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OTELCO INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
(Edgar Glimpses Via Acquire Media NewsEdge) Overview
General
We operate eleven rural local exchange carriers ("RLECs") serving subscribers
in north central Alabama, central Maine, western Massachusetts, central
Missouri, western Vermont and southern West Virginia. We are the sole wireline
telephone services provider for many of the rural communities we serve. We also
operate a competitive local exchange carrier ("CLEC") serving subscribers
throughout the states of Maine and New Hampshire. Our services include local and
long distance telephone services, network access, other telephone related
services, cable and satellite television (in some markets) and internet access.
We view, manage and evaluate the results of operations from the various
telecommunications services as one company and therefore have identified one
reporting segment as it relates to providing segment information.
As of September 30, 2012, we operated approximately 100,195 access line
equivalents and supplied an additional 162,700 wholesale network connections,
primarily to Time Warner Cable ("TW"). On April 20, 2012, we announced that TW
had indicated that it will not renew its existing contract for wholesale network
connections provided by us. Formal notification of non-renewal was received in
June 2012. Accordingly, this contract will expire on December 31, 2012. We are
currently negotiating an expected six month transition period into 2013 during
which TW's customers will be moved to TW's facilities. Revenue received directly
from TW represented approximately 11.7% and 12.3% of our consolidated revenue
for the nine months ended September 30, 2011 and 2012, respectively.
Additionally, other unrelated telecommunications providers pay us access revenue
for terminating calls through us to TW's customers representing another 3% to 4%
of our revenue.
The Federal Communications Commission (the "FCC") issued its Universal Service
Fund and Intercarrier Compensation ("ICC") order in November 2011. This order
makes substantial changes in the way telecommunications carriers are compensated
for serving high cost areas and for completing traffic with other carriers. We
began seeing the significant impact of the FCC's ICC order to our business in
July 2012. The expected initial consequences to our business will be to reduce
access revenue from intrastate calling in Maine and other states where
intrastate rates are higher than interstate rates. A portion of this revenue
loss is returned to us through the Connect America Fund for our RLEC properties.
There is no recovery mechanism for the lost revenue in our CLEC. The impact of
this order in conjunction with the non-renewal of the TW contract is expected to
reduce our revenue and net income in the coming years.
On April 20, 2012, we announced the suspension of dividends on our common
stock. On August 7, 2012, the Company announced that its board of directors had
exercised its contractual right under the indenture governing the Company's
senior subordinated notes to defer interest on the senior subordinated notes for
the third quarter 2012. On November 6, 2012, the Company announced that its
board of directors had exercised its contractual right under the indenture
governing the Company's senior subordinated notes to defer interest on the
senior subordinated notes for the fourth quarter 2012. Under the indenture, the
Company's board of directors is permitted to defer interest on up to four
occasions with respect to up to two quarters per occasion before resuming
interest payments, including interest on the deferred interest. Before deferring
interest for an additional period beyond fourth quarter 2012, the Company would
be required to pay the deferred interest of $7.0 million plus interest on the
deferred interest. The Company has engaged Evercore Partners, an investment
banking firm, to assist us in exploring our strategic alternatives to address
our existing levels of debt and to strengthen our balance sheet. Evercore
Partners' areas of expertise include debt and capital market transactions,
restructuring of balance sheet obligations and mergers and acquisitions advice.
On October 5, 2012, the Company retained restructuring counsel to aid in this
process. Together with its advisors, the Company will evaluate its alternatives.
Our acquisition of all of the issued and outstanding capital stock of Shoreham
Telephone Company, Inc. ("STC"), a privately-held integrated telecommunications
services provider serving customers in western Vermont, on October 14, 2011,
added approximately 5,100 access line equivalents on that date.
Our core businesses are local and long distance telecommunications services,
wholesale access to the local and long distance network and network access to
other wireline, long distance and wireless carriers for calls originated or
terminated on our network. Our core businesses generated approximately 75.7% of
our total revenues in the third quarter of 2012. The impacts associated with the
implementation of the FCC's ICC order will be reflected in core business
revenue. We also provide cable and satellite television service in some markets
and digital high-speed data lines and residual dial-up internet access in all of
our markets.
The following discussion and analysis should be read in conjunction with our
financial statements and the related notes included in Item 1 of Part I and the
other financial information appearing elsewhere in this report. The following
discussion and analysis addresses our financial condition and results of
operations on a consolidated basis.
17
-------------------------------------------------------------------------------- Revenue Sources
We offer a wide range of telecommunications and entertainment services to our
subscribers. More than half of our residential customers receive packages of
services that are delivered and billed together. Our CLEC subscribers contract
with us for selected services that meet their specific telecommunications
requirements. Our revenues are derived from five sources:
Local services. We receive revenues from providing local exchange
telecommunications services in our eleven rural territories, from the
wholesale network services in New England and on a competitive basis
throughout Maine and New Hampshire. These revenues include monthly subscription charges for basic service, calling beyond the local territory
on a fixed price and on a per minute basis, local private line services and
enhanced calling features, such as voicemail, caller identification, call
waiting and call forwarding. We also provide billing and collections
services for other carriers under contract and receive revenues from
directory advertising. A growing portion of our rural subscribers take
bundled service plans which include multiple services, including unlimited
domestic calling, for a flat monthly fee.
Network access. We receive revenues from charges established to compensate
us for the origination, transport and termination of calls of long distance
and other interexchange carriers. These include subscriber line charges
imposed on end users and switched and special access charges paid by
carriers. Switched access charges for long distance services within Alabama,
Maine, Massachusetts, Missouri, New Hampshire, Vermont and West Virginia are
generally based on rates approved by the Alabama Public Service Commission,
the Maine Public Utilities Commission (the "MPUC"), the Massachusetts
Department of Telecommunications and Cable, the Missouri Public Service
Commission, the New Hampshire Public Utilities Commission (the "NHPUC"), the
Vermont Public Service Board and the West Virginia Public Service
Commission, respectively, where appropriate. Switched and special access
charges for interstate and international services are based on rates
approved by the FCC. The FCC's ICC order has and will significantly change
the way telecommunication carriers receive compensation for exchanging
traffic. Over the next three years, all intrastate rates that exceed the
interstate rate will be reduced to the interstate rate. Beginning in 2014,
the interstate rate will be reduced over three years to "bill and keep" in
which carriers bill their customers for services and keep those charges but
neither pay for nor receive compensation from traffic sent to or received
from other carriers. In addition, subsidies to carriers serving high cost
areas will be phased out over an extended period. These changes began to
reduce access revenue beginning in July 2012.
Cable television. We offer basic, digital, high-definition, digital video
recording and pay per view cable television services to the majority of our
telephone service territory in Alabama, including Internet Protocol
television ("IPTV") and Video on Demand ("VOD"). We are a reseller of
satellite services for DirecTV and Dish in Missouri.
Internet. We receive revenues from monthly recurring charges for digital
high-speed data lines, dial-up internet access and ancillary services such
as web hosting and computer virus protection.
Transport. We receive monthly recurring revenues for the rental of fiber to
transport data and other telecommunications services in New England.
Voice and Data Access Line Trends
The number of access lines served is a fundamental factor in determining
revenue stability for a telecommunications provider. Reflecting the historical
trend in the RLEC industry, the number of rural voice access lines we serve has
been decreasing when normalized for territory acquisitions. We expect that this
trend will continue, and may continue to be impacted by the effect of the
economy on our customers as well as the availability of alternative
telecommunications products, such as cellular and Internet Protocol-based
services. These trends will be partially offset by the growth of data access
lines, also called digital high-speed internet access service. Our competitive
carrier voice and data access lines have grown as we continue to further
penetrate our chosen markets. Our ability to continue this growth and our
response to the rural trends will have an important impact on our future
revenues. Our primary strategy consists of leveraging our strong incumbent
market position, selling additional services to our rural customer base such as
alarm services and providing better service and support levels than the
incumbent carrier to our competitive customer base.
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Key Operating Statistics(2)
(Unaudited) Quarterly
% Change
December 31, March 31, June 30, September 30, from
2010 2011 2012 2012 2012 June 30, 2012
Otelco access line
equivalents(1) 99,639 102,378 101,885 101,184 100,195 (1.0 ) %
RLEC and other services:
Voice access lines 45,461 46,202 45,200 44,546 43,816 (1.6 ) %
Data access lines 20,852 22,904 23,105 23,156 22,977 (0.8 ) %
Access line
equivalents(1) 66,313 69,106 68,305 67,702 66,793 (1.3 ) %
Cable television
customers 4,227 4,201 4,216 4,163 4,181 0.4 %Satellite television
customers 125 226 229 231 232 0.4 %
Additional internet
customers 6,975 5,414 5,159 4,896 4,690 (4.2 ) %
RLEC dial-up 393 301 273 248 211 (14.9 ) %
Other dial-up 4,300 2,797 2,501 2,266 2,083 (8.1 ) %
Other data lines 2,282 2,316 2,385 2,382 2,396 0.6 %
CLEC:
Voice access lines 29,944 30,189 30,476 30,355 30,341 (0.0 ) %
Data access lines 3,382 3,082 3,104 3,127 3,061 (2.1 ) %
Access line
equivalents(1) 33,326 33,271 33,580 33,482 33,402 (0.2 ) %
Wholesale network
connections(3) 149,043 157,144 159,560 161,766 162,700 0.6
Years Ended Three Months Ended
December 31, March 31, June 30, September 30,
2010 2011 2012 2012 2012Total revenues (in
millions): $ 104.4 $ 101.8 $ 25.4 $ 24.7 $ 24.4
RLEC $ 58.4 $ 57.4 $ 14.2 $ 14.1 $ 13.6
CLEC $ 46.0 $ 44.4 $ 11.2 $ 10.6 $ 10.8
(1) We define access line equivalents as voice access lines and data access
lines (including cable modems, digital subscriber lines and dedicated data
access trunks).
(2) We acquired STC on October 14, 2011. At December 31, 2011, STC's successor,
Shoreham Telephone LLC, had 3,309 voice access lines and 1,672 data access
lines, or 4,981 access line equivalents, and 55 dial-up internet customers
which are included in the Key Operating Statistics.
(3) TW is the source for approximately 98% of wholesale network connections.
In our RLEC territories, access line equivalents decreased by 909 during third
quarter 2012, or 1.3%, compared to June 30, 2012. Voice access lines declined
1.6% and data access lines declined by 0.8% during the period. The continued
impacts of the economy, wireless substitution and cable competition in Maine and
Massachusetts accounted for the decline. We offer location specific bundled
service packages, many including unlimited domestic calling, tailored to the
telecommunications requirements of our customers and priced competitively.
In our Maine and New Hampshire CLEC operations, access line equivalents
decreased by 80 during third quarter 2012, or 0.2%, compared to June 30, 2012.
Voice access lines were basically flat and data access lines decreased 2.1%
during the period. Our hosted private branch exchange ("PBX") product continues
to grow with positive market acceptance, adding approximately 535 seats at 63
locations during third quarter 2012. Virtually all of our competitive customers
are businesses, with service bundles tailored to their specific business
requirements.
Competitive pricing and bundling of services have led Otelco's long distance
service to be the choice of the majority of the customers in the rural markets
we serve. In addition, almost all of our Maine and New Hampshire CLEC customers
have selected us as their long distance carrier. Our cable television customers
increased 0.4% from June 30, 2012 to 4,181 as of September 30, 2012. The
continued expansion of IPTV was partially offset by a decrease in basic cable
customers. Our other internet customers decreased 4.2% to 4,690 as of September
30, 2012 compared to June 30, 2012. This also includes the subscribers we
service outside of our RLEC telephone service area throughout Missouri and
Maine, reflecting the shift to digital high-speed internet services. In
Missouri, we are continuing the expansion of our data access lines for digital
high-speed internet in selected areas outside of our telephone service
territory. Approximately 51% of the other internet customers are served by
high-speed data capability from Otelco.
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--------------------------------------------------------------------------------Our Rate and Pricing Structure
Our CLEC pricing is based on market requirements. We combine varying services to
meet individual customer requirements, including technical support, and provide
multi-year contracts which are both market sensitive for the customer and
profitable for us. The MPUC and the NHPUC impose certain requirements on all
CLECs operating in their markets for reporting and for interactions with the
various incumbent local exchange and interexchange carriers. These requirements
provide wide latitude in pricing services.
Our RLECs operate in six states and are regulated in varying degrees by the
respective state regulatory authorities. The impact on pricing flexibility
varies by state. In Maine, two of our wholly owned subsidiaries, Saco River
Telephone LLC and Pine Tree Telephone LLC, have obtained authority to implement
pricing flexibility while remaining under rate-of-return regulation. Our rates
for other services we provide, including cable, long distance, data lines and
dial-up and high-speed internet access, are not price regulated. The market for
competitive services, such as wireless, also impacts our ability to adjust
prices. With the increase of bundled services offerings, including unlimited
long distance, pricing for individual services takes on reduced importance to
revenue stability. We expect this trend to continue into the immediate future.
Categories of Operating Expenses
Our operating expenses are categorized as cost of services; selling, general and
administrative expenses; and depreciation and amortization.
Cost of services. This includes expenses for salaries, wages and benefits
relating to plant operation, maintenance, sales and customer service; other
plant operations, maintenance and administrative costs; network access costs;
and costs of services for long distance, cable television, internet and
directory services.
Selling, general and administrative expenses. This includes expenses for
salaries, wages and benefits and contract service payments relating to
engineering, financial, human resources and corporate operations; information
management expenses, including billing; allowance for uncollectible revenue;
expenses for travel, lodging and meals; internal and external communications
costs; insurance premiums; stock exchange and banking fees; and postage.
Depreciation and amortization. This includes depreciation of our
telecommunications, cable and internet networks and equipment, and amortization
of intangible assets. Certain of these amortization expenses continue to be
deductible for tax purposes.
Impairment. During second quarter 2012, we evaluated goodwill and other
long-lived assets for impairment. On April 20, 2012, we announced that TW had
indicated that it will not renew its wholesale network contract when it expires
at the end of 2012. Formal notification of non-renewal was received in June
2012. We currently expect that the transition of services to TW will take no
more than six months from the expiration date of the contract. In addition, the
implementation of industry changes required by the FCC's ICC order began
reducing our CLEC revenue in July 2012 and will reduce our RLEC revenue
beginning in 2013. Also, during second quarter 2012, the market price of our
Income Deposit Securities ("IDSs") on the NASDAQ Global Market dropped
materially and has remained below historical levels. The impact of these changes
was considered a triggering event for the Company to review all of its
long-lived assets, including goodwill, to determine if any of the assets were
impaired. The results of that review are reflected in three separate operating
expenses categories included in our consolidated statements of operations in
Item 1 of Part I: Long-lived assets impairment - PP&E; Long-lived assets
impairment - intangibles; and Goodwill impairment. During third quarter 2012, we
finalized the calculation of the deferred income tax liability associated with
the acquisition of STC. We determined the deferred income tax liability to be
$1,889,202, rather than $2,233,458 as previously reported. The reduced liability
would have reduced goodwill by $344,256, except for the fact that the goodwill
impairment testing conducted during second quarter 2012 had determined that all
of the goodwill in our New England reporting unit was impaired, including the
goodwill associated with the STC acquisition. See Liquidity and Capital
Resources below for additional information.
Our Ability to Control Operating Expenses
We strive to control expenses in order to maintain our strong operating margins.
As our revenue shifts to non-regulated services and CLEC customers, operating
margins decrease reflecting the lower margins associated with these services.
The non-renewal of the TW contract is expected to lower margins in 2013. We
reduced employee costs at the end of second quarter 2012 and expect to further
reduce these costs once the TW conversion is completed during 2013.
20
--------------------------------------------------------------------------------Results of Operations
The following table sets forth our results of operations as a percentage of
total revenues for the periods indicated:
Three Months Ended Nine Months Ended
September 30, September 30,
2011 2012 2011 2012
Revenues
Local services 46.3 % 45.0 % 46.8 % 45.7 %
Network access 31.8 30.7 31.5 30.6
Cable television 3.0 3.2 2.9 3.2
Internet 13.6 15.1 13.6 14.9
Transport services 5.3 6.0 5.2 5.6
Total revenues 100.0 % 100.0 % 100.0 % 100.0 %
Operating expenses
Cost of services 43.4 % 42.4 % 43.0 % 43.0 %
Selling, general and administrative
expenses 12.8 13.6 12.5 13.6
Depreciation and amortization 19.5 18.9 19.9 20.2
Long-lived assets impairment - PP&E - - - 3.9
Long-lived assets impairment -
intangibles - - - 7.7
Goodwill impairment - (1.4 ) - 192.8
Total operating expenses 75.8 73.5 75.4 281.1
Income (loss) from operations 24.2 26.5 24.6 (181.1 )
Other income (expense)
Interest expense (24.6 ) (23.2 ) (24.4 ) (23.0 )
Change in fair value of derivatives 2.6 - 2.2 0.3
Other income 0.0 0.0 0.5 0.4
Total other expenses (22.0 ) (23.2 ) (21.7 ) (22.3 )
Income (loss) before income taxes 2.2 3.3 2.9 (203.4 )
Income tax benefit (expense) 1.3 (2.0 ) (0.0 ) 33.1
Net income (loss) available to common
stockholders 3.5 % 1.3 % 2.9 % (170.3 ) %
Three Months and Nine Months Ended September 30, 2012 Compared to Three Months
and Nine Months Ended September 30, 2011
Total revenues. Total revenues decreased 3.5% in the three months ended
September 30, 2012 to $24.4 million from $25.3 million in the three months ended
September 30, 2011. Total revenues decreased 2.2% in the nine months ended
September 30, 2012 to $74.5 million from $76.2 million in the nine months ended
September 30, 2011. The tables below provide the components of our revenues for
the three months and nine months ended September 30, 2012 compared to the same
periods of 2011.
21--------------------------------------------------------------------------------For the three months ended September 30, 2012 and 2011
Three Months Ended September 30, Change
2011 2012 Amount Percent
(dollars in thousands)
Local services $ 11,715 $ 11,003 $ (712 ) (6.1 ) %
Network access 8,048 7,500 (548 ) (6.8 )
Cable television 770 788 18 2.3
Internet 3,442 3,682 240 7.0
Transport services 1,328 1,455 127 9.6
Total $ 25,303 $ 24,428 $ (875 ) (3.5 )
Local services. Local services revenue decreased 6.1% in the three months ended
September 30, 2012 to $11.0 million from $11.7 million in the three months ended
September 30, 2011. The acquisition of STC added $0.2 million and hosted PBX and
wholesale network connection revenue increased $0.2 million. The FCC's ICC order
reduced or eliminated intrastate and local cellular revenue categorized as local
services revenue. A portion of the RLEC decrease is recovered through the
Connect America Fund, which is categorized as interstate access in network
access revenue. The impact in third quarter 2012 was a decrease of $0.9 million
in local services revenue. The decline in RLEC voice access lines accounted for
a decrease $0.2 million.
Network access. Network access revenue decreased 6.8% in the three months ended
September 30, 2012 to $7.5 million from $8.0 million in the three months ended
September 30, 2011. The acquisition of STC added $0.3 million and special access
added $0.2 million. Interstate and intrastate toll decreases primarily
associated with the FCC's ICC order were partially offset by the new Connect
America Fund revenue, but still represented a decline of $1.0 million. The
reduction mandated by the FCC's ICC order in intrastate toll rates had a
significant negative impact on CLEC revenue in Maine for which there is no
recovery mechanism.
Cable television. Cable television revenue in the three months ended September
30, 2012 increased 2.3% to remain at $0.8 million in the three months ended
September 30, 2012 and 2011. Growth in IPTV subscribers, VOD and the shift to
high-definition packages in Alabama was offset by the decline in basic cable
subscribers.
Internet. Internet revenue for the three months ended September 30, 2012
increased 7.0% to $3.7 million from $3.4 million in the three months ended
September 30, 2011. The growth was attributable to the STC acquisition. Growth
in other RLEC data lines was offset the loss of dial-up subscribers outside of
our service territory.
Transport services. Transport services revenue increased 9.6% to $1.5 million in
the three months ended September 30, 2012 from $1.3 million in the three months
ended September 30, 2011 from growth in both wide area network and wholesale
transport services.
For the nine months ended September 30, 2012 and 2011
Nine Months Ended September 30, Change
2011 2012 Amount Percent
(dollars in thousands)
Local services $ 35,659 $ 34,074 $ (1,585 ) (4.4 ) %
Network access 23,987 22,813 (1,174 ) (4.9 )
Cable television 2,229 2,387 158 7.1
Internet 10,356 11,095 739 7.1
Transport services 3,965 4,147 182 4.6
Total $ 76,196 $ 74,516 $ (1,680 ) (2.2 )
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Local services. Local services revenue decreased 4.5% to $34.1 million in the
nine months ended September 30, 2012 from $35.7 million in the nine months ended
September 30, 2011. The acquisition of STC accounted for an increase of $0.6
million, growth in our hosted PBX product accounted for an increase of $0.4
million and growth in wholesale network connections accounted for an increase of
$0.4 million. These gains were more than offset by reduced subscribers to our
traditional local services, including long distance revenue, accounting for a
reduction of $1.4 million in our CLEC and $1.5 million in our RLEC service
territories. A portion of the RLEC decrease is recovered through the Connect
America Fund, which is categorized as interstate access in network access
revenue.
Network access. Network access revenue decreased 4.9% to $22.8 million in the
nine months ended September 30, 2012 from $24.0 million in the nine months ended
September 30, 2011. The acquisition of STC added $1.1 million. Interstate and
intrastate toll decreases primarily associated with the FCC's ICC order were
partially offset by the new Connect America Fund revenue, but still represented
a decline of $2.3 million primarily in state access revenue.
Cable television. Cable television revenue increased 7.1% to $2.4 million in the
nine months ended September 30, 2012 from $2.2 million in the nine months ended
September 30, 2011. Growth in IPTV subscribers, the shift to high-definition
packages and growth in pay-per-view increased revenue $0.3 million, which was
partially offset by a $0.1 million decline associated with the conversion of our
Missouri cable customers to satellite services during first quarter 2011 and
fewer basic cable customers.
Internet. Internet revenue increased 7.1% to $11.1 million in the nine months
ended September 30, 2012 from $10.4 million in the nine months ended September
30, 2011. The acquisition of STC accounted for growth of $0.8 million and
increased fiber leases accounted for an increase of $0.1 million. The decline of
dial-up internet customers associated with the conversion to digital data access
lines, including those customers in Maine and Missouri that are outside of our
local service areas, accounted for a decrease of $0.2 million.
Transport services. Transport services revenue increased 4.6% to $4.1 million in
the nine months ended September 30, 2012 from $4.0 million in the nine months
ended September 30, 2011 from growth in wide area network revenue.
Operating expenses. Operating expenses in the three months ended September 30,
2012 decreased 6.5% to $17.9 million from $19.2 million in the three months
ended September 30, 2011. Operating expenses in the nine months ended September
30, 2012 increased to $191.5 million from $38.2 million in the nine months ended
September 30, 2011. The tables below provide the components of our operating
expenses for the three months and nine months ended September 30, 2012 compared
to the same periods of 2011.
For the three months ended September 30, 2012 and 2011
Three Months Ended September 30, Change
2011 2012 Amount Percent
(dollars in thousands)
Cost of services $ 10,986 $ 10,361 $ (625 ) (5.7 ) %
Selling, general and
administrative
expenses 3,249 3,310 61 1.9
Depreciation and
amortization 4,944 4,614 (330 ) (6.7 )
Goodwill impairment - (344 ) (344 ) NM
Total $ 19,179 $ 17,941 $ (1,238 ) (6.5 )
Cost of services. Cost of services decreased 5.7% to $10.4 million for the three
months ended September 30, 2012 from $11.0 million in the three months ended
September 30, 2011. Costs related to the acquisition of STC added $0.3 million.
These increases were offset by lower toll and access costs of $0.5 million and
lower operating costs, including the reduction in employees implemented at the
end of second quarter 2012.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased 1.9% to $3.3 million in the three months ended
September 30, 2012 from $3.2 million in the three months ended September 30,
2011. Expenses associated with the acquisition of STC added $0.1 million and
restructuring and legal costs added $0.6 million. These increases were mostly
offset by lower operating costs, including the reduction in employees
implemented at the end of second quarter 2012.
Depreciation and amortization. Depreciation and amortization for the three
months ended September 30, 2012 decreased 6.7% to $4.6 million from $4.9 million
in the three months ended September 30, 2011. The acquisition of STC accounted
for an increase of $0.2 million. Amortization of intangible assets associated
with the acquisition of three entities from Country Road Communications LLC
increased $0.2 million, reflecting the shorter remaining life of the TW
contract. The depreciation of RLEC assets decreased by $0.7 million.
23
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Impairment. There was a goodwill impairment decrease of $0.3 million in the
three months ended September 30, 2012 compared to no impairment in the three
months ended September 30, 2011. During third quarter 2012, we finalized the
calculation of deferred income tax liability associated with the STC
acquisition, reducing the amount of goodwill associated with the acquisition. In
second quarter 2012, the review of goodwill and long-lived assets had already
shown all of the New England reporting units' goodwill to be impaired resulting
in the decrease in goodwill impairment. See Liquidity and Capital Resources
below for additional information.
For the nine months ended September 30, 2012 and 2011
Nine Months Ended September 30, Change
2011 2012 Amount Percent
(dollars in thousands)
Cost of services $ 32,762 $ 32,038 $ (724 ) (2.2 ) %
Selling, general and
administrative
expenses 9,486 10,140 654 6.9
Depreciation and
amortization 15,176 15,019 (157 ) (1.0 )
Long-lived assets
impairment - PP&E - 2,874 2,874 NM
Long-lived assets
impairment -
intangibles - 5,748 5,748 NM
Goodwill impairment - 143,654 143,654 NM
Total $ 57,424 $ 209,473 $ 152,049 NM
Cost of services. Cost of services decreased 2.2% to $32.0 million in the
nine months ended September 30, 2012 from $32.8 million in the nine months ended
September 30, 2011. Costs related to the acquisition of STC added $1.2 million
and our hosted PBX product costs increased $0.1 million, reflecting continued
success with the product this year. These increases were more than offset by
lower toll and access costs of $0.7 million, lower sales and customer service
costs of $0.2 million, Universal Service Fund and federally mandated program
costs of $0.3 million and lower operating costs of $0.9 million, including the
reduction in employees implemented at the end of second quarter 2012.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased 6.9% to $10.1 million in the nine months ended
September 30, 2012 from $9.5 million in the nine months ended September 30,
2011. Expenses related to the acquisition of STC added $0.3 million,
restructuring expenses added $0.9 million and consultant expense associated with
the goodwill impairment study and the FCC's ICC order interpretation added $0.2
million. These increases were partially offset by reduction in property and
operating taxes of $0.2 million and lower operating costs of $0.4 million,
including the reduction in employees implemented at the end of second quarter
2012.
Depreciation and amortization. Depreciation and amortization decreased 1.0% to
$15.0 million in the nine months ended September 30, 2012 from $15.2 million in
the nine months ended September 30, 2011. The acquisition of STC accounted for
an increase of $0.6 million, the shortened life associated with the TW contract
increased amortization by $1.7 million and internet and CLEC depreciation
increased $0.3 million. These increases were more than offset by $0.5 million
associated with a telephone plant adjustment that was fully amortized in 2011,
lower RLEC depreciation of $1.5 million and lower amortization of intangibles of
$0.8 million.
Impairment. During the nine months ended September 30, 2012, impairment charges
were recorded totaling $152.3 million to reflect impairment of long-lived
assets, including goodwill. There were no similar charges in the same period of
2011. These charges recognize an impairment of property, plant and equipment of
$2.9 million, an impairment of intangible assets of $5.7 million and an
impairment of goodwill of $143.7 million. Based on a decline in the projected
revenue of the Company due to the non-renewal of the TW wholesale network
contract and the impacts of the FCC's ICC order, the fair value of the related
assets was below the book value. See Liquidity and Capital Resources below for
additional information.
For the three months ended September 30, 2012 and 2011
Three Months Ended September 30, Change
2011 2012 Amount Percent
(dollars in thousands)
Interest expense $ (6,222 ) $ (5,674 ) $ (548 ) (8.8 ) %
Change in fair value
of derivatives 655 - (655 ) NM
Other income 6 1 (5 ) NM
Income tax benefit
(expense) 323 (498 ) (821 ) NM
Interest expense. Interest expense decreased 8.8% to $5.7 million in the three
months ended September 30, 2012 from $6.2 million in the three months ended
September 30, 2011. The decrease in interest expense was primarily driven by the
lower effective interest rate on the outstanding balance of our senior long-term
notes payable upon expiration of our interest rate swaps on February 8, 2012.
Interest expense includes interest on our senior subordinated notes. The payment
of this interest was deferred for third quarter 2012 by our board of directors.
24
--------------------------------------------------------------------------------
Change in fair value of derivatives. As was required by our senior credit
facility, we had two interest rate swap agreements intended to hedge our
exposure to changes in interest rate costs associated with that facility. The
swap agreements did not qualify for hedge accounting under the technical
requirements of Accounting Standards Codification ("ASC") 815, Derivatives and
Hedging ("ASC 815"). Changes in value for the two swaps are reflected in change
in fair value of derivatives on the statements of operations and have no impact
on cash. The swaps expired on February 8, 2012, effectively lowering our
interest rate beginning February 9, 2012 from approximately 2.0% to the current
LIBOR rate, plus, in either case, a bank margin, which was 4.00% in third
quarter 2011 and 4.25% in third quarter 2012.
Other income. Other income, primarily interest income and gain on the sale of
equipment, was less than $0.1 million in the three months ended September 30,
2011 and 2012.
Income tax benefit (expense). Provision for income taxes was an expense of $0.5
million in the three months ended September 30, 2012, compared to a benefit of
$0.3 million in the three months ended September 30, 2011. The impact of changes
in goodwill impairment and the change in fair value of derivatives on the
effective tax rate caused the differences.
For the nine months ended September 30, 2012 and 2011
Nine Months Ended September 30, Change
2011 2012 Amount Percent
(dollars in thousands)
Interest expense $ (18,592 ) $ (17,162 ) $ (1,430 ) (7.7 ) %
Change in fair value of derivatives 1,641 241 (1,400 ) NM
Other income 389 312 (77 ) (19.8 )
Income tax benefit (expense) (36 ) 24,690 24,726 NM
Interest expense. Interest expense decreased 7.7% to $17.2 million in the nine
months ended September 30, 2012 from $18.6 million in the nine months ended
September 30, 2011. The decrease in interest expense was primarily driven by the
lower effective interest rate on the outstanding balance of our senior long-term
notes payable upon expiration of our interest rate swaps on February 8, 2012.
Interest expense includes interest on our senior subordinated notes. The payment
of this interest was deferred for third quarter 2012 by our board of directors.
Before deferring interest for an additional period beyond fourth quarter 2012,
the Company would be required to pay the deferred interest of $3.5 million for
each of the two deferred quarters plus interest on the deferred interest.
Change in fair value of derivatives. As was required by our senior credit
facility, we had two interest rate swap agreements intended to hedge our
exposure to changes in interest rate costs associated with that facility. The
swap agreements did not qualify for hedge accounting under the technical
requirements of ASC 815. Changes in value for the two swaps are reflected in
change in fair value of derivatives on the statements of operations and have no
impact on cash. The swaps expired on February 8, 2012, effectively lowering our
interest rate beginning February 9, 2012 from approximately 2.0% to the current
LIBOR rate, plus, in either case, a bank margin, which was 4.00% in the first
nine months of 2011 and 4.25% for the majority of the first nine months of 2012.
Other income. Other income decreased 19.8% to $0.3 million in the nine months
ended September 30, 2012 from $0.4 million in the nine months ended September
30, 2011, reflecting the annual CoBank dividends of $0.3 million that we receive
in the first quarter of each year. The difference was associated with lower
interest income in 2012 and a loss on the sale of equipment in 2012, as opposed
to a gain on the sale of equipment in 2011.
Income tax expense. Provision for income taxes was a benefit of $24.7 million in
the nine months ended September 30, 2012, reflecting the impact of the
long-lived asset and goodwill impairment, compared to an expense of less than
$0.1 million in the nine months ended September 30, 2011.
Net income. As a result of the foregoing, there was net income of $0.3 million
in the three months ended September 30, 2012 and $0.9 million in the three
months ended September 30, 2011. There was a net loss of $127.9 million in the
nine months ended September 30, 2012 and net income of $2.2 million in the nine
months ended September 30, 2011, which was primarily attributable to the impact
of long-lived asset and goodwill impairment recognized in second quarter 2012.
25
--------------------------------------------------------------------------------Liquidity and Capital Resources
Our liquidity needs arise primarily from: (i) interest payments related to our
senior credit facility and our senior subordinated notes; (ii) capital
expenditures; and (iii) working capital requirements. We suspended dividends on
our common stock on April 20, 2012 in order to free up cash for other purposes.
On August 7, 2012, we announced that our board of directors had exercised its
right under the indenture governing our senior subordinated notes to defer
interest on the senior subordinated notes for the third quarter 2012. In
addition, on November 6, 2012, we announced that our board of directors had
exercised its right under the indenture governing our senior subordinated notes
to defer interest on the senior subordinated notes for the fourth quarter 2012.
The deferred interest expense is $3.5 million for each of the third and fourth
quarters. Before deferring interest for an additional period beyond fourth
quarter 2012, the Company would be required to pay the deferred interest of $7.0
million plus interest on the deferred interest.
Historically, we satisfy our operating cash requirements from the cash generated
by our business and utilize borrowings under our senior credit facility to
facilitate acquisitions; however, we financed our acquisition of STC using cash
on hand. For the nine months ended September 30, 2012, we generated cash from
our business to invest in additional property and equipment and pay interest on
our senior debt. After meeting all of these needs of our business, cash
increased from $12.4 million at December 31, 2011 to $27.2 million at September
30, 2012. The most recent interest payment on our senior subordinated debt of
$3.5 million was made on July 2, 2012, as the normal distribution date of June
30, 2012 fell on a non-banking day. The third quarter payment on our senior
subordinated debt was deferred by our board of directors.
Cash flows from operating activities for the first nine months of 2012 amounted
to $21.1 million compared to $15.4 million for the first nine months of 2011.
Net income, when adjusted for its non-cash components, declined by $0.5 million.
The changes in operating assets and liabilities of $6.3 million reflects the
deferral of $3.5 million of interest on our senior subordinated debt in third
quarter 2012, a reduction of one month's accrued liability for interest on our
senior debt associated with electing one month LIBOR contracts in 2012 versus
three month LIBOR contracts in 2011, the recognition of prepaid expenses
associated with our shelf offering that is now unlikely to occur and an
additional month's receivable on the TW contract in 2011.
Cash flows used in investing activities for the first nine months of 2012 were
$3.4 million compared to $8.4 million in the first nine months of 2011,
reflecting a lower rate of capital expenditures for property and equipment in
the first nine months of 2012.
Cash flows used in financing activities for the first nine months of 2012 were
$2.9 million compared to $7.4 million in the first nine months of 2011,
reflecting payments of dividends to stockholders in three quarters of 2011 and
one quarter of 2012. The dividends paid were at the rate of $0.17625 per common
share per quarter. We suspended dividends on our common stock on April 20, 2012.
There was a repayment of $0.4 million on our long-term senior debt in 2011. In
2012, we have paid $0.6 million in pursuing an amendment to our senior credit
facility.
We do not invest in financial instruments as part of our business strategy. The
Company had two interest rate swaps that expired on February 8, 2012. From an
accounting perspective, the documentation for the swaps did not meet the
technical requirements of ASC 815 to allow the swaps to be considered highly
effective as hedging instruments and therefore the swaps did not qualify for
hedge accounting.
We also have received patronage shares, primarily from one of our lenders, over
a period of years for which there is a limited market to determine value until
the shares are redeemed by the issuing institution. Historically, these shares
have been redeemed at a value similar to their issued value. Due to the
uncertainty of this future value, these shares are carried at $1.5 million, or
approximately 55% of their issued value.
ASC 350, Intangibles - Goodwill and Other ("ASC 350"), requires that goodwill be
tested for impairment annually, unless potential interim indicators exist that
could result in impairment. During the second quarter of 2012, an interim
goodwill impairment test was performed in response to indicators revealed in the
annual forecasting process. Due to the expected expiration of the TW wholesale
network contract, and recent FCC reform, forecasted operating profits were
reduced below the levels projected during the fourth quarter of 2011 and first
quarter of 2012. Including an adjustment in third quarter 2012 for STC deferred
taxes that reduced goodwill associated with the acquisition, long-lived assets
have been reduced in 2012 by $8.6 million and goodwill has been reduced by
$143.7 million.
The impairment charges reflect our expectation that future cash flows will
decline from current levels as a consequence of the FCC's ICC order and the
non-renewal of the TW contract, in addition to the attrition of voice access
lines inherent in our business. The impairment of goodwill and other long-lived
assets has no cash impact.
26--------------------------------------------------------------------------------
We anticipate that operating cash flow will be adequate to meet our currently
anticipated operating and capital expenditure requirements for at least the next
12 months. The announced non-renewal of the TW contract will reduce future cash
flows of the business beginning in 2013 and the impacts of the FCC's ICC order
began reducing cash flows of the business in third quarter 2012. The Company has
taken steps to conserve cash, including the suspension of dividends on our
common stock beginning second quarter 2012, the exercise of our contractual
right to defer interest on our senior subordinated debt for third and fourth
quarter 2012, reductions in employees in second quarter 2012, with additional
reductions planned for 2013 upon completion of the TW customer transfers,
reductions in senior management and board of directors compensation and reduced
capital spending. Because of the negative impact of the FCC's ICC order and the
expiration of the TW contract, we are exploring our strategic alternatives to
address our existing levels of debt and strengthen our balance sheet. The
Company has engaged Evercore Partners, an investment banking firm, to assist us
in this process. Evercore Partners' areas of expertise include debt and capital
market transactions, restructuring of balance sheet obligations and mergers and
acquisitions advice. In addition, on October 5, 2012, the Company retained
restructuring counsel to aid in this process. Together with its advisors, the
Company will evaluate its alternatives.
The following table provides a summary of the extent to which cash generated
from operations is reinvested in our operations, used to pay interest on our
senior debt and senior subordinated notes or distributed as dividends to our
stockholders for the periods indicated.
Nine Months Ended September 30,
2011 2012
(dollars in thousands)
Cash generation
Revenues $ 76,196 $ 74,516
Other income 389 312
Cash received from operations $ 76,585 $ 74,828
Cost of services $ 32,762 $ 32,038
Selling, general and administrative expenses 9,486 10,140
Cash consumed by operations $ 42,248 $ 42,178
Cash generated from operations $ 34,337 $ 32,650
Cash utilization
Capital investment in operations $ 8,448 $ 3,396
Senior debt interest and fees 7,190 5,772
Interest on senior subordinated notes 10,497 6,998
Dividends 6,991 2,330
Cash utilized by the Company $ 33,126 $ 18,496
Percentage of cash utilized of cash generated 96.5 % 56.6 %
We use adjusted earnings before interest, taxes, depreciation and amortization
("Adjusted EBITDA") as an operational performance measurement. Adjusted EBITDA,
as presented in this Form 10-Q, corresponds to the definition of Adjusted EBITDA
in the indenture governing our senior subordinated notes and our senior credit
facility. Adjusted EBITDA, as presented in this Form 10-Q, is a supplemental
measure of our performance that is not required by, or presented in accordance
with, accounting principles generally accepted in the United States ("U.S.
GAAP"). Our senior credit facility requires that we report performance in this
format each quarter and involved lending institutions utilize this measure to
determine compliance with credit facility requirements. We report Adjusted
EBITDA in our quarterly earnings press release to allow current and potential
investors to understand this performance metric and because we believe that it
provides current and potential investors with helpful information with respect
to our operating performance and cash flows. However, Adjusted EBITDA should not
be considered as an alternative to net income or any other performance measures
derived in accordance with U.S. GAAP or as an alternative to net cash provided
by operating activities as a measure of our liquidity. Our presentation of
Adjusted EBITDA may not be comparable to similarly titled measures used by other
companies. Adjusted EBITDA for the three months and nine months ended September
30, 2011 and 2012, and its reconciliation to net income (loss), is reflected in
the table below:
27--------------------------------------------------------------------------------
Three Months Ended September 30, Nine Months Ended September 30,
2011 2012 2011 2012
(dollars in thousands)
Net income (loss) $ 885 $ 316 $ 2,173 $ (126,876 )
Add: Depreciation
2,922 2,467 8,751 7,942
Interest expense - net of premium 5,880 5,332 17,566 16,136
Interest expense - amortize loan cost 342 342 1,026 1,026
Income tax expense (benefit) (323 ) 498 36 (24,690 )
Change in fair value of derivatives (654 ) - (1,641 ) (241 )
Loan fees 19 19 57 57
Amortization - intangibles 2,023 2,147 6,425 7,076
Goodwill impairment - (344 ) - 143,654
Impairment of long-lived assets - - - 8,622
Restructuring expense - 592 - 953
Adjusted EBITDA $ 11,094 $ 11,369 $ 34,393 $ 33,659
Recent Accounting Pronouncements
During 2012, the Financial Accounting Standards Board (the "FASB") issued
Accounting Standards Update ("ASU") 2012-01 through 2012-07. Except for ASU
2012-02, which is discussed below, these ASUs provide technical corrections to
existing guidance and to specialized industries or entities and therefore, have
minimal, if any, impact on the Company.
In July 2012, the FASB issued ASU 2012-02, Testing Indefinite-Lived Intangible
Assets for Impairment, an amendment to ASC 350 Intangibles - Goodwill and Other.
This ASU provides an option for companies to use a qualitative approach to test
indefinite-lived intangible assets for impairment if certain conditions are met.
The amendments are effective for annual and interim indefinite-lived intangible
asset impairment tests performed for fiscal years beginning after September 15,
2012. The implementation of this ASU is not expected to have a material impact
on our consolidated financial position or results of operations.
Subsequent Events
The Company is continuing negotiations with the lenders under its senior credit
facility with respect to a potential balance sheet restructuring. On October 5,
2012, the Company retained restructuring counsel to aid in these negotiations.
Together with its advisors, the Company will evaluate its alternatives.
On November 6, 2012, the Company announced that its board of directors had
exercised its contractual right under the indenture governing the Company's
senior subordinated notes to defer interest on the senior subordinated notes for
the fourth quarter 2012. Under the indenture, the Company's board of directors
is permitted to defer interest on up to four occasions with respect to up to two
quarters per occasion before resuming interest payments, including paying
interest on the deferred interest. The Company previously deferred interest on
the senior subordinated notes for the third quarter 2012. The deferral of the
interest for fourth quarter 2012 will conserve $3.5 million in cash.
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