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, 2004
Commission File Number: 001-13891
HECTOR COMMUNICATIONS CORPORATION
Minnesota 41-1666660
- --------------------------------- -------------------
(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 Name of each exchange on which registered
- ---------------------------- ------------------------------------------
Common Stock, $.01 par value American Stock Exchange
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 and nonvoting common equity held by
non-affiliates of the Registrant (shareholders other than officers and
directors) was approximately $61,392,000 based upon the closing sale price of
the Company's common stock on the American Stock Exchange on June 30, 2004.
As of March 15, 2005 there were outstanding 3,736,723 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 24, 2005 are
incorporated by reference into Part III of this Form 10-K.
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 27
8. Financial Statements and Supplementary Data 28
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 50
9A Controls and Procedures 50
9B Other Information 50
PART III
10. Directors and Executive Officers of the Registrant 51
11. Executive Compensation 51
12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters 51
13. Certain Relationships and Related Transactions 52
14. Principal Accounting Fees and Services 52
PART IV
15. Exhibits and Financial Statement Schedules 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, directly and through its 100% owned subsidiary, Alliance Telecommunications
Corporation ("Alliance") operates nine local exchange company subsidiaries
(generally referred to as "local exchange carriers" or "LECs") which served
29,574 access lines in 28 rural communities in Minnesota, Wisconsin and North
Dakota at December 31, 2004. HCC, through its wholly-owned subsidiaries, also
provides cable television service or video service to 7,936 subscribers in
Minnesota.
Prior to July 7, 2003 Alliance was 68% owned by HCC. Golden West
Telecommunications Cooperative, Inc. ("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 periods prior
to July 7, 2003 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 has changed its segment data presentation to match its new
organization subsequent to the Split-up Transactions. Segment information is now
presented for two segments, POTS and Unregulated Services. The majority of the
Company's operations consist of 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 provides 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 and
equipment rental. The Company also makes retail sales of consumer
telecommunications equipment and sells wireless telephone services on a
commission basis.
Information regarding segment operations is provided in Note 13 to the financial
statements found under Item 8 of this report.
3
[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.
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
-----------------------------------------
2004 2003 2002
------- ------- -------
Local network 19.7% 18.9% 19.3%
Network access 48.5 49.7 50.1
Video services 10.5 11.1 12.1
Internet services 10.0 8.2 6.4
Other nonregulated services 11.3 12.1 12.1
------- ------- -------
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 directory 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. An "access line" is a single or
multi-party circuit between the customer's establishment and the central
switching office. The following chart presents the number of access lines served
by the Company's LEC subsidiaries at December 31, 2004, 2003 and 2002:
2004 2003 2002
------ ------ ------
Arrowhead Communications Corporation 787 804 806
Eagle Valley Telephone Company 715 719 747
Granada Telephone Company 284 287 296
Pine Island Telephone Company 3,303 3,339 3,368
Indianhead Telephone Company 2,376 2,383 2,403
Loretel Systems, Inc. 12,993 13,253 13,386
Sleepy Eye Telephone Company 6,366 6,298 6,503
Felton Telephone Company 717 732 765
Hager TeleCom, Inc. 2,033 2,067 2,061
------ ------ ------
Total Access Lines 29,574 29,882 30,235
====== ====== ======
4
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 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. 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. In 2004, 60% of the Company's access revenues were from interstate sources
and 29% were from intrastate sources and 11% came from the universal service
fund.
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. The
2000s have seen a leveling of this pattern as access minutes billed to IXCs have
declined and wireless access minutes have increased.
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 7,936 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.
The Company has 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, which is 18% owned by the Company. 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
maintenance and product support from Next Level Communications, Inc. If the
Company cannot obtain necessary support it could have a material adverse affect
on its broadband operations.
5
Internet
Revenues from internet services were $3,150,000, $2,647,000 and $1,945,000 in
2004, 2003 and 2002, 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 all the Company's service areas although access to the service is
restricted for some customers. The Company provided dial-up internet services to
6,679, 7,464 and 7,558 customers at December 31, 2004, 2003 and 2002
respectively. The Company provided DSL services to 3,881, 2,778 and 1,601
customers at December 31, 2004, 2003 and 2002, respectively. 57% 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 almost entirely within the LEC's local exchange
boundaries.
HCC's revenues from other nonregulated services were as follows:
2004 2003 2002
----------- ----------- -----------
Fiber leases $ 657,022 $ 682,521 $ 800,039
Engineering fees 70,378 305,423 438,534
Directory 529,796 491,902 404,136
Billing and collection 169,378 212,622 289,723
Retail sales 469,609 522,269 407,870
Cellular sales commissions 495,704 316,337 333,714
Long distance service sales commissions 382,936 381,825 250,937
Equipment rent 126,130 118,292 119,523
Customer equipment installation and repair 379,755 434,435 232,225
Other 289,963 437,381 417,803
----------- ----------- -----------
$ 3,570,671 $ 3,903,007 $ 3,694,504
=========== =========== ===========
(3) Unconsolidated Affiliates and Investments
Midwest Wireless Holdings LLC
Midwest Wireless Holdings LLC ("Midwest Wireless") provides wireless
telecommunications services to 405,000 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 LECs)
located within Midwest Wireless' operating footprint in southern Minnesota,
northern Iowa and west central 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 accounts for its
investment in Midwest Wireless using the equity method. Income recognized was
$2,766,000, $2,148,000 and $2,261,000 in 2004, 2003 and 2002, respectively.
6
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.
Fiber routes owned by these companies serve the major telecommunications markets
in Minnesota, Wisconsin, North Dakota and South Dakota including Minneapolis-St.
Paul, Milwaukee, Madison, Duluth-Superior, Sioux Falls, Fargo-Moorhead,
Rochester, St. Cloud and Grand Forks.
Other Investments
The Company is an investor in 702 Communications, a competitive local exchange
carrier ("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. The Company is an
investor in Independent Pinnacle Services, LLC, a telephone directory publishing
company that provides directory services to over 150 telephone companies in 15
states.
(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
$3,634,000 and $3,609,000 at December 31, 2004 and 2003 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. The Company's
investment in Onvoy debt totaled $672,000 and $626,000.at December 31, 2004 and
2003 respectively.
Other long-term investments
The Company has a long-term investments in 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
compete with wireline based local service.
- Voice over Internet Protocol (VoIP) based services that deliver
telecommunications services over high-speed internet connections.
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 present greater competition to 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.
VoIP providers typically offer unlimited internet based calling for a flat
monthly fee. Customers wishing to use the service must have a high speed
internet connection. Due to the cost of the service and the high speed internet
connection, VoIP customers tend to be high volume users of long distance
services. Due to the poorer quality of the service, businesses have been
reluctant to use VoIP for their customer contacts. However, recent improvements
in the technology have lead more business and government customers to utilize
the service. Vonage is probably the best known VoIP provider at this time, but
the RBOCs and internet service providers like AOL and Yahoo! are considering
product offerings.
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.
8
(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.
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 ("SLC"). The remaining portions of the interstate local loop costs were
recovered from interstate access charges to interexchange carriers.
9
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 increased
the maximum rate caps for SLCs in steps to the current rates of $6.50 for a
residential or single line business phone and $9.20 for a multi-line business
phone. 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 $1,744,000, $1,879,000 and $1,458,000 of the
Company's network access revenues in 2004, 2003 and 2002, 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. The data is 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.
Wireless Access
Access rates for wireless carriers are determined by a FCC mandated negotiation
process that takes place outside of the NECA tariff structure. Where no
agreement on access rates exist between a wireless carrier and the LEC, no
billing of access charges can be made. The Company's LECs have reciprocal
compensation agreements in place with many of the wireless carriers that use the
LECs facilities to terminate calls - but not all of them. Where agreements are
in place, they are at rates significantly below what an IXC would pay to
terminate a similar call. The Company believes the current wireless access rate
rules and rate structure give wireless carriers a significant competitive
advantage over landline carriers and have a materially negative effect on the
Company's access revenues.
10
VoIP Access
In October 2003 the U.S. District Court issued an injunction providing relief
from regulation to any service provider providing VoIP based services in
Minnesota. The ruling held that VoIP services are information services that can
be regulated only by the FCC and not telecommunications services that can be
regulated by the Minnesota Public Utilities Commission. Under current FCC rules
VoIP originated calls that cross over to the public switched telephone network
("PSTN") can use the PSTN without paying access charges. The Company cannot
predict what the impact of this ruling on future access revenues will be. (An
appeal of this ruling by the Minnesota PUC was rejected by the Federal Court of
Appeals, 8th Circuit in December, 2004.)
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.
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 co-location 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.
11
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.
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 ETC will serve the
public interest. Wireless providers have received ETC designation in each of the
Company's served areas. The addition of these ETCs could have the effect of
reducing the funding available to the Company's LECs from the federal Universal
Service Fund. Such a reduction could materially adversely affect the Company's
ability to achieve a reasonable rate of return on the capital invested in its
network.
12
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. All of HCC's Minnesota-based LEC subsidiaries (except Felton
Telephone Company) elected alternative rate regulation. Local rate increases
under alternative regulation 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.
For the past several years the Minnesota Public Utilities Commission has been
considering a plan to reduce intrastate access charges and implement a state
universal service fund to compensate high cost companies. In 2004 the PUC issued
orders referring elements of the proposed plan to a contested case hearing. In
Minnesota these hearings provide an opportunity for public debate before the PUC
issues final rules. In December 2004 the PUC suspended process of the proposed
new rules due to concerns expressed by state agencies that the proposed access
rate reductions would result in higher local service rates. The Company cannot
predict the outcome of the rate investigation or if any part of the proposed
plan will be adopted.
Wisconsin based LECs are subject to rate of return review where their
residential local service rate (the "R1" rate) exceeds the statewide average R1
rate (currently $13.93 per month). In November 2004 the Wisconsin Public Service
Commission conducted a rate of return review of the Company's Hager TeleCom LEC.
As a result of the review, the Company agreed to reduce its R1 rate by $3.10 per
month and to make certain other rate reductions. The new rates went into effect
January 1, 2005.
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.
13
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.
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, 2005, the Company had 134 full-time and part-time employees. None of
the Company's employees are represented under collective bargaining agreements.
HCC believes its employee relations to be good.
14
(9) Executive Officers of Registrant
The executive officers of the Company and their ages at March 1, 2005 were as
follows:
Name Age Position
Curtis A. Sampson 71 Chairman of the Board and Chief Executive Officer
Steven H. Sjogren 62 President and Chief Operating Officer
Paul N. Hanson 58 Vice President, Secretary and Treasurer
Charles A. Braun 47 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.
ITEM 2. PROPERTIES
The Company's telephone property consists of central office switching equipment,
the land and buildings in which the equipment is housed, 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 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.
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:
2004 2003
------------------------ -------------------------
Quarter High Low High Low
First $ 19.36 $ 13.85 $ 13.60 $ 11.80
Second 21.70 18.65 13.89 11.50
Third 21.50 19.80 14.35 12.45
Fourth 22.00 20.00 14.14 13.06
[b] HOLDERS
At March 1, 2005 there were 477 holders of record of Hector Communications
Corporation common stock.
[c] DIVIDENDS
HCC paid a cash dividend of $.05 per share on its common stock and preferred
stock on December 15, 2004, the first in Company history, and has adopted a
policy to pay regular quarterly dividends. The amount of future dividends will
be determined at the discretion of the Board of Directors. HCC has no obligation
to pay dividends on its preferred stock except that preferred stock receives the
same per share dividend as common stock.
The financing agreements between HCC's subsidiaries and their lenders, and HCC
and its lenders restrict the ability of HCC to pay dividends. 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] RECENT SALES OF UNREGISTERED SECURITIES
Not applicable.
[e] REPURCHASES OF ISSUER'S EQUITY SECURITIES
The Registrant did not repurchase any of its equity securities during the fourth
quarter of the fiscal year covered by this report. At December 31, 2004, the
Company was authorized to purchase in accordance with Rule 10b-18 215,000 shares
of its common stock pursuant to Board authorization granted on September 17,
2001.
16
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL INFORMATION
(in thousands except per share amounts)
Year Ended December 31
-------------------------------------------------------------
2004 2003 2002 2001 2000
- ---------------------------------------------------------------------------------------------------------------------------------
Selected Income Statement Information
Revenues from Continuing Operations $ 31,570 $ 32,322 $ 30,517 $ 31,073 $ 29,067
Costs and Expenses 24,588 24,365 23,875 24,404 21,913
- ---------------------------------------------------------------------------------------------------------------------------------
Operating Income from Continuing Operations 6,982 7,957 6,642 6,669 7,154
Other Income (Expenses), net 912 316 (1,053) 1,752 (1,539)
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations Before Income Taxes and
Minority Interest 7,894 8,273 5,589 8,421 5,615
Income Tax Expense 3,250 3,316 2,483 4,162 3,155
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations Before Minority Interest 4,644 4,957 3,106 4,259 2,460
Minority Interest in Earnings of Alliance
Telecommunications Corporation 660 782 1,078 411
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations 4,644 4,297 2,324 3,181 2,049
Income from Discontinued Operations 882 1,331 1,435 1,260
- ---------------------------------------------------------------------------------------------------------------------------------
Income Before Cumulative Effect of Change in Accounting
Principle 4,644 5,179 3,655 4,616 3,309
Cumulative Effect of Change in Accounting Principle,
net of Income Taxes and Minority Interest (3,147)
- ---------------------------------------------------------------------------------------------------------------------------------
Net Income $ 4,644 $ 5,179 $ 508 $ 4,616 $ 3,309
=================================================================================================================================
Basic Income from Continuing Operations per common share $ 1.28 $ 1.23 $ .67 $ .92 $ .58
Diluted Income from Continuing Operations per common share $ 1.17 $ 1.14 $ .62 $ .85 $ .53
Cash Dividends per share $ .05 $ - $ - $ - $ -
Average Shares Outstanding:
Common shares only 3,635 3,487 3,498 3,465 3,544
Common and potential common shares 3,970 3,765 3,770 3,763 3,851
=================================================================================================================================
Selected Balance Sheet Information
Working Capital $ 17,601 $ 13,314 $ 5,718 $ 7,633 $ 8,960
Property, Plant and Equipment, net 40,040 43,088 56,666 57,362 56,227
Excess of Cost Over Net Assets Acquired, net 30,921 31,692 49,075 53,663 55,475
Total Assets 124,923 123,059 154,486 158,251 158,678
Long-Term Debt 54,084 57,529 75,148 79,642 84,378
Stockholders' Equity 54,213 48,044 42,249 42,241 39,108
- ---------------------------------------------------------------------------------------------------------------------------------
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
HCC, directly and through its 100% owned subsidiary, Alliance Telecommunications
Corporation ("Alliance") operates nine local exchange company subsidiaries
(generally referred to as "local exchange carriers" or "LECs") which served
29,574 access lines in 28 rural communities in Minnesota, Wisconsin and North
Dakota at December 31, 2004. HCC, through its wholly-owned subsidiaries, also
provides cable television service or video service to 7,936 subscribers in
Minnesota. HCC's subsidiaries also have substantial ownership interests in other
telecommunications ventures, including, Midwest Wireless Holdings LLC.
Prior to July 7, 2003 Alliance was 68% owned by HCC. Golden West
Telecommunications Cooperative, Inc. ("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" below.) The disclosures in this report related to prior periods
have been restated to reflect the Company's continuing operations.
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 results 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.
18
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 may not be recoverable in future periods.
Results of Operations
2004 Compared to 2003
Revenues from continuing operations decreased 2% to $31,570,000 in 2004 from
$32,322,000 in 2003. The revenue breakdown was as follows:
2004 2003
------------ ------------
Plain old telephone service ("POTS"):
Local network $ 6,201,326 $ 6,117,238
Network access revenues:
Long distance providers (including NECA) 13,579,375 14,196,136
Universal service fund support 1,743,721 1,879,119
------------ ------------
Total network access revenues 15,323,096 16,075,254
------------ ------------
Total POTS revenues 21,524,422 22,192,492
------------ ------------
Other services:
Video services 3,324,588 3,579,773
Internet services 3,150,089 2,647,156
Other nonregulated services:
Fiber leases 657,022 682,521
Wireless sales commissions 495,704 316,337
Directory revenues 529,796 491,902
Retail sales 469,609 522,269
Long distance service sales commissions 382,936 381,825
Customer equipment installation and repair 379,755 434,435
Billing and collection 169,378 212,622
Equipment rent 126,130 118,292
Engineering services 70,378 305,423
All other revenues 289,963 437,381
------------ ------------
Total nonregulated services revenue 3,570,671 3,903,007
------------ ------------
Total other service revenues 10,045,348 10,129,936
------------ ------------
Total revenue $ 31,569,770 $ 32,322,428
============ ============
Total POTS revenues decreased $668,000 or 3%. Local network revenues increased
$84,000 or 1%. The increase was primarily due to increased revenues from CLASS
service features (such as caller identification, call waiting, call forwarding
and other related services) and increased extended area service ("EAS") revenues
in one exchange. EAS enables customers to call neighboring telephone systems
toll free in exchange for a flat monthly fee. The Company increased the rates
charged for CLASS services during the 2003 period. The Company's access lines
count declined 1% in 2004. The number of access lines served fell due to
substitution of cellular phones for landline phones by customers and the reduced
number of second lines being used for dial-up internet service.
Network access revenues decreased $752,000 or 5%. The Company's access minutes
provided to other telecommunications carriers in 2004 and 2003 were as follows:
Access minutes of use 2004 2003
- --------------------- --------------- --------------
Wireline carriers 109,500,000 114,900,000
Wireless carriers 23,200,000 17,500,000
--------------- --------------
132,700,000 132,400,000
=============== ==============
The revenue decrease was due to lower network access revenues from wireline
carriers, which reflected the declining minutes of use by these providers.
However, access revenues from wireless communications providers were also lower,
despite the increased minutes they used, due to the impact of the lower rates
included in new interconnection agreements that have been negotiated between the
Company and selected wireless carriers. Access revenues in 2003 were higher than
normal due to greater than anticipated recovery of bankruptcy reserves the
Company established against its MCI/World Com receivables in 2002. Universal
service support funding decreased $135,000 or 7%. Increases in support funds the
Company received in areas where it has newly installed Next Level equipment were
offset by decreases in support for other areas.
19
Total revenues from other services decreased $85,000 or 1%. Revenues from video
(cable television) services declined $255,000 or 7%. Video service revenues in
2004 were reduced by the sales of seven systems serving 2,080 subscribers during
the second quarter of 2003 and by the sale of the Hudson Township WI system in
June 2004. Revenues from internet services increased $503,000 or 19%, due to a
40% increase in the number of customers subscribing to high-speed digital
subscriber line ("DSL") service. At December 31, 2004 the Company had 3,881 DSL
customers and 6,679 dial-up internet customers, compared to 2,778 DSL customers
and 7,464 dial-up customers in December 2003. The DSL customer growth was
facilitated by the deployment of broadband equipment manufactured by Next Level
Communications, Inc. in the Company's Sleepy Eye, MN exchange in 2002 and 2003.
This equipment makes it possible to deliver voice, video and high speed internet
services to the customer over the same circuit.
Revenues from other nonregulated services declined $332,000 or 9%. The revenue
decline was due to lower fees from engineering services, lower billing and
collections revenues from long distance carriers and lower revenues from leases
of fiber optic facilities, which offset higher wireless sales commissions. The
Company sold its engineering service company in July 2004.
Operating costs and expenses were $24,588,000 in 2004, an increase of $222,000
or 1% from 2003. The breakdown of costs and expenses was as follows:
2004 2003
------------ ------------
Plain old telephone service ("POTS"):
Plant operations, excluding depreciation $ 4,335,140 $ 4,511,421
Depreciation and amortization 6,147,428 6,123,086
Customer operations 1,406,020 1,359,408
General and administrative 3,475,741 3,435,078
Other costs and expenses 752,647 413,019
------------ ------------
Total POTS costs and expenses 16,116,976 15,842,012
------------ ------------
Other services:
Plant operations 3,962 5,290
Depreciation and amortization 1,842,788 1,728,425
Customer operations 211,747 192,701
General and administrative 394,070 1,096,658
Other costs and expenses:
Video services expenses 3,059,031 3,026,613
Internet expenses 959,834 910,900
Other costs and expenses 1,999,182 1,563,183
------------ ------------
Total other service costs and expenses 8,470,614 8,523,770
------------ ------------
Total costs and expenses $ 24,587,590 $ 24,365,782
============ ============
Total POTS costs and expenses increased $275,000 or 2%. Plant operations
expenses decreased $176,000 or 4% reflecting a reduced headcount in 2004 and
that 2003 included severance charges for employee headcount reductions. Customer
operations expenses increased $47,000 or 3%. General and administrative expenses
increased $41,000 or 1%. The 2004 period included $305,000 in expenses for
write-offs of accounts receivable for access services provided to wireless
telephone service providers. Operating income in 2004 from POTS was $5,407,000,
a decrease of 15% from $6,350,000 in 2003.
Total costs and expenses for other services decreased $53,000 or 1% reflecting
the following: Video service expenses increased $32,000 or 1% as expense
reductions due to sales of cable television systems in 2004 and 2003 were offset
by higher fee payments to programming providers. Internet expenses increased
$49,000 or 5%. General and administrative expenses decreased $703,000 from 2003
mainly due to the sale of the Company's engineering business in 2004. 2003
expenses also compared unfavorably due to costs incurred in the Split-Up
Transaction. Depreciation and amortization expenses increased $114,000 or 7% due
to depreciation on new plant investments. Operating income in 2004 from other
services was $1,575,000, a decrease of 2% from $1,606,000 in 2003. Consolidated
operating income from continuing operations decreased 12% to $6,982,000.
20
Interest expenses for 2004 decreased $534,000 due to lower interest rates on
borrowings from CoBank. A significant portion of the Company's CoBank debt moved
from a higher fixed interest rate to lower floating market rates during the
fourth quarter of 2003. Interest and dividend income increased $53,000 due to
higher cash balances available for investment.
Income from the Company's investment in Midwest Wireless Holdings, LLC was
$2,766,000 in 2004 compared to $2,148,000 in 2003. Midwest Wireless operations
in 2004 benefited from determinations by regulators that its operations were
eligible to receive universal service high cost support funds. The Company had
income from other unconsolidated investments of $483,000 in 2004 compared to
$96,000 in 2003. In 2004, the Company sold the assets of the cable television
system serving Hudson Township, WI for a gain of $72,000 and sold the assets of
Hastad Engineering Company for a gain of $13,000. The Company sold two groups of
cable television systems during the second quarter of 2003 for a total gain of
$1,081,000.
Income from continuing operations before income taxes and minority interest
decreased 5% to $7,894,000. Income tax expense decreased to $3,250,000 in 2004
from $3,316,000 in 2003. The Company's tax rate varies from the federal tax rate
due to state income taxes. The Company's state tax rate varies from year to year
due to variability in apportioning earnings over the various taxing
jurisdictions. Income before minority interest in the earnings of Alliance was
$4,644,000 in 2004 compared to $4,957,000 in 2003. Minority interests in
earnings of Alliance from continuing operations in 2003 were $660,000. Income
from continuing operations totaled $4,644,000 compared to $4,297,000 in 2003.
Income from discontinued operations before minority interest in 2003 was
$989,000. Minority interests in those earnings were $316,000. The Company
recorded a gain on the split-up of Alliance, net of income taxes, of $210,000 in
2003. The Company had net income of $4,644,000 in 2004 compared to $5,179,000 in
2003.
2003 Compared to 2002
Revenues from continuing operations increased 6% to $32,322,000 in 2003 from
$30,517,000 in 2002. The revenue breakdown was as follows:
2003 2002
------------ ------------
Plain old telephone service ("POTS"):
Local network $ 6,117,238 $ 5,874,728
Network access revenues:
Long distance providers (including NECA) 14,196,136 13,845,948
Universal service fund support 1,879,119 1,457,909
------------ ------------
Total network access revenues 16,075,254 15,303,857
------------ ------------
Total POTS revenues 22,192,492 21,178,585
Other services:
Video services 3,579,773 3,698,790
Internet services 2,647,156 1,944,911
Other nonregulated services:
Fiber leases 682,521 800,039
Wireless sales commissions 316,337 333,714
Directory revenues 491,902 404,136
Retail sales 522,269 407,870
Long distance service sales commissions 381,825 250,937
Customer equipment installation and repair 434,435 232,225
Billing and collection 212,622 289,723
Equipment rent 118,292 119,523
Engineering services 305,423 438,534
All other revenues 437,381 417,803
------------ ------------
Total nonregulated services revenue 3,903,007 3,694,504
------------ ------------
Total other service revenues 10,129,936 9,338,205
------------ ------------
Total revenue $ 32,322,428 $ 30,516,790
============ ============
21
Total POTS revenues increased $1,014,000 or 5%. Local network revenues increased
$243,000 or 4%. The increase was primarily due to increased revenues from CLASS
service features and custom calling. The Company increased the rates for these
services in 2003. The Company's access lines count was 29,882 at December 31,
2003, a decrease of 1% from 2002. The number of access lines served fell due to
substitution of cellular phones for landline phones by customers and the reduced
number of second lines being used for dial-up internet service.
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 2002 access revenues also reflected $437,000
in write-offs associated with the bankruptcy filings of World Com and Global
Crossings.
Total revenues from other services increased $792,000 or 8% reflecting the
following: Video service revenues decreased 3% to $3,580,000 in 2003 due to 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.
Operating costs and expenses were $24,366,000 in 2003, an increase of $490,000
or 2% from 2002. The breakdown of costs and expenses was as follows:
2003 2002
------------ ------------
Plain old telephone service ("POTS"):
Plant operations, excluding depreciation $ 4,511,421 $ 4,069,318
Depreciation and amortization 6,123,086 6,259,750
Customer operations 1,359,408 1,651,034
General and administrative 3,435,078 3,434,099
Other costs and expenses 413,019 268,133
------------ ------------
Total POTS costs and expenses 15,842,012 15,682,334
------------ ------------
Other services:
Plant operations 5,290 11,098
Depreciation and amortization 1,728,425 1,727,900
Customer operations 192,701 199,051
General and administrative 1,096,658 998,143
Other costs and expenses:
Video services expenses 3,026,613 3,183,933
Internet expenses 910,900 1,019,121
Other costs and expenses 1,563,183 1,053,839
------------ ------------
Total other service costs and expenses 8,523,770 8,193,085
------------ ------------
Total costs and expenses $ 24,365,782 $ 23,875,419
============ ============
22
Total POTS costs and expenses increased $160,000 or 1% reflecting the following:
Plant operations expenses, excluding depreciation, increased 11% to $4,511,000
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 $137,000 due to lower expense on switching
equipment at a Wisconsin subsidiary. Customer operations expenses decreased 18%
to $1,359,000 in 2003 due to employee headcount reductions. General and
administrative expenses increased $1,000. Other costs and expenses increased
$145,000 due to increased state and local taxes on telephone properties and
services. Operating income in 2003 from POTS was $6,350,000, an increase of 16%
from $5,496,000 in 2002.
Total costs and expenses for other services increased $331,000 or 4% reflecting
the following. Video service expenses declined 5% to $3,027,000 in due to sales
of cable television systems, which offset increases in the fees the Company pays
to programming providers. Internet expenses decreased 11% to $911,000 in 2003
due to lower fees from "backbone" suppliers. General and administrative expenses
increased $99,000 from 2003 due to costs incurred in breaking up Alliance.
Depreciation and amortization expenses increased $1,000 as decreases associated
with sales of cable television properties were offset by depreciation on new
plant investments. Other costs and expenses increased $509,000 or 48% due to
higher selling expenses and product costs associated with retail sales and
wireless commissions. Operating income in 2003 from other services increased 40%
to $1,606,000. Consolidated operating income from continuing operations
increased 20% to $7,957,000.
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. An impairment loss on the Company's
marketable securities portfolio of $134,000 was recorded 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 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.
23
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 $10,464,000,
$12,953,000 and $13,116,000 in 2004, 2003 and 2002, respectively. At December
31, 2004, the Company's cash and cash equivalents totaled $19,981,000 compared
to $16,581,000 at December 31, 2003. Working capital at December 31, 2004 was
$17,601,000 compared to $13,314,000 at December 31, 2003. The current ratio was
2.7 to 1 at December 31, 2004 compared to 2.1 to 1 at December 31, 2003.
The Company makes periodic improvements to its facilities to provide up-to-date
telecommunications services to its customers. Plant additions in support of POTS
operations were $3,243,000, $2,872,000 and $5,997,000 in 2004, 2003 and 2002,
respectively. Plant additions for nonregulated operations in 2004, 2003 and 2002
were $940,000, $784,000 and $1,732,000 respectively. Plant additions for
discontinued operations up to the Alliance split-up date were $257,000 and
$1,536,000 in 2003 and 2002 respectively. Plant additions for 2005 are expected
to total $7,037,000. 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 $2,893,000, $5,998,000 and
$2,954,000 in 2004, 2003 and 2002, respectively. The average interest rate on
outstanding RUS and RTB loans is 5.0%. At December 31, 2004 unadvanced loan
commitments from the RUS and RTB to Hector's and Alliance's LEC subsidiaries
totaled $24,127,000.
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. At December 31, 2004, $12,223,000 of
subsidiaries' retained earnings was available for dividend payments to HCC. At
December 31, 2004, $37,198,000 of HCC's retained earnings was not available to
pay dividends to shareholders due to restrictions in the debt agreements. It is
the Company's plan, in so far as practical, to maintain its cash balances at the
subsidiary level to support their operations.
The Company incurred significant debt in 1996 to finance Alliance's acquisition
of Ollig Utilities Company. In concert with the Split-Up Transaction the Company
repaid the 1996 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 5.4% at December 31, 2004.
Principal payments are made quarterly and will continue until April 2013. The
outstanding balance on this loan at December 31, 2004 was $23,375,000. 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 $2,762,000 at
December 31, 2004.
24
As part of financing its ownership interest in Alliance in 1996, Hector received
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 switching services and fiber optic
transport facilities and other services. The Company's cash payments due for
these obligations are as follows (interest payments are estimated using December
31, 2004 interest rates):
Long-Term Interest Operating
Total Debt Payments Leases
------------ ------------ ------------ -------------
2005 $ 9,817,500 $ 6,532,000 $ 2,959,000 $ 326,500
2006 9,277,300 6,445,000 2,658,000 174,300
2007 9,124,100 6,717,000 2,347,000 60,100
2008 8,815,200 6,995,000 1,782,000 38,200
2009 8,808,200 7,327,000 1,442,000 39,200
After 2009(1) 29,625,580 26,420,480 3,177,000 28,100
------------ ------------ ------------ -------------
$ 75,467,880 $ 60,436,480 $ 14,365,000 $ 666,400
============ ============ ============ =============
(1) The Company has an obligation to pay Broadband Visions LLC ("BBV") $3,000
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 2005 through 2009. No amount is included after 2009.
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 2004 the Company invested $321,000 in the common stock of two other Minnesota
based telecommunications companies and may make additional investments if market
conditions warrant.
The Company is an investor in partnerships and limited liability companies that
provide wireless telecommunications services, fiber optic transport services,
directory services, competing local exchange (CLEC) services and video headend
services. Cash distributions to the Company from these investments have
generally been limited to amounts necessary to pay income taxes. The Company's
participation in these ventures makes certain services available to customers
which would otherwise be beyond the Company's means to provide. The Company
expects to make additional investments of this type as opportunities arise.
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 is 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. No
stock repurchases occurred in 2004. 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. At December 31, 2004 215,000 shares could
be repurchased under outstanding Board authorizations.
25
Proceeds to the Company from exercises of employee stock options and employee
stock purchase plan shares totaled $1,445,000, $431,000 and $320,000 in 2004,
2003 and 2002, respectively.
Dividends
HCC paid a cash dividend of $.05 per share on its common stock and preferred
stock on December 15, 2004, the first cash dividend since inception, and has
adopted a policy of paying quarterly dividends. 0HCC has no obligation to pay
dividends on its preferred stock except that preferred stock receives the same
per share dividend as common stock.
Sales of Cable Television Systems and Other Business
The Company continuously evaluates its investments in business properties. These
evaluations have led it to sell or discontinue investments where it does not
believe it can earn an adequate return or which do not fit its strategic plan.
In 2004 the Company sold the assets of Hastad Engineering Company to Finley
Engineering Company. Proceeds from the sale totaled $48,390 and the Company
recorded a gain of $12,805. In 2004 the Company sold the assets of the cable
television system serving Hudson Township, WI to Baldwin Telecom Inc. for
$193,000 of cash and a note receivable of $395,000. The Company recorded a gain
on the sale of $72,466. In 2003 the Company 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. The Company 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. The Company is considering sales of additional
cable television properties in areas where it does not plan to also provide
telephone and internet services.
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 Transactions
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 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.
26
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 ability to accommodate expense increases due to inflation are
constrained by the regulatory environment in which its POTS segment operates.
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 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.
New Accounting Standards
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Shared-Based
Payment" (SFAS 123R), which replaces SFAS No. 123, "Accounting for Stock-Based
Compensation," (SFAS 123) and supercedes APB Opinion No. 25, "Accounting for
Stock Issued to Employees." SFAS 123R requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
financial statements based on their fair values beginning with the first interim
or annual period after June 15, 2005, with early adoption encouraged. The pro
forma disclosures previously permitted under SFAS 123 will no longer be an
alternative to financial statement recognition. The Company is required to adopt
SFAS 123R in the third quarter of fiscal 2005, beginning July 1, 2005. Under
SFAS 123R, the Company must determine the appropriate fair value model to be
used for valuing share-based payments, the amortization method for compensation
cost and the transition method to be used at the date of adoption. The
transition methods include prospective and retroactive adoption options. Under
the retroactive option, prior periods may be restated either as of the beginning
of the year of adoption or for all periods presented. The prospective method
requires that compensation expense be recorded for all unvested stock options at
the beginning of the first quarter of adoption of SFAS 123R, while the
retroactive method would record compensation expense for all unvested stock
options beginning with the first period restated. The Company is evaluating the
requirements of SFAS 123R, has not yet determined the method of adoption, and
has not determined what impact the adoption of SFAS 123R will have on its
consolidated results of operations and earnings per share. It has not determined
whether adoption will result in amounts that are similar to the current pro
forma disclosures under SFAS No. 123.
In March 2004, the FASB Emerging Issues Task Force issued EITF 03-16 "Accounting
for Investments in Limited Liability Companies". The EITF states that an
investment in a limited liability company ("LLC") that maintains a specific
ownership account for each investor should use the equity method of accounting
unless the ownership interest is so minor the investor has virtually no
influence over operating and financial policies. Practice has generally viewed
investments of more than three to five percent to be more than minor. The rule
is effective for periods beginning after June 15, 2004. Adoption of the rule did
not have a material effect on the Company's financial statements.
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.
27
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.
Curtis A. Sampson Charles A. Braun
Chairman and Chief Executive Officer Chief Financial Officer
28
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and Board of Directors
Hector Communications Corporation
We have audited the accompanying consolidated balance sheets of Hector
Communications Corporation and subsidiaries as of December 31, 2004 and 2003,
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, 2004. 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 did not audit the financial
statements of Midwest Wireless Holdings L.L.C., a limited liability company, the
investment in which, as discussed in Note 5 to the consolidated financial
statements, is accounted for by the equity method of accounting. The investment
in Midwest Wireless Holdings L.L.C. was $15,380,543 and $13,349,155 as of
December 31, 2004 and 2003 and the equity earnings in its net income was
$2,765,887, $2,148,444 and $2,261,420 for the years ended December 31, 2004,
2003 and 2002. The financial statements of Midwest Wireless Holdings L.L.C. were
audited by other auditors whose report has been furnished to us, and our
opinion, insofar as it relates to the amounts included for Midwest Wireless
Holdings L.L.C., is based solely on the report of the other auditors.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). 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, based on our audits and the report of other auditors, 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, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004 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".
Olsen Thielen & Co., Ltd.
St. Paul, Minnesota
February 18, 2005
29
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31
-----------------------------
2004 2003
------------- -------------
CURRENT ASSETS:
Cash and cash equivalents $ 19,980,506 $ 16,581,315
Construction fund (Note 9) 3,944,684 3,240,073
Accounts receivable (net of allowance for
doubtful accounts of $1,026,000 and $538,000,
respectively) 3,017,569 4,140,052
Materials, supplies and inventories (Note 1) 820,081 944,099
Other current assets 250,276 285,071
------------- -------------
TOTAL CURRENT ASSETS 28,013,116 25,190,610
PROPERTY, PLANT AND EQUIPMENT,net (Notes 1 and 3) 40,040,493 43,088,106
INVESTMENTS AND OTHER ASSETS:
Excess of cost over net assets acquired (Note 4) 30,921,094 31,691,927
Investment in Midwest Wireless
Holdings LLC (Note 5) 15,380,543 13,349,155
Investments in other unconsolidated
affiliates (Note 6) 3,304,726 3,053,999
Other investments (Notes 1 and 7) 6,880,549 6,275,894
Other assets (Notes 1 and 4) 382,322 409,664
------------- -------------
TOTAL OTHER ASSETS 56,869,234 54,780,639
------------- -------------
TOTAL ASSETS $ 124,922,843 $ 123,059,355
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable and current portion of
long-term debt (Note 9) $ 6,352,000 $ 6,537,800
Accounts payable (Note 12) 2,072,722 1,557,969
Accrued expenses 1,936,188 2,238,587
Income taxes payable 51,701 1,541,830
------------- -------------
TOTAL CURRENT LIABILITES 10,412,611 11,876,186
LONG-TERM DEBT, less current portion (Note 9) 54,084,480 57,529,378
DEFERRED INVESTMENT TAX CREDITS (Note 8) 3,340 8,999
DEFERRED INCOME TAXES (Note 8) 5,460,554 4,902,870
DEFERRED COMPENSATION (Note 11) 749,128 698,254
COMMITMENTS AND CONTINGENCIES (Note 9)
STOCKHOLDERS' EQUITY: (Notes 1, 9 and 10)
Preferred stock, par value $1.00 per share;
3,000,000 shares authorized:
Convertible Series A, 157,800 and 220,100
shares issued and outstanding 157,800 220,100
Common stock, par value $.01 per share;
10,000,000 shares authorized; 3,723,390 and
3,515,482 shares issued and outstanding 37,234 35,155
Additional paid-in capital 15,621,048 13,828,414
Retained earnings 38,359,117 33,908,774
Accumulated other comprehensive income (Note 7) 37,531 51,225
------------- -------------
TOTAL STOCKHOLDERS' EQUITY 54,212,730 48,043,668
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 124,922,843 $ 123,059,355
============= =============
See notes to consolidated financial statements.
30
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31
--------------------------------------------------
2004 2003 2002
------------- ------------- -------------
REVENUES FROM CONTINUING OPERATIONS:
Local network $ 6,201,326 $ 6,117,238 $ 5,874,728
Network access 15,323,096 16,075,254 15,303,857
Video services 3,324,588 3,579,773 3,698,790
Internet services 3,150,089 2,647,156 1,944,911
Other nonregulated services 3,570,671 3,903,007 3,694,504
------------- ------------- -------------
TOTAL REVENUES 31,569,770 32,322,428 30,516,790
COSTS AND EXPENSES:
Plant operations, excluding depreciation 4,339,102 4,516,711 4,080,416
Depreciation and amortization 7,990,216 7,851,511 7,987,650
Customer operations 1,617,767 1,552,109 1,850,085
General and administrative 3,869,811 4,531,736 4,432,242
Other operating expenses:
Video service expenses 3,059,031 3,026,613 3,183,933
Internet expenses 959,834 910,900 1,019,121
Other 2,751,829 1,976,202 1,321,972
------------- ------------- -------------
TOTAL COSTS AND EXPENSES 24,587,590 24,365,782 23,875,419
------------- ------------- -------------
OPERATING INCOME FROM CONTINUING OPERATIONS 6,982,180 7,956,646 6,641,371
OTHER INCOME (EXPENSES):
Interest expense (2,867,135) (3,401,479) (3,457,093)
Income (loss) from investments in unconsolidated affilates:
Midwest Wireless Holdings, LLC (Note 5) 2,765,887 2,148,444 2,261,420
Other unconsolidated affiliates (Note 6) 482,847 96,299 (56,311)
Interest and dividend income 445,333 391,897 333,711
Gain on sale of cable television systems and other business (Note 14) 85,271 1,080,723
Loss on sale of marketable securities (Note 7) (134,498)
------------- ------------- -------------
OTHER INCOME (EXPENSES), net 912,203 315,884 (1,052,771)
------------- ------------- -------------
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND
MINORITY INTEREST 7,894,383 8,272,530 5,588,600
Income tax expense (Note 8) 3,250,000 3,316,000 2,483,000
------------- ------------- -------------
INCOME FROM CONTINUING OPERATIONS BEFORE MINORITY INTEREST 4,644,383 4,956,530 3,105,600
Minority interest in continuing operations of Alliance
Telecommunications Corporation (659,624) (781,403)
------------- ------------- -------------
INCOME FROM CONTINUING OPERATIONS 4,644,383 4,296,906 2,324,197
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
Minority interest in discontinued operations of
Alliance Telecommunications Corporation (316,399) (626,208)
Gain on split-up of Alliance Telecommunications Corp., net of income taxes 209,505
------------- ------------- -------------
INCOME FROM DISCONTINUED OPERATIONS - 881,854 1,330,692
------------- ------------- -------------
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 4,644,383 5,178,760 3,654,889
Cumulative effect of change in accounting principle,
net of income taxes and minority interest (3,146,569)
------------- ------------- -------------
NET INCOME $ 4,644,383 $ 5,178,760 $ 508,320
============= ============= =============
BASIC NET INCOME PER COMMON SHARE (Note 1):
Before cumulative effect of change in accounting principle:
Continuing operations $ 1.28 $ 1.23 $ .67
Discontinued operations .25 .38
Cumulative effect of accounting change (.90)
------------- ------------- -------------
$ 1.28 $ 1.48 $ .15
============= ============= =============
DILUTED NET INCOME PER COMMON SHARE (Note 1):
Before cumulative effect of change in accounting principle:
Continuing operations $ 1.17 $ 1.14 $ .62
Discontinued operations .23 .35
Cumulative effect of accounting change (.84)
------------- ------------- -------------
$ 1.17 $ 1.37 $ .13
============= ============= =============
AVERAGE SHARES OUTSTANDING (Notes 1 and 10):
Common shares only 3,635,000 3,487,000 3,498,000
Common and potential common shares 3,970,000 3,765,000 3,770,000
See notes to consolidated financial statements.
31
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Year Ended December 31
-----------------------------------------------------
2004 2003 2002
------------- ------------- -------------
Net income $ 4,644,383 $ 5,178,760 $ 508,320
Other comprehensive income (loss):
Unrealized holding gains (losses) on marketable securities (22,824) 97,612 (304,758)
Reclassification adjustment for losses (gains)
included in net income 134,498
------------- ------------- -------------
Other comprehensive loss before income taxes (22,824) 97,612 (170,260)
------------- ------------- -------------
Income tax expense (benefit) related to unrealized
holding gains and losses on marketable securities (9,130) 39,053 (125,492)
Income tax expense (benefit) related to reclassification
adjustment for gains and losses included in net income - - 53,799
------------- ------------- -------------
Income tax expense (benefit) related to items of other
comprehensive loss (9,130) 39,053 (71,693)
Minority interest in other comprehensive loss of
Alliance Telecommunications Corporation (3,783) (16,138)
------------- ------------- -------------
Other comprehensive income (loss) (13,694) 62,342 (82,429)
------------- ------------- -------------
Comprehensive income $ 4,630,689 $ 5,241,102 $ 425,891
============= ============= =============
See notes to consolidated financial statements
32
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, 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
Net income 4,644,383 4,644,383
Dividends (194,040) (194,040)
Conversion of preferred stock to
common stock (62,300) (62,300) 62,300 623 61,677 0
Issuance of common stock under
Employee Stock Purchase Plan 10,951 109 133,575 133,684
Issuance of common stock to
Employee Stock Ownership Plan 20,467 205 286,753 286,958
Issuance of common stock under
Employee Stock Option Plan 114,190 1,142 1,310,629 1,311,771
Change in unrealized gains on
marketable securities, net of
deferred taxes (13,694) (13,694)
--------- --------- --------- --------- ----------- ----------- ---------- -----------
BALANCE AT DECEMBER 31, 2004 157,800 $ 157,800 3,723,390 $ 37,234 $15,621,048 $38,359,117 $ 37,531 $54,212,730
========= ========= ========= ========= =========== =========== ========== ===========
See notes to consolidated financial statements.
33
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31
-----------------------------------------------------
2004 2003 2002
------------- ------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income $ 4,644,383 $ 5,178,760 $ 508,320
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 8,007,835 8,798,414 9,963,888
Minority stockholders' interest in earnings
of Alliance Telecommunications Corporation 976,023 12,632
Gain on split-up of Alliance Telecommunications Corporation (348,505)
Gains on sales of cable television systems and other business (85,271) (1,080,723)
Noncash marketable securities impairment charge 134,498
Income from Midwest Wireless Holdings LLC (2,765,887) (2,533,703) (2,928,251)
Income from other unconsolidated affiliates (482,847) (272,917) (142,535)
Cash distributions from Midwest Wireless Holdings LLC 734,499 905,051 869,723
Cash distributions from other unconsolidated affiliates 277,630 239,544 166,292
Noncash patronage refunds (207,951) (192,669) (260,233)
Noncash investment income (46,920)
Changes in assets and liabilities net of effects of
discontinued operations:
Accounts receivable 1,122,483 (259,394) (83,043)
Materials, supplies and inventories 124,018 64,449 73,522
Other current assets 34,795 (64,130) (45,234)
Accounts payable 514,753 (379,206) 26,074
Accrued expenses (15,441) 547,399 13,317
Income taxes payable (1,490,129) 1,361,111 119,804
Deferred investment tax credits (5,659) (18,555) (20,715)
Deferred income taxes 52,924 1,058 155
Deferred compensation 50,874 30,558 44,650
------------- ------------- -------------
Net cash provided by operating activities 10,464,089 12,952,565 13,115,903
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment (4,182,687) (3,912,756) (9,265,040)
Decrease (increase) in construction fund (704,611) (2,577,844) 97,702
Proceeds from sales of cable television systems and other business 241,301 1,665,782
Investments in other unconsolidated affiliates (45,510) (23,191) (50,000)
Purchases of other investments (453,144) (443,742) (1,301,265)
Proceeds from other investments 476,036 1,538,423 799,880
Increase in other assets (17,000) (130,696) (161,417)
Cash effect of split-up of Alliance Telecommunications
Corporation (5,214,465)
------------- ------------- -------------
Net cash used in investing activities (4,685,615) (9,098,489) (9,880,140)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of notes payable and long-term debt (6,523,531) (32,517,635) (6,835,525)
Proceeds from issuance of notes payable and long-term debt 2,892,833 32,810,607 2,954,316
Issuance of common stock 1,445,455 431,243 319,606
Cash dividends (194,040)
Purchase of stock (17,162) (737,455)
------------- ------------- -------------
Net cash provided by (used in) financing activities (2,379,283) 707,053 (4,299,058)
------------- ------------- -------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3,399,191 4,561,129 (1,063,295)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 16,581,315 12,020,186 13,083,481
------------- ------------- -------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 19,980,506 $ 16,581,315 $ 12,020,186
============= ============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid $ 3,156,583 $ 4,338,703 $ 5,039,440
Income taxes paid 4,318,608 3,491,394 3,596,254
See notes to consolidated financial statements.
34
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, 2004, the Company's subsidiaries
provided telephone service to 29,574 access lines in 28 rural communities in
Minnesota, Wisconsin and North Dakota and cable television services to 7,936
subscribers in Minnesota. 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 Telecommunications Cooperative, Inc. ("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, 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 2003 and 2002 financial statements have been reclassified
to conform to the 2004 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.
35
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:
2004 2003 2002
------------ ------------ ------------
Net income as reported $ 4,644,383 $ 5,178,760 $ 508,320
Less: Total stock-based employee
compensation expense determined
under the fair value method for
all awards (602,259) (472,941) (460,794)
------------ ------------- -------------
Pro forma net income $ 4,042,124 $ 4,705,819 $ 47,526
============ ============= =============
Basic net income per share:
As reported $ 1.28 $ 1.48 $ .15
Pro forma $ 1.11 $ 1.35 $ .01
Diluted net income per share
As reported $ 1.17 $ 1.37 $ .13
Pro forma $ 1.02 $ 1.25 $ .01
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.
Materials, supplies and inventories: Materials, supplies and inventories are
valued at the lower of average cost or market.
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
$7,966,772, $7,828,067 and $7,986,565 for 2004, 2003 and 2002, respectively.
Depreciation included in costs and expenses from discontinued operations was
$938,095 and $1,975,002 for 2003 and 2002 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.
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 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.
36
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, $23,444 and $1,085 for 2004, 2003 and 2002, 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 $56,865,000 and $62,334,000 at December 31, 2004 and 2003, respectively.
Fair values were estimated based on current rates offered to the Company for
debt with similar terms and maturities.
New accounting principles: In December 2004, the FASB issued SFAS No. 123
(revised 2004), "Shared-Based Payment" (SFAS 123R), which replaces SFAS No. 123,
"Accounting for Stock-Based Compensation", (SFAS 123) and supercedes APB Opinion
No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires all
share-based payments to employees, including grants of employee stock options,
to be recognized in the financial statements based on their fair values
beginning with the first interim or annual period after June 15, 2005, with
early adoption encouraged. The pro forma disclosures previously permitted under
SFAS 123 will no longer be an alternative to financial statement recognition.
The Company is required to adopt SFAS 123R in the third quarter of fiscal 2005,
beginning July 1, 2005. Under SFAS 123R, the Company must determine the
appropriate fair value model to be used for valuing share-based payments, the
amortization method for compensation cost and the transition method to be used
at the date of adoption. The transition methods include prospective and
retroactive adoption options. Under the retroactive option, prior periods may be
restated either as of the beginning of the year of adoption or for all periods
presented. The prospective method requires that compensation expense be recorded
for all unvested stock options at the beginning of the first quarter of adoption
of SFAS 123R, while the retroactive method would record compensation expense for
all unvested stock options beginning with the first period restated. The Company
is evaluating the requirements of SFAS 123R, has not yet determined the method
of adoption, and has not determined what impact the adoption of SFAS 123R will
have on its consolidated results of operations and earnings per share. It has
not determined whether adoption will result in amounts that are similar to the
current pro forma disclosures under SFAS No. 123.
In March 2004, the FASB Emerging Issues Task Force issued EITF 03-16 "Accounting
for Investments in Limited Liability Companies". The EITF states that an
investment in a limited liability company ("LLC") that maintains a specific
ownership account for each investor should use the equity method of accounting
unless the ownership interest is so minor the investor has virtually no
influence over operating and financial policies. Practice has generally viewed
investments of more than three to five percent to be more than minor. The rule
is effective for periods beginning after June 15, 2004. Adoption of the rule did
not have a material effect on the Company's financial statements.
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. Operating Operating results for the
discontinued operations in the respective periods of 2003 and 2002 were as
follows:
37
Six Months Twelve Months
Ended June Ended December
30, 2003 31, 2002
------------ ------------
Revenues $ 4,750,877 $ 9,204,856
Operating costs and expenses 2,919,858 5,804,474
------------ ------------
Operating income 1,831,019 3,400,382
Other income and (expenses):
Interest expense (680,059) (1,269,706)
Interest and dividend income 45,911 147,547
Income from investments in unconsolidated affilates:
Midwest Wireless Holdings, LLC 385,259 666,831
Other unconsolidated affiliates 176,618 198,846
------------ ------------
Other expense, net (72,271) (256,482)
Income before income taxes and minority interest 1,758,748 3,143,900
Income tax expense 770,000 1,187,000
------------ ------------
Income before minority interest 988,748 1,956,900
Minority interest in discontinued operations of
Alliance Telecommunications Corporation (316,399) (626,208)
Gain on split-up of Alliane Telecommunications
Corporation, net of income taxes 209,505
------------ ------------
Income from discontinued operations $ 881,854 $ 1,330,692
============ ============
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 Transactions $ 12,351,908
Less: Recorded value of assets and liabilities transferred
to Golden West and ACCI in Split-Up Transactions (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 Transactions $ 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 in 2003 according
to management estimates, net of related deferred taxes $ 576,000
Additional amounts allocated to plant assets in 2004
following finalization of appraisals,
net of related deferred taxes 770,833
-------------
Total Plant Adjustment $ 1,346,833
=============
Excess of fair value over book value allocated to goodwill
in 2003 per management estimates $ 7,909,006
Reduction in recorded goodwill following finalization
of asset appraisals (770,833)
-------------
Net Goodwill Adjustment $ 7,138,173
=============
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.
The effect of the Split-Up Transactions on recorded assets and liabilities at
the split-up date was as follows:
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
=============
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 2004 2003
----------- ------------- -------------
Land $ 447,638 $ 483,371
Buildings 5-40 years 5,633,898 5,697,302
Machinery and equipment 3-15 years 4,126,976 3,431,762
Furniture and fixtures 5-10 years 1,205,834 2,008,349
Telephone plant 5-33 years 81,948,811 76,879,020
Cable television plant 10-15 years 7,306,199 9,010,989
Construction in progress 252,155 663,753
------------- -------------
100,921,511 98,174,546
Less accumulated depreciation 60,881,018 55,086,440
------------- -------------
$ 40,040,493 $ 43,088,106
============= =============
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.
39
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 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
2004, 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:
POTS Other Services Consolidated
------------- ------------ -------------
Balance December 31, 2001 $ 50,145,387 $ 3,517,363 $ 53,662,750
Impairment loss (3,376,391) (1,211,366) (4,587,757)
------------- ------------- -------------
Balance December 31, 2002 46,768,996 2,305,997 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 30,356,603 1,335,324 31,691,927
Reduction in goodwill recorded following
completion of minority interest
acquisition appraisal (770,833) (770,883)
------------- ------------- -------------
Balance December 31, 2004 $ 29,585,770 $ 1,335,324 $ 30,921,094
============= ============= =============
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: 2005 - $44,500, 2006 - $44,000,
2007 - $34,400, 2008 - $21,000, 2009 - $21,000.
40
Changes in the Company's intangible assets are as follows:
Intangible Other
Assets Assets Consolidated
----------- ----------- -----------
Balance December 31, 2001 $ 77,060 $ 250,625 $ 327,685
Additions 106,058 54,123 160,181
Amortization (1,085) (1,085)
Impairment loss (75,282) (75,282)
----------- ----------- -----------
Balance December 31, 2002 106,751 304,748 411,499
Additions 167,845 167,845
Disposals (14,993) (14,993)
Amortization (32,052) (32,052)
Distributed in Alliance split-up (122,635) (122,635)
----------- ----------- -----------
Balance December 31, 2003 242,544 167,120 409,664
Additions 17,000 17,000
Amortization (41,063) (41,063)
Disposals (3,279) (3,279)
----------- ----------- -----------
Balance December 31, 2004 $ 218,481 $ 163,841 $ 382,322
=========== =========== ===========
NOTE 5 - MIDWEST WIRELESS HOLDINGS LLC
At December 31, 2004 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'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, 2004. At December 31, 2004, the Company's cumulative
share of income from Midwest Wireless was $13,458,000, of which $8,499,000 was
undistributed. Midwest Wireless has loan agreements with the Rural Telephone
Finance Cooperative ("RTFC") that place restrictions on distributions to
members.
Summarized audited financial information for Midwest Wireless for 2004, 2003 and
2002 is as follows:
Year Ended December 31
2004 2003 2002
------------ ------------ ------------
Current assets $ 27,685,169 $ 22,017,707 $ 12,445,979
Noncurrent assets 366,455,303 360,331,919 305,838,514
Current liabilities 54,760,003 42,224,377 56,909,149
Noncurrent liabilities 142,767,502 172,862,375 115,446,843
Minority interest 14,919,971 11,617,812 9,428,619
Members' equity 181,692,996 155,645,062 136,499,882
Revenues 220,679,372 179,563,840 162,697,183
Operating income 44,700,128 38,208,082 39,641,304
Net income 35,215,044 26,695,403 28,113,520
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 directory services,
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 2004, 2003 and
2002:
41
Book Value at
December 31 Income (Loss) on Investment
Ownership -------------------------- --------------------------------------
Interest 2004 2003 2004 2003 2002
--------- ----------- ----------- ---------- ---------- ----------
Broadband Visions 17.9% $ 673,425 $ 683,973 $ (10,548) $ (14,182) $ (2,190)
Communications Mgmt Grp 6.5% 232,215 196,300 35,915 20,058 (7,172)
Desktop Media 17.0% 152,938 159,964 - (167,036) (125,000)
Independent Pinnacle 7.7% 471,892 257,964 235,743
Northern Transport Group 20.0% 234,699 314,579 (79,880) (38,860) (40,621)
NW Minnesota Spec Access 5.3% 47,396 67,725 19,671 19,113 16,032
South Central Switching 25.0% 1,894 13,039
702 Communications 18.1% 1,289,003 1,151,302 270,980 236,813 28,838
West Central Transport 5.0% 203,158 222,192 10,966 38,499 60,763
----------- ----------- ---------- ---------- ----------
$ 3,304,726 $ 3,053,999 $ 482,847 $ 96,299 $ (56,311)
=========== =========== ========== ========== ==========
NOTE 7 - MARKETABLE SECURITIES AND GAINS ON SALES OF INVESTMENTS
Marketable securities consist principally of equity securities of other
telecommunications companies. The Company's marketable securities portfolio was
classified as available-for-sale at December 31, 2004 and December 31, 2003. 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, 2004 $ 447,483 $ 79,586 $ (17,035) $ 510,034
December 31, 2003 $ 126,482 $ 100,529 $ (15,165) $ 211,846
Net unrealized gains on marketable securities, net of related deferred taxes,
are included in stockholders' equity as accumulated other comprehensive income
(loss) at December 31, 2004 and 2003 as follows:
Net Deferred Accumulated
Unrealized Income Comprehensive
Gains (Losses) Taxes Income
------------- ---------- ----------------
December 31, 2004 $ 62,551 $ (25,020) $ 37,531
December 31, 2003 $ 85,364 $ (34,139) $ 51,225
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.
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
------------------------------------------
2004 2003 2002
------------ ------------ ------------
Currently payable taxes:
Federal $ 2,318,000 $ 2,434,000 $ 1,483,000
State 884,000 1,039,000 803,000
------------ ------------ ------------
3,202,000 3,473,000 2,286,000
Deferred income taxes (benefit) 53,000 (138,000) 218,000
Deferred investment tax credits (5,000) (19,000) (21,000)
------------ ------=----- ------------
$ 3,250,000 $ 3,316,000 $ 2,483,000
============ ============ ============
42
Deferred tax assets and liabilities as of December 31 related to the following:
2004 2003
------------ ------------
Deferred tax liabilities:
Accelerated depreciation $ 4,893,554 $ 4,766,870
Partnership and LLC investments 1,798,000 1,329,000
Marketable securities 30,000 39,000
Other 188,000 137,000
----------- ------------
6,909,544 6,271,870
Deferred tax assets:
Deferred compensation 292,000 274,000
Intangibles 127,000 200,000
Accrued expenses 245,000 261,000
Bad debts 406,000 213,000
Other 379,000 421,000
----------- ------------
1,449,000 1,369,000
----------- ------------
Net deferred tax liability $ 5,460,554 $ 4,902,870
=========== ============
The provision for income taxes varied from the federal statutory tax rate as
follows:
Year Ended December 31
----------------------------------
2004 2003 2002
------ ------ ------
Tax at U.S. statutory rate 35.0% 35.0% 35.0%
Surtax exemption (1.0) (.9) (1.0)
State income taxes, net of federal benefit 7.1 6.2 11.5
Investment tax credits - (.2) (.4)
Other .1 - (.7)
------ ------ ------
Effective tax rate 41.2% 40.1% 44.4%
====== ====== ======
NOTE 9 - NOTES PAYABLE AND LONG-TERM DEBT
December 31
-----------------------------
2004 2003
------------ ------------
Notes payable to CoBank by Hector Communications
Corporation in quarterly installments, average
interest rate of 5.4%, due 2005 to 2013 $ 23,375,000 $ 26,125,000
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 2005 to 2028 36,915,059 37,239,260
Notes payable to former owners of Felton
Telephone Company by Hector Communications
Corporation in monthly installments, interest
rate of 8.25%, due 2005 146,421 702,918
------------ ------------
60,436,480 64,067,178
Less current portion 6,352,000 6,537,800
------------ ------------
$ 54,084,480 $ 57,529,378
============ ============
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.
43
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, 2004, the Company's local exchange carrier subsidiaries had unadvanced loan
commitments under the RUS and RTB programs aggregating approximately $24,127,000
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 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, 2004, investment in CoBank stock was $2,762,000.
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 $245,000, $219,000 and $194,000 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 5.4% at December 31, 2004.
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, 2004, $12,223,000 of subsidiaries'
retained earnings was available for dividend payments to HCC. At December 31,
2004, $37,198,000 of HCC's retained earnings was not available to pay dividends
to shareholders due to restrictions in the debt agreements.
The Company is continuing its construction program to upgrade its telephone and
cable television properties. Planned expenditures for HCC and Alliance
properties in 2005 are $7,037,000. 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:
2005 $ 6,532,000
2006 6,445,000
2007 6,717,000
2008 6,995,000
2009 7,327,700
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.
44
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, 2004, 151,883 shares were available to
be issued under the plans. Changes in outstanding employee and director stock
options during the three years ended December 31, 2004 are as follows:
Average
Number of exercise price
shares per share
---------- ---------
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
Granted 123,850 18.63
Exercised (140,800) 10.83
Canceled (2,800) 10.61
---------- ---------
Outstanding at December 31, 2004 451,567 $ 13.80
========== =========
The Company receives an income tax benefit related to the gains received by
employees who make disqualifying dispositions of stock received on exercise of
qualified incentive stock options. The amount of tax benefit received by the
Company was $247,000, $23,000 and $25,000 in 2004, 2003 and 2002 respectively.
The tax benefit amounts have been credited to additional paid-in capital.
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,
2004, 353,000 stock options are currently exercisable at an average price of
$13.04 per share. The following table summarizes the status of stock options
outstanding at December 31, 2004:
Weighted Average Weighted
Remaining Average
Range of Exercise Prices Shares Option Life Exercise Price
- ------------------------ --------- ----------- -----------------
$ 6.87 to $ 9.99 6,000 1.6 years $ 7.78
$10.00 to $12.00 189,967 2.2 years 11.25
$12.01 to $15.00 133,750 3.6 years 13.28
$15.01 to $20.03 121,850 5.0 years 18.63
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.
45
At December 31, 2004 employees had subscribed to purchase 8,200 shares in the
current plan cycle ending August 31, 2005. Shares issued to employees under the
plan were 10,951 for the plan year ended August 31, 2004. Shares issued to
employees under the 1990 Employee Stock Purchase Plan were 15,685 and 11,578 for
the plan years ended August 31, 2003 and 2002, 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
--------------------------------------------
2004 2003 2002
----------- ----------- ------------
Net income $ 4,042,124 $ 4,705,819 $ 47,526
Basic net income per share $ 1.11 $ 1.35 $ .01
Diluted net income per share $ 1.02 $ 1.25 $ .01
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
----------------------------------------
2004 2003 2002
-------- -------- --------
Expected volatility 28.8% 29.6% 29.8%
Risk free interest rate 2.9% 2.9% 4.6%
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 $602,259, $472,941 and $460,794 in
2004, 2003 and 2002, respectively. Fair value of all options issued was
$712,191, $453,450 and $515,360 in 2004, 2003 and 2002, respectively.
HCC paid a cash dividend of $.05 per share on its common stock and preferred
stock on December 15, 2004. The dividend was the first in Company history. The
amount and timing of future dividends will be determined at the discretion of
the Board of Directors. HCC has no obligation to pay dividends on its preferred
stock except that preferred stock receives the same per share dividend as 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. No
shares were repurchased in 2004. The Company purchased and retired 1,106 and
70,239 in 2003 and 2002 respectively. Cost of the repurchased shares was $17,000
and $737,000 in 2003 and 2002 respectively. At December 31, 2004, 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 $328,100, $284,600 and $139,200 for 2004, 2003
and 2002, respectively. At December 31, 2004, the ESOP held 98,183 shares of the
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. 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.
46
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 2004, 2003 and 2002 were approximately $159,000, $166,000 and $181,000
respectively.
In 2002 employees of Alliance Telecommunications Corporation 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 were $235,000.
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 $116,000, $98,000 and $94,000 in 2004, 2003 and
2002 respectively. Payments made under the agreement by the Company's continuing
operations were $65,000, $63,000 and $63,000 in 2004, 2003 and 2002
respectively.
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
$293,000, $208,000 and $186,000 in 2004, 2003 and 2002 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
$217,000 and $229,000 at December 31, 2004 and 2003, respectively.
NOTE 13 - SEGMENT INFORMATION
The Company has changed its segment data presentation to match its new
organization subsequent to the split-up of Alliance Telecommunications
Corporation. Segment information is presented on a product line basis. The
majority of the Company's operations consist of 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 provides 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 and
equipment rental. The Company also makes retail sales of consumer
telecommunications equipment and sells wireless telephone services on a
commission basis.
No single customer accounted for a material portion of the Company's revenues in
any of the last three years. Segment information presents only continuing
operations except where noted:
47
Other
POTS Services Consolidated
------------ ------------ ------------
Year Ended December 31, 2004
Revenues from continuing operations $ 21,524,422 $ 10,045,348 $ 31,569,770
Costs and expenses 16,116,976 8,470,614 24,587,590
------------ ------------ ------------
Operating income from continuing operations $ 5,407,446 $ 1,574,734 $ 6,982,180
============ ============ ============
Depreciation and amortization:
Charged to operations $ 6,147,428 $ 1,842,788 $ 7,990,216
Charged to interest expense 17,618 17,618
------------ ------------ ------------
$ 6,147,428 $ 1,860,406 $ 8,007,834
============ ============ ============
Total assets $ 93,816,150 $ 31,106,693 $124,922,843
============ ============ ============
Capital expenditures $ 3,242,810 $ 939,877 $ 4,182,687
============ ============ ============
Year Ended December 31, 2003
Revenues from continuing operations $ 22,192,492 $ 10,129,936 $ 32,322,428
Costs and expenses 15,842,012 8,523,770 24,365,782
------------ ------------ ------------
Operating income from continuing operations 6,350,480 1,606,166 7,956,646
============ ============ ============
Depreciation and amortization:
Charged to operations $ 6,123,086 $ 1,728,425 $ 7,851,511
Charged to interest expense 8,808 8,808
------------ ------------ ------------
$ 6,123,678 $ 1,737,233 7,860,319
============ ============
Discontinued operations 938,095
------------
$ 8,798,414
============
Total assets $ 92,086,084 $ 30,973,271 $123,059,355
============ ============ ============
Capital expenditures $ 2,871,728 $ 784,133 $ 3,655,861
============ ============
Discontinued operations 256,895
------------
$ 3,912,756
============
Year Ended December 31, 2002
Revenues from continuing operations $ 21,178,585 $ 9,338,205 $ 30,516,790
Costs and expenses 15,682,334 8,193,085 23,875,419
------------ ------------ ------------
Operating income from continuing operations 5,496,251 1,145,120 6,641,371
============ ============ ============
Depreciation and amortization:
Charged to operations $ 6,259,750 $ 1,727,900 $ 7,987,650
Charged to interest expense 1,236 1,236
------------ ------------ ------------
$ 6,259,750 $ 1,729,136 7,988,886
============ ============
Discontinued operations 1,975,002
------------
$ 9,963,888
============
Total assets $ 92,873,100 $ 26,228,554 $119,101,654
============ ============
Discontinued operations 35,384,306
------------
$154,485,960
============
Capital expenditures $ 5,996,743 $ 1,732,378 $ 7,729,121
============ ============
Discontinued operations 1,535,919
------------
$ 9,265,040
============
48
NOTE 14 - SALES OF CABLE TELEVISION SYSTEMS AND OTHER BUSINESS
In 2004 the Company sold the assets of Hastad Engineering Company to Finley
Engineering Company. Proceeds from the sale totaled $48,390 and the Company
recorded a gain of $12,805.
Effective June 30, 2004 the Company sold the assets of the cable television
system serving Hudson Township, WI to Baldwin Telecom Inc. for $193,000 of cash
and a note receivable of $395,000. The Company recorded a gain on the sale of
$72,466.
Alliance completed sales of two groups of cable television systems during 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. 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
- ------------------------------------------------------------------------------------------------------------------
2004
Revenues from continuing operations $ 7,946 $ 7,992 $ 7,806 $ 7,826
Operating income from continuing operations 1,981 1,452 1,923 1,626
Net income 1,193 954 1,294 1,203
Basic net income per share $ .34 $ .26 $ .35 $ .32
Diluted net income per share $ .31 $ .24 $ .32 $ .30
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
========= ========= ========= ========
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A. CONTROLS AND PROCEDURES
The Company, under the supervision and with the participation of management,
including the Chief Executive Officer ("CEO") and Chief Financial Officer
("CFO"), evaluated the effectiveness of the design and operation of the
Company's disclosure controls and procedures (as defined in Rule 13a - 15(e)
under the Securities Exchange Act of 1934) as of the end of the period covered
by this report. Based on that evaluation, the CEO and CFO concluded that, as of
the end of the period covered by this report, the Company's disclosure controls
and procedures are operating effectively and are adequately designed to ensure
that information required to be disclosed in the reports filed or submitted
under the Exchange Act is recorded, processed, summarized and reported, within
the time periods specified in the applicable rules and forms and is accumulated
and communicated to management, including the CEO and CFO, as appropriate to
allow timely decisions regarding required disclosure. During the period covered
by this Report there was no change in the Company's internal control over
financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
Not applicable.
50
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 24, 2005 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 24, 2005 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
AND RELATED STOCKHOLDER MATTERS
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 24, 2005 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.
The following table presents information about the Company's equity compensation
plans, under which equity securities of the Company are authorized for issuance,
as of December 31, 2004:
Securities Authorized For Issuance Under Equity Compansations 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 71,850 $ 11.65 -
1999 Stock Plan 379,717 14.02 151,883
2003 Employee Stock Purchase Plan 8,164 17.42 80,885
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.
51
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 24, 2005 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 ACCOUNTING FEES AND SERVICES
The information called for by Item 14 of Form 10-K and by Item 9(e) of Schedule
14A will be set forth under the caption "The Company's Auditors" in the
Company's definitive proxy materials for its May 24, 2005 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 AND FINANCIAL STATEMENT SCHEDULES
(a)(1) Consolidated Financial Statements
---------------------------------
The following Consolidated Financial Statements of Hector Communications
Corporation and subsidiaries appear at pages 29 to 49 herein:
Report of Independent Registered Public Accounting Firm for the years ended
December 31, 2004, 2003 and 2002
Consolidated Balance Sheets as of December 31, 2004 and 2003
Consolidated Statements of Income for the years ended
December 31, 2004, 2003 and 2002
Consolidated Statements of Comprehensive Income for the years
ended December 31, 2004, 2003 and 2002
Consolidated Statements of Stockholders' Equity for the year
ended December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003 and 2002
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:
Report of Independent Registered Public Accounting Firm on
financial statement schedules for the years ended
December 31, 2004, 2003 and 2002 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. 60-76
(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 by Item 601 of
Regulation S-K, including each management contract or compensatory plan or
arrangement are described on the Exhibit Index which appears on page 77 of the
sequential numbering system used in this report.
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, 2005 /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, 2005
- ------------------------ Chief Executive Officer and Director
Curtis A. Sampson
/s/Steven H. Sjogren President, Chief Operating Officer, March 29, 2005
- ------------------------ and Director
Steven H. Sjogren
/s/Paul N. Hanson Vice President, Treasurer and March 29, 2005
- ------------------------ Director
Paul N. Hanson
/s/Charles A. Braun Chief Financial Officer and March 29, 2005
- ------------------------ Principal Accounting Officer
Charles A. Braun
/s/Ronald J. Bach Director March 29, 2005
- ------------------------
Ronald J. Bach
/s/James O. Ericson Director March 29, 2005
- -----------------------
James O. Ericson
/s/Luella Gross Goldberg Director March 29, 2005
- ------------------------
Luella Gross Goldberg
/s/Paul A. Hoff Director March 29, 2005
- ------------------------
Paul A. Hoff
/s/Gerald D. Pint Director March 29, 2005
- ------------------------
Gerald D. Pint
/s/Wayne E. Sampson Director March 29, 2005
- ------------------------
Wayne E. Sampson
54
HECTOR COMMUNICATIONS CORPORATION
FINANCIAL STATEMENT SCHEDULES
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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 18, 2005,
included the related financial statement schedules as listed in item 15(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 18, 2005
55
HECTOR COMMUNICATIONS CORPORATION
---------------------------------
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY)
BALANCE SHEETS
December 31
-------------------------------
2004 2003
------------- -------------
Assets:
Cash $ 310,226 $ 293,225
Investment in subsidiaries 64,518,405 68,115,882
Other current assets 2,240,322 1,412,500
Property, plant and equipment, net 736,967 761,108
Accounts with subsidiaries 9,138,554 3,418,743
Other investments 3,242,052 3,217,372
Other assets 142,023 159,238
------------- -------------
Total Assets $ 80,328,549 $ 77,378,068
============= =============
Liabilities and Stockholders' Equity:
Accounts payable $ 282,765 $ 305,738
Other current liabilities 2,311,633 2,200,744
Current portion of long-term debt 2,896,000 3,306,000
Long-term debt 20,625,421 23,521,918
------------- -------------
Total Liabilities 26,115,819 29,334,400
Stockholders' equity:
Preferred stock, par value $1.00 per share;
3,000,000 shares authorized:
Convertible Series A, 157, 800 and
220,100 shares issued and outstanding 157,800 220,100
Common stock, par value $.01 per share;
10,000,000 shares authorized; 3,723,390 and
3,515,482 shares issued and outstanding 37,234 35,155
Additional paid-in capital 15,621,048 13,828,414
Retained earnings 38,359,117 33,908,774
Accumulated other comprehensive income 37,531 51,225
------------- -------------
Total Stockholders' Equity 54,212,730 48,043,668
------------- -------------
Total Liabilities and Stockholders' Equity $ 80,328,549 $ 77,378,068
============= =============
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
-----------------------------------
2004 2003 2002
----------- ----------- ---------
Revenues:
Sales $ 340,957 $ 184,881 $ 175,232
Expenses:
Operating expenses 438,170 342,980 154,000
Interest expense, net 960,996 701,513 164,131
Income tax benefit (550,494) (358,773) (44,775)
----------- ----------- ---------
Total expenses 848,672 685,720 273,356
Income (loss) before equity in earnings
of subsidiaries (507,715) (500,839) (98,124)
Equity in earnings of subsidiaries 5,152,098 5,679,599 606,444
----------- ----------- ---------
Net income 4,644,383 5,178,760 508,320
Other comprehensive income (loss):
Unrealized holding gains (losses) of
subsidiaries on marketable securities (22,824) 97,612 (304,758)
Reclassification adjustment for losses
(gains) of subsidiaries included in
net income 134,498
----------- ----------- ---------
Other comprehensive income (loss) before
income taxes (22,824) 97,612 (170,260)
----------- ----------- ---------
Income tax expense (benefit) related to
unrealized holding gains and losses of
subsidiaries on marketable securities (9,130) 39,053 (125,492)
Income tax expense (benefit) related to
reclassification adjustment for gains of
subsidiaries included in net income 53,799
----------- ----------- ---------
Income tax expense (benefit) related to
items of other comprehensive income (9,130) 39,053 (71,693)
Minority interest in other comprehensive
income (loss)of subsidiaries (3,783) (16,138)
----------- ----------- ---------
Other comprehensive income (loss) (13,694) 62,342 (82,429)
----------- ----------- ---------
Comprehensive income $ 4,630,689 $ 5,241,102 $ 425,891
=========== =========== =========
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
-----------------------------------
2004 2003 2002
----------- ----------- ---------
Cash flows from operating activities:
Net income $ 4,644,383 $ 5,178,760 $ 508,320
Adjustments to reconcile net income to
net cash provided by (used in)
operating activities:
Loss from other investments 5,275 7,094 2,692
Noncash patronage refund (207,951) (12,368) (4,483)
Equity in earnings of subsidiaries (5,152,098) (5,679,599) (606,444)
Depreciation and amortization 158,875 86,492 74,027
Changes in assets and liabilities:
Other current assets (825,856) (1,199,393) 344,919
Accounts with subsidiaries 3,019,018 (3,251,012) 231,097
Accounts payable (22,973) 265,462 (65,911)
Other current liabilities 397,847 1,465,357 163,000
----------- ----------- ---------
Net cash provided by (used in)
operating activities 2,016,520 (3,139,207) 647,217
Cash flows from investing activities:
Purchases of property, plant and equipment (117,519) (225,118) (20,706)
Purchases of other investments (30,000) (2,554,925)
Cash proceeds from other investments 203,082 126,567 14,269
Decrease (increase) in other assets (167,845)
Investments in affiliates (17,999,944)
----------- ----------- ---------
Net cash provided by (used in)
investing activities 55,563 (20,821,265) (6,437)
Cash flows from financing activities:
Repayment of long-term debt (3,306,497) (3,141,633) (208,583)
Proceeds from issuance of notes payable
and long-term debt 26,812,500
Issuance of common stock 1,445,455 431,243 319,606
Purchase of stock (17,162) (737,455)
Cash dividends (194,040)
----------- ----------- ---------
Net cash provided by (used in)
financing activities (2,055,082) 24,084,948 (626,432)
----------- ----------- ---------
Net increase in cash and cash equivalents 7,001 124,476 14,348
Beginning cash and cash equivalents 293,225 168,749 154,401
----------- ----------- ---------
Ending cash and cash equivalents $ 310,226 $ 293,225 $ 168,749
=========== =========== =========
Supplemental disclosures of cash flow information:
Interest paid $ 1,210,618 $ 524,940 $ 177,004
Income taxes paid 3,640,000 1,446,590 371,000
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. In 2004 the Company received noncash dividends
from its subsidiaries totaling $8,739,000. The dividend was recorded in the
Company's accounts with its subsidiaries.
Note 3 - Long Term Debt
December 31
-----------------------------
2004 2003
------------ ------------
Note payable to CoBank in quarterly
installments, interest rate of 5.4%, due 2013 $ 23,375,000 $ 26,125,000
Notes payable to former owners of Felton
Telephone Company in monthly installments,
interest rate of 8.25%, due 2005 146,421 702,918
Less current portion (2,896,000) (3,306,000)
------------ ------------
$ 20,625,421 $ 23,521,918
============ ============
The annual requirements for principal payments on notes payable and long-term
debt are as follows:
2005 $ 2,896,000
2006 2,750,000
2007 2,750,000
2008 2,750,000
2009 2,750,000
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES Schedule II -
Valuation and Qualifying Accounts and Reserves
Balance at Additions Additions Deductions Balance
Beginning of Charged to Charged to from Other at End
Description Period Revenues Expense Reserves Adjustments of Period
- ----------- ------------ ----------- ---------- ---------- ----------- -----------
Allowance for doubtful accounts:
Year ended:
December 31, 2004 $ 538,000 $ 533,000 $ 336,000 $ 381,000 (A) $ 1,026,000
December 31, 2003 $ 716,000 $ 185,000 $ 78,000 (A) $ 285,000 (B) $ 538,000
December 31, 2002 $ 96,000 $ 1,017,000 $ 697,000 (A) $ 716,000
(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, 2004, 2003 and 2002
Index
- --------------------------------------------------------------------------------
Page(s)
Report of Independent Auditors...............................................61
Financial Statements
Consolidated Statements of Financial Position................................62
Consolidated Statements of Operations........................................63
Consolidated Statements of Changes in Members' Equity........................64
Consolidated Statements of Cash Flows........................................65
Notes to Consolidated Financial Statements................................66-76
60
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
financial position of Midwest Wireless Holdings L.L.C. (the "Company") and
subsidiaries at December 31, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 2004, 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. 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, 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 No. 143, Accounting for Asset
Retirement Obligations, on January 1, 2003.
PricewaterhouseCoopers LLP
Minneapolis, Minnesota
February 11, 2005
61
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Financial Position
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
2004 2003
Assets
Current assets
Cash and cash equivalents $ 1,174,378 $ 1,888,366
Accounts receivable, less allowance for
doubtful accounts of $716,100 and $690,115
in 2004 and 2003, respectively 20,348,616 16,248,082
Inventories 4,385,157 2,579,643
Other current assets 1,777,018 1,301,616
------------ ------------
Total current assets 27,685,169 22,017,707
Property, cellular plant and equipment, net 127,835,566 121,086,239
FCC licenses 212,347,514 212,093,566
Other intangible assets, net 17,151,736 18,047,447
Investments in cooperatives 9,120,487 9,104,667
------------ ------------
Total assets $394,140,472 $382,349,626
------------ ------------
Liabilities and Members' Equity
Current liabilities
Current portion of debt $ 22,590,500 $ 16,361,168
Accounts payable 7,350,406 6,136,971
Other accrued expenses 16,848,298 13,500,887
Deferred revenue 7,970,799 6,225,351
------------ ------------
Total current liabilities 54,760,003 42,224,377
Other liabilities 4,021,692 3,381,894
Debt 138,745,810 169,480,481
------------ ------------
Total liabilities 197,527,505 215,086,752
Minority interest 14,919,971 11,617,812
Commitments
Members' equity 181,692,996 155,645,062
------------ ------------
Total liabilities and members' equity $394,140,472 $382,349,626
============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
62
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Operations
Years Ended December 31, 2004, 2003 and 2002
- -----------------------------------------------------------------------------------------------
2004 2003 2002
Operating revenues
Subscriber service $171,410,835 $140,823,140 $118,573,698
Roamer service 29,540,968 28,107,407 37,205,402
Equipment sales and other 19,727,569 10,633,293 6,918,083
------------ ------------ ------------
220,679,372 179,563,840 162,697,183
------------ ------------ ------------
Operating expenses
Operations and maintenance (exclusive of
items shown separately below) 44,906,175 33,987,898 30,506,792
Cost of equipment sold 26,858,490 12,115,073 10,448,214
Home roamer costs 29,485,393 31,280,458 27,668,831
Depreciation 28,140,602 22,593,187 19,318,449
Amortization of intangible assets 1,712,858 267,278 -
Selling, general and administrative 44,875,726 41,111,864 35,113,593
----------- ------------ ------------
175,979,244 141,355,758 123,055,879
------------ ------------ ------------
Operating income 44,700,128 38,208,082 39,641,304
------------ ------------ ------------
Other income (expense)
Interest expense (7,584,944) (7,204,744) (8,078,374)
Interest and dividend income 6,453 2,887 92,915
Gain on disposal of FCC licenses 2,616,674 - -
Other (59,388) (61,529) 34,669
------------ ------------ ------------
Total other expense (5,021,205) (7,263,386) (7,950,790)
------------ ------------ ------------
Minority interest (4,463,879) (3,494,303) (3,576,994)
------------ ------------ ------------
Income before cumulative effect of change
in accounting principle 35,215,044 27,450,393 28,113,520
Cumulative effect of change in accounting
principle net of minority interest (Note 2) - (754,990) -
------------ ------------ ------------
Net income $ 35,215,044 $ 26,695,403 $ 28,113,520
============ ============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
63
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Changes in Members' Equity
Years Ended December 31, 2004, 2003 and 2002
- -----------------------------------------------------------------------------------------------
Total
Capital Accumulated Members'
Contributions Income Equity
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
Distributions to members - (9,167,110) (9,167,110)
Net income - 35,215,044 35,215,044
------------ ------------ ------------
Balances at December 31, 2004 $ 86,654,567 $ 95,038,429 $181,692,996
============ ============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
64
Midwest Wireless Holdings L.L.C.
Consolidated Statements of Cash Flows
Years Ended December 31, 2004, 2003 and 2002
- --------------------------------------------------------------------------------
2004 2003 2002
Cash flows from operating activities
Net income $ 35,215,044 $ 26,695,403 $ 28,113,520
Adjustments to reconcile net income to net cash
provided by operating activities
Net income allocated to minority interest 4,463,879 3,398,600 3,576,994
Provision for bad debts 1,605,361 1,327,703 928,358
Depreciation 28,140,602 22,593,187 19,318,449
Amortization of intangibles 1,712,858 267,278 -
Gain on disposal of assets (2,643,653) (125,277) (3,645)
Writeoff of Cellular 2000, Inc. investment - - 25,000
Patronage received in form of cooperative stock (298,301) (361,318) (310,848)
Appreciation Rights Plan compensation 1,618,494 1,359,360 1,287,172
Cumulative effect of accounting change - 850,693 -
Changes in assets and liabilities
Accounts receivable (5,705,896) (2,434,724) 1,851,263
Inventories (1,805,514) (1,168,070) 796,314
Other assets (475,402) 234,808 (277,868)
Accounts payable 1,213,435 493,555 1,674,214
Deferred revenue and accrued expenses 3,474,365 (1,179,906) (423,185)
Other liabilities 639,798 1,863,618 (425,552)
------------ ------------ ------------
Net cash provided by operating activities 67,155,070 53,814,910 56,130,186
------------ ------------ ------------
Cash flows from investing activities
Acquisition of cellular properties - (42,780,847) -
Payments for property, cellular plant and equipment (33,835,896) (29,234,491) (31,901,881)
Proceeds from the disposal of fixed assets 359,193 518,573 -
Proceeds from the disposal of FCC licenses 2,832,456 - -
Purchase of intangible assets (1,286,877) - (7,400,239)
Purchases of cooperative stock - - (22,440)
Redemption of cooperative stock 282,481 421,527 72,970
------------ ------------ ------------
Net cash used in investing activities (31,648,643) (71,075,238) (39,251,590)
------------ ------------ ------------
Cash flows from financing activities
(Payments) proceeds on revolving loan - (25,000,000) 5,000,000
Proceeds from debt borrowings - 68,297,657 -
Payments on debt (25,891,585) (14,815,075) (13,679,659)
Distributions to members (9,167,110) (9,491,691) (8,343,869)
Distribution from subsidiary to minority interest (1,161,720) (1,209,407) (1,062,371)
Redemption of units - - (457,951)
------------ ------------ ------------
Net cash (used in) provided by financing
activities (36,220,415) 17,781,484 (18,543,850)
------------ ------------ ------------
Net change in cash and cash equivalents (713,988) 521,156 (1,665,254)
Cash and cash equivalents
Beginning of year 1,888,366 1,367,210 3,032,464
------------ ------------ ------------
End of year $ 1,174,378 $ 1,888,366 $ 1,367,210
============ ============ ============
Supplemental disclosure
Cash paid during the year for interest $ 7,993,662 $ 8,165,844 $ 8,828,483
Equity units issued for acquisitions - 1,941,468 -
Noncash investing activities
Equipment acquired under capital leases 1,386,246 3,244,433 -
65
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 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
Consolidation:
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 that are readily convertible to
cash. The Company has funds on deposit with financial institutions that exceed
federally insured limits as of December 31, 2004 and 2003.
Inventories:
Inventories consist primarily of cellular phones and accessories held for
resale. Inventories are stated at the lower of cost or market, 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.
66
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
Property, Cellular Plant and Equipment:
Property, cellular plant and equipment is stated at its original cost.
Depreciation and amortization are provided on a straight-line basis over the
estimated useful lives of the assets. The estimated useful lives of property,
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 costs related to
qualifying construction projects are 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.
Asset Retirement Obligation:
On January 1, 2003, the Company adopted Statement of Financial Accounting
Standards ("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 asset. 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 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 for the period from
January 1, 1998 through December 31, 2002. After a minority interest effect of
$95,703, the net charge was $754,990. Accretion and depreciation expenses
related to the ARO for the years ended December 31, 2004 and 2003 were $192,748
and $186,161, respectively.
Intangible Assets and Other Long-Lived Assets 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 FCC licenses effective January
1, 2002, with the adoption of SFAS No. 142, Goodwill and Other Intangible Assets
(Note 3). Customer relationships are amortized on a straight-line basis over
their useful lives which range from two to six years.
67
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
The Company reviews goodwill and FCC licenses for impairment annually, or more
frequently if changes in circumstances or the occurrence of events suggest an
impairment exists. The test for impairment of goodwill and other intangible
assets requires the Company to make estimates about fair value.
The Company periodically reviews customer relationships and other long-lived
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.
Investments in Cooperatives:
Investments in cooperatives are recorded using the cost method as the Company
does not have the ability to exercise significant influence over the financial
and operating policies of the investees. The investments were originally
purchased pursuant to the terms of loan agreements with Rural Telephone Finance
Cooperative and CoBank, ACB (Note 7). Changes in the investment balances are due
to the receipt of additional shares of stock of the investees from noncash
patronage refunds net of the redemption of certain shares held by the Company.
Revenue Recognition:
Subscriber service revenue consists of the base monthly service fee and airtime
charges to our customers. Base monthly service fees are billed one month in
advance and are recognized in the month earned. Roamer service revenue includes
charges to other wireless providers' customers who use the Company's network.
Airtime and roamer revenues are recognized when the service is provided.
Billings in advance of the delivery of service are recorded as deferred revenue.
The Company recognizes equipment revenue when the equipment is delivered to
customers.
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
$4,584,877, $3,310,758 and $3,317,280 for the years ended December 31, 2004,
2003 and 2002, respectively.
Unit-Based Compensation:
The Company accounts for unit-based compensation using the intrinsic value
method. Accordingly, compensation cost for unit options granted to employees is
measured as the excess, if any, of the fair value of the unit at the date of
grant over the amount an employee must pay to acquire the units. Such
compensation costs are amortized over the underlying option's vesting term. No
such compensation expense was recognized in the financial statements for the
years ended December 31, 2004, 2003 and 2002.
68
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 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:
2004 2003 2002
------------ ------------ ------------
Net income $ 35,215,044 $ 26,695,403 $ 28,113,520
Deduct: Total unit-based employee
compensation expense determined
under fair value based method for
all awards (143,395) (199,789) (337,615)
------------ ------------ ------------
Operating income from continuing operations $ 35,071,649 $ 26,495,614 $ 27,775,905
============ ============ ============
For purposes of the pro forma disclosures above, the weighted average fair value
per unit option granted in 2004, 2003 and 2002 was $19.48, $10.67 and $66.12,
respectively. The fair value for each option was estimated at the date of grant
using the minimum value method with the following weighted average assumptions:
2004 2003 2002
-------- -------- --------
Dividend yield 3.36% 3.46% 2.33%
Risk free interest rate 4.50% 4.07% 5.20%
Expected lives 10 years 10 years 10 years
Reclassifications:
Certain reclassifications have been made to prior year amounts to conform to the
current year presentation. These reclassifications did not change the Company's
previously reported members' equity, net income or net cash flows.
3. FCC Licenses, Goodwill and Other Intangible Assets
Effective January 1, 2002, the Company adopted SFAS No. 142. Effective with the
adoption of this standard, the Company ceased amortizing FCC licenses, which
provide the Company with the exclusive right to utilize certain radio frequency
spectrum to provide wireless communication services. Although the FCC licenses
are issued for only a fixed time, generally ten years, they are subject to
renewal by the FCC; but the renewals 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 these
licenses. As a result, FCC licenses are treated as indefinite-lived intangible
assets and are not amortized, but rather are tested annually for impairment. The
Company evaluates the useful life determination for FCC licenses each reporting
period in order to determine whether events and circumstances continue to
support an indefinite life.
The Company completed the annual impairment assessments of its FCC licenses and
goodwill on December 31, 2004 and 2003, and determined that there were no
impairments.
69
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
On October 15, 2003, the Company acquired various cellular communications
properties (Note 5). The Company allocated the excess purchase price over the
fair value of the net assets acquired, including identifiable intangible assets,
to goodwill. As a result of this acquisition, $9,426,669 of goodwill was
recorded.
Indefinite-lived intangible assets consist of the following at December 31:
2004 2003
FCC Licenses $ 222,260,912 $ 222,015,830
Less: Accumulated amortization (9,913,398) (9,922,264)
------------- -------------
$ 212,347,514 $ 212,093,566
============= =============
The changes in the carrying amount of goodwill and FCC licenses for the year
ended December 31, 2004, are as follows:
Goodwill FCC Licenses
Balances as of December 31, 2002 $ - 194,612,163
Assets acquired or finally allocated
during the year 9,426,669 17,481,403
------------- -------------
Balances as of December 31, 2003 9,426,669 212,093,566
Assets acquired or finally allocated
during the year 18,321 395,363
FCC License sold or disposed of during the year - (141,415)
------------- -------------
Balances as of December 31, 2004 $ 9,444,990 $ 212,347,514
============= =============
Definite-lived intangible assets consist of the following at December 31:
2004 2003
Customer relationships $ 9,686,882 $ 8,888,056
Less: Accumulated amortization (1,980,136) (267,278)
------------- -------------
$ 7,706,746 $ 8,620,778
============= ==============
Amortization expense related to definite-lived intangible assets was $1,712,858,
$267,278 and $0 in 2004, 2003 and 2002, respectively.
Estimated amortization expense of definite-lived intangible assets for the next
five years is as follows:
2005 $ 1,947,949
2006 1,650,464
2007 1,450,000
2008 1,450,000
2009 1,208,333
70
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
Select Account Information
4. Property, Cellular Plant and Equipment
2004 2003
Land $ 6,343,474 $ 5,736,838
Plant in service 224,173,596 189,462,369
Plant under construction 9,563,128 10,378,016
------------- -------------
240,080,198 205,577,223
Less: Accumulated depreciation and amortization (112,244,632) (84,490,984)
------------- -------------
$ 127,835,566 $ 121,086,239
============= =============
The Company capitalized interest in the amount of $532,961, $385,157 and
$443,911 for the years ended December 31, 2004, 2003 and 2002, respectively. At
December 31, 2004 and 2003, accounts payable included $1,014,661 and $612,404,
respectively, related to the purchase of property, cellular, plant and
equipment. Property, cellular plant and equipment at December 31, 2004, includes
plant in service under lease with a cost basis of $4,630,679 and accumulated
amortization of $919,284. Property, cellular plant and equipment at December 31,
2003, includes plant in service under lease with a cost basis of $3,244,433 and
accumulated amortization of $118,251.
Other Accrued Expenses
2004 2003
Accrued commissions, wages and benefits $ 6,508,103 $ 5,079,768
Property and pass-through taxes payable 1,742,375 1,568,086
Interest payable 1,581,410 1,457,167
Other accrued expenses 7,016,410 5,395,866
------------- -------------
$ 16,848,298 $ 13,500,887
============= =============
5. Acquisition
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. The financial statements include the
operations related to the acquisition beginning at the acquisition date.
71
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 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
=============
6. Members' Capital
Members' capital includes capital contributions made by the members and the
accumulated income resulting from operations less distributions. 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.
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.
72
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
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 and 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. Distributions to
members of $9,167,110, $9,491,691 and $8,343,869 were declared and paid during
2004, 2003 and 2002, respectively.
7. Debt
Debt consists of the following:
Rate at Balance at
December 31 December 31
--------------------- ---------------------------------
Maturity 2004 2003 2004 2003
RTFC note, variable rate 5/12/09 6.15% 4.40% $ 7,127,106 $ 8,469,711
RTFC note, variable rate 4/30/09 6.15% 4.40% 14,916,540 17,726,490
RTFC note, variable rate 7/29/08 6.15% 4.40% 4,083,636 5,012,518
RTFC note, variable rate 7/28/08 6.15% 4.40% 3,736,044 4,585,861
RTFC note, variable rate 3/2/10 6.15% 4.40% 62,165,934 71,511,346
RTFC note, variable rate 2/3/15 6.15% 4.40% 6,726,973 7,152,796
CoBank note, variable rate 6/30/09 5.375% 4.75% 55,000,000 55,000,000
CoBank note, variable rate 6/30/09 5.50% 4.75% 4,000,000 13,297,657
Farm Credit Leasing 10/16/06 3.82% 3.82% 1,332,160 1,969,350
Farm Credit Leasing 12/1/08 4.00% 4.00% 861,671 1,115,920
Farm Credit Leasing 12/21/09 4.98% - 1,386,246 -
------------- -------------
$ 161,336,310 $ 185,841,649
Less: Current maturities (22,590,500) (16,361,168)
------------- -------------
$ 138,745,810 $ 169,480,481
============= =============
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 certain Iowa and Wisconsin cellular
markets and the construction of a new headquarters building. 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 RTFC agreements contain restrictions on, among other things, the payment of
dividends, except related to the members for income tax purposes, maintaining an
interest in RTFC by the Company, and redemptions of equity. In addition, the
agreements contain financial covenants requiring the Company, among other
things, to satisfy covenant ratios related to the levels of outstanding
long-term debt, net worth and debt service coverage. Substantially all assets of
the Company are pledged as collateral under the Agreement.
73
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
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. 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. 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 and a $20,000,000 revolving
loan ("Revolver B") each with interest at LIBOR plus a variable margin of 3.0%
to 3.5% or prime plus a variable margin of 2.0% to 2.5%, and a $5,000,000 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. The Company 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. 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. On December 21, 2004, the Company
entered into a third lease under the agreement for the lease of network
equipment. The cost of the equipment was $1,386,246. The lease provides for
monthly payments of $21,960 for 60 months. All three of these leases have been
recorded as capital leases and therefore the assets subject to the lease have
been capitalized and the present value of the lease obligation has been recorded
as debt.
Maturities of debt are as follows:
2005 $ 22,590,500
2006 26,676,010
2007 34,560,401
2008 42,312,090
2009 27,595,382
Thereafter 7,601,927
-------------
$ 161,336,310
=============
74
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
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,
2004, are as follows:
2005 $ 1,432,482
2006 1,198,900
2007 893,825
2008 555,056
2009 306,781
Thereafter 1,180,639
-------------
$ 5,567,683
=============
Rental expense under operating leases was $3,452,526, $2,079,076 and $1,645,524
for the years ended December 31, 2004, 2003 and 2002, 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
$614,909, $493,124 and $473,644 for the years ended December 31, 2004, 2003 and
2002, respectively. Employer matching contributions vest over one year. Profit
sharing contribution expenses were $788,605, $597,716 and $544,981 for the years
ended December 31, 2004, 2003 and 2002, respectively. Profit sharing
contributions are 100% vested after five years of employment.
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. The Company recognized $1,618,494, $1,359,360 and
$1,287,172 in compensation expense related to the Plan for the years ended
December 31, 2004, 2003 and 2002, respectively. Accrued compensation related to
the Plan was $3,183,430 and $2,344,943 at December 31, 2004 and 2003,
respectively.
75
Midwest Wireless Holdings L.L.C.
Notes to Consolidated Financial Statements
December 31, 2004 and 2003
- --------------------------------------------------------------------------------
10. Option Plan
During 2000, the Company's Board of Managers and Members adopted and approved
the Midwest Wireless Holdings L.L.C. Unit Option Plan (the "Option Plan"), as
amended. Under the Option Plan, options to purchase up to 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.
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
Granted (3,345) 3,345 $260.87
Cancelled 200 (200) $331.16
------- -------
Balances at December 31, 2004 27,198 19,544 $302.87
======= =======
The following table summarizes information about unit options outstanding
and exercisable at December 31, 2004:
Options Outstanding Options Exercisable
---------------------------------- --------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Exercise Contractual Exercise Exercise
Prices Number Life Price Number Price
$260.87 3,345 9.33 $260.87 - -
$263.84 2,788 8.01 $263.84 - -
$299.06 4,092 5.59 $299.06 4,092 $299.06
$318.32 4,285 6.01 $318.32 4,285 $318.32
$318.32 325 6.65 $318.32 325 $318.32
$344.00 4,709 7.01 $344.00 4,709 $344.00
------- -------
19,544 13,411
======= =======
76
HECTOR COMMUNICATIONS CORPORATION
EXHIBITS
Exhibit Index To
Form 10-K for the Year Ended December 31, 2004
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.
23.1 Consent of Independent Filed herewith.
Registered Public Accounting
Firm
23.2 Consent of Independent Filed herewith.
Accountants
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
32 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.
77