UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

Commission File Number 0-29752

 

Leap Wireless International, Inc.

(Exact name of registrant as specified in its charter)

 

 

(858) 882-6000

(Registrant’s telephone number, including area code)

 

Not applicable

(Former name, former address and former fiscal year, if changed since last reported)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.  Yes þ     No o

 

The number of shares of registrant’s common stock outstanding on November 1, 2006 was 67,763,650.

 

 

LEAP WIRELESS INTERNATIONAL, INC.

 

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended September 30, 2006

 

TABLE OF CONTENTS

 

 

 

LEAP WIRELESS INTERNATIONAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)

 

 

See accompanying notes to condensed consolidated financial statements.

LEAP WIRELESS INTERNATIONAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(In thousands, except per share data)

 

 

See accompanying notes to condensed consolidated financial statements.

LEAP WIRELESS INTERNATIONAL, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(In thousands)

 

 

See accompanying notes to condensed consolidated financial statements.

LEAP WIRELESS INTERNATIONAL, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

 

Leap Wireless International, Inc. (“Leap”), a Delaware corporation, together with its wholly owned subsidiaries, is a wireless communications carrier that offers digital wireless service in the United States of America under the “Cricket^®” and “Jump^tm Mobile” brands. Leap conducts operations through its subsidiaries and has no independent operations or sources of operating revenue other than through dividends, if any, from its operating subsidiaries. Cricket and Jump Mobile services are offered by Leap’s wholly owned subsidiary, Cricket Communications, Inc. (“Cricket”). Leap, Cricket and their subsidiaries are collectively referred to herein as “the Company.” Cricket and Jump Mobile services are also offered in certain markets by Alaska Native Broadband 1 License, LLC (“ANB 1 License”) and by LCW Wireless Operations, LLC (“LCW Operations”), both of which are designated entities under Federal Communications Commission (“FCC”) regulations. Cricket owns an indirect 75% non-controlling interest in ANB 1 License through a 75% non-controlling interest in Alaska Native Broadband 1, LLC (“ANB 1”), and an indirect 72% non-controlling interest in LCW Operations through a 72% non-controlling interest in LCW Wireless, LLC (“LCW Wireless”) (see Note 8). In May 2006, Cricket acquired a non-controlling interest in Denali Spectrum, LLC (“Denali”), which participated in Auction #66 as a designated entity through its wholly owned subsidiary, Denali Spectrum License, LLC (“Denali License”). Cricket currently holds an 82.5% non-controlling interest in Denali.

 

The Company operates in a single operating segment as a wireless communications carrier that offers digital wireless service in the United States of America. As of and for the nine months ended September 30, 2006, all of the Company’s revenues and long-lived assets related to operations in the United States of America.

 

 

Basis of Presentation

 

The accompanying interim condensed consolidated financial statements have been prepared by the Company without audit, in accordance with the instructions to Form 10-Q and, therefore, do not include all information and footnotes required by accounting principles generally accepted in the United States of America for a complete set of financial statements. These condensed consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. In the opinion of management, the unaudited financial information for the interim periods presented reflects all adjustments necessary for a fair statement of the results for the periods presented, with such adjustments consisting only of normal recurring adjustments. Operating results for interim periods are not necessarily indicative of operating results for an entire fiscal year.

 

The condensed consolidated financial statements include the accounts of Leap and its wholly owned subsidiaries as well as the accounts of ANB 1, LCW Wireless and Denali and their wholly owned subsidiaries. The Company consolidates its interests in ANB 1, LCW Wireless and Denali in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 46-R, “Consolidation of Variable Interest Entities,” because these entities are variable interest entities and the Company will absorb a majority of their expected losses. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.

 

Revenues

 

Cricket’s business revenues principally arise from the sale of wireless services, handsets and accessories. Wireless services are generally provided on a month-to-month basis. The Company’s Cricket service offers customers unlimited wireless service in their Cricket service area for a flat monthly rate, and the Jump Mobile service offers customers a per-minute prepaid service. The Company does not require any of its customers to sign fixed-term service commitments or submit to a credit check, and therefore some of its customers may be more likely to terminate service for inability to pay than the customers of other wireless providers. Amounts received in advance

for wireless services from customers who pay in advance of their billing cycle are initially recorded as deferred revenues and are recognized as service revenues as services are rendered. Service revenues for customers who pay in arrears are recognized only after the service has been rendered and payment has been received. Starting in May 2006, all new and reactivating customers pay for their service in advance.

 

Equipment revenues arise from the sale of handsets and accessories. Revenues and related costs from the sale of handsets are recognized when service is activated by customers. Revenues and related costs from the sale of accessories are recognized at the point of sale. The costs of handsets and accessories sold are recorded in cost of equipment. Sales of handsets to third-party dealers and distributors are recognized as equipment revenues when service is activated by customers, as the Company does not yet have sufficient relevant historical experience to establish reliable estimates of returns by such dealers and distributors. Handsets sold by third-party dealers and distributors are recorded as inventory until they are sold to and activated by customers. Once the Company believes it has sufficient relevant historical experience on which to establish reliable estimates of returns, it will begin to recognize equipment revenues upon sale to third-party dealers and distributors. The Company is currently reviewing its experience and may be able to establish reliable estimates of returns in the foreseeable future.

 

Sales incentives offered without charge to customers and volume-based incentives paid to the Company’s third-party dealers and distributors are recognized as a reduction of revenue and as a liability when the related service or equipment revenue is recognized. Customers have limited rights to return handsets and accessories based on time and/or usage. Customer returns of handsets and accessories have historically been insignificant.

 

Costs and Expenses

 

The Company’s costs and expenses include:

 

Cost of Service.  The major components of cost of service are: charges from other communications companies for long distance, roaming and content download services provided to the Company’s customers; charges from other communications companies for their transport and termination of calls originated by the Company’s customers and destined for customers of other networks; and expenses for tower and network facility rent, engineering operations, field technicians and related utility and maintenance charges, and salary and overhead charges associated with these functions.

 

Cost of Equipment.  Cost of equipment primarily includes the cost of handsets and accessories purchased from third-party vendors and resold to the Company’s customers in connection with its services, as well as lower-of-cost-or-market write-downs associated with excess and damaged handsets and accessories.

 

Selling and Marketing.  Selling and marketing expenses primarily include advertising, promotional and public relations costs associated with acquiring new customers, store operating costs such as retail associates’ salaries and rent, and overhead charges associated with selling and marketing functions.

 

General and Administrative.  General and administrative expenses primarily include call center and other customer care program costs and salary and overhead costs associated with the Company’s customer care, billing, information technology, finance, human resources, accounting, legal and executive functions.

 

Property and Equipment

 

Property and equipment are initially recorded at cost. Additions and improvements are capitalized, while expenditures that do not enhance the asset or extend its useful life are charged to operating expenses as incurred. Depreciation is applied using the straight-line method over the estimated useful lives of the assets once the assets are placed in service.

The following table summarizes the depreciable lives for property and equipment (in years):

 

 

The Company’s network construction expenditures are recorded as construction-in-progress until the network or assets are placed in service, at which time the assets are transferred to the appropriate property or equipment category. As a component of construction-in-progress, the Company capitalizes interest and salaries and related costs of engineering and technical operations employees, to the extent time and expense are contributed to the construction effort, during the construction period. Interest is capitalized on the carrying values of both wireless licenses and equipment during the construction period and is amortized over an estimated useful life of 10 years. During the three and nine months ended September 30, 2006, the Company capitalized $3.4 million and $12.3 million, respectively, of interest to property and equipment. During the three and nine months ended September 30, 2005, the Company capitalized $3.6 million and $4.3 million, respectively, of interest to property and equipment. Starting on January 1, 2006, site rental costs incurred during the construction period are recognized as rental expense in accordance with FASB Staff Position No. FAS 13-1, “Accounting for Rental Costs Incurred During a Construction Period.” Prior to fiscal 2006, such rental costs were capitalized as construction-in-progress.

 

Property and equipment to be disposed of by sale is not depreciated and is carried at the lower of carrying value or fair value less costs to sell. At September 30, 2006, there was no property and equipment classified as assets held for sale. At December 31, 2005, property and equipment with a net book value of $5.4 million was classified as assets held for sale.

 

Wireless Licenses

 

Wireless licenses are initially recorded at cost and are not amortized. Wireless licenses are considered to be indefinite-lived intangible assets because the Company expects to continue to provide wireless service using the relevant licenses for the foreseeable future, and wireless licenses may be renewed every ten to fifteen years for a nominal fee. Wireless licenses to be disposed of by sale are carried at the lower of carrying value or fair value less costs to sell. At September 30, 2006 and December 31, 2005, wireless licenses with a carrying value of $20.4 million and $8.2 million, respectively, were classified as assets held for sale.

 

Goodwill and Other Intangible Assets

 

Goodwill represents the excess of reorganization value over the fair value of identified tangible and intangible assets recorded in connection with fresh-start reporting as of July 31, 2004. Other intangible assets were recorded upon adoption of fresh-start reporting and consist of customer relationships and trademarks which are being amortized on a straight-line basis over their estimated useful lives of four and fourteen years, respectively. At September 30, 2006, there were no intangible assets classified as assets held for sale. At December 31, 2005, intangible assets with a net book value of $1.5 million were classified as assets held for sale.

 

Impairment of Long-Lived Assets

 

The Company assesses potential impairments to its long-lived assets, including property and equipment and certain intangible assets, when there is evidence that events or changes in circumstances indicate that the carrying value may not be recoverable. An impairment loss may be required to be recognized when the undiscounted cash flows expected to be generated by a long-lived asset (or group of such assets) is less than its carrying value. Any

required impairment loss would be measured as the amount by which the asset’s carrying value exceeds its fair value and would be recorded as a reduction in the carrying value of the related asset and charged to results of operations.

 

Impairment of Indefinite-Lived Intangible Assets

 

The Company assesses potential impairments to its indefinite-lived intangible assets, including goodwill and wireless licenses, annually and when there is evidence that events or changes in circumstances indicate that an impairment condition may exist. The Company’s wireless licenses in its operating markets are combined into a single unit of accounting for purposes of testing impairment because management believes that these wireless licenses as a group represent the highest and best use of the assets, and the value of the wireless licenses would not be significantly impacted by a sale of one or a portion of the wireless licenses, among other factors. An impairment loss is recognized when the fair value of the asset is less than its carrying value and is measured as the amount by which the asset’s carrying value exceeds its fair value. Any required impairment losses are recorded as a reduction in the carrying value of the related asset and charged to results of operations. The Company conducts its annual tests for impairment during the third quarter of each year. As a result of the annual impairment tests of wireless licenses, the Company recorded impairment charges of $4.7 million and $0.7 million during the quarters ended September 30, 2006 and 2005, respectively, to reduce the carrying values of certain non-operating wireless licenses to their estimated fair values. Estimates of the fair value of the Company’s wireless licenses are based primarily on available market prices, including successful bid prices in FCC auctions and selling prices observed in wireless license transactions.

 

During the second quarter of 2006, the Company recorded impairment charges of $3.2 million to reduce the carrying values of certain non-operating wireless licenses to their estimated fair values as a result of a sale transaction (see Note 8). During the second quarter of 2005, the Company recorded impairment charges of $11.4 million to reduce the carrying values of certain non-operating wireless licenses to their estimated fair values as a result of a sale transaction.

 

Basic and Diluted Earnings Per Share

 

Basic earnings per share is calculated by dividing net income by the weighted-average number of common shares outstanding during the reporting period. Diluted earnings per share reflects the potential dilutive effect of additional common shares that are issuable upon exercise of outstanding stock options and warrants, restricted stock awards and forward equity agreements calculated using the treasury stock method.

 

A reconciliation of weighted-average shares outstanding used in calculating basic and diluted net income per share is as follows (unaudited) (in thousands):

 

 

The number of shares not included in the computation of diluted net income per share because their effect would have been anti-dilutive totaled 1.2 million and 1.4 million for the three and nine months ended September 30,

2006, respectively, and 1.8 million and 0.4 million for the three and nine months ended September 30, 2005, respectively.

 

Comprehensive Income

 

Comprehensive income consists of the following (unaudited) (in thousands):

 

 

Components of accumulated other comprehensive income consist of the following (in thousands):

 

 

Share-Based Payments

 

The Company accounts for share-based awards exchanged for employee services in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment” (“SFAS 123R”). Under SFAS 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period. The Company adopted SFAS 123R, as required, on January 1, 2006. Prior to fiscal 2006, the Company recognized compensation expense for employee share-based awards based on their intrinsic value on the grant date pursuant to Accounting

Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”, and provided the required pro forma disclosures of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).

 

The Company adopted SFAS 123R using a modified prospective approach. Under the modified prospective approach, prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Compensation expense, net of estimated forfeitures, for awards outstanding at the effective date is recognized over the remaining service period using the compensation cost calculated in prior periods.

 

The Company has granted nonqualified stock options, restricted stock awards and deferred stock units under its 2004 Stock Option, Restricted Stock and Deferred Stock Unit Plan (the “2004 Plan”). Most of the Company’s stock options and restricted stock awards include both a service condition and a performance condition that relates only to vesting. The stock options and restricted stock awards generally vest in full three or five years from the grant date with no interim time-based vesting. In addition, the stock options and restricted stock awards generally provide for the possibility of annual accelerated performance-based vesting of a portion of the awards if the Company achieves specified performance conditions. Certain stock options and restricted stock awards include only a service condition and vest over periods of up to approximately three years from the grant date. All share-based awards provide for accelerated vesting if there is a change in control (as defined in the 2004 Plan). Compensation expense is amortized on a straight-line basis over the requisite service period for the entire award, which is generally the maximum vesting period of the award.

During the quarter ended March 31, 2006, the Board of Directors approved a modification of the accelerated vesting performance conditions for all outstanding share-based awards with such performance conditions to take into account changes in business conditions that were not considered when the performance conditions were originally established, including the planned build-out of new markets. The performance conditions were originally established and subsequently modified such that they are neither probable nor improbable of achievement. As a result, the modifications of the performance conditions did not result in changes in the expected lives of the awards and, therefore, did not result in changes in the fair value of the awards. The original compensation cost related to the modified awards continues to be recognized over the requisite service period.

 

Share-Based Compensation Information under SFAS 123R

 

Under SFAS 123R, the fair value of the Company’s restricted stock awards is based on the grant date fair value of the common stock. This was the basis for the intrinsic value method used to measure compensation expense for the restricted stock awards prior to fiscal 2006. All restricted stock awards were granted with an exercise price of $0.0001 per share. The weighted-average grant date fair value of the restricted common stock was $45.59 and $44.26 per share, respectively, during the three and nine months ended September 30, 2006.

 

The Company uses the Black-Scholes option pricing model to estimate the fair value of its stock options under SFAS 123R. This valuation model was previously used for the Company’s pro forma disclosures under SFAS 123. All stock options were granted with an exercise price equal to the fair value of the common stock on the grant date. The weighted-average grant date fair value of employee stock options granted during the three and nine months ended September 30, 2006 was $24.53 and $23.68 per share, respectively, which was estimated using the following weighted-average assumptions:

 

 

The determination of the fair value of stock options using an option pricing model is affected by the Company’s stock price, as well as assumptions regarding a number of complex and subjective variables. The methods used to determine these variables are generally similar to the methods used prior to fiscal 2006 for purposes of the Company’s pro forma information under SFAS 123. The volatility assumption is based on a combination of the historical volatility of the Company’s common stock and the volatilities of similar companies over a period of time equal to the expected term of the stock options. The volatilities of similar companies are used in conjunction with the Company’s historical volatility because of the lack of sufficient relevant history for the Company’s common stock equal to the expected term. The expected term of employee stock options represents the weighted-average period the stock options are expected to remain outstanding. The expected term assumption is estimated based primarily on the options’ vesting terms and remaining contractual life and employees’ expected exercise and post-vesting employment termination behavior. The risk-free interest rate assumption is based upon observed interest rates on the grant date appropriate for the term of the employee stock options. The dividend yield assumption is based on the expectation of no future dividend payouts by the Company.

 

As share-based compensation expense under SFAS 123R is based on awards ultimately expected to vest, it is reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were accounted for as they occurred in the Company’s pro forma disclosures under SFAS 123. The Company recorded a gain of $0.6 million as a cumulative effect of a change in accounting principle related to the change in accounting for forfeitures under SFAS 123R.

Total share-based compensation expense related to all of the Company’s share-based awards for the three and nine months ended September 30, 2006 was allocated as follows (unaudited) (in thousands, except per share data):

 

 

Prior to fiscal 2006, the restricted stock awards and deferred stock units were granted with an exercise price of $0.0001 per share and, therefore, the Company recognized compensation expense associated with these awards based on their intrinsic value. No compensation expense was recorded for stock options prior to adopting SFAS 123R, because the Company established the exercise price of the stock options based on the fair value of the underlying stock at the date of grant. During the three months ended September 30, 2005, the Company granted a total of 390,975 non-qualified stock options and 125,781 shares of restricted common stock to directors, executive officers and other employees of the Company. During the nine months ended September 30, 2005, the Company granted a total of 2,073,692 non-qualified stock options, 932,204 shares of restricted common stock and 246,484 deferred stock units to directors, executive officers and other employees of the Company. The Company recorded $2.7 million and $9.9 million of share-based compensation expense for the three and nine months ended September 30, 2005, respectively, resulting from the grant of the restricted common stock and immediately vested deferred stock units. The total intrinsic value of the deferred stock units of $6.9 million was recorded as share-based compensation expense during the nine months ended September 30, 2005. The total intrinsic value of the restricted stock awards is being amortized on a straight-line basis over the maximum vesting period of the awards of either three or five years.

 

Total share-based compensation expense for the three and nine months ended September 30, 2005 was allocated as follows (unaudited) (in thousands):

 

Pro Forma Information under SFAS 123 for Periods Prior to Fiscal 2006

 

The pro forma effects on net income and earnings per share of recognizing share-based compensation expense under the fair value method required by SFAS 123 was as follows (unaudited) (in thousands, except per share data):

 

 

For purposes of pro forma disclosures under SFAS 123, the estimated fair value of the stock options was amortized on a straight-line basis over the maximum vesting period of the awards.

 

The weighted-average fair value per share on the grant date for stock options granted during the three and nine months ended September 30, 2005 was $26.31 and $20.58, respectively, which was estimated using the Black-Scholes option pricing model and the following weighted-average assumptions:

 

 

Recent Accounting Pronouncements

 

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108 (“SAB 108”), which addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB 108 requires companies to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. When the effect of initial adoption is material, companies may record the effect as a cumulative effect adjustment to beginning of year retained earnings. SAB 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. The Company is required to adopt this interpretation by December 31, 2006. The Company does not believe the initial adoption will have a material impact on its consolidated financial statements.

 

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America and expands disclosure about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company will be

required to adopt SFAS 157 in the first quarter of fiscal year 2008. The Company is currently evaluating what impact, if any, SFAS 157 will have on its consolidated financial statements.

 

In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing what impact, if any, the Interpretation will have on its consolidated financial statements.

 

Note 3.  Supplementary Balance Sheet Information (in thousands):

 

 

Note 4. Long-Term Debt

 

Senior Secured Credit Facility

 

Long-term debt as of September 30, 2006 consisted of an amended and restated senior secured credit agreement (the “Credit Agreement”), which included a $900 million term loan and an undrawn $200 million revolving credit facility available until June 2011. Under the Credit Agreement, the term loan bears interest at the London Interbank Offered Rate (LIBOR) plus 2.75 percent, with interest periods of one, two, three or six months, or bank base rate plus 1.75 percent, as selected by Cricket, with the rate subject to adjustment based on Leap’s corporate family debt rating. Outstanding borrowings under the term loan must be repaid in 24 quarterly payments

of $2.25 million each, commencing September 30, 2006, followed by four quarterly payments of $211.5 million each, commencing September 30, 2012.

 

The maturity date for outstanding borrowings under the revolving credit facility is June 16, 2011. The commitment of the lenders under the revolving credit facility may be reduced in the event mandatory prepayments are required under the Credit Agreement. The commitment fee on the revolving credit facility is payable quarterly at a rate of between 0.25 and 0.50 percent per annum, depending on the Company’s consolidated senior secured leverage ratio. Borrowings under the revolving credit facility would currently accrue interest at LIBOR plus 2.75 percent or the bank base rate plus 1.75 percent, as selected by Cricket, with the rate subject to adjustment based on the Company’s consolidated senior secured leverage ratio.

 

The facilities under the Credit Agreement are guaranteed by Leap and all of its direct and indirect domestic subsidiaries (excluding Cricket, which is the primary obligor, and ANB 1, LCW Wireless and Denali and their respective subsidiaries) and are secured by substantially all of the present and future personal property and owned real property of Leap, Cricket and such direct and indirect domestic subsidiaries. Under the Credit Agreement, the Company is subject to certain limitations, including limitations on its ability to: incur additional debt or sell assets, with restrictions on the use of proceeds; make certain investments and acquisitions; grant liens; pay dividends; and make certain other restricted payments. In addition, the Company will be required to pay down the facilities under certain circumstances if it issues debt, sells assets or property, receives certain extraordinary receipts or generates excess cash flow (as defined in the Credit Agreement). The Company is also subject to a financial covenant with respect to a maximum consolidated senior secured leverage ratio and, if a revolving credit loan or uncollateralized letter of credit is outstanding, with respect to a minimum consolidated interest coverage ratio, a maximum consolidated leverage ratio and a minimum consolidated fixed charge ratio. In addition to investments in joint ventures relating to the FCC’s recent Auction #66, the Credit Agreement allows the Company to invest up to $325 million in ANB 1 and ANB 1 License, up to $85 million in LCW Wireless and its subsidiaries, and up to $150 million plus an amount equal to an available cash flow basket in other joint ventures, and allows the Company to provide limited guarantees for the benefit of ANB 1, LCW Wireless and other joint ventures.

 

Affiliates of Highland Capital Management, L.P. (a beneficial stockholder of Leap and an affiliate of James D. Dondero, a director of Leap) participated in the syndication of the Credit Agreement in initial amounts equal to $225 million of the term loan and $40 million of the revolving credit facility, and Highland Capital Management received a syndication fee of $300,000 in connection with their participation.

 

At September 30, 2006, the effective interest rate on the term loan was 7.8%, including the effect of interest rate swaps, and the outstanding indebtedness was $897.8 million. The terms of the Credit Agreement require the Company to enter into interest rate swap agreements in a sufficient amount so that at least 50% of the Company’s outstanding indebtedness for borrowed money bears interest at a fixed rate by December 31, 2006. The Company has entered into interest rate swap agreements with respect to $355 million of its debt. These swap agreements effectively fix the interest rate on $250 million of indebtedness at 6.7% and $105 million of indebtedness at 6.8% through June 2007 and 2009, respectively. The fair value of the swap agreements at September 30, 2006 and 2005 was $3.8 million and $2.0 million, respectively, and was recorded in other assets in the consolidated balance sheet.

 

Long-term debt at December 31, 2005 consisted of a senior secured credit agreement which included term loans with an aggregate outstanding balance of $594.4 million and an undrawn $110 million revolving credit facility. A portion of the proceeds from the new term loan under the Credit Agreement was used to repay these existing term loans in June 2006. Upon repayment of the existing term loans and execution of the new revolving credit facility, the Company wrote off unamortized deferred debt issuance costs related to the existing credit agreement of $5.6 million to other expense for the second quarter of 2006.

 

Bridge Loan Facility

 

On August 8, 2006, the Company entered into a bridge credit agreement consisting of an unsecured $850 million bridge loan facility, available until the earlier of March 31, 2007 and 15 days after the date payment was required in full to the FCC for wireless licenses acquired in Auction #66. In October 2006, the Company borrowed $570 million under the bridge loan facility to pay a portion of the final balance it owed to the FCC for its Auction #66 licenses and to loan Denali License $182.6 million to permit it to pay the final balance it owed to the

FCC for its Auction #66 license. The Company used a portion of the cash proceeds from the sale of unsecured senior notes issued in October 2006 (see Note 10) to repay the outstanding obligations, including accrued interest, under the bridge loan facility. Upon repayment of the outstanding indebtedness, the bridge loan facility was terminated.

 

 

The provision for income taxes during interim quarterly reporting periods is based on the Company’s estimate of the annual effective tax rate for the full fiscal year. The Company determines the annual effective tax rate based upon its estimated “ordinary” income (loss), which is its annual income (loss) from continuing operations before tax, excluding unusual or infrequently occurring items. Significant management judgment is required in projecting the Company’s annual income (loss) and determining its annual effective tax rate. The Company provides for income taxes in each of the jurisdictions in which it operates. This process involves estimating the actual current tax expense and any deferred income tax expense resulting from temporary differences arising from differing treatments of items for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities. Deferred tax assets are also established for the expected future tax benefits to be derived from net operating loss and capital loss carryforwards.

 

The Company must then assess the likelihood that its deferred tax assets will be recovered from future taxable income. To the extent that the Company believes it is more likely than not that its deferred tax assets will not be recovered, it must establish a valuation allowance. The Company considers all available evidence, both positive and negative, including the Company’s historical operating losses, to determine the need for a valuation allowance. The Company has recorded a full valuation allowance on its net deferred tax asset balances for all periods presented because of uncertainties related to utilization of the deferred tax assets. Deferred tax liabilities associated with wireless licenses, tax goodwill and investments in joint ventures cannot be considered a source of taxable income to support the realization of deferred tax assets, because these deferred tax liabilities will not reverse until some indefinite future period.

 

At such time as the Company determines that it is more likely than not that the deferred tax assets are realizable, the valuation allowance will be reduced. Pursuant to American Institute of Certified Public Accountants’ Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code,” future decreases in the valuation allowance established in fresh-start reporting will be accounted for as a reduction in goodwill rather than as a reduction of tax expense.

 

 

Stock Option Plan

 

The Company’s 2004 Plan allows for the grant of stock options, restricted stock and deferred stock units to employees, independent directors and consultants. A total of 4,800,000 shares of common stock were initially reserved for issuance under the 2004 Plan. A total of 970,108 shares of common stock were available for issuance under the 2004 Plan as of September 30, 2006. The stock options are exercisable for up to 10 years from the grant date.

A summary of stock option transactions follows:

 

 

A summary of unvested restricted stock follows:

 

 

No stock options or restricted stock vested during the three and nine months ended September 30, 2006. At September 30, 2006, total unrecognized compensation cost related to unvested stock options and restricted stock awards was $29.5 million and $16.1 million, respectively, which is expected to be recognized over weighted-average periods of 3.0 and 2.1 years, respectively. No share-based compensation cost was capitalized as part of inventory and fixed assets prior to fiscal 2006 or during the three and nine months ended September 30, 2006. No stock options were exercised during the three and nine months ended September 30, 2006.

 

Upon option exercise, the Company issues new shares of stock. The terms of the restricted stock grant agreements allow the Company to repurchase unvested shares at the option, but not the obligation, of the Company for a period of sixty days, commencing ninety days after the employee has a termination event. If the Company elects to repurchase all or any portion of the unvested shares, it may do so at the original purchase price per share.

 

Additional information about stock options outstanding at September 30, 2006 follows:

 

 

Employee Stock Purchase Plan

 

The Company’s Employee Stock Purchase Plan (the “ESP Plan”) allows eligible employees to purchase shares of common stock during a specified offering period. The purchase price is 85% of the lower of the fair market value

of such stock on the first or last day of the offering period. Employees may authorize the Company to withhold up to 15% of their compensation during any offering period for the purchase of shares under the ESP Plan, subject to certain limitations. A total of 800,000 shares of common stock were initially reserved for issuance under the ESP Plan, and a total of 778,989 shares remained available for issuance under the ESP Plan as of September 30, 2006. The current offering period under the ESP Plan is from July 1, 2006 through December 31, 2006. Compensation expense related to the ESP Plan has been insignificant.

 

 

Forward Sale Agreements

 

In August 2006, in connection with a public offering of Leap common stock, Leap entered into forward sale agreements for the sale of an aggregate of 6,440,000 shares of its common stock, including an amount equal to the underwriters’ over-allotment option in the public offering (which was fully exercised). The initial forward sale price was $40.11 per share, which was equivalent to the public offering price less the underwriting discount, and was subject to daily adjustment based on a floating interest factor equal to the federal funds rate, less a spread of 1.0%. The forward sale agreements allowed the Company to elect to physically settle the transactions, or to issue shares of its common stock in satisfaction of its obligations under the forward sale agreements, in all circumstances (unless the Company had previously elected otherwise). As a result, these forward sale agreements were initially measured at fair value and reported in permanent equity. Subsequent changes in fair value have not been recognized as the forward sale agreements continued to be classified as permanent equity. In October 2006, Leap issued 6,440,000 shares of its common stock to physically settle its forward sale agreements and received aggregate cash proceeds of $260.0 million (before expenses) from such physical settlements. Upon such full settlement, the forward sale agreements were fully performed.

 

 

In September 2006, a wholly owned subsidiary of Cricket was named the winning bidder in Auction #66 for 99 wireless licenses with an aggregate purchase price of $710.2 million and covering 121.2 million potential customers (adjusted to eliminate duplication among certain overlapping licenses won by it in Auction #66), and Denali License was named the winning bidder for one wireless license with a net purchase price of $274.1 million and covering 59.3 million potential customers (which includes markets covering 5.7 million potential customers which overlap with certain licenses won by Cricket’s wholly owned subsidiary in Auction #66). In July 2006, Cricket and Denali License paid to the FCC $255 million and $50 million, respectively, as bidding deposits for Auction #66. The balance of the purchase price for these licenses was paid to the FCC in October 2006.

 

In July 2006, the Company completed the sale of its wireless licenses and operating assets in its Toledo and Sandusky, Ohio markets in exchange for $28.0 million in cash and an equity interest in LCW Wireless. The Company also contributed to LCW Wireless $21.0 million in cash and two wireless licenses and related operating assets, resulting in Cricket owning a 72% non-controlling membership interest in LCW Wireless. The Company recognized a net gain of $21.5 million in the third quarter of 2006 associated with these transactions.

 

From June 2006 through October 2006, the Company entered into four agreements to sell wireless licenses that the Company was not using to offer commercial service for an aggregate sales price of $22.4 million. In October 2006, three of these transactions were completed. Completion of the remaining transaction is subject to customary closing conditions, including FCC approval. During the second quarter of 2006, the Company recorded impairment charges of $3.2 million to adjust the carrying values of four of the licenses to their estimated fair values, which were based on the agreed upon sales prices.

 

In March 2006, the Company entered into an agreement with a debtor-in-possession for the purchase of 13 wireless licenses in North Carolina and South Carolina for an aggregate purchase price of $31.8 million. Completion of this transaction is subject to customary closing conditions, including the receipt of certain FCC approvals and orders which have already been issued but which have not yet become final.

 

Outstanding Bankruptcy Claims

 

Although the Company’s plan of reorganization became effective and the Company emerged from bankruptcy in August 2004, a tax claim of approximately $4.9 million Australian dollars (approximately $3.8 million U.S. dollars as of November 2, 2006) asserted by the Australian government against Leap in the U.S. Bankruptcy Court for the Southern District of California has not yet been resolved. The Bankruptcy Court sustained the Company’s objection to the claim and dismissed the claim in June 2006. However, the Australian government has appealed the Bankruptcy Court order to the United States District Court for the Southern District of California. The Company, the Australian government and the trust established in bankruptcy for the benefit of the Leap general unsecured creditors have agreed in principle to settle this claim. The Company does not believe that the resolution of this claim will have a material adverse effect on its consolidated financial statements.

 

Patent Litigation

 

On June 14, 2006, the Company sued MetroPCS Communications, Inc. (“MetroPCS”) in the United States District Court for the Eastern District of Texas for infringement of U.S. Patent No. 6,813,497 “Method for Providing Wireless Communication Services and Network and System for Delivering Same,” issued to the Company. The Company’s complaint seeks damages and an injunction against continued infringement. On August 3, 2006, MetroPCS (i) answered the complaint, (ii) raised a number of affirmative defenses, and (iii) together with two related entities (referred to, collectively with MetroPCS, as the “MetroPCS entities”), counterclaimed against Leap, Cricket, numerous Cricket subsidiaries, ANB 1 License, Denali License, and current and former employees of Leap and Cricket, including Leap CEO Doug Hutcheson. The countersuit alleges claims for breach of contract, misappropriation, conversion and disclosure of trade secrets, misappropriation of confidential information and breach of confidential relationship, relating to information provided by MetroPCS to such employees, including prior to their employment by Leap, and asks the court to award damages, including punitive damages, impose an injunction enjoining the Company from participating in Auction #66, impose a constructive trust on the Company’s business and assets for the benefit of MetroPCS, and declare that the MetroPCS entities have not infringed U.S. Patent No. 6,813,497 and that such patent is invalid. MetroPCS’s claims allege that the Company and the other counterclaim defendants improperly obtained, used and disclosed trade secrets and confidential information of the MetroPCS entities and breached confidentiality agreements with the MetroPCS entities. On October 13, 2006, ANB 1 License, Denali License, and two of the individual counterclaim defendants filed motions to dismiss the claims against them, and the remaining counterclaim defendants answered the counterclaims. Based upon the Company’s preliminary review of the counterclaims, the Company believes that it has meritorious defenses and intends to vigorously defend against the counterclaims. If the MetroPCS entities were to prevail in their counterclaims, it could have a material adverse effect on the Company’s business, financial condition and results of operations. On September 22, 2006, Royal Street Communications, LLC (“Royal Street”), an entity affiliated with MetroPCS, filed an action in the United States District Court for the Middle District of Florida seeking a declaratory judgment that the Company’s U.S. Patent No. 6,813,497 is invalid and is not being infringed by Royal Street or its PCS systems. On October 17, 2006, the Company filed a motion to dismiss the case or, in the alternative, to transfer the case to the Eastern District of Texas. The Company intends to vigorously defend against these actions.

 

On August 3, 2006, MetroPCS filed a separate action in the United States District Court for the Northern District of Texas seeking a declaratory judgment that the Company’s U.S. Patent No. 6,959,183 “Operations Method for Providing Wireless Communication Services and Network and System for Delivering Same” is invalid and is not being infringed by MetroPCS and its affiliates. On October 13, 2006, Leap and Cricket filed a motion to dismiss this action or, in the alternative, to transfer the action to the United States District Court for the Eastern District of Texas where another suit is pending between the Company, MetroPCS and other parties as described in the preceding paragraph. The Company intends to vigorously defend against the action.

 

On August 17, 2006, the Company was served with a complaint filed by the MetroPCS entities in the Superior Court of the State of California, which names Leap, Cricket, certain of its subsidiaries, and certain current and former employees of Leap and Cricket, including Leap CEO Doug Hutcheson, as defendants. In the complaint, the MetroPCS entities allege unfair competition, misappropriation of trade secrets, (with respect to the individuals

sued) intentional and negligent interference with contract, breach of contract, intentional interference with prospective economic advantage and trespass, and ask the court to award damages, including punitive damages, and restitution. On October 13, 2006, all defendants joined in a motion to stay the case until resolution of the case in the Eastern District of Texas because of the substantial overlap of the cases. If and when the case proceeds, based on the initial complaint, it is unclear whether, if the MetroPCS entities were to prevail, it could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company intends to vigorously defend against the actions.

 

Tortious Interference and Unfair Competition Litigation

 

On July 10, 2006, the Company sued T-Mobile USA, Inc. (“T-Mobile”) in the District Court of Harris County, Texas for tortious interference with existing contract, tortious interference with prospective relations, business disparagement, and antitrust violations arising out of anticompetitive activities of T-Mobile in the Houston, Texas marketplace. In response, on August 8, 2006, T-Mobile filed a counterclaim against Cricket, alleging tortious interference with T-Mobile’s contracts with employees, ex-employees, authorized dealers and customers and unfair competition, and asking the court to award damages, including punitive damages, in an unspecified amount. If T-Mobile was to prevail in its counterclaim, it could have a material adverse effect on the Company’s business, financial condition and results of operations. The Company intends to vigorously defend against the counterclaim.

 

Other

 

On December 31, 2002, several members of American Wireless Group, LLC, referred to in these financial statements as AWG, filed a lawsuit against various officers and directors of Leap in the Circuit Court of the First Judicial District of Hinds County, Mississippi, referred to herein as the Whittington Lawsuit. Leap purchased certain FCC wireless licenses from AWG and paid for those licenses with shares of Leap stock. The complaint alleges that Leap failed to disclose to AWG material facts regarding a dispute between Leap and a third party relating to that party’s claim that it was entitled to an increase in the purchase price for certain wireless licenses it sold to Leap. In their complaint, plaintiffs seek rescission and/or damages according to proof at trial of not less than the aggregate amount paid for the Leap stock (alleged in the complaint to have a value of approximately $57.8 million in June 2001 at the closing of the license sale transaction), plus interest, punitive or exemplary damages in the amount of not less than three times compensatory damages, and costs and expenses. Plaintiffs contend that the named defendants are the controlling group that was responsible for Leap’s alleged failure to disclose the material facts regarding the third party dispute and the risk that the shares held by the plaintiffs might be diluted if the third party was successful with respect to its claim. The defendants in the Whittington Lawsuit filed a motion to compel arbitration or, in the alternative, to dismiss the Whittington Lawsuit. The motion noted that plaintiffs, as members of AWG, agreed to arbitrate disputes pursuant to the license purchase agreement, that they failed to plead facts that show that they are entitled to relief, that Leap made adequate disclosure of the relevant facts regarding the third party dispute and that any failure to disclose such information did not cause any damage to the plaintiffs. The court denied defendants’ motion and the defendants have appealed the denial of the motion to the state supreme court.

 

In a related action to the action described above, on June 6, 2003, AWG filed a lawsuit in the Circuit Court of the First Judicial District of Hinds County, Mississippi, referred to herein as the AWG Lawsuit, against the same individual defendants named in the Whittington Lawsuit. The complaint generally sets forth the same claims made by the plaintiffs in the Whittington Lawsuit. In its complaint, plaintiff seeks rescission and/or damages according to proof at trial of not less than the aggregate amount paid for the Leap stock (alleged in the complaint to have a value of approximately $57.8 million in June 2001 at the closing of the license sale transaction), plus interest, punitive or exemplary damages in the amount of not less than three times compensatory damages, and costs and expenses. Defendants filed a motion to compel arbitration or, in the alternative, to dismiss the AWG Lawsuit, making arguments similar to those made in their motion to dismiss the Whittington Lawsuit. The motion was denied and the defendants have appealed the ruling to the state supreme court.

 

Although Leap is not a defendant in either the Whittington or AWG Lawsuits, several of the defendants have indemnification agreements with the Company. Leap’s D&O insurers have not filed a reservation of rights letter and have been paying defense costs. Management believes that the liability, if any, from the AWG and Whittington

Lawsuits and the related indemnity claims of the defendants against Leap is not probable or estimable; therefore, no accrual has been made in Leap’s consolidated financial statements as of September 30, 2006 and December 31, 2005 related to these contingencies.

 

In addition to the matters described above, the Company is often involved in certain other claims arising in the course of business, seeking monetary damages and other relief. The amount of the liability, if any, from such claims cannot currently be reasonably estimated; therefore, no accruals have been made in the Company’s consolidated financial statements as of September 30, 2006 and December 31, 2005 for such claims.

 

Commitments

 

The Company has entered into non-cancelable operating lease agreements to lease its administrative and retail facilities, and sites for towers, equipment and antennae required for the operation of its wireless networks. These leases typically include renewal options and escalation clauses. In general, site leases have five year initial terms with four five year renewal options. The following table summarizes the approximate future minimum rentals under non-cancelable operating leases, including renewals that are reasonably assured, in effect at September 30, 2006 (unaudited) (in thousands):

 

 

 

Senior Notes

 

In October 2006, Cricket issued $750 million of unsecured senior notes due in 2014. The notes bear interest at the rate of 9.375% per year, payable semi-annually in cash in arrears beginning in May 2007. The notes are guaranteed on an unsecured senior basis by Leap and each of its existing and future domestic subsidiaries (excluding Cricket, which is the issuer of the notes, and ANB 1, LCW Wireless and Denali and their respective subsidiaries) that guarantee indebtedness for money borrowed of Leap, Cricket or any subsidiary guarantor. Currently, such guarantors include Leap and each of its direct or indirect wholly owned domestic subsidiaries, excluding Cricket. The notes and the guarantees are Leap’s, Cricket’s and the guarantors’ general senior unsecured obligations and rank equally in right of payment with all of Leap’s, Cricket’s and the guarantors’ existing and future unsubordinated unsecured indebtedness. The notes and the guarantees are effectively junior to Leap’s, Cricket’s and the guarantors’ existing and future secured obligations, including those under the senior secured credit facility, to the extent of the value of the assets securing such obligations, as well as to future liabilities of Leap’s and Cricket’s subsidiaries that are not guarantors and of ANB 1, LCW Wireless and Denali and their respective subsidiaries. In addition, the notes and the guarantees are senior in right of payment to any of Leap’s, Cricket’s and the guarantors’ future subordinated indebtedness.

 

Prior to November 1, 2009, Cricket may redeem up to 35% of the aggregate principal amount of the notes at a redemption price of 109.375% of the principal amount thereof, plus accrued and unpaid interest and additional interest, if any, thereon to the redemption date, from the net cash proceeds of specified equity offerings. Prior to November 1, 2010, Cricket may redeem the notes, in whole or in part, at a redemption price equal to 100% of the principal amount thereof plus the applicable premium and any accrued and unpaid interest. The applicable premium is calculated as the greater of (i) 1.0% of the principal amount of such notes and (ii) the excess of (a) the present value at such date of redemption of (1) the redemption price of such notes at November 1, 2010 plus (2) all remaining required interest payments due on such notes through November 1, 2010 (excluding accrued but unpaid

interest to the date of redemption), computed using a discount rate equal to the Treasury Rate plus 50 basis points, over (b) the principal amount of such notes. The notes may be redeemed, in whole or in part, at any time on or after November 1, 2010, at a redemption price of 104.688% and 102.344% of the principal amount thereof if redeemed during the twelve months ending October 31, 2011 and 2012, respectively, or at 100% of the principal amount if redeemed during the twelve months ending October 31, 2013 or thereafter, plus accrued and unpaid interest. If a “change of control” (as defined in the indenture governing the notes) occurs, each holder of the notes may require Cricket to repurchase all of such holder’s notes at a purchase price equal to 101% of the principal amount of the notes, plus accrued and unpaid interest.

 

The indenture governing the notes limits, among other things, Leap’s, Cricket’s and the guarantors’ ability to: incur additional debt; create liens or other encumbrances; place limitations on distributions from restricted subsidiaries; pay dividends; make investments; prepay subordinated indebtedness or make other restricted payments; issue or sell capital stock of restricted subsidiaries; issue guarantees; sell assets; enter into transactions with its affiliates; and make acquisitions or merge or consolidate with another entity.

 

Affiliates of Highland Capital Management, L.P. (a beneficial stockholder of Leap and an affiliate of James D. Dondero, a director of Leap) purchased an aggregate of $25.0 million principal amount of senior notes in the Company’s offering.

 

LCW Operations Senior Secured Credit Agreement

 

In October 2006, LCW Operations entered into a senior secured credit agreement consisting of two term loans for $40 million in the aggregate. The loans bear interest at LIBOR plus the applicable margin ranging from 2.70% to 6.33%. The obligations under the loans are guaranteed by LCW Wireless and LCW Wireless License, LLC, a wholly owned subsidiary of LCW Operations (and are non-recourse to Leap, Cricket and their other subsidiaries). Outstanding borrowings under the term loans must be repaid in varying quarterly installments starting in June 2008, with an aggregate final payment of $24.5 million due in June 2011. Under the senior secured credit agreement, LCW Operations and the guarantors are subject to certain limitations, including limitations on their ability to: incur additional debt or sell assets; make certain investments; grant liens; pay dividends; and make certain other restricted payments. In addition, LCW Operations will be required to pay down the facilities under certain circumstances if it or the guarantors issue debt, sell assets or generate excess cash flow. The senior secured credit agreement requires that LCW Operations and the guarantors comply with financial covenants related to earnings before interest, taxes, depreciation and amortization, gross additions of subscribers, minimum cash and cash equivalents and maximum capital expenditures, among other things.

 

As used in this report, the terms “we,” “our,” “ours,” and “us” refer to Leap Wireless International, Inc., a Delaware corporation, and its wholly owned subsidiaries, unless the context suggests otherwise. “Leap” refers to Leap Wireless International, Inc., and “Cricket” refers to Cricket Communications, Inc. Unless otherwise specified, information relating to population and potential customers, or POPs, is based on 2006 population estimates provided by Claritas Inc.

 

The following information should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in Item 1 of this Quarterly Report and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2005 filed with the Securities and Exchange Commission on March 27, 2006.

 

Except for the historical information contained herein, this report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements reflect management’s current forecast of certain aspects of our future. You can identify most forward-looking statements by forward-looking words such as “believe,” “think,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should,” “would” and similar expressions in this report. Such statements are based on currently available operating, financial and competitive information and are subject to various risks, uncertainties and assumptions that could cause actual results to differ materially from those anticipated or implied in our forward-looking statements. Such risks, uncertainties and assumptions include, among other things:

 

 

All forward-looking statements in this report should be considered in the context of these risk factors. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. Accordingly, users of this report are cautioned not to place undue reliance on the forward-looking statements.

 

Overview

 

Our Business.  We are a communications carrier that offers digital wireless service in the United States of America under the “Cricket^®” and “Jump^tm Mobile” brands. Our Cricket service offers customers unlimited wireless service in their Cricket service area for a flat monthly rate without requiring a fixed-term contract or credit check, and our new Jump Mobile service offers customers a per-minute prepaid service. Cricket and Jump Mobile services are also offered in certain markets by Alaska Native Broadband 1 License, LLC, or ANB 1 License, and by LCW Wireless Operations, LLC, or LCW Operations, both of which are designated entities. Cricket owns an indirect 75% non-controlling interest in ANB 1 License through a 75% non-controlling interest in Alaska Native

Broadband 1 LLC, or ANB 1, and an indirect 72% non-controlling interest in LCW Operations through a 72% non-controlling interest in LCW Wireless, LLC, or LCW Wireless. In May 2006, Cricket acquired a non-controlling interest in Denali Spectrum, LLC, or Denali, which participated in Auction #66 as a designated entity through its wholly owned subsidiary, Denali Spectrum License, LLC, or Denali License. Cricket currently holds an 82.5% non-controlling interest in Denali.

 

At September 30, 2006, Cricket and Jump Mobile services were offered in 21 states in the U.S.A. and had approximately 1,967,000 customers. As of September 30, 2006, we, ANB 1 License and LCW Wireless owned wireless licenses covering a total of 70.4 million potential customers, or POPs, in the aggregate, and our networks in our operating markets covered approximately 39.7 million POPs. In October 2006, LCW Wireless transferred its wireless licenses to LCW Wireless License, LLC, or LCW License, a wholly owned subsidiary of LCW Operations. We are currently building out and launching the new markets that we, ANB 1 License and LCW License have acquired or expect to acquire, and we anticipate that our combined network footprint will cover approximately 50 million POPs by mid 2007.

 

In addition, we participated as a bidder in Auction #66, both directly through a wholly owned subsidiary and as an investor in Denali License. In Auction #66, our wholly owned subsidiary was the winning bidder for 99 wireless licenses with an aggregate purchase price of $710.2 million and covering 121.2 million POPs (adjusted to eliminate duplication among certain overlapping licenses won by it in Auction #66), and Denali License was the winning bidder for one wireless license with a net purchase price of $274.1 million and covering 59.3 million POPs (which includes markets covering 5.7 million POPs which overlap with certain licenses won by our wholly owned subsidiary in Auction #66). We anticipate that these licenses will provide the opportunity to substantially enhance our coverage area and allow us and Denali License to launch Cricket service in numerous new markets in multiple construction phases over time. Moreover, the licenses for which we were the winning bidder, together with licenses we currently own, provide 20MHz coverage and the opportunity to offer enhanced data services in almost all markets that we currently operate or are building out. If Denali License were to make available to us certain spectrum for which it was the winning bidder in Auction #66, we would have 20MHz coverage in all markets in which we currently operate or are building out. The post-Auction grants of these licenses remain subject to FCC approval, and we cannot assure you that the FCC will award these licenses to us or Denali License. Assuming the FCC approves the post-Auction grants of these licenses, our spectrum portfolio, together with that of ANB 1 License, LCW License and Denali License (all of which entities or their affiliates currently offer or are expected to offer Cricket service), will consist of approximately 181.7 million POPs (adjusted to eliminate duplication of overlapping licenses among these entities).

 

Our premium Cricket service plan, which is our most popular service plan, offers customers unlimited local and domestic long distance service from their Cricket service area combined with unlimited use of multiple calling features and messaging services, generally for a flat rate of $45 per month. We also offer a basic service plan which allows customers to make unlimited calls within their Cricket service area and receive unlimited calls from any area, generally for $35 per month, and an intermediate service plan which also includes unlimited long distance service, generally for $40 per month. In 2005, we launched our first per-minute prepaid service, Jump Mobile, to bring Cricket’s attractive value proposition to customers who prefer active control over their wireless usage and to better target the urban youth market. During the last two years, we have added instant messaging, multimedia (picture) messaging, games and our “Travel Time^tm” roaming option to our product portfolio. In 2006, we broadened and expect to continue to broaden our data product and service offerings to better meet the needs of our customers.

 

We believe that our business model can be expanded successfully into adjacent and new markets because we offer a differentiated service and attractive value proposition to our customers at costs significantly lower than most of our competitors. For example:

 

 

 

We continue to seek additional opportunities to enhance our current market clusters and expand into new geographic markets by participating in FCC spectrum auctions (including the recently concluded Auction #66), by acquiring spectrum and related assets from third parties, or by participating in new partnerships or joint ventures.

 

Any large scale construction projects for the build-out of our new markets will require significant capital expenditures and may suffer cost overruns. In addition, we will experience higher operating expenses as we build out and after we launch our service in new markets. Any significant capital expenditures or increased operating expenses, including in connection with the build-out and launch of markets for any licenses that we and Denali License acquire in Auction #66, would negatively impact our earnings, operating income before depreciation and amortization, or OIBDA, and free cash flow for the periods in which we incur such capital expenditures and increased operating expenses.

 

Of the wireless licenses for which we and Denali License were named the winning bidders in Auction #66, licenses covering approximately 64.3 million POPs constitute additional overlay spectrum where we, ANB 1 License or LCW License already have existing licenses. Of the Auction #66 licenses for which we and Denali License were named the winning bidders that are located in new markets, we expect that we and Denali License (which we expect will offer Cricket service) will build-out markets located within these licenses for Cricket service in multiple construction phases over time. We currently expect that the first phase of construction for Auction #66 licenses that we and Denali License intend to build out will include networks covering approximately 24 million POPs. We currently expect that the aggregate capital expenditures for this first phase of construction will be less than $28.00 per covered POP. We also currently expect that the build-outs for this first phase of construction will commence in 2007 and will be substantially completed by the end of 2009. We generally build-out our Cricket networks in local population centers of metropolitan communities serving the areas where our customers live, work and play. Some of the Auction #66 licenses for which we and Denali License were named the winning bidders include large regional areas covering both rural and metropolitan communities. Based on our preliminary analysis of the Auction #66 licenses for which we and Denali License were named the winning bidders that are located in new markets, we believe that a significant portion of the POPs included within such new licenses may not be well-suited for Cricket service. Therefore, among other things, we may seek to partner with others, sell spectrum or pursue alternative products or services to utilize or benefit from the spectrum not otherwise used for Cricket service.

Our principal sources of liquidity are our existing unrestricted cash, cash equivalents and short-term investments, cash generated from operations, and cash available from borrowings under our $200 million revolving credit facility (which was undrawn at September 30, 2006). From time to time, we may also generate additional liquidity through the sale of assets that are not material to or are not required for the ongoing operation of our business. See “Liquidity and Capital Resources” below.

 

Results of Operations

 

Operating Items

 

The following tables summarize operating data for the Company’s consolidated operations (in thousands, except percentages):

 

 

 

The following tables summarize customer activity:

 

 

 

Three and Nine Months Ended September 30, 2006 Compared to Three and Nine Months Ended
September 30, 2005

 

Service revenues increased $55.4 million, or 28.6%, for the three months ended September 30, 2006 compared to the corresponding period of the prior year. This increase resulted from the 16.5% increase in average total customers and a 10.4% increase in average monthly revenues per customer. The increase in average revenues per customer was due primarily to the continued increase in customer adoption of our higher-end service plans.

 

Service revenues increased $126.3 million, or 22.2%, for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. This increase resulted from the 11.9% increase in average total customers and a 9.1% increase in average monthly revenues per customer. The increase in average revenues per customer was due primarily to the continued increase in customer adoption of our higher-end service plans.

 

Equipment revenues increased $1.6 million, or 4.3%, for the three months ended September 30, 2006 compared to the corresponding period of the prior year. An increase of 63.6% in handset sales volume was largely

offset by lower net revenue per handset sold as a result of bundling the first month of service with the initial handset price and eliminating activation fees for new customers purchasing equipment.

 

Equipment revenues increased $10.0 million, or 8.6%, for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. An increase of 44.5% in handset sales volume was largely offset by lower net revenue per handset sold as a result of bundling the first month of service with the initial handset price and eliminating activation fees for new customers purchasing equipment.

 

Cost of service increased $20.4 million, or 40.6%, for the three months ended September 30, 2006 compared to the corresponding period of the prior year. As a percentage of service revenues, cost of service increased to 28.4% from 26.0% in the prior year period. Network infrastructure costs increased by 2.1% of service revenues due primarily to lease costs and network transport costs associated with our new markets. Variable product costs increased by 0.4% of service revenues due to increased customer usage of our value-added services.

 

Cost of service increased $36.1 million, or 24.0%, for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. As a percentage of service revenues, cost of service increased to 26.8% from 26.4% in the prior year period. Variable product costs increased by 0.5% of service revenues due to increased customer usage of our value-added services.

 

Cost of equipment increased $19.0 million, or 38.4%, for the three months ended September 30, 2006 compared to the corresponding period of the prior year. This increase was primarily attributable to the 63.6% increase in handset sales volumes, partially offset by reductions in costs to support our handset replacement programs for existing customers.

 

Cost of equipment increased $38.0 million, or 26.9%, for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. This increase was primarily attributable to the 44.5% increase in handset sales volumes, partially offset by reductions in costs to support our handset replacement programs for existing customers.

 

Selling and marketing expenses increased $17.4 million, or 68.2%, for the three months ended September 30, 2006 compared to the corresponding period of the prior year. As a percentage of service revenues, such expenses increased to 17.2% from 13.2% in the prior year period. This increase was primarily due to increases in media and advertising costs and labor and related costs of 2.6% and 0.7% of service revenues, respectively, both of which were attributable to our new market launches. In addition, facility and other costs increased by 0.7% of service revenues due to the increase in infrastructure to support our new market launches.

 

Selling and marketing expenses increased $34.7 million, or 47.2%, for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. As a percentage of service revenues, such expenses increased to 15.5% from 12.9% in the prior year period. This increase was primarily due to increases in media and advertising costs and labor and related costs of 1.8% and 0.5% of service revenues, respectively, both of which were attributable to our new market launches.

 

General and administrative expenses increased $7.8 million, or 18.9%, for the three months ended September 30, 2006 compared to the corresponding period of the prior year. As a percentage of service revenues, such expenses decreased to 19.7% from 21.3% in the prior year period. Customer care expenses decreased by 2.1% of service revenues due to decreases in call center and other customer care-related program costs. Professional services fees decreased by 1.1% of service revenues due largely to incremental costs incurred in the prior year period related to Sarbanes-Oxley Section 404 compliance, and other expenses decreased by 0.8% of service revenues due to the increase in service revenues and consequent benefits in scale. Partially offsetting these decreases was an increase in labor and related costs of 2.6% of service revenues due primarily to new employee additions necessary to support our growth and the adoption of SFAS 123R in 2006.

 

General and administrative expenses increased $25.5 million, or 21.3%, for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. As a percentage of service revenues, such expenses decreased to 20.9% from 21.0% in the prior year period. Customer care expenses decreased by 1.7% of service revenues due to reductions in call center and other customer care-related program costs, and professional services fees and other expenses decreased by 0.6% of service revenues in the aggregate due to the increase in

service revenues and consequent benefits in scale. Offsetting these decreases was an increase in labor and related costs of 2.2% of service revenues due primarily to new employee additions necessary to support our growth and the adoption of SFAS 123R in 2006.

 

Depreciation and amortization expense increased $7.3 million, or 14.9%, and $19.3 million, or 13.4%, for the three and nine months ended September 30, 2006, respectively, compared to the corresponding periods of the prior year. The increases in the dollar amounts of depreciation and amortization expense were due primarily to the build-out of our new markets and the upgrade of network assets in our other markets. As a percentage of service revenues, such expenses decreased slightly as compared to prior year periods.

 

As a result of our annual impairment tests of wireless licenses, we recorded impairment charges of $4.7 million and $0.7 million during the three months ended September 30, 2006 and 2005, respectively, to reduce the carrying values of certain non-operating wireless licenses to their estimated fair market values. In addition, during the second quarters of 2006 and 2005, we recorded impairment charges of $3.2 million and $11.4 million, respectively, in connection with agreements to sell certain non-operating wireless licenses. We adjusted the carrying values of those licenses to their estimated fair values, which were based on the agreed upon sales prices.

 

During the three months ended September 30, 2006, we completed the sale of our wireless licenses and operating assets in the Toledo and Sandusky, Ohio markets in exchange for $28.0 million and an equity interest in LCW Wireless, resulting in a gain of $21.5 million. In addition, we completed the exchange of our wireless license in Grand Rapids, Michigan for a wireless license in Rochester, New York, resulting in a gain of $0.4 million during the same period. During the three months ended September 30, 2005, we completed the sale of 23 wireless licenses and substantially all of our operating assets in our Michigan markets for $102.5 million, resulting in a gain of $14.6 million.

 

Non-Operating Items

 

The following tables summarize non-operating data for the Company’s consolidated operations (in thousands).

 

 

 

Three and Nine Months Ended September 30, 2006 Compared to Three and Nine Months Ended September 30, 2005

 

Interest income increased $2.5 million and $9.1 million for the three and nine months ended September 30, 2006, respectively, compared to the corresponding periods of the prior year. These increases were primarily due to increases in the average cash and cash equivalents and investment balances resulting primarily from increased cash flows from operations and financing activities.

 

Interest expense increased $9.1 million and $8.2 million for the three and nine months ended September 30, 2006, respectively, compared to the corresponding periods of the prior year. The increases in interest expense

resulted primarily from the increase in the amount of the term loan under our amended and restated senior secured credit agreement (see “— Liquidity and Capital Resources” below), partially offset by the capitalization of $3.4 million and $12.3 million of interest during the three and nine months ended September 30, 2006, respectively. We capitalize interest costs associated with our wireless licenses and property and equipment during the build-out of new markets. The amount of such capitalized interest depends on the carrying values of the licenses and property and equipment involved in those markets and the duration of the build-out. We expect capitalized interest to continue to be significant during the build-out of our planned new markets in the fourth quarter of 2006. At September 30, 2006, the effective interest rate on our $900 million term loan was 7.8%, including the effect of interest rate swaps described below. We expect that interest expense will continue to increase due to our new unsecured senior notes. See “Liquidity and Capital Resources” below.

 

Other income, net of other expenses, decreased by $2.1 million and $6.1 million for the three and nine months ended September 30, 2006, respectively, compared to the corresponding periods of the prior year. During the second quarter of 2006, we wrote off $5.6 million of unamortized deferred debt issuance costs related to our previous credit agreement as a result of the repayment of the term loans and replacement of the revolving credit facility under the previous credit agreement.

 

During the three and nine months ended September 30, 2006, we recorded an income tax benefit of $3.1 million compared to income tax expense of $10.9 million and $17.8 million for the three and nine months ended September 30, 2005, respectively. Ordinary income tax expense for the full year 2006, which excludes the effect of unusual or infrequently occurring (or discrete) items, is projected to consist primarily of the deferred tax effect of the amortization of wireless licenses and tax goodwill for income tax purposes. We do not expect to release fresh-start related valuation allowances in fiscal 2006. Our estimated annual effective tax rate for 2006 is negative. Therefore, no income tax expense or benefit has been recorded relative to ordinary income or loss during the first three quarters of 2006, since the application of the negative annual tax rate to year-to-date pre-tax ordinary income would result in a tax benefit in these periods that would be reversed in a subsequent quarter. However, several discrete items resulted in an income tax benefit in the third quarter of 2006. In conjunction with the July 2006 contribution of the assets associated with our Eugene and Salem, Oregon markets to LCW Wireless, we transferred wireless licenses with a $3.3 million deferred tax liability and other assets with a $1.8 million deferred tax asset. As a result of the transfer, the net $1.5 million deferred tax liability has been reported as a book-tax basis difference in our investment in LCW Wireless. Because this deferred tax liability will not reverse until some indefinite future period and cannot be considered a source of taxable income to support the realization of our deferred tax assets, it has been recorded as a discrete income tax expense in the third quarter. The $3.3 million reduction in the deferred tax liability on our wireless licenses contributed to LCW Wireless has been recorded as a discrete income tax benefit in the third quarter of 2006. In addition, the impairment charge on certain of our wireless licenses resulted in a $1.4 million reduction in our wireless license deferred tax liability that has been recorded as a discrete income tax benefit in the third quarter. We expect to pay only minimal cash taxes for fiscal 2006.

 

During the three and nine months ended September 30, 2005, we recorded income tax expense at an effective tax rate of 39.9% and 41.5%, respectively. Despite the fact that we recorded a full valuation allowance on our deferred tax assets, we recognized income tax expense for the three and nine months ended September 30, 2005 because the release of the valuation allowance associated with the reversal of deferred tax assets recorded in fresh-start reporting is recorded as a reduction of goodwill rather than as a reduction of income tax expense. The effective tax rates for the three and nine months ended September 30, 2005 were higher than the statutory tax rate due primarily to permanent items not deductible for tax purposes.

 

Net income for the three months ended September 30, 2006 was $10.0 million, or $0.16 per diluted share, compared to net income of $16.4 million, or $0.27 per diluted share, for the three months ended September 30, 2005. Absent the $21.5 million net gain we recognized as a result of the sale of wireless licenses and operating assets in Toledo and Sandusky, Ohio in July 2006, we would have recorded a net loss of approximately $11.6 million for the three months ended September 30, 2006. Net income for the nine months ended September 30, 2006 was $35.2 million, or $0.57 per diluted share, compared to net income of $25.0 million, or $0.41 per diluted share, for the nine months ended September 30, 2005. We expect net income to decrease in the fourth quarter of fiscal 2006, and we expect to realize a net loss for the full year 2006, due mainly to our new market launches and expenses associated with our new debt.

Performance Measures

 

In managing our business and assessing our financial performance, management supplements the information provided by financial statement measures with several customer-focused performance metrics that are widely used in the telecommunications industry. These metrics include average revenue per user per month (ARPU), which measures service revenue per customer; cost per gross customer addition (CPGA), which measures the average cost of acquiring a new customer; cash costs per user per month (CCU), which measures the non-selling cash cost of operating our business on a per customer basis; and churn, which measures turnover in our customer base. CPGA and CCU are non-GAAP financial measures. A non-GAAP financial measure, within the meaning of Item 10 of Regulation S-K promulgated by the SEC, is a numerical measure of a company’s financial performance or cash flows that (a) excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with generally accepted accounting principles in the consolidated balance sheet, consolidated statement of operations or consolidated statement of cash flows; or (b) includes amounts, or is subject to adjustments that have the effect of including amounts, that are excluded from the most directly comparable measure so calculated and presented. See “Reconciliation of Non-GAAP Financial Measures” below for a reconciliation of CPGA and CCU to the most directly comparable GAAP financial measures.

 

ARPU is service revenue divided by the weighted-average number of customers, divided by the number of months during the period being measured. Management uses ARPU to identify average revenue per customer, to track changes in average customer revenues over time, to help evaluate how changes in our business, including changes in our service offerings and fees, affect average revenue per customer, and to forecast future service revenue. In addition, ARPU provides management with a useful measure to compare our subscriber revenue to that of other wireless communications providers. We believe investors use ARPU primarily as a tool to track changes in our average revenue per customer and to compare our per customer service revenues to those of other wireless communications providers. Other companies may calculate this measure differently.

 

CPGA is selling and marketing costs (excluding applicable share-based compensation expense included in selling and marketing expense), and equipment subsidy (generally defined as cost of equipment less equipment revenue), less the net loss on equipment transactions unrelated to initial customer acquisition, divided by the total number of gross new customer additions during the period being measured. The net loss on equipment transactions unrelated to initial customer acquisition includes the revenues and costs associated with the sale of handsets to existing customers as well as costs associated with handset replacements and repairs (other than warranty costs which are the responsibility of the handset manufacturers). We deduct customers who do not pay their first monthly bill from our gross customer additions, which tends to increase CPGA because we incur the costs associated with this customer without receiving the benefit of a gross customer addition. Management uses CPGA to measure the efficiency of our customer acquisition efforts, to track changes in our average cost of acquiring new subscribers over time, and to help evaluate how changes in our sales and distribution strategies affect the cost-efficiency of our customer acquisition efforts. In addition, CPGA provides management with a useful measure to compare our per customer acquisition costs with those of other wireless communications providers. We believe investors use CPGA primarily as a tool to track changes in our average cost of acquiring new customers and to compare our per customer acquisition costs to those of other wireless communications providers. Other companies may calculate this measure differently.

 

CCU is cost of service and general and administrative costs (excluding applicable share-based compensation expense included in cost of service and general and administrative expense) plus net loss on equipment transactions unrelated to initial customer acquisition (which includes the gain or loss on sale of handsets to existing customers and costs associated with handset replacements and repairs (other than warranty costs which are the responsibility of the handset manufacturers)), divided by the weighted-average number of customers, divided by the number of months during the period being measured. CCU does not include any depreciation and amortization expense. Management uses CCU as a tool to evaluate the non-selling cash expenses associated with ongoing business operations on a per customer basis, to track changes in these non-selling cash costs over time, and to help evaluate how changes in our business operations affect non-selling cash costs per customer. In addition, CCU provides management with a useful measure to compare our non-selling cash costs per customer with those of other wireless communications providers. We believe investors use CCU primarily as a tool to track changes in our non-selling

cash costs over time and to compare our non-selling cash costs to those of other wireless communications providers. Other companies may calculate this measure differently.

 

Churn, which measures customer turnover, is calculated as the net number of customers that disconnect from our service divided by the weighted-average number of customers divided by the number of months during the period being measured. Customers who do not pay their first monthly bill are deducted from our gross customer additions in the month that they are disconnected; as a result, these customers are not included in churn. Management uses churn to measure our retention of customers, to measure changes in customer retention over time, and to help evaluate how changes in our business affect customer retention. In addition, churn provides management with a useful measure to compare our customer turnover activity to that of other wireless communications providers. We believe investors use churn primarily as a tool to track changes in our customer retention over time and to compare our customer retention to that of other wireless communications providers. Other companies may calculate this measure differently.

 

The following table shows metric information for the three months ended September 30, 2006 and 2005:

 

 

Reconciliation of Non-GAAP Financial Measures

 

We utilize certain financial measures, as described above, that are widely used in the industry but that are not calculated based on GAAP. Certain of these financial measures are considered “non-GAAP” financial measures within the meaning of Item 10 of Regulation S-K promulgated by the SEC.

 

CPGA — The following table reconciles total costs used in the calculation of CPGA to selling and marketing expense, which we consider to be the most directly comparable GAAP financial measure to CPGA (in thousands, except gross customer additions and CPGA):