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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 JUNE 30, 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 June 30, 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 July 31,
2003 was 284,318,606.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Index
Page No.
--------
Part I. Financial Information (Unaudited)
Financial Statements
Consolidated Balance Sheets at June 30, 2003 and December 31, 2002 2
Consolidated Statements of Operations for the three months ended June 30, 2003 and 2002 3
Consolidated Statements of Operations for the six months ended June 30, 2003 and 2002 4
Consolidated Statements of Shareholders' Equity for the year ended December 31, 2002 and
the six months ended June 30, 2003 5
Consolidated Statements of Comprehensive Income for the three and six months ended June 30,
2003 and 2002 5
Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2002 6
Notes to Consolidated Financial Statements 7
Management's Discussion and Analysis of Financial Condition and Results of Operations 21
Quantitative and Qualitative Disclosures About Market Risk 32
Controls and Procedures 34
Part II. Other Information
Legal Proceedings 35
Submission of Matters to a Vote of Security Holders 36
Other Information 36
Exhibits and Reports on Form 8-K 36
Signature 38
1
PART I. FINANCIAL INFORMATION
Item 1.Financial Statements
--------------------
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
($ in thousands)
(Unaudited)
June 30, 2003 December 31, 2002
------------------- ------------------
ASSETS
- ------
Current assets:
Cash and cash equivalents $ 385,038 $ 393,177
Accounts receivable, less allowances of $40,052 and $38,946, respectively 279,472 310,929
Other current assets 38,390 49,114
Assets held for sale 471,331 447,764
------------------- ------------------
Total current assets 1,174,231 1,200,984
Property, plant and equipment, net 3,620,734 3,690,056
Goodwill, net 1,858,558 1,869,348
Other intangibles, net 875,904 942,970
Investments 37,619 29,846
Other assets 395,226 413,538
------------------- ------------------
Total assets $ 7,962,272 $ 8,146,742
=================== ==================
LIABILITIES AND EQUITY
- ----------------------
Current liabilities:
Long-term debt due within one year $ 105,776 $ 58,911
Accounts payable and other current liabilities 503,489 565,986
Liabilities related to assets held for sale 113,186 145,969
------------------- ------------------
Total current liabilities 722,451 770,866
Deferred income taxes 244,682 137,116
Customer advances for construction and contributions in aid of construction 133,811 146,661
Other liabilities 287,735 301,349
Equity units 460,000 460,000
Long-term debt 4,556,392 4,957,361
Company Obligated Manditorily Redeemable Convertible Preferred Securities* 201,250 201,250
Shareholders' equity:
Common stock, $0.25 par value (600,000,000 authorized shares; 284,273,000
and 282,482,000 outstanding and 295,312,000 and 294,080,000 issued at
June 30, 2003 and December 31, 2002, respectively) 73,828 73,520
Additional paid-in capital 1,951,460 1,943,406
Accumulated deficit (391,545) (553,033)
Accumulated other comprehensive loss (97,371) (102,169)
Treasury stock (180,421) (189,585)
------------------- ------------------
Total shareholders' equity 1,355,951 1,172,139
------------------- ------------------
Total liabilities and equity $ 7,962,272 $ 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 JUNE 30, 2003 AND 2002
($ in thousands, except per-share amounts)
(Unaudited)
2003 2002
-------------- --------------
Revenue $ 643,954 $ 662,439
Operating expenses:
Cost of services 113,537 113,786
Other operating expenses 232,493 251,426
Depreciation and amortization 150,359 186,378
Reserve for telecommunications bankruptcies 2,260 10,001
Restructuring and other expenses 10,113 18,280
-------------- --------------
Total operating expenses 508,762 579,871
-------------- --------------
Operating income 135,192 82,568
Investment and other income (loss), net 24,566 (29,188)
Gain on sales of assets 6,671 -
Interest expense 106,436 119,947
-------------- --------------
Income (loss) before income taxes 59,993 (66,567)
Income tax expense (benefit) 24,384 (26,560)
-------------- --------------
Income (loss) before dividends on convertible preferred securities 35,609 (40,007)
Dividends on convertible preferred securities, net of income tax benefit of $(963) 1,552 1,552
-------------- --------------
Net income (loss) attributable to common shareholders $ 34,057 $ (41,559)
============== ==============
Basic and diluted income (loss) per common share $ 0.12 $ (0.15)
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 OPERATIONS
FOR THE SIX MONTHS ENDED JUNE 30, 2003 AND 2002
($ in thousands, except per-share amounts)
(Unaudited)
2003 2002
-------------- --------------
Revenue $ 1,295,816 $ 1,341,773
Operating expenses:
Cost of services 226,756 242,024
Other operating expenses 468,314 512,280
Depreciation and amortization 288,907 364,552
Reserve for telecommunications bankruptcies 2,260 17,805
Restructuring and other expenses 10,092 22,185
-------------- --------------
Total operating expenses 996,329 1,158,846
-------------- --------------
Operating income 299,487 182,927
Investment and other income (loss), net 74,388 (78,139)
Gain on sales of assets, net 5,021 -
Interest expense 215,712 241,554
-------------- --------------
Income (loss) from continuing operations before income taxes, dividends on
convertible preferred securities and cumulative effect of change
in accounting principle 163,184 (136,766)
Income tax expense (benefit) 64,360 (53,502)
-------------- --------------
Income (loss) from continuing operations before dividends on convertible
preferred securities and cumulative effect of change in accounting principle 98,824 (83,264)
Dividends on convertible preferred securities, net of income tax benefit of $(1,926) 3,105 3,105
-------------- --------------
Income from continuing operations before cumulative effect of
change in accounting principle 95,719 (86,369)
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 95,719 81,479
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 $ 161,488 $ 41,667
============== ==============
Basic income (loss) per common share:
Income (loss) from continuing operations before cumulative effect of
change in accounting principle $ 0.34 $ (0.31)
Income from discontinued operations $ - $ 0.60
Income before cumulative effect of change in accounting principle $ 0.34 $ 0.29
Cumulative effect of change in accounting principle $ 0.23 $ (0.14)
Net income attributable to common shareholders $ 0.57 $ 0.15
Diluted income (loss) per common share:
Income (loss) from continuing operations before cumulative effect of
change in accounting principle $ 0.33 $ (0.31)
Income from discontinued operations $ - $ 0.59
Income before cumulative effect of change in accounting principle $ 0.33 $ 0.28
Cumulative effect of change in accounting principle $ 0.22 $ (0.13)
Net income attributable to common shareholders $ 0.55 $ 0.15
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 SHAREHOLDERS' EQUITY
FOR THE YEAR ENDED DECEMBER 31, 2002 AND THE SIX MONTHS ENDED JUNE 30, 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 1,232 308 8,054 - - 559 9,164 17,526
Net income - - - 161,488 - - - 161,488
Other comprehensive income, net
of tax and reclassifications
adjustments - - - - 4,798 - - 4,798
--------- --------- ----------- ------------ ------------ -------- ------------ -----------
Balances June 30, 2003 295,312 $73,828 $ 1,951,460 $ (391,545) $ (97,371) (11,039) $ (180,421) $1,355,951
========= ========= =========== ============ ============ ======== ============ ===========
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2003 AND 2002
($ in thousands)
(Unaudited)
For the three months ended June 30, For the six months ended June 30,
-------------------------------------- --------------------------------------
2003 2002 2003 2002
------------------ ------------------ ------------------ ------------------
Net income (loss) $ 34,057 $ (41,559) $ 161,488 $ 41,667
Other comprehensive income (loss), net of
tax and reclassifications adjustments* 908 (5,189) 4,798 (5,482)
------------------ ------------------ ------------------ ------------------
Total comprehensive income (loss) $ 34,965 $ (46,748) $ 166,286 $ 36,185
================== ================== ================== ==================
* Consists of unrealized gains/(losses) of
marketable securities.
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
5
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2003 AND 2002
($ in thousands)
2003 2002
--------------- ---------------
Income (loss) from continuing operations before cumulative
effect of change in accounting principle $ 95,719 $ (86,369)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization expense 288,907 364,552
Investment write-downs - 100,377
Gain on extinguishment of debt (71,889) (10,033)
Investment (gains)/losses - (3,363)
Gain on sales of assets, net (5,021) -
Allowance for equity funds used during construction (96) (895)
Deferred and accrued income taxes 104,591 (148,964)
Change in accounts receivable 39,407 9,049
Change in accounts payable, accrued expenses and
other liabilities (118,337) (145,085)
Change in other current assets 10,479 110,014
--------------- ---------------
Net cash provided by continuing operating activities 343,760 189,283
Cash flows from investing activities:
Proceeds from sales of assets, net of selling expenses 54,900 -
Capital expenditures (115,602) (162,558)
Securities purchased (605) (450)
Securities sold - 8,387
Securities matured - 2,014
Other - 498
--------------- ---------------
Net cash used by investing activities (61,307) (152,109)
Cash flows from financing activities:
Long-term debt principal payments (301,583) (664,632)
Issuance of common stock 15,706 8,079
Customer advances for construction
and contributions in aid of construction (4,715) (1,597)
--------------- ---------------
Net cash used by financing activities (290,592) (658,150)
Cash provided by (used by) discontinued operations
Proceeds from sale of discontinued operations - 859,065
Net cash used by discontinued operations - (32,889)
Increase (decrease) in cash and cash equivalents (8,139) 205,200
Cash and cash equivalents at January 1, 393,177 215,869
--------------- ---------------
Cash and cash equivalents at June 30, $ 385,038 $ 421,069
=============== ===============
Cash paid during the period for:
Interest $ 212,634 $ 247,139
Income taxes $ 1,236 $ 10,895
Non-cash investing and financing activities:
Change in fair value of interest rate swaps $ 864 $ 5,758
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
6
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.
7
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 and in May
2003 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 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 June 30, 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.
8
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 June 30, Six Months Ended June 30,
----------------------------- -------------------------
2003 2002 2003 2002
------------- ----------- ------------ ---------
($ in thousands)
Net income (loss) As reported $ 34,057 $ (41,559) $161,488 $41,667
Add: Stock-based employee
compensation expense
included in reported net
income, net of related tax
effects 2,721 314 3,565 1,604
Deduct: Total stock-based
employee compensation
expense determined under
fair value based method
for all awards, net of
related tax effects (5,035) (3,901) (8,140) (7,989)
--------- --------- -------- -------
Pro forma $ 31,743 $ (45,146) $156,913 $35,282
========= ========= ======== ========
Net income (loss) per
common share As reported:
Basic $ 0.12 $ (0.15) $ 0.57 $ 0.15
Diluted $ 0.12 $ (0.15) $ 0.55 $ 0.15
Pro forma:
Basic $ 0.11 $ (0.16) $ 0.56 $ 0.13
Diluted $ 0.11 $ (0.16) $ 0.53 $ 0.13
(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.
9
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 June 30, 2003 and December 31, 2002 is as
follows:
($ in thousands) June 30, 2003 December 31, 2002
---------------------- ---------------------
Property, plant and equipment $ 6,167,963 $ 6,139,772
Less accumulated depreciation (2,547,229) (2,449,716)
---------------------- ---------------------
Property, plant and equipment, net $ 3,620,734 $ 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 $118,729,000 and $156,050,000
for the three months ended June 30, 2003 and 2002, respectively and
$225,565,000 and $303,870,000 for the six months ended June 30, 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 $10,141,000 and $20,098,000, or $0.02 and $0.04 per share for
the three and six months ended June 30, 2003, respectively. For the three
and six months ended June 30, 2002, we recognized accelerated depreciation
of $900,000 and $12,800,000, respectively, related to the closing of our
Plano, Texas facility.
(3) Dispositions:
------------
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. The
pre-tax gain on the sale recognized in the second quarter of 2003 was
$2,274,000.
On April 4, 2003, we completed the sale of our wireless partnership
interest in Wisconsin for approximately $7,500,000 in cash. The pre-tax
gain on the sale recognized in the second quarter of 2003 was $4,397,000.
(4) 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 August 11,
2003), subject to adjustments specified in the agreements. The
transaction is subject to customary approvals and is expected to close
in the third quarter of 2003 (see Note 17 to Consolidated Financial
Statements).
10
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 and assumed liabilities, subject to adjustments under the
terms of the agreement. The transaction is subject to customary
approvals and is expected to close in the third quarter of 2003 (see
Note 17 to Consolidated Financial Statements).
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 six months ended June 30,
-------------------------------------------
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) June 30, 2003 December 31, 2002
-------------------- -------------------
Current assets $ 44,856 $ 49,549
Net property, plant and equipment 376,484 358,135
Other assets 49,991 40,080
-------------------- -------------------
Total assets held for sale $ 471,331 $ 447,764
==================== ===================
Current liabilities $ 54,402 $ 79,194
Other liabilities 58,784 66,775
-------------------- -------------------
Total liabilities related to assets held
for sale $ 113,186 $ 145,969
==================== ===================
11
(5) Goodwill:
--------
Goodwill at June 30, 2003 and December 31, 2002 is as follows:
($ in thousands) June 30, 2003 December 31, 2002
------------------------ ---------------------
Goodwill, net $ 1,858,558 $ 1,869,348
======================== =====================
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. The decline in
goodwill at June 30, 2003 is due to the April 1, 2003 sale of access lines
in North Dakota.
(6) Other Intangibles:
-----------------
Other intangibles at June 30, 2003 and December 31, 2002 are as follows:
($ in thousands) June 30, 2003 December 31, 2002
------------------------ ---------------------
Customer base - amortizable over 96 months $ 995,853 $ 1,000,816
Trade name - non-amortizable 122,058 122,058
------------------------ ---------------------
Other intangibles 1,117,911 1,122,874
Accumulated amortization (242,007) (179,904)
------------------------ ---------------------
Total other intangibles, net $ 875,904 $ 942,970
======================== =====================
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.
Amortization expense was $31,630,000 and $30,328,000 for the three months
ended June 30, 2003 and 2002, respectively and $63,342,000 and $60,682,000
for the six months ended June 30, 2003 and 2002, respectively. The decline
in customer base at June 30, 2003 is due to the April 1, 2003 sale of
access lines in North Dakota.
(7) Restructuring Charges and Other Expenses:
----------------------------------------
2003
----
Restructuring and other expenses primarily consist of expenses related to
reductions in personnel at our telecommunications operations and the write
off of software no longer useful. We continue to review our operations,
personnel and facilities to achieve greater efficiency.
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, and $6,800,000 of costs and expenses related to our tender offer in
June 2002 for all publicly held ELI common shares that we did not own.
2001
----
During 2001, we examined all aspects of our business operations and our
facilities to take advantage of operational and functional synergies among
all our telecommunications operations.
12
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 and we adjusted our accrual down by $92,000 for
the three months ended June 30, 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 and $9,000 for the three months ended June 30, 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 and second quarters of 2002, ELI
adjusted its original accrual down by $2,100,000 and $100,000,
respectively, due to the favorable settlement of termination charges for an
off-net circuit agreement. As of December 31, 2002, this accrual was
adjusted down by $725,000, $1,354,000 was paid and no accrual remained.
Tender Offer
During May 2002, we announced a tender offer for all of the shares of ELI
that we did not already own for a price of $0.70 per share. We completed
the tender offer in June 2002, resulting in ELI becoming a wholly-owned
subsidiary, for total costs and expenses of approximately $6,800,000. We
accounted for this transaction as a purchase and allocated the entire
amount to goodwill. We evaluated the recoverability of this goodwill in
accordance with SFAS No. 142 and determined that a write-down was necessary
based on fair market value as determined by discounted cash flows. This
charge is included in restructuring and other expenses.
($ 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 @ 6/30/2003 $ - $ - $ - $ - $ -
================= ============== ============== ============= ==========
13
(8) Long-Term Debt:
--------------
The activity in our long-term debt from December 31, 2002 to June 30, 2003
is as follows:
Six Months Ended June 30, 2003
---------------------------------------
Interest Rate*
at
December 31, Interest June 30, June 30,
($ in thousands) 2002 Payments** Rate Swap Other 2003 2003
------------ ---------- --------- ----- -------- --------------
FIXED RATE
Rural Utilities Service Loan
Contracts $ 30,874 $ (433) $ - $ $ 30,441 6.210%
Senior Unsecured Debt 4,508,880 (99,640) 864 - 4,410,104 8.095%
Equity Units 460,000 - - - 460,000 7.480%
ELI Notes 5,975 - - - 5,975 6.232%
ELI Capital Leases 135,200 (7,906) - (53,385) 73,909 10.267%
Industrial Development Revenue
Bonds 186,390 (74,655) - - 111,735 5.874%
Other 40 (9) - - 31 12.986%
----------- --------- --------- ---------- -----------
TOTAL FIXED RATE 5,327,359 (182,643) 864 (53,385) 5,092,195
----------- ---------- --------- ---------- -----------
VARIABLE RATE
Industrial Development Revenue Bonds 148,913 (118,940) - - 29,973 1.609%
----------- ---------- --------- ---------- -----------
TOTAL VARIABLE RATE 148,913 (118,940) - - 29,973
----------- ---------- --------- ---------- -----------
TOTAL $ 5,476,272 $(301,583) $ 864 $ (53,385) $ 5,122,168
----------- ========== ========= =========== -----------
Less: Current Portion (58,911) (105,776)
Less: Equity Units (460,000) (460,000)
----------- -----------
TOTAL LONG TERM DEBT $ 4,957,361 $ 4,556,392
=========== ===========
* 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.
During June 2003, we redeemed five separate issues of the Company's Industrial
Development Revenue Bonds aggregating $75,500,000, and seven issues of the
Company's Special Purpose Revenue Bonds aggregating $88,800,000. All of these
redemptions were funded with cash. In addition, we called for redemption two
additional Industrial Development Revenue Bond series aggregating $13,500,000,
$12,400,000 of which was redeemed with cash on July 2, 2003, with the remaining
$1,100,000 issue to be redeemed with cash on August 1, 2003.
During the first six months 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 $93,900,000 at a premium of approximately
$3,100,000.
In March 2003, we terminated a capital lease obligation at ELI, which resulted
in a non-cash pre-tax gain of $40,703,000 included in investment and other
income (loss), net. In addition, in June 2003, ELI reduced the number of optical
fibers leased under another capital lease, which resulted in a non-cash pre-tax
gain of approximately $25,021,000 included in investment and other income
(loss), net. Total future minimum cash payment commitments over the next 24
years under ELI's long-term capital leases amounted to $156,886,000 as of June
30, 2003.
On February 1, 2003, we repaid at maturity $35,000,000 of Frontier
Communications of Minnesota 7.61% Senior Notes.
14
(9) Income (Loss) Per Common Share:
------------------------------
The reconciliation of the income (loss) per common share calculation for
the three and six months ended June 30, 2003 and 2002, respectively, is as
follows:
($ in thousands, except per-share amounts) For the three months ended June 30, For the six months ended June 30,
------------------------------------ ------------------------------------
2003 2002 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 $ 34,057 $ (41,559) $ 95,719 $ (86,369)
Income from discontinued operations - - - 167,848
---------------- ---------------- ---------------- ----------------
Income (loss) before cumulative effect of change in
accounting principle 34,057 (41,559) 95,719 81,479
Cumulative effect of change in accounting principle - - 65,769 (39,812)
---------------- ---------------- ---------------- ----------------
Total basic net income (loss) $ 34,057 $ (41,559) $ 161,488 $ 41,667
================ ================ ================ ================
Effect of conversion of preferred securities 1,552 1,552 3,105 3,105
---------------- ---------------- ---------------- ----------------
Total diluted net income (loss) $ 35,609 $ (40,007) $164,593 $ 44,772
================ ================ ================ ================
Basic earnings (loss) per common share
Weighted-average shares outstanding - basic 282,180 280,610 281,934 280,432
---------------- ---------------- ---------------- ----------------
Income (loss) from continuing operations before
cumulative effect of change in accounting principle $ 0.12 $ (0.15) $ 0.34 $ (0.31)
Income from discontinued operations - - - 0.60
---------------- ---------------- ---------------- ----------------
Income (loss) before cumulative effect of change in
accounting principle 0.12 (0.15) 0.34 0.29
Cumulative effect of change in accounting principle - - 0.23 (0.14)
---------------- ---------------- ---------------- ----------------
Net income (loss) attributable to common shareholders $ 0.12 $ (0.15) $ 0.57 $ 0.15
================ ================ ================ ================
Diluted earnings (loss) per common share
Weighted-average shares outstanding 282,180 280,610 281,934 280,432
Effect of dilutive shares 5,389 4,644 4,763 4,418
Effect of conversion of preferred securities 15,134 15,134 15,134 15,134
---------------- ---------------- ---------------- ----------------
Weighted-average shares outstanding - diluted 302,703 300,388 301,831 299,984
================ ================ ================ ================
Income (loss) from continuing operations before
cumulative effect of change in accounting principle $ 0.12 $ (0.15) $ 0.33 $ (0.31)
Income from discontinued operations - - - 0.59
---------------- ---------------- ---------------- ----------------
Income (loss) before cumulative effect of change in
accounting principle 0.12 (0.15) 0.33 0.28
Cumulative effect of change in accounting principle - - 0.22 (0.13)
---------------- ---------------- ---------------- ----------------
Net income (loss) attributable to common shareholders $ 0.12 $ (0.15) $ 0.55 $ 0.15
================ ================ ================ ================
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. At June 30, 2003,
4,025,000 shares of 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 have been included in the diluted income (loss)
per common share calculation. We also have 11,284,000 potentially dilutive
stock options exercisable at prices ranging from $11.09 to $21.47 per share
and 18,400,000 potentially dilutive equity units. Each equity unit
initially consists of a 6.75% senior note due 2006 and a purchase contract
(warrant) for our common stock. These items were not included in the
diluted income (loss) per common share calculation for any of the above
periods as their effect was antidilutive. Restricted stock awards of
1,553,000 shares and 1,477,000 shares at June 30, 2003 and 2002
respectively, are excluded from our basic weighted average shares
outstanding and included in our dilutive shares until the shares are no
longer contingent upon the satisfaction of all specified conditions.
15
(10) Segment Information:
-------------------
We operate in four segments, ILEC, ELI (a competitive local exchange
carrier (CLEC)), gas and electric. The ILEC segment provides both regulated
and unregulated communications services to residential, business and
wholesale customers and is typically the incumbent provider in its service
areas. Our gas and electric segments are intended to be sold and are
classified as "assets held for sale" and "liabilities related to assets
held for sale."
As an ILEC, we compete with CLECs that may operate in our markets. As a
CLEC, we provide telecommunications services, principally to businesses, in
competition with the incumbent ILEC. As a CLEC, we frequently obtain the
"last mile" access to customers through arrangements with the applicable
ILEC. ILECs and CLECs are subject to different regulatory frameworks of the
Federal Communications Commission (FCC). Our ILEC operations and ELI do not
compete with each other.
16
($ in thousands) For the three months ended June 30, 2003
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 510,153 $ 43,719 $ 56,150 $ 33,932 $ 643,954
Depreciation and amortization 144,374 5,985 - - 150,359
Reserve for telecommunications
bankruptcies 1,113 1,147 - - 2,260
Restructuring and other expenses 9,482 631 - - 10,113
Operating income 121,814 2,350 6,159 4,869 135,192
Capital expenditures, net 56,415 2,254 4,296 4,827 67,792
($ in thousands) For the three months ended June 30, 2002
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 514,686 $ 45,287 $ 47,856 $ 54,610 $ 662,439
Depreciation and amortization 154,741 31,591 46 - 186,378
Reserve for telecommunications
bankruptcies 9,567 434 - - 10,001
Restructuring and other expenses 9,207 9,073 - - 18,280
Operating income (loss) 100,607 (38,976) 8,416 12,521 82,568
Capital expenditures, net 81,364 3,067 4,940 4,500 93,871
($ in thousands) For the six months ended June 30, 2003
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 1,023,762 $ 84,812 $ 119,681 $ 67,561 $ 1,295,816
Depreciation and amortization 276,729 12,178 - - 288,907
Reserve for telecommunications
bankruptcies 1,113 1,147 - - 2,260
Restructuring and other expenses 9,482 610 - - 10,092
Operating income 268,729 2,885 18,010 9,863 299,487
Capital expenditures, net 94,292 3,401 7,465 9,972 115,130
($ in thousands) For the six months ended June 30, 2002
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 1,022,717 $ 92,534 $ 119,221 $107,301 $ 1,341,773
Depreciation and amortization 313,031 51,391 130 - 364,552
Reserve for telecommunications
bankruptcies 17,371 434 - - 17,805
Restructuring and other expenses 15,212 6,973 - - 22,185
Operating income (loss) 192,828 (55,996) 20,304 25,791 182,927
Capital expenditures, net 137,404 5,656 9,319 9,704 162,083
The following table reconciles sector capital expenditures to total consolidated
capital expenditures.
($ in thousands) For the three months ended For the six months ended
June 30, June 30,
------------------------------ -----------------------------
2003 2002 2003 2002
-------------- -------------- --------------- -------------
Total segment capital expenditures $ 67,792 $ 93,871 $ 115,130 $ 162,083
General capital expenditures 58 248 472 475
-------------- -------------- --------------- -------------
Consolidated reported capital
expenditures $ 67,850 $ 94,119 $ 115,602 $ 162,558
============== ============== =============== =============
17
(11) Adelphia Investment:
-------------------
We recognized losses of $45,600,000 and $49,700,000 on our Adelphia
Communications Corp. (Adelphia) investment for the three months ended June
30, 2002 and March 31, 2002, respectively. 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.
(12) 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 June 30, 2003 and December 31, 2002 was $350,000,000 and $250,000,000,
respectively. Such contracts require us to pay variable rates of interest
(average pay rate of approximately 4.67% as of June 30, 2003) and receive
fixed rates of interest (average receive rate of 7.89% as of June 30,
2003). The fair value of these derivatives is reflected in other assets as
of June 30, 2003, in the amount of $17,523,000 and the related underlying
debt has been increased by a like amount. The amounts received during the
three and six months ended June 30, 2003 as a result of these contracts
amounted to $2,813,000 and $4,117,000 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.
(13) 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 (an "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.
(14) 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 six months ended
June 30, 2003 and 2002, we recognized income of $6,165,000 and $10,000,000,
respectively, which is reflected in investment and other income (loss),
net, as a result of these settlements.
(15) 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.
The following table presents 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.
18
For the three months ended June 30, For the six months ended June 30,
---------------------------------- ----------------------------------
(In thousands, except per-share amounts) 2003 2002 2003 2002
---------------- ---------------- ---------------- ----------------
Reported attributable to common shareholders $ 34,057 $ (41,559) $ 161,488 $ 41,667
Add back: Cost of removal in depreciation expense,
net of tax - 3,589 - 7,302
---------------- ---------------- ---------------- ----------------
Adjusted attributable to common shareholders $ 34,057 $ (37,970) $ 161,488 $ 48,969
================ ================ ================ ================
Basic earnings per share:
Reported attributable to common shareholders $ 0.12 $ (0.15) $ 0.57 $ 0.15
Cost of removal in depreciation expense - 0.01 - 0.03
---------------- ---------------- ---------------- ----------------
Adjusted attributable to common shareholders $ 0.12 $ (0.14) $ 0.57 $ 0.18
================ ================ ================ ================
Diluted earnings per share:
Reported attributable to common shareholders $ 0.12 $ (0.15) $ 0.55 $ 0.15
Cost of removal in depreciation expense - 0.01 - 0.02
---------------- ---------------- ---------------- ----------------
Adjusted attributable to common shareholders $ 0.12 $ (0.14) $ 0.55 $ 0.17
================ ================ ================ ================
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.
In April 2003, the FASB 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. This Statement is effective for contracts
entered into or modified after June 30, 2003. We are currently evaluating
the impact of the adoption of SFAS No. 149.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity."
The Statement requires issuers to classify as liabilities (or assets in
some circumstances) certain financial instruments that embody obligations
of the issuer. Generally, the Statement is effective for financial
instruments entered into or modified after May 31, 2003 and is otherwise
effective at the beginning of the first interim period beginning after June
15, 2003. We adopted the provisions of the Statement on July 1, 2003. The
adoption of SFAS No. 150 did not have any material impact on our financial
position or results of operations.
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.
(16) Commitments and Contingencies:
-----------------------------
We expect capital expenditures in 2003 to be approximately $270,000,000 for
ILEC and ELI and $45,200,000 (assuming we own all our utility businesses
for the entire year) for gas and electric. However, if we close on our
pending sales on the currently expected dates we will spend approximately
$25,000,000 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 $6,100,000 of
capital expenditures for these properties from July 1, 2003 through their
expected dates of sale. We did not expense any of our $17,437,000 of
capital additions related to these properties during the first half of
2003. If the sale of our Arizona utility businesses to UniSource is
completed, the sale agreement requires us to promptly redeem $31,240,000
principal amount of industrial development revenue bonds.
19
If the sale of our Hawaii gas operations to K-1 USA Ventures is completed,
the buyer has agreed to assume $17,593,000 of our special purpose
development bonds.
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. In
addition, in June 2003, ELI reduced the number of optical fibers leased
under another capital lease, which resulted in a non-cash pre-tax gain of
approximately $25,021,000. These gains were reported for the three months
ended March 31, 2003 and June 30, 2003 in investment and other income
(loss), net.
(17) Subsequent Events:
-----------------
On August 8, 2003, we completed the sale of our Gas Company in Hawaii to
K-1 USA Ventures, Inc. for approximately $115,000,000 in cash and assumed
liabilities.
On August 11, 2003, we completed the sale of our Arizona gas and electric
divisions to UniSource Energy Corporation for approximately $220,000,000 in
cash and issued call notices on $31,240,000 in industrial development
revenue bonds to be repaid in the fourth quarter of 2003.
20
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 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 changes in the telecommunications market, including the
likelihood of significantly increased price and service competition;
* 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.
21
Competition in the telecommunications industry is increasing. Although we have
not faced as much competition as larger, more urban telecommunications
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, New York 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. One of the ways we are
responding to actual and potential competition is by bundling services and
products and offering them for a single price. In addition, revenues from data
products and services such as DSL continue to increase as a percentage of our
total revenues. These factors may cause our margins to decrease.
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.
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 six months ended June 30, 2003, we used cash flow from continuing
operations and cash and investment balances to fund capital expenditures,
interest payments and debt repayments. As of June 30, 2003, we maintained cash
and short-term investment balances aggregating $385.0 million.
We expect to spend on 2003 capital projects approximately $258.0 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. However, if we close on our pending sales on the currently
expected dates we will spend approximately $25.0 million for gas and electric.
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 16 to
Consolidated Financial Statements).
For the six months ended June 30, 2003, our actual capital expenditures were
$94.3 million for the ILEC segment, $3.4 million for the ELI segment, $17.4
million for the public utilities segments and $0.5 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 June 30, 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 June 30, 2003, there were no outstanding borrowings under
these facilities.
22
If the sale of our Arizona utility businesses to UniSource is completed, the
sale agreement requires us to promptly redeem $31.2 million of the Company's
Arizona industrial development revenue bonds. We intend to fund these
redemptions 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
- --------------
On February 1, 2003, we repaid at maturity $35.0 million of Frontier
Communications of Minnesota 7.61% Senior Notes.
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 (loss), net. In addition, in June 2003, ELI reduced the number of optical
fibers leased under another capital lease, which resulted in a non-cash pre-tax
gain of $25.0 million included in investment and other income (loss), net.
During June 2003, we redeemed five separate issues of the Company's Industrial
Development Revenue Bonds aggregating $75.5 million, and seven issues of the
Company's Special Purpose Revenue Bonds aggregating $88.8 million. All of these
redemptions were funded with cash. In addition, we called for redemption two
additional Industrial Development Revenue Bond series aggregating $13.5 million,
$12.4 million of which was redeemed with cash on July 2, 2003, and the remaining
$1.1 million issue was redeemed with cash on August 1, 2003.
During the first six months 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 $93.9 million at a premium of approximately
$3.1 million.
During the period between June 15, 2003 and July 15, 2003, holders of the
Company's outstanding $15.1 million principal amount of 6.80% Debentures due
August 15, 2026 had the option to put the Debentures to the Company for
mandatory redemption at par on August 15, 2003. As a result, the entire
outstanding principal amount of these debentures has been classified as debt due
within one year on the Company's balance sheet since the third quarter of 2002.
By July 15, 2003 holders of $2.5 million of the debentures had exercised their
right to put the debentures to us on August 15, 2003. Accordingly, the $12.6 of
debentures that were not put to us for redemption has been reclassified as
long-term debt on the balance sheet, with a final maturity of August 15, 2026.
Interest Rate Management
- ------------------------
In order to manage our interest expense, we entered into five interest swap
agreements in 2002 and 2001 with investment grade financial institutions. During
the second quarter of 2003, we entered into two additional interest rate swaps.
Each agreement covers a notional amount of $50.0 million. Under the terms of the
agreements, we make semi-annual, floating 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
now five swaps that were executed in 2002 and 2003 that receive an 8.500% fixed
rate until their termination date of May 15, 2006. The underlying variable rate
on these 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, we have entered into agreements which set the
average effective rate on $200 million of swaps at 5.166% for the six month
period ending November 15, 2003, as well as setting the effective rate on $200
million of swaps at an average rate of 6.218% for the six month period beginning
November 15, 2003, all compared to the unhedged rate of 8.50%. 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.
23
Our $805.0 million credit facilities and our $200.0 million term loan facility
with the Rural Telephone Finance Cooperative (RTFC) contain a maximum 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 2002 we sold all of our water and wastewater treatment
operations and one electric business.
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 August 11, 2003) subject to
adjustments specified in the agreements. The transaction is subject to customary
approvals and is expected to close in the third quarter of 2003 (see Note 17 to
Consolidated Financial Statements).
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 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 and
assumed liabilities, subject to adjustments under the terms of the agreement.
The transaction is subject to customary approvals and is expected to close in
the third quarter of 2003 (see Note 17 to Consolidated Financial Statements).
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 during the first half of 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 16 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.
24
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.
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 of net
realizable value 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.
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. Based
upon market conditions existing at the end of June 2003, should market
conditions remain unchanged, an additional charge to equity of approximately $15
- - $20 million would be required at the end of 2003.
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.
25
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 disclosures 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. 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
recognized in the first quarter of 2003.
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.
In April 2003, the FASB 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. This Statement is effective for contracts entered into or
modified after June 30, 2003. We are currently evaluating the impact of the
adoption of SFAS No. 149.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity." The Statement
requires issuers to classify as liabilities (or assets in some circumstances)
certain financial instruments that embody obligations of the issuer. Generally,
the Statement is effective for financial instruments entered into or modified
after May 31, 2003 and is otherwise effective at the beginning of the first
interim period beginning after June 15, 2003. We adopted the provisions of the
Statement on July 1, 2003. The adoption of SFAS No. 150 did not have any
material impact on our financial position or results of operations.
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.
26
(b) Results of Operations
---------------------
REVENUE
Consolidated revenue for the three and six months ended June 30, 2003 decreased
$18.5 million and $46.0 million, respectively, or 3% as compared with the prior
year periods. The decrease in the second quarter is due to a $12.4 million net
decrease in gas and electric revenue, a $4.5 million decrease in ILEC revenue,
and a decrease in ELI revenue of $1.6 million. The year-to-date decrease is due
to a $39.3 million net decrease in gas and electric revenue, a $7.7 million
decrease in ELI revenue partially offset by an increase in ILEC revenue of $1.0
million. On April 1, 2003, we completed the sale of approximately 11,000
telephone access lines in North Dakota. The North Dakota revenues totaled $1.9
million and $5.6 million for the six months ended June 30, 2003 and 2002,
respectively.
TELECOMMUNICATIONS REVENUE
($ in thousands) For the three months ended June 30, For the six months ended June 30,
-------------------------------------------- -----------------------------------------------
2003 2002 $ Change % Change 2003 2002 $ Change % Change
---------- ------------ ----------- -------- ------------ ----------- ------------ ---------
Access services $ 160,142 $ 171,163 $ (11,021) -6% $ 325,139 $ 336,996 $ (11,857) -4%
Local services 220,710 217,638 3,072 1% 441,805 434,438 7,367 2%
Long distance and data services 76,487 71,029 5,458 8% 151,265 141,315 9,950 7%
Directory services 26,736 25,810 926 4% 53,779 52,054 1,725 3%
Other 26,078 29,046 (2,968) -10% 51,774 57,914 (6,140) -11%
---------- ------------ ----------- ----------- ----------- ------------
ILEC revenue 510,153 514,686 (4,533) -1% 1,023,762 1,022,717 1,045 0%
ELI 43,719 45,287 (1,568) -3% 84,812 92,534 (7,722) -8%
---------- ------------ ----------- ----------- ----------- ------------
$ 553,872 $ 559,973 $ (6,101) -1% $1,108,574 $1,115,251 $ (6,677) -1%
========== ============ =========== =========== =========== ============
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 disconnecting second lines by some customers when they
add DSL or other high-speed internet service. Excluding the North Dakota sale,
we lost approximately 14,600 access lines during the six months ended June 30,
2003 but added more than 21,000 DSL subscribers during this period. Residential
lines lost represented 81 percent of the total loss, excluding the North Dakota
sale. 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 the remainder of
2003. A continued decrease in access lines, combined with continuing difficult
economic conditions, lower access rates and increased competition, may cause our
revenues to decrease further during the remainder of 2003.
Beginning in the first quarter 2003, the presentation of revenue categories
includes certain reclassifications to ensure consistency among reporting
properties. All prior periods have been conformed to this presentation.
Access services revenue for the three months ended June 30, 2003 decreased $11.0
million or 6% as compared with the prior year period. Switched access revenue
decreased $5.2 million primarily due to the effect of access rate reductions
effective July 1, 2002. Subsidies revenue decreased $3.8 million due to lower
Universal Service Fund (USF) support.
Access services revenue for the six months ended June 30, 2003 decreased $11.9
million or 4% as compared with the prior year period primarily due to a decrease
of $10.4 million in switched access revenue due to the effect of access rate
reductions effective July 1, 2002. Our overall subsidy revenues in 2003 are
expected to be slightly lower than 2002.
Local services revenue for the three months ended June 30, 2003 increased $3.1
million or 1% as compared with the prior year period. Local revenue increased
$0.4 million primarily due to $3.4 million in higher subscriber line charges
(SLC) effective July 2002, partially offset by the $1.5 million impact of the
sale of our North Dakota exchanges in 2003, and a $1.6 million decrease from
continued losses of access lines. Enhanced services revenue increased $2.7
million primarily due to the sale of additional feature packages.
27
Local services revenue for the six months ended June 30, 2003 increased $7.4
million or 2% as compared with the prior year period. Local revenue increased
$2.0 million primarily due to $7.1 million in higher SLC effective July 2002,
partially offset by the $1.5 million impact of the sale of our North Dakota
exchanges in 2003, and a $5.5 million decrease from continued losses of access
lines. Enhanced services revenue increased $5.4 million primarily due to the
sale of additional feature packages.
Long distance and data services revenue for the three months ended June 30, 2003
increased $5.5 million or 8% as compared with the prior period primarily due to
growth of $7.8 million related to data partially offset by a decrease of $2.3
million in long distance revenue due to declining minutes of use.
Long distance and data services revenue for the six months ended June 30, 2003
increased $10.0 million or 7% as compared with the prior period primarily due to
growth of $11.2 million related to data partially offset by a decrease of $1.3
million in long distance revenue due to declining minutes of use. Our long
distance revenues decreased during the second quarter of 2003 because of
competition from wireless providers and declining minutes of use. We expect
these factors will continue to affect our long distance revenues during 2003.
Directory revenue for the three months ended June 30, 2003 increased $0.9
million or 4% as compared with the prior period primarily due to growth in
yellow pages advertising.
Directory revenue for the six months ended June 30, 2003 increased $1.7 million
or 3% as compared with the prior period primarily due to growth in yellow pages
advertising.
Other revenue for the three months ended June 30, 2003 decreased $3.0 million or
10% compared with the prior period primarily due to higher uncollectible revenue
of $1.1 million and the termination at December 31, 2002 of $1.1 million (for
the three months) in contract services provided to Global Crossing Ltd.
(Global).
Other revenue for the six months ended June 30, 2003 decreased $6.1 million or
11% compared with the prior period primarily due to the termination at December
31, 2002 of $2.5 million (for the six months) in contract services provided to
Global Crossing.
ELI revenue for the three and six months ended June 30, 2003 decreased $1.6
million, or 3%, and $7.7 million, or 8%, respectively, 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's revenue rose from $41.1 million for the
three months ended March 31, 2003 to $43.7 million for the three months ended
June 30, 2003, reversing a nine consecutive quarter trend of declining revenues.
GAS AND ELECTRIC REVENUE
($ in thousands) For the three months ended June 30, For the six months ended June 30,
-------------------------------------------- -----------------------------------------------
2003 2002 $ Change % Change 2003 2002 $ Change % Change
---------- ----------- ----------- --------- ------------ ----------- ------------ ---------
Gas revenue $ 56,150 $ 47,856 $ 8,294 17% $ 119,681 $ 119,221 $ 460 0%
Electric revenue $ 33,932 $ 54,610 $ (20,678) -38% $ 67,561 $ 107,301 $ (39,740) -37%
Gas revenue for the three months ended June 30, 2003 increased $8.3 million, or
17%, as compared with the prior year period primarily due to higher purchased
gas costs passed on to consumers in 2003. Under tariff provisions, the costs of
our gas purchases are primarily passed on to customers.
Gas revenue for the six months ended June 30, 2003 increased $0.5 million as
compared with the prior year period primarily due to higher purchased gas costs
passed on to consumers in Hawaii offset by an Arizona commission ruling
precluding higher purchased gas costs to be passed on to consumers during the
first three months of 2003.
Electric revenue for the three and six months ended June 30, 2003 decreased
$20.7 million, or 38%, and $39.7 million, or 37%, respectively, as compared with
the prior year periods primarily due to the sale of Kauai Electric on November
1, 2002 partially offset by the effect of a rate increase in Vermont on July 15,
2002 and a slight increase in unit sales.
28
COST OF SERVICES
($ in thousands) For the three months ended June 30, For the six months ended June 30,
------------------------------------------ -----------------------------------------------
2003 2002 $ Change % Change 2003 2002 $ Change % Change
--------- ----------- ----------- -------- ------------ ---------- ------------ ---------
Network access $ 58,168 $ 58,598 $ (430) -1% $ 114,683 $ 116,556 $ (1,873) -2%
Gas purchased 34,041 26,201 7,840 30% 69,987 69,801 186 0%
Electric energy and
fuel oil purchased 21,328 28,987 (7,659) -26% 42,086 55,667 (13,581) -24%
--------- ----------- ----------- ----------- ---------- ------------
$113,537 $ 113,786 $ (249) 0% $ 226,756 $ 242,024 $ (15,268) -6%
========= =========== =========== =========== ========== ============
Network access expenses for the three and six months ended June 30, 2003
decreased $0.4 million, or 1%, and $1.9 million, or 2%, respectively as compared
with the prior year periods. ELI costs have declined slightly due to a drop in
demand while ILEC sector costs have risen slightly due to increased circuit
expense associated with additional data product introductions and increased long
distance access expense.
Gas purchased for the three months ended June 30, 2003 increased $7.8 million,
or 30%, as compared with the prior year period primarily due to higher purchased
propane fuel expense due to an overall increase in petroleum prices.
Gas purchased for the six months ended June 30, 2003 increased $0.2 million as
compared with the prior year period primarily due to higher purchased propane
fuel expense offset by lower commodity pricing and 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 and six months ended June
30, 2003 decreased $7.7 million, or 26%, and $13.6 million, or 24%,
respectively, as compared with the prior year periods primarily due to the sale
of Kauai Electric on November 1, 2002 partially offset by increased purchased
power costs.
OTHER OPERATING EXPENSES
($ in thousands) For the three months ended June 30, For the six months ended June 30,
------------------------------------------- -----------------------------------------------
2003 2002 $ Change % Change 2003 2002 $ Change % Change
----------- ----------- ----------- ------- ------------- ----------- ------------ --------
Operating expenses $ 178,038 $ 191,019 $ (12,981) -7% $ 355,618 $ 390,272 $ (34,654) -9%
Taxes other than income taxes 28,566 31,384 (2,818) -9% 58,887 64,748 (5,861) -9%
Sales and marketing 25,889 29,023 (3,134) -11% 53,809 57,260 (3,451) -6%
----------- ----------- ----------- ----------- ----------- ------------
$ 232,493 $ 251,426 $ (18,933) -8% $ 468,314 $ 512,280 $ (43,966) -9%
=========== =========== =========== =========== =========== ============
Operating expenses for the three months ended June 30, 2003 decreased $13.0
million, or 7%, 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. Expenses were negatively impacted by increased
compensation expense of $4.3 million primarily because of variable stock plans
(under variable stock plans, the amount of compensation expense changes as our
stock price changes) and increased pension expenses as discussed below.
Operating expenses for the six months ended June 30, 2003 decreased $34.7
million, or 9%, 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. Expenses were negatively impacted by increased
compensation expense of $3.5 million related to variable stock plans and
increased pension expenses as 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. We incurred $2.7 million of severance costs in our telecommunications
operations during the three months ended June 30, 2003.
29
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 but that no contribution to
our pension plans will be required in 2003. 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.
Taxes other than income taxes for the three and six months ended June 30, 2003
decreased $2.8 million and $5.9 million, or 9%, respectively, as compared with
the prior year periods primarily due to decreased property taxes at ELI due to
lower asset values.
Sales and marketing expenses for the three and six months ended June 30, 2003
decreased $3.1 million, or 11%, and $3.5 million, or 6%, respectively, as
compared to the prior year period due to a reduction of personnel and related
costs in the ILEC sector.
DEPRECIATION AND AMORTIZATION EXPENSE
($ in thousands) For the three months ended June 30, For the six months ended June 30,
------------------------------------------- ----------------------------------------------
2003 2002 $ Change % Change 2003 2002 $ Change % Change
---------- ----------- ----------- -------- ---------- ----------- ------------ ----------
Depreciation expense $ 118,729 $ 156,050 $ (37,321) -24% $ 225,565 $ 303,870 $ (78,305) -26%
Amortization expense 31,630 30,328 1,302 4% 63,342 60,682 2,660 4%
---------- ----------- ----------- ----------- ----------- ------------
$ 150,359 $ 186,378 $ (36,019) -19% $ 288,907 $ 364,552 $ (75,645) -21%
========== =========== =========== =========== =========== ============
Depreciation expense for the three months ended June 30, 2003 decreased $37.3
million, or 24%, 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.
Depreciation expense for the six months ended June 30, 2003 decreased $78.3
million, or 26%, 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 $12.8 million relating to the closing of our Plano, Texas facility also
contributed to the decrease.
Amortization expense for the three and six months ended June 30, 2003 increased
$1.3 million and $2.7 million, or 4%, respectively, as compared with the prior
year periods primarily due to increased amortization of customer base, due to a
final purchase price allocation, resulting from the receipt of the final
valuation report of our Frontier acquisition during the second quarter of 2002.
RESERVE FOR TELECOMMUNICATIONS BANKRUPTCIES / RESTRUCTURING AND OTHER EXPENSES
($ in thousands) For the three months ended June 30, For the six months ended June 30,
------------------------------------------- -----------------------------------------------
2003 2002 $ Change % Change 2003 2002 $ Change % Change
---------- ----------- ----------- -------- ------------ ----------- ------------ ---------
Reserve for telecommunications
bankruptcies $ 2,260 $ 10,001 $ (7,741) -77% $ 2,260 $ 17,805 $ (15,545) -87%
Restructuring and other expenses $ 10,113 $ 18,280 $ (8,167) -45% $ 10,092 $ 22,185 $ (12,093) -55%
During the second quarter 2003, we reserved approximately $2.3 million of trade
receivables with Touch America as a result of Touch America's filing for
bankruptcy. These receivables were generated as a result of providing ordinary
course telecommunication services. If other telecommunications companies file
for bankruptcy we may have additional significant reserves in future periods.
During the second quarter 2002, we reserved approximately $21.6 million of trade
receivables with WorldCom, as a result of WorldCom's filing for bankruptcy.
These receivables were generated as a result of providing ordinary course
telecommunications services. This charge was partially offset by an $11.6
million settlement with Global as discussed below.
30
Concurrent with the acquisition of Frontier, we entered into several operating
agreements with Global. We have ongoing commercial relationships with Global
affiliates. We reserved a total of $29.0 million of Global receivables during
2001 and 2002 as a result of Global's filing for bankruptcy to reflect our best
estimate of the net realizable value of receivables incurred from these
commercial relationships. We recorded a write-down of such receivables in the
amount of $7.8 million in the first quarter 2002 and $21.2 million in the fourth
quarter of 2001. In the second quarter 2002, as the result of a settlement
agreement with Global, we reversed $11.6 million of our previous write-down of
the net realizable value of these receivables.
Restructuring and other expenses for 2003 primarily consist of expenses related
to reductions in personnel at our telecommunications operations and the write
off of software no longer useful.
During 2002, restructuring and other expenses primarily consist of expenses
related to our various restructurings, including reductions in personnel at our
telecommunications operations, and costs that were spent at our Plano, Texas
facility and at other locations as a result of transitioning functions and jobs.
INVESTMENT AND OTHER INCOME (LOSS), NET / GAIN (LOSS) ON SALE OF ASSETS /
INTEREST EXPENSE / INCOME TAX EXPENSE (BENEFIT)
($ in thousands) For the three months ended June 30, For the six months ended June 30,
------------------------------------------- ----------------------------------------------
2003 2002 $ Change % Change 2003 2002 $ Change % Change
----------- ---------- ----------- -------- ---------- ----------- ------------ ----------
Investment and
other income (loss), net $ 24,566 $ (29,188) $ 53,754 184% $ 74,388 $ (78,139) $ 152,527 195%
Gain (loss) on sale of assets $ 6,671 $ - $ 6,671 100% $ 5,021 $ - $ 5,021 100%
Interest expense $106,436 $ 119,947 $(13,511) -11% $215,712 $ 241,554 $ (25,842) -11%
Income tax expense (benefit) $ 24,384 $ (26,560) $ 50,944 192% $ 64,360 $ (53,502) $ 117,862 220%
Investment and other income (loss), net for the three months ended June 30, 2003
increased $53.8 million as compared with the prior year period primarily due a
$25.0 million non-cash pre-tax gain in 2003 related to a capital lease
restructuring at ELI. The 2002 activity included $10.0 million of income from
the settlement of certain retained liabilities at less than face value which
were associated with customer advances for construction from our disposed water
properties, and the recognition in 2002 of a $45.6 million non-cash pre-tax loss
resulting from an other than temporary decline in the value of our investment in
Adelphia (see Note 11 to Consolidated Financial Statements). The increase was
partially offset by lower income from money market balances and short-term
investments.
Investment and other income (loss), net for the six months ended June 30, 2003
increased $152.5 million as compared with the prior year period primarily due to
$65.7 million in non-cash pre-tax gains in 2003 related to capital lease
restructurings at ELI, $6.2 million of income in 2003 associated with the
retained liabilities settlements and the recognition in 2002 of a $95.3 million
non-cash pre-tax loss resulting from an other than temporary decline in the
value of our investment in Adelphia (see Note 11 to Consolidated Financial
Statements). The increase was partially offset by lower income from money market
balances and short-term investments.
Gain on sale of assets represents the gain on the sale of access lines in North
Dakota and the sale of our wireless partnership interest in Wisconsin, partially
offset by a loss recognized on the sale of our Plano office building in March
2003.
Interest expense for the three months ended June 30, 2003 decreased $13.5
million, or 11%, 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 June 30, 2003, we had average long-term debt (excluding
equity units and convertible preferred stock) outstanding of $4.7 billion
compared to $5.4 billion during the three months ended June 30, 2002. Our
weighted average borrowing rate for the three months ended June 30, 2003 as
compared with the prior year period was 27 basis points higher, increasing from
7.76% to 8.03%, due to the repayment of debt with interest rates below our
average rate.
31
Interest expense for the six months ended June 30, 2003 decreased $25.8 million,
or 11%, as compared with the prior year period primarily due to the retirement
of debt partially offset by higher average interest rates. During the six months
ended June 30, 2003, we had average long-term debt (excluding equity units and
convertible preferred stock) outstanding of $4.8 billion compared to $5.4
billion during the six months ended June 30, 2002. Our weighted average
borrowing rate for the six months ended June 30, 2003 as compared with the prior
year period was 25 basis points higher, increasing from 7.79% to 8.04%, due to
the repayment of debt with interest rates below our average rate.
Income taxes for the three and six months ended June 30, 2003 increased $50.9
million and $117.9 million, respectively, as compared with the prior year
periods primarily due to changes in taxable income. The effective tax rate for
the first six months of 2003 was 39.4% as compared with 39.1% for the first six
months of 2002. Assuming the Company's operating structure remains the same, we
estimate that our effective tax rate will increase to approximately 44% to 46%
for fiscal 2004.
DISCONTINUED OPERATIONS
($ in thousands) For the six months
ended June 30,
2003 2002
---------- ------------
Revenue $ - $ 4,650
Operating income (loss) $ - $ (419)
Income (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.
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
During the first quarter of 2003, as a result of our adoption of SFAS No. 143,
"Accounting for Asset Retirement Obligations", we recognized an after tax
non-cash gain of approximately $65.8 million. During the first quarter of 2002,
as a result of our adoption of SFAS No. 142, "Goodwill and Other Intangible
Assets", we recognized a transitional impairment loss of $39.8 million for
goodwill related to ELI (see Note 15 to Consolidated Financial Statements).
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.
32
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 June 30, 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 2002 and 2001 with investment grade financial
institutions. During the second quarter of 2003, we entered into two additional
interest rate swaps. 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 five swaps executed in 2002 and 2003 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 June 30, 2003, the fair value of our long-term debt and capital lease
obligations was estimated to be approximately $5.4 billion, based on our overall
weighted average rate of 8.0% and our overall weighted maturity of 12 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 approximately 3 basis points during 2003. A hypothetical increase
of 80 basis points (10% of our overall weighted average borrowing rate) would
result in an approximate $242.7 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 June 30, 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 June 30, 2003, 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.
As of June 30, 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 June 30, 2003, the fair value of the equity portion of our investment
portfolio was estimated to be $37.6 million. A hypothetical 10% decrease in
quoted market prices would result in an approximate $3.8 million decrease in the
fair value of the equity portion of our investment portfolio.
33
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 June 30, 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 June 30, 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
-----------------------
(a) Evaluation of disclosure controls and procedures.
We carried out an evaluation, under the supervision and with the participation
of our management, of the effectiveness of our disclosure controls and
procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the
end of the period covered by this report. Based on this evaluation, our
principal executive officer and principal financial officer concluded that our
disclosure controls and procedures were effective. 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.
(b) Changes in internal controls over financial reporting.
There was no change in our internal control over financial reporting that
occurred during the fiscal quarter covered by this report that has materially
affected, or is reasonably likely to materially affect, our internal controls
over financial reporting.
34
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
asserted that we wrongfully terminated these agreements and sought 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 have entered into a settlement agreement, which became effective on June
19, 2003, resolving all claims that were the subjects of the arbitration. There
was no impact on our financial position or results of operations.
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 joined 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. We are currently engaged in discussions with
Enron in an effort to resolve these claims without litigation.
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.
35
Item 4. Submission of Matters to a Vote of Security Holders
---------------------------------------------------
(a) The registrant held its 2003 Annual Meeting of the Stockholders on May
13, 2003.
(b) Proxies for the Annual Meeting were solicited pursuant to Regulation
14A; there was no solicitation in opposition to management's nominees
for directors as listed in the Proxy Statement. All such nominees were
elected pursuant to the following votes:
Number of Votes
---------------
DIRECTORS FOR WITHHELD
--------- --- --------
Aaron I. Fleischman 232,329,933 23,394,579
Rudy J. Graf 235,188,578 20,535,934
Stanley Harfenist 235,410,901 20,313,611
Andrew N. Heine 234,921,536 20,802,976
William M. Kraus 234,636,182 21,088,330
Scott N. Schneider 235,397,940 20,326,572
John L. Schroeder 234,937,237 20,787,275
Robert A. Stanger 235,031,327 20,693,185
Edwin Tornberg 235,362,909 20,361,603
Claire L. Tow 231,061,748 24,662,764
Leonard Tow 232,112,565 23,611,947
David H. Ward 235,373,974 20,350,538
(c) Ratification of appointment of KPMG LLP as the Company's independent
public accountants for 2003.
Number of vote FOR 250,568,674
Number of votes AGAINST/WITHHELD 2,751,007
Number of votes ABSTAINING 2,404,831
Number of BROKER NON-VOTES 0
Item 5. Other Information
-----------------
As disclosed in our proxy statement for the 2003 Annual Meeting under our
bylaws, if any stockholder intends to propose any matter at the 2004 annual
meeting, the proponent must give written notice to us not earlier than January
14, 2004 nor later than February 13, 2004. Furthermore, in accordance with the
proxy rules and regulations of the Securities and Exchange Commission, if a
stockholder does not notify us by February 13, 2004 of a proposal, then our
proxies would be able to use their discretionary voting authority if a
stockholder's proposal is raised at the meeting.
Item 6. Exhibits and Reports on Form 8-K
--------------------------------
a) Exhibits:
31.1 Certification of Principal Executive Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934.
31.2 Certification of Principal Financial Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934.
32.1 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.
32.2 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.
36
b) Reports on Form 8-K:
We furnished on Form 8-K on May 6, 2003 under Item 9 "Regulation FD
Disclosure", a press release announcing our earnings for the quarter ended
March 31, 2003.
37
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: August 12, 2003
38