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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]
For the fiscal year ended December 31, 2003
Commission File Number: 001-13891
HECTOR COMMUNICATIONS CORPORATION
Minnesota 41-1666660
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(State or other jurisdiction (Federal Employer
of incorporation or organization) Identification No.)
211 South Main Street
P.O. Box 428
Hector, MN 55342
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (320) 848-6611
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Common Stock, $.01 par value
Securities registered pursuant to Section 12(g) of the Act: None
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 and (2) has been subject to such filing requirements for
the past 90 days. Yes [X] No [ ]
Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by a check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Act). Yes [ ] No [X]
The aggregate market value of the voting stock held by non-affiliates of the
Registrant was approximately $54,586,000 based upon the closing sale price of
the Company's common stock on the American Stock Exchange on March 22, 2004.
As of March 22, 2004 there were outstanding 3,608,813 shares of the Registrant's
common stock.
Documents Incorporated by Reference: Portions of the Company's definitive proxy
statement for its Annual Meeting of Shareholders to be held on May 20, 2004 are
incorporated by reference into Part III of this Form 10-K.
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TABLE OF CONTENTS
Item Page
PART I
1. Business 3
2. Properties 15
3. Legal Proceedings 15
4. Submission of Matters to a Vote of Security Holders 15
PART II
5. Market for Company's Common Equity and Related Stockholder Matters 16
6. Selected Financial Data 17
7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 18
7A Quantitative and Qualitative Disclosures About Market Risk 26
8. Financial Statements and Supplementary Data 27
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 51
9A Controls and Procedures 51
PART III
10. Directors and Executive Officers of the Registrant 52
11. Executive Compensation 52
12. Security Ownership of Certain Beneficial Owners and Management 52
13. Certain Relationships and Related Transactions 52
14. Principal Accountant Fees and Services 52
PART IV
15. Exhibits, Financial Statement Schedule and Reports on Form 8-K 53
2
PART I.
ITEM 1. BUSINESS
[a] GENERAL DEVELOPMENT OF BUSINESS
Hector Communications Corporation ("HCC" or "Company") is a
telecommunications holding company which, through its wholly-owned subsidiaries,
primarily provides local telephone, cable television and internet access
services. The Company also participates in the ownership of other companies
providing wireless telephone and other telecommunications related services.
HCC operates five local exchange company subsidiaries (generally referred
to as "local exchange carriers" or "LECs") which served 7,532 access lines in 9
rural communities in Minnesota and Wisconsin at December 31, 2003. HCC, through
its wholly-owned subsidiaries, also provides cable television service or video
service to 4,357 subscribers in Minnesota and Wisconsin.
HCC's 100% owned subsidiary, Alliance Telecommunications Corporation
("Alliance"), owns and operates four additional LEC subsidiaries which served
22,350 access lines in 19 rural communities in Minnesota, Wisconsin and North
Dakota at December 31, 2003. Alliance, through its subsidiaries, also served
4,752 cable television and video subscribers in Minnesota.
Prior to July 7, 2003 Alliance Telecommunications Corporation
("Alliance") was 68% owned by HCC. ("Golden West") of Wall, South Dakota and
Alliance Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota
owned the remaining interests in Alliance. Effective July 7, 2003 Alliance was
reorganized under Section 355 of the Internal Revenue Code ("the split-up
transactions'). In the split-up transactions, Golden West exchanged its minority
ownership interest in Alliance for all of the outstanding stock of Sioux Valley
Telephone Company, which included a pro rata share of Alliance's ownership
interest in Midwest Wireless Holdings, LLC and certain other Alliance assets.
ACCI exchanged its minority ownership interest in Alliance for all of the
outstanding stock of Hills Telephone Company, which included a pro rata share of
Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain
other Alliance assets. HCC became the 100% owner of all remaining Alliance
assets and operations. (See "Split-up of Alliance Telecommunications
Corporation" in Item 7.) The disclosures in this report related to prior periods
have been restated to reflect the Company's continuing operations.
The Company maintains a website at www.hectorcom.com. Our Annual Reports
on Form 10-K, our Quarterly Reports on Form 10-Q and our periodic reports on
Form 8-K (and any amendments to these reports) are available free of charge by
linking from our website to the Securities & Exchange Commission's website.
[b] FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Company is organized in two business segments, Hector Communications
Corporation and its subsidiaries, and Alliance Telecommunications Corporation
and its subsidiaries. Information regarding segment operations is provided in
Note 13 to the financial statements found under Item 8 of this report.
[c] NARRATIVE DESCRIPTION OF BUSINESS
The Company derives the majority of its revenues from providing basic
telephone services (often referred to as "plain old telephone service" or
"POTS") to residential and business customers within its service territories.
POTS revenues consist mainly of fees for local service which are billed directly
to customers and access revenues which are received for intrastate and
interstate exchange services provided to long distance carriers. POTS revenues
are subject to regulation by a number of state and federal government agencies.
The Company also earns revenues by providing a number of nonregulated
telecommunications services to customers. These services include cable
television or video service, internet access services, lease of fiber optic
transport facilities, billing and collection services to long distance carriers,
telephone directory services, engineering services and equipment rental. The
Company also makes retail sales of consumer telecommunications equipment and
sells wireless telephone services on a commission basis.
3
The following table presents the percentage of revenues derived from
local service revenues, access revenues, nonregulated telecommunications
activities and cable television operations for the last three years:
Year Ended December 31
----------------------------------------
2003 2002 2001
------ ------ ------
Local network 18.9% 19.3% 18.0%
Network access 49.7 50.1 51.2
Video services 11.1 12.1 11.4
Internet services 8.2 6.4 5.1
Other nonregulated services 12.1 12.1 14.3
------ ------ ------
100.0% 100.0% 100.0%
====== ====== ======
The Company also owns minority interests in joint ventures, partnerships
and limited liability corporations ("LLCs") that provide a wide variety of
telecommunications services, including wireless telephone services, fiber-optic
transport services and telephone switching services. The Company's most
significant minority ownership position is its 8% interest in Midwest Wireless
Holdings LLC.
(1) Plain Old Telephone Service ("POTS")
Local Network
-------------
The Company's LEC subsidiaries provide basic local telephone services to
residential and business customers in Minnesota, Wisconsin and North Dakota.
Local service revenues are earned by providing customers with local service to
connecting points within the local exchange boundaries and, in certain cases, to
nearby local exchanges under extended area service ("EAS") plans that eliminate
long distance charges to the neighboring exchanges. Monthly rates for telephone
service differ among the LECs depending upon the cost of providing service, the
type and grade of service, the number of customers and calling patterns within
the toll free calling area and other factors. The following chart presents the
number of access lines served by the Company's LEC subsidiaries at December 31,
2003, 2002 and 2001:
Access Lines*
--------------------------------
December 31
--------------------------------
2003 2002 2001
------ ------- ------
Hector Communications Corporation:
Arrowhead Communications Corporation 804 806 808
Eagle Valley Telephone Company 719 747 727
Granada Telephone Company 287 296 289
Pine Island Telephone Company 3,339 3,368 3,313
Indianhead Telephone Company 2,383 2,403 2,392
------ ------ ------
Total Hector Access Lines 7,532 7,620 7,529
------ ------ ------
Alliance Telecommunications Corporation:
Loretel Systems, Inc. 13,253 13,286 13,300
Sleepy Eye Telephone Company 6,298 6,503 6,556
Felton Telephone Company 732 765 752
Hager TeleCom, Inc. 2,067 2,061 2,037
------ ------ ------
Total Alliance Access Lines 22,350 22,615 22,645
------ ------ ------
Total Access Lines 29,882 30,235 30,174
====== ====== ======
* An "access line" is a single or multi-party circuit between the customer's
establishment and the central switching office.
The Company's LEC subsidiaries offer their customers a number of enhanced
telecommunications services, including custom calling features like call
waiting, caller identification and voice mail. Charges for custom calling
services are generally billed monthly together with the customers' local service
bill.
The Company maintains a local presence in each of its LEC subsidiaries.
The Company provides its LEC subsidiaries with various services, including
4
finance, accounting and treasury services, marketing, customer service,
purchasing, engineering and construction, customer billing, rate administration,
credit and collection, and development of administrative and procedural
practices.
Access Revenues
---------------
Access revenues are received by LECs for intrastate and interstate
exchange services provided to long distance carriers (generally referred to as
interexchange carriers or "IXCs"). These services enable IXCs to provide long
distance service to end users in the local exchange network.
Access revenues are determined, in the case of interstate calls,
according to rules promulgated by the Federal Communications Commission ("FCC")
and administered by the National Exchange Carriers Association ("NECA"). In the
case of intrastate calls, access revenues are determined by state regulatory
agencies. In 2003, approximately 70% of the Company's access revenues were from
interstate sources and 30% were from intrastate sources.
A portion of the Company's interstate access revenue is derived from
subscriber line charges ("SLCs") determined by the FCC and billed directly to
end users for access to long distance carriers. Another portion consists of
universal service funds received based upon the high cost of providing service
to rural areas. The balance of the interstate access revenue is received from
NECA, which collects payments from IXCs and distributes settlement payments to
LECs.
Settlement payments are based on a number of factors, including the cost
of providing service and the amount of time the local network is utilized to
provide long distance services. Through the 1980s and 1990s a variety of
factors, including increased subscriber counts, cultural and technological
changes, and rate reductions by IXCs, resulted in a consistent pattern of
increasing use of the nation's telephone network. This growth produced higher
revenues for NECA and increased settlements for its participating LECs.
Intrastate access revenues are received from long distance carriers based
on recorded customer usage multiplied by the appropriate tariff rate. Where
applicable, HCC's LECs participate in intrastate access tariffs approved by
state regulatory authorities for intrastate intra-LATA (Local Access Transport
Area) and inter-LATA services. These intrastate arrangements are intended to
compensate LECs for the costs, including a fair rate of return, of facilities
provided in originating and terminating intrastate long distance services.
(2) Nonregulated Telecommunications Activities
Video services
--------------
The Company, through its cable television and LEC subsidiaries, provide
cable television services to 9,109 subscribers in Minnesota and the surrounding
states. Video service revenues are derived almost exclusively from monthly fees
for basic and premium programming. Fees for basic services range from $9.00 to
$44.85 per month. Basic service generally includes the major television
networks, non-network independent stations, sports programming, news services
and automated information channels, children's programming, access channels for
public, governmental, educational and leased use, senior citizens' programming
and religious programming. Premium programming services, such as the HBO or
ShowTime movie services, are provided to subscribers for an additional fee of
$1.75 to $11.00 per month per channel. Premium programming is obtained from
suppliers for a flat monthly fee per subscriber and/or a fee based on the
monthly charge to subscribers for the service.
In 2001 and 2002 the Company deployed broadband equipment manufactured by
Next Level Communications, Inc. in its exchanges serving Pine Island, MN,
Goodhue, MN and Sleepy Eye, MN. This equipment makes it possible to deliver
POTS, video and high speed Internet services to the customer over the same
circuit. Video programming is delivered utilizing a digital "super headend"
owned by Broadband Visions, LLC, in which the Company is an investor. The
Company is planning to install broadband equipment in additional exchanges in
future years. The Company's broadband product offerings are dependent on the
availability of equipment from Next Level Communications, Inc. If the Company
cannot obtain necessary equipment it could have a material adverse affect on its
operations.
5
Internet
--------
Revenues from internet services were $2,647,000, $1,945,000 and
$1,591,000 in 2003, 2002 and 2001, respectively. Internet access is available,
through local dial-up telephone numbers, to all of the Company's local service
customers. Digital subscriber lines ("DSL") permit high-speed Internet access
and are available in many of the Company's service areas. The Company provided
dial-up internet services to 7,464, 7,558 and 7,217 customers at December 31,
2003, 2002 and 2001 respectively. The Company provided DSL services to 2,778,
1,601 and 709 customers at December 31, 2003, 2002 and 2001, respectively.
Nearly two-thirds of the Company's DSL subscribers are in the Pine Island,
Sleepy Eye and Goodhue exchanges where service is available utilizing Next Level
equipment.
Other services
--------------
HCC's LECs provide fiber optic transport facilities, sell and lease
customer premise telephone equipment, provide inside wiring services and sell
and lease other facilities for private line, teletype, data transmission and
other communications services. They also provide billing and collection services
for certain IXCs in lieu of such IXCs directly billing customers within the
LEC's service areas.
Due to changes in market conditions the Company renegotiated several of
its fiber leases in 2001 and 2003, resulting in a significant decline in lease
revenue. All of the fiber-optic facilities leased are owned by HCC's LEC
subsidiaries and are located within the LEC's local exchange boundaries.
HCC's revenues from other nonregulated services were as follows:
2003 2002 2001
----------- ----------- -----------
Fiber leases $ 682,521 $ 800,039 $ 1,136,612
Engineering fees 305,423 438,534 464,807
Directory 491,902 404,136 426,250
Billing and collection 212,622 289,723 409,557
Retail sales 522,269 346,508 540,595
Cellular sales commissions 316,337 333,714 300,146
Resale of long distance service 381,825 250,937 214,385
Equipment rent 118,292 62,457 91,696
Other 871,816 768,456 861,564
----------- ----------- -----------
$ 3,903,007 $ 3,694,504 $ 4,445,612
=========== =========== ===========
(3) Unconsolidated Affiliates and Investments
Midwest Wireless Holdings LLC
-----------------------------
Midwest Wireless Holdings LLC ("Midwest Wireless") provides wireless
telecommunications services to 357,000 customers in fourteen rural service areas
and one metropolitan service area in Minnesota, Wisconsin and Iowa. Population
of the service areas is approximately 1,910,000. Midwest Wireless offers a
complete package of services, including custom calling features, facsimile and
data transmission.
Midwest Wireless is owned by telecommunications companies (principally
ILECs) located within Midwest Wireless' operating footprint in southern
Minnesota, northern Iowa and southeastern Wisconsin. HCC is presently the second
largest member of Midwest Wireless Holdings LLC, with an 8.0% ownership stake.
HCC actively participates in Midwest Wireless' operations and has had a seat on
the Board of Directors since the inception of the Company. HCC influences
Midwest Wireless policies and procedures applying to administration, planning
and budgeting, cell siting, technology selection, roaming agreements,
affiliation agreements, marketing and customer service, financing, accounting
policies and financial reporting and disclosure policies and the timing of
financial reports. HCC accounts for its investment in Midwest Wireless using the
equity method. Income recognized was $2,148,000, $2,261,000 and $1,153,000 in
2003, 2002 and 2001, respectively.
Fiber-Optic Transport Investments
---------------------------------
The Company is an investor in three companies that build and lease fiber-
optic transport facilities. These facilities afford high-quality, high-capacity
communications links and generally are used to carry long-distance traffic.
Through these investments, the Company owns pieces of fiber routes serving the
Twin Cities, Milwaukee, Madison, Duluth-Superior, Sioux Falls, Fargo-Moorhead,
Rochester, St. Cloud and Grand Forks.
6
Other Investments
-----------------
The Company is an investor in 702 Communications, a CLEC providing
telecommunications services in the Fargo-Moorhead area, Wahpeton, ND and
Breckinridge MN. The Company is also an investor in Desktop Media, Inc., a CLEC
using a network employing ethernet architecture to provide telecommunications
services in southeastern Minnesota.
Wireless North, LLC
-------------------
The Company was a 10.4% owner of Wireless North, which provided personal
communications services ("PCS") to parts of Minnesota, Wisconsin, Iowa, North
Dakota and South Dakota. Wireless North was unsuccessful and has been
liquidated. Its licenses and systems were sold to other operators, or were shut
down. In 2001, the Company made payments to Wireless North's primary lender of
$1,129,000 to satisfy loan guarantees it gave with respect to Wireless North's
debt. Cash investments in Wireless North by the Company totaled $3,202,000. The
Company has written off its entire investment in Wireless North, has no
obligation to provide additional funding and does not expect to realize any
additional value from this investment.
(4) Other Investments
Bank Stocks
-----------
As part of its borrowing agreements, the Company has investments in
CoBank, Rural Telephone Finance Cooperative and the Rural Telephone Bank that
totaled $3,609,000 and $5,241,000 at December 31, 2003 and 2002 respectively.
Onvoy, Inc.
-----------
Onvoy, Inc. is a privately held company that provides integrated voice,
data, and network services through its fiber optic communications network
linking communities throughout Minnesota, including all major metropolitan
areas. Onvoy, Inc. is a provider of Internet, long distance, video-conferencing
and high-speed data networking services. Onvoy's customers include Minnesota
based Fortune 500 companies and many small-to-medium sized businesses. Onvoy
also serves the state's higher education institutions, the state's K-12 schools,
public libraries, state and county governments, more than 70 regional Internet
service providers and the state's independent local telephone companies. During
2001 the Company purchased $190,000 of debt issued by Onvoy to provide
additional working capital to Onvoy's operations. At December 31, 2003, the
Company's investment in Onvoy debt totaled $626,000.
Other long-term investments
---------------------------
The Company has long-term investments in Independent Information Services
Corp. and NECA, Inc., which it accounts for using the cost method. The Company
also has receivables from economic development loans made through the Rural
Utilities Service and has other small investments.
(5) Competition
Telephone Service
LECs are subject to many forms of competition. Its competitors
principally are:
- Facilities-based competition from providers, including cable television
service providers, with their own local service network;
- Resale competition from resale interconnection (providers who purchase
local services from the LEC at wholesale rates and resell the services to
their customers);
- Competition from unbundled network element interconnection (providers who
lease some of the network elements from the LEC)
- Wireless providers who may charge a competitive fee for services that
could compete with wireline based local service.
7
Rural areas like those served by the Company are less likely to
experience competition from facilities-based competitors due to the significant
investment in plant and equipment required in relation to the lower customer
density in rural markets. Competition from resale interconnection or unbundled
network element interconnection is more likely. Under the Telecommunications Act
of 1996, (the "Telecommunications Act") the Company's LECs are not currently
required to lease facilities to competitors seeking to interconnect with its
networks. However, there is no assurance that interconnection may not be
required in the future.
Wireless service has always competed directly with wireline local service
among certain classes of customers, principally customers with seasonal or lake
homes. Newer wireless service offerings that bundle local and long distance
minutes for a flat fee are competing with wireline services over a broader class
of customers. These wireless service offerings can be particularly attractive in
rural areas, where the toll free dialing areas offered by wireline carriers are
usually quite small. The Company believes that significant numbers of long
distance minutes are migrating from the wireline to the wireless network due to
these rate plans. This drives down the revenues of IXCs and reduces the
Company's access revenues. Developments in technology related to cellular, PCS,
digital microwave, coaxial cable, fiber optics and other wireline or wireless
services could also lead to greater competition for traditional local services.
LECs are increasingly subject to competition from competing access
providers ("CAPs") which construct, modify or lease facilities that enable high
volume long distance users to bypass the local telephone network. Cable
television companies may also be able to modify their networks to carry
telephone messages that bypass the local telephone network. The Company believes
its LEC subsidiaries have experienced only a small loss of traffic due to
bypass.
Video Services
In addition to competition from off-air television, other technologies
also supply services that compete with cable television. These include low power
television stations, multi-point distribution systems, over-the-air subscription
television and direct broadcast satellite ("DBS"). Cable television also
competes for customers in local markets with providers of other forms of
entertainment, news and information. These competitors include radio,
newspapers, magazines, motion picture theaters, video cassettes and Internet
service providers.
All of the Company's cable television franchises are non-exclusive. The
1992 Cable Act prohibits franchising authorities from unreasonably refusing to
grant franchises to competing cable television systems. The Company competes
with a municipally owned cable system in one community it serves. It also
competes with a much larger multi-system operator in Sleepy Eye, where the
Company is using broadband equipment to deliver video services. The degree of
competition from other cable providers will be dependent upon the state and
federal regulations concerning entry, interconnection requirements and the
degree of unbundling of the LECs' networks. The Company expects to compete based
upon product, service quality, breadth of services offered and, to a lesser
extent, on price.
Maintaining and expanding the Company's subscriber base depends on
numerous factors, including the quality and quantity of signals available from
"off-air" television stations, demand for satellite and premium television
channels and average household income in the service area. Promotional efforts
for video services include telephone and door-to-door selling and local media
advertising.
(6) Regulation
The Company's LECs and cable television systems are subject to federal,
state and local regulation. The Communications Act of 1934 and the
Telecommunications Act govern Federal regulations. Under these federal statutes,
the FCC exercises jurisdiction over all interstate telecommunications
activities. Intrastate activities are governed by rules and regulations set by
the respective state public utility commissions.
8
Federal Regulations
-------------------
Under federal regulations, incumbent local exchange carriers ("ILECs")
are required to comply with the Communications Act of 1934 and rules issued by
the FCC. While the Telecommunications Act of 1996 amended the earlier law to
reduce regulatory burdens and promote competition, ILECs remain subject to
extensive regulatory requirements. ILECs are required to maintain accounting
records according to Uniform System of Accounts, to structure access charges
according to FCC rules and to reflect their charges for interstate services at a
rate of return prescribed by the FCC. The FCC also regulates transfer of control
and assignments of operating authorizations and construction licenses. The FCC
requires carriers providing access services to file tariffs with the FCC
reflecting rates, terms and conditions of the services. Tariffs filed are
subject to review and potential objection by third parties.
Regulation of Cost Recovery and Nonregulated Revenue Allocation As a
regulated common carrier, the Company's LEC subsidiaries can set
maximum rates at a level that allows recovery of reasonable costs incurred to
provide regulated service and earns a reasonable return on the investment
required to provide these services.
Costs are recovered through:
- Monthly charges to end users for basic local telephone services and
enhanced services;
- Access charges to interexchange carriers for originating and terminating
interstate and intrastate interexchange calls; and
- Payments from the federal Universal Service Fund and the state universal
service funds (where applicable) that offset the high cost of providing
service in certain rural markets.
Rates for regulated services and the amount of universal service fund
support are set forth by the FCC with respect to interstate services and by
state regulatory agencies with respect to intrastate services.
In conjunction with the recovery of costs and establishment of rates, a
LEC must first determine its aggregate costs and then allocate those costs
between regulated and nonregulated services. After identifying the regulated
costs of providing local telephone service, a LEC must allocate those costs
among its various local exchange and interstate and intrastate interexchange
services and between state and federal jurisdictions. Allocating costs is
complicated because the same pieces of a LEC's plant and equipment are utilized
for different services, such as local telephone and interstate and intrastate
access services. The allocation process is called "separation" and is governed
primarily by FCC regulations. The purpose of separation is to determine how a
carrier's expenses are allocated and recovered from federal and state
jurisdictions. The FCC is considering whether to change or eliminate this
process. Any change in separation rules by the FCC could reduce or increase the
LEC's revenues. However, at this time it is not possible to predict what
changes, if any, may be made.
Interstate End-User Rates
The part of the local telephone network running from the switching
facility to the customer is called the "local loop." Costs to construct, operate
and maintain the loop are among the most significant costs incurred by a local
exchange carrier. In 1984 the FCC established a rate structure that provides for
the recovery of a portion of the cost of the local loop allocated to interstate
jurisdiction directly from end-users through the assessment of a subscriber line
charge. The SLC was increased in 1989 to a $3.50 cap on residence and single
line business lines and a $6.00 cap on multi-line business lines. The remaining
portions of the interstate local loop costs were recovered from interstate
access charges to interexchange carriers.
In November 2001 the FCC adopted access charge reforms based in part on a
proposal by the Multi-Association Group (the "MAG Plan"). The MAG Plan increases
the maximum rate caps for SLCs as follows:
Residential and Single Line Business
January 1, 2002 Increase from $3.50 to $5.00
July 1, 2002 Increase from $5.00 to $6.00
July 1, 2003 Increase from $6.00 to $6.50
Multi-line Business
January 1, 2002 Increase from $6.00 to $9.20
9
The increased SLC revenues are offset by reductions in recovery of local
loop costs from interexchange carriers. The plan is intended to be revenue
neutral for affected LECs.
Due to demographic and geographic conditions, costs to provide local loop
and switching services are often higher, on a per customer basis, in rural areas
compared to urban areas. Absent a regulatory framework to permit recovery of
these costs, rural LECs would be compelled to charge considerably higher rates
for local network services. Consequently, the FCC provides for additional
interstate recovery by eligible telecommunications carriers through the federal
Universal Service Fund. Funds from the federal Universal Service Fund are
available to local exchange carriers whose local loop costs are significantly
above the national average as determined by FCC rules. Interstate universal
service fund support accounted for $1,879,000, $1,458,000 and $1,412,000 of the
Company's network access revenues in 2003, 2002 and 2001, respectively.
Interstate Access Rates
-----------------------
Interstate access rates are developed on the basis of a LEC's measurement
of its interstate costs to provide access service to IXCs divided by its
projected demand for service. The resulting rates are published in the LEC's
interstate access tariff and filed with the FCC, at which time they are subject
to challenge by third parties and to review by the FCC.
The FCC recognized that the rate making and tariff filing process is
administratively burdensome for small local exchange carriers. In 1983, the FCC
established the National Exchange Carriers Association ("NECA") to develop and
administer interstate access service rates, terms and conditions. NECA develops
interstate access rates on the basis of data provided by participating local
exchange carriers and blended to yield average rates. These rates are intended
to generate revenue equal to the aggregate costs plus a return on the investment
of all of the participants.
Individual LECs are likely to have service costs that differ from the
revenues generated by applying the overall NECA tariff rates. To allow for this,
revenues generated by participating LECs are pooled and redistributed on the
basis of each individual company's costs. This process eliminates the burden of
individual tariff filing and produces a system in which small companies can
share and spread risk. For example, if a small local exchange carrier filed its
own tariff and subsequently suffered the loss of major customers that utilize
interstate access service, the local exchange carrier could suffer significant
under-recovery of its costs. In the NECA pool environment, the impact of this
loss is reduced because it is spread over all of the pool participants.
NECA operates separate pools for traffic sensitive costs (primarily
switching costs) and non-traffic sensitive costs (primarily loop costs). LECs
can choose to develop and administer their own interstate access charges and not
participate in the NECA pools. All of HCC's LECs participate in the traffic
sensitive and non-traffic sensitive NECA pools.
The FCC is reviewing its rates and policies governing interstate access
and the rate of return applicable to incumbent local exchange carriers who are
subject to rate-of-return, rather than price cap, regulation. The outcome of
this review could directly affect HCC's earnings, however, the outcome of this
proceeding cannot be predicted at this time.
The Telecommunications Act
--------------------------
The Telecommunications Act was enacted to promote competition without
jeopardizing the availability of nationwide universal service at affordable
rates. These two objectives have resulted in a complex set of rules intended to
promote competitive entry in the provision of local telephone services, except
where entry would adversely effect the provision of universal service or the
public interest.
10
Promotion of Local Service Competition and the Rural Exemptions
---------------------------------------------------------------
The Telecommunications Act made competitive entry into the local
telephone business more attractive to other carriers by removing barriers to
competition. In order to promote competition the Telecommunications Act
established new interconnection rules generally requiring local exchange
carriers to allow competing carriers to interconnect with their local networks.
Congress recognized, however, that the desire to promote competition conflicted
with the ability of some existing LECs to provide universal service to high cost
customers. Congress exempted these LECs (classified as "Rural Telephone
Companies") from interconnection requirements until the continuation of the
exemption was no longer in the public interest, as defined in the
Telecommunications Act.
Under the Telecommunications Act, all local exchange carriers, including
both incumbent local exchange carriers and new competitive carriers, are
required to:
- Offer reasonable and nondiscriminatory resale of their telecommunications
services,
- Ensure that customers can keep their telephone numbers when changing
carriers,
- Ensure that competitors' customers can use the same number of digits when
dialing and receive nondiscriminatory access to telephone numbers,
operator service, directory assistance and directory listing,
- Ensure access to telephone poles, ducts, conduits and rights of way and
- Compensate competitors for the costs of terminating traffic.
The Telecommunications Act also requires incumbent local exchange
carriers to:
- Negotiate in good faith the terms and conditions of interconnection with
any competitive carrier making a bona fide request for same,
- Interconnect their facilities and equipment with any requesting
telecommunications carrier at any technically feasible point,
- Unbundle and provide nondiscriminatory access to unbundled network
elements, such as local loops, switches and transport facilities, at
nondiscriminatory rates and on nondiscriminatory terms and conditions,
- Offer resale interconnection at wholesale rates,
- Provide reasonable notice of changes in the information necessary for
transmission and routing of services over the incumbent local exchange
carrier's facilities or in the information necessary for interoperability
and
- Provide for the physical collocation of equipment necessary for
interconnection or access to unbundled network elements at the premises
of the incumbent local exchange carrier, at rates, terms and conditions
that are just, reasonable and nondiscriminatory.
In order to implement interconnection requirements, local exchange
carriers generally enter into negotiated interconnection arrangements with
competing carriers. Local exchange carriers may also offer interconnection
tariffs, available to all competitors.
Competitors are required to compensate a local exchange carrier for the
cost of providing interconnection services. In the case of resale
interconnection, the rules provide that the rates charged should be on a
wholesale basis and reflect the current retail rates of the incumbent local
exchange carrier, excluding the portion of costs avoided by the incumbent local
exchange carrier. In the case of unbundled network element interconnection,
rates are based on costing methodologies that employ a forward-looking economic
cost pricing methodology known as total element long run incremental cost. The
Telecommunications Act specifies that resale and unbundled network element rates
are to be negotiated among the parties, or, if the parties fail to reach an
agreement, arbitrated by the relevant state regulatory authority. Once the
parties have come to agreement, the proposed rates are subject to final approval
by the state regulatory commission.
11
The Company's LEC subsidiaries are defined as "rural telephone companies"
under the Telecommunications Act. As rural telephone companies, they were
granted rural exemptions from the requirements relating to both resale
interconnection and unbundled network element interconnections. The rural
exemptions are continued until regulatory authorities determine that
interconnection is technically feasible, not unduly economically burdensome and
consistent with the Telecommunications Act's universal service provisions.
Promotion of Universal Service
------------------------------
While the Telecommunications Act promoted Congress' policy of ensuring
that affordable service is provided to consumers universally in rural, high-cost
areas of the country, the Telecommunications Act altered the framework for
providing universal service by:
- Providing for the identification of those services eligible for universal
service support,
- Requiring the FCC to make implicit subsidies explicit,
- Expanding the types of communications carriers required to pay universal
service support and
- Allowing competitive local exchange carriers to be eligible for funding.
These and other provisions were intended to make provision of universal
service support compatible with a competitive market.
Pursuant to the Telecommunications Act, federal Universal Service Fund
payments are only available to carriers that are designated as eligible
telecommunications carriers ("ETC") by a state public utilities commission. In
areas served by rural LECs, the Telecommunications Act provides that a state
public utilities commission may designate more than one eligible
telecommunications carrier, in addition to the incumbent local exchange carrier,
only after determining that the designation of an additional eligible
telecommunications carrier will serve the public interest. Wireless providers
have received ETC designation in Company served areas in North Dakota and Iowa,
and have applied for ETC designation in Minnesota. The addition of a second
eligible telecommunications carrier in these service areas could have the effect
of reducing the amount of funds available to HCC's LECs from the federal
Universal Service Fund. Such a reduction could materially adversely affect HCC's
ability to achieve a reasonable rate of return on the capital invested in its
network.
State Regulation of Rural LECs
------------------------------
HCC's LEC subsidiaries are subject to regulation by Minnesota, North
Dakota and Wisconsin regulatory agencies with respect to:
- Intrastate toll rates,
- Intrastate access charges billed to intrastate IXCs,
- Service areas,
- Service standards,
- Accounting and related matters, and
- The use of radio frequencies in telephone operations
In some cases state regulations also apply to local service rates, rate
of return, depreciation rates, construction plans and borrowings, and certain
other financial transactions.
Local service rates are not directly determined by regulatory
authorities, but are limited by regulation of these other areas. The Company has
sought appropriate increases in local and other service rates and approval for
changes in rate structures necessary to achieve reasonable rates and earnings.
The bulk of the Company's access lines are located in Minnesota. A bill
passed by the 1995 Minnesota legislature allows telephone companies serving
fewer than 50,000 access lines to elect to provide service under an alternate
form of regulation. Companies choosing alternative regulation agreed not to
increase rates for two years, other than in extraordinary circumstances. These
12
companies are not subject to rate of return review by the Public Utilities
Commission for the same two years. All of HCC's Minnesota-based LEC subsidiaries
(except Felton Telephone Company) elected alternative rate regulation election
effective January 1, 1996. Local rate increases after January 1, 1998 are not
subject to review by the Minnesota Public Utilities Commission unless the lower
of 500 or five percent of customers file a petition requesting such review. In
2001, the Company increased its local service rate for Sleepy Eye Telephone
Company. The commission did not review the rate increase.
The Minnesota Public Utilities Commission is investigating intrastate
access rates charged by local telephone companies to IXCs. The commission has
proposed a plan reducing intrastate access charges and implementing a state
universal service fund to compensate high cost companies. The Company cannot
predict the outcome of the rate investigation or if any part of the proposed
plan will be adopted.
Cable Television System Regulation
----------------------------------
The FCC regulates the providers of satellite communications services and
facilities for the transmission of programming services, the cable television
systems that carry such services, and, to some extent, the availability of the
programming services themselves through its regulation of program licensing.
Municipalities and other state and local government authorities also regulate
cable television systems. FCC regulations contain many detailed provisions
including:
- "Must carry" rules regarding the broadcast television and translator
signals that must be included in channel offerings to subscribers,
- Exclusivity provisions which require the deletion of certain programming
carried by out-of-area stations where it would duplicate programming
carried by local stations,
- Technical standards and performance testing requirements, and - Franchise
fees applicable to state and local cable television franchises.
Thus far, HCC's cable systems have not experienced any difficulty in complying
with the FCC rules.
In Minnesota, the award of cable franchises and certain aspects of cable
operations are subject to rules of the Minnesota Cable Communications Board.
Cable television systems are operated under 15 year, non-exclusive franchises
granted by local government authorities. Franchises contain many conditions,
including time limitations on commencement or completion of construction,
approval of initial fees charged to subscribers for basic service, the number of
channels offered and the types of programming. HCC does not anticipate
difficulty in obtaining renewal of its franchises at the expiration of their
current terms.
The regulation of cable television at the federal, state and local levels
is subject to the political process and has been in constant flux over the past
decade. This process continues in the context of legislative proposals for new
laws and the adoption or deletion of administrative regulations and policies.
The Company anticipates further material developments in these areas, but cannot
anticipate their direction and impact on its cable television operations.
(7) Business Strategy
The Company is focused on business opportunities in rural
telecommunications. Its three-part strategy is to:
- Expand its existing operations through internal growth - Pursue
acquisitions of attractive properties, particularly the
acquisition of additional rural telephone exchanges and cable television
properties
- Participate in opportunities afforded by new telecommunications
technologies
Future growth in existing telephone and cable operations is expected to
come from providing service to new or presently unserved homes and businesses,
from sales of enhanced services to existing customers and from providing new
services made possible by improvements in technology.
13
The Company continually assesses possible acquisition opportunities.
Competition to acquire attractive telephone or cable television properties is
intense. Acquisitions of rural telephone exchanges are subject to the approval
of regulatory agencies in some states and, in some cases, to federal waivers
that may affect the form of regulation or amount of interstate cost recovery of
acquired telephone exchanges. The Company will aggressively pursue acquisitions
of telephone exchanges, but there is no assurance that acquisitions can be made
on acceptable terms or that regulatory approval, where required, will be
received.
The Company has aggressively invested in new telecommunications
technologies, primarily through investments in partnerships and limited
liability companies. The Company has substantial investments in wireless
communications companies, fiber optic transport groups, CLECs and Internet
service providers. The Company intends to pursue additional investment
opportunities in the future.
(8) Employees
At March 1, 2004, the Company had 146 full-time and part-time employees,
of which 86 employees work in the Alliance operations and 60 work in Hector
operations. None of the Company's employees are represented under collective
bargaining agreements. HCC believes its employee relations to be good.
(9) Executive Officers of Registrant
The executive officers of the Company and their ages at March 1, 2004
were as follows:
Name Age Position
----------------- --- -------------------------------
Curtis A. Sampson 70 Chairman of the Board and Chief
Executive Officer
Steven H. Sjogren 61 President and Chief Operating Officer
Paul N. Hanson 57 Vice President and Treasurer
Charles A. Braun 46 Chief Financial Officer
Executive officers serve at the pleasure of the Board of Directors and
are elected annually for one-year terms. Each officer above has served the
Company in the indicated capacity since 1990.
Mr. Sjogren devotes his full time to the Company's business. Messrs.
Sampson, Hanson and Braun devote approximately 50%, 50% and 80% respectively of
their working time to the Company's business with the balance devoted to
management responsibilities at Communications Systems, Inc. ("CSI"), a
diversified telecommunications holding company also located in Hector,
Minnesota, for which they are separately compensated by CSI.
[d] FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT
SALES
Not Applicable.
14
ITEM 2. PROPERTIES
The Company's telephone property consists mainly of central office
switching equipment, the land and buildings in which the equipment is housed,
and connecting lines consisting of aerial and underground cable, conduit, and
poles and wires which connect customers' premises with central offices.
Connecting lines are generally located under or above public rights of way or
land owned, for the most part, by others, pursuant to consents of various
governmental bodies or private leases, permits, easements, agreements or
licenses. The Company also owns customer-leased telephones and related terminal
equipment and a small amount of connecting lines that are located on customers'
premises.
The connecting lines constitute approximately 52% of the Company's
telephone property in service. Central office switching equipment represents
approximately 32%. Telephones, customer premise broadband equipment and related
equipment constitute approximately 2%. Land, buildings, data processing
equipment, service vehicles and construction equipment constitute the remaining
14%. The Company owns substantially all the land and buildings in which its
central office equipment is located. HCC's principal general offices,
administrative services department and business office are located in Hector,
Minnesota and are rented by HCC from CSI.
The physical assets of the Company's cable television systems consist of
signal reception equipment and distribution electronics and cables. The
receiving equipment is comprised of a tower and antennas for reception of
broadcast television signals and one or more satellite dishes for reception of
satellite signals. The Company owns or leases the land on which the towers for
its cable systems and the buildings containing other receiving equipment are
located. Pole attachment space is rented from utilities serving the community.
See Note 9 of "Notes to Consolidated Financial Statements" for additional
information regarding pledged assets.
ITEM 3. LEGAL PROCEEDINGS
No material litigation or other claims are presently pending against the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
15
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
[a] MARKET INFORMATION
The Company's common stock is traded on the American Stock Exchange
("AMEX"). The table below presents the range of high and low trading prices for
the Company's stock for each period as reported by AMEX:
2003 2002
------------------ ------------------
Quarter High Low High Low
------- ------- ------- -------
First $ 13.60 $ 11.80 $ 16.95 $ 12.50
Second 13.89 11.50 14.85 11.62
Third 14.35 12.45 11.90 9.00
Fourth 14.14 13.06 12.65 8.90
[b] HOLDERS
At March 1, 2004 there were 511 holders of record of Hector
Communications Corporation common stock.
[c] DIVIDENDS
HCC has not paid cash dividends on its common stock or preferred stock
since it began operating as a public company in 1990, nor does HCC have any
obligation to pay dividends on its preferred stock. The financing agreements
between HCC's subsidiaries and their lenders, and HCC and its lenders restrict
the ability of HCC to pay dividends. At the present time, HCC intends to retain
earnings to finance the expansion of its business, and does not anticipate any
cash dividends will be paid in the foreseeable future. See Management's
Discussion and Analysis of Financial Condition and Results of Operations, and
also Note 9 to the Consolidated Financial Statements under Item 8 herein for a
description of restrictions on dividends.
[d] OTHER INFORMATION REGARDING EQUITY COMPENSATION PLANS
The following table presents information about our equity compensation
plans as of December 31, 2003:
Securities Authorized For Issuance Under Equity Compensations Plans
(a) (b) (c)
Number of shares of
Number of shares of common stock remaining
common stock to be available for future
issued upon exercise Weighted-average issuance under equity
of outstanding exercise price of compensation plans
options, warrants and outstanding options, (excluding shares in
Plan Category (1) rights warrants and rights column (a))
----------------- --------------------- -------------------- ----------------------
Equity compensation plans approved by security holders:
1990 Stock Plan 148,100 $ 10.86 -
1999 Stock Plan 323,217 $ 11.97 273,833
2003 Employee Stock Purchase Plan 12,369 11.92 87,631
Equity compensation plans not approved by security holders:
None
(1) The Company does not have individual compensation arrangements involving
the granting of options, warrants and rights.
16
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL INFORMATION
(in thousands except per share amounts)
Year Ended December 31
-------------------------------------------------------------
2003 2002 2001 2000 1999
- ---------------------------------------------------------------------------------------------------------------------------------
Selected Income Statement Information
Revenues from Continuing Operations $ 32,322 $ 30,517 $ 31,073 $ 29,067 $ 25,747
Costs and Expenses 24,365 23,875 24,404 21,913 18,400
- ---------------------------------------------------------------------------------------------------------------------------------
Operating Income from Continuing Operations 7,957 6,642 6,669 7,154 7,347
Other Income (Expenses), net 316 (1,053) 1,752 (1,539) 8,664
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations Before Income Taxes and
Minority Interest 8,273 5,589 8,421 5,615 16,011
Income Tax Expense 3,316 2,483 4,162 3,155 6,682
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations Before Minority Interest 4,957 3,106 4,259 2,460 9,329
Minority Interest in Earnings of Alliance
Telecommunications Corporation 660 782 1,078 411 2,947
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations 4,297 2,324 3,181 2,049 6,382
Income from Discontinued Operations 882 1,331 1,435 1,260 1,097
- ---------------------------------------------------------------------------------------------------------------------------------
Income Before Cumulative Effect of Change in Accounting
Principle 5,179 3,655 4,616 3,309 7,479
Cumulative Effect of Change in Accounting Principle,
net of Income Taxes and Minority Interest 3,147
- ---------------------------------------------------------------------------------------------------------------------------------
Net Income $ 5,179 $ 508 $ 4,616 $ 3,309 $ 7,479
=================================================================================================================================
Basic Income from Continuing Operations per common share $ 1.23 $ .67 $ .92 $ .58 $ 2.06
Diluted Income from Continuing Operations per common share $ 1.14 $ .62 $ .85 $ .53 $ 1.69
Average Shares Outstanding:
Common shares only 3,487 3,498 3,465 3,544 3,095
Common and potential common shares 3,765 3,770 3,763 3,851 3,945
=================================================================================================================================
Selected Balance Sheet Information
Working Capital $ 13,314 $ 5,718 $ 7,633 $ 8,960 $ 18,736
Property, Plant and Equipment, net 43,088 56,666 57,362 56,227 51,410
Excess of Cost Over Net Assets Acquired, net 31,692 49,075 53,663 55,475 51,405
Total Assets 123,059 154,486 158,251 158,678 166,797
Long-Term Debt 57,529 75,148 79,642 84,378 86,282
Stockholders' Equity 48,044 42,249 42,241 39,108 39,982
- ---------------------------------------------------------------------------------------------------------------------------------
Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets".
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Hector Communications Corporation ("HCC") owns a 100% interest in five
LEC subsidiaries and one cable television subsidiary. At December 31, 2003,
these subsidiaries provided telephone service to 7,532 customers in 9 rural
communities in Minnesota and Wisconsin. They also owned cable television systems
serving 4,357 customers in Minnesota and Wisconsin. HCC's 100%-owned
subsidiaries also have substantial ownership interests in other
telecommunications ventures, including, Midwest Wireless Holdings LLC.
HCC also owns a 100% interest in Alliance Telecommunications Corporation
("Alliance"). At December 31, 2003, Alliance, through its four LEC subsidiaries,
provided telephone service to 22,350 customers in 19 rural communities in
Minnesota, Wisconsin and North Dakota. Alliance's subsidiaries also provided
cable television services to 4,752 subscribers in Minnesota. Alliance's
subsidiaries also have substantial ownership interests in Midwest Wireless
Holdings LLC and have other investments.
Prior to July 7, 2003 Alliance Telecommunications Corporation
("Alliance") was 68% owned by HCC. ("Golden West") of Wall, South Dakota and
Alliance Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota
own the remaining interests in Alliance. Effective July 7, 2003 Alliance was
reorganized under Section 355 of the Internal Revenue Code ("the split-up
transactions'). In the split-up transactions, Golden West exchanged its minority
ownership interest in Alliance for all of the outstanding stock of Sioux Valley
Telephone Company, which included a pro rata share of Alliance's ownership
interest in Midwest Wireless Holdings, LLC and certain other Alliance assets.
ACCI exchanged its minority ownership interest in Alliance for all of the
outstanding stock of Hills Telephone Company, which included a pro rata share of
Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain
other Alliance assets. HCC became the 100% owner of all remaining Alliance
assets and operations. (See "Split-up of Alliance Telecommunications
Corporation" below.) The disclosures in this report related to prior periods
have been restated to reflect the Company's continuing operations.
Results of Operations
- ----------------------
2003 Compared to 2002
- ---------------------
Consolidated revenues from continuing operations increased 6% to
$32,322,000 in 2003 from $30,517,000 in 2002. The following table shows revenues
by operating group for 2003 compared to 2002:
Alliance Hector
Year Ended December 31 Year Ended December 31
2003 2002 2003 2002
--------------- ---------------- ---------------- -----------------
Local network $ 4,403,635 $ 4,263,544 $ 1,713,603 $ 1,611,184
Network access 11,001,000 10,195,887 5,074,254 5,107,970
Video services 1,929,285 2,098,331 1,650,488 1,600,459
Internet services 1,941,759 1,467,700 705,397 477,211
Other nonregulated services 3,092,427 3,025,315 810,580 669,189
--------------- ---------------- ---------------- -----------------
$ 22,368,106 $ 21,050,777 $ 9,954,322 $ 9,466,013
--------------- ---------------- ---------------- -----------------
Consolidated local service revenues increased 4% to $6,117,000 in 2003
from $5,875,000 in 2001. The increase was primarily due to increased revenues
from CLASS service features (which include caller identification, call-waiting,
call-forwarding and other related services) and custom calling. The Company
increased the rates charged for these services during 2003. Access lines served
were 29,882 at December 31, 2003, a decrease of 1% from 2002. The number of
access lines the Company serves fell due to the reduced number of second lines
being used for dial-up internet service and increased substitution of cellular
phones for landline phones by customers.
Network access revenues increased $771,000 or 5% to $16,075,000 in 2003.
Universal service support funds received in 2003 increased $421,000 over 2002
due to investment in plant and equipment in the Sleepy Eye and Pine Island
telephone exchanges. The Company's access revenues were reduced $437,000 in 2002
due to write-offs associated with the bankruptcy filings of World Com and Global
Crossings.
18
Video service revenues decreased 3% to $3,580,000 in 2003. Revenues in
2003 were reduced by the sales of seven cable television systems serving 2,080
subscribers during the June 30 quarter. The lost revenues were offset in part by
growth in Sleepy Eye and Pine Island, where broadband video services are
available to customers. Revenues from internet services increased 36% to
$2,647,000 due to increased availability of broadband DSL services to customers.
The number of customers purchasing DSL services from the Company increased 74%
in 2003, while the number of dial-up customers declined 1%. Revenues from other
nonregulated services increased 6% to $3,903,000 due to higher retail sales,
higher revenues from reselling long distance services and higher directory
revenues which offset lower revenues from leases of fiber optic transport
facilities, lower billing and collections revenues and lower fees from
engineering services.
Consolidated operating costs and expenses from continuing operations were
$24,366,000 in 2003 compared to $23,875,000 in 2002. Costs and expenses by
operating group were as follows:
Alliance Hector
Year Ended December 31 Year Ended December 31
2003 2002 2003 2002
--------------- ---------------- ---------------- -----------------
Plant operations, excluding
depreciation $ 3,084,408 $ 2,498,750 $ 1,432,303 $ 1,581,666
Depreciation and amortization 4,858,000 4,847,972 2,993,511 3,139,678
Customer operations 1,118,434 1,452,099 433,675 397,986
General and administrative 3,453,303 3,093,981 1,078,433 1,338,261
Other operating expenses:
Video service expenses 1,599,510 1,760,900 1,427,103 1,423,033
Internet expenses 586,011 807,150 324,889 211,971
Other 1,499,547 873,358 476,655 448,614
--------------- ---------------- ---------------- -----------------
$ 16,199,213 $ 15,334,210 $ 8,166,569 $ 8,541,209
--------------- ---------------- ---------------- -----------------
Plant operations expenses, excluding depreciation, increased 11% to
$4,517,000 in 2003 due to reduced capitalization of labor expenditures for new
construction projects and severance charges for employee headcount reductions.
Depreciation and amortization expenses decreased $136,000 due to sales of cable
television properties during 2003. Customer operations expenses decreased 16% to
$1,552,000 in 2003 due to employee headcount reductions. General and
administrative expenses increased 2% to $4,532,000 in 2003 due to accounting and
legal expenses incurred in the breakup of Alliance. Video service expenses
declined 5% to $3,027,000 in 2003 due to the cable television systems sales,
which offset increases in the fees the Company pays to video signal suppliers.
Internet expenses decreased 11% to $911,000 in 2003 due to lower fees from
"backbone" suppliers. Other operating expenses increased $654,000 or 49% due to
increased cost of goods sold from retail sales and increased labor and materials
charges for customer wiring installations and repairs and Next Level
installations.
Operating income from continuing operations increased 20% to $7,957,000
in 2003 from $6,641,000 in 2002.
Consolidated interest expenses decreased $56,000 to $3,401,000 as lower
interest rates on variable rate loans were offset by charges on new loan funds
drawn down from the Rural Utilities Service and the Rural Telephone Bank.
Income from the Company's investment in Midwest Wireless Holdings LLC
decreased to $2,148,000 in 2003 from $2,261,000 in 2002. Midwest Wireless' 2003
income declined due to decreases in roamer service revenues and increased costs
for converting customers from TDMA to CDMA technology. Income from investments
in other unconsolidated affiliates was $96,000 in 2003 compared to a loss of
$56,000 in 2002. Interest and dividend income increased to $392,000 in 2003 from
$334,000 in 2002 due to increases in the Company's cash balances available for
investment. The Company recorded gains on sales of cable television systems
totaling $1,081,000 in the 2003 period. Alliance recorded an impairment loss on
its marketable securities portfolio of $134,000 in 2002.
Income from continuing operations before income taxes and minority
interest increased to $8,273,000 in 2003 from $5,589,000 in 2002. The Company's
effective income tax rate was 40% in 2003 compared to 44% in 2002. The Company's
tax rate declined due to the reduced effects of state income taxes caused by
19
changes in apportionment. Minority interest on earnings of Alliance's continuing
operations was $660,000 for the period of 2003 prior to the split-up transaction
compared to $781,000 for all of 2002. Income from continuing operations
increased to $4,297,000 in 2003 from $2,324,000 in 2002.
Income from discontinued operations before minority interest and gain on
the split-up transaction in 2003 was $989,000. Minority interests in those
earnings were $316,000. Income from discontinued operations in 2002 was
$1,957,000. Minority interests in those earnings were $626,000. The Company
recorded a gain, net of income taxes, of $210,000 on the Alliance breakup
transactions. In 2002, the Company took a charge against earnings related to the
cumulative effect of impairment of the value of its goodwill and intangible
assets of $3,147,000, net of income taxes and minority interest. The Company had
net income of $5,179,000 in 2003 compared to $508,000 in 2002.
2002 Compared to 2001
- ---------------------
Consolidated revenues from continuing operations decreased 2% to
$30,517,000 in 2002 from $31,073,000 in 2001. The following table shows revenues
by operating group for 2002 compared to 2001:
Alliance Hector
Year Ended December 31 Year Ended December 31
2002 2001 2002 2001
--------------- ---------------- ---------------- -----------------
Local network $ 4,263,544 $ 4,015,282 $ 1,611,184 $ 1,562,398
Network access 10,195,887 10,275,933 5,107,970 5,652,977
Video services 2,098,331 2,064,549 1,600,459 1,465,078
Internet services 1,467,700 1,282,484 477,211 308,924
Other nonregulated services 3,025,315 3,627,880 669,189 817,732
--------------- ---------------- ---------------- -----------------
$ 21,050,777 $ 21,266,128 $ 9,466,013 $ 9,807,109
--------------- ---------------- ---------------- -----------------
Local network revenues increased 5% to $5,875,000 in 2002. Revenue growth
in Alliance was due to the full year effect of a 2001 local service rate
increase at Sleepy Eye Telephone Company. Hector's local network revenues
increased due to increases in the number of access lines served.
Network access revenues declined $625,000 or 4% to $15,304,000 in 2002.
The Company's access revenues were reduced $437,000 in 2002 due to write-offs
associated with the bankruptcy filings of World Com and Global Crossings.
Interstate access revenues were negatively affected by FCC mandated reductions
in NECA's tariff rates. Universal service support increased due to Alliance's
increased investment in plant and equipment in Sleepy Eye.
Video service revenues increased 5% to $3,699,000 due to rate increases
and introduction of broadband video services in Sleepy Eye. Revenues from
internet services increased 22% to $1,945,000 due to increased customer
acceptance of the technology and increased availability of broadband DSL
services to customers. Revenues from other nonregulated services decreased
$751,000 to $3,695,000 due to lower revenues from leases of fiber optic
transport facilities, lower billing and collections revenues and lower retail
sales.
Consolidated operating costs and expenses were $23,875,000 in 2002
compared to $24,404,000 in 2001. If the provisions of SFAS 142 had been in
effect at January 1, 2001, 2001 operating costs would have been $22,574,000.
Costs and expenses by operating group were as follows:
Alliance Hector
Year Ended December 31 Year Ended December 31
2002 2001 2002 2001
--------------- ---------------- ---------------- -----------------
Plant operations, excluding
depreciation $ 2,498,750 $ 2,492,728 $ 1,581,666 $ 1,381,781
Depreciation and amortization 4,847,972 6,342,827 3,139,678 3,178,259
Customer operations 1,452,099 1,442,561 397,986 384,286
General and administrative 3,093,981 2,621,067 1,338,261 1,268,523
Other operating expenses:
Video service expenses 1,760,900 1,511,890 1,423,033 1,329,244
Internet expenses 807,150 826,931 211,971 176,692
Other 873,358 998,540 448,614 448,682
--------------- ---------------- ---------------- -----------------
$ 15,334,210 $ 16,236,544 $ 8,541,209 $ 8,167,467
--------------- ---------------- ---------------- -----------------
20
Plant operations expenses, excluding depreciation, increased 5% to
$4,080,000. Depreciation expense increased $297,000 due to depreciation on new
plant additions. Amortization expense decreased $1,830,000 due to the adoption
of SFAS #142. Customer operations expenses increased 1% to $1,850,000 in 2002.
General and administrative expenses increased 14% to $4,432,000 in 2002 due to
accounting and legal expenses incurred in the breakup of Alliance. Video service
expenses increased 12% to $3,184,000 in 2002 due to increases in the fees the
Company pays to video signal suppliers. Internet expenses increased $15,000.
Other operating expenses decreased $125,000 or 9% due to decreased costs
associated with lower retail sales.
Operating income from continuing operations decreased $28,000 to
$6,641,000 in 2002.
Interest expenses decreased $371,000 to $3,457,000 in 2002. The decrease
was due to lower interest rates on variable rate debt from CoBank and lower debt
levels due to principal payments.
Income from the Company's investment in Midwest Wireless Holdings LLC
increased to $2,261,000 in 2002 from $1,152,000 in 2001. Midwest Wireless' 2001
results included amortization of intangible assets totaling $721,000, which
ceased with the adoption of SFAS 142. The Company had a loss from investments in
other unconsolidated affiliates of $56,000 in 2002 compared to income of
$336,000 in 2001 due to lower profits from fiber optic transport company
investments and losses from the Company's investment in Desktop Media.
Alliance recorded an impairment loss on its marketable securities
portfolio of $134,000 in 2002. Alliance had gains on sales of marketable
securities of Illuminet, Inc. totaling $3,659,000 in 2001. Interest and dividend
income decreased to $334,000 in 2002 from $432,000 in 2001 due to lower interest
rates on invested funds and lower dividend yields from marketable security
investments.
Income from continuing operations before income taxes and minority
interest decreased to $5,589,000 in 2002 from $8,422,000 in 2001. The Company's
effective income tax rate was 44% compared to 49% in 2001. The Company's tax
rate declined due to the adoption of SFAS #142, which eliminated amortization of
nondeductible goodwill. Income from continuing operations before the minority
interest in Alliance's earnings decreased to $3,106,000 in 2002 from $4,260,000
in 2001. Minority interest on earnings of Alliance was $781,000 compared to
$1,078,000 in 2001. Income from continuing operations was $2,324,000 in 2002
compared to $3,181,000 in 2001.
Income from discontinued operations before minority interest was
$1,957,000 in 2002 compared to $2,110,000 in 2001. Minority interests in those
earnings were $626,000 and $675,000, respectively. In 2002, the Company took a
charge against earnings related to the cumulative effect of impairment of the
value of its goodwill and intangible assets, before income tax benefits and
minority interest, of $4,663,000. After income tax benefits of $121,000 and
minority interest of $1,395,000, the net charge against earnings was $3,147,000
(see Note 4 to the consolidated financial statements). Net income for 2002 was
$508,000 compared to $4,616,000 in 2001.
Liquidity and Capital Resources
- -------------------------------
Operations
Cash flows from consolidated operating activities (including the
activities of discontinued operations up to the Alliance split-up date) were
$12,953,000, $13,116,000 and $14,103,000 in 2003, 2002 and 2001, respectively.
At December 31, 2003, the Company's cash and cash equivalents totaled
$16,581,000 compared to $12,020,000 at December 31, 2002. Cash and cash
equivalents held by discontinued operations were $2,428,000 of this total at
December 31, 2002. Working capital at December 31, 2003 was $13,314,000 compared
to $5,718,000 at December 31, 2002. The current ratio was 2.1 to 1 at December
31, 2003 compared to 1.4 to 1 at December 31, 2002.
The Company makes periodic improvements to its facilities to provide
up-to-date services to its telephone and cable television customers. Hector's
plant additions in 2003, 2002 and 2001 were $1,398,000, $2,609,000 and
$3,985,000 respectively. Alliance's plant additions for continuing operations in
2003, 2002 and 2001 were $2,258,000, $5,121,000 and $4,635,000 respectively.
Plant additions for discontinued operations up to the split-up date were
$257,000, $1,536,000 and $1,999,000 in 2003, 2002 and 2001, respectively. Plant
additions for 2004 for Hector and Alliance are expected to total $4,387,000.
21
These plant additions will upgrade the Company's telephone equipment to allow
local number portability and other advanced telecommunications services, expand
telecommunications services into new construction developments and increase
usage of Next Level broadband equipment and high capacity fiber optics in the
telephone network.
Long-Term Obligations and Commitments
--------------------------------------
The Company's LEC subsidiaries borrow from the Rural Utilities Service
("RUS") and the Rural Telephone Bank ("RTB") to help finance asset additions.
Proceeds from long-term borrowings from RUS and RTB were $5,998,000, $2,954,000
and $2,201,000 in 2003, 2002 and 2001, respectively. The average interest rate
on outstanding RUS and RTB loans is 5.0%. At December 31, 2003 unadvanced loan
commitments from the RUS and RTB to Hector's and Alliance's LEC subsidiaries
totaled $13,299,000.
Substantially all of the assets of the Company's LEC subsidiaries are
pledged or are subject to mortgages to secure obligations to the RUS and RTB.
The Company's loan agreements place significant restrictions on cash
distributions from the subsidiaries to the parent company. Alliance's loan
covenants with CoBank also restrict dividend payments at the Alliance level. At
December 31, 2003, $11,863,000 of subsidiaries' retained earnings was available
for dividend payments to HCC. At December 31, 2003, $32,614,000 of HCC's
retained earnings were not available to pay dividends to shareholders due to
restrictions in the debt agreements. It is the Company's plan, in so far as
possible, to maintain its cash balances at the subsidiary level to support their
operations.
The Company carries a significant amount of debt due to borrowing to
finance Alliance's acquisition of Ollig Utilities Company. Prior to the split-up
transaction, Alliance and its subsidiaries carried this debt. In July 2003 the
Company repaid the acquisition loan with proceeds from a new term loan provided
to Hector by CoBank. The loan is secured by a pledge of the stock of Hector's
subsidiary companies. Interest rates on long-term portions of the loan are fixed
through 2007, while the non-fixed portion floats at short-term market rates. The
average rate on the total loan was approximately 4.4% at December 31, 2003.
Principal payments are made quarterly and will continue until April 2013. The
outstanding balance on this loan at December 31, 2003 was $26,125,000. CoBank is
a cooperative, owned and controlled by its customers. Each customer borrowing
from the bank on a patronage basis shares in the bank's net income through
payment of patronage refunds. As a condition of maintaining the loan, Hector
owns stock in the bank. Its investment in CoBank stock was $2,555,000 at
December 31, 2003.
As part of financing its ownership interest in Alliance, Hector had a
15-year term loan from Rural Telephone Finance Cooperative ("RTFC"). At December
31, 2002 the outstanding balance on this loan was $3,157,000. The loan was
repaid in July 2003 as part of the CoBank refinancing.
In addition to its debt agreements, Hector and its subsidiaries have
entered into contracts with suppliers to provide capital equipment, switching
services and fiber optic transport facilities. The Company's cash payments due
for these obligations are as follows (interest payments are estimated using
December 31, 2003 interest rates):
Long-Term Interest Purchase Operating
Total Debt Payments Obligations Leases
--------------- --------------- ---------------- ---------------- -----------------
2004 $ 10,453,500 $ 6,537,800 $ 2,920,500 $ 639,900 $ 355,300
2005 9,216,800 6,340,900 2,639,400 236,500
2006 8,975,500 6,451,800 2,369,400 154,300
2007 8,818,300 6,650,000 2,094,200 74,100
2008 8,201,000 6,650,000 1,476,800 74,200
After 2008(1) 35,499,278 31,436,678 4,031,400 31,200
--------------- --------------- ---------------- ---------------- -----------------
$ 81,164,378 $ 64,067,178 $ 15,531,700 $ 639,900 $ 925,600
=============== --------------- ---------------- ---------------- -----------------
(1) The Company has an obligation to pay Broadband Visions LLC ("BBV") $6,000
per month for fiber optic transport facilities until such time that the Company
is not a member of BBV. This obligation is reflected in the table for each year
from 2004 through 2008. No amount is included after 2008.
22
Investments
-----------
Investment income has been derived almost exclusively from interest
earned on the Company's cash and cash equivalents. Interest income has
fluctuated in relation to changes in interest rates and availability of cash for
investment. In 2001 Alliance received $3,675,000 from sales of marketable
securities, principally Illuminet, Inc. common stock. The Company does not
expect proceeds from marketable securities sales in future years be significant.
The Company regularly invests cash in new telecommunications technologies
and ventures and in support of its existing affiliated interests. In 2001 the
Company invested $500,000 in Desktop Media, Inc., a start-up company providing
voice, data and internet telecommunications services in southeastern Minnesota.
The Company also invested $360,000 to support its investment in a fiber optic
transport company in northwestern Minnesota. The Company expects to make
additional investments of this type as opportunities arise.
The Company owned 10.4% of Wireless North, which provided personal
communications services ("PCS") to parts of Minnesota, Wisconsin, Iowa, North
Dakota and South Dakota. Wireless North was unsuccessful and has been
liquidated. Its licenses and systems were sold to other operators, or were shut
down. In 2001, the Company made payments to Wireless North's primary lender of
$1,129,000 to satisfy loan guarantees it gave with respect to Wireless North's
debt. Cash investments in Wireless North by the Company totaled $3,202,000. The
Company has written off its entire investment in Wireless North, has no
obligation to provide additional funding and does not expect to realize any
additional value from this investment.
The Company's other investments consist primarily of loan related bank
stocks, long-term investments in non-marketable corporations, and notes
receivable. In 2002, the Company made investments in mutual funds and rural
development note receivables that were funded by no-interest loans from the
Rural Utilities Service.
Credit Risk
-----------
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and temporary cash
investments. The Company places its cash investments with high credit quality
financial institutions. The Company maintains its cash in bank deposit accounts.
The account balances at times exceed the federally insured limits. The Company
has not experienced losses in these accounts and does not believe they are
exposed to any significant credit risk.
A significant portion of the Company's revenues are received from long
distance carriers in the telephone industry. Consequently, the Company is
directly affected by the financial well-being of that industry. The credit risk
associated with these accounts is minimized due to the large number of long
distance carriers.
Common Stock
------------
The Company's Board of Directors has authorized the purchase and
retirement, from time to time, of shares of the Company's stock on the open
market, or in private transactions consistent with overall market and financial
conditions. In 2003 the Company purchased and retired 1,106 shares at a cost of
$17,000. In 2002 the Company purchased and retired 70,239 shares at a cost of
$737,000. In 2001 the Company purchased and retired 109,704 shares at a cost of
$1,268,000. At December 31, 2003 215,000 shares could be repurchased under
outstanding Board authorizations.
Proceeds to the Company from exercises of employee stock options and
employee stock purchase plan shares totaled $431,000, $320,000 and $550,000 in
2003, 2002 and 2001, respectively.
Sales of Cable Television Systems
---------------------------------
Alliance completed sales of two groups of cable television systems during
the second quarter of 2003. Alliance sold four systems in rural North Dakota
serving 930 subscribers to MLGC, LLC for $200,000 of cash and a note receivable
of $650,000. Alliance sold systems serving 1,150 subscribers in three
communities surrounding the Fargo, ND - Moorhead, MN area to Cable One, Inc. for
$1,545,000 of cash (including $80,000 of escrowed funds). Effect of the asset
sales was as follows:
23
Sales Price $ 2,395,032
Less: Property, plant and equipment (net) (343,636)
Less: Intangible assets (goodwill) (970,673)
-------------
Gain on sale of cable assets $ 1,080,723
=============
By utilizing cash flow from operations, current cash and investment
balances, and other available financing sources, the Company feels it has
adequate resources to meet its anticipated operating, debt service and capital
expenditure requirements.
Split-Up of Alliance Telecommunications Corporation
---------------------------------------------------
In July 2001, Golden West and ACCI, respectively the 20% and 12% minority
shareholders of Alliance, advised the Company that they were interested in
exchanging their minority investment for a share of the assets and liabilities
of Alliance. Thereafter the parties engaged in negotiations that continued
through December 2002. The negotiation process included evaluations and
appraisals of Alliance's business components, negotiations with Alliance's
lenders (CoBank, Rural Utilities Service and Rural Telephone Bank) regarding
waivers, lien releases, interest penalties where applicable and future financing
terms. The process also included seeking necessary regulatory approvals from
local, state and national regulators.
The Company completed the Alliance split-up transactions on July 7, 2003.
As agreed among the parties, in the split-up, Golden West exchanged its 20%
ownership interest in Alliance for all of the outstanding stock of Sioux Valley
Telephone Company, which included a pro rata share of Alliance's ownership in
Midwest Wireless Holdings, LLC and certain other Alliance assets. ACCI exchanged
its 12% ownership interest in Alliance for all of the outstanding stock of Hills
Telephone Company, which included a pro rata share of Alliance's ownership in
Midwest Wireless Holdings, LLC and certain other Alliance assets. Immediately
prior to the breakup Sioux Valley and Hills paid a dividend to Alliance of
approximately $12,849,000. The dividend proceeds were applied to repay a portion
of Alliance's acquisition loan from CoBank. Concurrent with the split-up, the
balance of Alliance's debt to CoBank and the balance of the Company's debt to
Rural Telephone Finance Cooperative were retired using proceeds from a new
$26,813,000 loan from CoBank to Hector Communications Corporation. A number of
other stock and asset transfers also occurred among Alliance and its
subsidiaries prior to the split-up in order to satisfy various regulatory and
lender requirements.
The Company believes the split-up transactions are tax-free under Section
355 of the Internal Revenue Code. The Company also believes that related
internal stock and asset transfers that occurred prior to the split-up are
tax-free under Section 355, related Code provisions and the consolidated return
regulations, although no private letter ruling was sought from the IRS in
connection with the split-up. Prior to conducting the split-up transactions, the
parties entered agreements with regard to cooperation, exchange of information,
interim use of common services, employee benefits, tax allocations and
indemnification generally in proportion to ownership percentages with respect to
unexpected adverse tax consequences, and other matters arising after the
split-up transactions which relate to commitments, events or circumstances in
effect as of the date of the split-up transactions.
Acquisitions
------------
The Company is continually evaluating possible acquisitions that advance
its plan to be a provider of top quality telecommunications services to rural
customers. In the past, the Company has been a member of investor groups that
sought unsuccessfully to acquire rural telephone properties offered for sale by
major telephone companies. The Company cannot predict if it will be successful
in acquiring additional properties and does not currently have financing plans
in place to pay for possible acquisitions.
Effects of Inflation
--------------------
The Company's local exchange telephone companies are subject to the
jurisdiction of Minnesota, North Dakota and Wisconsin regulatory authorities
with respect to a variety of matters, including rates for intrastate access
services, the conditions and quality of service, issuance of debt, depreciation
rates and accounting methods. Rates for local telephone service are not
24
established directly by regulatory authorities, but their authority over other
matters limits the Company's ability to implement rate increases. In addition,
the regulatory process inherently restricts the Company's ability to immediately
pass cost increases along to customers unless the cost increases are anticipated
and the rate increases implemented prospectively.
Critical Accounting Policies
----------------------------
The presentation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reporting of the Company's operating resulting and
financial position. The estimates and assumptions used in the Company's
financial statements are based upon management's evaluation of the relevant
facts and circumstances as of the time of the financial statements. These
estimates are often difficult, subjective and complex. Actual results could
differ from the estimates. HCC also gives accounting recognition to the actions
of federal and state regulatory authorities where appropriate as prescribed by
SFAS No. 71.
Revenue recognition: Revenues are recognized when earned, regardless of the
period in which they are billed. Network access revenues are furnished in
conjunction with interexchange carriers and are determined by cost separation
studies and nationwide average schedules. Revenues include estimates pending
finalization of cost studies. Network access revenues are based upon interstate
tariffs filed with the Federal Communications Commission by the National
Exchange Carriers Association and state tariffs filed with state regulatory
agencies. Management believes recorded revenues are reasonable based on
estimates of final cost separation studies, which are typically settled within
two years.
Allowance for Doubtful Accounts: The allowance for doubtful accounts is an
estimate based on specifically identified problem accounts and historical
collection experience. Specific accounts are evaluated where the Company has
information that the customer may not be able to meet its financial obligations,
where payment is delinquent or where charges are in dispute. Reserves are
reevaluated and adjusted as information affecting the accounts is received. If
circumstances change, recoverability of amounts due the Company could be
materially affected.
Property, plant and equipment: The Company regularly reviews the carrying value
of its fixed assets for impairment. Carrying values are estimated based on
expected future cash flows and/or established market valuations of other similar
assets. Depreciation is calculated using the straight-line method based on the
estimated useful lives of the various asset classes. Reserves established for
asset retirement obligations have not been significant.
Goodwill and intangible assets: Effective January 1, 2002 the Company adopted
SFAS No. 142, "Goodwill and Other Intangible Assets". Under the provisions of
this accounting standard, goodwill and intangible assets with indefinite useful
lives are no longer amortized but are instead tested for impairment on at least
an annual basis. The goodwill impairment test requires the Company to determine
the fair value of its reporting units. The valuation is estimated based on
access line and customer valuations and cash flow multiple valuations the
Company considers appropriate in the current marketplace. If circumstances or
assumptions supporting these estimates change, the carrying value of the
Company's goodwill could be materially affected.
Income taxes: The Company estimates its income tax expense for each jurisdiction
in which it operates. The process includes apportioning the Company's income
among the jurisdictions, estimating current tax liabilities and establishing
deferred tax assets and liabilities. Deferred taxes are calculated where the
carrying amounts of assets and liabilities are different for financial and tax
reporting purposes. Valuation allowances are recorded in the tax accounts for
amounts management believes are not recoverable in future periods.
New Accounting Standards
------------------------
Effective January 1, 2003 the Company adopted the provisions of Statement
of Financial Accounting Standards ("SFAS") No. 143, "Accounting for Asset
Retirement Obligations". The statement establishes accounting standards for
recognition and measurement of a liability for an asset retirement obligation
and an associated asset retirement cost. The statement applies to tangible
long-lived assets, including individual assets, functional groups of related
assets and significant parts of assets. It covers a company's legal obligations
resulting from the acquisition, construction, development or normal operation of
25
a capital asset. The FCC has notified the Company's ILEC subsidiaries that SFAS
No. 143 will not be adopted for regulatory purposes. Current regulatory
accounting requires ILECs to accrue for asset retirement obligations through
prescribed depreciation rates. The amount of asset retirement obligations the
Company is required to record under SFAS No. 143 is not significant. Adoption of
the provisions of SFAS No. 143 did not have a material impact on the Company's
financial position or operating results.
In November 2002 the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others". This
interpretation elaborates on the disclosures required in financial statements
concerning obligations under certain guarantees. It also clarifies the
requirements related to the recognition of liabilities by a guarantor at the
inception of certain guarantees. The disclosure requirements of this
interpretation were effective on December 31, 2002, but did not require any
additional disclosures on the part of the Company. The recognition provisions of
the interpretation effective for 2003 are applicable only to guarantees issued
or modified after December 31, 2002. Adoption of these provisions did not have a
material impact on the Company's financial position or results of operations.
In June 2002 the FASB issued SFAS No.146, "Accounting for Costs
Associated with Exit or Disposal Activities". SFAS No. 146 nullifies Emerging
Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)." This statement requires that a
liability for a cost associated with an exit or disposal activity be recognized
when the liability is incurred. Under EITF Issue No. 94-3, a liability for an
exit cost was recognized at the date of the entity committed to an exit plan.
The provisions of this statement were effective for exit or disposal activities
initiated after December 31, 2002. Adoption of SFAS No. 146 did not have a
material impact on the Company's financial position or results of operations.
In April 2003 the FASB issued SFAS No. 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities." This statement amends and
clarifies accounting and reporting for derivative instruments. SFAS No. 149 is
effective for contracts made or modified after June 30, 2003. Adoption of SFAS
No. 149 did not have a material effect on the Company's financial position or
results of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards
No. 150, "Accounting for Certain Financial Instruments with Characteristics of
Both Liabilities and Equities", which became effective for the Company with this
report. Adoption of this statement did not have a material impact on the
Company's consolidated results of operations and financial position.
In December 2003, the FASB issued a revision of SFAS No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits". The statement
revises the disclosures required for pension and other post-retirement benefit
plans. The new disclosure requirements are reflected in the Company's Notes to
Consolidated Financial Statements in this report as appropriate.
In December 2003, the FASB issued a revised Financial Interpretation
("FIN") No. 46, "Consolidation of Variable Interest Entities". FIN No. 46
requires the assets, liabilities and results of operations of variable interest
entities to be included in the Company's financial statements if the entities
have certain financial characteristics. FIN No. 46 is effective for investments
in special-purpose entities for periods ending after December 15, 2003, and for
other types of entities for periods ending after March 15, 2004. Adoption of FIN
No. 46 did not result in consolidation or change the Company's disclosures for
any of the entities in which it maintains investments.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company does not use derivative financial instruments in its
operations or investment portfolio. Its operations are not subject to risks
associated with changes in the value of foreign currencies. Portions of the
Company's long-term debt have variable interest rates based on the lenders' cost
of money. The Company has investments in money market funds and mutual funds
that earn interest at prevailing market rates. In the opinion of management, the
Company does not have a material exposure to loss caused by market risk.
26
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
(a) FINANCIAL STATEMENTS
REPORT OF MANAGEMENT
The management of Hector Communications Corporation and its subsidiary companies
is responsible for the integrity and objectivity of the financial statements and
other financial information contained in the annual report. The financial
statements and related information were prepared in accordance with accounting
principles generally accepted in the United States of America and include
amounts that are based on management's informed judgments and estimates.
In fulfilling its responsibilities for the integrity of financial information,
management maintains accounting systems and related controls. These controls
provide reasonable assurance, at appropriate costs, that assets are safeguarded
against losses and that financial records are reliable for use in preparing
financial statements. Management recognizes its responsibility for conducting
the Company's affairs according to the highest standards of personal and
corporate conduct.
The Audit Committee of the Board of Directors, composed solely of outside
directors, meets with the independent auditors and management periodically to
review accounting, auditing, financial reporting and internal control matters.
The independent auditors have free access to this committee, without management
present to discuss the results of their audit work and their opinion on the
adequacy of internal financial controls and the quality of financial reporting.
/s/ Curtis A. Sampson /s/ Charles A. Braun
---------------------------- -----------------------------------
Curtis A. Sampson Charles A. Braun
Chairman and Chief Executive Officer Chief Financial Officer
INDEPENDENT AUDITORS' REPORT
To the Shareholders and Board of Directors of
Hector Communications Corporation
We have audited the accompanying consolidated balance sheets of Hector
Communications Corporation and subsidiaries as of December 31, 2003 and 2002 and
the related consolidated statements of income, comprehensive income,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 2003. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Hector
Communications Corporation and subsidiaries as of December 31, 2003 and 2002 and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 2003 in conformity with accounting principles
generally accepted in the United States of America.
As described in Note 4 to the consolidated financial statements, effective
January 1, 2002 the Company adopted Statement of Financial Accounting Standards
No. 142, "Goodwill and Other Intangible Assets".
/s/ Olsen Thielen & Co., Ltd.
Olsen Thielen & Co., Ltd.
February 13, 2004
St. Paul, Minnesota
27
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31
-----------------------------------
2003 2002
-------------- --------------
CURRENT ASSETS:
Cash and cash equivalents $ 16,581,315 $ 12,020,186
Construction fund (Note 9) 3,240,073 662,232
Accounts receivable (net of allowance for doubtful accounts of
$538,000 and $716,000, respectively) 4,140,052 4,819,174
Materials, supplies and inventories, at average cost 944,099 1,175,587
Other current assets 285,071 231,685
-------------- --------------
TOTAL CURRENT ASSETS 25,190,610 18,908,864
PROPERTY, PLANT AND EQUIPMENT, net (Notes 1 and 3) 43,088,106 56,665,798
INVESTMENTS AND OTHER ASSETS:
Excess of cost over net assets acquired (Notes 1 and 4) 31,691,927 49,074,993
Investment in Midwest Wireless Holdings LLC (Note 5) 13,349,155 16,232,707
Investments in other unconsolidated affiliates (Note 6) 2,796,035 4,373,597
Other investments (Notes 1 and 7) 6,533,858 8,818,502
Other assets (Notes 1 and 4) 409,664 411,499
-------------- --------------
TOTAL OTHER ASSETS 54,780,639 78,911,298
-------------- --------------
TOTAL ASSETS $ 123,059,355 $ 154,485,960
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable and current portion of long-term debt (Note 9) $ 6,537,800 $ 7,364,600
Accounts payable (Note 12) 1,557,969 2,523,878
Accrued expenses 2,238,587 2,422,986
Income taxes payable 1,541,830 879,417
-------------- --------------
TOTAL CURRENT LIABILITES 11,876,186 13,190,881
LONG-TERM DEBT, less current portion (Note 9) 57,529,378 75,147,560
DEFERRED INVESTMENT TAX CREDITS (Note 8) 8,999 27,554
DEFERRED INCOME TAXES (Note 8) 4,902,870 5,866,754
DEFERRED COMPENSATION (Note 11) 698,254 976,179
COMMITMENTS AND CONTINGENCIES (Note 9)
MINORITY INTEREST IN ALLIANCE TELECOMMUNICATIONS, CORP. 17,027,697
STOCKHOLDERS' EQUITY: (Notes 1, 9 and 10)
Preferred stock, par value $1.00 per share; 3,000,000 shares authorized:
Convertible Series A, 220,100 shares issued and outstanding 220,100 220,100
Common stock, par value $.01 per share; 10,000,000 shares authorized;
3,515,482 and 3,455,067 shares issued and outstanding 35,155 34,551
Additional paid-in capital 13,828,414 13,262,969
Retained earnings 33,908,774 28,742,832
-------------- --------------
47,992,443 42,260,452
Accumulated other comprehensive income (loss) (Note 7) 51,225 (11,117)
-------------- --------------
TOTAL STOCKHOLDERS' EQUITY 48,043,668 42,249,335
-------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 123,059,355 $ 154,485,960
============== ==============
See notes to consolidated financial statements.
28
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31
---------------------------------------------
2003 2002 2001
----------- ----------- -----------
REVENUES FROM CONTINUING OPERATIONS:
Local network $ 6,117,238 $ 5,874,728 $ 5,577,680
Network access 16,075,254 15,303,857 15,928,910
Video services 3,579,773 3,698,790 3,529,627
Internet services 2,647,156 1,944,911 1,591,408
Other nonregulated services 3,903,007 3,694,504 4,445,612
----------- ----------- -----------
TOTAL REVENUES 32,322,428 30,516,790 31,073,237
COSTS AND EXPENSES:
Plant operations, excluding depreciation 4,516,711 4,080,416 3,874,509
Depreciation and amortization 7,851,511 7,987,650 9,521,086
Customer operations 1,552,109 1,850,085 1,826,847
General and administrative 4,531,736 4,432,242 3,889,590
Other operating expenses:
Video service expenses 3,026,613 3,183,933 2,841,134
Internet expenses 910,900 1,019,121 1,003,623
Other 1,976,202 1,321,972 1,447,222
----------- ----------- -----------
TOTAL COSTS AND EXPENSES 24,365,782 23,875,419 24,404,011
----------- ----------- -----------
OPERATING INCOME FROM CONTINUING OPERATIONS 7,956,646 6,641,371 6,669,226
OTHER INCOME (EXPENSES):
Interest expense (3,401,479) (3,457,093) (3,827,678)
Income (loss) from investments in unconsolidated affilates:
Midwest Wireless Holdings, LLC (Note 5) 2,148,444 2,261,420 1,152,574
Other unconsolidated affiliates (Note 6) 96,299 (56,311) 336,039
Interest and dividend income 391,897 333,711 432,356
Gain on sale of cable television systems (Note 14) 1,080,723
Gain (loss) on sale of marketable securities (Note 7) (134,498) 3,659,055
----------- ----------- -----------
OTHER INCOME (EXPENSES), net 315,884 (1,052,771) 1,752,346
----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND
MINORITY INTEREST 8,272,530 5,588,600 8,421,572
Income tax expense (Note 8) 3,316,000 2,483,000 4,162,000
----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS BEFORE MINORITY INTEREST 4,956,530 3,105,600 4,259,572
Minority interest in continuing operations of Alliance Telecommunications Corp. (659,624) (781,403) (1,078,391)
----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS 4,296,906 2,324,197 3,181,181
DISCONTINUED OPERATIONS (Note 2):
Income from operations of asset group distributed in split-up of Alliance
Telecommunications Corporation, net of income taxes 988,748 1,956,900 2,110,255
Minority interest in discontinued operations of Alliance Telecommunications Corp. (316,399) (626,208) (675,282)
Gain on split-up of Alliance Telecommunications Corp., net of income taxes 209,505
----------- ----------- -----------
INCOME FROM DISCONTINUED OPERATIONS 881,854 1,330,692 1,434,973
----------- ----------- -----------
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 5,178,760 3,654,889 4,616,154
Cumulative effect of change in accounting principle, net of income taxes and
minority interest (3,146,569)
----------- ----------- -----------
NET INCOME $ 5,178,760 $ 508,320 $ 4,616,154
=========== =========== ===========
BASIC NET INCOME PER COMMON SHARE (Note 1):
Before cumulative effect of change in accounting principle:
Continuing operations $ 1.23 $ .67 $ .92
Discontinued operations .25 .38 .41
Cumulative effect of accounting change (.90)
----------- ----------- -----------
$ 1.48 $ .15 $ 1.33
=========== =========== ===========
DILUTED NET INCOME PER COMMON SHARE (Note 1):
Before cumulative effect of change in accounting principle:
Continuing operations $ 1.14 $ .62 $ .85
Discontinued operations .23 .35 .38
Cumulative effect of accounting change (.84)
----------- ----------- -----------
$ 1.37 $ .13 $ 1.23
=========== =========== ===========
AVERAGE SHARES OUTSTANDING (Notes 1 and 10):
Common shares only 3,487,000 3,498,000 3,465,000
Common and potential common shares 3,765,000 3,770,000 3,763,000
See notes to consolidated financial statements.
29
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Year Ended December 31
-----------------------------------------------------
2003 2002 2001
------------- ------------- -------------
Net income $ 5,178,760 $ 508,320 $ 4,616,154
Other comprehensive income (loss):
Unrealized holding gains (losses) on marketable securities 97,612 (304,758) 1,199,251
Reclassification adjustment for losses (gains)
included in net income 134,498 (3,659,055)
------------- ------------- -------------
Other comprehensive income (loss) before income taxes 97,612 (170,260) (2,459,804)
------------- ------------- -------------
Income tax expense (benefit) related to unrealized
holding gains and losses on marketable securities 39,053 (125,492) 492,948
Income tax expense (benefit) related to reclassification
adjustment for gains and losses included in net income 0 53,799 (1,504,043)
------------- ------------- -------------
Income tax expense (benefit) related to items of other
comprehensive loss 39,053 (71,693) (1,011,095)
Minority interest in other comprehensive loss of
Alliance Telecommunications Corporation (3,783) (16,138) (458,786)
------------- ------------- -------------
Other comprehensive income (Ioss) 62,342 (82,429) (989,923)
------------- ------------- -------------
Comprehensive income $ 5,241,102 $ 425,891 $ 3,626,231
============= ============= =============
See notes to consolidated financial statements
30
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Accumulated
Preferred Stock Common Stock Additional Other
-------------------- -------------------- Paid-in Retained Comprehensive
Shares Amount Shares Amount Capital Earnings Income (Loss) Total
--------- --------- --------- -------- ------------ ------------ ----------- ------------
BALANCE AT DECEMBER 31, 2000 221,300 $ 221,300 3,504,363 $ 35,044 $ 12,844,776 $ 24,945,512 $ 1,061,235 $ 39,107,867
Net income 4,616,154 4,616,154
Issuance of common stock under
Employee Stock Purchase Plan 11,626 116 136,998 137,114
Issuance of common stock under
Employee Stock Option Plan 52,375 524 412,351 412,875
Issuance of common stock in
exchange for preferred stock (1,200) (1,200) 1,200 12 1,188 0
Issuance of common stock to ESOP 16,709 167 225,026 225,193
Purchase and retirement of
common stock (109,704) (1,097) (407,369) (859,521) (1,267,987)
Change in unrealized gains on
marketable securities, net of
deferred taxes (989,923) (989,923)
--------- --------- --------- -------- ------------ ------------ ----------- ------------
BALANCE AT DECEMBER 31, 2001 220,100 220,100 3,476,569 34,766 13,212,970 28,702,145 71,312 42,241,293
Net income 508,320 508,320
Issuance of common stock under
Employee Stock Purchase Plan 11,578 116 96,827 96,943
Issuance of common stock under
Employee Stock Option Plan 37,159 371 222,292 222,663
Purchase and retirement of
common stock (70,239) (702) (269,120) (467,633) (737,455)
Change in unrealized gains on
marketable securities, net of
deferred taxes (82,429) (82,429)
--------- --------- --------- -------- ------------ ------------ ----------- ------------
BALANCE AT DECEMBER 31, 2002 220,100 220,100 3,455,067 34,551 13,262,969 28,742,832 (11,117) 42,249,335
Net income 5,178,760 5,178,760
Issuance of common stock under
Employee Stock Purchase Plan 15,685 157 131,166 131,323
Issuance of common stock under
Employee Stock Option Plan 34,836 348 299,572 299,920
Issuance of common stock to
Employee Stock Ownership Plan 11,000 110 139,040 139,150
Purchase and retirement of
common stock (1,106) (11) (4,333) (12,818) (17,162)
Change in unrealized gains on
marketable securities, net of
deferred taxes 62,342 62,342
--------- --------- --------- -------- ------------ ------------ ----------- ------------
BALANCE AT DECEMBER 31, 2003 220,100 $ 220,100 3,515,482 $ 35,155 $ 13,828,414 $ 33,908,774 $ 51,225 $ 48,043,668
========= ========= ========= ======== ============ ============ =========== ============
See notes to consolidated financial statements.
31
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31
-----------------------------------------------
2003 2002 2001
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income $ 5,178,760 $ 508,320 $ 4,616,154
Adjustments to reconcile net income to net cash
provided by operating activities:
Noncash cumulative effect of change in accounting principle 4,663,039
Depreciation and amortization 8,798,414 9,963,888 11,318,010
Minority stockholders' interest in earnings
of Alliance Telecommunications Corporation 976,023 12,632 1,753,673
Gain on split-up of Alliance Telecommunications Corporation (348,505)
Gains on sales of cable television systems (1,080,723)
Gains on sales of marketable securities (3,659,055)
Noncash marketable securities impairment charge 134,498
Income from Midwest Wireless Holdings LLC (2,533,703) (2,928,251) (1,474,865)
Income from other unconsolidated affiliates (272,917) (142,535) (665,365)
Cash distributions from Midwest Wireless Holdings LLC 905,051 869,723 901,295
Cash distributions from other unconsolidated affiliates 239,544 166,292 423,581
Noncash patronage refunds (192,669) (260,233) (270,793)
Noncash investment income (48,325)
Changes in assets and liabilities net of effects of
discontinued operations:
Accounts receivable (259,394) (83,043) 812,491
Materials, supplies and inventories 64,449 73,522 (423,436)
Other current assets (64,130) (45,234) 116,253
Accounts payable (379,206) 26,074 (166,716)
Accrued expenses 547,399 13,317 155,083
Income taxes payable 1,361,111 119,804 335,697
Deferred investment tax credits (18,555) (20,715) (31,399)
Deferred income taxes 1,058 155 382,904
Deferred compensation 30,558 44,650 27,458
------------ ------------ ------------
Net cash provided by operating activities 12,952,565 13,115,903 14,102,645
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment (3,912,756) (9,265,040) (10,618,722)
Sales of marketable securities 3,675,519
Decrease (increase) in construction fund (2,577,844) 97,702 (442,097)
Proceeds from sales of cable television systems 1,665,782
Investments in other unconsolidated affiliates (23,191) (50,000) (1,988,606)
Purchases of other investments (443,742) (1,301,265) (366,643)
Proceeds from other investments 1,538,423 799,880 63,240
Increase in other assets (130,696) (161,417) (135,987)
Cash effect of split-up of Alliance Telecommunications
Corporation (5,214,465)
------------ ------------ ------------
Net cash used in investing activities (9,098,489) (9,880,140) (9,813,296)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of notes payable and long-term debt (32,517,635) (6,835,525) (6,523,180)
Proceeds from issuance of notes payable and long-term debt 32,810,607 2,954,316 2,201,200
Issuance of common stock 431,243 319,606 549,989
Purchase of stock (17,162) (737,455) (1,267,987)
------------ ------------ ------------
Net cash provided by (used in) financing activities 707,053 (4,299,058) (5,039,978)
------------ ------------ ------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 4,561,129 (1,063,295) (750,629)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 12,020,186 13,083,481 13,834,110
------------ ------------ ------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 16,581,315 $ 12,020,186 $ 13,083,481
============ ============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid $ 4,338,703 $ 5,039,440 $ 5,710,494
Income taxes paid 3,491,394 3,596,254 4,650,094
See notes to consolidated financial statements.
32
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
- ---------------------------------------------------
Description of business: Hector Communications Corporation owns a 100% interest
in five local exchange telephone subsidiaries and one cable television
subsidiary. The Company also owns a 100% interest in Alliance Telecommunications
Corporation, which owns and operates four local exchange telephone companies and
an engineering company. At December 31, 2003, the Company's subsidiaries
provided telephone service to 29,882 access lines in 28 rural communities in
Minnesota, Wisconsin and North Dakota and cable television services to 9,109
subscribers in Minnesota and Wisconsin. The Company is also an investor in
partnerships and corporations providing wireless telephone and other
telecommunications related services.
Prior to July 7, 2003 Alliance Telecommunications Corporation ("Alliance") was
68% owned by HCC. ("Golden West") of Wall, South Dakota and Alliance
Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota own the
remaining interests in Alliance. Effective July 7, 2003 Alliance was reorganized
under Section 355 of the Internal Revenue Code ("the split-up transactions'). In
the split-up transactions, Golden West exchanged its minority ownership interest
in Alliance for all of the outstanding stock of Sioux Valley Telephone Company,
its pro rata share of Alliance's ownership interest in Midwest Wireless
Holdings, LLC and certain other Alliance assets. ACCI exchanged its minority
ownership interest in Alliance for all of the outstanding stock of Hills
Telephone Company, its pro rata share of Alliance's ownership interest in
Midwest Wireless Holdings, LLC and certain other Alliance assets (Note 2). The
disclosures in the Notes for prior periods have been restated to reflect the
Company's continuing operations.
Basis of presentation: The Company's operating results for the prior periods
have been restated pursuant to the discontinued operations rules of SFAS 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets" to reflect the
effects of the split-up of Alliance Telecommunications Corporation. Certain
other amounts in the 2002 and 2001 financial statements have been reclassified
to conform to the 2003 financial statement presentation. These reclassifications
had no effect on net income or stockholders' equity as previously reported.
Principles of consolidation: The consolidated financial statements include the
accounts of Hector Communications Corporation and its subsidiaries ("HCC" or the
"Company"). All material intercompany transactions and accounts have been
eliminated.
Regulatory accounting: Accounting practices prescribed by regulatory authorities
have been considered in the preparation of the financial statements and
formulation of accounting policies for telephone subsidiaries. These policies
conform to accounting principles generally accepted in the United States of
America as applied to regulated public utilities in accordance with Statement of
Financial Accounting Standards No. 71, "Accounting for the Effects of Certain
Types of Regulation" (SFAS 71).
Estimates: The presentation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets, liabilities, and disclosure of contingent assets and
liabilities at the balance sheet date, and the reported amounts of revenues and
expenses during the reporting period. The estimates and assumptions used in the
accompanying consolidated financial statements are based upon management's
evaluation of the relevant facts and circumstances as of the time of the
financial statements. Actual results could differ from those estimates. The
Company's financial statements are also affected by depreciation rates
prescribed by regulators, which may result in different depreciation rates than
for an unregulated enterprise.
Revenue recognition: Revenues are recognized when earned, regardless of the
period in which they are billed. Network access revenues are furnished in
conjunction with interexchange carriers and are determined by cost separation
studies and nationwide average schedules. Revenues include estimates pending
finalization of cost studies. Network access revenues are based upon interstate
tariffs filed with the Federal Communications Commission by the National
Exchange Carriers Association and state tariffs filed with state regulatory
agencies. Management believes recorded revenues are reasonable based on
estimates of final cost separation studies, which are typically settled within
two years.
33
Income taxes and investment tax credits: The provision for income taxes consists
of an amount for taxes currently payable and a provision for tax consequences
deferred to future periods. For financial statement purposes, deferred
investment tax credits are being amortized as a reduction of the provision for
income taxes over the estimated useful lives of the related property, plant and
equipment.
Net income per share: Basic net income per common share is based on the weighted
average number of common shares outstanding during each year. Diluted net income
per common share takes into effect the dilutive effect of potential common
shares outstanding. The Company's potential common shares outstanding include
preferred stock, stock options and warrants. The calculation of the Company's
net income per share is included in Exhibit 11 of this form 10-K.
Stock compensation: The Company has stock plans under which stock options, stock
appreciation rights, restricted stock or deferred stock may be granted to
officers, key employees and nonemployee directors. Employees may also
participate in an employee stock purchase plan which allows them to purchase
shares through payroll deductions on favorable terms. These plans are described
more fully in Note 10. The Company has elected to apply APB Opinion No. 25,
"Accounting for Stock Issued to Employees" for measurement and recognition of
stock-based transactions with its employees and directors. If the Company had
elected to recognize compensation cost for its stock-based transactions based on
the fair value of the options method prescribed by SFAS No. 123 (see Note 10),
net income and net income per share would have been as follows:
2003 2002 2001
------------ ------------ ------------
Net income as reported $ 5,178,760 $ 508,320 $ 4,616,154
Less: Total stock-based employee
compensation expense determined
under the fair value method for
all awards (472,941) (460,794) (348,388)
------------ ------------ ------------
Pro forma net income $ 4,705,819 $ 47,526 $ 4,267,766
============ ============ ============
Basic net income per share:
As reported $ 1.48 $ .15 $ 1.33
Pro forma $ 1.35 $ .01 $ 1.23
Diluted net income per share:
As reported $ 1.37 $ .13 $ 1.23
Pro forma $ 1.25 $ .01 $ 1.13
Cash and cash equivalents: The Company considers temporary cash investments with
an original maturity of three months or less to be cash equivalents.
Accounts receivable: Receivables are stated at the amount the Company expects to
collect from outstanding balances. The Company provides for probable
uncollectible amounts through a charge to earnings and a credit to a valuation
allowance based on its assessment of the current status of individual accounts.
Balances that are still outstanding after the Company has used reasonable
collection efforts are written off through a charge to the valuation allowance
and a credit to the receivable accounts.
Property, plant and equipment: Property, plant and equipment is recorded at
cost. Depreciation is computed using principally the straight-line method.
Depreciation included in costs and expenses from continuing operations was
$7,828,067, $7,986,565 and $7,690,347 for 2003, 2002 and 2001, respectively. .
Depreciation included in costs and expenses from discontinued operations was
$938,095, $1,975,002 and $1,792,576 for 2003, 2002 and 2001, respectively.
Maintenance and repairs are charged to operations and additions or improvements
are capitalized. Items of property sold, retired or otherwise disposed of in the
ordinary course of business are removed from assets and any gains or losses are
included in accumulated depreciation.
34
Goodwill: In July, 2001 the Financial Accounting Standards Board issued SFAS No.
141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible
Assets". The Company adopted these standards effective January 1, 2002. Under
the new standards, goodwill is no longer amortized but is reviewed annually for
impairment (Note 4).
Prior to the adoption of SFAS No. 142, goodwill was amortized on the
straight-line method over periods ranging from fifteen to forty years.
Amortization included in costs and expenses from continuing operations was
$1,812,679 in 2001.
Investments in unconsolidated affiliates: The Company is a co-investor with
other rural ILECS in Midwest Wireless Holdings LLC (Note 5) and several other
partnerships and limited liability corporations (Note 6). The Company's
percentage of ownership in these joint ventures ranges from 5% to 25%. The
Company has board of director representation in each of these joint ventures and
has the ability to influence their operations. The Company uses the equity
method of accounting for these investments, which reflects original cost and
recognition of the Company's share of operating income or losses from the
respective operations.
Other investments: The Company owns Rural Telephone Bank stock, CoBank stock,
long-term certificates of deposit, and investments in the stock of other
telecommunications service providers. Long-term investments in corporations that
are not intended for resale or are not readily marketable and in which the
Company does not exercise significant influence are valued at cost, which does
not exceed net realizable value.
Other assets: Other assets owned by the Company include cable television
franchises, customer lists and other deferred charges. In accordance with SFAS
142, intangible assets determined to have an indefinite useful life are not
amortized. Intangible assets with a determinable life are amortized over the
useful life. Amortization included in expenses from continuing operations was
$23,444, $1,085 and $18,060 for 2003, 2002 and 2001, respectively (Note 4).
Financial instruments: The fair value of the Company's financial instruments
approximates carrying value except for long-term investments in other companies
and long-term debt. Other long-term investments are not intended for resale and
not readily marketable, thus a reasonable estimate of fair value is not
practicable. The fair value of long-term debt (including the current portion)
was $62,334,000 and $83,883,000 at December 31, 2003 and 2002, respectively.
Fair values were estimated based on current rates offered to the Company for
debt with similar terms and maturities.
New accounting principles: Effective January 1, 2003 the Company adopted the
provisions of Statement of Financial Accounting Standards ("SFAS") No. 143,
"Accounting for Asset Retirement Obligations". The statement establishes
accounting standards for recognition and measurement of a liability for an asset
retirement obligation and an associated asset retirement cost. The statement
applies to tangible long-lived assets, including individual assets, functional
groups of related assets and significant parts of assets. It covers a company's
legal obligations resulting from the acquisition, construction, development or
normal operation of a capital asset. The FCC has notified the Company's ILEC
subsidiaries that SFAS No. 143 will not be adopted for regulatory purposes.
Current regulatory accounting requires ILECs to accrue for asset retirement
obligations through prescribed depreciation rates. The amount of asset
retirement obligations the Company is required to record under SFAS No. 143 is
not significant. Adoption of the provisions of SFAS No. 143 did not have a
material impact on the Company's financial position or operating results.
In November 2002 the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others". This
interpretation elaborates on the disclosures required in financial statements
concerning obligations under certain guarantees. It also clarifies the
requirements related to the recognition of liabilities by a guarantor at the
inception of certain guarantees. The disclosure requirements of this
interpretation were effective on December 31, 2002, but did not require any
additional disclosures on the part of the Company. The recognition provisions of
the interpretation effective for 2003 are applicable only to guarantees issued
or modified after December 31, 2002. Adoption of these provisions did not have a
material impact on the Company's financial position or results of operations.
35
In June 2002 the FASB issued SFAS No.146, "Accounting for Costs Associated with
Exit or Disposal Activities". SFAS No. 146 nullifies Emerging Issues Task Force
(EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring)." This statement requires that a liability for a cost
associated with an exit or disposal activity be recognized when the liability is
incurred. Under EITF Issue No. 94-3, a liability for an exit cost was recognized
at the date of the entity committed to an exit plan. The provisions of this
statement were effective for exit or disposal activities initiated after
December 31, 2002. Adoption of SFAS No. 146 did not have a material impact on
the Company's financial position or results of operations.
In April 2003 the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." This statement amends and
clarifies accounting and reporting for derivative instruments. SFAS No. 149 is
effective for contracts made or modified after June 30, 2003. Adoption of SFAS
No. 149 did not have a material effect on the Company's financial position or
results of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards No.
150, "Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equities", which became effective for the Company with this
report. Adoption of this statement did not have a material impact on the
Company's consolidated results of operations and financial position.
In December 2003, the FASB issued a revision of SFAS No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits". The statement
revises the disclosures required for pension and other post-retirement benefit
plans. The new disclosure requirements are reflected in the Company's Notes to
Consolidated Financial Statements in this report as appropriate.
In December 2003, the FASB issued a revised Financial Interpretation ("FIN") No.
46, "Consolidation of Variable Interest Entities". FIN No. 46 requires the
assets, liabilities and results of operations of variable interest entities to
be included in the Company's financial statements if the entities have certain
financial characteristics. FIN No. 46 is effective for investments in
special-purpose entities for periods ending after December 15, 2003, and for
other types of entities for periods ending after March 15, 2004. Adoption of FIN
No. 46 did not result in consolidation or change the Company's disclosures for
any of the entities in which it maintains investments.
NOTE 2 - SPLIT-UP OF ALLIANCE TELECOMMUNICATIONS CORPORATION
- ------------------------------------------------------------
Effective July 7, 2003, Alliance was reorganized under Section 355 of the
Internal Revenue Code. As a result of the split-up transactions, Golden West
exchanged its 20% minority ownership interest in Alliance for all of the
outstanding stock of Sioux Valley Telephone Company, which included a pro rata
share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and
certain other Alliance assets. ACCI exchanged its 12% minority ownership
interest in Alliance for all of the outstanding stock of Hills Telephone
Company, which included a pro rata share of Alliance's ownership interest in
Midwest Wireless Holdings, LLC and certain other Alliance assets. HCC became the
100% owner of all the remaining Alliance operations and assets. The Company's
operating results have been restated to separately reflect the continuing and
discontinued Alliance operations. The effect of the split-up transactions on
recorded assets and liabilities at the split-up date was as follows:
36
Fair value of net assets transferred in split-up transactions $ 12,351,908 Gain
on split-up transactions (348,505) Noncash change in recorded assets and
liabilities:
Property, plant and equipment $ (9,339,881)
Excess of cost over net assets acquired (13,315,447)
Investment in Midwest Wireless Holdings, LLC (4,500,496)
Investments in other unconsolidated affiliates (1,634,126)
Other investments (2,209,494)
Other assets (122,635)
Noncash current assets (1,116,302)
Current liabilities 3,597,049
Long-term debt, less current portion 17,018,954
Deferred income taxes 1,387,994
Deferred compensation 308,483
Minority stockholders interest in Alliance
Telecommunications Corp. net assets transferred 3,136,963 (6,788,938)
------------ -------------
Cash transferred in split-up transactions $ 5,214,465
=============
Summarized balance sheet information for the discontinued operations that was
included in the balance sheet at December 31, 2002 was as follows:
Cash $ 2,428,061
Other current assets 1,466,404
Property, plant and equipment, net 10,021,081
Excess of cost over net assets acquired, net 13,315,447
Investment in Midwest Wireless Holdings, LLC 4,262,316
Investments in other unconsolidated affiliates 1,443,496
Other investments 2,502,593
Other assets 121,637
Current liabilities (2,398,781)
Long-term debt (17,583,631)
Deferred compensation (312,377)
Deferred taxes (1,387,286)
-------------
Net assets $ 13,878,960
=============
Operating results for the discontinued operations in the respective periods of
2003, 2002 and 2001 were as follows:
37
Six Months Ended Twelve Months Ended
June 30 December 31
----------- ---------------------------
2003 2002 2001
----------- ----------- -----------
Revenues $ 4,750,877 $ 9,204,856 $ 9,559,675
Operating costs and expenses 2,919,858 5,804,474 5,707,885
----------- ----------- -----------
Operating income 1,831,019 3,400,382 3,851,790
Other income and (expenses):
Interest expense (680,059) (1,269,706) (1,474,380)
Income from investments in unconsolidated affilates:
Midwest Wireless Holdings, LLC 385,259 666,831 322,291
Other unconsolidated affiliates 176,618 198,846 329,326
Interest and dividend income 45,911 147,547 240,228
----------- ----------- -----------
Other expense, net (72,271) (256,482) (582,535)
Income before income taxes and minority interest 1,758,748 3,143,900 3,269,255
Income tax expense 770,000 1,187,000 1,159,000
----------- ----------- -----------
Income before minority interest 988,748 1,956,900 2,110,255
Minority interest in discontinued operations of
Alliance Telecommunications Corp. (316,399) (626,208) (675,282)
Gain on split-up of Alliane Telecommunications
Corp., net of income taxes 209,505
----------- ----------- -----------
Income from discontinued operations $ 881,854 $ 1,330,692 $ 1,434,973
=========== =========== ===========
The Company accounted for this transaction using the purchase method. The
Company recognized a gain on the transaction to the extent that the fair value
of the assets transferred to Golden West and ACCI exceeded book value. The gain
was recorded as follows:
Fair value of the Company's 68% ownership interest
in assets and liabilities transferred to Golden West
and ACCI in split-up transaction $ 12,351,908
Less: Recorded value of assets and liabilities transferred
to Golden West and ACCI in split-up transaction (12,003,403)
------------
Gain on disposal before income taxes 348,505
Deferred income tax expense (139,000)
------------
Net gain $ 209,505
============
The acquisition of the minority interest in Alliance's continuing operations was
recorded as follows:
Fair value of the Company's 68% ownership interest
in assets and liabilities transferred to Golden West
and ACCI in split-up transaction $ 12,351,908
Less: Recorded value of minority interest in assets and
liabilities of continuing operations, excluding goodwill (3,866,902)
------------
Excess of fair value over book value $ 8,485,006
============
Excess of fair value over book value allocated to plant assets,
net of related deferred taxes $ 576,000
Excess of fair value over book value allocated to goodwill 7,909,006
The allocation of the excess fair value is based on management's best estimate,
pending appraisal results.
38
Immediately prior to the split-up Sioux Valley Telephone Company and Hills
Telephone Company paid dividends to Alliance totaling $12,849,000. The dividend
proceeds were applied to repay a portion of Alliance's acquisition loan from
CoBank. Concurrent with the split-up, the balance of Alliance's debt to CoBank
and the balance of the Company's debt to Rural Telephone Finance Cooperative
($3,047,000 at June 30, 2003) were retired using proceeds from a new $26,813,000
term loan from CoBank to Hector Communications Corporation.
NOTE 3 - PROPERTY, PLANT AND EQUIPMENT
- --------------------------------------
The cost of property, plant and equipment and the estimated useful lives are as
follows:
December 31
Estimated ----------------------------
useful life 2003 2002
------------ ------------- ------------
Land $ 483,371 $ 634,160
Buildings 5-40 years 5,697,302 6,658,469
Machinery and equipment 3-15 years 3,431,762 4,032,923
Furniture and fixtures 5-10 years 2,008,349 2,221,407
Telephone plant 5-33 years 76,879,020 91,153,581
Cable television plant 10-15 years 9,010,989 10,445,523
Construction in progress 663,753 400,533
------------ ------------
98,174,546 115,546,596
Less accumulated depreciation 55,086,440 58,880,798
------------ ------------
$ 43,088,106 $ 56,665,798
============ ============
NOTE 4 - GOODWILL AND INTANGIBLE ASSETS
- ---------------------------------------
Effective January 1, 2002 the Company adopted SFAS No. 142, "Goodwill and Other
Intangible Assets". Under the provisions of this accounting standard, goodwill
and intangible assets with indefinite useful lives are no longer amortized but
are instead tested for impairment on at least an annual basis.
At December 31, 2001 the Company had excess of cost over net assets acquired or
"goodwill" of $53,663,000, which was net of an amortization reserve of
$10,025,000. The Company determined that these assets have indefinite useful
lives and ceased amortization effective January 1, 2002.
During the first half of 2002, the Company tested the beginning value of its
goodwill and intangible assets as required by SFAS No. 142. As a result of this
test, the Company concluded that the carrying value of the goodwill and
intangible assets in certain of its operating units exceeded the market value.
Accordingly, the Company recognized an impairment loss and reduced its goodwill
and intangible assets by $4,663,000. After income tax benefits of $121,000 and
minority interest of $1,395,000, the charge against earnings was $3,147,000
which was recognized as a cumulative effect of change in accounting principle
and carried back to the first quarter of 2002.
In calculating the impairment charge, the fair value of the impaired reporting
units underlying the segments were estimated using used the same valuation
methodology the Company used to negotiate the breakup of Alliance. The valuation
is an average of access line and customer valuations and cash flow multiple
valuations considered appropriate in the current marketplace. The Company
believes the valuations placed on these units are consistent with values placed
on properties in recent comparable transactions and that valuation of the
reporting units using different methods would have yielded similar results.
The goodwill impairment is associated principally with goodwill resulting from
the Company's acquisition of Hager TeleCom, Inc, but also included charges from
cable television acquisitions and the acquisition of Ollig Utilities. The amount
of the impairment primarily reflects the decline in the market valuations for
telephone access lines and internet customers and valuations of competing local
exchange carrier ("CLEC") assets that have occurred since the acquisition. For
2003, the Company performed its annual impairment test of goodwill during the
third quarter. The determined fair value was sufficient to pass the impairment
test, and no impairment was recorded. Changes in the Company's goodwill by
segment are as follows:
39
Hector Alliance Consolidated
----------------- ---------------- ----------------
Balance December 31, 2001 $ 623,721 $ 53,039,029 $ 53,662,750
Impairment loss (228,447) (4,359,310) (4,587,757)
----------------- ---------------- ----------------
Balance December 31, 2002 395,274 48,678,719 49,074,993
Cable television system sales (970,673) (970,673)
Split-up of Alliance Telecommunications
Corporation:
Goodwill included in discontinued operations (13,315,447) (13,315,447)
Eliminate previously recorded goodwill related
to the minority interest acquired (11,005,952) (11,005,952)
Excess fair value allocated to goodwill in
acquisition of minority interest 7,909,006 7,909,006
----------------- ---------------- ----------------
Balance December 31, 2003 $ 395,274 $ 31,296,653 $ 31,691,927
================= ================ ================
The Company's other intangible assets consist of deferred loan origination fees,
cable television franchises and internet customer lists. Amortization expense
for the next five years is estimated as follows: 2004 - $38,900, 2005 - $38,900,
2006 - $38,400, 2007 - $36,000, 2008 - $17,200.
At December 31, 2001, the Company had an investment in cable television
franchises of $77,000, net of an amortization reserve of $146,000. Under the
provisions of SFAS 142, the Company determined its cable television franchises
have an indefinite useful life and ceased amortization effective January 1,
2002. Cable television franchises are limited to 15 years, but are renewable as
long as the Company continues to comply with the applicable Federal
Communications Commission (FCC) rules and policies and the terms of the local
franchising authorities. Franchises may be renewed at minimal cost. The Company
intends to renew the franchises indefinitely, and has had no problems obtaining
necessary renewals. The Company will evaluate each reporting period whether
events and circumstances continue to support an indefinite useful life for the
franchises.
Changes in the Company's intangible assets by segment are as follows:
Hector Alliance
----------- ----------------------------
Intangible Intangible
Assets Assets Other Assets Consolidated
------------ ------------ ------------ ------------
Balance at December 31, 2001 $ 77,060 $ - $ 250,625 $ 327,685
Additions 7,700 98,358 54,123 160,181
Amortization (1,085) - - (1,085)
Impairment loss (75,282) - - (75,282)
------------ ------------ ------------ ------------
Balance at December 31, 2002 8,393 98,358 304,748 411,499
Additions 167,845 167,845
Disposals (14,993) (14,993)
Amortization (10,592) (21,460) (32,052)
Distributed in Alliance split-up (122,635) (122,635)
------------ ------------ ------------ ------------
Balance at December 31, 2003 $ 165,646 $ 76,898 $ 167,120 $ 409,664
============ ============ ============ ============
The following table provides a reconciliation of reported net income to pro
forma net income, including net income per share information, for the periods
ended December 31, 2003, 2002 and 2001 as if the provisions of SFAS 142 had been
effective January 1, 2001:
40
2003 2002 2001
----------- ----------- -----------
Net income as reported $ 5,178,760 $ 508,320 $ 4,616,154
Amortization 1,833,851
Midwest Wireless amortization 468,609
Midwest Wireless goodwill 252,780
Income tax expense (289,000)
Minority interest (669,282)
----------- ----------- -----------
Pro forma net income $ 5,178,760 $ 508,320 $ 6,213,112
=========== =========== ===========
Basic net income per share:
As reported $ 1.48 $ .15 $ 1.33
Pro forma $ 1.48 $ .15 $ 1.79
Diluted net income per share
As reported $ 1.37 $ .13 $ 1.23
Pro forma $ 1.37 $ .13 $ 1.65
NOTE 5 - MIDWEST WIRELESS HOLDINGS LLC
- --------------------------------------
At December 31, 2003 the Company owned 8.0% of Midwest Wireless Holdings LLC,
which provides cellular service to rural service areas in Minnesota, Wisconsin
and Iowa and the Rochester, Minnesota MSA. The Company actively participates in
Midwest Wireless' operations and has had a seat on the Board of Directors since
the inception of the Company. The Company influences Midwest Wireless policies
and procedures applying to administration, planning and budgeting, cell siting,
technology selection, roaming agreements, affiliation agreements, marketing and
customer service, financing, accounting policies and financial reporting and
disclosure policies and the timing of financial reports. The Company's ownership
is recorded on the equity method of accounting, which reflects original cost and
recognition of the Company's share of income or losses. The excess of cost over
the Company's share of equity in Midwest Wireless at the time of acquisition was
$5,595,000 at December 31, 2003. Excess cost was amortized in 2001 on the
straight-line method over periods ranging from twenty-five to forty years.
Amortization expense was $179,000 in 2001. At December 31, 2003, the Company's
cumulative share of income from Midwest Wireless was $10,692,000, of which
$6,468,000 was undistributed.
Midwest Wireless has loan agreements with the Rural Telephone Finance
Cooperative ("RTFC") that restrict distributions to members. At December 31,
2003, under these covenants Midwest Wireless could not make distributions to
members except for amounts necessary to pay income taxes.
Summarized audited financial information for Midwest Wireless for 2003, 2002 and
2001 is as follows:
Year Ended December 31
2003 2002 2001
--------------- -------------- --------------
Current assets $ 15,927,067 $ 12,445,979 $ 17,409,300
Noncurrent assets 360,331,919 305,838,514 285,615,880
Current liabilities 36,133,737 56,909,149 48,394,693
Noncurrent liabilities 172,862,375 115,446,843 130,528,309
Minority interest 11,617,812 9,428,619 6,913,996
Members' equity 155,645,062 136,499,882 117,188,182
Revenues 179,563,840 162,697,183 140,538,515
Expenses 152,868,437 134,583,663 123,950,155
Net income 26,695,403 28,113,520 16,588,360
41
NOTE 6 - INVESTMENTS IN UNCONSOLIDATED AFFILIATES
- -------------------------------------------------
The Company is a co-investor with other rural ILECS in several other
partnerships and limited liability corporations. These joint ventures make it
possible to offer certain services to customers, including centralized switching
or fiber optic transport of messaging, that the Company could not afford to
offer on its own. These joint ventures also make it possible to invest in new
technologies with a lower level of financial risk. The Company recognizes income
and losses from these investments on the equity method of accounting. The
following table summarizes the Company's ownership percentage, current
investment and income or loss from these investments in 2003, 2002 and 2001:
Book Value at
December 31 Income (Loss) on Investment
Ownership -------------------------- -----------------------------------------
Interest 2003 2002 2003 2002 2001
---------- ----------- ----------- --------- --------- ---------
Broadband Visions 17.3% $ 683,973 $ 698,155 $ (14,182) $ (2,190) $ (949)
Communications Mgmt Grp 6.5% 196,300 176,242 20,058 (7,172) (56,134)
Desktop Media 10.0% 159,964 375,000 (167,036) (125,000)
Northern Transport Group 20.0% 314,579 353,439 (38,860) (40,621) 121,204
NW Minnesota Spec Access 5.3% 67,725 88,612 19,113 16,032 53,232
South Central Switching 25.0% 101,399 1,894 13,039 41,906
Val-Ed Joint Venture 18.1% 1,151,302 923,561 236,813 28,838 150,671
West Central Transport 5.0% 222,192 213,693 38,499 60,763 53,533
Wireless North 10.4% - - (27,424)
----------- ----------- --------- --------- ---------
Investments owned by
continuing operations 2,796,035 2,930,101 96,299 (56,311) 336,039
Investments owned by
discontinued operations 1,443,496 176,618 198,846 329,326
----------- ----------- --------- --------- ---------
$ 2,796,035 $ 4,373,597 $ 272,917 $ 142,535 $ 665,365
=========== =========== ========= ========= =========
NOTE 7 - MARKETABLE SECURITIES AND GAINS ON SALES OF INVESTMENTS
- ----------------------------------------------------------------
Marketable securities consist principally of equity securities of other
telecommunications companies obtained by the Company's subsidiaries in sales of
investments in wireless telephone partnerships. The Company's marketable
securities portfolio was classified as available-for-sale at December 31, 2003
and December 31, 2002. The cost and fair values of available-for-sale investment
securities were as follows:
Gross Gross
Unrealized Unrealized Fair
Cost Gains Losses Value
--------- --------- --------- ---------
December 31, 2003 $ 126,482 $ 100,529 $ (15,165) $ 211,846
December 31, 2002 $ 126,482 $ 21,292 $ (33,540) $ 114,234
Net unrealized gains on marketable securities, net of related deferred taxes and
minority interest, are included in stockholders' equity as accumulated other
comprehensive income (loss) at December 31, 2003 and 2002 as follows:
Net Deferred Accumulated
Unrealized Income Minority Comprehensive
Gains(Losses) Taxes Interest Income(Loss)
--------- --------- --------- ---------
December 31, 2003 $ 85,364 $ (34,139) $ - $ 51,225
December 31, 2002 $ (12,248) $ 4,914 $ (3,783) $ (11,117)
These amounts have no cash effect and are not included in the statement of cash
flows.
During 2002 the Company determined that its investment in certain
available-for-sale securities was permanently impaired. Due to the impairment,
the Company reduced the cost basis of its marketable securities by $134,500 and
recorded a charge against net income.
42
Gross proceeds from sales of available-for-sale securities were $3,676,000 in
2001. Gross realized gains on sales of securities were $3,659,000 in 2001.
Realized gains on sales are based on the difference between net sales proceeds
and the book value of the securities sold, using the specific identification
method.
NOTE 8 - INCOME TAXES
- ---------------------
Before completion of the split-up of Alliance Telecommunications Corporation,
Hector Communications Corporation and its wholly owned subsidiaries filed a
consolidated tax return separate from the consolidated return for Alliance and
its subsidiaries. Since the split-up date all subsidiary companies are included
in Hector's consolidated return. Income tax expenses (benefits) from continuing
operations on the last three years were:
Year Ended December 31
-----------------------------------------
2003 2002 2001
----------- ------------ -----------
Currently payable taxes:
Federal $ 2,434,000 $ 1,483,000 $ 3,154,000
State 1,039,000 803,000 943,000
----------- ----------- -----------
3,473,000 2,286,000 4,097,000
Deferred income taxes (benefit) (138,000) 218,000 96,000
Deferred investment tax credits (19,000) (21,000) (31,000)
----------- ----------- -----------
$ 3,316,000 $ 2,483,000 $ 4,162,000
=========== =========== ===========
Deferred tax assets and liabilities as of December 31 related to the following:
2003 2002
----------- -----------
Deferred tax liabilities:
Accelerated depreciation $ 4,766,870 $ 6,158,754
Partnership and LLC investments 1,329,000 903,000
Marketable securities 39,000 1,000
Other 137,000 -
----------- -----------
6,271,870 7,062,754
Deferred tax assets:
Deferred compensation 274,000 376,000
Intangibles 200,000 238,000
Accrued expenses 261,000 272,000
Bad debts 213,000 255,000
Other 421,000 55,000
----------- -----------
1,369,000 1,196,000
----------- -----------
Net deferred tax liability $ 4,902,870 $ 5,866,754
=========== ===========
The provision for income taxes varied from the federal statutory tax rate as
follows:
Year Ended December 31
---------------------------
2003 2002 2001
------- ------- -------
Tax at U.S. statutory rate 35.0% 35.0% 35.0%
Surtax exemption (.9) (1.0) (1.0)
State income taxes, net of federal benefit 6.2 11.5 7.7
Excess of cost over net assets acquired - - 7.1
Investment tax credits (.2) (.4) (.4)
Other - (.7) 1.0
------- ------- -------
Effective tax rate 40.1% 44.4% 49.4%
======= ======= =======
43
NOTE 9 - NOTES PAYABLE AND LONG-TERM DEBT
- -----------------------------------------
December 31
------------------------------
2003 2002
------------ ------------
Notes payable to CoBank by Hector Communications
Corporation in quarterly installments, average interest rate
of 4.4%, due 2004 to 2013 $ 26,125,000
Notes payable to CoBank by Alliance Telecommunications
Corporation $ 38,186,000
Rural Utilities Service ("RUS") and Rural Telephone
Bank ("RTB") mortgage notes, payable by telephone
company subsidiaries in monthly and quarterly
installments, average rate of 5.0%, due 2004 to 2028 37,239,260 39,953,618
Notes payable to Rural Telephone Finance Cooperative 3,157,051
Notes payable to former owners of Felton Telephone
Company by Hector Communications Corporation in
monthly installments, interest rate of 8.25%, due 2005 702,918 1,215,491
------------ ------------
64,067,178 82,512,160
Less current portion 6,537,800 7,364,600
------------ ------------
$ 57,529,378 $ 75,147,560
============ ============
The Rural Utilities Service (RUS) and the Rural Telephone Bank (RTB) are the
Company's primary sources of long-term financing for additions to telephone
plant and equipment. The RUS has made long-term, low-interest loans to telephone
companies since 1949 for the purpose of improving telephone service in rural
areas. The RUS is authorized to make hardship loans at a 5% interest rate and
cost-of-money loans at a rate reflecting the government's cost of money for a
like term. The RTB advances funds at the average U.S. government cost-of-money
for the year for like maturities. In some cases RTB loans are made concurrently
with RUS loans.
Substantially all of the telephone plant of the LEC subsidiaries is pledged or
is subject to mortgages to secure obligations to the RUS and RTB. At December
31, 2003, the Company's local exchange carrier subsidiaries had unadvanced loan
commitments under the RUS and RTB programs aggregating approximately $13,299,000
to finance specific construction activities in future years.
Alliance had a term loan agreement with CoBank which was used to fund the
acquisition of Ollig Utilities Company. As part of the Alliance split-up
transaction, the original acquisition loan was repaid with funds from a new term
loan to HCC from CoBank. As a condition of maintaining the loan, the Company
owns stock in the bank. At December 31, 2003, investment in CoBank stock was
$2,555,000.
CoBank is a cooperative, owned and controlled by its customers. Each customer
borrowing from the bank on a patronage basis shares in the bank's net income
through payment of patronage refunds. Patronage refunds included in continuing
operations were $219,000, $194,000 and $210,000 in 2003, 2002 and 2001,
respectively. Approximately 50% of patronage refunds are received in cash, with
the balance in stock in the bank. The accrued patronage refund is reflected in
the Company's operating statement as a reduction of interest expense. The
Company cannot predict what patronage refunds might be in future years.
Pledges of the parent company assets and the stock of the Company's subsidiaries
secure CoBank's loan. Interest rates on long-term portions of the loan are fixed
through 2007, while the non-fixed portion floats at short-term market rates. The
average rate on the total loan was approximately 4.4% at December 31, 2003.
Principal payments are made quarterly and will continue until April 2013.
The amount of dividends on common stock that may be paid by the subsidiaries to
the Company is limited by certain financial covenants set forth in the RUS, RTB
and CoBank mortgages. At December 31, 2003, $11,863,000 of subsidiaries'
retained earnings was available for dividend payments to HCC. At December 31,
2003, $32,614,000 of HCC's retained earnings were not available to pay dividends
to shareholders due to restrictions in the debt agreements.
44
The Company is continuing its construction program to upgrade its telephone and
cable television properties. Planned expenditures for HCC and Alliance
properties in 2004 are $4,387,000. The Company intends to use RUS and RTB loan
funds to help finance these projects. Loan funds received are deposited in
construction fund accounts and disbursements are restricted, subject to RUS
approval, to construction costs authorized by the loan agreements.
Until July 7, 2003 the Company had a term loan and a $5,000,000 revolving line
of credit from Rural Telephone Finance Cooperative ("RTFC"). Part of the
proceeds of the Company's new term loan from CoBank was used to repay the RTFC
loan and terminate the revolving line of credit.
The annual requirements for principal payments on notes payable and long-term
debt are as follows:
2004 $ 6,537,800
2005 6,340,900
2006 6,451,800
2007 6,650,000
2008 6,847,700
NOTE 10 - STOCKHOLDERS' EQUITY
- ------------------------------
Preferred stock is entitled to share ratably with common shareholders in any
dividends or distributions paid by the Company, but are not entitled to any
dividend distribution separate from common shareholders. Preferred shareholders
have no voting rights. Each share of preferred stock is convertible into one
share of common stock.
Common shares are reserved for issuance in connection with stock option plans
under which 1,100,000 shares may be issued pursuant to stock options, stock
appreciation rights, restricted stock or deferred stock granted to officers and
key employees. Exercise prices of stock options under the plan cannot be less
than fair market value of the stock on the date of grant. Rules and conditions
governing awards of stock options, stock appreciation rights and restricted or
deferred stock are determined by the Compensation Committee of the Board of
Directors, subject to certain limitations incorporated into the plan. Another
provision of the plans automatically grants 3,000 shares of nonqualified stock
options per year to each nonemployee director. Options issued under this
provision have a ten-year term and an exercise price not less than fair market
value at date of grant. At December 31, 2003, 273,833 shares were available to
be issued under the plans. Changes in outstanding employee and director stock
options during the three years ended December 31, 2003 are as follows:
Average
Number of exercise price
shares per share
------- ---------
Outstanding at December 31, 2000 349,075 $ 9.83
Granted 105,550 10.28
Exercised (64,800) 7.79
Canceled (750) 10.84
------- ---------
Outstanding at December 31, 2001 389,075 10.29
Granted 111,800 13.27
Exercised (53,800) 8.24
Canceled (900) 11.91
------- ---------
Outstanding at December 31, 2002 446,175 11.28
Granted 115,850 12.18
Exercised (67,125) 10.22
Canceled (23,583) 11.86
------- ---------
Outstanding at December 31, 2003 471,317 $ 11.62
======= =========
Options issued to officers and key employees are subject to vesting. Options are
vested and become exercisable one-third at the date of issue, one-third one year
from date of issue and one-third two years from date of issue. At December 31,
2003, 373,800 stock options are currently exercisable at an average price of
$11.42 per share. The following table summarizes the status of stock options
outstanding at December 31, 2003 :
45
Weighted Average Weighted
Remaining Average
Range of Exercise Prices Shares Option Life Exercise Price
- ------------------------ -------- ----------- --------------
$ 6.87 to $ 9.99 48,800 .6 years $ 8.57
$10.00 to $12.00 265,267 2.9 years 11.22
$12.01 to $14.43 157,250 4.4 years 13.26
At the 2003 Annual Meeting shareholders adopted the 2003 Employee Stock Purchase
Plan ("ESPP"), for which 100,000 shares are reserved. Under terms of the plan,
eligible employees may acquire shares of common stock through payroll deductions
of not more than 10% of compensation. The price of shares purchased by the
employees is 85% of the lower of fair market value for such shares on one of two
specified dates in each plan year. A participant is limited to the acquisition
in any plan year to the number of shares which their payroll deductions for the
year would purchase based on the market price on the first day of the year or
$25,000, whichever is less. At December 31, 2003 employees had subscribed to
purchase an additional 12,400 shares in the current plan cycle ending August 31,
2004. Shares issued to employees under the 1990 Employee Stock Purchase Plan
were 15,685, 11,578 and 11,626 for the plan years ended August 31, 2003, 2002
and 2001, respectively.
The Company has adopted the disclosure provisions of SFAS No. 123, "Accounting
for Stock-Based Compensation", but applies APB Opinion No. 25, "Accounting for
Stock Issued to Employees" for measurement and recognition of stock-based
transactions with its employees. If the Company had elected to recognize
compensation cost for its stock based transactions using the method prescribed
by SFAS No. 123, net income and earnings per share would have been as follows:
Year Ended December 31
---------------------------------------------
2003 2002 2001
----------- ----------- -----------
Net income $ 4,705,819 $ 47,526 $ 4,267,766
Basic net income per share $ 1.35 $ .01 $ 1.23
Diluted net income per share $ 1.25 $ .01 $ 1.13
The fair value of the Company's stock options and Employee Stock Purchase Plan
transactions used to compute pro forma net income and net income per share
disclosures is the estimated present value at grant date using the Black-Scholes
option-pricing model. The following table displays the assumptions used in the
model:
Year Ended December 31
--------------------------------------
2003 2002 2001
---------- ---------- ----------
Expected volatility 29.6% 29.8% 29.3%
Risk free interest rate 2.9% 4.6% 4.7%
Expected holding period - employees 4 years 4 years 4 years
Expected holding period - directors 7 years 7 years 7 years
Dividend yield 0% 0% 0%
Pro forma stock-based compensation cost was $472,941, $460,794 and $348,388 in
2003, 2002 and 2001, respectively. Fair value of all options issued was
$453,450, $515,360 and $358,950 in 2003, 2002 and 2001, respectively.
The Company's Board of Directors has authorized the purchase and retirement,
from time to time, of shares of the Company's stock on the open market, or in
private transactions consistent with overall market and financial conditions.
The Company purchased and retired 1,106, 70,239 and 109,704 shares in 2003, 2002
and 2001 respectively. Cost of the repurchased shares was $17,000, $737,000 and
$1,268,000 in 2003, 2002 and 2001 respectively. At December 31, 2003, 215,000
shares could be repurchased under outstanding Board authorizations.
Effective August 1, 1990, the Board of Directors adopted an employee stock
ownership plan ("ESOP"). Contributions to the ESOP are determined by the Board
on an annual basis and can be made in cash or by issuing shares of the Company's
common stock. ESOP expense reflects the market value of company stock
contributed to the accounts of eligible employees at the time of the
contribution. ESOP expense was $284,600, $139,200 and $133,200 for 2003, 2002
and 2001, respectively. At December 31, 2003, the ESOP held 86,138 shares of the
46
Company's common stock, all of which had been allocated to the accounts of
participating employees. All eligible employees of Hector Communications
Corporation and its subsidiaries participate in the plan after completing one
year of service. Employees of Alliance Telecommunications Corporation did not
participate in the plan in 2002 and 2001. Contributions are allocated to each
participant based on compensation and vest 30% after three years of service and
incrementally thereafter, with full vesting after seven years.
In 1999 the Board of Directors adopted a shareholders' rights plan. Under the
plan, the Board of Directors declared a distribution of one right per share of
common stock. Each right entitles the holder to purchase 1/100th of a share of a
new series of Junior Participating Preferred Stock of the Company at an initial
exercise price of $65. The rights expire on July 27, 2009. The rights will
become exercisable only following the acquisition by a person or group, without
the prior consent of the Board of Directors, of 15% or more of the Company's
voting stock, or following the announcement of a tender offer or exchange offer
to acquire an interest of 15% or more. If the rights become exercisable, each
rightholder will be entitled to purchase, at the exercise price, common stock
with a market value equal to twice the exercise price. Should the Company be
acquired, each right would entitle the holder to purchase, at the exercise
price, common stock of the acquiring company with a market value equal to twice
the exercise price. Any rights owned by the acquiring person or group would
become void.
NOTE 11 - EMPLOYEE BENEFIT PLANS
The Company has 401(k) savings plans for its employees. Employees who meet
certain age and service requirements may contribute up to 15% of their salaries
to the plan on a pretax basis. The Company matches a portion of employee
contributions. Contributions to the plan by the Company's continuing operations
for 2003, 2002 and 2001 were approximately $166,000, $181,000 and $178,000
respectively.
In 2002 and 2001, employees of Alliance who met certain age and service
requirements were eligible to participate in a profit sharing plan. The plan was
terminated in 2003 and employees of Alliance's continuing operations now
participate in the Company's ESOP. Contributions to the plan by the Company's
continuing operations in 2002 and 2001 were $235,000 and $207,000 respectively.
Alliance had a deferred compensation agreement with two former officers of Ollig
Utilities, Inc. Under the agreement, the salaries of these officers were
continued after their retirement based on a formula stated in the agreement.
Under the terms of the split-up agreement, the Company is responsible for 68% of
the remaining deferred compensation, Golden West is responsible for 20% and ACCI
is responsible for 12%. Deferred compensation expense included in continuing
operations under the plan was $98,000, $94,000 and $82,000 in 2003, 2002 and
2001 respectively. Payments made under the agreement by the Company's continuing
operations were $63,000 in each of the last three years.
NOTE 12 - TRANSACTIONS WITH COMMUNICATIONS SYSTEMS, INC.
Transactions between the Company and Communications Systems, Inc. (CSI), the
Company's former parent, are based on a distribution agreement, which provides
for the Company's use of certain of CSI's staff and facilities, with related
costs paid by the Company. Services provided by CSI aggregated approximately
$208,000, $186,000 and $286,000 in 2003, 2002 and 2001 respectively.
Costs of services from CSI may not be indicative of the costs of such services
had they been obtained from a different party. Intercompany accounts with CSI
are handled on an open account basis. Outstanding amounts payable to CSI were
$229,000 and $74,000 at December 31, 2003 and 2002, respectively.
NOTE 13 - SEGMENT INFORMATION
The Company is organized into two business segments: Hector Communications
Corporation and its subsidiaries, and Alliance Telecommunications Corporation
and its subsidiaries. No single customer accounted for a material portion of the
Company's revenues in any of the last three years. Segment information is as
follows:
47
Hector Alliance Consolidated
-------------- -------------- ---------------
Year Ended December 31, 2003
- ----------------------------
Revenues from continuing operations $ 9,954,322 $ 22,368,106 $ 32,322,428
Costs and expenses 8,166,569 16,199,213 24,365,782
-------------- -------------- ---------------
Operating income from continuing operations 1,787,753 6,168,893 7,956,646
Interest expense (1,420,001) (1,981,478) (3,401,479)
Income from unconsolidated affiliates:
Midwest Wireless Holdings LLC 803,096 1,345,348 2,148,444
Other unconsolidated affiliates 26,991 69,308 96,299
Interest and dividend income 110,994 280,903 391,897
Gain on sale of cable television systems 1,080,723 1,080,723
-------------- -------------- ---------------
Income from continuing operations before
income taxes and minority interest $ 1,308,833 $ 6,963,697 $ 8,272,530
============== ============== ===============
Depreciation and amortization:
Continuing operations $ 2,993,511 $ 4,858,000 $ 7,851,511
Continuing operations - charged to interest expense 8,607 201 8,808
Discontinued operations 938,095 938,095
-------------- -------------- ---------------
$ 3,002,118 $ 5,796,296 $ 8,798,414
============== ============== ===============
Total assets $ 38,256,910 $ 84,802,445 $ 123,059,355
============== ============== ===============
Capital expenditures:
Continuing operations $ 1,397,656 $ 2,258,205 $ 3,655,861
Discontinued operations 256,895 256,895
-------------- -------------- ---------------
$ 1,397,656 $ 2,515,100 $ 3,912,756
============== ============== ===============
Year Ended December 31, 2002
- ----------------------------
Revenues from continuing operations $ 9,466,013 $ 21,050,777 $ 30,516,790
Costs and expenses 8,541,209 15,334,210 23,875,419
-------------- -------------- ---------------
Operating income from continuing operations 924,804 5,716,567 6,641,371
Interest expense (891,553) (2,565,540) (3,457,093)
Income from unconsolidated affiliates:
Midwest Wireless Holdings LLC 844,403 1,417,017 2,261,420
Other unconsolidated affiliates 46,892 (103,203) (56,311)
Interest and dividend income 135,169 198,542 333,711
Loss on marketable securities (134,498) (134,498)
-------------- --------------- ----------------
Income from continuing operations before
income taxes and minority interest $ 1,059,715 $ 4,528,885 $ 5,588,600
============== ============== ===============
Depreciation and amortization:
Continuing operations $ 3,139,678 $ 4,847,972 $ 7,987,650
Continuing operations - charged to interest expense 1,236 1,236
Discontinued operations 1,975,002 1,975,002
-------------- -------------- ---------------
$ 3,139,678 $ 6,824,210 $ 9,963,888
============== ============== ===============
Total assets:
Continuing operations $ 30,564,628 $ 88,537,026 $ 119,101,654
Discontinued operations 35,384,306 35,384,306
-------------- -------------- ---------------
$ 30,564,628 $ 123,921,332 $ 154,485,960
============== ============== ===============
Capital expenditures:
Continuing operations $ 2,608,523 $ 5,120,598 $ 7,729,121
Discontinued operations 1,535,919 1,535,919
-------------- -------------- ---------------
$ 2,608,523 $ 6,656,517 $ 9,265,040
============== ============== ===============
48
Hector Alliance Consolidated
-------------- -------------- ----------------
Year Ended December 31, 2001
Revenues from continuing operations $ 9,807,109 $ 21,266,128 $ 31,073,237
Costs and expenses 8,167,467 16,236,544 24,404,011
-------------- -------------- ----------------
Operating income from continuing operations 1,639,642 5,029,584 6,669,226
Interest expense (903,875) (2,923,803) (3,827,678)
Income from unconsolidated affiliates:
Midwest Wireless Holdings LLC 467,708 684,866 1,152,574
Other unconsolidated affiliates 93,581 242,458 336,039
Interest and dividend income 263,542 168,814 432,356
Gain on sale of marketable securities 3,659,055 3,659,055
-------------- -------------- ----------------
Income from continuing operations before
income taxes and minority interest $ 1,560,598 $ 6,860,974 $ 8,421,572
============== ============== ================
Depreciation and amortization:
Continuing operations $ 3,178,259 $ 6,342,827 $ 9,521,086
Continuing operations - charged to interest expense 1,236 1,236
Discontinued operations 1,795,688 1,795,688
-------------- -------------- ---------------
$ 3,178,259 $ 8,139,751 $ 11,318,010
============== ============== ===============
Total assets:
Continuing operations $ 31,030,867 $ 91,296,203 $ 122,327,070
Discontinued operations 35,923,983 35,923,983
-------------- -------------- ---------------
$ 31,030,867 $ 127,220,186 $ 158,251,053
============== ============== ===============
Capital expenditures:
Continuing operations $ 3,984,562 $ 4,634,739 $ 8,619,301
Discontinued operations 1,999,421 1,999,421
-------------- -------------- ---------------
$ 3,984,562 $ 6,634,160 $ 10,618,722
============== ============== ===============
NOTE 14 - SALES OF CABLE TELEVISION SYSTEMS
Alliance completed sales of two groups of cable television systems during the
second quarter of 2003. Alliance sold four systems in rural North Dakota serving
930 subscribers to MLGC, LLC for $200,000 of cash and a note receivable of
$650,000. Alliance sold systems serving 1,150 subscribers in three communities
surrounding the Fargo, ND - Moorhead, MN area to Cable One, Inc. for $1,545,000
of cash (including $80,000 of escrowed funds). Effect of the asset sales was as
follows:
Sales Price $ 2,395,032
Less: Property, plant and equipment (net) (343,636)
Less: Intangible assets (goodwill) (970,673)
-----------------
Gain on sale of cable assets $ 1,080,723
=================
49
(b) SUPPLEMENTAL FINANCIAL INFORMATION
Unaudited Quarterly Operating Results
(in thousands except per share amounts)
Quarter Ended
March 31 June 30 Sept 30 Dec 31
- ------------------------------------------------------------------------------------------------------------------
2003
Revenues from continuing operations $ 8,033 $ 8,054 $ 8,107 $ 8,128
Operating income from continuing operations 1,832 1,820 2,120 2,184
Income from continuing operations 732 1,290 1,008 1,267
Income from discontinued operations 395 278 209
Net income 1,127 1,568 1,217 1,267
Basic net income per share:
Continuing operations $ .21 $ .37 $ .29 $ .36
Discontinued operations .11 .08 .06
--------- --------- --------- --------
$ .32 $ .45 $ .35 $ .36
======== ========= ========= ========
Diluted net income per share:
Continuing operations $ .20 $ .34 $ .27 $ .33
Discontinued operations .10 .08 .05
--------- --------- --------- --------
$ .30 $ .42 $ .32 $ .33
======== ========= ========= ========
2002
Revenues from continuing operations $ 7,544 $ 7,223 $ 8,299 $ 7,451
Operating income from continuing operations 1,795 1,170 2,629 1,047
Income from continuing operations 755 365 1,087 118
Income from discontinued operations 330 372 242 386
Income before cumulative effect of
change in accounting principle 1,085 737 1,329 504
Cumulative effect of change in accounting principle (3,147)
Net income (loss) (2,062) 737 1,329 504
Basic net income (loss) per share:
Continuing operations $ .22 $ .10 $ .31 $ .03
Discontinued operations .09 .11 .07 .11
Cumulative effect of accounting change (.90)
--------- --------- --------- --------
$ (.59) $ .21 $ .38 $ .14
========= ========= ========= ========
Diluted net income (loss) per share:
Continuing operations $ .20 $ .09 $ .29 $ .03
Discontinued operations .09 .10 .06 .11
Cumulative effect of accounting change (.84)
--------- --------- --------- --------
$ (.55) $ .19 $ .35 $ .14
========= ========= ========= ========
50
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A. CONTROLS AND PROCEDURES
The Company, with the participation of management, including the Chief Executive
Officer ("CEO") and Chief Financial Officer ("CFO"), evaluated the effectiveness
of the Company's disclosure controls and procedures as of the end of the period
covered by this report. Disclosure controls and procedures are designed to
provide a reasonable level of assurance that information required to be
disclosed in the Company's reports under the Securities Exchange Act of 1934 is
recorded and reported within the appropriate time periods. Based upon that
evaluation, the CEO and CFO concluded that the Company's disclosure controls and
procedures are effective. During the period covered by this report, there have
been no changes in internal control over financial reporting that have
materially affected or are reasonably likely to materially affect the Company's
internal control over financial reporting.
51
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by paragraphs (a), (c), (d), (e), and (f) of Item 401
under Regulation S-K, to the extent applicable, will be set forth under the
caption "Election of Directors" in the Company's definitive proxy material for
its May 20, 2004 Annual Meeting of Shareholders to be filed within 120 days from
the end of the Registrant's fiscal year, which information is expressly
incorporated by reference herein. The information called for by paragraph (b) of
Item 401 is set forth under Item 1(a)(c) herein. The information called for by
Item 405 under Regulation S-K, to the extent applicable, will be set forth under
the caption "Certain Transactions" in the Company's above referenced definitive
proxy material.
Code of Ethics
The Company has adopted a Code of Ethics and Business Conduct applicable to all
officers of the Company as well as certain other key accounting personnel. A
copy of the Code of Ethics can be obtained free of charge upon written request
directed to HCC's Assistant Secretary at the executive offices of the Company.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by Item 402 under Regulation S-K to the extent
applicable, will be set forth under the caption "Executive Compensation" in the
Company's definitive proxy materials for its May 20, 2004 Annual Meeting to be
filed within 120 days from the end of the Registrant's fiscal year, which
information is expressly incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by Item 403 under Regulation S-K will be set forth
under the captions "Security Ownership of Certain Beneficial Owners and
Management" and "Election of Directors" in the Company's definitive proxy
materials for its May 20, 2004 Annual Meeting to be filed within 120 days from
the end of the Registrant's fiscal year, which information is expressly
incorporated herein by reference. In addition, the information required by Item
201(d) of Regulation S-K appears herein under Item 5(d).
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by Item 404 under Regulation S-K will be set forth
under the caption "Certain Transactions" in the Company's definitive proxy
materials for its May 20, 2004 Annual Meeting to be filed within 120 days from
the end of the Registrant's fiscal year, which information is expressly
incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information called for will be set forth under the caption "The Company's
Auditors" in the Company's definitive proxy materials for its May 20, 2004
Annual Meeting to be filed within 120 days from the end of the Registrant's
fiscal year, which information is expressly incorporated herein by reference.
52
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
(a) (1) Consolidated Financial Statements
The following Consolidated Financial Statements of Hector Communications
Corporation and subsidiaries appear at pages 27 to 49 herein:
Independent Auditors' Report for the years ended December 31, 2003, 2002
and 2001
Consolidated Balance Sheets as of December 31, 2003 and 2002
Consolidated Statements of Income for the years ended December 31, 2003,
2002 and 2001
Consolidated Statements of Comprehensive Income for the years ended
December 31, 2003, 2002 and 2001
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the years ended December 31,
2003, 2002 and 2001
Notes to Consolidated Financial Statements
(a) (2) Financial Statement Schedules Page Herein
----------------------------- -----------
The following financial statement schedules are being filed as part of
this Form 10-K Report:
Independent Auditors' Report on financial statement
schedules for the years ended December 31, 2003, 2002 and 2001 55
Schedule I - Condensed Financial Information of Registrant 56-59
Schedule II - Valuation and Qualifying Accounts and Reserves 59
All other schedules are omitted as the required information is inapplicable or
the information is presented in the financial statements or related notes.
Separate financial statements of Midwest Wireless Holdings LLC, a 50
percent or less owned equity method investment, included as this entity
constitutes a "significant subsidiary" pursuant to the provisions of
Regulation S-X, Article 3-09. 60-78
(a) (3) Exhibits
The exhibits which accompany or are incorporated by reference in this
report, including all exhibits required to be filed with this report, are
described on the Exhibit Index which appears on page 79 of the sequential
numbering system used in this report.
(b) REPORTS ON FORM 8-K FILED DURING THE THREE MONTHS ENDED DECEMBER 31, 2003
The Company furnished a Form 8-K on November 19, 2003 reporting under
Item 7 and Item 12 a press release announcing its third quarter operating
results.
53
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
HECTOR COMMUNICATIONS CORPORATION
Dated: March 29, 2004 /s/ Curtis A. Sampson
----------------------------------------
Curtis A. Sampson, Chairman of the Board
of Directors and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated:
Signature Title Date
- ------------------------- ------------------------------------ --------------
/s/Curtis A. Sampson Chairman of the Board of Directors, March 29, 2004
- ------------------------- Chief Executive Officer and Director
Curtis A. Sampson
/s/Steven H. Sjogren President, Chief Operating Officer, March 29, 2004
- ------------------------- and Director
Steven H. Sjogren
/s/Paul N. Hanson Vice President, Treasurer and March 29, 2004
- ------------------------- Director
Paul N. Hanson
/s/Charles A. Braun Chief Financial Officer and March 29, 2004
- ------------------------- Principal Accounting Officer
Charles A. Braun
/s/Ronald J. Bach Director March 29, 2004
- -------------------------
Ronald J. Bach
/s/James O. Ericson Director March 29, 2004
- -------------------------
James O. Ericson
/s/Luella Gross Goldberg Director March 29, 2004
- -------------------------
Luella Gross Goldberg
/s/Paul A. Hoff Director March 29, 2004
- -------------------------
Paul A. Hoff
/s/Gerald D. Pint Director March 29, 2004
- -------------------------
Gerald D. Pint
/s/Wayne E. Sampson Director March 29, 2004
- -------------------------
Wayne E. Sampson
54
HECTOR COMMUNICATIONS CORPORATION
FINANCIAL STATEMENT SCHEDULES
INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES
Shareholders and Board of Directors
Hector Communications Corporation
The audit of the consolidated financial statements of Hector Communications
Corporation and subsidiaries referred to in our opinion dated February 13, 2004,
included the related financial statement schedules as listed in item 14(a) 2. In
our opinion, these financial statement schedules, when considered in relation to
the basic consolidated financial statements, present fairly in all material
respects the information set forth therein.
/s/ Olsen Thielen and Co., Ltd.
- -------------------------------
Olsen Thielen and Co., Ltd.
St. Paul, Minnesota
February 13, 2004
55
HECTOR COMMUNICATIONS CORPORATION
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)
BALANCE SHEETS
December 31
-----------------------------
2003 2002
------------ ------------
Assets:
Cash $ 293,225 $ 168,749
Investment in subsidiaries 68,115,882 44,381,330
Other current assets 1,412,500 217,996
Property, plant and equipment, net 761,108 613,875
Accounts with subsidiaries 3,418,743 167,731
Other investments 3,217,372 771,518
Other assets 159,238
------------ ------------
Total Assets $ 77,378,068 $ 46,321,199
============ ============
Liabilities and Stockholders' Equity:
Accounts payable $ 305,738 $ 40,276
Other current liabilities 2,200,744 874,537
Current portion of long-term debt 3,306,000 223,000
Long-term debt 23,521,918 2,934,051
Stockholders' equity:
Preferred stock, par value $1.00 per share;
3,000,000 shares authorized:
Convertible Series A, 220,100 shares
issued and outstanding 220,100 220,100
Common stock, par value $.01 per share;
10,000,000 shares authorized; 3,515,482 and
3,455,067 shares issued and outstanding 35,155 34,551
Additional paid-in capital 13,828,414 13,262,969
Retained earnings 33,908,774 28,742,832
Accumulated other comprehensive income (loss) 51,225 (11,117)
------------ ------------
Total Liabilities and Stockholders' Equity $ 77,378,068 $ 46,321,199
============ ============
See notes to condensed financial statements of registrant.
56
HECTOR COMMUNICATIONS CORPORATION
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)
STATEMENT OF INCOME AND COMPREHENSIVE INCOME
Year Ended December 31
-------------------------------------------------
2003 2002 2001
------------- ------------- -------------
Revenues:
Sales $ 184,881 $ 175,232 $ 181,623
Expenses:
Operating expenses 342,980 154,000 140,331
Amortization of goodwill 34,721
Interest expense, net 701,513 164,131 204,236
Income tax benefit (358,773) (44,775) (33,999)
------------- ------------- -------------
Total expenses 685,720 273,356 345,289
Loss before equity in earnings of subsidiaries (500,839) (98,124) (163,666)
Equity in earnings of subsidiaries 5,679,599 606,444 4,779,820
------------- ------------- -------------
Net income 5,178,760 508,320 4,616,154
Other comprehensive income (loss):
Unrealized holding gains (losses) of subsidiaries on
marketable securities 97,612 (304,758) 1,199,251
Reclassification adjustment for losses (gains) of
subsidiaries included in net income 134,498 (3,659,055)
------------- ------------- -------------
Other comprehensive income (loss) before
income taxes 97,612 (170,260) (2,459,804)
------------- ------------- -------------
Income tax expense (benefit) related to unrealized holding
gains (losses) of subsidiaries on marketable securities 39,053 (125,492) 492,948
Income tax expense (benefit) related to reclassification
adjustment for gains of subsidiaries included in net income 53,799 (1,504,043)
------------- ------------- -------------
Income tax expense (benefit) related to items of other
comprehensive income 39,053 (71,693) (1,011,095)
Minority interest in other comprehensive loss
of subsidiaries (3,783) (16,138) (458,786)
------------- ------------- -------------
Other comprehensive income (loss) 62,342 (82,429) (989,923)
------------- ------------- -------------
Comprehensive income $ 5,241,102 $ 425,891 $ 3,626,231
============= ============= =============
See notes to condensed financial statements of registrant.
57
HECTOR COMMUNICATIONS CORPORATION
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)
STATEMENTS OF CASH FLOWS
Year Ended December 31
-------------------------------------------------
2003 2002 2001
------------- ------------- -------------
Cash flows from operating activities:
Net income $ 5,178,760 $ 508,320 $ 4,616,154
Adjustments to reconcile net income to net cash
provided by operating activities:
Loss from other investments 7,094 2,692 448
Noncash patronage refund (12,368) (4,483) (8,326)
Equity in earnings of subsidiaries (5,679,599) (606,444) (4,779,820)
Depreciation and amortization 86,492 74,027 108,135
Changes in assets and liabilities:
Other current assets (1,199,393) 344,919 16,721
Accounts with subsidiaries (3,251,012) 231,097 1,075,849
Accounts payable 265,462 (65,911) (82,693)
Other current liabilities 1,465,357 163,000 190,440
------------- ------------- -------------
Net cash provided by operating activities (3,139,207) 647,217 1,136,908
Cash flows from investing activities:
Purchases of property, plant and equipment (225,118) (20,706) (82,243)
Purchases of other investments (2,554,925)
Cash proceeds from other investments 126,567 14,269 922
Increase in other assets (167,845)
Investments in affiliates (17,999,944)
------------- ------------- -------------
Net cash used in investing activities (20,821,265) (6,437) (81,321)
Cash flows from financing activities:
Repayment of long-term debt (3,141,633) (208,583) (195,271)
Proceeds from issuance of notes payable and long-term debt 26,812,500
Issuance of common stock 431,243 319,606 549,989
Purchase of stock (17,162) (737,455) (1,267,987)
------------- ------------- -------------
Net cash provided by (used in) financing activities 24,084,948 (626,432) (913,269)
------------- ------------- -------------
Net increase in cash and cash equivalents 124,476 14,348 142,318
Beginning cash and cash equivalents 168,749 154,401 12,083
------------- ------------- -------------
Ending cash and cash equivalents $ 293,225 $ 168,749 $ 154,401
============= ============= =============
Supplemental disclosures of cash flow information:
Interest paid $ 524,940 $ 177,004 $ 342,242
Income taxes paid 1,446,590 371,000 285,000
See notes to condensed financial statements of registrant.
58
NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT
Note 1 - Basis of Presentation
Pursuant to the rules and regulations of the Securities and Exchange Commission,
the Condensed Financial Statements of the Registrant do not include all of the
information and notes normally included in financial statements prepared in
accordance with generally accepted accounting principles. It is suggested that
these Condensed Financial Statements be read in conjunction with the
Consolidated Financial Statements and Notes thereto included in the Registrant's
Annual Report as referenced in Form 10-K, Part II, Item 8.
Note 2 - Investment in Subsidiaries
In 2003 the Company acquired the 32% minority interest in Alliance
Telecommunications Corporation.
Note 3 - Long Term Debt
December 31
2003 2002
-------------------- ------------------
Note payable to CoBank in quarterly installments, interest
Rate of 4.4%, due 2013 $ 26,125,000
Notes payable to former owners of Felton Telephone
Company in monthly installments, interest rate of 8.25%,
due 2005 702,918
Notes payable to Rural Telephone Finance Cooperative
in quarterly installments, interest rate of 5.5%, due 2013 $ 3,365,634
Less current portion (3,306,000) (209,000)
--------------------- -------------------
$ 23,521,918 $ 3,156,634
===================== ==================
The annual requirements for principal payments on notes payable and long-term
debt are as follows:
2004 $ 3,306,000
2005 2,896,000
2006 2,750,000
2007 2,750,000
2008 2,750,000
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES Schedule II -
Valuation and Qualifying Accounts and Reserves
Balance at Additions Deductions Balance
Beginning of Charged to from Other at End
Description Period Revenues Reserves Adjustments of Period
--------- ----------- -------------- ----------- -----------
Allowance for doubtful accounts:
Year ended:
December 31, 2003 $ 716,000 $ 185,000 $ 78,000 (A) $ 285,000 (B) $ 538,000
December 31, 2002 $ 396,000 $ 1,017,000 $ 697,000 (A) $ 716,000
December 31, 2001 $ 360,000 $ 311,000 $ 275,000 (A) $ 396,000
(A) Accounts determined to be uncollectible and charged off against reserve.
(B) Reserves from operations discontinued in Alliance split-up.
59
Midwest Wireless
Holdings L.L.C.
Consolidated Financial Statements
December 31, 2003, 2002 and 2001
60
Midwest Wireless Holdings L.L.C.
Index
December 31, 2003 and 2002
- -------------------------------------------------------------------------------
Page(s)
Report of Independent Auditors...............................................62
Financial Statements
Consolidated Statements of Financial Position................................63
Consolidated Statements of Operations........................................64
Consolidated Statements of Changes in Members' Equity........................65
Consolidated Statements of Cash Flows........................................66
Notes to Consolidated Financial Statements................................67-78
61
Report of Independent Auditors
To the Board of Managers and Members of
Midwest Wireless Holdings L.L.C.
In our opinion, the accompanying consolidated statements of financial
position and the related consolidated statements of operations, changes in
members' equity, and cash flows present fairly, in all material respects, the
consolidated financial position of Midwest Wireless Holdings L.L.C. (the
"Company") and subsidiaries at December 31, 2003 and 2002, and the
consolidated results of their operations, changes in members' equity, and
their cash flows for each of the three years in the period ended December 31,
2003, in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility
of the Company's management; our responsibility is to express an opinion on
these financial statements based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted in
the United States of America, which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
As discussed in Note 2 to the financial statements, the Company adopted
Statement of Financial Accounting Standards ("SFAS") No. 143, Accounting for
Asset Retirement Obligations, on January 1, 2003.
As discussed in Note 3 to the financial statements, the Company adopted SFAS
No. 142, Goodwill and Other Intangible Assets, on January 1, 2002.
PricewaterhouseCoopers LLP
Minneapolis, Minnesota
February 6, 2004
62
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Financial Position
December 31, 2003 and 2002
- ------------------------------------------------------------------------------------------------------------------
2003 2002
Assets
Current assets
Cash and cash equivalents $ 1,888,366 $ 1,367,210
Accounts receivable, less allowance for doubtful accounts of
$690,115 and $550,403 in 2003 and 2002, respectively 10,157,442 8,155,607
Inventories 2,579,643 1,411,573
Other current assets 1,301,616 1,511,589
------------------- ------------------
Total current assets 15,927,067 12,445,979
Property, cellular plant and equipment, net 121,086,239 102,219,504
Intangible assets, net 230,141,013 194,612,163
Investments in cooperatives 9,104,667 9,006,847
------------------- ------------------
Total assets $ 376,258,986 $ 318,284,493
=================== ==================
Liabilities and Members' Equity
Current liabilities
Current portion of debt $ 16,361,168 $ 14,655,912
Revolving loan - 25,000,000
Accounts payable 6,136,971 5,643,416
Accrued commissions 1,941,673 1,436,325
Other accrued expenses 11,693,925 10,173,496
------------------- ------------------
Total current liabilities 36,133,737 56,909,149
Other liabilities 3,381,894 988,120
Debt 169,480,481 114,458,723
------------------- ------------------
Total liabilities 208,996,112 172,355,992
Minority interest 11,617,812 9,428,619
Commitments
Members' equity 155,645,062 136,499,882
------------------- ------------------
Total liabilities and members' equity $ 376,258,986 $ 318,284,493
=================== ==================
The accompanying notes are an integral part of these consolidated financial
statements.
63
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Operations
Years Ended December 31, 2003, 2002 and 2001
- -----------------------------------------------------------------------------------------------------------------
2003 2002 2001
Operating revenues
Subscriber service $ 140,823,140 $ 118,573,698 $ 93,477,223
Roamer service 28,107,407 37,205,402 36,953,474
Equipment sales 6,244,201 6,352,249 10,058,368
Service fees 4,389,092 565,834 49,450
------------------- ------------------- ------------------
179,563,840 162,697,183 140,538,515
------------------- ------------------- ------------------
Operating expenses
Operations and maintenance (exclusive of
items shown separately below) 33,987,898 30,506,792 24,776,324
Cost of equipment sold 12,115,073 10,448,214 13,654,007
Home roamer costs 31,280,458 27,668,831 20,468,432
Depreciation 22,593,187 19,318,449 17,822,738
Amortization of intangible assets 267,278 - 4,505,851
Selling, general and administrative 41,111,864 35,113,593 31,292,529
------------------- ------------------- ------------------
141,355,758 123,055,879 112,519,881
------------------- ------------------- ------------------
Operating income 38,208,082 39,641,304 28,018,634
------------------- ------------------- ------------------
Other income (expense)
Interest expense (7,204,744) (8,078,374) (9,416,290)
Interest and dividend income 2,887 92,915 136,870
Other (61,529) 34,669 (41,784)
------------------- ------------------- ------------------
Total other expense (7,263,386) (7,950,790) (9,321,204)
------------------- ------------------- ------------------
Minority interest (3,494,303) (3,576,994) (2,109,070)
------------------- ------------------- ------------------
Income from continuing operations before
cumulative effect of change in accounting
principle 27,450,393 28,113,520 16,588,360
Cumulative effect of change in accounting
principle net of minority interest (754,990) - -
------------------- ------------------- ------------------
Net income $ 26,695,403 $ 28,113,520 $ 16,588,360
=================== =================== ==================
The accompanying notes are an integral part of these consolidated financial
statements.
64
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Changes in Members' Equity
Years Ended December 31, 2003, 2002 and 2001
- ------------------------------------------------------------------------------------------------------------------
Total
Capital Accumulated Members'
Contributions Income Equity
Balances at December 31, 2000 $ 84,797,020 $ 23,977,701 $ 108,774,721
Distributions to members - (8,174,899) (8,174,899)
Net income - 16,588,360 16,588,360
----------------- ------------------ ------------------
Balances at December 31, 2001 84,797,020 32,391,162 117,188,182
Redemption (83,921) (374,030) (457,951)
Distributions to members - (8,343,869) (8,343,869)
Net income - 28,113,520 28,113,520
----------------- ------------------ ------------------
Balances at December 31, 2002 84,713,099 51,786,783 136,499,882
Issuance of units related to the acquisition
of Iowa properties 1,941,468 - 1,941,468
Distributions to members - (9,491,691) (9,491,691)
Net income - 26,695,403 26,695,403
----------------- ------------------ ------------------
Balances at December 31, 2003 $ 86,654,567 $ 68,990,495 $ 155,645,062
================= ================== ==================
The accompanying notes are an integral part of these consolidated financial
statements.
65
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Cash Flows
Years Ended December 31, 2003, 2002 and 2001
- -----------------------------------------------------------------------------------------------------------------
2003 2002 2001
Cash flows from operating activities
Net income $ 26,695,403 $ 28,113,520 $ 16,588,360
Adjustments to reconcile net income to net cash provided by
operating activities
Net income allocated to minority interest 3,398,600 3,576,994 2,109,070
Provision for bad debts 1,327,703 928,358 1,115,719
Depreciation 22,593,187 19,318,449 17,822,738
Amortization of intangibles 267,278 - 4,505,851
Gain on disposal of fixed assets (125,277) (3,645) (2,124)
Writeoff of Cellular 2000, Inc. investment - 25,000 -
Patronage received in form of cooperative stock (361,318) (310,848) (132,785)
Cumulative effect of accounting change 850,693 - -
Changes in assets and liabilities
Accounts receivable (2,434,724) 1,851,263 (3,299,942)
Inventories (1,168,070) 796,314 510,885
Other assets 234,808 (277,868) (546,637)
Accounts payable 493,555 1,674,214 (2,156,106)
Accrued expenses 179,454 863,987 1,888,444
Other liabilities 1,863,618 (425,552) (689,617)
-------------- -------------- --------------
Net cash provided by operating activities 53,814,910 56,130,186 37,713,856
-------------- -------------- --------------
Cash flows from investing activities
Acquisition of cellular properties (42,780,847) - -
Payments for property, cellular plant and equipment (29,234,491) (31,901,881) (33,804,163)
Proceeds from the disposal of fixed assets 518,573 - 37,571
Purchase of FCC licenses - (7,400,239) (22,400,000)
Purchases of cooperative stock - (22,440) (1,176,440)
Redemption of cooperative stock 421,527 72,970 68,313
Payments for deferred acquisition costs - - (192,511)
-------------- -------------- --------------
Net cash used in investing activities (71,075,238) (39,251,590) (57,467,230)
-------------- -------------- --------------
Cash flows from financing activities
(Payments) proceeds on revolving loan (25,000,000) 5,000,000 17,500,000
Proceeds from debt borrowings 68,297,657 - 23,473,686
Payments on debt (14,815,075) (13,679,659) (11,016,802)
Distributions to members (9,491,691) (8,343,869) (8,174,899)
Distribution from subsidiary to minority interest (1,209,407) (1,062,371) (1,039,851)
Redemption of units - (457,951) -
-------------- -------------- --------------
Net cash provided by (used in) financing activities 17,781,484 (18,543,850) 20,742,134
-------------- -------------- --------------
Net change in cash and cash equivalents 521,156 (1,665,254) 988,760
Cash and cash equivalents
Beginning of year 1,367,210 3,032,464 2,043,704
-------------- -------------- --------------
End of year $ 1,888,366 $ 1,367,210 $ 3,032,464
-------------- -------------- --------------
Supplemental disclosure
Cash paid during the year for interest $ 8,165,844 $ 8,828,483 $ 10,540,203
Equity units issued for acquisitions 1,941,468 - -
Noncash investing activities
Equipment acquired under capital leases $ 3,244,433 - -
The accompanying notes are an integral part of these consolidated financial
statements.
66
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
1. Business Description
Midwest Wireless Holdings L.L.C. (the "Company") was formed in November
1999 as a Delaware limited liability company to acquire and operate
cellular communications properties in the Midwest portion of the United
States of America. Upon its formation, the Company exchanged its equity
units for approximately 86% of the equity units of Midwest Wireless
Communications, L.L.C.
2. Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements include the Company's wholly owned
subsidiaries, Midwest Wireless Iowa, L.L.C. and Midwest Wireless
Wisconsin, L.L.C., as well as its majority owned subsidiary, Midwest
Wireless Communications, L.L.C. All significant intercompany balances and
transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities at the date of the financial statements
and disclosure of contingent assets and liabilities at the date of the
financial statements. Estimates also affect the reported amounts of
revenues and expenses during the periods reported. Actual results could
differ from those estimates.
Concentration of Credit Risk
The Company provides cellular service and cellular telephones to a
diversified group of consumers within a concentrated geographical area.
The Company performs credit evaluations of its customers and requires a
deposit when deemed necessary. Receivables are generally due within 30
days.
Cash and Cash Equivalents
Cash and cash equivalents include cash on deposit and highly liquid
investments with original maturities of three months or less. The Company
has funds in excess of federally insured limits as of December 31, 2003
and 2002.
Cellular Telephone Inventories
Inventories consist primarily of cellular phones and accessories held for
resale with cost determined using the specific identification method.
Losses on sales of cellular phones are recognized in the period in which
sales are made as a cost of acquiring subscribers.
67
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
Property, Cellular Plant and Equipment
Property, cellular plant and equipment is stated at its original cost.
Depreciation is provided on a straight-line basis over the estimated
useful lives of the cellular plant and equipment. The estimated useful
lives of the cellular plant and equipment are as follows:
Buildings and improvements 3-30 years
Other equipment 2-20 years
Communications and network equipment 7-15 years
Vehicles 3 years
Computer equipment 3 years
Major renewals or betterments are capitalized, while repair and
maintenance expenditures are charged to operations as incurred. Interest
incurred on external borrowings during construction is capitalized. The
cost and accumulated depreciation of property, cellular plant and
equipment disposed of or sold are eliminated from their respective
accounts, and the resulting gain or loss is recorded in operations.
Intangible Assets
Customer relationships are amortized on a straight-line basis over two to
six years. FCC licenses consist of the cost of acquiring cellular,
personal communication services ("PCS"), and local multi-point
distribution licenses. It also includes the value assigned to cellular
licenses acquired through the acquisitions of operating cellular systems.
The Company ceased amortization of its licenses effective January 1,
2002, with the adoption of Statement of Financial Accounting Standards
("SFAS") No. 142, Goodwill and Other Intangible Assets (Note 3).
Long-Lived Assets
The Company periodically reviews long-lived assets and fixed assets for
impairment whenever events or changes in circumstances indicate that the
carrying value of the assets may not be recoverable. Recoverability is
based on projected cash flows on an undiscounted basis.
On January 1, 2003, the Company adopted SFAS No. 143, Accounting for
Asset Retirement Obligations. This statement relates to the costs of
closing facilities and removing assets. SFAS No. 143 requires entities to
record the fair value of a legal liability for an asset retirement
obligation ("ARO") in the period it is incurred if a reasonable estimate
of fair value can be made. This cost is initially capitalized and
amortized over the remaining life of the underlying assets. Once the
obligation is ultimately settled, any difference between the final cost
and the recorded liability is recognized as a gain or loss. For the
Company, an ARO includes those costs associated with removing component
equipment that is subject to retirement from cell sites that reside upon
leased property. As a result of adopting SFAS No. 143, on January 1,
2003, the Company recorded an ARO of $1,266,744 and a cumulative effect
of this reduction in net income, reflecting the change in accounting
principle of $850,693. The cumulative effect of this change resulted from
accumulated accretion and depreciation of the ARO and related asset as of
January 1, 2003 through December 31, 2002. After a minority interest
effect of $95,703, the net charge was $754,990. Accretion and
depreciation expenses for the year 2003 related to the ARO were $186,161.
68
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
Revenue Recognition
Service revenue consists of the base monthly service fee and airtime
revenue. Base monthly service fees are billed one month in advance and
are recognized in the month earned. Airtime and roamer revenue is
recognized when the service is provided. The Company recognizes revenue
for equipment installation when the installation is completed and the
Company recognizes equipment revenue when the equipment is delivered and
accepted by customers.
Roaming Revenue Reclassification
The Company generates revenue from charges to its customers when they use
their cellular phones in other wireless providers' markets ("Incollect
Revenue"). Until 2002, the Company included Incollect Revenue on a net
basis as a component of Home Roamer Costs as an operating expense in its
statement of operations. Expense associated with Incollect Revenue,
charged by third-party wireless providers, is also included in Home
Roamer Costs. The Company used this method because, historically, it had
passed through to its customers most of the costs related to Incollect
Revenue. However, the wireless industry and the Company have increasingly
been using pricing plans that include flat rate pricing and larger home
service areas. Under these types of plans, amounts charged to the Company
by other wireless providers may not necessarily be passed through to its
customers.
In 2002, the Company adopted a policy to include Incollect Revenue as
Subscriber Service revenue rather than in Home Roamer Costs on a net
basis. Roamer Service Revenue includes only the revenue from other
wireless providers' customers who use the Company's network ("Outcollect
Revenue"). Subscriber Service Revenue and Home Roamer Costs in the 2001
and 2000 consolidated financial statements were reclassified to conform
to this presentation. This change in presentation has no impact on
operating income, net income or members' equity.
The Company recorded Incollect Revenue of $9,021,044, $8,434,482 and
$7,549,289 for the years ended December 31, 2003, 2002 and 2001,
respectively.
Income Taxes
No provision for income taxes has been recorded since all income, losses
and tax credits are allocated to the members for inclusion in their
respective income tax returns.
Advertising
Advertising costs are expensed as incurred. Total advertising expenses
were $3,310,758, $3,317,280 and $4,448,949 for the years ended December
31, 2003, 2002 and 2001, respectively.
Stock-Based Compensation
The Company accounts for stock-based compensation using the intrinsic
value method. Accordingly, compensation cost for stock options granted to
employees is measured as the excess, if any, of the fair value of the
stock at the date of the grant over the amount an employee must pay to
acquire the stock. Such compensation costs are amortized on a
straight-line basis over the underlying option's vesting term. No such
compensation expense was recognized for the years ended December 31,
2003, 2002 and 2001.
69
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
If the Company had elected to recognize compensation expense for options
granted using the fair value method, net income would have been as
follows:
2003 2002 2001
Net income, as reported $ 26,695,403 $ 28,113,520 $ 16,588,360
Deduct: Total stock-based employee
compensation expense determined
under fair value based method for
all awards (199,789) (337,615) (214,783)
------------ ------------ ------------
Pro forma net income $ 26,495,614 $ 27,775,905 $ 16,373,577
============ ============ ============
3. Goodwill, FCC Licenses and Other Intangible Assets
Effective January 1, 2002, the Company adopted SFAS No. 142. Effective
with the adoption of this standard, the Company no longer amortizes FCC
licenses ("licenses"), which consist of licenses that provide the Company
with the exclusive right to utilize certain radio frequency spectrum to
provide wireless communication services. Although the licenses are issued
for only a fixed time, generally ten years, they are subject to renewal
by the FCC; but the renewals of licenses have occurred routinely and at
nominal cost. Moreover, there are currently no legal, regulatory,
contractual, competitive, economic, or other factors that limit the
useful lives of the licenses. As a result, licenses are treated as
indefinite-lived intangible assets and will not be amortized but rather
are tested annually for impairment. The Company evaluates the useful life
determination for licenses each reporting period to determine whether
events and circumstances continue to support an indefinite life.
In connection with the adoption of SFAS No. 142, the Company completed a
transitional and impairment test for its licenses and determined that
there was no impairment. The Company also completed annual impairment
tests on December 31, 2003 and 2002, and determined that there was no
impairment. The Company utilized a fair value approach, primarily using
discounted cash flows, to complete the impairment tests.
On October 15, 2003, the Company acquired various cellular communications
properties (Note 5). The Company allocated a portion of the excess
purchase price over the fair value of the net tangible assets acquired to
goodwill. The Company does not amortize goodwill, but will complete
annual impairment tests of the goodwill to determine if impairment
exists. As a result of this acquisition, $9,426,669 of goodwill was
recorded with no accumulated amortization.
On a prospective basis, the Company is required to test both goodwill and
indefinite-lived intangible assets for impairment on an annual basis
based upon a fair value approach. Additionally, goodwill will be tested
for impairment between annual tests if an event occurs or circumstances
change that would more likely than not reduce the fair value of entity
below its carrying value. These events or circumstances would include a
significant change in the business climate, including a significant
sustained decline in an entity's market value, legal factors, operating
performance indicators, competition, sale or disposition of a significant
portion of the business, or other factors. Other indefinite-lived
intangible assets will be tested between annual tests if events or
changes in circumstances indicate that the asset might be impaired. The
Company will next perform its annual impairment test for both goodwill
and licenses during the fourth quarter of 2004.
70
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
Indefinite-lived intangible assets consist of the following at December
31:
2003 2002
FCC Licenses $ 222,015,830 $ 204,534,427
Less: Accumulated amortization (9,922,264) (9,922,264)
------------- -------------
$ 212,093,566 $ 194,612,163
============= =============
The changes in the carrying amount of goodwill and FCC licenses for the
year ended December 31, 2003, are as follows:
Goodwill FCC Licenses
Balance as of January 1, 2003 $ - $ 194,612,163
Goodwill or FCC licenses acquired or
finally allocated during the year 9,426,669 17,481,403
------------- -------------
Balance as of December 31, 2003 $ 9,426,669 $ 212,093,566
============= =============
The adjusted amounts shown below reflect the effect of retroactive
application of discontinuance of the amortization of licenses as if the
new method of accounting had been in effect during 2001.
2003 2002 2001
Net income
Reported net income $ 26,695,403 $ 28,113,520 $ 16,588,360
Amortization - - 4,505,851
------------ ------------ -------------
Adjusted net income $ 26,695,403 $ 28,113,520 $ 21,094,211
============ ============ =============
Definite-lived intangible assets consist of the following at December 31:
2003 2002
Customer relationships $ 8,888,056 $ -
Less: Accumulated amortization (267,278) -
-------------- -------------
$ 8,620,778 $ -
============== =============
Amortization expense related to definite-lived intangible assets was
$267,278 in 2003.
71
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
Estimated amortization expense of identified intangible assets for the
next five years is as follows:
2004 $ 1,551,518
2005 1,510,927
2006 1,450,000
2007 1,450,000
2008 1,450,000
4. Select Account Information
Property, Cellular Plant and Equipment
2003 2002
Land $ 5,736,838 $ 3,643,696
Plant in service 189,462,369 153,533,992
Plant under construction 10,378,016 6,815,296
------------- -------------
205,577,223 163,992,984
Less: Accumulated amortization (84,490,984) (61,773,480)
------------- -------------
$ 121,086,239 $ 102,219,504
============= =============
The Company capitalized interest in the amount of $385,157, $443,911 and
$581,879 for the years ended December 31, 2003, 2002 and 2001,
respectively. At December 31, 2003 and 2002, accounts payable included
$612,404 and 2,100,831, respectively, related to the purchase of
property, cellular, plant and equipment. Property, cellular plant and
equipment includes plant in service under lease with a cost basis of
$3,244,433 and accumulated depreciation of $118,251.
5. Acquisitions
On October 15, 2003, the Company, through its wholly owned subsidiary,
Midwest Wireless Iowa, L.L.C., completed an acquisition of cellular
communications properties providing services to a 17-county area of Iowa.
The acquisition was accounted for as a purchase. Accordingly, the Company
allocated the excess purchase price over the fair value of the net
tangible assets acquired to FCC licenses, Goodwill and Customer
Relationships. The fair value of the acquired intangible assets was based
on an independent appraisal of the FCC licenses and Customer
Relationships. The Company is amortizing the value of Customer
Relationships over six years. As a result, the financial statements
include the operations related to the acquisition beginning at the
acquisition date.
72
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
The following table presents the computation of the purchase price, the
estimated fair value of tangible assets, FCC Licenses, Customer
Relationships acquired, and the amount allocated to goodwill. Amounts
were allocated to tangible assets and liabilities based upon their fair
values as of the date of acquisition. The fair value of property,
cellular plant and equipment was based upon an independent appraisal.
Cash $ 41,018,532
Equity units issued 1,941,468
Acquisition costs 1,092,858
Liabilities assumed and resulting from acquisition
Accounts payable and accrued liabilities 19,250
Customer deposits 64,450
Deferred revenue 425,393
Allowance for customer conversion 1,337,230
-------------
Total purchase price 45,899,181
-------------
Estimated fair value of tangible assets acquired
Accounts receivable 816,334
Prepaid expenses and unbilled revenue 103,315
Investment in cooperatives 158,029
Property, cellular plant and equipment 9,694,834
-------------
Total tangible assets 10,772,512
-------------
Estimated fair value of intangible assets acquired
Customer relationships 8,700,000
FCC licenses 17,000,000
-------------
Total intangible assets 25,700,000
-------------
Net assets acquired 36,472,512
-------------
Goodwill $ 9,426,669
=============
On June 25, 2001, the Company acquired eight digital PCS licenses from
McLeod USA, Inc. for a total purchase price of $22,400,000. The purchase
is for spectrum licenses only and does not include any other assets. The
licenses cover a total population of approximately 1.4 million in 63
counties in northern Iowa, southern Minnesota, eastern South Dakota,
eastern Nebraska and western Illinois. The purchase price together with
costs incurred of approximately $100,000 to complete the transaction was
allocated to FCC licenses.
In July 2002, the Company acquired three digital PCS licenses for
$7,385,058. The agreement is for the purchase of spectrum licenses only
and does not include any other assets. The licenses cover 26 counties
primarily in southern Minnesota.
6. Members' Capital
Members' capital includes capital contributions made by the members and
the accumulated income resulting from operations. Company income or loss
is allocated to the individual members based upon their ownership
percentage, as defined in the Limited Liability Company Agreement (the
"Agreement"). Pursuant to the Agreement, members are not obligated for
the debts and obligations of the Company, including accumulated losses in
excess of capital contributions.
73
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
Under the Agreement certain restrictions exist that dictate the specific
terms of any transfer or sale of units. Upon receipt of a bona fide offer
in writing from a third party, the other members and then the Company
have the right to purchase all, but not less than all, of the units at
the bona fide offer price within a specified time frame.
The Agreement also contains the right of co-sale under which no member
may transfer its units to an acquiring person, as defined in the
Agreement, who after such transfer would be an acquiring person without
assuring that each of the other members may participate in the transfer
of units under the same terms and conditions. The right of co-sale would
terminate in the event the Company completes a sale of securities
pursuant to a securities act or if the Company's market capitalization
would exceed $200,000,000.
Each member is entitled to one vote for each unit owned. Certain
restrictions on voting rights exist when units are sold to an acquiring
person.
7. Debt
Debt consists of the following:
Rate at Balance at
December 31 December 31
--------------------- ------------------------------------
Maturity 2003 2002 2003 2002
RTFC note, variable rate 5/12/09 4.40% 5.50% $ 8,469,711 $ 9,735,315
RTFC note, variable rate 4/30/09 4.40% 5.50% 17,726,490 20,375,286
RTFC note, variable rate 7/29/08 4.40% 5.75% 5,012,518 5,882,114
RTFC note, variable rate 7/28/08 4.40% 5.50% 4,585,861 5,381,438
RTFC note, variable rate 3/2/10 4.40% 5.50% 71,511,346 80,191,775
RTFC note, variable rate 2/3/15 4.40% 5.50% 7,152,796 7,548,707
CoBank note, variable rate 10/20/03 5.00% - 25,000,000
CoBank note, variable rate 6/30/09 4.75% 55,000,000 -
CoBank note, variable rate 6/30/09 4.75% 13,297,657 -
Farm Credit Leasing 10/16/06 3.82% 1,969,350 -
Farm Credit Leasing 11/30/08 4.00% 1,115,920 -
-------------- --------------
$ 185,841,649 $ 154,114,635
Less: Current maturities (16,361,168) (39,655,912)
-------------- --------------
$ 169,480,481 $ 114,458,723
============== ==============
The Company has entered into various agreements (the "Agreements") with
the Rural Telephone Finance Cooperative ("RTFC"). In 2000, the Company
entered into an agreement to fund the acquisitions of the Iowa and
Wisconsin cellular markets and the construction of a new headquarters
building. The Agreements provide for borrowings of up to $159,725,739.
The principal and interest on the variable and fixed rate notes are
payable in quarterly installments. The Agreements provide the Company the
option to fix the interest rate on borrowings (or portions thereof)
through the maturity date. The variable rate is based on RTFC's cost of
capital and is adjusted monthly. The Agreements also provide for a
revolving loan of up to $10,000,000. Borrowings under the revolving loan
bear interest at the prime rate plus 1.5%. The outstanding principal and
interest are due upon maturity. At December 31, 2003 and 2002, the
Company had no borrowings outstanding under the RTFC revolving loan.
74
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
The Agreements require the Company to maintain an investment in RTFC in
the amount of at least 5% of the outstanding debt balance. The Agreements
also contain covenants that restrict distributions to members and require
the Company to maintain a current ratio of not less than 1.25. At
December 31, 2002 and 2003, the Company was not in compliance with this
covenant, but a waiver was provided by RTFC. Substantially all assets of
the Company are pledged as collateral under the Agreement.
On October 22, 2001, the Company entered into an agreement with CoBank,
ACB ("CoBank") to fund the acquisition of various PCS licenses, capital
expenditures and operating funds. The original agreement provided for
borrowings of up to $40,000,000 (the "revolving loan"). At December 31,
2001, the Company had drawn $20,000,000 on the revolving loan. At
December 31, 2001, borrowings under the agreement bore interest at LIBOR
plus 2.5% or 4.85%. On November 22, 2002, the Company amended the
agreement to provide for borrowings of up to $65,000,000, amended the
interest rate pricing, and extended the expiration date to October 20,
2003. At December 31, 2002, the Company had drawn $25,000,000 on the
revolving loan. At December 31, 2002, borrowings under the agreement bore
interest at LIBOR plus 3.5% or 5.0%. On October 15, 2003, the Company
amended the agreement to provide for borrowings up to $80,000,000
including a single draw term loan of $55,000,000 with interest at LIBOR
plus 3.5% or prime plus 2.5%, a $20,000,000 revolving loan ("Revolver B")
with interest at LIBOR plus 3.5% or prime plus 2.5%, and a $5,000,000
secured cash management revolving loan ("Revolver A") with interest at
prime plus 0.75%. The total facility matures on June 30, 2009. The term
facility has scheduled principal payments beginning the first quarter of
2005, Revolver B has mandatory commitment reductions beginning in the
first quarter of 2007.
The CoBank loan is subject to various covenants including a limit on the
ratio of indebtedness to annualized operating cash flow, a minimum ratio
of operating cash flow to interest paid, and a minimum debt coverage
service ratio. Substantially all the assets of the Company are pledged as
collateral under the agreement with CoBank.
RTFC and CoBank have agreed to share a security interest in the Company's
assets on a pro rata basis.
On October 10, 2003, the Company entered into a lease agreement with Farm
Credit Leasing. It entered into a lease under the agreement on October
15, 2003, for the lease of a switch and related equipment located in Des
Moines, Iowa. The cost of the equipment leased was $2,000,000. The lease
provides for monthly payments of $48,385 for 36 months. The Company has
the option to acquire the equipment at the end of the lease for $400,000
or renew the lease for an additional 12 months. On December 24, 2003, the
Company entered into a second lease under the agreement for the lease of
network equipment. The cost of the equipment was $1,040,177. The lease
provides for monthly payments of $15,963 for 60 months. The Company has
the option to acquire the equipment at the end of the lease for $208,035
or renew the lease for an additional 12 months. Both of these leases have
been recorded as capital leases and therefore the assets subject to the
lease have been capitalized and the lease obligation has been recorded as
debt.
75
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
Maturities of debt are as follows:
2004 $ 16,361,168
2005 22,566,421
2006 26,521,849
2007 34,353,076
2008 43,385,638
Thereafter 42,653,497
----------------
$ 185,841,649
================
8. Operating Lease Commitments
Future minimum rental payments required under operating leases,
principally for real estate related to tower sites, and other contractual
commitments that have initial or remaining noncancellable terms in excess
of one year at December 31, 2003, are as follows:
2004 $ 1,366,937
2005 1,154,048
2006 920,650
2007 648,342
2008 335,151
Thereafter 814,999
----------------
$ 5,240,127
================
Rental expense was $2,079,076, $1,645,524 and $955,514 for the years
ended December 31, 2003, 2002 and 2001, respectively.
9. Employee Benefits
The Company established the Midwest Wireless Holdings L.L.C. and
Subsidiary Companies 401(k) Profit Sharing Plan and Trust (formerly the
Midwest Wireless Communications L.L.C. Profit Sharing Plan and Trust)
(the "401(k) Plan") for all employees who meet certain service and age
requirements. The 401(k) Plan is comprised of an employer matching
contribution component and a profit sharing component. Employer matching
contributions to this component of the plan were $493,124, $473,644 and
$376,783 for the years ended December 31, 2003, 2002 and 2001,
respectively. Profit sharing contribution expenses were $597,716,
$544,981 and $455,778 for the years ended December 31, 2003, 2002 and
2001, respectively. Profit sharing contributions are 100% vested after
five years of employment.
76
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
Effective January 1, 1997, the Company established the Midwest Wireless
Holdings L.L.C. Appreciation Rights Plan, as amended (formerly the
Midwest Wireless Communications L.L.C. Appreciation Rights Plan) (the
"Plan") for certain key employees. The Plan is designed to create two
classes of appreciation rights, Class A and Class B, which become fully
vested three years and five years, respectively, after the first day of
the year the rights are granted. Participants in the Plan are eligible to
receive awards based on defined increases in members' equity from the
date of grant through the end of the vesting period. The Board of
Managers granted both Class A and Class B appreciation rights in 1997.
Under the terms of the Plan, no additional Class B appreciation rights
will be granted, and additional Class A appreciation rights will be
granted at the discretion of the Board of Managers. However, effective
January 1, 2002, the Plan was amended to enable additional Class B
appreciation rights to be granted in 2002. In 2000 and 2001, the Board of
Managers issued additional Class A appreciation rights to certain key
employees and in 2000 authorized an additional 9,000 rights for new Plan
participants. The Company recognized $1,359,360, $1,287,172 and
$1,053,863 in compensation expense related to the Plan for the years
ended December 31, 2003, 2002 and 2001, respectively.
10. Option Plan
During 2000, the Company's Board of Managers adopted and approved the
Midwest Wireless Holdings L.L.C. Unit Option Plan, as amended. Effective
July 2001, the Plan was amended to clarify certain language and
definitions in the Plan. Under the Plan, options to purchase 46,742 of
the Company's membership units may be granted to employees with terms and
vesting periods determined by the Company's Board of Managers at the date
of grant. The exercise price is equal to the fair value of the units at
the time the option is granted, as determined by the Board of Managers.
Options granted under the plan expire ten years from the date of grant.
The options granted vest 100% three years after they are granted. At
December 31, 2003, there were 30,343 units available for issuance under
this plan.
Options Outstanding
----------------------
Weighted
Available Average
for Number Price Per
Grant of Units Unit
Balances at December 31, 2001 37,940 8,802 $309.37
Granted (4,809) 4,809 $344.00
------- -------
Balances at December 31, 2002 33,131 13,611 $321.60
Granted (2,788) 2,788 $263.84
------- -------
Balances at December 31, 2003 30,343 16,399 $311.78
======= =======
The weighted average fair value of options at the date of grant was
$58.03, $66.12 and $52.73 in 2003, 2002 and 2001, respectively.
77
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2003
- --------------------------------------------------------------------------------
The following table summarizes information about stock options
outstanding and exercisable at December 31, 2003:
Options Outstanding Options Exercisable
----------------------------- -------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Contractual Exercise Exercise
Exercise Prices Number Life Price Number Price
$263.84 2,788 9.01 $263.84 - -
$299.06 4,092 6.59 $299.06 4,092 $299.06
$318.32 4,285 7.01 $318.32 4,285 $318.32
$318.32 425 7.65 $318.32 425 $318.32
$344.00 4,809 8.01 $344.00 - -
The fair value for each option grant was estimated at the date of grant
using the minimum value method with the following assumptions:
Fiscal Year
------------------------------------
2003 2002 2001
Dividend yield 3.46% 2.33% 2.47%
Risk-free interest rate 4.07% 5.20% 4.73%
Expected lives 10 years 10 years 10 years
78
HECTOR COMMUNICATIONS CORPORATION
EXHIBITS
Exhibit Index To
Form 10-K for the Year Ended December 31, 2003
Regulation S-K Location in Consecutive Numbering
Exhibit Table System as Filed With the
Reference Title of Document Securities and Exchange Commission
- -------------------------------------------------------------------------------
3.1 Articles of Incorporation, Filed as Exhibit 3.1 to the Form 10
as amended of the Company, File No. 0-18587
(the "Form 10") and incorporated
hereby by reference
3.2 Bylaws, as amended Filed as Exhibit 3.2 to the Form 10
of the Company and incorporated
hereby by reference.
10.1 1990 Stock Plan Filed as Exhibit 10.1 to the Form 10
of the Company and incorporated
herein by reference.
10.2 2003 Employee Stock Purchase Filed as Exhibit 4.2 to Form S-8 of
Plan the Company dated Februart 24, 2004
and incorporated herein by reference.
10.3 Employee Stock Ownership Plan Filed as Exhibit 10.3 to the Form 10
of the Company and incorporated
herein by reference.
10.4 Employee Savings Plan and Trust Filed as Exhibit 10.4 to the Form 10
of the Company and incorporated
herein by reference.
10.5 Distribution Agreement Filed as Exhibit 10.5 to the Form 10
of the Company and incorporated
herein by reference.
10.7 Flexible Benefit Plan Filed as Exhibit 10.7 to the 1993
Form 10-K and incorporated herein
by reference.
10.8 Form of Rights Agreement dated Filed as Exhibit 1 to the Company's
as of July 27, 1999 between the Form 8-A on August 9, 1999 and
Company and Norwest Bank, incorporated herein by reference.
Minnesota, National Association
10.9 1999 Stock Plan Filed by the Company on Form S-8 on
December 3, 1999 and incorporated
herein by reference.
11 Calculation of Earnings Filed herewith.
Per Share
21 Subsidiaries of the Registrant Filed herewith.
23 Independent Auditors' Consent Filed herewith.
24 Power of Attorney Filed herewith.
31.a Certification of the Chief Filed herewith.
Executive Officer pursuant to
Section 302 of the Sarbanes-
Oxley Act of 2002
31.b Certification of the Chief Filed herewith.
Financial Officer pursuant to
Section 302 of the Sarbanes-
Oxley Act of 2002
99.1 Certification under 18 U.S.C. Filed herewith.
ss. 1350
The exhibits referred to in this Exhibit Index will be supplied to a shareholder
at a charge of $.25 per page upon written request directed to HCC's Assistant
Secretary at the executive offices of the Company.
79