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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 SEPTEMBER 30, 2004
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 September 30, 2004
------------------
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 October
29, 2004 was 335,451,474.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Index
Page No.
--------
Part I. Financial Information (Unaudited)
Financial Statements
Consolidated Balance Sheets at September 30, 2004 and December 31, 2003 2
Consolidated Statements of Operations for the three months ended September 30, 2004 and 2003 3
Consolidated Statements of Operations for the nine months ended September 30, 2004 and 2003 4
Consolidated Statements of Shareholders' Equity for the year ended
December 31, 2003 and the nine months ended September 30, 2004 5
Consolidated Statements of Comprehensive Income for the three and nine
months ended September 30, 2004 and 2003 5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7
Management's Discussion and Analysis of Financial Condition and Results of Operations 23
Quantitative and Qualitative Disclosures about Market Risk 38
Controls and Procedures 39
Part II. Other Information
Legal Proceedings 39
Other Information 39
Exhibits and Reports on Form 8-K 40
Signature 42
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
--------------------
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
($ in thousands)
(Unaudited)
September 30, 2004 December 31, 2003
------------------ -----------------
ASSETS
- ------
Current assets:
Cash and cash equivalents $ 199,027 $ 583,671
Accounts receivable, less allowances of $35,558 and
$47,332, respectively 230,348 253,652
Other current assets 35,752 40,984
Assets held for sale - 23,130
------------- -------------
Total current assets 465,127 901,437
Property, plant and equipment, net 3,375,980 3,525,640
Goodwill, net 1,940,318 1,940,318
Other intangibles, net 716,706 812,407
Investments 21,738 57,103
Other assets 477,661 457,384
------------- -------------
Total assets $ 6,997,530 $ 7,694,289
============= =============
LIABILITIES AND EQUITY
- ----------------------
Current liabilities:
Long-term debt due within one year $ 6,366 $ 88,002
Accounts payable 145,311 166,819
Other current liabilities 296,262 322,805
Liabilities related to assets held for sale - 11,128
------------- -------------
Total current liabilities 447,939 588,754
Deferred income taxes 446,182 447,056
Customer advances for construction and contributions in aid of
construction 94,598 122,035
Other liabilities 300,250 264,382
Equity units - 460,000
Long-term debt 4,324,817 4,195,629
Company Obligated Mandatorily Redeemable Convertible Preferred
Securities* - 201,250
Shareholders' equity:
Common stock, $0.25 par value (600,000,000 authorized shares;
334,811,000 and 284,709,000 outstanding and 334,816,000 and
295,434,000 issued at September 30, 2004 and December 31,
2003, respectively) 83,704 73,858
Additional paid-in capital 1,693,979 1,953,317
Accumulated deficit (304,499) (365,181)
Accumulated other comprehensive loss, net of tax (89,368) (71,676)
Treasury stock (72) (175,135)
------------- -------------
Total shareholders' equity 1,383,744 1,415,183
------------- -------------
Total liabilities and equity $ 6,997,530 $ 7,694,289
============= =============
* 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 consolidation of this
item changed effective January 1, 2004 as a result of the application of a
newly mandated accounting standard "FIN 46R." Please see footnote 14 for a
complete discussion.
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 SEPTEMBER 30, 2004 AND 2003
($ in thousands, except per-share amounts)
(Unaudited)
2004 2003
-------------- --------------
Revenue $ 545,393 $595,037
Operating expenses:
Cost of services (exclusive of depreciation and amortization) 51,273 85,869
Other operating expenses 204,928 220,134
Depreciation and amortization 141,380 151,878
Loss on impairment - 4,000
Management succession and strategic alternatives expenses (see Note 12) 75,858 -
-------------- --------------
Total operating expenses 473,439 461,881
-------------- --------------
Operating income 71,954 133,156
Investment and other income (loss), net (13,651) (24,277)
Interest expense 90,864 103,124
-------------- --------------
Income (loss) before income taxes, dividends on convertible preferred
securities (32,561) 5,755
Income tax benefit (21,271) (7,210)
-------------- --------------
Income (loss) before dividends on convertible preferred securities (11,290) 12,965
Dividends on convertible preferred securities, net of tax benefit
of $0 and $(963), respectively* - 1,553
-------------- --------------
Net income (loss) available to common shareholders $ (11,290) $ 11,412
============== ==============
Basic and diluted income (loss) available to common shareholders $ (0.04) $ 0.04
============== ==============
* The consolidation of this item changed effective January 1, 2004 as a
result of the application of a newly mandated accounting standard "FIN
46R." Please see footnote 14 for a complete discussion.
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 NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
($ in thousands, except per-share amounts)
(Unaudited)
2004 2003
-------------- --------------
Revenue $1,647,952 $1,890,853
-
Operating expenses:
Cost of services (exclusive of depreciation and amortization) 156,632 312,625
Other operating expenses 631,103 688,590
Depreciation and amortization 429,650 440,785
Reserve for telecommunications bankruptcies - 2,260
Restructuring and other expenses - 9,950
Loss on impairment - 4,000
Management succession and strategic alternatives expenses (see Note 12) 90,632 -
-------------- --------------
Total operating expenses 1,308,017 1,458,210
-------------- --------------
Operating income 339,935 432,643
Investment and other income, net 16,856 55,132
Interest expense 286,298 318,836
-------------- --------------
Income before income taxes, dividends on convertible preferred
securities, and cumulative effect of change in accounting principle 70,493 168,939
Income tax expense 15,123 57,150
-------------- --------------
Income before dividends on convertible preferred securities and
cumulative effect of change in accounting principle 55,370 111,789
Dividends on convertible preferred securities, net of tax benefit
of $0 and $(2,889), respectively* - 4,658
-------------- --------------
Income before cumulative effect of change in accounting principle 55,370 107,131
Cumulative effect of change in accounting principle, net of tax
of $0 and $41,591, respectively - 65,769
-------------- --------------
Net income available to common shareholders $ 55,370 $ 172,900
============== ==============
Basic income available to common shareholders:
Income before cumulative effect of change in accounting principle $ 0.19 $ 0.38
Cumulative effect of change in accounting principle - 0.23
-------------- --------------
Net income available to common shareholders $ 0.19 $ 0.61
============== ==============
Diluted income available to common shareholders:
Income before cumulative effect of change in accounting principle $ 0.18 $ 0.37
Cumulative effect of change in accounting principle - 0.22
-------------- --------------
Net income available to common shareholders $ 0.18 $ 0.59
============== ==============
* The consolidation of this item changed effective January 1, 2004 as a
result of the application of a newly mandated accounting standard "FIN
46R." Please see footnote 14 for a complete discussion.
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, 2003 AND THE NINE MONTHS ENDED SEPTEMBER 30, 2004
($ in thousands)
(Unaudited)
Accumulated
Common Stock Additional Other Treasury Stock Total
------------------ Paid-In Accumulated Comprehensive ------------------- Shareholders'
Shares Amount Capital Deficit Loss Shares Amount Equity
-------- --------- ------------ ----------- ------------ -------- ----------- -----------
Balances January 1, 2003 294,080 $73,520 $ 1,943,406 $ (553,033) $(102,169) (11,598) $(189,585) $1,172,139
Stock plans 1,354 338 9,911 - - 873 14,450 24,699
Net income - - - 187,852 - - - 187,852
Other comprehensive income, net
of tax and reclassifications
adjustments - - - - 30,493 - - 30,493
-------- --------- ------------ ----------- ------------ -------- ----------- -----------
Balances December 31, 2003 295,434 73,858 1,953,317 (365,181) (71,676) (10,725) (175,135) 1,415,183
Stock plans 3,195 799 (5,428) - - 6,404 106,759 102,130
Conversion of EPPICS 7,704 1,926 97,806 - - 725 11,646 111,378
Conversion of Equity Units 28,483 7,121 396,221 - - 3,591 56,658 460,000
Dividends on common stock of
$2.25 per share - - (747,937) - - - - (747,937)
Net income - - - 55,370 - - - 55,370
Tax benefit on equity forward
contracts - - - 5,312 - - - 5,312
Other comprehensive loss, net of
tax and reclassifications
adjustments - - - - (17,692) - - (17,692)
-------- --------- ------------ ----------- ------------ -------- ----------- -----------
Balances September 30, 2004 334,816 $83,704 $ 1,693,979 $ (304,499) $ (89,368) (5) $ (72) $1,383,744
======== ========= ============ =========== ============ ======== =========== ===========
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
($ in thousands)
(Unaudited)
For the three months ended September 30, For the nine months ended September 30,
--------------------------------------- ----------------------------------------
2004 2003 2004 2003
------------------ ------------------ -------------------- -----------------
Net income (loss) $ (11,290) $ 11,412 $ 55,370 $ 172,900
Other comprehensive income (loss), net of
tax and reclassifications adjustments* (16,652) 2,520 (17,692) 7,318
------------------ ------------------ -------------------- -----------------
Total comprehensive income (loss) $ (27,942) $ 13,932 $ 37,678 $ 180,218
================== ================== ==================== =================
* Consists of unrealized holding gains/(losses) of
marketable securities and/or the transfer of previously
unrealized gains to the current period income statement as a
result of the sale of 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 NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
($ in thousands)
(Unaudited)
2004 2003
---------------- ----------------
Income before cumulative effect of change in accounting principle $ 55,370 $ 107,131
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization expense 429,650 440,785
Gain on expiration/settlement of customer advances (25,345) (6,165)
Gain on capital lease termination/restructuring - (65,724)
Stock based compensation expense 43,631 5,720
Loss on extinguishment of debt 20,368 10,704
Loss on impairment - 4,000
(Gain)/loss on sale of assets (9,365) 11,792
Other non-cash adjustments 8,449 (130)
Deferred taxes, net 15,123 91,488
Change in accounts receivable 17,895 57,091
Change in accounts payable and other liabilities (22,674) (88,062)
Change in other current assets 5,232 6,547
---------------- ----------------
Net cash provided by operating activities 538,334 575,177
Cash flows from (used by) investing activities:
Proceeds from sale of assets, net of selling expenses 59,045 380,735
Capital expenditures (201,310) (191,658)
Other assets purchased (26,715) (770)
---------------- ----------------
Net cash from (used by) investing activities (168,980) 188,307
Cash flows from (used by) financing activities:
Dividends paid (747,937) -
Long-term debt payments (513,798) (551,425)
Premiums paid to retire debt (20,368) (10,704)
Issuance of common stock 530,197 10,357
Repayment of customer advances for
construction and contributions in aid of construction (2,092) (7,765)
---------------- ----------------
Net cash used by financing activities (753,998) (559,537)
Increase (decrease) in cash and cash equivalents (384,644) 203,947
Cash and cash equivalents at January 1, 583,671 393,177
---------------- ----------------
Cash and cash equivalents at September 30, $ 199,027 $ 597,124
================ ================
Cash paid during the period for:
Interest $ 264,174 $ 303,913
Income taxes $ 2,196 $ 2,425
Non-cash investing and financing activities:
Change in fair value of interest rate swaps $ 973 $ (1,238)
Conversion of EPPICS $ 111,379 $ -
Investment writedowns $ 5,286 $ 201
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
6
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
(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 2003 Annual Report on
Form 10-K. Certain reclassifications of balances previously reported
have been made to conform to current presentation. All significant
intercompany balances and transactions have been eliminated in
consolidation. 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,
reserves established for receivables, income taxes and contingencies.
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.
(b) Cash Equivalents:
We consider all highly liquid investments with an original maturity of
three months or less to be cash equivalents.
(c) 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 liabilities on our consolidated
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, LLC. (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.
(d) 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 and liabilities acquired and
allocate purchase prices to assets and liabilities, including
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 tested
for impairment, at least annually. In performing this test, the
7
Company first compares the carrying amount of its reporting units to
their respective fair values. If the carrying amount of any reporting
unit exceeds its fair value, the Company is required to perform step
two of the impairment test by comparing the implied fair value of the
reporting unit's goodwill with its carrying amount. 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
trade name to determine whether there are any impairment losses.
SFAS No. 142 also requires that intangible assets with estimated
useful lives be amortized over those lives and be reviewed for
impairment in accordance with SFAS No. 144, "Accounting for Impairment
or Disposal of Long-Lived Assets" to determine whether any changes to
these lives are required. We periodically reassess the useful life of
our intangible assets with estimated useful lives to determine whether
any changes to those lives are required.
(e) 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. 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.
(f) Derivative Instruments and Hedging Activities:
We account for derivative instruments and hedging activities in
accordance with SFAS No. 149, "Accounting for Derivative Instruments
and Hedging Activities," as amended. SFAS No. 149, as amended,
requires that all derivative instruments, such as interest rate swaps,
be recognized in the financial statements and measured at fair value
regardless of the purpose or intent of holding them.
We have interest rate swap arrangements 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 assets and the related
underlying liabilities are also adjusted to fair value by the same
amount.
(g) Employee Stock Plans:
We have various employee stock-based compensation plans. Awards under
these plans are granted to eligible officers, management employees and
non-management employees. Awards may be made in the form of incentive
stock options, non-qualified stock options, stock appreciation rights,
restricted stock or other stock based awards. As permitted by current
accounting rules, we 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.
SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS No.
148, "Accounting for Stock-Based Compensation - Transition and
Disclosure, an amendment of SFAS No. 123," established accounting and
disclosure requirements using a fair-value-based method of accounting
for stock-based employee compensation plans. As permitted by existing
accounting standards, the Company has elected to continue to apply the
intrinsic-valued-based method of accounting described above, and has
adopted only the disclosure requirements of SFAS No. 123, as amended.
We provide pro forma net income and pro forma net income per common
share disclosures for employee stock option grants on the fair value
of the options at the date of grant. 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 Management Equity Incentive Plan (MEIP), Equity
Incentive Plan (EIP), Employee Stock Purchase Plan (ESPP) and
Directors' Deferred Fee Equity Plan, our pro forma net income (loss)
and net income (loss) per common share available for common
shareholders would have been as follows:
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- -------------------------------
2004 2003 2004 2003
--------------- ------------- ------------- --------------
($ in thousands)
Net income (loss)
available for common
shareholders As reported $(11,290) $ 11,412 $ 55,370 $ 172,900
Add: Stock-based employee
compensation expense
included in reported net
income, net of related tax
effects 23,590 527 27,407 4,275
Deduct: Total stock-based
employee compensation
expense determined under
fair value based method
for all awards, net of
related tax effects (27,339) (3,472) (35,024) (12,421)
-------- --------- --------- -----------
Pro forma $(15,039) $ 8,467 $ 47,753 $ 164,754
======== ======== ======== =========
Net income (loss) per
common share available for
common shareholders As reported:
Basic $ (0.04) $ 0.04 $ 0.19 $ 0.61
Diluted $ (0.04) $ 0.04 $ 0.18 $ 0.59
Pro forma:
Basic $ (0.05) $ 0.03 $ 0.16 $ 0.58
Diluted $ (0.05) $ 0.03 $ 0.16 $ 0.56
In connection with the payment of the special dividend of $2 per
common share on September 2, 2004, the exercise price and number of
all outstanding options was adjusted such that each option had the
same value to the holder after the dividend as it had before the
dividend. In accordance with FASB Interpretation No. 44 ("FIN 44"),
"Accounting for Certain Transactions Involving Stock Compensation" and
EITF 00-23, "Issues Related to the Accounting for Stock Compensation
under APB No. 25 and FIN 44", there is no accounting consequence for
changes made to the exercise price, the number of shares, or both, of
a fixed stock option or award as a direct result of the special
dividend.
(h) Net Income Per Common Share Available for Common Shareholders:
Basic net income per common share is computed using the weighted
average number of common shares outstanding during the period being
reported on. Except when the effect would be antidilutive, diluted net
income per common share reflects the dilutive effect of the assumed
exercise of stock options using the treasury stock method at the
beginning of the period being reported on as well as common shares
that would result from the conversion of convertible preferred stock.
In addition, the related interest on preferred stock dividends (net of
tax) is added back to income since it would not be paid if the
preferred stock was converted to common stock.
9
(2) Recent Accounting Literature and Changes in Accounting Principles:
-----------------------------------------------------------------
Accounting for Asset Retirement Obligations
-------------------------------------------
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.
Exit or Disposal Activities
---------------------------
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.
Guarantees
----------
In November 2002, the FASB issued FASB Interpretation No. 45 ("FIN 45"),
"Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Guarantees of Indebtedness of Others." FIN 45 requires that a
guarantor be required to recognize, at the inception of a guarantee, a
liability for the fair value of the obligation assumed under the guarantee.
FIN 45 also requires additional disclosures by a guarantor in its interim
and annual financial statements about the obligations associated with the
guarantee. The provisions of FIN 45 are effective for guarantees issued or
modified after December 31, 2002, whereas the disclosure requirements were
effective for financial statements for periods ending after December 15,
2002. The adoption of FIN 45 on January 1, 2003 did not have any material
impact on our financial position or results of operations (see Note 16).
Variable Interest Entities
--------------------------
In December 2003, the FASB issued FASB Interpretation No. 46 (revised
December 2003) ("FIN 46R"), "Consolidation of Variable Interest Entities,"
which addresses how a business enterprise should evaluate whether it has a
controlling financial interest in an entity through means other than voting
rights and accordingly should consolidate the entity. FIN 46R replaces FASB
Interpretation No. 46, "Consolidation of Variable Interest Entities," which
was issued in January 2003. We are required to apply FIN 46R to variable
interests in variable interest entities or VIEs created after December 31,
2003. For any VIEs that must be consolidated under FIN 46R that were
created before January 1, 2004, the assets, liabilities and noncontrolling
interests of the VIE initially would be measured at their carrying amounts
with any difference between the net amount added to the balance sheet and
any previously recognized interest being recognized as the cumulative
effect of an accounting change. If determining the carrying amounts is not
practicable, fair value at the date FIN 46R first applies may be used to
measure the assets, liabilities and noncontrolling interest of the VIE. We
reviewed all of our investments and determined that the Trust Convertible
Preferred Securities (EPPICS), issued by our consolidated wholly-owned
subsidiary, Citizens Utilities Trust and the related Citizens Utilities
Capital L.P., were our only VIEs. The adoption of FIN 46R on January 1,
2004 did not have any material impact on our financial position or results
of operations.
Derivative Instruments and Hedging
----------------------------------
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 adopted SFAS No. 149 on
July 1, 2003. The adoption of SFAS No. 149 did not have any material impact
on our financial position or results of operations.
10
Financial Instruments with Characteristics of Both Liabilities and Equity
-------------------------------------------------------------------------
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity."
The Statement establishes standards for the classification and measurement
of certain financial instruments with characteristics of both liabilities
and equity. 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.
Pension and Other Postretirement Benefits
-----------------------------------------
In December 2003, the FASB issued SFAS No. 132 (revised), "Employers'
Disclosures about Pensions and Other Postretirement Benefits." This
Statement retains and revises the disclosure requirements contained in the
original Statement. It requires additional disclosures including
information describing the types of plan assets, investment strategy,
measurement date(s), plan obligations, cash flows, and components of net
periodic benefit cost recognized in interim periods. This Statement is
effective for fiscal years ending after December 15, 2003. We have adopted
the expanded disclosure requirements of SFAS No. 132 (revised).
The FASB has issued an Exposure Draft that would require stock-based
employee compensation to be recorded as a charge to earnings for interim or
annual periods beginning after June 15, 2005. We will continue to monitor
the progress on the issuance of this standard.
(3) Accounts Receivable:
-------------------
The components of accounts receivable, net at September 30, 2004 and
December 31, 2003 are as follows:
($ in thousands) September 30, 2004 December 31, 2003
--------------------- --------------------
Customers $ 227,248 $ 250,515
Other 38,658 50,469
Less: Allowance for doubtful accounts (35,558) (47,332)
--------------------- --------------------
Accounts receivable, net $ 230,348 $ 253,652
===================== ====================
The Company maintains an allowance for estimated bad debts based on its
estimate of collectibility of its accounts receivables. Bad debt expense,
which is recorded as a reduction of revenue, was $7,196,000 and $4,355,000
for the three months ended September 30, 2004 and 2003, respectively and
$13,754,000 and $15,153,000 for the nine months ended September 30, 2004
and 2003, respectively. Additional reserves are provided for known or
impending telecommunications bankruptcies, disputes or other significant
collection issues.
(4) Property, Plant and Equipment, Net:
----------------------------------
Property, plant and equipment, net at September 30, 2004 and December 31,
2003 is as follows:
($ in thousands) September 30, 2004 December 31, 2003
--------------------- --------------------
Property, plant and equipment $ 6,398,721 $ 6,221,307
Less: Accumulated depreciation (3,022,741) (2,695,667)
--------------------- --------------------
Property, plant and equipment, net $ 3,375,980 $ 3,525,640
===================== ====================
Depreciation expense is principally based on the composite group method.
Depreciation expense was $109,750,000 and $120,012,000 for the three months
ended September 30, 2004 and 2003, respectively and $334,760,000 and
$345,577,000 for the nine months ended September 30, 2004 and 2003,
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 in our ILEC segment. As part of the preparation
and adoption of SFAS No. 143, we analyzed depreciation rates for the ILEC
segment and compared them to industry averages and historical expense data.
Based on this review, the Company shortened the depreciable lives of
certain assets.
11
(5) Dispositions:
------------
In October 2004, we sold cable assets in California, Arizona, Indiana, and
Wisconsin, and we have signed a definitive agreement to sell cable assets
in New Mexico. The $1,286,000 pre-tax loss on these sales was recognized
during the third quarter of 2004.
During the third quarter of 2004, we sold our corporate aircraft for
approximately $15,298,000 in cash.
On April 1, 2003, we completed the sale of approximately 11,000 access
lines in North Dakota for approximately $25,700,000 in cash. The pre-tax
gain on the sale 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 was $2,173,000.
(6) 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 our water, gas
and electric businesses. All of these properties have been sold.
Electric and Gas
----------------
On August 8, 2003, we completed the sale of The Gas Company in Hawaii
division for $119,290,000 in cash and assumed liabilities. The pre-tax loss
on the sale recognized in 2003 was $19,180,000.
On August 11, 2003, we completed the sale of our Arizona gas and electric
divisions for $224,100,000 in cash. The pre-tax loss on the sale recognized
in 2003 was $18,491,000.
On December 2, 2003, we completed the sale of substantially all of our
Vermont electric division's transmission assets for $7,344,000 in cash
(less $1,837,000 in refunds to customers as ordered by the Vermont Public
Service Board).
On April 1, 2004, we completed the sale of our Vermont electric
distribution operations for approximately $13,992,000 in cash, net of
selling expenses.
Losses on the sales of our Vermont properties were included in the
impairment charges recorded during 2003.
Summarized balance sheet information for the electric operations (assets
held for sale) is set forth below (no data for September 30, 2004 because
all of the properties had been sold as of that date).
($ in thousands) December 31, 2003
--------------------
Current assets $ 4,688
Net property, plant and equipment 7,225
Other assets 11,217
--------------------
Total assets held for sale $ 23,130
====================
Current liabilities $ 3,651
Other liabilities 7,477
--------------------
Total liabilities related to assets held for sale $ 11,128
====================
12
(7) Intangibles:
-----------
Intangibles at September 30, 2004 and December 31, 2003 are as follows:
($ in thousands) September 30, 2004 December 31, 2003
------------------------ ---------------------
Customer base - amortizable over 96 months $ 994,590 $ 995,853
Trade name - non-amortizable 122,058 122,058
------------------------ ---------------------
Other intangibles 1,116,648 1,117,911
Accumulated amortization (399,942) (305,504)
------------------------ ---------------------
Total other intangibles, net $ 716,706 $ 812,407
======================== =====================
Amortization expense was $31,630,000 and $31,866,000 for the three months
ended September 30, 2004 and 2003, respectively and $94,890,000 and
$95,208,000 for the nine months ended September 30, 2004 and 2003,
respectively. The decline in customer base at September 30, 2004 is due to
the sale of cable assets. Amortization expense for each of the next five
years, based on our estimate of useful lives, is estimated to be
$126,520,000 per year.
(8) Long-Term Debt:
--------------
The activity in our long-term debt from December 31, 2003 to September 30,
2004 is as follows:
Nine Months Ended September 30, 2004
-----------------------------------------
Interest Rate*
at
December 31, Interest September 30, September 30,
($ in thousands) 2003 Payments Rate Swap Reclassification 2004 2004
------------ -------- --------- ---------------- ------------- --------------
Rural Utilities Service Loan
Contracts $ 30,010 $ (685) $ $ - $ 29,325 6.120%
Senior Unsecured Debt 4,167,123 (80,955) 973 51,770 4,138,911 8.161%
EPPICS** (reclassified as a
result of adopting FIN 46R) - - - 100,377 100,377 5.000%
Equity Units 460,000 (408,230) - (51,770) - -
ELI Notes 5,975 (5,975) - - - -
ELI Capital Leases 10,061 (5,640) - - 4,421 10.363%
Industrial Development Revenue
Bonds 70,440 (12,300) - - 58,140 5.559%
Other 22 (13) - 9 12.990%
------------ -------- -------- ---------- -----------
TOTAL LONG TERM DEBT $ 4,743,631 $(513,798) $ 973 $ 100,377 $4,331,183
------------ ========= ======== ========== -----------
Less: Current Portion (88,002) (6,366)
Less: Equity Units (460,000) -
------------ -----------
$ 4,195,629 $4,324,817
============ ===========
* 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.
** In accordance with FIN 46R, the Trust holding the EPPICS and the related
Citizens Utilities Capital L.P. are now deconsolidated (see Note 14).
On January 15, 2004 we repaid at maturity the remaining outstanding
$80,955,000 of our 7.45% Debentures.
On January 15, 2004, we redeemed at 101% the remaining outstanding
$12,300,000 of our Hawaii Special Purpose Revenue Bonds, Series 1993A and
Series 1993B.
On May 17, 2004, we repaid at maturity the remaining outstanding $5,975,000
of Electric Lightwave, LLC's 6.05% Notes. These Notes had been guaranteed
by Citizens.
13
On July 15, 2004, we renegotiated and prepaid with $4,954,000 of cash the
entire remaining $5,524,000 Electric Lightwave capital lease obligation to
a third party.
On July 30, 2004, we purchased $300,000,000 of the 6.75% notes that were a
component of our equity units at 105.075% of par, plus accrued interest, at
a premium of approximately $15,225,000 recorded in investment and other
income (loss), net.
During August and September 2004, we repurchased through a series of
transactions an additional $108,230,000 of the 6.75% notes due 2006 at a
weighted average price of 104.486% of par, plus accrued interest, at a
premium of approximately $4,855,000 recorded in investment and other income
(loss), net.
As of September 30, 2004, EPPICS representing a total principal amount of
$111,379,000 were converted into 8,429,020 shares of Citizens common stock.
Total future minimum cash payment commitments over the next 20 years under
ELI's long-term capital leases amounted to $10,017,000 as of September 30,
2004.
(9) Net Income (Loss) Per Common Share:
----------------------------------
The reconciliation of the income (loss) per common share calculation for
the three and nine months ended September 30, 2004 and 2003, respectively,
is as follows:
For the three months ended For the nine months ended
($ in thousands, except per-share amounts) September 30, September 30,
------------------------------------ ----------------------------------
2004 2003 2004 2003
----------------- ----------------- --------------- -----------------
Net income (loss) used for basic and diluted earnings (loss)
- ------------------------------------------------------------
available to common shareholders:
---------------------------------
Income (loss) before cumulative effect of change in accounting
principle $ (11,290) $ 11,412 $ 55,370 $ 107,131
Cumulative effect of change in accounting principle - - - 65,769
----------------- ----------------- --------------- -----------------
Total basic net income (loss) available to common
shareholders $ (11,290) $ 11,412 $ 55,370 $ 172,900
================= ================= =============== =================
Effect of conversion of preferred securities - - - 4,658
----------------- ----------------- --------------- -----------------
Total diluted net income (loss) available to common
shareholders $ (11,290) $ 11,412 $ 55,370 $ 177,558
================= ================= =============== =================
Basic earnings (loss) available to common shareholders:
- -------------------------------------------------------
Weighted-average shares outstanding - basic 309,732 282,838 294,455 282,217
================= ================= =============== =================
Income (loss) before cumulative effect of change in
accounting principle $ (0.04) $ 0.04 $ 0.19 $ 0.38
Cumulative effect of change in accounting principle - - - 0.23
----------------- ----------------- --------------- -----------------
Net income (loss) available to common shareholders $ (0.04) $ 0.04 $ 0.19 $ 0.61
================= ================= =============== =================
Diluted earnings (loss) available to common shareholders:
- ---------------------------------------------------------
Weighted-average shares outstanding 309,732 282,838 294,455 282,217
Effect of dilutive shares 4,480 5,264 5,783 4,900
Effect of conversion of preferred securities - - - 15,134
----------------- ----------------- --------------- -----------------
Weighted-average shares outstanding - diluted 314,212 288,102 300,238 302,251
================= ================= =============== =================
Income (loss) before cumulative effect of change in
accounting principle $ (0.04) $ 0.04 $ 0.18 $ 0.37
Cumulative effect of change in accounting principle - - - 0.22
----------------- ----------------- --------------- -----------------
Net income (loss) available to common shareholders $ (0.04) $ 0.04 $ 0.18 $ 0.59
================= ================= =============== =================
For the three and nine months ended September 30, 2004, options of
1,913,135 and 2,494,634, respectively, at exercise prices ranging from
$13.30 to $18.46 issuable under employee compensation plans were excluded
from the computation of diluted EPS for those periods because the exercise
prices were greater than the average market price of common shares and,
therefore, the effect would be antidilutive.
14
For the three and nine months ended September 30, 2003, options of
10,420,894 and 10,770,894, respectively, at exercise prices ranging from
$11.41 to $21.47 issuable under employee compensation plans were excluded
from the computation of diluted EPS for those periods because the exercise
prices were greater than the average market price of common shares and,
therefore, the effect would be antidilutive.
In connection with the payment of the special dividend of $2 per common
share on September 2, 2004, the exercise price and number of all
outstanding options was adjusted such that each option had the same value
to the holder after the dividend as it had before the dividend. In
accordance with FASB Interpretation No. 44 ("FIN 44"), "Accounting for
Certain Transactions involving Stock Compensation" and EITF 00-23, "Issues
Related to the Accounting for Stock Compensation under APB No. 25 and FIN
44", there is no accounting consequence for changes made to the exercise
price, the number of shares, or both, of a fixed stock option or award as a
direct result of the special dividend,
For the three and nine months ended September 30, 2004 and 2003, restricted
stock awards of 1,543,000 and 1,453,000 shares, 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.
On August 17, 2004 we issued 32,073,633 shares of common stock, including
3,591,000 treasury shares, to our equity unit holders in settlement of the
equity purchase contract component of the equity units. With respect to the
$460,000,000 Senior Note component of the equity units, we repurchased
$300,000,000 principal amount of these Notes in July 2004. The remaining
$160,000,000 of the Senior Notes were repriced and a portion was remarketed
on August 12, 2004 as the 6.75% Notes due August 17, 2006. During August
and September, 2004, we repurchased an additional $108,230,000 of the 6.75%
Notes which, in addition to the $300,000,000 purchased in July, resulted in
a pre-tax charge of approximately $20,080,000 during the third quarter of
2004, but will result in an annual reduction in interest expense of about
$27,555,000 per year.
As a result of our July dividend announcement with respect to our common
shares, our 5% Company Obligated Mandatorily Redeemable Convertible
Preferred Securities due 2036 (EPPICS) began to convert to Citizens common
shares. As of September 30, 2004, approximately 55% of the EPPICS
outstanding, or about $111,379,000 aggregate principal amount of units,
have converted to 8,429,020 Citizens common shares, including 725,000
treasury shares.
At September 30, 2004, we had 1,797,428 shares of potentially dilutive
EPPICS, which were convertible into common stock at a 4.36 to 1 ratio at an
exercise price of $11.46 per share. As a result of the September 2004
special dividend, the EPPICS exercise price for conversion into common
stock was reduced from $13.30 to $11.46. These securities have not been
included in the diluted income per share calculation for the three and nine
months ended September 30, 2004 because their inclusion would have had an
antidilutive effect.
At September 30, 2003, we had 4,025,000 shares of potentially dilutive
EPPICS which were convertible into common stock at a 3.76 to 1 ratio at an
exercise price of $13.30 per share that have been included in the diluted
income per common share calculation for the nine months ended September 30,
2003. These securities have not been included in the diluted income per
share calculation for the three months ended September 30, 2003 because
their inclusion would have had an antidilutive effect.
(10) Segment Information:
-------------------
As of April 1, 2004, we operate in two segments, ILEC and ELI (a
competitive local exchange carrier (CLEC)). The ILEC segment provides both
regulated and unregulated communications services to residential, business
and wholesale customers and is typically the incumbent provider in its
service areas.
As an ILEC, we compete with CLECs that may operate in our markets. As a
CLEC, we provide telecommunications services, principally to businesses, in
competition with the ILEC. As a CLEC, we frequently obtain the "last mile"
access to customers through arrangements with the applicable ILEC. ILECs
and CLECs are subject to different regulatory frameworks of the Federal
Communications Commission (FCC) and state regulatory agencies. Our ILEC
operations and ELI do not compete with each other.
15
As permitted by SFAS No. 131, we have utilized the aggregation criteria in
combining our markets because all of the Company's ILEC properties share
similar economic characteristics: they provide the same products and
services to similar customers using comparable technologies in all the
states in which we operate. The regulatory structure is generally similar.
Differences in the regulatory regime of a particular state do not
materially impact the economic characteristics or operating results of a
particular property.
($ in thousands) For the three months ended September 30, 2004
------------------------------------------------------------
Total
ILEC ELI Electric (1) Segments
-------------- -------------- --------------- -------------
Revenue $ 506,183 $ 39,210 $ - $ 545,393
Depreciation and amortization 135,259 6,121 - 141,380
Management succession and
strategic alternatives expenses 73,051 2,807 - 75,858
Operating income (loss) 71,191 774 (11) 71,954
Capital expenditures 65,960 1,907 - 67,867
($ in thousands) For the three months ended September 30, 2003
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 511,574 $ 40,416 $ 18,005 $ 25,042 $ 595,037
Depreciation and amortization 146,261 5,617 - - 151,878
Loss on impairment - - - 4,000 4,000
Operating income (loss) 133,807 3,773 (2,806) (1,618) 133,156
Capital expenditures 66,968 3,113 2,412 3,515 76,008
(1) Consists principally of post-sale activities associated with the
completion of our utility divestiture program. These costs could not be
accrued as a selling cost at the time of sale. The Company believes it has
an adequate provision for its remaining post-divestiture liabilities. We do
not anticipate any material future costs associated with these activities.
($ in thousands) For the nine months ended September 30, 2004
------------------------------------------------------------
Total
ILEC ELI Electric Segments
-------------- -------------- --------------- -------------
Revenue $ 1,520,940 $ 117,277 $ 9,735 $ 1,647,952
Depreciation and amortization 411,749 17,901 - 429,650
Management succession and
strategic alternatives expenses 87,279 3,353 - 90,632
Operating income (loss) 337,146 5,121 (2,332) 339,935
Capital expenditures 192,491 8,066 573 201,130
($ in thousands) For the nine months ended September 30, 2003
---------------------------------------------------------------------------
Total
ILEC ELI Gas Electric Segments
-------------- -------------- --------------- ------------- --------------
Revenue $ 1,535,336 $ 125,228 $ 137,686 $ 92,603 $ 1,890,853
Depreciation and amortization 422,990 17,795 - - 440,785
Reserve for telecommunications
bankruptcies 1,113 1,147 - - 2,260
Restructuring and other expenses 9,482 468 - - 9,950
Loss on impairment - - - 4,000 4,000
Operating income 402,536 6,658 15,204 8,245 432,643
Capital expenditures 161,260 6,514 9,877 13,487 191,138
16
The following table reconciles sector capital expenditures to total
consolidated capital expenditures.
($ in thousands) For the three months ended For the nine months ended
September 30, September 30,
------------------------------ -----------------------------
2004 2003 2004 2003
-------------- -------------- --------------- -------------
Total segment capital expenditures $ 67,867 $ 76,008 $ 201,130 $ 191,138
General capital expenditures 9 48 180 520
-------------- -------------- --------------- -------------
Consolidated reported capital
expenditures $ 67,876 $ 76,056 $ 201,310 $ 191,658
============== ============== =============== =============
(11) 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 September 30, 2004 and December 31, 2003 were $550,000,000 and
$400,000,000, respectively. Such contracts require us to pay variable rates
of interest (estimated average pay rates of approximately 6.31% as of
September 30, 2004 and approximately 5.46% as of December 31, 2003) and
receive fixed rates of interest (average receive rates of 8.47% and 8.38%
as of September 30, 2004 and December 31, 2003, respectively). The fair
value of these derivatives is reflected in other assets as of September 30,
2004, in the amount of $11,574,000 and the related underlying debt has been
increased by a like amount. The net amounts received during the three and
nine months ended September 30, 2004 as a result of these contracts
amounted to $1,577,000 and $7,093,000, respectively, and are included as a
reduction of interest expense.
We do not anticipate any nonperformance by counterparties to our derivative
contracts as all counterparties have investment grade credit ratings.
(12) Management Succession and Strategic Alternatives Expenses:
---------------------------------------------------------
On July 11, 2004, our Board of Directors announced that it had completed
its review of the Company's financial and strategic alternatives and on
September 2, 2004 the Company paid a special dividend of $2 per common
share and a quarterly dividend of $0.25 per common share to shareholders of
record on August 18, 2004. Concurrently, Leonard Tow decided to step down
from his position as chief executive officer, effective immediately, and
resigned his position as Chairman of the board on September 27, 2004. The
Board of Directors named Mary A. Wilderotter president and chief executive
officer (effective November 1, 2004) on September 21, 2004 and Rudy J. Graf
was elected Chairman of the board on September 30, 2004.
Through the first nine months of 2004, we expensed approximately
$90,632,000 of costs related to management succession and our exploration
of financial and strategic alternatives. Included are $36,618,000 of
non-cash expenses for the acceleration of stock benefits, cash expenses of
$19,229,000 for advisory fees, $19,339,000 for severance and retention
arrangements and $15,446,000 primarily for tax reimbursements. We do not
anticipate any significant future costs for these items.
17
(13) Investment and Other Income, Net:
--------------------------------
The components of investment and other income, net are as follows:
Three Months Ended September 30, Nine Months Ended September 30,
----------------------------------- -----------------------------------
($ in thousands) 2004 2003 2004 2003
----------------- ---------------- ----------------- -----------------
Investment income (loss) $ (2,742) $ 1,809 $ 2,869 $ 7,113
Gain on capital lease termination/restructuring - - - 65,724
Gain on expiration/settlement of customer advances - - 25,345 6,165
Premium on debt repurchases (20,368) (7,250) (20,368) (10,704)
Gain (loss) on sale of assets 10,735 (16,813) 9,365 (11,792)
Other, net (1,276) (2,023) (355) (1,374)
----------------- ---------------- ----------------- -----------------
Total investment and other income, net $ (13,651) $ (24,277) $ 16,856 $ 55,132
================= ================ ================= =================
During 2003 and 2004, we recognized income in connection with certain
retained liabilities associated with customer advances for construction
from our disposed water properties, as a result of some of these
liabilities terminating. During 2003, we recognized gains in connection
with the termination/restructuring of capital leases at ELI. Gain (loss) on
sale of assets in 2004 represents various gains (losses) recognized
including the gain on sales of non strategic investments during the third
quarter. In 2003, the amount is attributable to the sales of The Gas
Company in Hawaii and our Arizona gas and electric divisions during the
third quarter, and the sale of access lines in North Dakota and our
wireless partnership interest in Wisconsin during the second quarter, and
the sale of our Plano, Texas office building in March 2003.
(14) Company Obligated Mandatorily Redeemable Convertible Preferred Securities:
-------------------------------------------------------------------------
In 1996, our consolidated wholly-owned subsidiary, Citizens Utilities Trust
(the Trust), issued, in an underwritten public offering, 4,025,000 shares
of 5% Company Obligated Mandatorily Redeemable Convertible Preferred
Securities due 2036 (EPPICS), representing preferred undivided interests in
the assets of the Trust, with a liquidation preference of $50 per security
(for a total liquidation amount of $201,250,000). The proceeds from the
issuance of the Trust Convertible Preferred Securities and a Company
capital contribution were used to purchase $207,475,000 aggregate
liquidation amount of 5% Partnership Convertible Preferred Securities due
2036 from another wholly-owned subsidiary, Citizens Utilities Capital L.P.
(the Partnership). These securities have an adjusted conversion price of
$11.46 per Citizens common share. The conversion price was reduced from
$13.30 to $11.46 during the third quarter of 2004 as a result of the $2.00
per share special dividend. The proceeds from the issuance of the
Partnership Convertible Preferred Securities and a Company capital
contribution were used to purchase from us $211,756,000 aggregate principal
amount of 5% Convertible Subordinated Debentures due 2036. The sole assets
of the Trust are the Partnership Convertible Preferred Securities, and our
Convertible Subordinated Debentures are substantially all the assets of the
Partnership. Our obligations under the agreements related to the issuances
of such securities, taken together, constitute a full and unconditional
guarantee by us of the Trust's obligations relating to the Trust
Convertible Preferred Securities and the Partnership's obligations relating
to the Partnership Convertible Preferred Securities.
In accordance with the terms of the issuances, we paid the annual 5%
interest in quarterly installments on the Convertible Subordinated
Debentures in the first, second and third quarters of 2004 and the four
quarters of 2003. Only cash was paid (net of investment returns) to the
Partnership in payment of the interest on the Convertible Subordinated
Debentures. The cash was then distributed by the Partnership to the Trust
and then by the Trust to the holders of the EPPICS.
As of September 30, 2004, EPPICS representing a total principal amount of
$111,379,000 had been converted into 8,429,020 shares of Citizens common
stock.
We have adopted the provisions of FIN 46R (revised December 2003) ("FIN
46R"), "Consolidation of Variable Interest Entities," effective January 1,
2004. We have not restated prior periods.
18
We have included the following description to provide readers a comparative
analysis of the accounting impact of this standard. Both the Trust and the
Partnership have been consolidated from the date of their creation through
December 31, 2003. As a result of the new consolidation standards
established by FIN 46R, the Company, effective January 1, 2004,
deconsolidated the activities of the Trust and the Partnership. We have
highlighted the comparative effect of this change in the following table:
Balance Sheet
As of
-------------------------------------------------------------
($ in thousands) December 31, 2003 September 30, 2004 Change
--------------------- -------------------- --------------
Assets:
Cash $ 2,103 $ - $ (2,103) (1)
Investments - 12,645 12,645 (2)
Liabilities:
Long-term debt - 100,377 (3) (100,873(3)
EPPICS 201,250 - (3)
Statement of Operations
As reported for the nine months ended
-------------------------------------------------------------
($ in thousands) September 30, 2003 September 30, 2004 Change
--------------------- -------------------- --------------
Investment income $ - $ 474 $ 474 (4)
Interest expense - 7,044 7,044 (5)
Dividends on EPPICS (before tax) 7,548 - (7,548) (6)
--------------------- -------------------- --------------
Net $ 7,548 $ 6,570 $ (978)
===================== ==================== ==============
(1) Represents a cash balance on the books of the Partnership that is
removed as a result of the deconsolidation.
(2) Represents Citizens' investments in the Partnership and the Trust. At
December 31, 2003, these investments were eliminated in consolidation
against the equity of the Partnership and the Trust.
(3) As a result of the deconsolidation, the Trust and the Partnership
balance sheets were removed, leaving debt issued by Citizens to the
Partnership in the amount of $211,756,000. The nominal effect of an
increase in debt of $10,506,000 is debt that is "intercompany." FIN
46R does not impact the economics of the EPPICS structure. As of
September 2004, Citizens has $100,377,000 (approximately $111,378,600
converted during third quarter) of debt outstanding to third parties
and will continue to pay interest on that amount at 5%.
(4) Represents interest income to be paid by the Partnership and the Trust
to Citizens for its investments noted in (2) above. The Partnership
and the Trust have no source of cash except as provided by Citizens.
Interest is payable at the rate of 5% per annum.
(5) Represents interest expense on the convertible debentures issued by
Citizens to the Partnership. Interest is payable at the rate of 5% per
annum.
(6) As a result of the deconsolidation of the Trust, previously reported
dividends on the convertible preferred securities issued to the public
by the Trust are removed and replaced by the interest accruing on the
debt issued by Citizens to the Partnership. Citizens remains the
guarantor of the EPPICS debt and continues to be the sole source of
cash for the Trust to pay dividends.
19
(15) Retirement Plans:
----------------
The following tables provides the components of net periodic benefit cost
for the three and nine months ended September 30, 2004 and 2003:
Pension Benefits
--------------------------------------------------------
For the three months ended For the nine months ended
September 30, September 30,
---------------------------- -------------------------
($ in thousands) 2004 2003 2004 2003
------------- ------------- ------------ ------------
Components of net periodic benefit cost
- ---------------------------------------
Service cost $ 1,133 $ 1,763 $ 4,311 $ 5,607
Interest cost on projected benefit obligation 11,859 13,364 34,851 42,502
Return on plan assets (14,286) (14,697) (42,902) (46,739)
Amortization of prior service cost and
unrecognized net obligation (61) (47) (183) (149)
Amortization of unrecognized loss 2,911 3,002 6,619 9,544
------------- ------------- ------------ ------------
Net periodic benefit cost 1,556 3,385 2,696 10,765
Curtailment/settlement charge - 6,585 - 6,585
------------- ------------- ------------ ------------
Total periodic benefit cost $ 1,556 $ 9,970 $ 2,696 $ 17,350
============= ============= ============ ============
Other Postretirement Benefits
--------------------------------------------------------
For the three months ended For the nine months ended
September 30, September 30,
---------------------------- -------------------------
($ in thousands) 2004 2003 2004 2003
------------- ------------- ------------ ------------
Components of net periodic benefit cost
- ---------------------------------------
Service cost $ 48 $ 292 $ 846 $ 876
Interest cost on projected benefit obligation 3,203 2,863 9,517 8,591
Return on plan assets (641) (449) (1,701) (1,347)
Amortization of prior service cost and
unrecognized net obligation (162) 5 (150) 15
Amortization of unrecognized loss 809 838 3,927 2,515
------------- ------------- ------------ ------------
Net periodic benefit cost $ 3,257 $ 3,549 $ 12,439 $ 10,650
============= ============= ============ ============
We expect that our pension expense for 2004 will be $3,000,000 - $4,000,000
(it was $12,400,000 in 2003) and no contribution will be required to be
made by us to the pension plan in 2004. No contribution was made, or
required, for 2003.
In December 2003, the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (the Act) became law. The Act introduces a
prescription drug benefit under Medicare as well as a federal subsidy to
sponsors of retiree health care benefit plans that provide a benefit that
is at least actuarially equivalent to the Medicare benefit. The amount of
the federal subsidy will be based on 28 percent of an individual
beneficiary's annual eligible prescription drug costs ranging between $250
and $5,000. Currently, the Company has not yet been able to conclude
whether the benefits provided by its postretirement medical plan are
actuarially equivalent to Medicare Part D under the Act. Therefore, the
Company cannot quantify the effects, if any, that the Act will have on its
future benefit costs or accumulated postretirement benefit obligation and
accordingly, the effects of the Act have not been reflected in the
accompanying unaudited consolidated financial statements.
(16) Income Taxes:
------------
The effective tax rate for the nine months ended September 30, 2004 and
2003 was 21.5% and 33.8%, respectively. Our effective tax rate has declined
as a result of the completion of audits with federal and state taxing
authorities in the third quarter 2004 and changes in the structure of
certain of our subsidiaries.
20
(17) Commitments and Contingencies:
-----------------------------
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). We intend to
defend ourselves vigorously against the City's lawsuit. 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 has asserted that money damages and other relief
at issue in the lawsuit could exceed $50,000,000. 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 counterclaims
against the City. In addition, we have identified a number of other
potentially responsible parties that may be liable for the damages alleged
by the City and have 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. On March 11,
2004, the Magistrate in charge of the case granted our motion for partial
summary judgment with respect to the City's CERCLA claims, and that
decision was affirmed by the District Court on May 5, 2004. In an order
issued on July 6, 2004, the Magistrate dismissed the City's claim for
punitive damages. The case could be set for trial as early as the first
quarter of 2005. We have demanded that various of our insurance carriers
defend and indemnify us with respect to the City's lawsuit, and on 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 this lawsuit to obtain from our insurance
carriers indemnification for any damages that may be assessed against us in
the City's lawsuit as well as to recover the costs of our defense of that
lawsuit.
On June 7, 2004, representatives of Robert A. Katz Technology Licensing,
LP, contacted us regarding possible infringement of several patents held by
that firm. The patents cover a wide range of operations in which telephony
is supported by computers, including obtaining information from databases
via telephone, interactive telephone transactions, and customer and
technical support applications. We are cooperating with the patent holder
to determine if we are currently using any of the processes that are
protected by its patents. If we determine that we are utilizing the patent
holder's intellectual property, we expect to commence negotiations on a
license agreement.
On June 24, 2004, one of our subsidiaries, Frontier Subsidiary Telco Inc.,
received a "Notice of Indemnity Claim" from Citibank, N.A., that is related
to a complaint pending against Citibank and others in the U.S. Bankruptcy
Court for the Southern District of New York as a part of the Global
Crossing Bankruptcy proceeding. Citibank bases its claim for indemnity on
the provisions of a credit agreement that was entered into in October 2000
between Citibank and our subsidiary. We purchased Frontier Subsidiary
Telco, Inc., in June 2001 as part of our acquisition of the Frontier
telephone companies. The complaint against Citibank, for which it seeks
indemnification, alleges that the seller improperly used a portion of the
proceeds from the Frontier transaction to pay off the Citibank credit
agreement, thereby defrauding certain debt holders of Global Crossing North
America Inc. Although the credit agreement was paid off at the closing of
the Frontier transaction, Citibank claims the indemnification obligation
survives. Damages sought against Citibank and its co-defendants could
exceed $1,000,000,000. We have advised Citibank that we believe its demand
for indemnification is unfounded. If Citibank elects to pursue its claims
for indemnification in a legal proceeding, we will vigorously contest those
claims.
We are party to other legal 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.
We have budgeted capital expenditures in 2004 of approximately
$276,000,000, including $265,000,000 for ILEC (approximately $10,300,000 of
which relates to our billing system conversion) and $11,000,000 for ELI.
Capitalized costs during 2004 associated with our billing system conversion
amounted to $7,755,000.
21
The Company sold all of its utility businesses as of April 1, 2004.
However, we have retained a potential payment obligation associated with
our previous electric utility activities in the state of Vermont. The
Vermont Joint Owners (VJO), a consortium of 14 Vermont utilities, including
us, entered into a purchase power agreement with Hydro-Quebec in 1987. The
agreement contains "step-up" provisions that state that if any VJO member
defaults on its purchase obligation under the contract to purchase power
from Hydro-Quebec the other VJO participants will assume responsibility for
the defaulting party's share on a pro-rata basis. Our pro-rata share of the
purchase power obligation was 10%. If any member of the VJO defaults on its
obligations under the Hydro-Quebec agreement, the remaining members of the
VJO, including us, may be required to pay for a substantially larger share
of the VJO's total power purchase obligation for the remainder of the
agreement (which runs through 2015). Paragraph 13 of FIN 45 requires that
we disclose "the maximum potential amount of future payments (undiscounted)
the guarantor could be required to make under the guarantee." Paragraph 13
also states that we must make such disclosure "... even if the likelihood
of the guarantor's having to make any payments under the guarantee is
remote..." As noted above, our obligation only arises as a result of
default by another VJO member such as upon bankruptcy. Therefore, to
satisfy the "maximum potential amount" disclosure requirement we must
assume that all members of the VJO simultaneously default, a highly
unlikely scenario given that the two members of the VJO that have the
largest potential payment obligations are publicly traded with investment
grade credit ratings, and that all VJO members are regulated utility
providers with regulated cost recovery. Regardless, despite the remote
chance that such an event could occur, or that the State of Vermont could
or would allow such an event, assuming that all the members of the VJO
defaulted by January 1, 2005 and remained in default for the duration of
the contract (another 10 years), we estimate that our undiscounted purchase
obligation for 2005 through 2015 would be approximately $1,600,000,000. In
such a scenario the Company would then own the power and could seek to
recover its costs. We would do this by seeking to recover our costs from
the defaulting members and/or reselling the power to other utility
providers or the northeast power grid. There is an active market for the
sale of power. We believe that we would receive full recovery of our costs
through sales to others. If pricing became more favorable we could
potentially sell the power on the open market at a profit. We could
potentially lose money if we were unable to sell the power at cost. We
caution that all of the above-described scenarios are unlikely to occur and
we cannot predict with any degree of certainty any potential outcome.
(18) Subsequent Event:
----------------
On October 29, 2004, Citizens Communications Company entered into a
$250,000,000 credit agreement with a maturity date of October 29, 2009. The
$805,000,000 lines of credit, which would have matured on October 24, 2006,
were canceled as of the same date. During the term of the $250,000,000
credit agreement, Citizens may borrow, repay and re-borrow funds. The new
credit facility contains a maximum leverage ratio covenant, which requires
that we maintain a ratio of no greater than 4.50 to 1. Although the new
credit facility is unsecured, it will be equally and ratably secured by
certain liens and equally and ratably guaranteed by certain of our
subsidiaries if we issue debt that is secured or guaranteed. The new credit
agreement is available for general corporate purposes but may not be used
to fund dividend payments.
22
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, and our future
results may be materially affected by, 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), voice over internet protocol (VOIP) or otherwise),
high speed cable modems and cable telephony;
* The effects of general and local economic and employment 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 that are both
profitable to us and attractive to our customers, and our ability to
sell enhanced and data services in order to offset declines in highly
profitable revenue from local services, access services and subsidies;
* Our ability to comply with Section 404 of the Sarbanes-Oxley Act,
which requires management to assess its internal control systems and
disclose whether the internal control systems are effective and the
identification of any material weaknesses in the Company's internal
control over financial reporting;
* 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 potential
changes in access charges and subsidy payments, regulatory network
upgrade and reliability requirements, and portability requirements;
* Our ability to successfully renegotiate certain ILEC state regulatory
plans as they expire or come up for renewal from time to time;
* Our ability to manage our operating expenses, capital expenditures,
pay dividends and reduce or refinance 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 more price competition and potential bad debts;
* The effects of technological changes on our capital expenditures and
product and service offerings, 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 medical expenses and related funding
requirements;
* The effect of changes in the telecommunications market, including the
likelihood of significantly increased price and service competition;
* Our ability to successfully convert the billing system for
approximately 770,000 of our access lines on a timely basis and within
our expected amount for 2004 of $18.0 - $20.0 million (a portion of
which is expected to be capitalized and amortized) and, beginning in
2005, to achieve our expected cost savings from conversion;
23
* The effects of 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
covering approximately 140 employees that are scheduled to expire
during the remainder of 2004;
* Our ability to pay a $1.00 per common share dividend annually may be
affected by our cash flow from operations, amount of capital
expenditures, debt service requirements and cash taxes and our
liquidity;
* The effects of any future liabilities or compliance costs in
connection with environmental and worker health and safety matters;
* The effects of any unfavorable outcome with respect to any of our
current or future legal, governmental, or regulatory proceedings,
audits or disputes; 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.
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
2003 Annual Report on Form 10-K. We have no obligation to update or revise these
forward-looking statements.
Overview
- --------
We are a telecommunications company providing wireline communications services
to rural areas and small and medium-sized towns and cities as an incumbent local
exchange carrier, or ILEC. We offer our ILEC services under the "Frontier" name.
In addition, we provide competitive local exchange carrier, or CLEC, services to
business customers and to other communications carriers in certain metropolitan
areas in the western United States through Electric Lightwave, LLC, or ELI, our
wholly-owned subsidiary. We also provided (through March 31, 2004), electric
distribution services to primarily rural customers in Vermont.
Competition in the telecommunications industry is increasing. We experience
competition from other wireline local carriers through Unbundled Network
Elements (UNE), VOIP 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 cable telephony, and from wireless carriers.
Most of the wireline competition we face is in our Rochester, New York market,
with competition also present in a few other areas. Time Warner Cable is selling
VOIP service in our Rochester market and other portions of our New York markets.
Competition from cable companies and other internet service providers with
respect to internet access is intense. Competition from wireless companies and
other long distance companies is increasing in all of our markets.
The telecommunications industry is undergoing significant changes and
difficulties. The market for internet access, long distance, long-haul and
related services in the United States is extremely competitive, with substantial
overcapacity in the market. Demand and pricing for certain CLEC services (such
as long-haul services) have decreased substantially. There is also increasing
price pressure on certain of our ILEC services such as special access, business
services, long distance and internet access. These trends are likely to continue
and result in a challenging revenue environment. These factors could also result
in more bankruptcies in the sector and therefore affect our ability to collect
money owed to us by carriers. Several long distance and Interexchange Carriers
(IXCs) 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.
24
Our ILEC business has been experiencing declining access lines, switched minutes
of use and revenues because of economic conditions, unemployment levels,
increasing competition (as described above), changing consumer behavior (such as
wireless displacement of wireline use, email use, instant messaging and
increasing use of VOIP) and regulatory constraints. During the nine months ended
September 30, 2004, our access lines declined 2.4%, our switched minutes of use
declined 1.6% and our ILEC revenues declined 0.9%, in each case as compared to
the first nine months of 2003. These factors are likely to cause our local
network service, switched network access, long distance and subsidy revenues to
continue to decline during the remainder of 2004 and 2005. During the nine
months ended September 30, 2004, our switched network access revenue declined
6.9%, our long distance revenue declined 8.4%, our subsidy revenue declined 9.2%
and our local service revenue declined 2.2%, in each case as compared to 2003.
One of the ways we are responding to competition is by bundling services and
products and offering them for a single price, which results in lower pricing
than purchasing the services separately. During the nine months ended September
30, 2004, approximately 58,300 customers started buying one of our bundled
packages and we increased our revenue from enhanced services by 7.2%. In
addition, we added approximately 67,000 DSL subscribers during the nine months
ended September 30, 2004 and increased our data revenue by 28.7%. Our average
ILEC revenue per month per average number of ILEC access lines during the nine
months ended September 30, 2004 was $71.43 compared to $70.38 during the nine
months ended September 30, 2003. Revenues from data services such as DSL
continue to increase as a percentage of our total revenues and revenues from
high margin services such as local line and access charges and subsidies are
decreasing as a percentage of our revenues. These factors, along with increasing
operating and employee costs may cause our profitability to decrease. In
addition, costs we will incur during the remainder of 2004 to convert the
billing system for some of our access lines, to enable our systems to be capable
of local number portability (LNP) and to retain certain employees will affect
our profitability and capital expenditures during the remainder of 2004.
(a) Liquidity and Capital Resources
-------------------------------
For the nine months ended September 30, 2004, we used cash flow from operations,
proceeds from the sale of equity and non-strategic investments, cash and cash
equivalents to fund capital expenditures, interest payments, dividend payments
and debt repayments. As of September 30, 2004, we had cash and cash equivalents
aggregating $199.0 million.
We have budgeted approximately $276.0 million for our 2004 capital projects,
including $265.0 million for the ILEC segment (approximately $10.3 million of
which relates to our billing system conversion) and $11.0 million for the ELI
segment. Capitalized costs during 2004 associated with our billing system
conversion amount to $7.8 million through September 30.
For the nine months ended September 30, 2004, our capital expenditures were
$201.3 million, including $192.5 million for the ILEC segment, $8.0 million for
the ELI segment, $0.6 million for the public utilities segment and $0.2 million
for general capital expenditures. Our capital spending has been trending lower
over the last several years as we continue to closely scrutinize all of our
capital projects, emphasize return on investment and focus our capital
expenditures on areas and services that have the greatest opportunities with
respect to revenue growth and cost reduction. We will continue to focus on
managing our costs while increasing our investment in certain new product areas
such as DSL, VOIP and other Broadband services.
We have an available shelf registration for $719.9 million. As of September 30,
2004 we had available lines of credit with financial institutions in the
aggregate amount of $805.0 million. Associated facility fees varied depending on
our credit ratings and were 0.40% per annum as of September 30, 2004. The
expiration date for these facilities was October 24, 2006. No amounts were ever
borrowed under these facilities. On October 29, 2004, the $805.0 million lines
of credit were cancelled and replaced with a new $250.0 million line of credit
with a maturity date of October 29, 2009. Associated facility fees for the new
credit facility vary depending on our leverage ratio and were 0.375% as of
October 29, 2004. During the term of the new credit facility we may borrow,
repay and re-borrow funds. The new credit facility is available for general
corporate purposes but may not be used to fund dividend payments. There are no
outstanding borrowings under the new facility.
In July 2004, our Board of Directors concluded a review of financial and
strategic alternatives. After analysis of alternatives by the Board of Directors
and its financial and legal advisors, the Board determined to pay a special
dividend of $2 per common share and institute a regular annual dividend of $1
per common share which will be paid quarterly. The special dividend and first
quarterly dividend were paid on September 2, 2004 to shareholders of record on
August 18, 2004, utilizing the Company's available cash on hand. The next
quarterly dividend of $0.25 per common share will be paid on December 31, 2004
to shareholders of record on December 10, 2004.
25
The dividends paid on September 2, 2004 totaled $747.9 million and significantly
reduced our cash balances and liquidity. In addition, our ongoing annual
dividends of approximately $335.0 million will reduce our operating and
financial flexibility and our ability to significantly increase capital
expenditures. While we believe that the amount of our dividends will allow for
adequate amounts of cash flow for other purposes, any reduction in cash
generated by operations and any increases in capital expenditures, interest
expense or cash taxes would reduce the amount of cash generated in excess of
dividends. Losses of access lines, increases in competition, lower subsidy and
access revenues and the other factors described above may reduce our cash
generated by operations and require us to increase capital expenditures. The
downgrades in our credit ratings in July, 2004 to below investment grade may
make it more difficult and expensive to refinance our maturing debt. We have in
recent years paid relatively low amounts of cash taxes. We expect that over time
our cash taxes will increase.
As a result of our dividend policy, Standard and Poor's lowered its ratings on
Citizens debt from "BBB" to "BB-plus", Moody's Investors Service lowered its
ratings from "Baa3" to "Ba3" and Fitch Ratings lowered its ratings from "BBB" to
"BB".
We believe our operating cash flows, existing cash balances, and credit
facilities will be adequate to finance our working capital requirements, make
required debt payments through 2005, pay dividends to our shareholders in
accordance with our dividend policy, and support our short-term and long-term
operating strategies. We have approximately $927.8 million of debt that matures
in 2006. We will refinance most of this debt. Based on current market
conditions, any refinancing of such debt is likely to result in ongoing lower
interest expense but in the period during which the refinancing occurs we will
expense repayment premiums and the write off of unamortized deferred financing
costs as a result of retiring debt prior to its maturity.
Issuance of Common Stock
- ------------------------
On August 17, 2004 we issued 32,073,633 shares of common stock, including
3,591,000 treasury shares, to our equity unit holders in settlement of the
equity purchase contract component of the equity units. With respect to the
$460.0 million Senior Note component of their equity units, we repurchased
$300.0 million principal amount of these Notes in July 2004. The remaining
$160.0 million of the Senior Notes were repriced and a portion was remarketed on
August 12, 2004 as the 6.75% Notes due August 17, 2006. During August and
September, 2004, we repurchased an additional $108.2 million of the 6.75% Notes
which, in addition to the $300.0 million purchased in July, resulted in a
pre-tax charge of approximately $20.1 million during the third quarter of 2004,
but will result in an annual reduction in interest expense of about $27.6
million per year.
As a result of our July dividend announcement with respect to our common shares,
our 5% Company Obligated Mandatorily Redeemable Convertible Preferred Securities
due 2036 (EPPICS) began to convert to Citizens common shares. As of September
30, 2004, approximately 55% of the EPPICS outstanding, or about $111.4 million
aggregate principal amount of units, have converted to 8,429,020 Citizens common
shares, including 725,000 treasury shares.
Debt Reduction
- --------------
On January 15, 2004, we repaid at maturity the remaining outstanding $81.0
million of our 7.45% Debentures.
On January 15, 2004, we redeemed at 101% the remaining outstanding $12.3 million
of our Hawaii Special Purpose Revenue Bonds, Series 1993A and Series 1993B.
On May 17, 2004, we repaid at maturity the remaining outstanding $6.0 million of
Electric Lightwave, LLC's 6.05% Notes. These Notes had been guaranteed by
Citizens.
On July 15, 2004, we renegotiated and prepaid with $5.0 million of cash the
entire remaining $5.5 million Electric Lightwave capital lease obligation to a
third party.
On July 30, 2004, we purchased $300.0 million of the 6.75% notes that were a
component of our equity units at 105.075% of par, plus accrued interest, at a
premium of approximately $15.2 million.
During August and September 2004, we repurchased through a series of
transactions an additional $108.2 million of the 6.75% notes due 2006 at a
weighted average price of 104.486% of par, plus accrued interest, at a premium
of approximately $4.9 million.
We may from time to time repurchase our debt in the open market, through tender
offers or privately negotiated transactions.
26
Interest Rate Management
- ------------------------
In order to manage our interest expense, we have entered into interest swap
agreements. Under the terms of these agreements, we make semi-annual, floating
rate interest payments based on six month LIBOR and receive a fixed rate on the
notional amount. The underlying variable rate on these swaps is set either in
advance, in arrears or, based on each period's daily average six-month LIBOR.
The notional amounts of fixed-rate indebtedness hedged as of September 30, 2004
and December 31, 2003 was $550.0 million and $400.0 million, respectively. Such
contracts require us to pay variable rates of interest (estimated average pay
rates of approximately 6.31% as of September 30, 2004 and approximately 5.46% as
of December 31, 2003) and receive fixed rates of interest (average receive rates
of 8.47% and 8.38% as of September 30, 2004 and December 31, 2003,
respectively). All swaps are accounted for under SFAS No. 133 as fair value
hedges. For the three and nine months ended September 30, 2004, the cash
interest savings resulting from these interest rate swaps was approximately $1.6
million and $7.1 million, respectively, and is reflected as a reduction of
interest expense in the accompanying statements of operations.
Sale of Non-Strategic Investments
- ---------------------------------
On August 13, 2004, we sold our entire 1,333,500 shares of D & E Communications,
Inc. (D & E) for approximately $13.3 million in cash.
On September 3, 2004, we sold our entire holdings of 2,605,908 common share
equivalents in Hungarian Telephone and Cable Corp. for approximately $13.2
million in cash.
During the third quarter of 2004, we sold our corporate aircraft for
approximately $15.3 million in cash.
Off-Balance Sheet Arrangements
- ------------------------------
We do not maintain any off-balance sheet arrangements, transactions, obligations
or other relationships with unconsolidated entities that would be expected to
have a material current or future effect upon our financial statements.
Management Succession and Strategic Alternatives Expenses
- ---------------------------------------------------------
On July 11, 2004, our Board of Directors announced that it completed its review
of the Company's financial and strategic alternatives. Through the first nine
months of 2004, we expensed approximately $90.6 million of costs related to
management succession and our exploration of financial and strategic
alternatives. Included are $36.6 million of non-cash expenses for the
acceleration of stock benefits, cash expenses of $19.2 million for advisory
fees, $19.3 million for severance and retention arrangements and $15.5 million
primarily for tax reimbursements. We do not anticipate any significant future
costs for these items.
EPPICS
- ------
In 1996, our consolidated wholly-owned subsidiary, Citizens Utilities Trust (the
Trust), issued, in an underwritten public offering, 4,025,000 shares of 5%
Company Obligated Mandatorily Redeemable Convertible Preferred Securities due
2036 (Trust Convertible Preferred Securities or EPPICS), representing preferred
undivided interests in the assets of the Trust, with a liquidation preference of
$50 per security (for a total liquidation amount of $201.3 million). The
proceeds from the issuance of the Trust Convertible Preferred Securities and a
Company capital contribution were used to purchase $207.5 million aggregate
liquidation amount of 5% Partnership Convertible Preferred Securities due 2036
from another wholly owned consolidated subsidiary, Citizens Utilities Capital
L.P. (the Partnership). These securities have an adjusted conversion price of
$11.46 per Citizens common share. The conversion price was reduced from $13.30
to $11.46 during the third quarter of 2004 as a result of the $2.00 per share
special dividend. The proceeds from the issuance of the Partnership Convertible
Preferred Securities and a Company capital contribution were used to purchase
from us $211.8 million aggregate principal amount of 5% Convertible Subordinated
Debentures due 2036. The sole assets of the Trust are the Partnership
Convertible Preferred Securities, and our Convertible Subordinated Debentures
are substantially all the assets of the Partnership. Our obligations under the
agreements related to the issuances of such securities, taken together,
constitute a full and unconditional guarantee by us of the Trust's obligations
relating to the Trust Convertible Preferred Securities and the Partnership's
obligations relating to the Partnership Convertible Preferred Securities.
In accordance with the terms of the issuances, we paid the annual 5% interest in
quarterly installments on the Convertible Subordinated Debentures in the first,
second and third quarters of 2004 and the four quarters of 2003. Only cash was
paid (net of investment returns) to the Partnership in payment of the interest
on the Convertible Subordinated Debentures. The cash was then distributed by the
Partnership to the Trust and then by the Trust to the holders of the EPPICS.
As of September 30, 2004, EPPICS representing a total principal amount of $111.4
million had been converted into 8,429,020 shares of Citizens common stock.
27
We have adopted the provisions of FASB Interpretation No. 46R (revised December
2003) ("FIN 46R"), "Consolidation of Variable Interest Entities," effective
January 1, 2004. We have not restated prior periods.
We have included the following description to provide readers a comparative
analysis of the accounting impact of this standard. Both the Trust and the
Partnership have been consolidated from the date of their creation through
December 31, 2003. As a result of the new consolidation standards established by
FIN 46R, the Company, effective January 1, 2004, deconsolidated the activities
of the Trust and the Partnership. We have highlighted the comparative effect of
this change in the following table:
Balance Sheet
As of
-------------------------------------------------------------
($ in thousands) December 31, 2003 September 30, 2004 Change
--------------------- -------------------- --------------
Assets:
Cash $ 2,103 $ - $ (2,103) (1)
Investments - 12,645 12,645 (2)
Liabilities:
Long-term debt - 100,377 (3) (100,873) (3)
EPPICS 201,250 - (3)
Statement of Operations
As reported for the nine months ended
-------------------------------------------------------------
($ in thousands) September 30, 2003 September 30, 2004 Change
--------------------- -------------------- --------------
Investment income $ - $ 474 $ 474 (4)
Interest expense - 7,044 7,044 (5)
Dividends on EPPICS (before tax) 7,548 - (7,548) (6)
--------------------- -------------------- --------------
Net $ 7,548 $ 6,570 $ (978)
===================== ==================== ==============
(1) Represents a cash balance on the books of the Partnership that is
removed as a result of the deconsolidation.
(2) Represents Citizens' investments in the Partnership and the Trust. At
December 31, 2003, these investments were eliminated in consolidation
against the equity of the Partnership and the Trust.
(3) As a result of the deconsolidation, the Trust and the Partnership
balance sheets were removed, leaving debt issued by Citizens to the
Partnership in the amount of $211.8 million. The nominal effect of an
increase in debt of $10.5 million is debt that is "intercompany." FIN
46R does not impact the economics of the EPPICS structure. As of
September 2004, Citizens has $100.4 million (approximately $111.4
million converted during the third quarter) of debt outstanding to
third parties and will continue to pay interest on that amount at 5%.
(4) Represents interest income to be paid by the Partnership and the Trust
to Citizens for its investments noted in (2) above. The Partnership
and the Trust have no source of cash except as provided by Citizens.
Interest is payable at the rate of 5% per annum.
(5) Represents interest expense on the convertible debentures issued by
Citizens to the partnership. Interest is payable at the rate of 5% per
annum.
(6) As a result of the deconsolidation of the Trust, previously reported
dividends on the convertible preferred securities issued to the public
by the Trust are removed and replaced by the interest accruing on the
debt issued by Citizens to the Partnership. Citizens remains the
guarantor of the EPPICS debt and continues to be the sole source of
cash for the Trust to pay dividends.
Covenants
- ---------
The terms and conditions contained in our indentures and credit facilities
agreements include the timely and punctual payment of principal and interest
when due, the maintenance of our corporate existence, keeping proper books and
records in accordance with GAAP, restrictions on the allowance of liens on our
assets, and restrictions on asset sales and transfers, mergers and other changes
in corporate control. We currently have no restrictions on the payment of
dividends by us either by contract, rule or regulation.
Our $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 $50.0 million to (ii) consolidated
adjusted EBITDA (as defined in the agreements) over the last four quarters no
greater than 4.25 to 1 through December 30, 2004, and 4.00 to 1 thereafter.
28
Our new $250 million credit facility contains 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 $50.0 million to
(ii) consolidated adjusted EBITDA (as defined in the agreement) over the last
four quarters no greater than 4.50 to 1. Although the new credit facility is
unsecured, it will be equally and ratably secured by certain liens and equally
and ratably guaranteed by certain of our subsidiaries if we issue debt that is
secured or guaranteed.
We are in compliance with all of our debt and credit facility 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. As of April 1, 2004, we have sold all of these
properties. All of the agreements relating to the sales provide that we will
indemnify the buyer against certain liabilities (typically liabilities relating
to events that occurred prior to sale), including environmental liabilities, for
claims made by specified dates and that exceed threshold amounts specified in
each agreement.
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 31, 2002, we completed the sale of approximately 4,000 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 April 1, 2003, we completed the sale of approximately 11,000 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.
On August 8, 2003, we completed the sale of The Gas Company in Hawaii division
for $119.3 million in cash and assumed liabilities.
On August 11, 2003, we completed the sale of our Arizona gas and electric
divisions for $224.1 million in cash.
On December 2, 2003, we completed the sale of our electric transmission
facilities in Vermont for $7.3 million in cash.
On April 1, 2004, we completed the sale of our electric distribution facilities
in Vermont for $14.0 million in cash, net of selling expenses.
In October 2004, we sold cable assets in California, Arizona, Indiana, and
Wisconsin, and we have signed a definitive agreement to sell cable assets in New
Mexico. The $1.3 million pre-tax loss on these sales was recognized during the
third quarter of 2004.
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,
contingencies, and pension and postretirement benefits expenses among others.
29
Accounting standards require that we record an additional minimum pension
liability when the plan's "accumulated benefit obligation" exceeds the fair
market value of plan assets at the pension plan measurement (balance sheet)
date. In the fourth quarter of 2002, due to weak performance in the equity
markets during 2002 as well as a decrease in the year-end discount rate, we
recorded an additional minimum pension liability in the amount of $181.0 million
with a corresponding charge to shareholders' equity of $112.0 million, net of
taxes of $69.0 million. In the fourth quarter of 2003, due to strong performance
in the equity markets during 2003, partially offset by a decrease in the
year-end discount rate, the Company recorded a reduction to its minimum pension
liability in the amount of $35.0 million with a corresponding credit to
shareholders' equity of $22.0 million, net of taxes of $13.0 million. These
adjustments did not impact our earnings or cash flows. Based upon market
conditions existing at the end of October 2004, an additional charge to equity
of approximately $25.0 million - $30.0 million on a pre-tax basis would be
required at the end of 2004 should market conditions remain unchanged.
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.
There have been no material changes to our critical accounting policies and
estimates from the information provided in Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations included in our 2003
Annual Report on Form 10-K.
New Accounting Pronouncements
- -----------------------------
Accounting for Asset Retirement Obligations
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 $65.8 million. 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.
Exit or Disposal Activities
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.
Guarantees
In November 2002, the FASB issued FASB Interpretation No. 45 ("FIN 45"),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Guarantees of Indebtedness of Others." FIN 45 requires that a guarantor be
required to recognize, at the inception of a guarantee, a liability for the fair
value of the obligation assumed under the guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual financial
statements about the obligations associated with the guarantee. The provisions
of FIN 45 are effective for guarantees issued or modified after December 31,
2002, whereas the disclosure requirements were effective for financial
statements for period ending after December 15, 2002. The adoption of FIN 45 on
January 1, 2003 did not have any material impact on our financial position or
results of operations.
30
The Company has sold all of its utility businesses as of April 1, 2004. However,
we have retained a potential payment obligation associated with our previous
electric utility activities in the state of Vermont. The Vermont Joint Owners
(VJO), a consortium of 14 Vermont utilities, including us, entered into a
purchase power agreement with Hydro-Quebec in 1987. The agreement contains
"step-up" provisions that state that if any VJO member defaults on its purchase
obligation under the contract to purchase power from Hydro-Quebec the other VJO
participants will assume responsibility for the defaulting party's share on a
pro-rata basis. Our pro-rata share of the purchase power obligation was 10%. If
any member of the VJO defaults on its obligations under the Hydro-Quebec
agreement, the remaining members of the VJO, including us, may be required to
pay for a substantially larger share of the VJO's total power purchase
obligation for the remainder of the agreement (which runs through 2015).
Paragraph 13 of FIN 45 requires that we disclose, "the maximum potential amount
of future payments (undiscounted) the guarantor could be required to make under
the guarantee." Paragraph 13 also states that we must make such disclosure "...
even if the likelihood of the guarantor's having to make any payments under the
guarantee is remote..." As noted above, our obligation only arises as a result
of default by another VJO member such as upon bankruptcy. Therefore, to satisfy
the "maximum potential amount" disclosure requirement we must assume that all
members of the VJO simultaneously default, a highly unlikely scenario given that
the two members of the VJO that have the largest potential payment obligations
are publicly traded with investment grade credit ratings, and that all VJO
members are regulated utility providers with regulated cost recovery.
Regardless, despite the remote chance that such an event could occur, or that
the State of Vermont could or would allow such an event, assuming that all the
members of the VJO defaulted by January 1, 2005 and remained in default for the
duration of the contract (another 10 years), we estimate that our undiscounted
purchase obligation for 2005 through 2015 would be approximately $1.6 billion.
In such a scenario the Company would then own the power and could seek to
recover its costs. We would do this by seeking to recover our costs from the
defaulting members and/or reselling the power to other utility providers or the
northeast power grid. There is an active market for the sale of power. We
believe that we would receive full recovery of our costs through sales to
others. If pricing became more favorable we could potentially sell the power on
the open market at a profit. We could potentially lose money if we were unable
to sell the power at cost.
We caution that all of the above-described scenarios are unlikely to occur and
we cannot predict with any degree of certainty any potential outcome.
Variable Interest Entities
In December 2003, the FASB issued FASB Interpretation No. 46 (revised December
2003) ("FIN 46R"), "Consolidation of Variable Interest Entities," which
addresses how a business enterprise should evaluate whether it has a controlling
financial interest in an entity through means other than voting rights and
accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation
No. 46, "Consolidation of Variable Interest Entities," which was issued in
January 2003. We are required to apply FIN 46R to variable interests in variable
interest entities or VIEs created after December 31, 2003. For any VIEs that
must be consolidated under FIN 46R that were created before January 1, 2004, the
assets, liabilities and noncontrolling interests of the VIE initially would be
measured at their carrying amounts with any difference between the net amount
added to the balance sheet and any previously recognized interest being
recognized as the cumulative effect of an accounting change. If determining the
carrying amounts is not practicable, fair value at the date FIN 46R first
applies may be used to measure the assets, liabilities and noncontrolling
interest of the VIE. We reviewed all of our investments and determined that the
EPPICS, issued by our consolidated wholly-owned subsidiary, Citizens Utilities
Trust, was our only VIE. The adoption of FIN 46R on January 1, 2004 did not have
any material impact on our financial position or results of operations.
Derivative Instruments and Hedging
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 adopted SFAS No. 149 on July 1, 2003. The
adoption of SFAS No. 149 did not have any material impact on our financial
position or results of operations.
Financial Instruments with Characteristics of Both Liabilities and Equity
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity." The Statement
establishes standards for the classification and measurement of certain
financial instruments with characteristics of both liabilities and equity.
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.
31
Pension and Other Postretirement Benefits
In December 2003, the FASB issued SFAS No. 132 (revised), "Employers'
Disclosures about Pensions and Other Postretirement Benefits." This Statement
retains and revises the disclosure requirements contained in the original
Statement. It requires additional disclosures including information describing
the types of plan assets, investment strategy, measurement date(s), plan
obligations, cash flows, and components of net periodic benefit cost recognized
in interim periods. This Statement is effective for fiscal years ending after
December 15, 2003. We have adopted the expanded disclosure requirements of SFAS
No. 132 (revised).
The FASB has issued an Exposure Draft that would require stock-based employee
compensation to be recorded as a charge to earnings for interim or annual
periods beginning after June 15, 2005. We will continue to monitor the progress
on the issuance of this standard.
(b) Results of Operations
---------------------
REVENUE
ILEC revenue is generated primarily through the provision of local, network
access, long distance and data services. Such services are provided under either
a monthly recurring fee or based on usage at a tariffed rate and is not
dependent upon significant judgments by management, with the exception of a
determination of a provision for uncollectible amounts.
CLEC revenue is generated through local, long distance, data and long-haul
services. These services are primarily provided under a monthly recurring fee or
based on usage at agreed upon rates and are not dependent upon significant
judgments by management with the exception of the determination of a provision
for uncollectible amounts and realizability of reciprocal compensation. CLEC
usage based revenue includes amounts determined under reciprocal compensation
agreements. While this revenue is governed by specific contracts with the
counterparty, management defers recognition of disputed portions of such revenue
until realizability is assured. Revenue earned from long-haul contracts is
recognized over the term of the related agreement.
Consolidated revenue for the three and nine months ended September 30, 2004
decreased $49.6 million, or 8% and $242.9 million, or 13%, as compared with the
prior year periods. The decrease for the three months ended September 30, 2004
is due to a $5.4 million decrease in ILEC revenue, a $1.2 million decrease in
ELI revenue and a $43.0 million decrease in gas and electric revenue. The
decrease for the nine months ended September 30, 2004 is due to a $14.4 million
decrease in ILEC revenue, a $7.9 million decrease in ELI revenue and a $220.6
million decrease in gas and electric revenue.
On April 1, 2003, we sold approximately 11,000 access lines in North Dakota. The
revenues related to these access lines totaled $1.9 million for the nine months
ended September 30, 2003.
TELECOMMUNICATIONS REVENUE
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
----------- ----------- ----------- -------- ----------- ----------- ------------ ----------
Access services $ 157,692 $ 167,321 $ (9,629) -6% $ 474,399 $ 503,517 $ (29,118) -6%
Local services 214,299 216,349 (2,050) -1% 640,458 644,511 (4,053) -1%
Long distance and data services 82,002 76,145 5,857 8% 240,177 230,315 9,862 4%
Directory services 27,312 26,817 495 2% 82,987 80,596 2,391 3%
Other 24,878 24,942 (64) 0% 82,919 76,397 6,522 9%
----------- ----------- ----------- ----------- ----------- ------------
ILEC revenue 506,183 511,574 (5,391) -1% 1,520,940 1,535,336 (14,396) -1%
ELI 39,210 40,416 (1,206) -3% 117,277 125,228 (7,951) -6%
----------- ----------- ----------- ----------- ----------- ------------
$ 545,393 $ 551,990 $ (6,597) -1% $1,638,217 $1,660,564 $(22,347) -1%
=========== =========== =========== =========== =========== ============
Change in the number of our access lines is the most fundamental driver of
changes in our telecommunications revenue. Many rural local telephone companies
(including us) have been experiencing a loss of access lines primarily because
of difficult economic conditions, increased competition from competitive
wireline providers, from wireless providers and from cable companies (with
respect to broadband and cable telephony), and by some customers disconnecting
second lines when they add high speed data service. We lost approximately 40,400
access lines during the nine months ended September 30, 2004 but added
approximately 67,000 DSL subscribers during this period. The loss of lines
during the first nine months of 2004 was primarily residential customers. The
non-residential line losses were principally in Rochester, New York, while the
residential losses were throughout our markets. We expect to continue to lose
access lines during the fourth quarter of 2004. A continued decrease in access
lines, combined with increased competition and the other factors discussed in
this MD&A, may cause our revenues to decrease during the remainder of 2004.
32
Access Services
Access services revenue for the three months ended September 30, 2004 decreased
$9.6 million or 6%, as compared with the prior year period. Switched access
revenue decreased $3.1 million, as compared with the prior year period,
primarily due to $2.7 million attributable to a decline in minutes of use.
Subsidies revenue decreased $7.0 million, as compared with the prior year
period, primarily due to a $2.4 million decline in federal universal service
fund support because of increases in the national average cost per loop, a $3.5
million accrual recorded during the third quarter of 2004 for mistakes made
during 2002 and 2003 by the agency that calculates subsidy payments and true ups
related to 2002.
Access services revenue for the nine months ended September 30, 2004 decreased
$29.1 million or 6%, as compared with the prior year period. Switched access
revenue decreased $16.1 million, as compared with the prior year period,
primarily due to the $7.4 million effect of federally mandated access rate
reductions effective as of July 1, 2003, $2.7 million associated with state
intrastate access rate reductions, $3.6 million attributable to a decline in
minutes of use and a $2.0 million decrease related to carrier disputes.
Subsidies revenue decreased $12.7 million, as compared with the prior year
period, primarily due to a $5.2 million decline in federal universal service
fund support because of increases in the national average cost per loop, a $3.5
million accrual recorded during the third quarter of 2004 for mistakes made
during 2002 and 2003 by the agency that calculates subsidy payments and true ups
related to 2002.
We expect our subsidy revenue to be approximately $10.0 million lower in 2004
than in 2003 primarily because of increases in the ceiling on national average
loop costs that is compared to our costs to determine the amount of subsidy
payments we receive. Our switched access revenues are impacted by the program,
known as the Coalition for Affordable Local and Long Distance Services, or CALLS
plan, which establishes a price floor for interstate-switched access services.
We have been able to offset some of the reduction in interstate access rates
through end-user charges. There are no material increases in end-user charges
scheduled to take effect during the remainder of 2004 or 2005. We believe the
net effect of reductions in interstate access rates and increases in end-user
charges will reduce our revenues by approximately $8.0 million in 2004 compared
to 2003 assuming constant interstate switched access minutes of use (which have
been declining). Annual reductions in interstate switched access rates will
continue through 2005. Our switched access revenues have also been adversely
affected by declining switched access minutes of use, which we expect to
continue.
We currently expect that our subsidy revenue in 2005 will be at least $19.0
million lower than 2004 because of the improvement in prior years in the
profitability of our operations and lower expenses and capital expenditures in
prior years than previously anticipated, and because of a recently announced
increase in the national average cost per loop (NACPL) from $286.18 to $298.45,
effective January 1, 2005. Increases in the number of competitive communications
companies (including wireless companies) receiving federal subsidies may lead to
further increases in the NACPL, thereby resulting in further decreases in our
subsidy revenue in the future. Increases in the NACPL during 2004 are expected
to decrease our subsidy revenue by $6.3 million in 2004 compared to 2003. The
FCC and state regulators are currently considering a number of proposals for
changing the manner in which eligibility for federal subsidies is determined as
well as the amounts of such subsidies. The FCC is also reviewing the mechanism
by which subsidies are funded. We cannot predict when or how these matters will
be decided nor the effect on our subsidy revenues.
Our subsidy and switched access revenues are very profitable so any reductions
in those revenues will reduce our profitability.
Local Services
Local services revenue for the three months ended September 30, 2004 decreased
$2.1 million or 1% as compared with the prior year period. Local revenue
decreased $4.7 million primarily due to $3.1 million related to continued losses
of access lines. Enhanced services revenue increased $2.6 million, as compared
with the prior year period, primarily due to sales of additional feature
packages.
Local services revenue for the nine months ended September 30, 2004 decreased
$4.1 million or 1% as compared with the prior year period. Local revenue
decreased $11.8 million primarily due to $5.0 million related to continued
losses of access lines, the termination of an operator services contract of $3.2
million and $2.0 million in decreased local measured service revenue. Enhanced
services revenue increased $7.8 million, as compared with the prior year period,
primarily due to sales of additional feature packages. Economic conditions or
increasing competition could make it more difficult to sell our packages and
bundles and cause us to lower our prices for those products and services, which
would adversely affect our revenues.
33
Long Distance and Data Services
Long distance and data services revenue for the three months ended September 30,
2004 increased $5.9 million or 8%, as compared with the prior year period
primarily due to growth of $8.4 million related to data services (data includes
DSL) partially offset by decreased long distance revenue of $2.6 million because
of a 22% decline in the average rate per minute. Long distance minutes of use,
however, grew 15% as a result of new long distance products we started offering
earlier this year that drove both market penetration and minutes of use.
Long distance and data services revenue for the nine months ended September 30,
2004 increased $9.9 million or 4%, as compared with the prior year period
primarily due to growth of $22.6 million related to data services (data includes
DSL) partially offset by decreased long distance revenue of $12.7 million
primarily attributable to a 20% decline in the average rate per minute. Our long
distance revenues could decrease in the future due to lower long distance
minutes of use because consumers are increasingly using their wireless phones or
calling cards to make long distance calls and lower average rates per minute
because of unlimited and packages of minutes for long distance plans. We expect
these factors will continue to adversely affect our long distance revenues
during the remainder of 2004.
Directory Services
Directory revenue for the nine months ended September 30, 2004 increased $2.4
million or 3%, as compared with the prior year period due to growth in yellow
pages advertising.
Other
Other revenue for the nine months ended September 30, 2004 increased $6.5
million or 9%, as compared with the prior year period primarily due to a $4.4
million carrier dispute settlement, $3.0 million in increased conferencing
revenue and a decline in bad debt expense of $2.6 million, partially offset by a
decrease of $3.2 million in sales of customer premise equipment.
ELI revenue for the three and nine months ended September 30, 2004 decreased
$1.2 million, or 3%, and $8.0 million, or 6%, respectively, as compared to the
prior year period primarily due to lower demand and prices for long-haul
services.
GAS AND ELECTRIC REVENUE
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
---------- ----------- ----------- -------- ----------- ----------- ------------ ----------
Gas revenue $ - $ 18,005 $ (18,005) -100% $ - $ 137,686 $ (137,686) -100%
Electric revenue $ - $ 25,042 $ (25,042) -100% $ 9,735 $ 92,603 $ (82,868) -89%
We did not have any gas or electric operations in the quarter ended June 30,
2004 due to the sales of our Vermont Electric division, The Gas Company in
Hawaii, and our Arizona gas and electric divisions.
Electric revenue for the nine months ended September 30, 2004 decreased $82.9
million, or 89%, as compared with the prior year period. We completed the sale
of our remaining electric utility property on April 1, 2004. We have sold all of
our electric operations and as a result will have no operating results in future
periods for these businesses.
COST OF SERVICES
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
----------- ----------- ----------- -------- ------------ ----------- ----------- ----------
Network access $ 51,273 $ 57,133 $ (5,860) -10% $ 151,109 $ 171,816 $ (20,707) -12%
Gas purchased - 12,324 (12,324) -100% - 82,311 (82,311) -100%
Electric energy and
fuel oil purchased - 16,412 (16,412) -100% 5,523 58,498 (52,975) -91%
----------- ----------- ----------- ----------- ----------- ------------
$ 51,273 $ 85,869 $ (34,596) -40% $ 156,632 $ 312,625 $ (155,993) -50%
=========== =========== =========== =========== =========== ============
34
Network access expenses for the three months ended September 30, 2004 decreased
$5.9 million, or 10%, as compared with the prior year period primarily due to
decreased costs in long distance access expense related to rate changes
partially offset by increased long distance usage and greater demand for data
products in the ILEC sector. Network access expenses for the nine months ended
September 30, 2004 decreased $20.7 million, or 12%, as compared with the prior
year period primarily due to decreased costs in long distance access expense
related to rate changes partially offset by increased circuit expense associated
with additional data product sales in the ILEC sector. ELI costs have declined
due to a drop in demand coupled with improved network cost efficiencies. If we
continue to increase our sales of data products such as DSL or expand the
availability of our unlimited calling plans, our network access expense could
increase.
We did not have any gas or electric operations in the quarter ended September
30, 2004 due to the sales of our Vermont Electric division, The Gas Company in
Hawaii, and our Arizona gas and electric divisions.
Electric energy and fuel oil purchased for the nine months ended September, 2004
decreased $53.0 million, or 91%, as compared with the prior year period. We
completed the sale of our remaining electric utility property on April 1, 2004.
We have sold all of our electric operations and as a result will have no
operating results in future periods for these businesses.
OTHER OPERATING EXPENSES
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
----------- ----------- ----------- -------- ----------- ----------- ------------ ----------
Operating expenses $ 156,571 $ 165,356 $ (8,785) -5% $ 473,445 $ 521,116 $ (47,671) -9%
Taxes other than income taxes 20,000 26,095 (6,095) -23% 72,015 84,982 (12,967) -15%
Sales and marketing 28,357 28,683 (326) -1% 85,643 82,492 3,151 4%
----------- ----------- ----------- ----------- ----------- ------------
$ 204,928 $ 220,134 $ (15,206) -7% $ 631,103 $ 688,590 $ (57,487) -8%
=========== =========== =========== =========== =========== ============
Operating expenses for the three months ended September 30, 2004 decreased $8.8
million, or 5%, as compared with the prior year period primarily due to
decreased operating expenses in the public services sector due to the sales of
our Vermont Electric division, The Gas Company in Hawaii, and our Arizona gas
and electric divisions and increased operating efficiencies and a reduction of
personnel in the ELI sector partially offset by higher payroll and employee
benefits expenses in the ILEC sector.
Operating expenses for the nine months ended September 30, 2004 decreased $47.7
million, or 9%, as compared with the prior year period primarily due to
decreased operating expenses in the public services sector due to the sales of
our Vermont Electric division, The Gas Company in Hawaii, and our Arizona gas
and electric divisions and increased operating efficiencies and a reduction of
personnel in the ELI sector. We routinely review our operations, personnel and
facilities to achieve greater efficiencies. These reviews may result in
reductions in personnel and an increase in severance costs.
Included in operating expenses is stock compensation expense. Compensation
arrangements entered into in connection with management succession and strategic
alternatives will result in stock compensation expense of approximately $5.2
million in 2005, $5.1 million in 2006 and $1.0 million in 2007.
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 decrease from $12.4 million in
2003 to approximately $3.0 million - $4.0 million in 2004 and that no
contribution to our pension plans will be required to be made by us to the
pension plan in 2004. In addition, as medical costs increase the costs of our
postretirement benefit costs also increase. Our retiree medical costs for 2003
were $16.9 million and our current estimate for 2004 is $17.0 - $19.0 million.
Taxes other than income taxes for the three months ended September 30, 2004
decreased $6.1 million, or 23%, as compared with the prior year period primarily
due to decreased property taxes in the public services sector due to the sales
of our Vermont Electric division, The Gas Company in Hawaii, and our Arizona gas
and electric divisions of $2.2 million and lower gross receipts taxes of $4.9
million in the ILEC sector partially offset by higher payroll and franchise
taxes of $2.4 million.
Taxes other than income taxes for the nine months ended September 30, 2004
decreased $13.0 million, or 15%, as compared with the prior year period
primarily due to decreased property taxes in the public services sector due to
the sales of our Vermont Electric division, The Gas Company in Hawaii, and our
Arizona gas and electric divisions of $11.6 million.
35
Sales and marketing expenses for the nine months ended September 30, 2004
increased $3.2 million, or 4%, as compared with the prior year period primarily
due to increased costs in the ILEC sector.
DEPRECIATION AND AMORTIZATION EXPENSE
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
----------- ----------- ----------- -------- ----------- ----------- ------------ ----------
Depreciation expense $ 109,750 $ 120,012 $ (10,262) -9% $ 334,760 $ 345,577 $ (10,817) -3%
Amortization expense 31,630 31,866 (236) -1% 94,890 95,208 (318) 0%
----------- ----------- ----------- ----------- ----------- ------------
$ 141,380 $ 151,878 $ (10,498) -7% $ 429,650 $ 440,785 $ (11,135) -3%
=========== =========== =========== =========== =========== ============
Depreciation expense for the three and nine months ended September 30, 2004
decreased $10.3 million, or 9%, and $10.8 million, or 3%, respectively, as
compared to the prior year because the net asset base is declining.
RESERVE FOR TELECOMMUNICATIONS BANKRUPTCIES / RESTRUCTURING AND OTHER EXPENSES /
MANAGEMENT SUCCESSION AND STRATEGIC ALTERNATIVES EXPENSES
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
----------- ----------- ----------- -------- ----------- ----------- ------------ ----------
Reserve for telecommunications
bankruptcies $ - $ - $ - - $ - $ 2,260 $ (2,260) -100%
Restructuring and other expenses $ - $ - $ - - $ - $ 9,950 $ (9,950) -100%
Management succession and
strategic alternatives expenses $ 75,858 $ - $ 75,858 100% $ 90,632 $ - $ 90,632 100%
During the second quarter 2003, we reserved approximately $2.3 million of trade
receivables with Touch America as a result of Touch America's filing for
bankruptcy. These receivables were generated as a result of providing ordinary
course telecommunication services. If other telecommunications companies file
for bankruptcy we may have additional significant reserves in future periods.
Restructuring and other expenses for 2003 primarily consist of expenses related
to reductions in personnel at our telecommunications operations and the write
off of software no longer useful.
Management succession and strategic alternatives expenses in 2004 include a mix
of cash retention payments, equity awards and severance agreements (see Note 12
for a complete discussion).
INVESTMENT AND OTHER INCOME (LOSS), NET / INTEREST EXPENSE / INCOME TAX EXPENSE (BENEFIT)
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
----------- ----------- ----------- -------- ----------- ----------- ------------ ----------
Investment and other
income (loss), net $ (13,651) $ (24,277) $ 10,626 44% $ 16,856 $ 55,132 $ (38,276) -69%
Interest expense $ 90,864 $ 103,124 $ (12,260) -12% $ 286,298 $ 318,836 $ (32,538) -10%
Income tax expense
(benefit) $ (21,271) $ (7,210) $ (14,061) 195% $ 15,123 $ 57,150 $ (42,027) -74%
Investment and other income (loss), net for the three months ended September 30,
2004 increased $10.6 million, or 44%, as compared with the prior year period
primarily due to gains on sales of assets in 2004 of $10.7 million compared to
losses on sales of assets of $16.8 million in 2003, partially offset by an
increase in premiums paid on debt repurchases of $12.8 million due to the 2004
repurchase of our debt.
Investment and other income (loss), net for the nine months ended September 30,
2004 decreased $38.3 million, or 69%, as compared with the prior year period.
The decrease is primarily due to gains on sales of assets in 2004 of $9.4
million compared to losses on sales of assets of $11.8 million in 2003, an
increase of $19.2 million in income from the expiration of certain retained
liabilities at less than face value, which are associated with customer advances
for construction from our disposed water properties, partially offset by an
increase in premiums paid on debt repurchases of $9.4 million due to the 2004
repurchase of our debt, and the recognition in 2003 of $65.7 million in non-cash
pre-tax gains related to a capital lease termination and a capital lease
restructuring at ELI.
36
Interest expense for the three months ended September 30, 2004 decreased $12.3
million, or 12%, as compared with the prior year period primarily due to the
retirement of debt. During the three months ended September 30, 2004, we had
average long-term debt (excluding equity units and convertible preferred stock)
outstanding of $4.2 billion compared to $4.4 billion during the three months
ended September 30, 2003. Our composite average borrowing rate for the three
months ended September 30, 2004 as compared with the prior year period was 8
basis points lower, decreasing from 8.08% to 8.0%.
Interest expense for the nine months ended September 30, 2004 decreased $32.5
million, or 10%, as compared with the prior year period primarily due to the
retirement of debt. During the nine months ended September 30, 2004, we had
average long-term debt (excluding equity units and convertible preferred stock)
outstanding of $4.2 billion compared to $4.6 billion during the nine months
ended September 30, 2003. Our composite average borrowing rate for the nine
months ended September 30, 2004 as compared with the prior year period was 3
basis points lower, decreasing from 8.09% to 8.06%.
Income taxes decreased $14.1 million for the third quarter of 2004 and $42.0
million, or 74%, for the nine months ended September 30, 2004 as compared with
the prior year periods primarily due to changes in taxable income. The effective
tax rate for the first nine months of 2004 was 21.5% as compared with 33.8% for
the first nine months of 2003. Our effective tax rate has declined as a result
of the completion of audits with federal and state taxing authorities in the
third quarter 2004 and changes in the structure of certain of our subsidiaries.
Our income tax expense is computed utilizing an estimated annual effective
income tax rate in accordance with Accounting Principles Board Opinions (APB)
No. 28, "Interim Financial Reporting." The tax rate is computed using estimates
as to the Company's net income before income taxes for the entire year and the
impact of estimated permanent book tax differences relative to that forecast.
LOSS ON IMPAIRMENT
($ in thousands) For the three months ended September 30, For the nine months ended September 30,
-------------------------------------------- -----------------------------------------------
2004 2003 $ Change % Change 2004 2003 $ Change % Change
--------- ------------- ----------- -------- ----------- ----------- ------------ ----------
Loss on impairment $ - $ 4,000 $ (4,000) -100% $ - $ 4,000 $ (4,000) -100%
During the third quarter of 2003, we recognized an additional non-cash pre-tax
impairment loss of $4.0 million related to our Vermont property, such that the
net assets were written down to our best estimate of the net realizable value
upon sale. As of April 1, 2004, we sold all of these properties.
37
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
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 weighted average interest rates.
Our objectives in managing our interest rate risk are to limit the impact of
interest rate changes on earnings and cash flows and to lower our overall
borrowing costs. To achieve these objectives, a majority of our borrowings have
fixed interest rates. Consequently, we have limited material future earnings or
cash flow exposures from changes in interest rates on our long-term debt and
capital lease obligations. A hypothetical 10% adverse change in interest rates
would increase the amount that we pay on our variable obligations and could
result in fluctuations in the fair value of our fixed rate obligations. Based
upon our overall interest rate exposure at September 30, 2004, 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 have entered into
interest rate swap agreements. 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.
Sensitivity analysis of interest rate exposure
At September 30, 2004, the fair value of our long-term debt and capital lease
obligations was estimated to be approximately $4.4 billion, based on our overall
weighted average rate of 8.04% 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, 2003. The overall weighted average interest
rate decreased approximately 5 basis points during the first nine months of
2004. A hypothetical increase of 80 basis points (10% of our overall weighted
average borrowing rate) would result in an approximate $209.1 million decrease
in the fair value of our fixed rate obligations.
Equity Price Exposure
Our exposure to market risks for changes in equity prices is minimal and, as of
September 30, 2004, is limited to our investment in Adelphia.
As of September 30, 2004 and December 31, 2003, we owned 3,059,000 shares of
Adelphia common stock. The stock price of Adelphia was $0.38 and $0.55 at
September 30, 2004 and December 31, 2003, respectively.
On August 13, 2004, we sold our entire 1,333,500 shares of D & E Communications,
Inc. (D & E) for approximately $13.3 million in cash.
On September 3, 2004, we sold our entire holdings of 2,605,908 common share
equivalents in Hungarian Telephone and Cable Corp. (HTCC) for approximately
$13.2 million in cash.
Sensitivity analysis of equity price exposure
At September 30, 2004, the fair value of the equity portion of our investment
portfolio was estimated to be $1.2 million. A hypothetical 10% decrease in
quoted market prices would result in an approximate $120,000 decrease in the
fair value of the equity portion of our investment portfolio.
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 September 30, 2004. 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.
38
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, regarding the effectiveness of the design and operation of
our disclosure controls and procedures. Based upon this evaluation, our
principal executive officer and principal financial officer concluded, as of the
end of the period covered by this report, September 30, 2004, that our
disclosure controls and procedures are effective.
(b) Changes in internal control over financial reporting
We reviewed our internal control over financial reporting at September 30, 2004.
There have been no changes in our internal control over financial reporting
identified in an evaluation thereof that occurred during the third fiscal
quarter of 2004, that materially affected or is reasonably likely to materially
affect our internal control over financial reporting.
PART II. OTHER INFORMATION
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Item 1. Legal Proceedings
-----------------
There have been no material changes to our legal proceedings from the
information provided in Item 1. Legal Proceedings included in our Quarterly
Report on Form 10-Q for the period ended June 30, 2004.
We are party to other legal 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.
Item 5. Other Information
-----------------
On October 29, 2004, we entered into a new $250.0 million line of credit
pursuant to a Competitive Advance Revolving Credit Facility Agreement among us,
the lenders party to the agreement, Bank of America, N.A., as administrative
agent and issuing bank, JPMorgan Chase Bank, as Syndication Agent and Morgan
Stanley Bank, Deutsche Bank Trust Company Americas, the Royal Bank of Scotland
PLC, and UBS Loan Finance LLC, as co-documentation agents. The maturity date of
the new facility is October 29, 2009.
The new facility permits borrowings at interest rates equal to (i) the
eurodollar base rate, plus an applicable rate or a margin, or (ii) an alternate
base rate. Associated facility fees for the new credit facility vary depending
on our leverage ratio and were 0.375% as of October 29, 2004. During the term of
the new credit facility we may borrow, repay and re-borrow funds. The new credit
facility is available for general corporate purposes but may not be used to fund
dividend payments. There are no outstanding borrowings under the new facility as
of the date of this report.
The new facility contains, among other things, conditions precedent to borrowing
(including absence of a material adverse change), covenants, representations and
warranties and events of default customary for facilities of this type. Such
covenants include certain restrictions on incurrence of secured indebtedness,
mergers and sales of assets. The new credit facility also contains 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 $50.0 million to (ii) consolidated adjusted EBITDA (as defined in the
agreement) over the last four quarters no greater than 4.50 to 1.00 through the
term of the credit facility. Although the new credit facility is unsecured, it
will be equally and ratable secured by certain liens and equally and ratable
guaranteed by certain of our subsidiaries if we issue debt that is secured or
guaranteed.
Under certain conditions the lending commitments under the new facility may be
terminated by the lenders and amounts outstanding under the new facility may be
accelerated. Bankruptcy and insolvency events with respect to us or certain of
our subsidiaries will result in an automatic termination of lending commitments
and acceleration of the indebtedness under the new facility. Subject to notice
and cure periods in certain cases, other events of default under the new
facility will result in termination of lending commitments and acceleration of
indebtedness under the new facility at the option of the lenders. Such other
events of default include failure to pay any principal when due, failure to
comply with covenants, breach of representations or warranties in any material
respect, non-payment or acceleration of our and our subsidiaries' other material
debt or a change of control of our company. A complete copy of the new credit
facility agreement has been filed as an exhibit to this Form 10-Q.
The new credit facility replaces the $805.0 million lines of credit under
Competitive Advance and Revolving Credit Facility Agreements dated October 24,
2001. As of the time of the cancellation, there were no outstanding borrowings
under the lines of credit.
39
Item 6. Exhibits and Reports on Form 8-K
--------------------------------
a) Exhibits:
3.200.5 By-laws of Citizens Communications Company, as amended through
July 10, 2004.
10.16 Employment Agreement between Citizens Communications Company
and Mary A. Wilderotter, effective November 1, 2004.
10.17 Employment Agreement between Citizens Communications Company
and Jerry Elliott, effective September 1, 2004.
10.18 Employment Agreement between Citizens Communications Company
and Robert Larson, effective September 1, 2004.
10.19 Competitive Advance and Revolving Credit Facility Agreement
for $250,000,000 dated October 29, 2004.
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.
99.1 Disclaimed Employment and Retention Agreement between Michael
G. Harris and Citizens Communications Company, effective June
1, 2004.
b) Reports on Form 8-K:
We filed a Form 8-K on July 8, 2004 under Item 11 "Temporary
Suspension of Trading Under Registrant's Employee Benefit Plan",
announcing the blackout period associated with the Company's election
to change the record keeper for the Citizens 401(k) Savings Plan.
We filed on Form 8-K on July 12, 2004 under Item 5 "Other Events", a
press release announcing the completion of our review of financial and
strategic alternatives.
We furnished on Form 8-K on August 3, 2004 under Item 12 "Disclosure
of Results of Operations and Financial Condition", a press release
announcing our earnings for the quarter and six months ended June 30,
2004.
We filed on Form 8-K on August 5, 2004 under Item 5 "Other Events", a
press release announcing the expected reset interest rate on our 6.75%
Senior Notes.
40
We filed on Form 8-K on September 21, 2004 under Item 1.01 "Entry into
Material Definitive Agreements", Item 5.02 "Departure of Directors or
Principal Officers; Election of Directors; Appointment of Principal
Officers" and Item 8.01 "Other Events", information concerning the
entry by the Company into employment agreements and the appointment of
Mary A. Wilderotter as President and Chief Executive Officer of the
Company, including a press release announcing Ms. Wilderotter's
appointment.
We filed on Form 8-K on September 27, 2004 under Item 5.02 "Departure
of Directors or Principal Officers; Election of Directors; Appointment
of Principal Officers" and Item 8.01 "Other Events" and Item 9.01
"Financial Statements and Exhibits", information concerning the
resignation of Leonard Tow as Director and Chairman of the Company's
Board of Directors, and the resignation of Claire Tow, Mr. Tow's wife,
as a Director of the Company, including a press release announcing
these events.
We filed on Form 8-K on September 30, 2004 under Item 5.02 "Departure
of Directors or Principal Officers; Election of Directors; Appointment
of Principal Officers" and Item 8.01 "Other Events" and Item 9.01
"Financial Statements and Exhibits", information concerning the
appointment of Rudy J. Graf Chairman of the Company's Board of
Directors, and the election of Mary A. Wilderotter, who became
President and Chief Executive Officer of the Company on November 1,
2004, and Jerry Elliott, Executive Vice President and Chief Financial
Officer of the Company to the Board of Directors, including a press
release announcing these events.
41
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CITIZENS COMMUNICATIONS COMPANY
-------------------------------
(Registrant)
By: /s/ Robert J. Larson
--------------------------------
Robert J. Larson
Senior Vice President and
Chief Accounting Officer
Date: November 4, 2004
42