our long-term debt under our credit facilities have
variable interest based on either the prime rate or LIBOR. If interest rates on
our variable debt averaged 10% more, our
26
<Page>
interest expense would have increased, and our loss from continuing operations
before taxes would have increased by approximately $2.3 million for the year
ended December 31, 2001.
We have entered into interest rate swaps to manage our exposure to
fluctuations in interest rates on our variable rate debt. The fair value of
these swaps was approximately $(13.3) million at December 31, 2001. The fair
value indicates an estimated amount we would have to pay to cancel the contracts
or transfer them to other parties. In connection with our Credit Facility, we
used six interest rate swap agreements, with notional amounts of $25.0 million
each, to effectively convert a portion of our variable interest rate exposure to
fixed rates ranging from 8.07% to 10.34%. The swap agreements expire from
November 2003 to May 2004. In connection with our floating rate notes, we used
an interest rate swap agreement, with a notional amount of $75.0 million to
effectively convert our variable interest rate exposure to a fixed rate of
10.78%. This swap agreement expires in May 2003. FairPoint Solutions used two
interest rate swap agreements with notional amounts of $25.0 million and
$50.0 million to effectively convert a portion of its variable interest rate
exposure under the FairPoint Solutions Amended and Restated Credit Agreement to
fixed rates ranging from 9.09% to 10.59%. We expect that FairPoint Solutions
will be in default under these interest rate swap agreements as of April 1,
2002. FairPoint Solutions' liability under such agreements was approximately
$3.1 million as of March 22, 2002. These swap agreements expire in May 2003 and
November 2003, respectively.
27
<Page>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
FairPoint Communications, Inc.:
We have audited the accompanying consolidated balance sheets of FairPoint
Communications, Inc. and subsidiaries as of December 31, 2000 and 2001, and the
related consolidated statements of operations, stockholders' equity (deficit),
comprehensive losses, and cash flows for each of the years in the three-year
period ended December 31, 2001. These consolidated financial statements are the
responsibility of FairPoint Communications, Inc.'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 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 consolidated 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 FairPoint
Communications, Inc. and subsidiaries as of December 31, 2000 and 2001, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2001, in conformity with accounting
principles generally accepted in the United States of America.
As discussed in note 1 to the consolidated financial statements, the Company
changed its method of accounting for derivative instruments and hedging
activities in 2001.
/s/ KPMG LLP
March 8, 2002
Charlotte, North Carolina
28
<Page>
FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2001 AND 2000
ASSETS
<Table>
<Caption>
2000 2001
---------- ----------
(AMOUNTS IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Current assets:
Cash........................................................ $ 4,130 3,063
Accounts receivable, net of allowance for doubtful accounts
of $1,434 in 2000 and $1,355 in 2001...................... 32,693 30,949
Prepaid and other........................................... 5,157 6,245
Investments available-for-sale.............................. 936 693
Income taxes recoverable.................................... 387 160
-------- --------
Total current assets.................................. 43,303 41,110
-------- --------
Property, plant, and equipment, net......................... 277,369 283,280
-------- --------
Other assets:
Goodwill, net of accumulated amortization................. 451,486 454,306
Investments............................................... 50,047 48,941
Debt issue costs, net of accumulated amortization......... 20,445 18,758
Covenants not to compete, net of accumulated
amortization............................................ 2,982 1,755
Other..................................................... 1,067 868
-------- --------
Total other assets.................................... 526,027 524,628
-------- --------
Total assets.......................................... $846,699 $849,018
======== ========
</Table>
See accompanying notes to consolidated financial statements.
29
<Page>
FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2001 AND 2000
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
<Table>
<Caption>
2000 2001
---------- ----------
(AMOUNTS IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Current liabilities:
Accounts payable.......................................... $ 18,066 18,089
Other accrued liabilities................................. 15,174 11,709
Accrued interest payable.................................. 10,647 10,882
Current portion of long-term debt......................... 5,182 5,523
Accrued property taxes.................................... 2,201 2,262
Current portion of obligation for covenants not to
compete................................................. 1,298 1,236
Demand notes payable...................................... 535 464
Net liabilities of discontinued operations................ 27,584 134,379
-------- --------
Total current liabilities............................. 80,687 184,544
-------- --------
Long-term liabilities:
Long-term debt, net of current portion.................... 671,630 776,279
Other liabilities......................................... 12,505 22,934
Net liabilities of discontinued operations................ 10,256 9,735
Obligation for covenants not to compete, net of current
portion................................................. 1,833 650
Unamortized investment tax credits 384 233
-------- --------
Total long-term liabilities........................... 696,608 809,831
-------- --------
Minority interest........................................... 15 17
-------- --------
Common stock subject to put options, 382 shares at
December 31, 2000 and 315 shares at December 31, 2001..... 5,011 4,136
-------- --------
Stockholders' equity (deficit):
Preferred stock:
Series D nonvoting, convertible, cumulative
participating, par value $.01 per share, 100,000
shares authorized..................................... -- --
Common stock:
Class A voting, par value $.01 per share, 236,200 shares
authorized, issued and outstanding 45,527 shares at
December 31, 2000 and 45,611 shares at December 31,
2001.................................................. 455 456
Class B nonvoting, convertible, par value $.01 per
share, 150,000 shares authorized...................... -- --
Class C nonvoting, convertible, par value $.01 per
share, 13,800 shares authorized, issued and
outstanding 4,269 shares at December 31, 2000 and
December 31, 2001..................................... 43 43
Additional paid-in capital.................................. 227,245 217,936
Unearned compensation....................................... (9,707) --
Accumulated other comprehensive income (loss)............... 440 (2,247)
Accumulated deficit......................................... (154,098) (365,698)
-------- --------
Total stockholders' equity (deficit).................. 64,378 (149,510)
-------- --------
Total liabilities and stockholders' equity
(deficit)........................................... $846,699 849,018
======== ========
</Table>
See accompanying notes to consolidated financial statements.
30
<Page>
FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1999, 2000, AND 2001
<Table>
<Caption>
1999 2000 2001
-------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Revenues.................................................... $136,422 195,696 235,213
-------- ------- --------
Operating expenses:
Network operating costs................................... 40,652 55,741 69,133
Selling, general and administrative....................... 31,866 41,846 48,668
Depreciation and amortization............................. 30,885 47,070 56,064
Stock-based compensation.................................. 3,386 12,323 1,337
-------- ------- --------
Total operating expenses................................ 106,789 156,980 175,202
-------- ------- --------
Income from operations.................................. 29,633 38,716 60,011
-------- ------- --------
Other income (expense):
Net gain (loss) on sale of investments and other assets... 514 6,648 (648)
Interest income........................................... 406 996 103
Dividend income........................................... 1,452 1,403 1,887
Interest expense.......................................... (50,464) (59,556) (89,187)
Other nonoperating, net................................... 2,520 4,234 4,918
-------- ------- --------
Total other expense..................................... (45,572) (46,275) (82,927)
-------- ------- --------
Loss from continuing operations before income taxes..... (15,939) (7,559) (22,916)
Income tax expense.......................................... (2,179) (5,607) (431)
Minority interest in income of subsidiaries................. (100) (3) (2)
-------- ------- --------
Loss from continuing operations......................... (18,218) (13,169) (23,349)
-------- ------- --------
Discontinued operations:
Loss from discontinued competitive communications
operations, net of income tax benefits of $7,794 and
$37,642 in 1999 and 2000, respectively.................. (10,822) (75,948) (92,967)
Loss on disposal of competitive communications operations,
including provision of $28,090 for operating losses
during phase-out period................................. -- -- (95,284)
-------- ------- --------
Loss from discontinued operations......................... (10,822) (75,948) (188,251)
-------- ------- --------
Net loss.................................................. $(29,040) (89,117) (211,600)
======== ======= ========
</Table>
See accompanying notes to consolidated financial statements.
31
<Page>
FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
YEARS ENDED DECEMBER 31, 1999, 2000, AND 2001
(AMOUNTS IN THOUSANDS)
<Table>
<Caption>
SERIES D CLASS A CLASS B CLASS C
PREFERRD COMMON COMMON COMMON
------------------- ------------------- ------------------- --------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT SHARES
-------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance December 31, 1998........................... -- $ -- 34,451 $ 345 -- $ -- --
Net loss............................................ -- -- -- -- -- -- --
Other comprehensive income from available-for-sale
securities........................................ -- -- -- -- -- -- --
Compensation expense for stock-based awards......... -- -- -- -- -- -- --
------- ----- ------- ----- ------- ----- -----
Balance December 31, 1999........................... -- -- 4,451 345 -- -- --
Net loss............................................ -- -- -- -- -- -- --
Issuance of common stock under stock options and
warrants.......................................... -- -- 307 3 -- -- --
Issuance of capital stock for cash, net of direct
offering expenses of $23.9 million................ 4,674 47 100 1 4,244 42 4,269
Exchange of Class A common shares for Class B common
and Series D preferred shares..................... 16,788 168 (25,088) (251) 8,300 83 --
Cancellation of put options on common shares........ -- -- 1,752 17 -- -- --
Unearned stock option compensation.................. -- -- -- -- -- -- --
Compensation expense for stock-based awards......... -- -- -- -- -- -- --
Forfeit of unvested stock options................... -- -- -- -- -- -- --
Other comprehensive loss from available-for-sale
securities........................................ -- -- -- -- -- -- --
Conversion of Series D preferred and Class B common
shares to Class A common shares................... (21,462) (215) 34,006 340 (12,544) (125) --
Repurchase and cancellation of shares of common
stock............................................. -- -- (1) -- -- -- --
------- ----- ------- ----- ------- ----- -----
Balance at December 31, 2000........................ -- -- 45,527 455 -- -- 4,269
Net loss............................................ -- -- -- -- -- -- --
Compensation expense for stock-based awards......... -- -- -- -- -- -- --
Forfeit of unvested stock options................... -- -- -- -- -- -- --
Other comprehensive loss from available-for-sale
securities........................................ -- -- -- -- -- -- --
Exercise of stock options........................... -- -- 92 1 -- -- --
Other comprehensive loss from cash flow hedges...... -- -- -- -- -- -- --
Repurchase and cancellation of shares of common
stock............................................. -- -- (8) -- -- -- --
------- ----- ------- ----- ------- ----- -----
Balance at December 31, 2001........................ -- $ -- 45,611 $ 456 -- $ -- 4,269
======= ===== ======= ===== ======= ===== =====
<Caption>
CLASS C ACCUMULATED
COMMON ADDITIONAL OTHER
-------- PAID-IN UNEARNED COMPREHENSIVE ACCUMULATED
AMOUNT CAPITAL COMPENSATION INCOME (LOSS) DEFICIT
-------- ---------- ------------ ------------- ------------
<S> <C> <C> <C> <C> <C>
Balance December 31, 1998........................... $ -- $ 45,482 -- -- (35,941)
Net loss............................................ -- -- -- -- (29,040)
Other comprehensive income from available-for-sale
securities........................................ -- -- -- 4,187 --
Compensation expense for stock-based awards......... -- 3,386 -- -- --
---- -------- -------- ------- ---------
Balance December 31, 1999........................... -- 48,868 -- 4,187 (64,981)
Net loss............................................ -- -- -- -- (89,117)
Issuance of common stock under stock options and
warrants.......................................... -- 3,810 -- -- --
Issuance of capital stock for cash, net of direct
offering expenses of $23.9 million................ 43 150,281 -- -- --
Exchange of Class A common shares for Class B common
and Series D preferred shares..................... -- -- -- -- --
Cancellation of put options on common shares........ -- 2,983 -- -- --
Unearned stock option compensation.................. -- 15,926 (15,926) -- --
Compensation expense for stock-based awards......... -- 8,510 3,097 -- --
Forfeit of unvested stock options................... -- (3,122) 3,122 -- --
Other comprehensive loss from available-for-sale
securities........................................ -- -- -- (3,747) --
Conversion of Series D preferred and Class B common
shares to Class A common shares................... -- -- -- -- --
Repurchase and cancellation of shares of common
stock............................................. -- (11) -- -- --
---- -------- -------- ------- ---------
Balance at December 31, 2000