##### 



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-K
 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 FOR THE YEAR ENDED DECEMBER 31, 2005
 Commission
File Number: 0-24061
 US LEC CORP.
  DELAWARE
    
    56-2065535(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer
Identification No.)
 MORROCROFT III, 6801 MORRISON BOULEVARD
    
    28211CHARLOTTE, NORTH CAROLINA
    
    (Zip Code)(Address of principal executive offices)
   Securities registered pursuant to Section 12(g) of the Act: Class A Common Stock, par value
$.01 per share.
 o þ
 o þ
 þ o
 o
  o o þ
 o þ
   DOCUMENTS INCORPORATED BY REFERENCE




---



##### 



US LEC CORP.
2005 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
 PagePART IItem 1:
    
    Business
    
    
    3Item 1A:
    
    Risk Factors
    
    
    12Item 2:
    
    Properties
    
    
    19Item 3:
    
    Legal Proceedings
    
    
    19PART IIItem 5:
    
    Market for Registrants Common
Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
    
    
    20Item 6:
    
    Selected Financial Data
    
    
    21Item 7:
    
    Managements Discussion and
Analysis of Financial Condition and Results of Operations
    
    
    22Item 7A:
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    31Item 8:
    
    Financial Statements and Supplementary Data
    
    
    33Item 9A.
    
    Controls and Procedures
    
    
    53PART IIIItem 10:
    
    Directors and Executive Officers of the Registrant
    
    
    53Item 11:
    
    Executive Compensation
    
    
    53Item 12:
    
    Security Ownership of Certain
Beneficial Owners and Management and Related Stockholder Matters
    
    
    53Item 13:
    
    Certain Relationships and Related Transactions
    
    
    53Item 14:
    
    Principal Accountant Fees and Services
    
    
    53PART IVItem 15:
    
    Exhibits and Financial Statement Schedules
    
    
    54
 2




---



##### 



CAUTION REGARDING FORWARD-LOOKING STATEMENTS
   PART I
 ITEM 1. BUSINESS
  SM ®
   www.uslec.com
 3




---



##### 



BUSINESS STRATEGY
 US LECs Mission Statement:
  Offer a Broad Range of Next-Generation and Traditional Communications Services. SM SM ®
 Overlay the Existing Network to Support the Shift to IP-based Solutions.
 Maintain a Robust Technology Platform. ® ®
 Provide Outstanding Customer Service. SM SM
 Target Telecommunications-Intensive Customers.
 Focus of Operations.
 4




---



##### 



THE US LEC NETWORK
 ®
      SERVICES
  SM SM
 SM
   5




---



##### 



SM
 TM
  
    
    MPLS VPNis US LECs IP-based solution that allows customers to streamline their
telecommunications program by placing all applications on a single network. MPLS VPN
delivers all applications, including legacy voice and data services, while offering
Quality of Service (QoS) guarantees that ensure critical traffic such as voice,
video and CRM applications will receive priority queuing and delivery.
    
    Data Backup and Recoverysolutions provide businesses a state-of-the-art
online data backup and recovery solution over an encrypted Internet connection.
Two copies of the backup are stored in off-site, US LEC data vaults.
    
    Dynamic TSMSIPallows direct IP peering with IP PBXs utilizing
Session Initiated Protocol. Dynamic T SIP also allows for interconnection with
legacy TDM PBXs, providing a migration path to next-generation IP-based
communications.
    
    BIGVoiceSM allows Dynamic T customers to break through traditional T1
voice limitations, providing 24 concurrent phone calls over a single 1.5 MB T1 while
still delivering 1.5 MBs of dedicated Internet access.
    
    Ethernet Local Loopprovides a scalable and flexible Internet and data networking
solution that requires no special equipment. US LEC offers tiered bandwidth speeds
ranging from 3 Mbps to 500 Mbps with bursting available to handle heavy,
intermittent traffic.
    
    Dynamic TSMVoice and Mobility Pakadds universal messaging and
find-me features to US LECs VoIP-based service. These features give users the
flexibility to dictate inbound and outbound calling options including find-me,
follow-me calling, appearing in-office while traveling and call forwarding for
specific numbers.
    
    PowerSUITESM offers the first triple play solution of digital
video-on-demand (VOD), voice and high-speed Internet access through a single
carrier.
    
    BIGDataSM allows Dynamic T customers to utilize greater Internet and
data networking speeds, while utilizing VoIP service. BIGData is available in
bandwidth tiers from 4.5 Mbps to 45 Mbps that provide a scalable solution to meet
high-speed dedicated Internet and data networking needs.
 SALES AND MARKETING
 Sales.
 Marketing and Branding.
 6




---



##### 



Billing. SM
 EMPLOYEES
  REGULATION
  Overview.
 Federal Legislation.
  7




---



##### 



Federal Regulation and Related Proceedings.
  i.e.
 e.g.
     8




---



##### 



9




---



##### 



State Regulation.
   COMPETITION
  10




---



##### 



ILECs.
  Mega Mergers.
 Other CLECs.
 Internet Service Providers (ISPs).
 IXCs.
 VoIP Providers.
  Other Competitors.
 11




---



##### 



EXECUTIVE OFFICERS OF THE REGISTRANT
  Name
    
    Age
    
    PositionRichard T. Aab
    
    56
    
    Chairman of the BoardAaron D. Cowell, Jr.
    
    43
    
    Chief Executive Officer, President and DirectorJ. Lyle Patrick
    
    53
    
    Executive Vice President and Chief Financial Officer
 Richard T. Aab, Chairman of the Board,
 Aaron D. Cowell, Jr., President, Chief Executive Officer and Director,
 J. Lyle Patrick, Executive Vice President and Chief Financial Officer
 ITEM 1A. RISK FACTORS
 In addition to the risks described below, you should consider carefully the information
contained in Item 1, BusinessRegulation and the discussion in Note 7 to our consolidated
financial statements.
 The Companys continued success depends on the ability to manage and expand operations
effectively.
  
    
    offer high-quality, reliable services at reasonable costs;
    
    install and operate telecommunications switches and related equipment;
    
    lease access to suitable transmission facilities at competitive prices;
    
    scale operations;
    
    obtain successful outcomes in disputes and in litigation, rule-making, legislation and
regulatory proceedings;
 12




---



##### 




    
    successfully negotiate, adopt or arbitrate interconnection agreements with other carriers;
    
    acquire necessary equipment, software and facilities;
    
    integrate existing and newly acquired technology and facilities, such as switches and
related equipment;
    
    evaluate markets;
    
    add products;
    
    monitor operations;
    
    control costs;
    
    maintain effective quality controls;
    
    hire, train and retain qualified personnel;
    
    enhance operating and accounting systems;
    
    address operating challenges; adapt to market and regulatory developments; and
    
    obtain and maintain required governmental authorizations.
   The Company will not be able to expand operations if capital is not available when it is
needed.
    If the Company makes acquisitions, it will incur additional risks that could be harmful to our
business.
  13




---



##### 




    
    difficulties assimilating acquired operations and personnel;
    
    potential disruptions of the Companys ongoing business;
    
    the diversion of resources and management time;
    
    the possibility that uniform standards, controls, procedures and policies may not be maintained;
    
    risks associated with entering new markets in which the Company has little or no experience;
    
    risks related to providing new services with which the Company has little experience;
    
    the potential impairment of relationships with employees or customers as a result of
changes in management;
    
    difficulties in evaluating the historical or future financial performance of the acquired business;
    
    integration of network equipment and operating support systems;
    
    brand awareness issues related to the acquired assets or customers; and
    
    prepayment of assumed liabilities from acquired companies.
  An inability to market and develop additional services may adversely affect the Companys
ability to retain existing customers or attract new customers.
  The Company faces intense competition that could adversely affect its business.
  
    
    long-distance carriers, or IXCs;
    
    incumbent local exchange carriers, or ILECs;
    
    other competitive local exchange carriers, or CLECs;
    
    competitive access providers, or CAPS;
    
    cable television companies;
    
    electric utilities;
    
    microwave carriers;
    
    wireless telephone system operators;
    
    private networks built by large end-users; and
    
    VoIP providers.
  14




---



##### 



The loss of key personnel could adversely affect the Companys operations and growth.
   A failure to manage processes and systems for ordering, provisioning and billing effectively,
or the failure of third parties to deliver these services on a timely and accurate basis, could
have a material adverse effect on the Companys ability to retain existing customers or to attract
and retain new customers.
  A failure to operate switches and other network equipment successfully could have a material
adverse effect on the Companys operations and the ability to attract and retain customers or to
enter additional markets.
  We and other industry participants are frequently involved in disputes over issues that are
important to our financial and operational success. Further legislation and regulatory rulemaking
is expected to occur as the industry continues to deregulate and as we enter new markets or offer
new products. Rulings or legislation adverse to us could have a material adverse effect on our
operations and financial well being.
  15




---



##### 



There are significant uncertainties about the future availability and pricing of unbundled
network elements and related elements from incumbent local exchange carriers.
    The FCC has undertaken a review of Special Access pricing which, if decided adversely to us,
could have an adverse impact on the prices we pay for components of our network.
  The outcome of pending rule-making proceedings addressing the proper framework for all
intercarrier compensation could have an adverse effect on our results of operations and cash flow.
 16




---



##### 



An adverse outcome in pending litigation with an IXC involving access charges, if ultimately
successful, could have a material adverse impact on our financial condition, results of operations
and cash flow.
  The inability to negotiate new interconnection agreements, or extensions or replacements of
existing interconnection agreements, on acceptable terms and conditions could adversely affect the
Companys results of operations.
  System disruptions could cause delays or interruptions of service, which could cause the
Company to lose customers.
  The interest expense associated with the Notes will reduce the cash available to fund our
operations, execute our growth strategy and repay the principal amount of the Notes.
  17




---



##### 




    
    increase our vulnerability to general adverse economic and industry conditions
and adverse changes in governmental regulations;
    
    limit our flexibility to plan for, and react to, changes in our business;
    
    limit our ability to borrow additional funds; and
    
    limit our ability to accumulate cash to satisfy our obligations to repay the
outstanding principal amount of the Notes in 2009.
  The indenture relating to the Notes and the loan and security agreement relating to our
Revolving Facility contain restrictive covenants that may limit the Companys flexibility, and a
breach of any of the covenants may cause the Company to be in default under either or both of these
instruments.
  
    
    incurring additional debt;
    
    paying dividends;
    
    making investments or other restricted payments;
    
    engaging in sale-leaseback transactions;
    
    engaging in transactions with stockholders and affiliates;
    
    guaranteeing debts;
    
    creating liens;
    
    selling assets;
    
    issuing or selling capital stock of subsidiaries; and
    
    engaging in mergers and acquisitions.
  We may not have the cash or access to alternative sources of financing to redeem our Series A
Convertible Preferred Stock (the Preferred Stock) in April of 2010.
  The interests of the holders of the Companys Preferred Stock may not be aligned with the
interests of the Companys common stockholders.
  18




---



##### 



ITEM 2. PROPERTIES
  ITEM 3. LEGAL PROCEEDINGS
  19




---



##### 



PART II
 ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
OF EQUITY SECURITIES
   Stock Price
 2004
    
    High
    
    
    LowFirst Quarter
    
    $
    8.09
    
    
    $
    5.75Second Quarter
    
    $
    6.05
    
    
    $
    3.69Third Quarter
    
    $
    4.79
    
    
    $
    3.01Fourth Quarter
    
    $
    3.83
    
    
    $
    3.00
 2005
    
    High
    
    
    LowFirst Quarter
    
    $
    3.18
    
    
    $
    2.54Second Quarter
    
    $
    2.73
    
    
    $
    2.04Third Quarter
    
    $
    2.51
    
    
    $
    1.81Fourth Quarter
    
    $
    2.05
    
    
    $
    1.52
 20




---



##### 



ITEM 6. SELECTED FINANCIAL DATA
   (Dollars in thousands, except per share data)2001
    
    
    2002
    
    
    2003
    
    
    2004
    
    
    2005Statement of Operations:Revenue
    
    $
    178,602
    
    
    $
    250,363
    
    
    $
    310,825
    
    
    $
    356,181
    
    
    $
    387,738Network Expenses
    
    
    90,298
    
    
    
    121,127
    
    
    
    148,699
    
    
    
    171,292
    
    
    
    186,924Depreciation and Amortization
    
    
    35,103
    
    
    
    45,062
    
    
    
    48,374
    
    
    
    49,851
    
    
    
    50,668Selling, General and Administrative (1)
    
    
    114,898
    
    
    
    112,878
    
    
    
    126,267
    
    
    
    139,231
    
    
    
    148,902Provision (Recovery) for Doubtful Accounts Related to WorldCom (1)
    
    
    
    
    
    
    9,500
    
    
    
    (5,867
    )
    
    
    
    
    
    
    Provision (Recovery) for Disputed Receivables (2)
    
    
    (7,042
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Charge Related to Carrier Access Disputes (1)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,292Loss from Operations
    
    
    (54,655
    )
    
    
    (38,204
    )
    
    
    (6,648
    )
    
    
    (4,193
    )
    
    
    (22,048
    )Charges Related to Early Extinguishment of Debt (3)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,416
    )
    
    
    Other Income
    
    
    
    
    
    
    
    
    
    
    267
    
    
    
    
    
    
    
    202Net Interest
Expense
    
    
    (8,699
    )
    
    
    (7,688
    )
    
    
    (8,159
    )
    
    
    (11,153
    )
    
    
    (16,802
    )Net Loss
    
    
    (63,354
    )
    
    
    (45,892
    )
    
    
    (14,540
    )
    
    
    (19,762
    )
    
    
    (38,648
    )Less: Dividends on Preferred Stock
    
    
    12,810
    
    
    
    13,596
    
    
    
    14,431
    
    
    
    15,316
    
    
    
    16,256Accretion of Preferred Stock Issuance Cost
    
    
    491
    
    
    
    521
    
    
    
    553
    
    
    
    587
    
    
    
    623Net Loss Attributable to Common Stockholders
    
    $
    (76,655
    )
    
    $
    (60,009
    )
    
    $
    (29,524
    )
    
    $
    (35,665
    )
    
    $
    (55,527
    )Net Loss
Attributable to Common Shareholders Per ShareBasic
    
    $
    (2.83
    )
    
    $
    (2.26
    )
    
    $
    (1.08
    )
    
    $
    (1.19
    )
    
    $
    (1.83
    )Net Loss Attributable to Common Shareholders Per ShareDiluted
    
    $
    (2.83
    )
    
    $
    (2.26
    )
    
    $
    (1.08
    )
    
    $
    (1.19
    )
    
    $
    (1.83
    )Weighted Average Number of Shares OutstandingBasic
    
    
    27,108
    
    
    
    26,546
    
    
    
    27,392
    
    
    
    29,927
    
    
    
    30,399Weighted Average Number of Shares OutstandingDiluted
    
    
    27,108
    
    
    
    26,546
    
    
    
    27,392
    
    
    
    29,927
    
    
    
    30,399Other Financial Data:Cash Capital Expenditures
    
    $
    40,425
    
    
    $
    32,029
    
    
    $
    35,767
    
    
    $
    33,395
    
    
    $
    34,954Net Cash Flow Provided by (Used in) Operating Activities
    
    
    (5,971
    )
    
    
    (5,645
    )
    
    
    55,333
    
    
    
    25,219
    
    
    
    17,736Net Cash Flow Used in Investing Activities
    
    
    (40,425
    )
    
    
    (31,809
    )
    
    
    (42,202
    )
    
    
    (35,724
    )
    
    
    (34,638
    )Net Cash Flow Provided by (Used in) Financing Activities
    
    
    21,077
    
    
    
    (17,333
    )
    
    
    4,280
    
    
    
    15,611
    
    
    
    (626
    )Operating Data (4):Number of States Served with All Services (including Washington, DC)
    
    
    13
    
    
    
    14
    
    
    
    16
    
    
    
    16
    
    
    
    17Number of Local Switch Locations
    
    
    26
    
    
    
    26
    
    
    
    27
    
    
    
    27
    
    
    
    27Number of Business Class Customers
    
    
    6,823
    
    
    
    10,290
    
    
    
    16,814
    
    
    
    22,324
    
    
    
    26,225Number of Employees
    
    
    892
    
    
    
    911
    
    
    
    1,016
    
    
    
    1,065
    
    
    
    1,128Number of Sales and Sales Support Employees
    
    
    365
    
    
    
    367
    
    
    
    412
    
    
    
    460
    
    
    
    485Balance Sheet Data:Cash and Cash Equivalents
    
    $
    80,502
    
    
    $
    25,715
    
    
    $
    43,126
    
    
    $
    48,232
    
    
    $
    30,704Working Capital
    
    
    59,972
    
    
    
    26,620
    
    
    
    12,574
    
    
    
    32,605
    
    
    
    10,889Accounts Receivable, Net
    
    
    42,972
    
    
    
    57,989
    
    
    
    48,294
    
    
    
    60,745
    
    
    
    49,841Current Assets
    
    
    135,644
    
    
    
    96,030
    
    
    
    101,622
    
    
    
    119,721
    
    
    
    89,901Property and Equipment, Net
    
    
    188,436
    
    
    
    178,810
    
    
    
    165,793
    
    
    
    158,617
    
    
    
    144,350Total Assets
    
    
    333,313
    
    
    
    285,314
    
    
    
    285,299
    
    
    
    298,311
    
    
    
    252,352Long-Term Debt (including current portion)
    
    
    150,000
    
    
    
    130,617
    
    
    
    125,818
    
    
    
    149,288
    
    
    
    149,438Series A Redeemable Convertible Preferred Stock
    
    
    216,155
    
    
    
    230,272
    
    
    
    245,255
    
    
    
    261,158
    
    
    
    278,037Total Stockholders Deficiency
    
    $
    (97,325
    )
    
    $
    (153,991
    )
    
    $
    (171,161
    )
    
    $
    (205,304
    )
    
    $
    (260,014
    )
 
 (1)
    
    See Note 7 of the Companys consolidated financial statements
for the year ended December 31, 2002, 2003 and 2005. Normal and
recurring
provisions for doubtful accounts are included in selling, general and administrative expenses for all periods presented.(2)
    
    Included in the 2001 statement of operations is an amount approximating $7,042, representing a net recovery of a portion of the $40,000 provision
recorded in 2000 for disputed receivables and certain other related accruals related to BellSouth and Sprint.(3)
    
    See Note 5 of the Companys consolidated financial statements for the year ended December 31, 2004.(4)
    
    Amounts presented are as of the end of the period. 21




---



##### 



ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 Overview
 General. SM ®
  
    
    total revenue;
    
    end customer revenue in total and as a percentage of total revenue;
    
    customer retention;
    
    control of network expense, general and administrative expenses; and
    
    working capital management.
  Total and End Customer Revenue.
 (Dollars in millions)2005
    
    
    2004
    
    
    2003End Customer RevenueVoice Monthly Recurring Charges
    
    $
    159.2
    
    
    $
    143.4
    
    
    $
    121.3Data Monthly Recurring Charges
    
    
    120.8
    
    
    
    92.2
    
    
    
    46.9Long Distance
    
    
    50.8
    
    
    
    48.4
    
    
    
    43.1$
    330.8
    
    
    $
    284.0
    
    
    $
    211.3Percent of Total Revenue
    
    
    85
    %
    
    
    80
    %
    
    
    68
    %Inter-Carrier CompensationCarrier Access
    
    $
    35.0
    
    
    $
    50.3
    
    
    $
    78.9Reciprocal Compensation
    
    
    8.7
    
    
    
    10.6
    
    
    
    10.4$
    43.7
    
    
    $
    60.9
    
    
    $
    89.3Percent of Total Revenue
    
    
    11
    %
    
    
    17
    %
    
    
    29
    %Other Revenue
    
    $
    13.2
    
    
    $
    11.3
    
    
    $
    10.3Percent of Total Revenue
    
    
    3
    %
    
    
    3
    %
    
    
    3
    %Total Revenue
    
    $
    387.7
    
    
    $
    356.2
    
    
    $
    310.8
  22




---



##### 



Uncertainties That Could Adversely Affect Revenue.
    Customer Retention.
 Network Expense.
 23




---



##### 



Working Capital Management.
 Results of Operations
 Comparison of Year Ended December 31, 2005 to Year Ended December 31, 2004
 Revenue.
    Network Expenses.
 24




---



##### 



Depreciation and Amortization.
 Selling, General and Administrative Expenses .
  Charge Related to Carrier Access Disputes.
 Charges Related to the Early Extinguishment of Debt.
 Interest Income and Expense.
 Income Taxes.
 Net Loss.
 25




---



##### 



Comparison of Year Ended December 31, 2004 to Year Ended December 31, 2003
 Revenue.
   Network Expenses.
 Depreciation and Amortization.
 Selling, General and Administrative Expenses .
  Charges Related to the Early Extinguishment of Debt.
 26




---



##### 



Interest Income and Expense.
 Income Taxes.
 Net Loss.
 Liquidity and Capital Resources
     27




---



##### 



Payment Due by Period (in millions)Less than
    
    
    1-3
    
    
    3-5
    
    
    After 5Total
    
    
    1 year
    
    
    years
    
    
    years
    
    
    yearsContractual ObligationsLong-term debt (1)
    
    $
    150.0
    
    
    $
    
    
    
    $
    
    
    
    $
    150.0
    
    
    $
    Operating leases
    
    
    43.7
    
    
    
    8.8
    
    
    
    26.1
    
    
    
    5.8
    
    
    
    3.0Total contractual cash
obligations
    
    $
    193.7
    
    
    $
    8.8
    
    
    $
    26.1
    
    
    $
    155.8
    
    
    $
    3.0
 
 (1)
    
    Amount excludes interest which is payable semi-annually on the $150.0 million face
value of the Notes at an annual rate of six-month LIBOR plus 8.50% which is estimated to total
approximately $75.0 million over the remaining term of the Notes, assuming current interest
rates of 13.5% over the period. The discount on the Notes, totaling $0.75 million, is being
amortized to interest expense on the statement of operations through the maturity date of
October 1, 2009. There were no amounts outstanding under our $10.0 million Revolving Facility.      28




---



##### 



Critical Accounting Policies and Estimates
 Revenue Recognition
     Network
Expenses
 29




---



##### 



Provisions for Doubtful Accounts 
 Deferred Customer and Network Installation Costs 
  Impairment of Long-Lived Assets
 Stock Based Compensation
  30




---



##### 



2005
    
    2004
    
    2003Net loss, as reported
    
    $
    (38,648
    )
    
    $
    (19,762
    )
    
    $
    (14,540
    )Preferred dividends
    
    
    (16,256
    )
    
    
    (15,316
    )
    
    
    (14,431
    )Accretion of preferred stock issuance fees
    
    
    (623
    )
    
    
    (587
    )
    
    
    (553
    )Net loss attributable to common stockholders, as reported
    
    
    (55,527
    )
    
    
    (35,665
    )
    
    
    (29,524
    )Add: Stock-based employee compensation expense included
in reported net income
    
    
    
    
    
    
    
    
    
    
    Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards
    
    
    (1,823
    )
    
    
    (6,357
    )
    
    
    (8,174
    )Pro forma net loss
    
    $
    (57,350
    )
    
    $
    (42,022
    )
    
    $
    (37,698
    )Weighted average shares outstanding
    
    
    30,399
    
    
    
    29,927
    
    
    
    27,392Net loss per share:Basic and diluted, as reported
    
    $
    (1.83
    )
    
    $
    (1.19
    )
    
    $
    (1.08
    )Basic and diluted, pro forma
    
    $
    (1.89
    )
    
    $
    (1.40
    )
    
    $
    (1.38
    )
      ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  31




---



##### 



32




---



##### 



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
    
 33




---



##### 



US LEC Corp. and Subsidiaries
Consolidated Balance Sheets
(In Thousands)
 December 31,
    
    December 31,2005
    
    2004AssetsCurrent AssetsCash and cash equivalents
    
    $
    30,704
    
    
    $
    48,232Restricted cash
    
    
    67
    
    
    
    169Accounts receivable (net of allowance of $10,349 and $10,137
at December 31, 2005 and December 31, 2004, respectively)
    
    
    49,841
    
    
    
    60,745Prepaid expenses and other assets
    
    
    9,289
    
    
    
    10,575Total current assets
    
    
    89,901
    
    
    
    119,721Property and Equipment, Net
    
    
    144,350
    
    
    
    158,617Other Assets
    
    
    18,101
    
    
    
    19,973Total Assets
    
    $
    252,352
    
    
    $
    298,311Liabilities and StockholdersDeficiencyCurrent Liabilities
Accounts payable
    
    $
    9,125
    
    
    $
    13,593Notes payable
    
    
    
    
    
    
    980Accrued network costs
    
    
    20,252
    
    
    
    28,730Commissions payable
    
    
    984
    
    
    
    7,873Accrued expenses  other
    
    
    31,567
    
    
    
    20,860Deferred revenue
    
    
    14,292
    
    
    
    13,573Deferred income taxes
    
    
    2,792
    
    
    
    1,507Total current liabilities
    
    
    79,012
    
    
    
    87,116Long-Term Debt
    
    
    149,438
    
    
    
    149,288Other Liabilities
    
    
    5,879
    
    
    
    6,053Commitments and Contingencies (Note 7)Series A Mandatorily Redeemable Convertible Preferred Stock
(10,000 authorized shares, 281 and 265 shares issued with redemption
values of $281,167 and $264,911 at December 31, 2005 and 2004,
respectively) (Note 6)
    
    
    278,037
    
    
    
    261,158Stockholders DeficiencyCommon stock-Class A, $.01 par value (122,925 authorized shares, 30,751 and
30,283 shares outstanding at December 31, 2005 and December 31, 2004)
    
    
    307
    
    
    
    303Additional paid-in capital (Note 10)
    
    
    93,181
    
    
    
    92,368Retained deficit
    
    
    (353,502
    )
    
    
    (297,975
    )Total stockholders deficiency
    
    
    (260,014
    )
    
    
    (205,304
    )Total Liabilities and Stockholders Deficiency
    
    $
    252,352
    
    
    $
    298,311
 See notes to consolidated financial statements
 34




---



##### 



US LEC Corp. and Subsidiaries
Consolidated Statements of Operations
For the Years Ended December 31, 2005, 2004, and 2003
(In Thousands, Except Per Share Data)
 2005
    
    2004
    
    2003Revenue
    
    $
    387,738
    
    
    $
    356,181
    
    
    $
    310,825Network Expenses
    
    
    186,924
    
    
    
    171,292
    
    
    
    148,699Depreciation and Amortization
    
    
    50,668
    
    
    
    49,851
    
    
    
    48,374Selling, General and Administrative Expenses
    
    
    148,902
    
    
    
    139,231
    
    
    
    126,267Recovery of Doubtful Accounts related to WorldCom (Note 7)
    
    
    
    
    
    
    
    
    
    
    (5,867
    )Charge
Related to Carrier Access Disputes (Note 7)
    
    
    23,292
    
    
    
    
    
    
    
    Loss from Operations
    
    
    (22,048
    )
    
    
    (4,193
    )
    
    
    (6,648
    )Other (Income) ExpenseOther Income
    
    
    (202
    )
    
    
    
    
    
    
    (267
    )Charges Related to Early Extinguishment of Debt (Note 5)
    
    
    
    
    
    
    4,416
    
    
    
    Interest Income
    
    
    (1,003
    )
    
    
    (581
    )
    
    
    (418
    )Interest Expense (Note 6)
    
    
    17,805
    
    
    
    11,734
    
    
    
    8,577Net Loss
    
    
    (38,648
    )
    
    
    (19,762
    )
    
    
    (14,540
    )Less: Preferred Stock Dividends (Note 6)
    
    
    16,256
    
    
    
    15,316
    
    
    
    14,431Less: Accretion of Preferred Stock Issuance Cost (Note 6)
    
    
    623
    
    
    
    587
    
    
    
    553Net Loss Attributable to Common Stockholders
    
    $
    (55,527
    )
    
    $
    (35,665
    )
    
    $
    (29,524
    )Net Loss Attributable to Common Stockholders Per Common Share (Note 11):Basic and Diluted
    
    $
    (1.83
    )
    
    $
    (1.19
    )
    
    $
    (1.08
    )Weighted Average Number of Shares Outstanding (Note 11):Basic and Diluted
    
    
    30,399
    
    
    
    29,927
    
    
    
    27,392
 See notes to consolidated financial statements
 35




---



##### 



US LEC Corp. and Subsidiaries
Consolidated Statements of Cash Flows
(In Thousands)
 2005
    
    
    2004
    
    
    2003Operating ActivitiesNet loss
    
    $
    (38,648
    )
    
    $
    (19,762
    )
    
    $
    (14,540
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    50,668
    
    
    
    49,851
    
    
    
    48,374Charges related to early extinguishment of debt
    
    
    
    
    
    
    4,416
    
    
    
    Accretion of debt
    
    
    150
    
    
    
    509
    
    
    
    628Accretion of lease exit costs
    
    
    70
    
    
    
    73
    
    
    
    Other Income
    
    
    (45
    )
    
    
    118
    
    
    
    255Recovery for significant receivables, net
    
    
    
    
    
    
    
    
    
    
    (5,867)Charge related to carrier access disputes
    
    
    23,292
    
    
    
    
    
    
    
    Changes in assets and liabilities which provided (used) cash:Accounts receivable
    
    
    (12,260
    )
    
    
    (12,451
    )
    
    
    16,587Notes receivable
    
    
    (150
    )
    
    
    
    
    
    
    Prepaid expenses and other assets
    
    
    1,436
    
    
    
    202
    
    
    
    (1,677
    )Other assets
    
    
    (24
    )
    
    
    1,522
    
    
    
    384Accounts payable
    
    
    (289
    )
    
    
    2,712
    
    
    
    (1,442
    )Deferred revenue
    
    
    718
    
    
    
    (473
    )
    
    
    1,165Accrued network costs
    
    
    (8,452
    )
    
    
    3,642
    
    
    
    (1,864
    )Customer commissions payable
    
    
    (4,288
    )
    
    
    (7,586
    )
    
    
    10,695Other liabilities  noncurrent
    
    
    (392
    )
    
    
    (881
    )
    
    
    (352
    )Accrued expenses  other
    
    
    5,950
    
    
    
    3,327
    
    
    
    2,987Total adjustments
    
    
    56,384
    
    
    
    44,981
    
    
    
    69,873Net cash provided by operating activities
    
    
    17,736
    
    
    
    25,219
    
    
    
    55,333Investing ActivitiesPurchase of property and equipment
    
    
    (34,954
    )
    
    
    (33,395
    )
    
    
    (35,767
    )Businesses and assets acquired
    
    
    (34
    )
    
    
    (2,321
    )
    
    
    (8,686
    )Proceeds from insurance claim
    
    
    202
    
    
    
    
    
    
    
    2,256Increase (decrease) in restricted cash
    
    
    148
    
    
    
    (8
    )
    
    
    (5
    )Net cash used in investing activities
    
    
    (34,638
    )
    
    
    (35,724
    )
    
    
    (42,202
    )Financing ActivitiesIssuance of common shares
    
    
    
    
    
    
    
    
    
    
    9,200Proceeds from exercise of stock options, warrants, and ESPP
    
    
    817
    
    
    
    1,458
    
    
    
    1,312Proceeds from issuance of subordinated notes and related warrants
    
    
    
    
    
    
    
    
    
    
    350Proceeds from long-term debt
    
    
    
    
    
    
    149,250
    
    
    
    Payments on long-term debt
    
    
    
    
    
    
    (128,330
    )
    
    
    (6,358
    )Payments on notes payable
    
    
    (980
    )
    
    
    (1,300
    )
    
    
    Payment for deferred loan fees
    
    
    (463
    )
    
    
    (5,467
    )
    
    
    (224
    )Net cash provided by (used in) financing activities
    
    
    (626
    )
    
    
    15,611
    
    
    
    4,280Net (Decrease) Increase in Cash and Cash Equivalents
    
    
    (17,528
    )
    
    
    5,106
    
    
    
    17,411Cash and Cash Equivalents, Beginning of Period
    
    
    48,232
    
    
    
    43,126
    
    
    
    25,715Cash and Cash Equivalents, End of Period
    
    $
    30,704
    
    
    $
    48,232
    
    
    $
    43,126Supplemental Cash Flow DisclosuresCash Paid for Interest
    
    $
    17,033
    
    
    $
    7,565
    
    
    $
    8,976Cash Paid for Income Taxes
    
    $
    
    
    
    $
    
    
    
    $
    Supplemental Noncash Investing and Financing Activities:At December 31, 2005, 2004, and 2003, $3,537, $7,677 and $1,767, respectively, of
property and equipment additions are included in outstanding accounts payable.During fiscal year 2003 the Company issued approximately 2,153 shares of common
stock in connection with a private placement offering and the acquisition of Fastnet.
 See notes to consolidated financials statements.
 36




---



##### 



US LEC Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF STOCKHOLDERS DEFICIENCY
For the years ended December 31, 2005, 2004 and 2003
(In Thousands)
 Common Stock
    
    Common Stock
    
    AdditionalClass A
    
    Class B
    
    Paid-In
    
    RetainedShares
    
    Amount
    
    Shares
    
    Amount
    
    Capital
    
    Deficit
    
    TotalBalance, December 31, 2002
    
    
    26,895
    
    
    $
    269
    
    
    
    
    
    
    $
    
    
    
    $
    78,526
    
    
    $
    (232,786
    )
    
    $
    (153,991
    )Exercise of stock options and warrants
    
    
    253
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    379
    
    
    
    
    
    
    
    381Issuance of ESPP Stock
    
    
    376
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    949
    
    
    
    
    
    
    
    953Private Placement of Class A Common Stock
    
    
    2,000
    
    
    
    20
    
    
    
    
    
    
    
    
    
    
    
    9,180
    
    
    
    
    
    
    
    9,200Shares Issued Related to Fastnet Acquisition
    
    
    153
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    998
    
    
    
    
    
    
    
    1,000Preferred Stock Dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,431
    )
    
    
    (14,431
    )Accretion of Preferred Stock Issuance Fees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (553
    )
    
    
    (553
    )Issuance of Warrants (Note 3)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    820
    
    
    
    
    
    
    
    820Net Loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,540
    )
    
    
    (14,540
    )Balance, December 31, 2003
    
    
    29,677
    
    
    $
    297
    
    
    
    
    
    
    $
    
    
    
    $
    90,852
    
    
    $
    (262,310
    )
    
    $
    (171,161
    )Exercise of stock options and warrants
    
    
    227
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    295
    
    
    
    
    
    
    
    297Issuance of ESPP Stock
    
    
    379
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    1,157
    
    
    
    
    
    
    
    1,161Private Placement of Class A Common Stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    64
    
    
    
    
    
    
    
    64Preferred Stock Dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (15,316
    )
    
    
    (15,316
    )Accretion of Preferred Stock Issuance Fees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (587
    )
    
    
    (587
    )Net Loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (19,762
    )
    
    
    (19,762
    )Balance, December 31, 2004
    
    
    30,283
    
    
    $
    303
    
    
    
    
    
    
    $
    
    
    
    $
    92,368
    
    
    $
    (297,975
    )
    
    $
    (205,304
    )Exercise of stock options
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    24
    
    
    
    
    
    
    
    24Issuance of ESPP Stock
    
    
    458
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    789
    
    
    
    
    
    
    
    793Preferred Stock Dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,256
    )
    
    
    (16,256
    )Accretion of Preferred Stock Issuance Fees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (623
    )
    
    
    (623
    )Net Loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (38,648
    )
    
    
    (38,648
    )Balance, December 31, 2005
    
    
    30,751
    
    
    $
    307
    
    
    
    
    
    
    $
    
    
    
    $
    93,181
    
    
    $
    (353,502
    )
    
    $
    (260,014
    )
 See notes to consolidated financial statements
 37




---



##### 



US LEC Corp. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 For the years ended December 31, 2005, 2004 and 2003
(In Thousands, Except Per Share Data)
 1. ORGANIZATION AND NATURE OF BUSINESS
   2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 Revenue Recognition
    Network
Expenses
 38




---



##### 



Cash and Cash Equivalents
 Restricted Cash
 Accounts Receivable
 Deferred Customer and Network Installation Costs 
  Property and Equipment
  Telecommunications switching and other equipment
    
    5  9 yearsOffice equipment, furniture and other
    
    5 yearsLeasehold improvements
    
    The lesser of the estimated
useful lives or the lease term
  39




---



##### 



Long-Lived Assets
 Intangible
Assets
 Debt Issuance Cost
 Fair Value of Financial Instruments
 Income Taxes
 Concentration of Risk
  Use of Estimates
 Advertising
 40




---



##### 



Stock Based Compensation
  2005
    
    2004
    
    2003Net loss, as reported
    
    $
    (38,648
    )
    
    $
    (19,762
    )
    
    $
    (14,540
    )Preferred dividends
    
    
    (16,256
    )
    
    
    (15,316
    )
    
    
    (14,431
    )Accretion of preferred stock issuance fees
    
    
    (623
    )
    
    
    (587
    )
    
    
    (553
    )Net loss attributable to common stockholders, as reported
    
    
    (55,527
    )
    
    
    (35,665
    )
    
    
    (29,524
    )Add: Stock-based employee compensation expense included
in reported net income
    
    
    
    
    
    
    
    
    
    
    Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards
    
    
    (1,823
    )
    
    
    (6,357
    )
    
    
    (8,174
    )Pro forma net loss
    
    $
    (57,350
    )
    
    $
    (42,022
    )
    
    $
    (37,698
    )Weighted average shares outstanding
    
    
    30,399
    
    
    
    29,927
    
    
    
    27,392Net loss per share:Basic and diluted, as reported
    
    $
    (1.83
    )
    
    $
    (1.19
    )
    
    $
    (1.08
    )Basic and diluted, pro forma
    
    $
    (1.89
    )
    
    $
    (1.40
    )
    
    $
    (1.38
    )
   Reclassifications
 Recent
Accounting Pronouncements
  41




---



##### 



3. ACQUISITIONS
  December 31,2004Current assets
    
    $
    980Current liabilities
    
    
    (696
    )Property and equipment
    
    
    96Identifiable intangible assets
    
    
    2,009$
    2,389
    42




---



##### 



4. PROPERTY AND EQUIPMENT
  2005
    
    
    2004
    
    
    2003Telecommunications and other equipment
    
    $
    257,710
    
    
    $
    234,524
    
    
    $
    204,072Office equipment, furniture and other
    
    
    101,596
    
    
    
    97,079
    
    
    
    91,084Leasehold improvements
    
    
    30,937
    
    
    
    30,862
    
    
    
    30,614390,243
    
    
    
    362,465
    
    
    
    325,770Less accumulated depreciation and amortization
    
    
    (245,893
    )
    
    
    (203,848
    )
    
    
    (159,977
    )Total
    
    $
    144,350
    
    
    $
    158,617
    
    
    $
    165,793
 5. LONG-TERM DEBT
     43




---



##### 



6. SERIES A MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK
    7. COMMITMENTS AND CONTINGENCIES
  44




---



##### 



45




---



##### 



46




---



##### 



Legislation
  Interconnection
Agreements with ILECs
 Interconnection with Other Carriers
 Other Litigation
 Leases
 47




---



##### 



2006
    
    $
    8,7722007
    
    
    8,8652008
    
    
    8,8452009
    
    
    8,4252010
    
    
    4,393Beyond
    
    
    4,463$
    43,763
 Indemnifications
 8. INCOME TAXES
  2005
    
    
    2004
    
    
    2003Statutory federal rate
    
    
    (35.00
    )%
    
    
    (35.00
    )%
    
    
    (35.00
    )%State income taxes
    
    
    
    
    
    
    
    
    
    
    Change in valuation allowance
    
    
    34.99
    
    
    
    35.24
    
    
    
    33.60Miscellaneous
    
    
    0.01
    
    
    
    (0.24
    )
    
    
    1.40Effective tax rate
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
  48




---



##### 



2005
    
    
    2004Deferred tax assets:Net operating loss carryforward
    
    $
    134,597
    
    
    $
    122,346Accrued expenses
    
    
    3,395
    
    
    
    5,253Deferred tax assets
    
    
    137,992
    
    
    
    127,599Less: Valuation Allowance
    
    
    (108,995
    )
    
    
    (94,312
    )Total deferred tax assets
    
    
    28,997
    
    
    
    33,287Deferred tax liabilities:Net deferred revenues
    
    
    1,549
    
    
    
    1,404Depreciation and amortization
    
    
    24,721
    
    
    
    29,451Capitalized salaries and interest
    
    
    2,727
    
    
    
    2,432Total deferred tax liabilities
    
    
    28,997
    
    
    
    33,287Net Deferred Taxes
    
    $
    
    
    
    $
    
   9. EMPLOYEE BENEFIT PLAN
  10. STOCKHOLDERS DEFICIENCY
 Common Stock
 Employee Stock Purchase Plan
 Stock
Option Plan
 49




---



##### 



Options
    
    
    WarrantsWeighted
    
    
    Weighted
    
    
    
    
    
    
    WeightedAverage
    
    
    Average
    
    
    
    
    
    
    AverageExercise
    
    
    Fair Value
    
    
    
    
    
    
    ExerciseNumber of
    
    
    Price Per
    
    
    at Date
    
    
    Number of
    
    
    Price PerShares
    
    
    Shares
    
    
    of Grant
    
    
    Warrants
    
    
    WarrantBalance at December 31, 2002
    
    
    4,021
    
    
    $
    9.06
    
    
    
    
    
    
    
    2,775
    
    
    $
    2.00Granted at fair market value
    
    
    3,853
    
    
    $
    4.08
    
    
    $
    2.84
    
    
    
    947
    
    
    $
    2.02Exercised
    
    
    (107
    )
    
    $
    3.15
    
    
    
    
    
    
    
    (226
    )
    
    $
    1.96Forfeited or cancelled
    
    
    (3,165
    )
    
    $
    10.47
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2003
    
    
    4,602
    
    
    $
    4.05
    
    
    
    
    
    
    
    3,496
    
    
    $
    2.01Granted at fair market value
    
    
    509
    
    
    $
    4.27
    
    
    $
    2.85
    
    
    
    
    
    
    
    Exercised
    
    
    (89
    )
    
    $
    3.33
    
    
    
    
    
    
    
    (184
    )
    
    $
    1.90Forfeited or cancelled
    
    
    (274
    )
    
    $
    4.01
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2004
    
    
    4,748
    
    
    $
    4.09
    
    
    
    
    
    
    
    3,312
    
    
    $
    2.01Granted at fair market value
    
    
    522
    
    
    $
    2.32
    
    
    $
    1.57
    
    
    
    
    
    
    
    Exercised
    
    
    (9
    )
    
    $
    2.43
    
    
    
    
    
    
    
    
    
    
    $
    Forfeited or cancelled
    
    
    (358
    )
    
    $
    4.19
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2005
    
    
    4,903
    
    
    $
    3.90
    
    
    
    
    
    
    
    3,312
    
    
    $
    2.01
  Options OutstandingNumber of
    
    
    Weighted
    
    
    Weighted
    
    
    Number of
    
    
    WeightedRange of
    
    
    Options
    
    
    Avg. Remaining
    
    
    Avg. Exercise
    
    
    Options
    
    
    Avg. ExerciseExercise Price
    
    
    Outstanding
    
    
    Contractual Life
    
    
    Price
    
    
    Exercisable
    
    
    PriceOptions granted at
fair market value:$
    1.74 - 2.34
    
    
    
    543
    
    
    8.8 years
    
    $
    2.19
    
    
    
    80
    
    
    $
    2.062.40 - 3.30
    
    
    
    351
    
    
    8.3 years
    
    
    3.00
    
    
    
    131
    
    
    
    3.043.41 - 3.41
    
    
    
    333
    
    
    5.4 years
    
    
    3.41
    
    
    
    333
    
    
    
    3.413.44 - 4.05
    
    
    
    364
    
    
    7.4 years
    
    
    3.74
    
    
    
    195
    
    
    
    3.664.06 - 4.06
    
    
    
    2,561
    
    
    7.6 years
    
    
    4.06
    
    
    
    2,558
    
    
    
    4.064.11 - 5.03
    
    
    
    360
    
    
    7.0 years
    
    
    4.27
    
    
    
    234
    
    
    
    4.315.19 - 7.31
    
    
    
    384
    
    
    7.6 years
    
    
    5.97
    
    
    
    200
    
    
    
    5.8910.00 - 27.69
    
    
    
    7
    
    
    3.6 years
    
    
    23.96
    
    
    
    7
    
    
    
    23.96Total options
outstanding at
December 31, 2005
    
    $
    1.74-$27.69
    
    
    
    4,903
    
    
    7.6 years
    
    $
    3.90
    
    
    
    3,738
    
    
    $
    4.05
 50




---



##### 



Warrants OutstandingNumber of
    
    
    Weighted
    
    
    WeightedRange of
    
    
    Warrants
    
    
    Avg. Remaining
    
    
    Avg. ExerciseExercise Price
    
    
    Outstanding
    
    
    Contractual Life
    
    
    PriceWarrants granted at
    
    
    6.21
    
    
    
    26
    
    
    2.9 years
    
    $
    6.21fair market value
    
    
    2.86
    
    
    
    128
    
    
    1.0 years
    
    
    2.862.06
    
    
    
    895
    
    
    3.8 years
    
    
    2.061,049
    
    
    3.4 years
    
    
    2.26Warrants granted at less
than fair market value
    
    
    1.90
    
    
    
    2,263
    
    
    3.8 years
    
    
    1.90Total warrants outstanding
at December 31, 2005
    
    $
    1.90-$6.21
    
    
    
    3,312
    
    
    3.6 years
    
    $
    2.01
   11. LOSS PER SHARE
  51




---



##### 



12. QUARTERLY FINANCIAL DATA (UNAUDITED)
  Quarter EndedMarch 31,
    
    
    June 30,
    
    
    September 30,
    
    
    December 31,2005
    
    
    2005
    
    
    2005
    
    
    2005Revenue
    
    $
    93,516
    
    
    $
    95,343
    
    
    $
    98,824
    
    
    $
    100,055Network Expenses
    
    
    45,784
    
    
    
    46,597
    
    
    
    47,680
    
    
    
    46,863Depreciation and Amortization
    
    
    12,931
    
    
    
    12,638
    
    
    
    12,684
    
    
    
    12,415Selling, General and Administrative
    
    
    35,868
    
    
    
    36,590
    
    
    
    37,560
    
    
    
    38,884Charge
Related to Carrier Access Disputes(1)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,292Income (Loss) from Operations
    
    
    (1,067
    )
    
    
    (482
    )
    
    
    900
    
    
    
    (21,399
    )Other Income
    
    
    
    
    
    
    
    
    
    
    202
    
    
    
    Net Interest Expense
    
    
    (3,712
    )
    
    
    (4,279
    )
    
    
    (4,228
    )
    
    
    (4,583
    )Net Loss
    
    
    (4,779
    )
    
    
    (4,761
    )
    
    
    (3,126
    )
    
    
    (25,982
    )Preferred Stock Dividends
    
    
    3,974
    
    
    
    4,033
    
    
    
    4,094
    
    
    
    4,155Accretion of Preferred Stock Issuance Cost
    
    
    152
    
    
    
    155
    
    
    
    157
    
    
    
    159Net Loss Attributable to Common
Stockholders
    
    $
    (8,905
    )
    
    $
    (8,949
    )
    
    $
    (7,377
    )
    
    $
    (30,296
    )Net Loss Attributable to Common
Stockholders per Share:Basic and Diluted
    
    $
    (0.29
    )
    
    $
    (0.30
    )
    
    $
    (0.24
    )
    
    $
    (0.99
    )Weighted Average Share Outstanding:Basic and Diluted
    
    
    30,255
    
    
    
    30,295
    
    
    
    30,504
    
    
    
    30,507
 Quarter EndedMarch 31,
    
    
    June 30,
    
    
    September 30,
    
    
    December 31,2004
    
    
    2004
    
    
    2004
    
    
    2004Revenue
    
    $
    85,186
    
    
    $
    91,633
    
    
    $
    87,262
    
    
    $
    92,100Network Expenses
    
    
    41,450
    
    
    
    42,322
    
    
    
    44,016
    
    
    
    43,504Depreciation and Amortization
    
    
    12,485
    
    
    
    11,822
    
    
    
    12,570
    
    
    
    12,974Selling, General and Administrative
    
    
    32,416
    
    
    
    36,371
    
    
    
    32,876
    
    
    
    37,568Income (Loss) from Operations
    
    
    (1,165
    )
    
    
    1,118
    
    
    
    (2,200
    )
    
    
    (1,946
    )Charges Related to Early
Extinguishment of Debt
    
    
    
    
    
    
    
    
    
    
    (4,416
    )
    
    
    Net Interest Expense
    
    
    (2,152
    )
    
    
    (2,276
    )
    
    
    (2,810
    )
    
    
    (3,915
    )Net Loss
    
    
    (3,317
    )
    
    
    (1,158
    )
    
    
    (9,426
    )
    
    
    (5,861
    )Preferred Stock Dividends
    
    
    3,744
    
    
    
    3,800
    
    
    
    3,857
    
    
    
    3,915Accretion of Preferred Stock Issuance Cost
    
    
    143
    
    
    
    146
    
    
    
    148
    
    
    
    150Net Loss Attributable to Common
Stockholders
    
    $
    (7,204
    )
    
    $
    (5,104
    )
    
    $
    (13,431
    )
    
    $
    (9,926
    )Net Loss Attributable to Common
Stockholders per Share:Basic and Diluted
    
    $
    (0.24
    )
    
    $
    (0.17
    )
    
    $
    (0.45
    )
    
    $
    (0.33
    )Weighted Average Share Outstanding:Basic and Diluted
    
    
    29,751
    
    
    
    29,853
    
    
    
    30,045
    
    
    
    30,056
 
 (1)
    
    The quarter ended December 31, 2005 Loss from Operations includes the
impact of carrier access disputes settlements as discussed in Note 7. 52




---



##### 



ITEM 9A. CONTROLS AND PROCEDURES
  PART III
 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
  ITEM 11. EXECUTIVE COMPENSATION
  ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS
  ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
  ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
  53




---



##### 



PART IV
 ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
           No.
    
    Exhibit3.1
    
    Restated Certificate of Incorporation of the Company (1)3.2
    
    Amended and Restated Bylaws of the Company (2)3.3
    
    Certificate of Designation Related to Series A Convertible Preferred Stock (3)3.4
    
    Amendment to Certificate of Designation Related to Series A Convertible Preferred Stock (4)3.5
    
    Certificate of Amendment of Restated Certificate of Incorporation (5)3.6
    
    Certificate of Retirement and Prohibition of Reissuance of Class B common Stock of US LEC
Corp. (5)4.1
    
    Form of Class A Common Stock Certificate (1)4.2
    
    Preferred Stock Purchase Agreement, dated April 11, 2000 (3)4.4
    
    Corporate Governance Agreement, dated April 11, 2000 (3)4.5
    
    Registration Rights Agreement, dated April 11, 2000 (3)4.6
    
    Voting and Tag Along Agreement dated as of April 11, 2000 by and among certain Investors,
Richard T. Aab, Melrich Associates, L.P., Tansukh V. Ganatra and Super STAR Associates
Limited Partnership (4)4.7
    
    Amendment to Voting and Tag Along Agreement dated as of August 6, 2001 by and among
Richard T. Aab, Melrich Associates, L.P., Super STAR Associates Limited Partnership, Bain
Capital CLEC Investors, L.L.C., Thomas H. Lee Equity Fund IV, L.P., Thomas H. Lee Foreign
Fund IV-B, L.P. and Thomas H. Lee Foreign Fund IV, L.P. (4)4.8
    
    Form of Second Priority Senior Secured Floating Rate Note due 2009, Series B (9)4.9
    
    Indenture, dated September 30, 2004, by and among US LEC Corp., as Issuer, the Guarantors
party thereto, as Guarantors, and U.S. Bank National Association, as trustee, relating to
the Second Priority Senior Secured Floating Rate Notes due 2009 (8)4.10
    
    Registration Rights Agreement, dated September 30, 2004, by and among US LEC Corp., the
Guarantors party thereto and Deutsche Bank Securities Inc. and Libertas Partners, LLC (8)4.11
    
    Security Agreement, dated September 30, 2004, by and among US LEC Corp., the Guarantors
party thereto and U.S. Bank National Association, as trustee (8)4.12
    
    Trademark Security Agreement, dated September 30, 2004, by and among US LEC Corp. and U.S.
National Association, as trustee (8)4.13
    
    Form of Common Stock Purchase Warrant (6)4.14
    
    Registration Rights Agreement, dated December 31, 2002 (6)10.1
    
    Consulting Agreement dated as of February 7, 2002 by and between the Company and Tansukh
V. Ganatra (4) (7)
 54




---



##### 



No.
    
    Exhibit10.2
    
    Purchase Agreement, dated September 23, 2004, by and among US LEC Corp., the Guarantors
party thereto and Deutsche Bank Securities Inc. and Libertas Partners, LLC (8)10.3
    
    Loan and Security Agreement dated October 25, 2005, by and among US LEC Corp., the
Guarantors party thereto, and Wachovia Bank, National Association, as Lender.10.4
    
    Pledge and Security Agreements dated October 25, 2005, by US LEC Corp., to and in favor of
Wachovia Bank, National Association.10.5
    
    Trademark Security Agreement dated October 25, 2005, by US LEC Corp., to and in favor of
Wachovia Bank, National Association.10.6
    
    Guarantee dated October 25, 2005, by the Guarantors in favor of Wachovia Bank, National
Association.21
    
    Subsidiaries of the Registrant23
    
    Consent of Deloitte & Touche LLP31.1
    
    Rule 13a-14(a) Certification of Chief Executive Officer31.2
    
    Rule 13a 14(a) Certification of Chief Financial Officer32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 (1)
    
    Incorporated by reference to Registration Statement from Form S-1 (File No.
333-46341) filed February 13, 1998.(2)
    
    Incorporated by reference to the Companys Quarterly Report on Form 10-Q for its
quarter ended March 31, 2004.(3)
    
    Incorporated by reference to the Companys Current Report on Form 8-K filed May 12,
2000.(4)
    
    Incorporated by reference to the Companys Annual Report on Form 10-K for its year
ended December 31, 2001.(5)
    
    Incorporated by reference to Amendment No. 1 to the Companys Registration Statement
on Form 8-A filed January 16, 2004.(6)
    
    Incorporated by reference to the Companys Current Report on Form 8-K filed January
17, 2003.(7)
    
    Management or compensatory plan or arrangement.(8)
    
    Incorporated by reference to the Companys Current Report on Form 8-K filed October
6, 2004.(9)
    
    Incorporated by reference to Exhibit 4.4 to Registration Statement on Form S-4 (File
No. 333-120232) filed November 4, 2004. 55




---



##### 



SCHEDULE II
 VALUATION AND QUALIFYING ACCOUNTS
 US LEC Corp. (IN THOUSANDS)
 AdditionsBalance at
    
    
    
    
    
    Charged to
    
    
    
    
    
    Balance atBeginning
    
    Charged to Costs
    
    Other
    
    
    
    
    
    End ofDescription
    
    of Period
    
    and Expenses
    
    Accounts
    
    Deductions
    
    PeriodAllowance against accounts
receivableYear ended December 31, 2005
    
    $
    10,137
    
    
    $
    28,116
    (4)
    
    
    
    
    
    $
    27,904
    (4)
    
    $
    10,349Year ended December 31, 2004
    
    $
    10,998
    
    
    $
    7,270
    
    
    $
    417
    (3)
    
    $
    8,548
    
    
    $
    10,137Year ended December 31, 2003
    
    $
    23,180
    
    
    $
    523
    (1)
    
    $
    390
    (2)
    
    $
    13,095
    
    
    $
    10,998Allowance against deferred
tax assetsYear ended December 31, 2005
    
    $
    94,312
    
    
    $
    14,683
    
    
    $
    
    
    
    $
    
    
    
    $
    108,995Year ended December 31, 2004
    
    $
    85,695
    
    
    $
    8,617
    
    
    $
    
    
    
    $
    
    
    
    $
    94,312Year ended December 31, 2003
    
    $
    79,689
    
    
    $
    6,006
    
    
    $
    
    
    
    $
    
    
    
    $
    85,695
 
 (1)
    
    Includes $5,867 recovery for doubtful accounts related to WorldCom.(2)
    
    Represents allowance for doubtful accounts related to the accounts receivable purchased from Fastnet on December 15, 2003.(3)
    
    Represents allowance for doubtful accounts related to the accounts receivable purchased from StarNet on November 10, 2004.(4)
    
    Contains $22,893 included in charge related to carrier access
disputes. 56




---



##### 



SIGNATURES
  Date: March 7, 2006
    
    By:
    
    /s/ J. Lyle PatrickJ. Lyle PatrickExecutive Vice President and
Chief Financial Officer
  Signature
    
    Title
    
    Date/s/ Richard T. Aab
    
    Chairman and Director
    
    March 7, 2006Richard T. Aab/s/ Aaron D. Cowell, Jr.
    
    Chief Executive Officer, President and Director
(Principal Executive Officer)
    
    March 7, 2006Aaron D. Cowell, Jr./s/ J. Lyle Patrick
    
    Executive Vice President and
Chief Financial Officer
(Principal Financial and Accounting Officer)
    
    March 7, 2006J. Lyle Patrick/s/ Tansukh V. Ganatra
    
    Director
    
    March 7, 2006Tansukh V. Ganatra/s/ David M. Flaum
    
    Director
    
    March 7, 2006David M. Flaum/s/ Steven L. Schoonover
    
    Director
    
    March 7, 2006Steven L. Schoonover/s/ Anthony J. DiNovi
    
    Director
    
    March 7, 2006Anthony J. DiNovi/s/ Michael A. Krupka
    
    Director
    
    March 7, 2006Michael A. Krupka/s/ Michael C. Mac Donald
    
    Director
    
    March 7, 2006Michael C. Mac Donald
 57




---



##### 



INDEX TO EXHIBITS
 No.
    
    Exhibit3.1
    
    Restated Certificate of Incorporation of the Company (1)3.2
    
    Amended and Restated Bylaws of the Company (2)3.3
    
    Certificate of Designation Related to Series A Convertible Preferred Stock (3)3.4
    
    Amendment to Certificate of Designation Related to Series A Convertible Preferred Stock (4)3.5
    
    Certificate of Amendment of Restated Certificate of Incorporation (5)3.6
    
    Certificate of Retirement and Prohibition of Reissuance of Class B common Stock of US LEC
Corp. (5)4.1
    
    Form of Class A Common Stock Certificate (1)4.2
    
    Preferred Stock Purchase Agreement, dated April 11, 2000 (3)4.4
    
    Corporate Governance Agreement, dated April 11, 2000 (3)4.5
    
    Registration Rights Agreement, dated April 11, 2000 (3)4.6
    
    Voting and Tag Along Agreement dated as of April 11, 2000 by and among certain Investors,
Richard T. Aab, Melrich Associates, L.P., Tansukh V. Ganatra and Super STAR Associates
Limited Partnership (4)4.7
    
    Amendment to Voting and Tag Along Agreement dated as of August 6, 2001 by and among
Richard T. Aab, Melrich Associates, L.P., Super STAR Associates Limited Partnership, Bain
Capital CLEC Investors, L.L.C., Thomas H. Lee Equity Fund IV, L.P., Thomas H. Lee Foreign
Fund IV-B, L.P. and Thomas H. Lee Foreign Fund IV, L.P. (4)4.8
    
    Form of Second Priority Senior Secured Floating Rate Note due 2009, Series B (9)4.9
    
    Indenture, dated September 30, 2004, by and among US LEC Corp., as Issuer, the Guarantors
party thereto, as Guarantors, and U.S. Bank National Association, as trustee, relating to
the Second Priority Senior Secured Floating Rate Notes due 2009 (8)4.10
    
    Registration Rights Agreement, dated September 30, 2004, by and among US LEC Corp., the
Guarantors party thereto and Deutsche Bank Securities Inc. and
Libertas Partners, LLC (8)4.11
    
    Security Agreement, dated
September 30, 2004, by and among US LEC Corp., the Guarantors
party thereto and U.S. Bank National Association, as trustee (8)4.12
    
    Trademark Security Agreement, dated
September 30, 2004, by and among US LEC Corp. and U.S. National Association, as trustee (8)4.13
    
    Form of Common Stock Purchase Warrant (6)4.14
    
    Registration Rights Agreement, dated December 31, 2002 (6)10.1
    
    Consulting Agreement dated as of February 7, 2002 by and between the Company and Tansukh
V. Ganatra (4) (7)10.2
    
    Purchase Agreement, dated September 23, 2004, by and among US LEC Corp., the Guarantors
party thereto and Deutsche Bank Securities Inc. and Libertas Partners, LLC (8)10.3
    
    Loan and Security Agreement dated October 25, 2005, by and among US LEC Corp., the
Guarantors party thereto, and Wachovia Bank, National Association, as Lender.10.4
    
    Pledge and Security Agreements dated October 25, 2005, by US LEC Corp., to and in favor of
Wachovia Bank, National Association.10.5
    
    Trademark Security Agreement dated October 25, 2005, by US LEC Corp., to and in favor of
Wachovia Bank, National Association.10.6
    
    Guarantee dated October 25, 2005, by the Guarantors in favor of Wachovia Bank, National
Association.21
    
    Subsidiaries of the Registrant23
    
    Consent of Deloitte & Touche LLP31.1
    
    Rule 13a-14(a) Certification of Chief Executive Officer31.2
    
    Rule 13a 14(a) Certification of Chief Financial Officer32.1
    
    Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 (1)
    
    Incorporated by reference to Registration Statement from Form S-1 (File No.
333-46341) filed February 13, 1998.(2)
    
    Incorporated by reference to the Companys Quarterly Report on Form 10-Q for its
quarter ended 58




---



##### 



March 31, 2004.(3)
    
    Incorporated by reference to the Companys Current Report on Form 8-K filed May 12,
2000.(4)
    
    Incorporated by reference to the Companys Annual Report on Form 10-K for its year
ended December 31, 2001.(5)
    
    Incorporated by reference to Amendment No. 1 to the Companys Registration Statement
on Form 8-A filed January 16, 2004.(6)
    
    Incorporated by reference to the Companys Current Report on Form 8-K filed January
17, 2003.(7)
    
    Management or compensatory plan or arrangement.(8)
    
    Incorporated by reference to the Companys Current Report on Form 8-K filed October
6, 2004.(9)
    
    Incorporated by reference to Exhibit 4.4 to Registration Statement on Form S-4 (File
No. 333-120232) filed November 4, 2004. 59