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CITIZENS COMMUNICATIONS COMPANY
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2003
--------------
or
--
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________to__________
Commission file number: 001-11001
---------
CITIZENS COMMUNICATIONS COMPANY
-------------------------------
(Exact name of registrant as specified in its charter)
Delaware 06-0619596
-------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3 High Ridge Park
Stamford, Connecticut 06905
- --------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(203) 614-5600
---------------------------------------------------
(Registrant's telephone number, including area code)
N/A
----------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
---- ----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.)
Yes X No
---- ----
The number of shares outstanding of the registrant's Common Stock as of April
30, 2003 was 283,448,803.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Index to Consolidated Financial Statements
Page No.
--------
Part I. Financial Information (Unaudited)
Consolidated Balance Sheets at March 31, 2003 and December 31, 2002 2
Consolidated Statements of Operations for the three months ended March 31, 2003 and 2002 3
Consolidated Statements of Shareholders' Equity for the year ended December 31, 2002 and the
three months ended March 31, 2003 4
Consolidated Statements of Comprehensive Income for the three months ended March 31,
2003 and 2002 4
Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and 2002 5
Notes to Consolidated Financial Statements 6
Management's Discussion and Analysis of Financial Condition and Results of Operations 18
Quantitative and Qualitative Disclosures about Market Risk 29
Controls and Procedures 30
Part II. Other Information
Legal Proceedings 31
Exhibits and Reports on Form 8-K 32
Signature 33
Certifications 34
1
ITEM 1. FINANCIAL STATEMENTS
--------------------
PART I. FINANCIAL INFORMATION
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
($ in thousands)
(Unaudited)
March 31, 2003 December 31, 2002
------------------- ------------------
ASSETS
- ------
Current assets:
Cash and cash equivalents $ 455,923 $ 393,177
Accounts receivable, less allowances of $39,661 and $38,946, respectively 288,415 310,929
Other current assets 36,717 49,114
Assets held for sale 464,491 447,764
------------------- ------------------
Total current assets 1,245,546 1,200,984
Property, plant and equipment, net 3,707,554 3,690,056
Goodwill, net 1,869,348 1,869,348
Other intangibles, net 911,259 942,970
Investments 36,148 29,846
Other assets 428,713 413,538
------------------- ------------------
Total assets $ 8,198,568 $ 8,146,742
=================== ==================
LIABILITIES AND EQUITY
- ----------------------
Current liabilities:
Long-term debt due within one year $ 110,305 $ 58,911
Accounts payable and other current liabilities 567,101 561,902
Liabilities related to assets held for sale 129,527 150,053
------------------- ------------------
Total current liabilities 806,933 770,866
Deferred income taxes 206,553 137,116
Customer advances for construction and contributions in aid of construction 134,751 146,661
Other liabilities 298,896 301,349
Equity units 460,000 460,000
Long-term debt 4,783,255 4,957,361
Company Obligated Mandatorily Redeemable Convertible Preferred Securities* 201,250 201,250
Shareholders' equity:
Common stock, $0.25 par value (600,000,000 authorized shares; 283,282,000
and 282,482,000 outstanding and 294,324,000 and 294,080,000 issued at
March 31, 2003 and December 31, 2002, respectively) 73,581 73,520
Additional paid-in capital 1,937,693 1,943,406
Accumulated deficit (425,602) (553,033)
Accumulated other comprehensive loss (98,279) (102,169)
Treasury stock (180,463) (189,585)
------------------- ------------------
Total shareholders' equity 1,306,930 1,172,139
------------------- ------------------
Total liabilities and equity $ 8,198,568 $ 8,146,742
=================== ==================
* Represents securities of a subsidiary trust, the sole assets of which are securities of a subsidiary
partnership, substantially all the assets of which are convertible debentures of the Company.
The accompanying Notes are an integral part of these Consolidated
Financial Statements.
2
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
($ in thousands, except per-share amounts)
(Unaudited)
2003 2002
-------------- --------------
Revenue $ 651,862 $ 679,334
Operating expenses:
Cost of services 113,219 128,238
Other operating expenses 235,821 260,854
Depreciation and amortization 138,548 178,174
Reserve for telecommunications bankruptcies - 7,804
Restructuring and other expenses (21) 3,905
-------------- --------------
Total operating expenses 487,567 578,975
-------------- --------------
Operating income 164,295 100,359
Investment and other income (loss), net 49,822 (48,508)
Loss on sale of assets 1,650 -
Interest expense 109,276 122,050
-------------- --------------
Income (loss) from continuing operations before income taxes, dividends on
convertible preferred securities, and cumulative effect of change
in accounting principle 103,191 (70,199)
Income tax expense (benefit) 39,976 (26,942)
-------------- --------------
Income (loss) from continuing operations before dividends on convertible
preferred securities, and cumulative effect of change in accounting principle 63,215 (43,257)
Dividends on convertible preferred securities, net of income tax benefit of $(963) 1,553 1,553
-------------- --------------
Income (loss) from continuing operations before cumulative effect of
change in accounting principle 61,662 (44,810)
Loss from discontinued operations, net of income tax benefit of $(920) - (1,478)
Gain on disposal of water segment, net of tax of $139,874 - 169,326
-------------- --------------
Total income from discontinued operations, net of tax of $138,954 - 167,848
Income before cumulative effect of change in accounting principle 61,662 123,038
Cumulative effect of change in accounting principle, net of tax of
$41,591 and $0, respectively 65,769 (39,812)
-------------- --------------
Net income attributable to common shareholders $ 127,431 $ 83,226
============== ==============
Basic income per common share:
Income (loss) from continuing operations before cumulative effect of
change in accounting principle $ 0.22 $ (0.16)
Income from discontinued operations $ - $ 0.60
Income before cumulative effect of change in accounting principle $ 0.22 $ 0.44
Cumulative effect of change in accounting principle $ 0.23 $ (0.14)
Net income attributable to common shareholders $ 0.45 $ 0.30
Diluted income per common share:
Income (loss) from continuing operations before cumulative effect of
change in accounting principle $ 0.22 $ (0.16)
Income from discontinued operations $ - $ 0.59
Income before cumulative effect of change in accounting principle $ 0.22 $ 0.43
Cumulative effect of change in accounting principle $ 0.23 $ (0.14)
Net income attributable to common shareholders $ 0.45 $ 0.29
The accompanying Notes are an integral part of these Consolidated
Financial Statements.
3
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEAR ENDED DECEMBER 31, 2002 AND THE THREE MONTHS ENDED MARCH 31, 2003
($ in thousands)
(Unaudited)
Retained Accumulated
Common Stock Additional Earnings Other Treasury Stock Total
------------------ Paid-In (Accumulated Comprehensive ---------------- Shareholders'
Shares Amount Capital Deficit) Income (Loss) Shares Amount Equity
--------- -------- ----------- ------------ -------------- -------- ------- -----------
Balances January 1, 2002 292,840 $73,210 $ 1,927,518 $ 129,864 $ 4,907 (11,551) $ (189,357) $1,946,142
Stock plans 1,240 310 15,888 - - (47) (228) 15,970
Net loss - - - (682,897) - - - (682,897)
Other comprehensive income, net of
tax and reclassifications adjustments - - - - (107,076) - - (107,076)
--------- --------- ----------- ------------ ------------ -------- ----------- -----------
Balances December 31, 2002 294,080 73,520 1,943,406 (553,033) (102,169) (11,598) (189,585) 1,172,139
Stock plans 244 61 (5,713) - - 556 9,122 3,470
Net income - - - 127,431 - - - 127,431
Other comprehensive income, net of
tax and reclassifications adjustments - - - - 3,890 - - 3,890
--------- --------- ----------- ------------ ------------ -------- ----------- -----------
Balances March 31, 2003 294,324 $73,581 $ 1,937,693 $ (425,602) $ (98,279) (11,042) $ (180,463) $1,306,930
========= ========= =========== ============ ============ ======== =========== ===========
The accompanying Notes are an integral part of these Consolidated
Financial Statements.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
($ in thousands)
(Unaudited)
For the three months ended March 31,
---------------------------------------------
2003 2002
--------------------- ---------------------
Net income $ 127,431 $ 83,226
Other comprehensive income (loss), net of
tax and reclassifications adjustments* 3,890 (293)
--------------------- ---------------------
Total comprehensive income $ 131,321 $ 82,933
===================== =====================
* Consists of unrealized holding gains/(losses) of marketable securities.
The accompanying Notes are an integral part of these Consolidated
Financial Statements.
4
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002
($ in thousands)
2003 2002
--------------- ---------------
Income (loss) from continuing operations before cumulative
effect of change in accounting principle $ 61,662 $ (44,810)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization expense 138,548 178,174
Investment write-down - 49,740
Gain on extinguishment of debt (46,868) -
Investment (gains)/losses 201 -
Loss on sale of assets 1,650 -
Allowance for equity funds used during construction (34) (475)
Deferred and accrued income taxes 79,808 (156,291)
Change in accounts receivable 24,281 8,185
Change in accounts payable, accrued expenses and
other liabilities (71,288) 6,431
Change in other current assets 12,392 98,043
--------------- ---------------
Net cash provided by continuing operating activities 200,352 138,997
Cash flows from investing activities:
Proceeds from sale of assets, net of selling expenses 553 -
Capital expenditures (47,752) (68,439)
Securities purchased (22) (450)
Securities matured - 2,014
Other - 447
--------------- ---------------
Net cash used by investing activities (47,221) (66,428)
Cash flows from financing activities:
Long-term debt principal payments (89,438) (148,097)
Issuance of common stock 3,198 4,832
Customer advances for construction
and contributions in aid of construction (4,145) 1,402
--------------- ---------------
Net cash used by financing activities (90,385) (141,863)
Cash provided by (used by) discontinued operations
Proceeds from sale of discontinued operations - 859,065
Net cash used by discontinued operations - (32,889)
Increase in cash and cash equivalents 62,746 756,882
Cash and cash equivalents at January 1, 393,177 215,869
--------------- ---------------
Cash and cash equivalents at March 31, $ 455,923 $ 972,751
=============== ===============
Cash paid during the period for:
Interest $ 107,982 $ 104,273
Income taxes $ 306 $ 1,644
Non-cash investing and financing activities:
Change in fair value of interest rate swaps $ 711 $ (364)
Note receivable from sale of assets $ 21,306 $ -
The accompanying Notes are an integral part of these Consolidated
Financial Statements.
5
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Summary of Significant Accounting Policies:
------------------------------------------
(a) Basis of Presentation and Use of Estimates:
Citizens Communications Company and its subsidiaries are referred to
as "we," "us" "our" or the "Company" in this report. Our unaudited
consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of
America (GAAP) and should be read in conjunction with the consolidated
financial statements and notes included in our 2002 Annual Report on
Form 10-K. These unaudited consolidated financial statements include
all adjustments, which consist of normal recurring accruals necessary
to present fairly the results for the interim periods shown.
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions which affect the
amounts of assets, liabilities, revenue and expenses we have reported
and our disclosure of contingent assets and liabilities at the date of
the financial statements. Actual results may differ from those
estimates. We believe that our critical estimates are depreciation
rates, pension assumptions, calculations of impairment amounts,
intangible assets, income taxes and contingencies, and allowance for
doubtful accounts, including reserves established for
telecommunication bankruptcies.
Certain information and footnote disclosures have been excluded and/or
condensed pursuant to Securities and Exchange Commission rules and
regulations. The results of the interim periods are not necessarily
indicative of the results for the full year. Certain reclassifications
of balances previously reported have been made to conform to current
presentation.
(b) Cash Equivalents:
We consider all highly liquid investments with an original maturity of
three months or less to be cash equivalents.
(c) Goodwill and Other Intangibles:
Intangibles represent the excess of purchase price over the fair value
of identifiable tangible assets acquired. We undertake studies to
determine the fair values of assets acquired and allocate purchase
prices to property, plant and equipment, goodwill and other
identifiable intangibles. On January 1, 2002, we adopted Statement of
Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other
Intangible Assets," which applies to all goodwill and other intangible
assets recognized in the statement of financial position at that date,
regardless of when the assets were initially recognized. This
statement requires that goodwill and other intangibles with indefinite
useful lives no longer be amortized to earnings, but instead be
reviewed for impairment, at least annually. The amortization of
goodwill and other intangibles with indefinite useful lives ceased
upon adoption of the statement on January 1, 2002. We annually (during
the fourth quarter) examine the carrying value of our goodwill and
other intangibles with indefinite useful lives to determine whether
there are any impairment losses.
(d) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed
of:
We adopted SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets" as of January 1, 2002. In accordance with SFAS No.
144, we review long-lived assets to be held and used and long-lived
assets to be disposed of, including intangible assets with estimated
useful lives, for impairment whenever events or changes in
circumstances indicate that the carrying amount of such assets may not
be recoverable. Recoverability of assets to be held and used is
measured by comparing the carrying amount of the asset to the future
undiscounted net cash flows expected to be generated by the asset.
Recoverability of assets held for sale is measured by comparing the
carrying amount of the assets to their estimated fair market value. If
any assets are considered to be impaired, the impairment is measured
by the amount by which the carrying amount of the assets exceeds the
estimated fair value.
(e) Derivative Instruments and Hedging Activities:
On the date the derivative contract is entered into, we designate the
derivative as either a fair value or cash flow hedge. A hedge of the
fair value of a recognized asset or liability or of an unrecognized
firm commitment is a fair value hedge. A hedge of a forecasted
transaction or the variability of cash flows to be received or paid
related to a recognized asset or liability is a cash flow hedge. We
formally document all relationships between hedging instruments and
hedged items, as well as its risk-management objective and strategy
for undertaking the hedge transaction. This process includes linking
all derivatives that are designated as fair value or cash flow hedges
to specific assets and liabilities on the balance sheet or to specific
firm commitments or forecasted transactions.
6
We also formally assess, both at the hedge's inception and on an
ongoing basis, whether the derivatives that are used in hedging
transactions are highly effective in offsetting changes in fair values
or cash flows of hedged items. If it is determined that a derivative
is not highly effective as a hedge or that it has ceased to be a
highly effective hedge, we would discontinue hedge accounting
prospectively.
All derivatives are recognized on the balance sheet at their fair
value. Changes in the fair value of derivative financial instruments
are either recognized in income or shareholders equity (as a component
of other comprehensive income), depending on whether the derivative is
being used to hedge changes in fair value or cash flows.
We entered into interest rate swap arrangements during 2002 related to
a portion of our fixed rate debt. These hedge strategies satisfy the
fair value hedging requirements of SFAS No. 133. As a result, the fair
value of the hedges is carried on the balance sheet in other current
assets and the related underlying liabilities are also adjusted to
fair value by the same amount.
(f) Employee Stock Plans:
We have various employee stock-based compensation plans. Awards under
these plans are granted to eligible officers, management employees and
non-management employees. Awards may be made in the form of incentive
stock options, non-qualified stock options, stock appreciation rights,
restricted stock or other stock based awards. As permitted by current
accounting rules, we recognize compensation expense in the financial
statements only if the market price of the underlying stock exceeds
the exercise price on the date of grant.
At March 31, 2003, we have four stock based compensation plans: the
Management Equity Incentive Plan (MEIP), the Equity Incentive Plan
(EIP), the Employee Stock Purchase Plan (ESPP) and our Directors'
Deferred Fee Equity Plan. We apply Accounting Principles Board
Opinions (APB) No. 25 and related interpretations in accounting for
the employee stock plans resulting in the use of the intrinsic value
to value the stock option. In addition, we grant restricted stock
awards to key employees in the form of our Common Stock. Compensation
expense is recognized as a component of operating expense for our
Directors' Deferred Fee Equity Plan and restricted stock grants.
Compensation cost is not generally recognized in the financial
statements for options issued pursuant to the MEIP or EIP, as the
exercise price for such options was equal to the market price of the
stock at the time of grant. Compensation cost is also not recognized
in the financial statements related to the ESPP because the purchase
price is 85% of the fair value. For purposes of presenting pro forma
information the fair value of options granted is computed using the
Black Scholes option-pricing model.
7
Had we determined compensation cost based on the fair value at the
grant date for the MEIP, EIP and ESPP, our pro forma net income and
net income per common share would have been as follows:
Three Months Ended March 31,
----------------------------
2003 2002
------------ ------------
($ in thousands)
Net income As reported $ 127,431 $ 83,226
Add: Stock-based employee
compensation expense included
in reported net income, net of
related tax effects
844 1,290
Deduct: Total stock-based
employee compensation expense
determined under fair
value based method for all
awards, net of related tax
effects (3,084) (4,073)
------------ ----------
Pro forma $ 125,191 $ 80,443
============ ==========
Net income per common share As reported:
Basic $ 0.45 $ 0.30
Diluted 0.45 0.29
Pro forma:
Basic $ 0.44 $ 0.29
Diluted 0.44 0.28
(g) Revenue Recognition:
Incumbent Local Exchange Carrier (ILEC) - Revenue is recognized when
services are provided or when products are delivered to customers.
Revenue that is billed in advance includes: monthly recurring network
access services, special access services and monthly recurring local
line charges. The unearned portion of this revenue is initially
deferred as a component of other current liabilities on our balance
sheet and recognized in revenue over the period that the services are
provided. Revenue that is billed in arrears includes: non-recurring
network access services, switched access services, non-recurring local
services and long-distance services. The earned but unbilled portion
of this revenue is recognized in revenue in our statement of
operations and accrued in accounts receivable in the period that the
services are provided. Excise taxes are recognized as a liability when
billed. Installation fees and their related direct and incremental
costs are initially deferred and recognized as revenue and expense
over the average term of a customer relationship. We recognize as
current period expense the portion of installation costs that exceeds
installation fee revenue.
Electric Lightwave, Inc. (ELI) - Revenue is recognized when the
services are provided. Revenue from long-term prepaid network services
agreements including Indefeasible Rights to Use (IRU), are deferred
and recognized on a straight-line basis over the terms of the related
agreements. Installation fees and their related direct and incremental
costs are initially deferred and recognized as revenue and expense
over the average term of a customer relationship. We recognize as
current period expense the portion of installation costs that exceeds
installation fee revenue.
8
Public Utilities Services - Revenue is recognized when services are
provided for public utilities services. Certain revenue is based upon
consumption while other revenue is based upon a flat fee. Earned but
unbilled public services revenue is accrued and included in accounts
receivable and revenue.
(h) Net Income Per Common Share:
Basic net income per common share is computed using the weighted
average number of common shares outstanding during the period being
reported on. Diluted net income per common share reflects the
potential dilution that could occur if securities or other contracts
to issue common stock that are in the money were exercised or
converted into common stock at the beginning of the period being
reported on.
(2) Property, Plant and Equipment, Net:
----------------------------------
Property, plant and equipment at March 31, 2003 and December 31, 2002 is as
follows:
($ in thousands) March 31, 2003 December 31, 2002
---------------------- ---------------------
Property, plant and equipment $ 6,120,913 $ 6,139,772
Less accumulated depreciation (2,413,359) (2,449,716)
---------------------- ---------------------
Property, plant and equipment, net $ 3,707,554 $ 3,690,056
====================== =====================
Depreciation expense, calculated using the straight-line method, is based
upon the estimated service lives of various classifications of property,
plant and equipment. Depreciation expense was $106,836,000 and $147,820,000
for the three months ended March 31, 2003 and 2002, respectively. Effective
January 1, 2003, as a result of the adoption of SFAS No. 143, "Accounting
for Asset Retirement Obligations", we ceased recognition of the cost of
removal provision in depreciation expense and eliminated the cumulative
cost of removal included in accumulated depreciation. In addition, we
increased the average depreciable lives for certain of our equipment. This
change in estimate reduced depreciation expense by $18,463,000, or $0.04
per share, for the quarter ended March 31, 2003 as compared to March 31,
2002. For the three months ended March 31, 2002, we recognized accelerated
depreciation of $11,900,000 related to the closing of our Plano, Texas
facility.
(3) Discontinued Operations and Net Assets Held for Sale:
----------------------------------------------------
On August 24, 1999, our Board of Directors approved a plan of divestiture
for our public utilities services businesses, which included gas, electric
and water and wastewater businesses.
Water and Wastewater
--------------------
On January 15, 2002, we completed the sale of our water and wastewater
operations to American Water Works, Inc. for $859,100,000 in cash and
$122,500,000 of assumed debt and other liabilities. The pre-tax gain
on the sale recognized in the first quarter of 2002 was $309,200,000,
subsequently adjusted to $316,672,000 in the fourth quarter of 2002.
Electric and Gas
----------------
On October 29, 2002, we entered into definitive agreements to sell our
Arizona gas and electric divisions to UniSource Energy Corporation for
$230,000,000 in cash ($220,000,000 if we close the sale by July 28,
2003), subject to adjustments specified in the agreements. The
transaction, which is subject to regulatory and other customary
approvals, is expected to close during the second half of 2003.
On November 1, 2002, we completed the sale of our Kauai electric
division to Kauai Island Utility Cooperative (KIUC) for $215,000,000
in cash. The pre-tax gain on the sale recognized in the fourth quarter
of 2002 was $8,273,000.
On December 19, 2002, we entered into a definitive agreement to sell
The Gas Company in Hawaii to K-1 USA Ventures, Inc. for $115,000,000
in cash, subject to adjustments under the terms of the agreement. The
transaction, which is subject to regulatory and other customary
approvals, is expected to close during the second half of 2003.
9
We have entered into definitive agreements to sell the assets of our
Vermont electric division to Vermont Electric Power Company, Inc. and
Vermont Electric Cooperative, Inc. for an aggregate of approximately
$25,000,000 in cash, subject to adjustments under the terms of the
agreements. The transactions, which are subject to regulatory and
other customary approvals, are expected to close by mid-2004.
All our gas and electric assets (comprised of Arizona gas and electric,
Hawaii gas and Vermont electric) and their related liabilities are
classified as "assets held for sale" and "liabilities related to assets
held for sale," respectively. These assets have been written down to our
best estimate of the net realizable value upon sale.
Discontinued operations in the consolidated statements of operations
reflect the results of operations of the water/wastewater properties sold
in January 2002 including allocated interest expense for the periods
presented. Interest expense was allocated to the discontinued operations
based on the outstanding debt specifically identified with these
businesses.
Summarized financial information for the water/wastewater operations
(discontinued operations) is set forth below:
($ in thousands) For the three months ended March 31,
--------------------------------------------
2003 2002
-------------------- ---------------------
Revenue $ - $ 4,650
Operating loss $ - $ (419)
Income tax benefit $ - $ (920)
Loss from discontinued operations, net of tax $ - $ (1,478)
Gain on disposal of water segment, net of tax $ - $ 169,326
Summarized financial information for the gas and electric operations
(assets held for sale) is set forth below:
($ in thousands) March 31, 2003 December 31, 2002
-------------------- -------------------
Current assets $ 48,839 $ 49,549
Net property, plant and equipment 368,519 358,135
Other assets 47,133 40,080
-------------------- -------------------
Total assets held for sale $ 464,491 $ 447,764
==================== ===================
Current liabilities $ 68,314 $ 83,278
Other liabilities 61,213 66,775
-------------------- -------------------
Total liabilities related to assets held for sale $ 129,527 $ 150,053
==================== ===================
(4) Other Intangibles:
-----------------
Other intangibles at March 31, 2003 and December 31, 2002 are as follows:
($ in thousands) March 31, 2003 December 31, 2002
------------------------ ---------------------
Customer base - amortizable over 96 months $ 1,000,816 $ 1,000,816
Trade name - non-amortizable 122,058 122,058
------------------------ ---------------------
Other intangibles 1,122,874 1,122,874
Accumulated amortization (211,615) (179,904)
------------------------ ---------------------
Total other intangibles, net $ 911,259 $ 942,970
======================== =====================
10
We have reflected assets acquired at fair market values at the time of
acquisition in accordance with purchase accounting standards. Our
allocations are based upon an independent appraisal of the respective
properties acquired.
(5) Restructuring Charges:
---------------------
2002
----
Restructuring and other expenses primarily consist of expenses related to
our various restructurings, including reductions in personnel at our
telecommunications operations, costs that were spent at our Plano, Texas
facility and at other locations as a result of transitioning functions and
jobs. These costs were partially offset by a $2,100,000 reversal of a 2001
ELI accrual recognized in the first quarter of 2002, which was subsequently
adjusted to $2,825,000 in the fourth quarter of 2002. See further
discussion below.
2001
----
During 2001, we examined all aspects of our business operations and our
facilities to take advantage of operational and functional synergies
between Frontier and the original Citizens businesses. We continue to
review our operations, personnel and facilities to achieve greater
efficiency.
Plano Restructuring
Pursuant to a plan adopted in the third quarter of 2001, we closed our
operations support center in Plano, Texas in August 2002. In
connection with this plan, we recorded a pre-tax charge of $839,000
for the three months ended March 31, 2002. The restructuring expenses
primarily consist of severance benefits, retention earned through
March 31, 2002 and other planning and communication costs. We sold our
Plano office building in March 2003.
Sacramento Call Center Restructuring
In April 2002, we closed our Sacramento Customer Care Center pursuant
to a plan adopted in the fourth quarter of 2001. In connection with
this closing, we recorded a pre-tax charge of $62,000 for the three
months ended March 31, 2002.
ELI Restructuring
In the first half of 2002, ELI redeployed the Internet routers, frame
relay switches and ATM switches from the Atlanta, Cleveland, Denver,
Philadelphia and New York markets to other locations in ELI's network
pursuant to a plan adopted in the fourth quarter of 2001. ELI ceased
leasing the collocation facilities and off-net circuits for the
backbone and local loops supporting the service delivery in these
markets. It was anticipated that this would lead to $4,179,000 of
termination fees, which were accrued for but not paid at December 31,
2001. In the first quarter 2002, ELI adjusted their original accrual
down by $2,100,000 due to the favorable settlement of termination
charges for an off-net circuit agreement. By December 31, 2002, this
accrual was adjusted down by $725,000.
($ in thousands)
2001 Severance Benefits Retention Other Total
-------------- -------------- -------------- ------------- ----------
2001 Plano Restructuring
Original accrued amount $ 9,353 $ 1,535 $ 1,178 $ 936 $ 13,002
Amount paid (8,985) (1,390) (3,832) (523) (14,730)
Additional accrual 616 - 2,943 27 3,586
Adjustments (984) (132) (289) (440) (1,845)
------------- -------------- -------------- ------------ ----------
Accrued @ 12/31/2002 - 13 - - 13
------------- -------------- -------------- ------------ ----------
Amount paid - (13) - - (13)
Additional accrual - - - - -
Adjustments - - - - -
------------- -------------- -------------- ------------ ----------
Accrued @ 3/31/2003 $ - $ - $ - $ - $ -
============= ============== ============== ============ ==========
11
(6) Long-Term Debt:
--------------
The activity in our long-term debt from December 31, 2002 to March 31, 2003
is as follows:
Three Months Ended March 31, 2003
--------------------------------------
Interest Interest Rate* at
December 31, Rate Swap/ March 31, March 31,
($ in thousands) 2002 Payments** Reclassification Other 2003 2003
------------ ---------- ---------------- --------- --------- ---------
FIXED RATE
Rural Utilities Service Loan $ 30,874 $ (218) $ - $ - $ 30,656 6.210%
Contracts
Senior Unsecured Debt 4,508,880 (88,700) 711 - 4,420,891 8.199%
Equity Units 460,000 - - - 460,000 7.480%
ELI Notes 5,975 - - - 5,975 6.232%
ELI Capital Leases 135,200 (517) (33,985) 100,698 10.282%
Industrial Development Revenue 186,390 - - - 186,390 6.091%
Bonds
Other
40 (3) - - 37 12.985%
--------- ---------- -------- ---------- -----------
TOTAL FIXED RATE 5,327,359 (89,438) 711 (33,985) 5,204,647
--------- ---------- -------- ---------- -----------
VARIABLE RATE
Industrial Development Revenue
Bonds 148,913 - - - 148,913 2.410%
--------- -----------
TOTAL VARIABLE RATE 148,913 - - - 148,913
--------- -----------
TOTAL LONG TERM DEBT 5,476,272 $ (89,438) $ 711 $ (33,985) $5,353,560
--------- ========== ======== ========== -----------
Less: Current Portion (58,911) (110,305)
Less: Equity Units (460,000) (460,000)
---------- -----------
$4,957,361 $4,783,255
========== ===========
* Interest rate includes amortization of debt issuance expenses, debt premiums
or discounts. The interest rate for Rural Utilities Service Loan Contracts,
Senior Unsecured Debt, and Industrial Development Revenue Bonds represent a
weighted average of multiple issuances.
** Includes purchases on the open market.
On February 1 2003, we repaid at maturity $35,000,000 million of Frontier
Communications of Minnesota 7.61% Senior Notes.
During the first quarter of 2003, we executed a series of purchases in the open
market of our outstanding debt securities. The aggregate principal amount of
debt securities purchased was $53,700,000 at a premium of approximately
$2,400,000 which is included in investment and other income (loss), net.
In March 2003, we terminated a capital lease obligation at ELI with a principal
amount of approximately $33,985,000. The lease termination resulted in a pre-tax
non-cash gain of $40,703,000. This reduced our future minimum cash payment
commitments by approximately $96,900,000 over the next 20 years. Total future
minimum cash payment commitments over the next 24 years under ELI's long-term
capital leases amounted to $218,530,000 as of March 31, 2003.
12
(7) Income (Loss) Per Common Share:
------------------------------
The reconciliation of the income (loss) per common share calculation for
the three months ended March 31, 2003 and 2002, respectively, is as
follows:
($ in thousands, except per-share amounts) For the three months ended March 31,
------------------------------------------
2003 2002
------------------ -------------------
Net income (loss) used for basic and diluted earnings
per common share
Income (loss) from continuing operations before
cumulative effect of change in accounting principle $ 61,662 $ (44,810)
Income from discontinued operations - 167,848
------------------ -------------------
Income before cumulative effect of change in
accounting principle 61,662 123,038
Cumulative effect of change in accounting principle 65,769 (39,812)
------------------ -------------------
Net income attributable to common shareholders $ 127,431 $ 83,226
================== ===================
Basic earnings per common share
Weighted-average shares outstanding - basic 281,637 280,257
------------------ -------------------
Income (loss) from continuing operations before
cumulative effect of change in accounting principle $ 0.22 $ (0.16)
Income from discontinued operations - 0.60
------------------ -------------------
Income before cumulative effect of change in
accounting principle 0.22 0.44
Cumulative effect of change in accounting principle 0.23 (0.14)
------------------ -------------------
Net income attributable to common shareholders $ 0.45 $ 0.30
================== ===================
Diluted earnings per common share
Weighted-average shares outstanding 281,637 280,257
Effect of dilutive shares 4,398 4,350
------------------ -------------------
Weighted-average shares outstanding - diluted 286,035 284,607
================== ===================
Income (loss) from continuing operations before
cumulative effect of change in accounting principle $ 0.22 $ (0.16)
Income from discontinued operations - 0.59
------------------ -------------------
Income before cumulative effect of change in
accounting principle 0.22 0.43
Cumulative effect of change in accounting principle 0.23 (0.14)
------------------ -------------------
Net income attributable to common shareholders $ 0.45 $ 0.29
================== ===================
All share amounts represent weighted average shares outstanding for each
respective period. The diluted income (loss) per common share calculation
excludes the effect of potentially dilutive shares when their exercise
price exceeds the average market price over the period. We have 4,025,000
shares of potentially dilutive Mandatorily Redeemable Convertible Preferred
Securities which are convertible into common stock at a 3.76 to 1 ratio at
an exercise price of $13.30 per share and 11,361,000 potentially dilutive
stock options exercisable at prices ranging from $10.24 to $21.47 per
share. We also have 18,400,000 potentially dilutive equity units. Each
equity unit initially consists of a 6.75% senior note due 2006 and a
purchase contract (warrant) for our common stock. These items were not
included in the diluted income (loss) per common share calculation for any
of the above periods as their effect was antidilutive. Restricted stock
awards of 1,553,000 shares and 1,197,000 shares at March 31, 2003 and 2002
respectively, are excluded from our basic weighted average shares
outstanding and included in our dilutive shares until the shares are no
longer contingent upon the satisfaction of all specified conditions.
13
(8) Segment Information:
-------------------
We operate in four segments, ILEC, ELI (a competitive local exchange
carrier (CLEC)), gas and electric. The ILEC segment provides both regulated
and unregulated communications services to residential, business and
wholesale customers and is typically the incumbent provider in its service
areas. Our gas and electric segments are intended to be sold and are
classified as "assets held for sale" and "liabilities related to assets
held for sale."
As an ILEC, we compete with CLECs that may operate in our markets. As a
CLEC, we provide telecommunications services, principally to businesses, in
competition with the incumbent ILEC. As a CLEC, we frequently obtain the
"last mile" access to customers through arrangements with the applicable
ILEC. ILECs and CLECs are subject to different regulatory frameworks of the
Federal Communications Commission (FCC). Our ILEC operations and ELI do not
compete with each other.
($ in thousands) For the three months ended March 31, 2003
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 513,609 $ 41,093 $ 63,532 $ 33,628 $ 651,862
Depreciation and amortization 132,355 6,193 - - 138,548
Operating income (loss) 146,915 535 11,851 4,994 164,295
Capital expenditures, net 37,877 1,147 3,169 5,145 47,338
($ in thousands) For the three months ended March 31, 2002
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 508,031 $ 47,247 $ 71,365 $ 52,691 $ 679,334
Depreciation and amortization 158,290 19,800 84 - 178,174
Reserve for telecommunications
bankruptcies 7,804 - - - 7,804
Restructuring and other expenses 6,005 (2,100) - - 3,905
Operating income (loss) 92,221 (17,020) 11,888 13,270 100,359
Capital expenditures, net 56,040 2,589 4,379 5,204 68,212
The following table reconciles sector capital expenditures to total
consolidated capital expenditures.
($ in thousands) For the three months ended
March 31,
------------------------------
2003 2002
-------------- --------------
Total segment capital expenditures $ 47,338 $ 68,212
General capital expenditures 414 227
-------------- --------------
Consolidated reported capital
expenditures $ 47,752 $ 68,439
============== ==============
(9) Adelphia Investment:
-------------------
We recognized a loss of $49,700,000 on our Adelphia Communications Corp.
(Adelphia) investment as a reduction to investment income in the three
months ended March 31, 2002. This non-cash charge reflected an other than
temporary decline in Adelphia's stock price. As of June 30, 2002, we had
written this investment down to zero, and therefore we have no additional
exposure related to the market value of Adelphia stock.
14
(10) Derivative Instruments and Hedging Activities:
---------------------------------------------
Interest rate swap agreements are used to hedge a portion of our debt that
is subject to fixed interest rates. Under our interest rate swap
agreements, we agree to pay an amount equal to a specified variable rate of
interest times a notional principal amount, and to receive in return an
amount equal to a specified fixed rate of interest times the same notional
principal amount. The notional amounts of the contracts are not exchanged.
No other cash payments are made unless the agreement is terminated prior to
maturity, in which case the amount paid or received in settlement is
established by agreement at the time of termination and represents the
market value, at the then current rate of interest, of the remaining
obligations to exchange payments under the terms of the contracts.
The interest rate swap contracts are reflected at fair value in our
consolidated balance sheet and the related portion of fixed-rate debt being
hedged is reflected at an amount equal to the sum of its book value and an
amount representing the change in fair value of the debt obligations
attributable to the interest rate risk being hedged. Changes in the fair
value of interest rate swap contracts, and the offsetting changes in the
adjusted carrying value of the related portion of the fixed-rate debt being
hedged, are recognized in the consolidated statements of operations in
interest expense. The notional amounts of fixed-rate indebtedness hedged as
of March 31, 2003 and December 31, 2002 was $250,000,000. Such contracts
require us to pay variable rates of interest (average pay rate of
approximately 4.85% as of March 31, 2003) and receive fixed rates of
interest (average receive rate of 7.65% as of March 31, 2003). The fair
value of these derivatives is reflected in other assets as of March 31,
2003, in the amount of $17,369,000 and the related underlying debt has been
increased by a like amount. The amounts received during the three months
ended March 31, 2003 as a result of these contracts amounted to $1,304,000
and are included as a reduction of interest expense. We do not anticipate
any nonperformance by counterparties to its derivative contracts as all
counterparties have investment grade credit ratings.
(11) Shareholder Rights Plan:
-----------------------
On March 6, 2002, our Board of Directors adopted a Shareholder Rights Plan.
The purpose of the Shareholder Rights Plan is to deter coercive takeover
tactics and to encourage third parties interested in acquiring us to
negotiate with our Board of Directors. It is intended to strengthen the
ability of our Board of Directors to fulfill its fiduciary duties to take
actions which are in the best interest of our shareholders. The rights were
distributed to shareholders as a dividend at the rate of one right for each
share of our common stock held by shareholders of record as of the close of
business on March 26, 2002. The rights generally are exercisable only if a
person or group acquired beneficial ownership of 20 percent or more of our
common stock (the "Acquiror") without the consent of our independent
directors. Each right not owned by an Acquiror becomes the right to
purchase our common stock at a 50 percent discount.
(12) Settlement of Retained Liabilities:
----------------------------------
We were actively pursuing the settlement of certain retained liabilities at
less than face value, which are associated with customer advances for
construction from our disposed water properties. For the three months ended
March 31, 2003, we recognized income of $6,165,000 which is reflected in
investment and other income (loss), net, as a result of these settlements.
(13) Change in Accounting Principle and New Accounting Pronouncements:
----------------------------------------------------------------
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 143, "Accounting for Asset Retirement Obligations." We adopted SFAS No.
143 effective January 1, 2003. As a result of our adoption of SFAS No. 143,
we recognized an after tax non-cash gain of approximately $65,769,000. This
gain resulted from the elimination of the cumulative cost of removal
included in accumulated depreciation as a cumulative effect of a change in
accounting principle in our statement of operations in the first quarter of
2003 as the Company has no legal obligation to remove certain of its
long-lived assets.
15
The following table presents a reconciliation between reported net income
and adjusted net income. Adjusted net income excludes depreciation expense
recognized in prior periods related to the cost of removal provision as
required by SFAS No. 143.
For the three months ended March 31,
---------------------------------------------
(In thousands, except per-share amounts) 2003 2002
--------------------- -----------------
Reported attributable to common shareholders $ 127,431 $ 83,226
Add back: Cost of removal in depreciation expense, net of tax - 3,713
--------------------- -----------------
Adjusted attributable to common shareholders $ 127,431 $ 86,939
===================== =================
Basic earnings per share:
Reported attributable to common shareholders $ 0.45 $ 0.30
Cost of removal in depreciation expense - 0.01
--------------------- -----------------
Adjusted attributable to common shareholders $ 0.45 $ 0.31
===================== =================
Diluted earnings per share:
Reported attributable to common shareholders $ 0.45 $ 0.29
Cost of removal in depreciation expense - 0.01
--------------------- -----------------
Adjusted attributable to common shareholders $ 0.45 $ 0.30
===================== =================
In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." As a result of our adoption of SFAS No. 142, we recognized a
transitional impairment loss of $39,800,000 for goodwill related to ELI as
a cumulative effect of a change in accounting principle in our statement of
operations in the first quarter of 2002.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which nullified Emerging
Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity." SFAS
No. 146 requires that a liability for a cost associated with an exit or
disposal activity be recognized when the liability is incurred, rather than
on the date of commitment to an exit plan. This Statement is effective for
exit or disposal activities that are initiated after December 31, 2002. We
adopted SFAS No. 146 on January 1, 2003. The adoption of SFAS No. 146 did
not have any material impact on our financial position or results of
operations.
The FASB recently issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging," which clarifies financial accounting
and reporting for derivative instruments including derivative instruments
embedded in other contracts. We are currently evaluating the impact of the
adoption of SFAS No. 149.
The FASB also recently indicated that it will require stock-based employee
compensation to be recorded as a charge to earnings beginning in 2004. We
will continue to monitor the progress on the issuance of this standard.
(14) Commitments and Contingencies:
-----------------------------
We have budgeted capital expenditures in 2003 of approximately $280,000,000
for ILEC and ELI and $45,200,000 (assuming we own all our utility
businesses for the entire year) for gas and electric. Our public utility
properties are currently carried at amounts that do not exceed their net
realizable values upon sale. Under the terms of the definitive agreements
relating to the sale of these properties, there will be no adjustment to
the sales prices for most of the capital expenditures we will make for
these properties prior to their sale. To the extent that the carrying
amounts of these properties increase above their realizable values upon
sale as a result of capital expenditures or for any other reason, we would
record an impairment charge for such excess. We currently estimate we will
make $20,000,000 of capital expenditures for these properties from April 1,
2003 through their dates of sale. We did not expense any of our $8,314,000
of capital additions related to these properties during the first quarter
of 2003. If the sale of our Arizona utility businesses to UniSource is
completed, the sale agreement requires us to promptly redeem $111,760,000
principal amount of industrial revenue bonds.
16
In March 1999, ELI entered into a 20-year fiber agreement. Under the
agreement, we were to pay the other carrier approximately $96,900,000 over
the next 20 years. ELI terminated the capital lease obligation in March
2003, which resulted in a non-cash pre-tax gain of $40,703,000.
(15) Subsequent Events:
-----------------
On April 1, 2003, we completed the sale of approximately 11,000 telephone
access lines in North Dakota for approximately $25,700,000 in cash.
On April 4, 2003, we completed the sale of our wireless partnership
interest in Wisconsin for approximately $7,500,000 in cash.
17
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and Results
-----------------------------------------------------------------------
of Operations
-------------
This quarterly report on Form 10-Q contains forward-looking statements that are
subject to risks and uncertainties which could cause actual results to differ
materially from those expressed or implied in the statements. Forward-looking
statements (including oral representations) are only predictions or statements
of current plans, which we review continuously. Forward-looking statements may
differ from actual future results due to, but not limited to, any of the
following possibilities:
* Changes in the number of our access lines;
* The effects of competition from wireless, other wireline carriers
(through Unbundled Network Elements (UNE), Unbundled Network Elements
Platform (UNEP) or otherwise), high speed cable modems and cable
telephony;
* The effects of general and local economic conditions on our revenues;
* Our ability to effectively manage and otherwise monitor our
operations, costs, regulatory compliance and service quality;
* Our ability to divest our remaining public utilities services
businesses and the effect of the timing of the divestitures on the
capital expenditures we make with respect to such businesses;
* Our ability to successfully introduce new product offerings including
our ability to offer bundled service packages on terms attractive to
our customers, and our ability to sell enhanced and data services;
* Our ability to manage our operating expenses, capital expenditures and
reduce our debt;
* The effects of greater than anticipated competition requiring new
pricing, marketing strategies or new product offerings and the risk
that we will not respond on a timely or profitable basis;
* The effects of bankruptcies in the telecommunications industry which
could result in higher network access costs and potential bad debts;
* The effects of technological changes, including the lack of assurance
that our ongoing network improvements will be sufficient to meet or
exceed the capabilities and quality of competing networks;
* The effects of increased pension and retiree medical expenses and
related funding requirements;
* The effects of changes in regulation in the telecommunications
industry as a result of the Telecommunications Act of 1996 and other
federal and state legislation and regulation, including changes in
access charges and subsidy payments;
* The effect of restructuring of portions of the telecommunications
market;
* The effects of possible state regulatory cash management policies on
our ability to transfer cash among our subsidiaries and to the parent
company;
* Our ability to successfully renegotiate expiring union contracts,
including the contract covering the 668 Communications Workers of
America members in Rochester that is scheduled to expire in January
2004; and
* The effects of more general factors, including changes in economic
conditions; changes in the capital markets; changes in industry
conditions; changes in our credit ratings; and changes in accounting
policies or practices adopted voluntarily or as required by generally
accepted accounting principles or regulators.
18
Competition in the telecommunications industry is increasing. Although we have
not faced as much competition as larger, more urban telecom companies, we do
experience competition from other wireline local carriers through Unbundled
Network Elements (UNE) and potentially in the future through Unbundled Network
Elements Platform (UNEP), from other long distance carriers (including Regional
Bell Operating Companies), from cable companies and internet service providers
with respect to internet access and potentially in the future cable telephony,
and from wireless carriers. Most of the wireline competition we face is in our
Rochester market, with limited competition in a few other areas. Competition
from cable companies with respect to high-speed Internet access is intense in
Rochester and a few of our other markets such as Elk Grove, California (which is
near Sacramento). Competition from wireless companies, other long distance
companies and internet service providers is present in varying degrees in all of
our markets.
The telecommunications industry in general, and the CLEC sector in particular,
are undergoing significant changes and difficulties. Demand and pricing for CLEC
services have decreased substantially, particularly for long haul services, and
economic and competitive pressures are likely to cause these trends to continue.
These factors result in a challenging environment with respect to revenues for
our CLEC business and to a lesser extent our ILEC business. These factors could
also result in more bankruptcies in the sector and therefore affect our ability
to collect money owed to us by bankrupt carriers. We reserved approximately
$10.9 million and $21.2 million of receivables owed to us from bankrupt telecom
companies in 2002 and 2001, respectively.
The market for internet access, long-haul and related services in the United
States is extremely competitive, with substantial overcapacity in the market. In
addition, new and enhanced internet services are constantly under development in
the market and we expect additional innovation in this market by a range of
competitors. Several Interexchange Carriers (IXC's) have filed for bankruptcy
protection, which will allow them to substantially reduce their cost structure
and debt. This could enable such companies to further reduce prices and increase
competition.
You should consider these important factors in evaluating any statement in this
Form 10-Q or otherwise made by us or on our behalf. The following information is
unaudited and should be read in conjunction with the consolidated financial
statements and related notes included in this report and as presented in our
2002 Annual Report on Form 10-K. We have no obligation to update or revise these
forward-looking statements.
(a) Liquidity and Capital Resources
-------------------------------
For the three months ended March 31, 2003, we used cash flow from continuing
operations and cash and investment balances to fund capital expenditures,
interest payments and debt repayments. As of March 31, 2003, we maintained cash
and short-term investment balances aggregating $455.9 million.
We have budgeted for our 2003 capital projects approximately $268.0 million for
the ILEC segment, $12.0 million for the ELI segment and $45.2 million (assuming
we own all of our remaining utility businesses for the entire year) for the
public utilities segment. In the ordinary course of business, capital
expenditures for the public utilities segment would increase the amount of
assets that would be reflected on the balance sheet. However, we may expense
certain of our capital expenditures with respect to our public utilities segment
during 2003 if book values exceed our estimate of expected net realizable sales
prices. (see Note 14 to Consolidated Financial Statements).
For the three months ended March 31, 2003, our actual capital expenditures were
$37.9 million for the ILEC segment, $1.2 million for the ELI segment, $8.3
million for the public utilities segments and $0.4 million for general capital
expenditures. Funds necessary for our 2003 capital expenditures were, and are
expected to continue to be, provided from our operations and our existing cash
and investment balances.
We have an available shelf registration for $825.6 million and we have available
lines of credit with financial institutions in the aggregate amount of $805
million. Associated facility fees vary depending on our credit ratings and are
0.25% per annum as of March 31, 2003. The expiration date for these facilities
is October 24, 2006. During the term of the facilities we may borrow, repay and
reborrow funds. As of March 31, 2003, there were no outstanding borrowings under
these facilities.
19
If the sale of our Arizona utility businesses to UniSource is completed, the
sale agreement requires us to promptly redeem $111.8 million of industrial
development revenue bonds. We intend to fund this redemption using cash flows
from continuing operations, the proceeds from the sale of utility properties,
and/or cash and cash equivalents and investment balances.
Debt Reduction
- --------------
In March 2003, we terminated a capital lease obligation at ELI, which resulted
in a non-cash pre-tax gain of $40.7 million included in investment and other
income, net.
On February 1, 2003, we repaid at maturity $35.0 million of Frontier
Communications of Minnesota 7.61% Senior Notes.
During the first quarter of 2003, we executed a series of purchases in the open
market of our outstanding debt securities. The aggregate principal amount of
debt securities purchased was $53.7 million at a premium of approximately $2.4
million.
Interest Rate Management
- ------------------------
In order to manage our interest expense, we entered into five interest swap
agreements in 2001 and 2002 with investment grade financial institutions. Each
agreement covered a notional amount of $50.0 million. Under the terms of the
agreements, we make semi-annual, floating interest rate interest payments based
on six month LIBOR and receive a fixed rate on the notional amount. There are
two interest rate swap agreements that were executed in 2001 that receive a
6.375% fixed rate until the swaps' termination date of August 15, 2004, and
there are three swaps that were executed in 2002 that receive an 8.500% fixed
rate until their termination date of May 15, 2006. The underlying variable rate
on the swaps is set either in advance, in arrears or, as in the case of one
agreement, based on each period's daily average six-month LIBOR. In connection
with these swaps, the Company entered into a series of supplemental rate
agreements which had the effect of setting the floating rate portion of the
swaps in advance of the contractually agreed upon rate determination date.
In connection with these swaps, on August 8, 2002, we entered into a Forward
Rate Agreement (FRA), which set the effective rate for one of the swaps for the
period of November 15, 2002 to May 15, 2003 at 5.310%, as compared to the
unhedged rate of 8.50%. In addition, on August 28, 2002, we entered into another
FRA, and set the effective rate on another swap during the period of February
18, 2003 to August 15, 2003 at 4.195%, as compared to the unhedged rate of
6.375%. All swaps and associated supplemental rate agreements are accounted for
under SFAS No. 133 as fair value hedges.
Covenants
- ---------
The terms and conditions contained in our indentures and credit facility
agreements are of a general nature, and do not currently impose significant
financial performance criteria on us. These general covenants include the timely
and punctual payment of principal and interest when due, the maintenance of our
corporate existence, keeping proper books and records in accordance with GAAP,
restrictions on the allowance of liens on our assets, and restrictions on asset
sales and transfers, mergers and other changes in corporate control. We
currently have no restrictions on the payment of dividends by us either by
contract, rule or regulation.
Our $805.0 million credit facilities and our $200.0 million term loan facility
with the Rural Telephone Finance Cooperative (RTFC) previously contained a
minimum net worth covenant. Additionally, under the RTFC loan, if we were to
lose investment grade ratings from either Moody's Investors Service or Standard
& Poor's, we would become subject to interest coverage and leverage ratio
covenants. Effective March 31, 2003, we amended these facilities to replace all
of these covenants with a leverage ratio covenant. Under the leverage ratio
covenant, we are required to maintain a ratio of (i) total indebtedness minus
cash and cash equivalents in excess of $50 million to (ii) consolidated adjusted
EBITDA (as defined in the agreements) over the last four quarters no greater
than 4.50 to 1 through December 30, 2003, 4.25 to 1 from then until December 30,
2004, and 4.00 to 1 thereafter. We are in compliance with all of our debt
covenants.
Divestitures
- ------------
On August 24, 1999, our Board of Directors approved a plan of divestiture for
our public utilities services businesses, which included gas, electric and water
and wastewater businesses. During 2001, we sold two of our natural gas
operations and in January 2002 we sold all of our water and wastewater treatment
operations and one electric business.
20
On January 15, 2002, we sold our water and wastewater services operations for
$859.1 million in cash and $122.5 million in assumed debt and other liabilities.
On October 29, 2002, we entered into definitive agreements to sell our Arizona
gas and electric divisions to UniSource Energy Corporation for $230.0 million in
cash ($220.0 million if we close the sale by July 28, 2003) subject to
adjustments specified in the agreements. The transaction, which is subject to
regulatory and other customary approvals, is expected to close during the second
half of 2003.
On October 31, 2002, we completed the sale of approximately 4,000 telephone
access lines in North Dakota for approximately $9.7 million in cash.
On November 1, 2002, we completed the sale of our Kauai electric division to
Kauai Island Utility Cooperative for $215.0 million in cash.
On December 19, 2002, we entered into a definitive agreement to sell The Gas
Company in Hawaii to K-1 USA Ventures, Inc. for $115.0 million in cash, subject
to adjustments under the terms of the agreement. The transaction, which is
subject to regulatory and other customary approvals, is expected to close during
the second half of 2003.
We have entered into definitive agreements to sell the assets of our Vermont
electric division to Vermont Electric Power Company, Inc. and Vermont Electric
Cooperative, Inc. for an aggregate of approximately $25.0 million in cash
subject to adjustments under the terms of the agreements. The transactions,
which are subject to regulatory and other customary approvals, are expected to
close by mid-2004.
On April 1, 2003, we completed the sale of approximately 11,000 telephone access
lines in North Dakota for approximately $25.7 million in cash.
On April 4, 2003, we completed the sale of our wireless partnership interest in
Wisconsin for approximately $7.5 million in cash.
All of our gas and electric assets and their related liabilities are classified
as "assets held for sale" and "liabilities related to assets held for sale,"
respectively. These assets have been written down to our best estimate of the
net realizable value upon sale. As discussed in Note 14 to Consolidated
Financial Statements we may record additional impairment losses during 2003.
Discontinued operations in the consolidated statements of operations reflect the
results of operations and the gain on sale of the water/wastewater properties
sold in January 2002 including allocated interest expense for the periods
presented. Interest expense was allocated to the discontinued operations based
on the outstanding debt specifically identified with this business.
Critical Accounting Policies and Estimates
- ------------------------------------------
We review all significant estimates affecting our consolidated financial
statements on a recurring basis and record the effect of any necessary
adjustment prior to their publication. Uncertainties with respect to such
estimates and assumptions are inherent in the preparation of financial
statements; accordingly, it is possible that actual results could differ from
those estimates and changes to estimates could occur in the near term. The
preparation of our financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of the contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Estimates and judgments are used when accounting for allowance for
doubtful accounts, impairment of long-lived assets, intangible assets,
depreciation and amortization, employee benefit plans, income taxes and
contingencies, among others.
Our estimate of anticipated losses related to telecommunications bankruptcies is
a "critical accounting estimate." We have significant on-going normal course
business relationships with many telecom providers, some of which have filed for
bankruptcy. We generally reserve approximately 95% of the net outstanding
pre-bankruptcy balances owed to us and believe that our estimate of the net
realizable value of the amounts owed to us by bankrupt entities is appropriate.
We believe that the accounting estimate related to asset impairment is a
"critical accounting estimate." With respect to ELI, the estimate is highly
susceptible to change from period to period because it requires management to
make significant judgments and assumptions about future revenue, operating costs
and capital expenditures over the life of the property, plant and equipment
(generally 5 to 15 years) as well as the probability of occurrence of the
various scenarios and appropriate discount rates. Management's assumptions about
ELI's future revenue, operating costs and capital expenditures as well as the
probability of occurrence of these various scenarios require significant
judgment because the CLEC industry is changing and because actual revenue,
operating costs and capital expenditures have fluctuated dramatically in the
past and may continue to do so in the future.
21
The calculation of depreciation and amortization expense is based on the
estimated economic useful lives of the underlying property, plant and equipment
and identifiable intangible assets. Rapid changes in technology or changes in
market conditions could result in revisions to such estimates that could affect
the carrying value of these assets and our future consolidated operating
results. Our depreciation expense has decreased substantially from prior periods
as a result of the impairment write down we recorded during 2002, the adoption
of SFAS No. 143 and the increase in the average depreciable lives for certain of
our equipment.
With respect to our remaining gas and electric properties, our estimate is based
upon expected future sales prices of these properties.
Our indefinite lived intangibles consist of goodwill and trade name, which
resulted from the purchase of ILEC properties. We test for impairment of these
assets annually, or more frequently, as circumstances warrant. All of our ILEC
properties share similar economic characteristics and as a result, our reporting
unit is the ILEC segment. In determining fair value during 2002 we utilized two
tests. One test utilized recent trading prices for completed ILEC acquisitions
of similarly situated properties. A second test utilized current trading values
for the Company's publicly traded common stock. We reviewed the results of both
tests for consistency to insure that our conclusions were appropriate.
Additionally, we utilized a range of prices to gauge sensitivity. Our tests
determined that fair values exceeded book value. Unless economic conditions
change significantly (i.e. we experience unanticipated declines in revenue, and
or material declines in both our stock price and ILEC property values) we do not
believe that a charge for impairment is reasonably likely to occur in the near
future.
Our estimates of pension expense, other post retirement benefits including
retiree medical benefits and related liabilities are "critical accounting
estimates." Our pension and other post retirement benefits expenses are based
upon a set of assumptions that include projections of future interest rates and
asset returns. Actual results may vary from these estimates. We are assuming a
long-term rate of return on plan assets of 8.25% and a discount rate of 6.75%
for 2003. Actual returns have been negative in recent years. If future market
conditions cause either a decline in interest rates used to value our pension
plan liabilities or reductions to the value of our pension plan assets we
potentially could incur additional charges to our shareholder's equity at the
end of 2003. Based upon market conditions existing at the end of April 2003, an
additional charge to equity of approximately $30 - $35 million would be required
at the end of 2003 should market conditions remain unchanged.
Our income tax expense is computed utilizing an estimated annual effective
income tax rate in accordance with Accounting Principles Board Opinions (APB)
No. 28, "Interim Financial Reporting." The tax rate is computed using estimates
as to the Company's net income before income taxes for the entire year and the
impact of estimated permanent book-tax differences relative to that forecast.
Management has discussed the development and selection of these critical
accounting estimates with the audit committee of our board of directors and our
audit committee has reviewed our disclosure relating to them.
New Accounting Pronouncements
- -----------------------------
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations." SFAS No. 143 applies to fiscal years beginning after June 15,
2002, and addresses financial accounting and reporting obligations associated
with the retirement of tangible long-lived assets and the associated asset
retirement costs. We adopted SFAS No. 143 effective January 1, 2003. The
standard applies to legal obligations associated with the retirement of
long-lived assets that result from acquisition, construction, development or
normal use of the assets and requires that a legal liability for an asset
retirement obligation be recognized when incurred, recorded at fair value and
classified as a liability in the balance sheet. When the liability is initially
recorded, the entity will capitalize the cost and increase the carrying value of
the related long-lived asset.
22
The liability is then accreted to its present value each period and the
capitalized cost is depreciated over the estimated useful life of the related
asset. At the settlement date, the entity will settle the obligation for its
recorded amount or recognize a gain or loss upon settlement.
Depreciation expense for the Company's wireline operations has historically
included an additional provision for cost of removal. Effective with the
adoption of SFAS No. 143, on January 1, 2003, the Company ceased recognition of
the cost of removal provision in depreciation expense and eliminated the
cumulative cost of removal included in accumulated depreciation as the Company
has no legal obligation to remove certain long-lived assets. The cumulative
effect of retroactively applying these changes to periods prior to January 1,
2003, resulted in an after tax non-cash gain of approximately $65.8 million.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities," which nullified Emerging Issues Task Force
(EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity." SFAS No. 146 requires that a
liability for a cost associated with an exit or disposal activity be recognized
when the liability is incurred, rather than on the date of commitment to an exit
plan. This Statement is effective for exit or disposal activities that are
initiated after December 31, 2002. We adopted SFAS No. 146 on January 1, 2003.
The adoption of SFAS No. 146 did not have any material impact on our financial
position or results of operations.
The FASB recently issued SFAS No. 149, "Amendment of Statement 133 on Derivative
Instruments and Hedging," which clarifies financial accounting and reporting for
derivative instruments including derivative instruments embedded in other
contracts. We are currently evaluating the impact of the adoption of SFAS No.
149.
The FASB also recently indicated that it will require stock-based employee
compensation to be recorded as a charge to earnings beginning in 2004. We will
continue to monitor the progress on the issuance of this standard.
23
(b) Results of Operations
---------------------
REVENUE
Consolidated revenue for the three months ended March 31, 2003 decreased $27.5
million, or 4%, as compared with the prior year period. The decrease is due to a
$6.2 million decrease in ELI revenue and a $26.9 million decrease in gas and
electric revenue partially offset by a $5.6 million increase in ILEC revenue.
TELECOMMUNICATIONS REVENUE
($ in thousands) For the three months ended March 31,
--------------------------------------------------------
2003 2002 $ Change % Change
-------------- ------------- --------------- -------------
Access services $ 164,997 $ 165,833 $ (836) -1%
Local services 221,095 216,800 4,295 2%
Long distance and data services 74,778 70,286 4,492 6%
Directory services 27,043 26,244 799 3%
Other 25,696 28,868 (3,172) -11%
-------------- ------------- ---------------
ILEC revenue 513,609 508,031 5,578 1%
ELI 41,093 47,247 (6,154) -13%
-------------- ------------- ---------------
$ 554,702 $ 555,278 $ (576) 0%
============== ============= ===============
Changes in the number of our access lines is the most fundamental driver of
changes in our telecommunications revenue. Historically, rural local telephone
companies experienced steady growth in access lines because of positive
demographic trends, steady rural local economies and little competition. In
recent quarters many rural local telephone companies (including ours) have
experienced a loss of access lines because of difficult economic conditions,
increased competition and by some customers disconnecting second lines when they
add DSL or cable modem service. We lost approximately 9,200 access lines during
the three months ended March 31, 2003 but added approximately the same number of
DSL subscribers during this period. Residential lines lost represented 65
percent of the total loss. The non-residential line losses were principally in
Rochester, New York while the residential losses were throughout our markets
other than Arizona and California. We expect to continue to lose access lines
during 2003. A continued decrease in access lines, combined with continuing
difficult economic conditions and increased competition, may cause our revenues
to decrease in 2003.
Prior to 2003, we reported service activation revenue in network access
services, local network services, long distance and data services, and other
revenue categories. Beginning in the first quarter 2003, all service activation
revenue is reported in the "other" category. All prior periods have been
conformed to this presentation.
Access services revenue for the three months ended March 31, 2003 decreased $0.8
million or 1% as compared with the prior year period. Switched access revenue
decreased $6.6 million due to the effect of tariff rate reductions effective
July 1, 2002 and the reclassification of universal service fund (USF) high cost
funds and National Exchange Carrier Association (NECA) settlements to subsidies.
Special access revenue increased $1.3 million as compared with the prior year
period due to growth in circuit sales. Subsidies revenue increased $4.4 million
due to higher USF surcharges, Federal Rural Task Force support and NECA
settlements. Our subsidy revenues in 2003 are expected to be slightly lower than
2002.
Local services revenue for the three months ended March 31, 2003 increased $4.3
million or 2% as compared with the prior year period. Local revenue increased
$1.7 million primarily due to higher subscriber line charges (SLC) effective
July 2002, partially offset by continued losses of access lines. Enhanced
services revenue increased $2.6 million primarily due to the sale of additional
feature packages. Although we continue to increase our penetration of enhanced
services, in current economic conditions the rate of increase in revenues is
lower than in prior periods and we expect this trend to continue.
Long distance and data services revenue for the three months ended March 31,
2003 increased $4.5 million or 6% as compared with the prior period primarily
due to an increase of $1.0 million in long distance in addition to a growth of
$3.5 million in data services related to Internet and digital subscriber lines
(DSL). The rate of increases in our data and long distance revenues has been
slowing recently because of economic conditions and intense competition in some
of our markets. We expect these factors will continue to affect our long
distance and data services revenues during 2003.
24
Directory revenue for the three months ended March 31, 2003 increased $0.8
million or 3% as compared with the prior period primarily due to the growth of
yellow pages advertising.
Other revenue for the three months ended March 31, 2003 decreased $3.2 million
or 11% compared with the prior period primarily due to the termination at
December 31, 2002 of $1.4 million in contract services provided to Global
Crossing. Other decreases include conferencing revenue of $0.7 million and
paystation revenue of $0.6 million, partially offset by lower uncollectible
revenue of $0.9 million.
ELI revenue for the three months ended March 31, 2003 decreased $6.2 million, or
13%, as compared to the prior year period primarily due to a decline in
Integrated Service Digital Network (ISDN) services due to less demand from
Internet service providers and lower demand for long haul services. ELI has
experienced nine consecutive quarters of declining revenue.
GAS AND ELECTRIC REVENUE
($ in thousands) For the three months ended March 31,
----------------------------------------------------------
2003 2002 $ Change % Change
-------------- ------------- --------------- -------------
Gas revenue $ 63,532 $ 71,365 $ (7,833) -11%
Electric revenue $ 33,628 $ 52,691 $ (19,063) -36%
Gas revenue for the three months ended March 31, 2003 decreased $7.8 million, or
11%, as compared with the prior year period primarily due to an Arizona
commission ruling precluding higher purchased gas costs to be passed on to
consumers in 2003.
Electric revenue for the three months ended March 31, 2003 decreased $19.1
million, or 36%, as compared with the prior year period primarily due to the
sale of Kauai electric partially offset by increased unit sales and the effect
of a rate increase in Vermont on July 15, 2002.
COST OF SERVICES
($ in thousands) For the three months ended March 31,
----------------------------------------------------------
2003 2002 $ Change % Change
-------------- ------------- --------------- -------------
Network access $ 56,515 $ 57,958 $ (1,443) -2%
Gas purchased 35,946 43,600 (7,654) -18%
Electric energy and
fuel oil purchased 20,758 26,680 (5,922) -22%
-------------- ------------- ---------------
$ 113,219 $ 128,238 $ (15,019) -12%
============== ============= ===============
Network access expenses for the three months ended March 31, 2003 decreased $1.4
million, or 2%, as compared with the prior year period primarily due to lower
costs at ELI as a result of decreases in demand partially offset by increased
costs in the ILEC sector due to increased circuit expense associated with
additional data product introductions and increased long distance access
expense.
Gas purchased for the three months ended March 31, 2003 decreased $7.7 million,
or 18%, as compared with the prior year period primarily due to the effect of an
Arizona commission ruling precluding higher purchased gas costs from being
passed on to consumers, thus deferring recoverability to a future period.
Electric energy and fuel oil purchased for the three months ended March 31, 2003
decreased $5.9 million, or 22%, as compared with the prior year period primarily
due to the sale of Kauai electric on November 1, 2002 partially offset by
increased purchased power costs.
25
In Arizona, power costs charged by our supplier were in excess of the rates we
charged our customers by approximately $128.5 million through March 31, 2003. We
believe that we are allowed to recover these charges from ratepayers through the
Purchase Power Fuel Adjustment clause that was approved by the Arizona
Corporation Commission and has been in place for several years. However, in an
attempt to limit "rate shock" to our customers, we requested in September 2001
that our unrecovered power costs, plus interest, be recovered over a seven-year
period. As a result, we deferred these costs on the balance sheet in
anticipation of recovery through the regulatory process. This balance was
reduced by the public service impairment charge recorded during the third
quarter of 2002, which reduced the net assets of these businesses to their
estimated net realizable value. In January 2003, the Commission agreed to
consolidate this matter with the application for approval of the sale of our
Arizona electric property.
OTHER OPERATING EXPENSES
($ in thousands) For the three months ended March 31,
----------------------------------------------------------
2003 2002 $ Change % Change
-------------- ------------- --------------- -------------
Operating expenses $ 177,580 $ 199,253 $ (21,673) -11%
Taxes other than income taxes 30,321 33,364 (3,043) -9%
Sales and marketing 27,920 28,237 (317) -1%
-------------- ------------- ---------------
$ 235,821 $ 260,854 $ (25,033) -10%
============== ============= ===============
Operating expenses for the three months ended March 31, 2003 decreased $21.7
million, or 11%, as compared with the prior year period primarily due to
increased operating efficiencies and a reduction of personnel in the ILEC and
ELI sectors and decreased operating expenses in the electric sector due to the
sale of Kauai electric partially offset by increased pension expense discussed
below. We routinely review our operations, personnel and facilities to achieve
greater efficiencies. These reviews may result in reductions in personnel and an
increase in severance costs.
Included in operating expenses is pension expense. In future periods, if the
value of our pension assets decline and/or projected benefit costs increase, we
may have increased pension expenses. Based on current assumptions and plan asset
values, we estimate that our pension expense will increase from $4.3 million in
2002 to approximately $13.0 - $15.0 million in 2003 and that a contribution to
our pension plans will be required in 2003 in an amount currently estimated at
$0 - $5.0 million. In addition, as medical costs increase the costs of our
retiree medical obligations also increase. Our retiree medical costs for 2002
were $15.1 million and our current estimate for 2003 is $15.0 - $16.0 million.
In future periods, compensation expense related to variable stock plans may be
materially affected by our stock price. A $1.00 change in our stock price
impacts compensation expense by approximately $1.0 million. There was no
material impact for the three months ended March 31, 2003.
Taxes other than income taxes decreased $3.0 million, or 9%, as compared with
the prior year period primarily due to decreased property taxes at ELI due to
lower asset property values.
DEPRECIATION AND AMORTIZATION EXPENSE
($ in thousands) For the three months ended March 31,
--------------------------------------------------------
2003 2002 $ Change % Change
-------------- ------------- --------------- -------------
Depreciation expense $ 106,836 $ 147,820 $ (40,984) -28%
Amortization expense 31,712 30,354 1,358 4%
-------------- ------------- ---------------
$ 138,548 $ 178,174 $ (39,626) -22%
============== ============= ===============
Depreciation expense for the three months ended March 31, 2003 decreased $41.0
million, or 28%, as compared with the prior year period primarily due to the ELI
impairment charge recognized during the third quarter of 2002, which reduced
ELI's asset base, the adoption of SFAS No. 143 and the increase in the average
depreciable lives for certain of our equipment. Accelerated depreciation in 2002
of $11.9 million relating to the closing of our Plano, Texas facility also
contributed to the decrease.
26
Amortization expense for the three months ended March 31, 2003 increased $1.4
million, or 4%, as compared with the prior year period primarily due to
increased amortization of customer base, due to a final purchase price
allocation, resulting from the receipt of the final valuation report of our
Frontier acquisition during the second quarter of 2002.
RESERVE FOR TELECOMMUNICATIONS BANKRUPTCIES /
RESTRUCTURING AND OTHER EXPENSES
($ in thousands) For the three months ended March 31,
--------------------------------------------------------
2003 2002 $ Change % Change
-------------- ------------- --------------- -----------
Reserve for telecommunications
bankruptcies $ - $ 7,804 $ (7,804) -100%
Restructuring and other expenses $ (21) $ 3,905 $ (3,926) -101%
Concurrent with the acquisition of Frontier, we entered into several operating
agreements with Global Crossing Ltd. (Global). We have ongoing commercial
relationships with Global affiliates. As a result of Global's filing for
bankruptcy, we recorded a write-down of the net realizable value of our
receivables from Global in the amount of $7.8 million in the first quarter 2002.
Prior to the date of Global's bankruptcy filing, we provided ordinary course
telecommunications services as well as transitional services to Global. Global
has provided us certain customer billing and collection functions as well as
other transitional services. Although some of these arrangements have continued
after the bankruptcy filing, we are in the process of transitioning some
services and functions to provide them ourselves. The Bankruptcy Court has
granted relief to us and other telecommunications companies that provide service
to Global by, among other things, directing a shortened payment period with
respect to post-petition invoices, an expedited court process for post-petition
defaults in payments by Global, and a priority for post-petition expense items
over other unsecured debt. These procedures should minimize future economic loss
to us although we cannot guarantee that additional losses will not occur. If
other telecommunications companies file for bankruptcy we may have additional
significant reserves in future periods.
Restructuring and other expenses primarily consist of expenses related to our
various restructurings, including reductions in personnel at our
telecommunications operations, and costs that were spent at our Plano, Texas
facility and at other locations as a result of transitioning functions and jobs.
These costs were partially offset by a $2.1 million reversal of a 2001 ELI
accrual recognized in the first quarter of 2002, which was subsequently adjusted
to $2.8 million in the fourth quarter of 2002. See further discussion below.
Plano Restructuring
Pursuant to a plan adopted in the third quarter of 2001, we closed our
operations support center in Plano, Texas in August 2002. In connection
with this plan, we recorded a pre-tax charge of $0.8 million for the three
months ended March 31, 2002. The restructuring expenses primarily consist
of severance benefits, retention earned through March 31, 2002 and other
planning and communication costs. We sold our Plano office building in
March 2003.
Sacramento Call Center Restructuring
In April 2002, we closed our Sacramento Customer Care Center pursuant to a
plan adopted in the fourth quarter of 2001. In connection with this
closing, we recorded a pre-tax charge of $0.1 million for the three months
ended March 31, 2002.
ELI Restructuring
In the first half of 2002, ELI redeployed the Internet routers, frame relay
switches and ATM switches from the Atlanta, Cleveland, Denver, Philadelphia
and New York markets to other locations in ELI's network pursuant to a plan
adopted in the fourth quarter of 2001. ELI ceased leasing the collocation
facilities and off-net circuits for the backbone and local loops supporting
the service delivery in these markets. It was anticipated that this would
lead to $4.2 million of termination fees, which were accrued for but not
paid at December 31, 2001. In the first quarter 2002, ELI adjusted their
original accrual down by $2.1 million due to the favorable settlement of
termination charges for an off-net circuit agreement. This accrual was
further adjusted down by $0.7 million in the fourth quarter of 2002.
27
INVESTMENT AND OTHER INCOME (LOSS), NET / GAIN ON SALE OF
ASSETS / INTEREST EXPENSE / INCOME TAX EXPENSE (BENEFIT)
($ in thousands) For the three months ended March 31,
---------------------------------------------------------
2003 2002 $ Change % Change
-------------- ------------- --------------- -------------
Investment and
other income (loss), net $ 49,822 $ (48,508) $ 98,330 203%
Loss on sale of assets $ 1,650 $ - $ 1,650 100%
Interest expense $109,276 $ 122,050 $ (12,774) -10%
Income tax expense (benefit) $ 39,976 $ (26,942) $ 66,918 248%
Investment and other income, net for the three months ended March 31, 2003
increased $98.3 million as compared with the prior year period primarily due to
a $40.7 million non-cash pre-tax gain related to a capital lease termination at
ELI and the recognition in 2002 of a $49.7 million non-cash pre-tax loss
resulting from an other than temporary decline in the value of our investment in
Adelphia Communications Corp. (Adelphia) (see Note 9 to Consolidated Financial
Statements).
Loss on sale of assets represents the loss recognized on the sale of our Plano
office building in March 2003.
Interest expense for the three months ended March 31, 2003 decreased $12.8
million, or 10%, as compared with the prior year period primarily due to the
retirement of debt partially offset by higher average interest rates. During the
three months ended March 31, 2003, we had average long-term debt (excluding
equity units and convertible preferred stock) outstanding of $4.9 billion
compared to $6.0 billion during the three months ended March 31, 2002. Our
composite average borrowing rate for the three months ended March 31, 2003 as
compared with the prior year period was 40 basis points higher, increasing from
7.65% to 8.05%, due to the repayment of debt with interest rates below our
average rate.
Income taxes for the three months ended March 31, 2003 increased $66.9 million
as compared with the prior year period primarily due to changes in taxable
income. The effective tax rate for the first quarter of 2003 was 38.7% as
compared with 38.4% for the first quarter of 2002.
DISCONTINUED OPERATIONS
($ in thousands) For the three months
ended March 31,
2003 2002
-------------- -------------
Revenue $ - $ 4,650
Operating loss $ - $ (419)
Loss from discontinued
operations, net of tax $ - $ (1,478)
Gain on disposal of water
segment, net of tax $ - $ 169,326
On January 15, 2002, we completed the sale of our water and wastewater
operations to American Water Works, Inc. for $859.1 million in cash and $122.5
million of assumed debt and other liabilities. The pre-tax gain on the sale
recognized in the first quarter of 2002 was $309.2 million, subsequently
adjusted to $316.7 million in the fourth quarter of 2002. The gain on the
disposal of the water segment, net of tax was $169.3 million.
28
Item 3. Quantitative and Qualitative Disclosures about Market Risk
----------------------------------------------------------
Disclosure of primary market risks and how they are managed
We are exposed to market risk in the normal course of our business operations
due to ongoing investing and funding activities. Market risk refers to the
potential change in fair value of a financial instrument as a result of
fluctuations in interest rates and equity and commodity prices. We do not hold
or issue derivative instruments, derivative commodity instruments or other
financial instruments for trading purposes. As a result, we do not undertake any
specific actions to cover our exposure to market risks and we are not party to
any market risk management agreements other than in the normal course of
business or to hedge long-term interest rate risk. Our primary market risk
exposures are interest rate risk and equity and commodity price risk as follows:
Interest Rate Exposure
Our exposure to market risk for changes in interest rates relates primarily to
the interest-bearing portion of our investment portfolio and interest on our
long term debt and capital lease obligations. The long term debt and capital
lease obligations include various instruments with various maturities and
interest rates.
Our objectives in managing our interest rate risk are to limit the impact of
interest rate changes on earnings and cash flows and to lower our overall
borrowing costs. To achieve these objectives, a majority of our borrowings have
fixed interest rates. Consequently, we have limited material future earnings or
cash flow exposures from changes in interest rates on our long-term debt and
capital lease obligations. A hypothetical 10% adverse change in interest rates
would increase the amount that we pay on our variable obligations and could
result in fluctuations in the fair value of our fixed rate obligations. Based
upon our overall interest rate exposure at March 31, 2003, a near-term change in
interest rates would not materially affect our consolidated financial position,
results of operations or cash flows.
In order to manage our interest rate risk exposure, we entered into five
interest swap agreements in 2001 and 2002 with investment grade financial
institutions. Each agreement covered a notional amount of $50.0 million. Under
the terms of the agreements, we make semi-annual, floating interest rate
interest payments based on six month LIBOR and receive a fixed rate on the
notional amount. There are two interest rate swap agreements that were executed
in 2001 that receive a 6.375% fixed rate until the swaps' termination date of
August 15, 2004, and there are three swaps executed in 2002 that receive an
8.500% fixed rate until their termination date of May 15, 2006. The underlying
variable rate on the swaps is set either in advance, in arrears or, as in the
case of one agreement, based on each period's daily average six-month LIBOR. In
connection with these swaps, the Company entered into a series of supplemental
rate agreements which had the effect of setting the floating rate portion of the
swaps in advance of the contractually agreed upon rate determination date.
Sensitivity analysis of interest rate exposure
At March 31, 2003, the fair value of our long-term debt and capital lease
obligations was estimated to be approximately $5.6 billion, based on our overall
weighted average rate of 8.0% and our overall weighted maturity of 13 years.
There has been no material change in the weighted average maturity applicable to
our obligations since December 31, 2002. The overall weighted average interest
rate declined by approximately 1 basis point during the first quarter of 2003. A
hypothetical increase of 80 basis points (10% of our overall weighted average
borrowing rate) would result in an approximate $262.6 million decrease in the
fair value of our fixed rate obligations.
Equity Price Exposure
Our exposure to market risk for changes in equity prices relate primarily to the
equity portion of our investment portfolio. The equity portion of our investment
portfolio includes marketable equity securities of media and telecommunications
companies.
As of March 31, 2003, we owned 3,059,000 shares of Adelphia common stock. As of
June 30, 2002, we had written this investment down to zero, and therefore we
have no additional exposure related to the market value of Adelphia stock.
As of March 31, 2002, we owned 2,305,908 common shares which represent an
ownership of 19% of the equity in Hungarian Telephone and Cable Corp., a company
of which our Chairman and Chief Executive Officer is a member of the Board of
Directors. In addition, we hold 30,000 shares of non-voting convertible
preferred stock, each share having a liquidation value of $70 per share and is
convertible at our option into 10 shares of common stock.
29
As of March 31, 2003, we owned 1,333,500 shares of D & E Communications (D & E)
common stock. As the result of an other than temporary decline in the stock
price of D & E, we recognized a non-cash pre-tax loss of $16.4 million on our
investment during the fourth quarter 2002.
Sensitivity analysis of equity price exposure
At March 31, 2003, the fair value of the equity portion of our investment
portfolio was estimated to be $36.1 million. A hypothetical 10% decrease in
quoted market prices would result in an approximate $3.6 million decrease in the
fair value of the equity portion of our investment portfolio.
Commodity Price Exposure
We purchase monthly gas future contracts, from time to time, to manage commodity
price fluctuations, caused by weather and other unpredictable factors,
associated with our commitments to deliver natural gas to customers at fixed
prices. Customers pay for gas service based upon prices that are defined by a
tariff. A tariff is an agreement between the public utility commission and us,
which determines the price that will be charged to the customer. Fluctuations in
gas prices are routinely handled through a pricing mechanism called the purchase
gas adjustor (PGA). The PGA allows for a process whereby any price change from
the agreed upon tariff will be settled as a pass through to the customer. As a
result, if gas prices increase, the PGA will increase and pass more costs on to
the customer. If gas prices decrease, the PGA will decrease and refunds will be
provided to the customer. This commodity activity relates to our gas businesses
and is not material to our consolidated financial position or results of
operations. In all instances we take physical delivery of the gas supply
purchased or contracted for by us. These gas future contracts and gas supply
contracts are considered derivative instruments as defined by SFAS 133. However,
such contracts are excluded from the provisions of SFAS 133 since they are
purchases made in the normal course of business and not for speculative
purposes. Based upon our overall commodity price exposure at March 31, 2003, a
material near-term change in the quoted market price of gas would not materially
affect our consolidated financial position or results of operations.
Disclosure of limitations of sensitivity analysis
Certain shortcomings are inherent in the method of analysis presented in the
computation of fair value of financial instruments. Actual values may differ
from those presented should market conditions vary from assumptions used in the
calculation of the fair value. This analysis incorporates only those exposures
that exist as of March 31, 2003. It does not consider those exposures or
positions, which could arise after that date. As a result, our ultimate exposure
with respect to our market risks will depend on the exposures that arise during
the period and the fluctuation of interest rates and quoted market prices.
Item 4. Controls and Procedures
-----------------------
Within 90 days prior to the date of this report, we carried out an evaluation,
under the supervision and with the participation of our management, of the
effectiveness of the design and operation of our disclosure controls and
procedures. Based on this evaluation, our principal executive officer and
principal financial officer concluded that our disclosure controls and
procedures are effective in timely alerting them to material information
required to be included in our periodic SEC reports. It should be noted that the
design of any system of controls is based in part upon certain assumptions, and
there can be no assurance that any design will succeed in achieving its stated
goals.
In addition, we reviewed our internal controls, and there have been no
significant changes in our internal controls or in other factors that could
significantly affect those controls subsequent to the date of their last
evaluation.
We presented the results of our most recent evaluation to our independent
auditors, KPMG LLP, and the audit committee of our board of directors. Based on
such evaluation, our management, including the principal executive officer and
principal financial officer, concluded that our disclosure controls and
procedures are adequate to insure the clarity and material completeness of our
disclosure in our periodic reports required to be filed with the SEC and there
are no significant deficiencies in the design or operation of internal controls,
which could significantly affect our ability to record, process, summarize and
report financial data.
30
PART II. OTHER INFORMATION
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Item 1. Legal Proceedings
-----------------
On July 20, 2001, we notified Qwest Corporation (Qwest) that we were terminating
eight acquisition agreements. On July 23, 2001, Qwest filed a notice of claim
for arbitration with respect to the terminated acquisition agreements. Qwest
asserts that we wrongfully terminated these agreements and is seeking
approximately $64.0 million in damages, which is the aggregate of liquidated
damages under letters of credit established in the terminated acquisition
agreements. On September 7, 2001, we filed a response and counterclaims in the
same arbitration proceedings, contesting Qwest's asserted claims and asserting
substantial claims against Qwest for material breaches of representations,
warranties, and covenants in the terminated acquisition agreements and in the
acquisition agreement relating to North Dakota assets that we purchased from
Qwest. The parties are currently engaged in discovery. An arbitration hearing
has been scheduled to commence in the third quarter of 2003.
The City of Bangor, Maine, filed suit against us on November 22, 2002, in the
U.S. District Court for the District of Maine (City of Bangor v. Citizens
Communications Company, Civ. Action No. 02-183-B-S). The City has alleged, among
other things, that we are responsible for the costs of cleaning up environmental
contamination alleged to have resulted from the operation of a manufactured gas
plant by Bangor Gas Company, which we owned from 1948-1963. The City alleged the
existence of extensive contamination of the Penobscot River and nearby land
areas and has asserted that money damages and other relief at issue in the
lawsuit could exceed $50.0 million. The City also requested that punitive
damages be assessed against us. We have filed an answer denying liability to the
City, and have asserted a number of counter claims against the City. We intend
to defend ourselves vigorously against the City's lawsuit. In addition, we have
identified a number of other potentially responsible parties that may be
responsible for the damages alleged by the City and have filed to join them as
parties to the lawsuit. These additional parties include Honeywell Corporation,
the Army Corps of Engineers, Guilford Transportation (formerly Maine Central
Railroad), UGI Utilities, Inc., and Centerpoint Energy Resources Corporation. We
also have demanded that various of our insurance carriers defend and indemnify
us with respect to the City's lawsuit. On or about December 26, 2002, we filed a
declaratory judgment action against those insurance carriers in the Superior
Court of Penobscot County, Maine, for the purpose of establishing their
obligations to us with respect to the City's lawsuit. We intend to vigorously
pursue insurance coverage for the City's lawsuit.
On February 7, 2003, we received a letter from counsel representing Enron North
America Corporation (formerly known as Enron Gas Marketing, Inc.) demanding
payment of an "early termination liability" of approximately $12.5 million that
Enron claims it is owed under a gas supply agreement that we lawfully terminated
in November 2001. The demand was made in connection with Enron's ongoing
bankruptcy proceeding in the United States Bankruptcy Court for the Southern
District of New York. We believe Enron's claim lacks any merit and have so
advised that company's counsel. Enron has threatened to initiate an adversary
proceeding in the bankruptcy court to recover the amount of its demand plus
applicable interest and attorney's fees. If that occurs, we will vigorously
defend against any such action.
In connection with an inquiry that we believe has arisen as a result of
allegations made to federal authorities during their investigation of an
embezzlement by two of our former officers, our employees and we are cooperating
fully with the Office of the U.S. Attorney for the Southern District of New York
and with the New York office of the Securities and Exchange Commission. We have
provided requested documents to the SEC and we have agreed to comply with an SEC
request that, in connection with the informal inquiry that it has initiated, we
preserve financial, audit, and accounting records. Since the filing of our Form
10-K on March 24, 2003, there have been no material developments concerning this
matter.
We are party to proceedings arising in the normal course of our business. The
outcome of individual matters is not predictable. However, we believe that the
ultimate resolution of all such matters, after considering insurance coverage,
will not have a material adverse effect on our financial position, results of
operations, or our cash flows.
31
Item 6. Exhibits and Reports on Form 8-K
--------------------------------
a) Exhibits:
10.1 First Amendment, dated as of March 31, 2003, to the Competitive Advance and
Revolving Credit Facility Agreement for $705,000,000 dated October 24,
2001.
10.2 Amendment No. 1 to the Loan Agreement between Citizens Communications
Company and Rural Telephone Finance Cooperative for $200,000,000 dated
October 24, 2001.
99.1 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 2002.
99.2 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.
b) Reports on Form 8-K:
We filed on Form 8-K on January 21, 2003 under Item 5 "Other Events and
Regulation FD Disclosure" and Item 7 "Financial Statements and Exhibits",
information concerning Amendment No. 1 to our Shareholder Rights Plan.
We filed on Form 8-K on March 4, 2003 under Item 7 "Financial Statements
and Exhibits", a press release announcing our earnings for the quarter and
year ended December 31, 2002.
32
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CITIZENS COMMUNICATIONS COMPANY
-------------------------------
(Registrant)
By: /s/ Robert J. Larson
---------------------
Robert J. Larson
Senior Vice President and
Chief Accounting Officer
Date: May 9, 2003
33
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CERTIFICATIONS
I, Leonard Tow, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Citizens Communications
Company;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 9, 2003
By: /s/ Leonard Tow
---------------------------
Leonard Tow
Chief Executive Officer and
Chairman of the Board of Directors
(principal executive officer)
34
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CERTIFICATIONS (continued)
I, Jerry Elliott, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Citizens Communications
Company;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 9, 2003
By: /s/ Jerry Elliott
----------------------------
Jerry Elliott
Chief Financial Officer
(principal financial officer)
35