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SECURITIES & EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2004
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or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File No. 1-15097
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LYNCH INTERACTIVE CORPORATION
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(Exact name of Registrant as specified in its charter)
Delaware 06-1458056
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State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
401 Theodore Fremd Avenue, Rye, New York 10580
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(Address of principal executive offices) (Zip Code)
(914) 921-8821
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Registrant's telephone number, including area code
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2of the Act). Yes No X
Indicate the number of shares outstanding of each of the Registrant's classes of
Common Stock, as of the latest practical date.
Class Outstanding at April 30, 2004
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Common Stock, $.0001 par value 2,782,151
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INDEX
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
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PART I. FINANCIAL INFORMATION
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Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets:
- March 31, 2004
- December 31, 2003
- March 31, 2003
Condensed Consolidated Statements of Operations:
- Three months ended March 31, 2004 and 2003
Condensed Consolidated Statements of Cash Flows:
- Three months ended March 31, 2004 and 2003
Notes to Condensed Consolidated Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
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Item 1. Legal Proceedings
Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
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CERTIFICATIONS
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i
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
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LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
March 31, December 31, March 31,
2004 2003 2003
-------------------------------------
(Unaudited) (Audited) (Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents ............................... $ 29,572 $ 26,556 $ 25,744
Receivables, less allowances of $310,
$262 and $303, respectively ........................... 7,923 8,183 8,700
Material and supplies ................................... 2,736 2,597 3,470
Prepaid expenses and other current assets ............... 1,110 1,272 1,583
--------- --------- ---------
Total Current Assets ...................................... 41,341 38,608 39,497
Property, Plant And Equipment:
Land .................................................... 840 840 833
Buildings and improvements .............................. 13,336 13,336 12,908
Machinery and equipment ................................. 216,855 213,939 201,002
--------- --------- ---------
231,031 228,115 214,743
Less: Accumulated Depreciation .......................... (107,683) (102,556) (92,717)
--------- --------- ---------
123,348 125,559 122,026
Goodwill .................................................. 60,580 60,580 60,580
Other intangibles ......................................... 10,321 8,168 7,906
Investments in and advances to affiliated entities ........ 5,310 7,223 10,462
Other assets .............................................. 13,176 12,048 12,123
--------- --------- ---------
Total assets .............................................. $ 254,076 $ 252,186 252,594
========= ========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Notes payable to banks .................................. $ 3,535 $ 3,456 10,639
Trade accounts payable .................................. 4,457 5,336 3,462
Accrued interest payable ................................ 696 697 362
Accrued liabilities ..................................... 10,925 8,732 14,172
Current maturities of long-term debt ..................... 13,071 13,162 18,474
--------- --------- ---------
Total current liabilities ................................. 32,684 31,383 47,109
Long-term debt ............................................ 160,388 162,621 162,898
Deferred income taxes ..................................... 15,812 15,517 6,573
Other liabilities ......................................... 2,976 3,015 2,986
--------- --------- ---------
Total liabilities ....................................... 211,860 212,536 219,566
Minority Interests ........................................ 10,297 9,763 9,051
Commitments and Contingencies
Shareholders' equity
Common stock, $0.0001 par value-10,000,000
shares authorized; 2,824,766 issued; 2,774,651
2,779,951 and 2,790,651 outstanding .................. -- -- --
Additional paid-in capital .............................. 21,406 21,406 21,456
Retained earnings ....................................... 10,872 9,269 3,292
Accumulated other comprehensive income .................. 1,253 686 467
Treasury stock, 50,115, 44,815 and 34,115 shares, at cost (1,612) (1,474) (1,238)
--------- --------- ---------
Total shareholder's equity ................................ 31,919 29,887 23,977
--------- --------- ---------
Total liabilities and shareholders' equity ................ $ 254,076 $ 252,186 $ 252,594
========= ========= =========
See accompanying Notes to Condensed Consolidated Financial Statements.
-1-
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED) (In thousands,
except per share and share amounts)
Three Months Ended
March 31,
------------------------
2004 2003
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Revenues ............................................ $ 21,888 $ 21,303
Costs and expenses:
Cost of revenue ..................................... 7,480 7,437
General and administrative costs at operations ...... 3,326 3,407
Corporate office expenses ........................... 973 770
Depreciation and amortization ....................... 5,221 4,915
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Operating profit .................................... 4,888 4,774
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Other income (expense):
Investment income ................................ 728 558
Interest expense ................................. (2,819) (3,026)
Equity in earnings of affiliated companies ....... 712 384
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(1,379) (2,084)
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Income before income taxes and minority interests ... 3,509 2,690
Provision for income taxes .......................... (1,449) (1,076)
Minority interests .................................. (457) (201)
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Net income .......................................... $ 1,603 $ 1,413
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Basic and diluted weighted average shares outstanding 2,777 2,791
Basic and diluted earnings per share ................ $ 0.58 $ 0.51
See accompanying Notes to Condensed Consolidated Financial Statements.
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LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(UNAUDITED) (in thousands,
except share data)
Accumulated
Shares of Other
Common Additional Compre-hensive
Stock Common Paid-in Retained Income Treasury
Out-standing Stock Capital Earnings Stock Total
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Balance as of December 2003 .. 2,779,951 $ 0 $ 21,406 $ 9,269 $ 686 $ (1,474) $ 29,887
Net income for the period .... -- -- -- 1,603 -- -- 1,603
Unrealized losses on available
for
sale securities, net ....... -- -- -- -- 567 -- 567
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Comprehensive income ......... -- -- -- -- -- -- 2,153
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Purchase of treasury stock ... (5,300) -- -- -- -- (138) (138)
---------- ---------- ---------- ---------- ---------- ---------- ----------
Balance at March 31, 2004 .... 2,774,651 $ 0 $ 21,406 $ 10,872 $ 1,253 $ (1,612) $ 31,919
========== ========== ========== ========== ========== ========== ==========
See accompanying Note to Condensed Consolidated Financial Statements.
-3-
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED) (In thousands)
Three Months Ended
March 31,
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2004 2003
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Operating activities:
Net Income .......................................................... $ 1,603 $ 1,413
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization .................................... 5,221 4,915
Equity in earnings of affiliated companies ....................... (712) (384)
Minority interests ............................................... 457 201
Changes in operating assets and liabilities:
Receivables ................................................. 307 216
Accounts payable and accrued liabilities .................... 1,324 (1,039)
Other ............................................................ (189) (583)
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Net cash provided by operating activities ........................... 8,011 4,739
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Investing activities:
Capital expenditures ................................................ (2,614) (4,229)
Acquisition of business ............................................. (377) --
Acquisition of subscriber lists ..................................... (91) (369)
Investment in and advances to affiliated entities ................... (63) (34)
Distributions received from investments ............................. 821 164
Other ............................................................... 30 (340)
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Net cash used in investing activities ............................... (2,294) (4,808)
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Financing activities:
Issuance of long term debt .......................................... 949 7,773
Repayments of long term debt ........................................ (3,273) (3,022)
Net proceeds (repayments) on lines of credit ........................ 79 (2,243)
Purchase of treasury stock .......................................... (138) (51)
Other ............................................................... (318) --
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Net cash provided by (used in) financing activities ................. (2,701) 2,457
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Net increase in cash and cash equivalents ........................... 3,016 2,388
Cash and cash equivalents at beginning of period .................... 26,556 23,356
-------- --------
Cash and cash equivalents at end of period .......................... $ 29,572 $ 25,744
======== ========
Cash paid for:
Interest expense .................................................. $ 2,826 $ 3,071
======== ========
Income taxes ...................................................... $ 175 $ 329
======== ========
See accompanying Notes to Condensed Consolidated Financial Statements.
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LYNCH INTERACTIVE CORPORATION & SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
A. Basis of Presentation
Lynch Interactive Corporation ("Interactive" or the "Company") consolidates the
operating results of its telephone and cable television subsidiaries (81%-100%
owned at March 31, 2004, December 31, 2003 and March 31, 2003). In addition,
certain less than 50% owned investments in limited liability companies which
were accounted for in accordance with the equity method of accounting as of
December 31, 2003 have been consolidated at March 31, 2004. See Note B. All
material intercompany transactions and balances have been eliminated.
Investments in affiliates in which the Company does not have a majority voting
control are accounted for in accordance with the equity method. The Company
accounts for the following affiliated companies on the equity basis of
accounting: Coronet Communications Company (20% owned at March 31, 2004,
December 31, 2003 and March 31, 2003), Capital Communications Company, Inc. (49%
owned at March 31, 2004, December 31, 2003 and March 31, 2003; we note, however,
that Interactive owns a convertible preferred stock which, if converted, would
increase its ownership in Capital Communications to 50%) and the cellular
partnership operations in New Mexico (both 33% owned at March 31, 2004, December
31, 2003 and March 31, 2003).
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and with the
instructions to Form 10-Q and Articles 10 and 11 of Regulation S-X. Accordingly,
they are not audited and do not include all of the information and footnotes
required for complete financial statements. The consolidated financial
statements and footnotes included in this Form 10-Q should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's annual report on Form 10-K for the year ended December
31, 2003. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three month period ended March 31, 2004 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 2004. The preparation of consolidated financial statements
in conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from those estimates.
B. Recently Issued Accounting Pronouncements
The Financial Accounting Standards Board ("FASB") issued Financial
Interpretation No. 46, "Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51" (FIN 46) in January 2003 and revised it in
December 2003 (FIN 46R). FIN 46 requires certain variable interest entities to
be consolidated by the primary beneficiary of the entity if the equity investors
in the entity do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other parties.
The provisions of FIN 46R must be applied for the first interim or annual period
ending after March 15, 2004 for both new and existing variable interest
entities. Certain less than 50% owned investments in limited liability
companies, which were considered to be variable interest entities, needed to be
consolidated as a result of the implementation of FIN 46. The effect of
consolidating such operations resulted in increasing intangible assets and
decreasing investments in and advances to affiliated companies by approximately
$2 million and had no other significant effect on the Company's consolidated
financial statements.
-5-
C. Acquisitions and Dispositions
In March 2004, the Company signed an agreement to acquire California-Oregon
Telecommunications Company ("Cal-Ore") located in Dorris, California. Cal-Ore's
subsidiary Cal-Ore Telephone Company is the incumbent service provider for a
rural area of about 850 square miles along the Northern California border with
Oregon with approximately 2,500 access lines. Cal-Ore's other businesses include
an Internet service provider, a CLEC that is planning to provide services in the
surrounding area and interests in certain cellular partnerships. The acquisition
price is $21.2 million, subject to certain closing adjustments. The acquisition
will close after certain conditions are met, including the approval by the
California Public Utilities Commission and other regulatory authorities.
Therefore, the Company's consolidated financial statements for the three months
ended March 31, 2004 do not include the results of Cal-Ore.
In February 2004, a 100% owned subsidiary of the Company completed the
acquisition of cable television assets at a cost of $0.4 million. The allocation
of the purchase price to the assets acquired and liabilities assumed was based
on preliminary estimates of fair value which will be finalized in the second
quarter of 2004.
D. Investments in Affiliated Companies
Interactive has equity investments in both broadcasting and telecommunications
companies.
Summarized financial information for companies accounted for by the equity
method as of and for the three months ended March 31, 2004 and 2003 and as of
December 31, 2003 is as follows (in thousands):
Broadcasting Combined Information
March 31, December 31, March 31,
2004 2003 2003
--------------------------------
Current assets ................................. $ 5,213 $ 5,330 $ 5,666
Property, plant & equipment, intangibles & other 9,187 9,615 10,514
-------- -------- --------
Total assets ................................... $ 14,400 $ 14,945 $ 16,180
======== ======== ========
Current liabilities ............................ $ 3,115 $ 3,182 $ 3,356
Long term liabilities .......................... 15,857 16,483 17,456
Equity ......................................... (4,572) (4,720) (4,632)
-------- -------- --------
Total liabilities & equity ..................... $ 14,400 $ 14,945 $ 16,180
======== ======== ========
Three months ended
Revenues ....................................... $ 3,490 $ 2,838
Gross profit ................................... 1,256 673
Net (Loss) Profit .............................. 354 (205)
-6-
Telecommunications Combined Information
March 31, December 31, March 31,
2004 2003 2003
--------------------------------
Current assets ................................. $29,425 $30,340 $ 9,229
Property, plant & equipment, intangibles & other 26,856 27,114 28,461
------- ------- -------
Total assets ................................... $56,281 $57,454 $37,690
======= ======= =======
Current liabilities ............................ $22,322 $23,073 $ 5,453
Long term liabilities .......................... 8,938 9,056 11,661
Equity ......................................... 25,021 25,325 20,576
------- ------- -------
Total liabilities & equity ..................... $56,281 $57,454 $37,690
======= ======= =======
Three months ended
Revenues ....................................... $12,306 $10,506
Gross profit ................................... 5,475 3,429
Net income ..................................... 3,295 2,518
At March 31, 2004, December 31, 2003, and March 31, 2003 the Company's
investment in Coronet Communications Company ("Coronet") was carried at a
negative $758,000, a negative $810,000, and a negative $821,000 respectively,
due to the Company's guarantee of $3.8 million of Coronet's third party debt.
Long-term debt of Coronet, at March 31, 2004, totaled $9.9 million due to a
third party lender which is due in quarterly payments through December 31, 2005.
The Company's investment in Capital Communications Company, Inc. was carried at
$0 for all periods.
In March 2004, a subsidiary of the Company invested $250,000 for a 7% interest
in an entity which provides wireline telecommunication transport services in New
York State.
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E. Indebtedness
Interactive maintains a short-term line of credit facility totaling $10.0
million. This facility was renewed during the third quarter of 2003 and
currently expires on August 31, 2004. There were no borrowings under this
facility at March 31, 2004, December 31, 2003, or at March 31, 2003. Long-term
debt consists of (all interest rates are at March 31, 2004) (in thousands):
March 31, December 31, March 31,
2004 2003 2003
---------------------------------------
Rural Electrification Administration (REA) and Rural
Telephone Bank (RTB) notes payable due from 2006 to
2027 at fixed interest rates ranging from 2% to 7.5%
(5% weighted average, secured by assets of the
telephone companies with a net book value of $150
million) ............................................. $ 59,892 $ 59,917 $ 58,800
Bank Credit facilities utilized by certain telephone
and telephone holding companies due from 2005 to
2016, $26.7 million at fixed interest rates averaging
7.8 % and $49.9 million at variable interest rates
averaging 3.7% ...................................... 76,601 78,646 84,556
Unsecured notes issued in connection with acquisitions
through 2006, at fixed interest rates of 10.0% ........ 34,389 34,389 34,690
Other ................................................. 2,577 2,831 3,326
--------- --------- ---------
173,459 175,783 181,372
Current maturities .................................... (13,071) (13,162) (18,474)
---------- --------- ---------
$ 160,388 $ 162,621 $ 162,898
========= ========= =========
F. Comprehensive Income
Balances of accumulated other comprehensive income, net of tax, which consists
of unrealized gains (losses) on available for sale securities, at March 31,
2004, December 31, 2003 and March 31, 2003 are as follows (in thousands):
Unrealized
Gain Tax Effect Net
-------------------------
Balance at December 31, 2003 .. $1,040 $ (354) $ 686
Current period unrealized gains 861 (294) 567
------ ------ ------
Balance at March 31, 2004 ... $1,901 $ (648) $1,253
====== ====== ======
Balance at March 31, 2003 ..... $ 800 $ (333) $ 467
====== ====== ======
G. Treasury Stock Purchases
During the three months ended March 31, 2004, the Company purchased 5,300 shares
of its common stock for treasury at an average cost of $26.11 per share.
-8-
H. Litigation
Interactive and several other parties, including the CEO, and Fortunet
Communications, L.P., which was Sunshine PCS Corporation's
predecessor-in-interest, have been named as defendants in a lawsuit brought
under the so-called "qui tam" provisions of the federal False Claims Act in the
United States District Court for the District of Columbia. The complaint was
filed under seal with the court on February 14, 2001. At the initiative of one
of the defendants, the seal was lifted on January 11, 2002. Under the False
Claims Act, a private plaintiff, termed a "relator," may file a civil action on
the U.S. government's behalf against another party for violation of the statute.
In return, the relator receives a statutory bounty from the government's
litigation proceeds if he is successful.
The main allegation in the case is that the defendants participated in the
creation of "sham" bidding entities that allegedly defrauded the federal
Treasury by improperly participating in certain Federal Communications
Commission spectrum auctions restricted to small businesses, as well as
obtaining bidding credits in other spectrum auctions allocated to "small" and
"very small" businesses. While the complaint seeks to recover an unspecified
amount of damages, which would be subject to mandatory trebling under the
statute, a document filed by the relator with the Court on February 24, 2004,
discloses an initial computation of damages of not less than $88 million
resulting from bidding credits awarded to the defendants in FCC auctions and
$120 million of unjust enrichment through the sale or assignment of licenses
obtained by the defendants in FCC auctions, in each prior to trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's initial damage computation is without basis, and intends to
defend the suit vigorously. The U.S. Department of Justice has notified the
court that it has declined to intervene in the case. Nevertheless, we cannot
predict the ultimate outcome of the litigation, nor can we predict the effect
that the lawsuit or its outcome will have on our business or plan of operation.
Interactive does not have any insurance to cover its cost of defending this
lawsuit, which costs will be material. Interactive does have a directors and
officers liability policy but the insurer has reserved its rights under the
policy and, as a result, any coverage to be provided to any director or officer
of Interactive in connection with a judgment rendered in this action is unclear
at this time.
Interactive was formally served with the complaint on July 10, 2002. On
September 19, 2002, Interactive filed two motions with the United States
District Court for the District of Columbia: a motion to dismiss the lawsuit and
a motion to transfer the action to the Southern District of New York. On
November 25, 2002, the relator filed an opposition reply to our motion to
dismiss and on December 5, 2002, Interactive filed a reply in support of its
motion to dismiss. On September 30, 2003, the Court granted our motion to
transfer the action to the Southern District of New York. A scheduling
conference was held on February 10, 2004, at which the judge approved a
scheduling order. Discovery has now commenced as the parties await a ruling on
the defendants' motion to dismiss the case.
In addition to the litigation described above, Interactive is a party to routine
litigation incidental to its business. Based on information currently available,
Interactive believes that none of this ordinary routine litigation, either
individually or in the aggregate, will have a material effect on its financial
condition and results of operations.
History of Lynch's "C" Block Activities
- ---------------------------------------
On December 18, 1995, Lynch Interactive Corporation (through its predessor Lynch
Corporation) had investments in five entities that participated in the Federal
Communications Commission Auction for Broadband PCS "C" Block Spectrum (Auction
5). When the auction closed, on May 6, 1996, these five entities, on a combined
basis, were the higher bidders for thirty-one 30 MHz licenses at a gross cost of
$288.2 million. These entities were initially put together under the FCC's
initiative to include, among others, qualified women, African Americans, Native
Americans and Asian Americans. As a result of changes in these
-9-
initiatives, these same individuals were qualified as small businesses and
remained eligible as bidders. These entities received $72 million of bidding
credits, and accordingly the net cost was $216.2 million. The federal government
provided financing for 90% of the cost of these licenses, or $194.6 million.
Lynch's investments in these entities totaled $21 million.
Events during and subsequent to Auction 5, made financing these licenses through
the capital markets much more difficult than originally anticipated. On April
18, 1997, in order to obtain some economies of scale, the five entities merged
into Fortunet Communications, Inc. The FCC, in partial response to actions by
Nextwave and others, promoted a plan of refinancing of "C" block. In 1997, many
of the license holders from Auction 5, including Fortunet, petitioned the FCC
for relief in order to afford these small businesses the opportunity to more
realistically restructure and build out their systems. The response from the
FCC, which was announced on September 26, 1997 and modified on March 24, 1998,
afforded license holders four options. One of these options was the resumption
of current debt payments, which had been suspended earlier in 1997 for all such
license holders.
On June 8, 1998, Fortunet selected to apply its eligible credits relating to its
original down payment to the purchase of three licenses for 15 MHz of PCS
spectrum in Tallahassee, Panama City and Ocala, Florida. Consistent with an FCC
promulgated disaggregation alternative, Fortunet surrendered all the remaining
licenses and forfeited 30% of its original down payment in full satisfaction of
the government debt and the forgiveness of all accrued interest. Accordingly,
Fortunet retained 15 MHz of spectrum in the three Florida markets covering a
population of approximately 962,000 at a net auction cost of $15.8 million. As a
result of following this FCC process, Fortunet lost $6.0 million of its down
payment. The disaggregation also resulted in a reduction of the bidding credits
to $5.3 million. Yet, the attorneys for the plaintiff continue to state that the
"C" Block entities were involved in receiving $72 million of bidding credits.
Either they didn't do their homework or choose deliberately to ignore the fact
of the disaggregation. A lawyer for many applications for FCC licenses, Mr.
Taylor is intimately aware of the details of these FCC initiated alternatives to
the "C" Block, as was and should be his law firm. As a result of this decision,
during 1997, Interactive recorded a $7.0 million write down of its investment in
Fortunet.
On April 15, 1999, the FCC completed a reauction of all the C-Block licenses
that were surrendered, including the 15 MHz of spectrum that Fortunet returned
to the FCC on June 8, 1998 in respect of the Tallahassee, Panama City and Ocala,
Florida markets. In that reauction, the successful bidders paid a total of $2.7
million for those three 15 MHz licenses returned by Fortunet versus the $15.8
million paid by Fortunet. As a result of this auction, Interactive recorded a
further write down of its investment of $15.4 million, including capitalized
costs, to reflect the amount bid for the similar licenses in the reauction.
In February 2000, Fortunet merged with Sunshine PCS Corporation, which by way of
a spin-off from Lynch Interactive became a public company. It traded under the
symbol SUNPA.
On December 31, 2003, Sunshine, after undergoing appropriate corporate and
regulatory processes, sold its three 15 MHz licenses to Cingular Wireless for
$13.75 million. Interactive received $7.6 million as part of the sale
transaction versus its cash investment of $21 million it initially invested in
the original five entities in 1992.
I. Subsequent Event
On April 30, 2004, the Company acquired a 37% interest in an entity whose
principal assets consist of a $6.0 million subordinated note and a 17% equity
interest in Lynch Telephone Corporation, which is an 83% owned subsidiary of the
Company. The acquisition cost of this interest will be $5.0 million, which has
been funded through the issuance of a five-year amortizing subordinated note of
the parent.
-10-
Item 2. Management's Discussion and Analysis of Financial Condition and Results
------------------------------------------------------------------------
of Operations
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Forward Looking Information
- ---------------------------
Included in this Management Discussion and Analysis of Financial Condition and
Results of Operations are certain forward looking financial and other
information, including without limitation, the Company's effort to monetize
certain assets, Liquidity and Capital Resources and Market Risk. It should be
recognized that such information are estimates or forecasts based upon various
assumptions, including the matters, risks, and cautionary statements referred to
therein, as well as meeting the Registrant's internal performance assumptions
regarding expected operating performance and the expected performance of the
economy and financial markets as it impacts Registrant's businesses. As a
result, such information is subject to uncertainties, risks and inaccuracies,
which could be material.
Overview
- --------
Interactive has grown primarily through the selective acquisition of rural local
exchange carriers (RLECs) and by offering additional services such as Internet
service, alarm services, long distance service and competitive local exchange
carrier (CLEC) service. From 1989 through 2003, Interactive acquired fourteen
telephone companies, four of which have indirect minority ownership of 2% to
19%, whose operations range in size from approximately 800 to over 10,000 access
lines. The Company's telephone operations are located in Iowa, Kansas, Michigan,
New Hampshire, New Mexico, New York, North Dakota, Utah and Wisconsin.
The telecommunications industry in general and the RLECS that comprise
Interactive's business face a number of economic or industry-wide issues and
challenges.
o Regulatory- The Telecommunications Act of 1996 and other federal and state
legislation and regulations have a significant impact on the industry and
on rural carriers in particular. Interactive's telephone companies are all
RLECs serving very high cost areas with a significant portion of their
revenues being derived from federal or state support mechanisms, which are
referred to as Universal Service Funds ("USF"). The revenues and margins of
our RLEC subsidiaries are largely dependant on the continuation of such
support mechanisms.
o Competition- The effects of competition from CLECs, wireless service, high
speed cable, Voice Over Internet Protocol ("VoIP") and other internet
providers is an industry-wide issue that is felt to varying degrees by our
rural telephone companies.
o The economy- Unemployment, building starts, business bankruptcies and the
overall health of the economy have a significant effect on demand for our
services.
o Telecommunication bankruptcies- Interactive's telephone companies have
significant, normal course of business receivables from interexchange
carriers, such as MCI or Global Crossings who filed for bankruptcy and, as
a result, have been written-off. Additional bankruptcies could have a
significant effect on our financial condition.
o Market challenges- Our phone companies are required to comply with
industry-wide initiatives such as local number portability and the
requirements of the Communications Assistance for Law Enforcement Acto
(CALEA) that are expensive to implement and that in some cases have limited
demand in our markets.
-11-
Interactive generates cash and earns telecommunications revenues primarily from
local network access, intrastate and interstate access revenue and from state
and federal USF support mechanisms. Due to the nature of the Company's regulated
telephone operations revenues and operating expenses are relatively stable
period to period.
o Local Revenues - The number of access lines is the primary driver of local
network access revenues. In addition, the ratio of business lines to
residential, as well as the number of features subscribed to by customers
are secondary drivers.
o Intrastate access revenues - Customer usage, primarily based on minutes of
use, and the number of access lines are the primary drivers of intrastate
access revenues since the Company's RLECs are on a "bill-and-keep" basis.
o Interstate access revenues depend upon whether the RLEC has elected to be
"cost-based" or has remained an "average schedule" carrier. The revenues of
our ten cost-based carriers directly correlate to their approved rate of
return on regulated net investment plus the amount of regulated operating
expenses including taxes. The revenues of the Company's four average
schedule subsidiaries correlate to usage based measurements such as access
lines, interstate minutes-of-use, the number and mileage of different types
of circuits, etc. The average schedule method is intended to be a proxy for
cost-based recovery.
o USF subsidies are primarily driven by investments in specific types of
infrastructure as well as the operating expenses and taxes of the Company.
Interstate and intrastate USF subsidies are included in the respective
interstate and intrastate access revenue captions in the breakdown of
revenue and operating expenses which follows.
o Other business revenue: Interactive's companies also provide non-regulated
telecommunications related services, including Internet access service,
wireless and long distance resale service, in certain of its telephone
service and adjacent areas. Interactive also provides and intends to
provide more local telephone and other telecommunications service outside
certain of its franchise areas by establishing CLEC operations in selected
nearby areas. In addition, certain of Interactive's companies have expanded
into cable and security businesses in the areas in which they operate.
o Long Distance revenues are only retained by the Company if we are providing
the long distance service to the end user customer as the toll provider.
For unaffiliated IXCs, we provide a billing service and receive an
administrative handling fee.
The following are the material opportunities, challenges and risks that
Interactive's executives are currently focused on and what actions are being
taken to address the concerns:
o Universal Service Reform: The Federal-State Joint Board on Universal
Service (Joint Board) issued a recommendation that the FCC modify the USF
support mechanisms for RLECs such as those owned by the Company. The
Company will participate with the RLEC industry to analyze the potential
impact of the Joint Board's recommendation and provide the FCC information
with the potential impact to customers and RLECs in rural America. Total
USF support payments are material to the Company's financial results.
o Intercarrier Compensation and Access Charge Reform: The Company is actively
participating in the RLEC industry's efforts to determine how intercarrier
compensation and access charges should be modified without sustaining
revenue losses for RLECs.
-12-
o Loss of Access Revenues from VoIP and wireless usage: The Company is
experiencing revenue losses as usage transfers from landline service
provided by the Company's subsidiaries to either VoIP or wireless services.
The Company is trying to install more broadband service to offset revenue
losses from traditional voice services.
Three months ended March 31, 2004 compared to March 31, 2003
- ------------------------------------------------------------
The following is a breakdown of revenues and operating costs and expenses for
the first quarter ended March 31, 2004 and 2003 (in thousands):
First Quarter ended March 31, Increase
(Decrease)
--------------------------------------
2004 2003
--------------------------------------
(Unaudited)
Revenues:
Local access ................................. $ 3,002 $ 3,031 $ (29)
Interstate access ............................ 9,540 9,057 483
Intrastate access ............................ 3,994 3,923 71
Other telephone .............................. 722 733 (11)
Other business ............................... 4,630 4,559 71
------- ------- -------
Total ...................................... 21,888 21,303 585
------- ------- -------
Operating Cost and Expense:
Cost of revenue .............................. 7,480 7,437 43
General and administrative costs at operations 3,326 3,407 (81)
Corporate office expenses .................... 973 770 203
Depreciation and amortization ................ 5,221 4,915 306
------- ------- -------
Total ...................................... 17,000 16,529 471
------- ------- -------
Operating profit ........................... $ 4,888 $ 4,774 $ 114
======= ======= =======
Total revenues for the three months ended March 31, 2004 increased by $0.6
million, or 2.7%, to $21.9 million compared to the first quarter of 2003. Local
access revenue decreased by $29,000 in the first quarter of 2004 resulting from
a 1.8% decrease in access lines, which was offset by the sale of additional
features and rate increases. Interstate access revenue increased $0.5 million in
the first quarter of 2004 primarily due to infrastructure development undertaken
in 2002 and 2003, which entitled the company to increased USF support primarily
at the Haviland Telephone Company in Kansas. The Company's February 1, 2004
acquisition of a small cable company in Utah resulted in $0.1 million increase
in other business revenue. Other business revenue also benefited from revenue
growth at a competitive local exchange carrier in Kansas.
Total costs and expenses increased by $0.5 million to $17.0 million in the first
quarter of 2004. Costs of revenue and general and administrative costs incurred
at the operations were relatively flat. Corporate office expenses increased $0.2
million resulting from $0.4 million of legal costs incurred defending the "qui
tam" litigation in the first quarter of 2004 offset by the absence of costs
incurred in the first quarter of 2003 relating to stock options issued which
were subsequently reversed in the second quarter of 2003. Depreciation and
amortization increased $0.3 million primarily as a result of the Haviland
capital spending program.
As a result of the above, operating profit for the three months ended March 31,
2004, increased by $.1 million to $4.9 million compared to the first quarter of
2003.
-13-
EBITDA
EBITDA represents the Company's earnings before interest, taxes, depreciation
and amortization. EBITDA is not intended to represent cash flows from operating
activities and should not be considered as an alternative to net income or loss
(as determined in conformity with generally accepted accounting principles), as
an indicator of the Company's operating performance or to cash flows as a
measure of liquidity. EBITDA from operations is presented herein because the
Company's chief operating decision maker evaluates and measures each business
unit's performance based on their EBITDA results. The Company believes that
EBITDA from operations is the most accurate indicator of the Company's results,
because it focuses on revenue and operating cost items driven by operating
managers' performance, and excludes non-recurring items and items largely
outside of operating managers' control. In addition, Interactive utilizes EBITDA
as one of its metrics for valuing potential acquisitions. The following table
reconciles EBITDA to Operating profit and to Income before income taxes and
minority interests (in thousands).
First Quarter ended March 31, Increase
(Decrease)
----------------------------------------------
2004 2003
----------------------------------------------
(Unaudited)
EBITDA from operations ......... $ 11,082 $ 10,459 $ 623
Corporate office expenses ...... (973) (770) (203)
-------- -------- --------
Total EBITDA ................. 10,109 9,689 420
Depreciation ................... 5,069 4,768 301
Amortization ................... 152 147 5
-------- -------- --------
Operating profit ............. 4,888 4,774 114
Investment income .............. 728 558 170
Interest expenses .............. (2,819) (3,026) 207
Equity in earnings of affiliates 712 384 328
-------- -------- --------
Income before income taxes and
minority interest $ 3,509 $ 2,690 $ 819
======== ======== ========
Other Income (Expense)
- ----------------------
For the three months ended March 31, 2004, investment income increased by $0.2
million due to a cash distribution from Sunshine PCS Corporation.
Interest expense decreased by $0.2 million in the first quarter of 2004 from the
prior year due primarily to lower amount of borrowings, including lines of
credit.
Equity in earnings of affiliates for the three-month ending March 31, 2004,
increased from the same period in the previous year due to higher earnings at
the Company's New Mexico cellular investments (RSA 3 and 5).
Income Tax Provision
- --------------------
The income tax provision includes federal, as well as state and local taxes. The
tax provision for the three months ended March 31, 2004 and 2003, represent
effective tax rates of 41.4% and 40.0%, respectively. The difference between
these effective rates and the federal statutory rate is principally due to state
income taxes, including the effect of earnings attributable to different state
jurisdictions.
Minority Interests
- ------------------
Minority interests decreased earnings by $0.5 million for the three months ended
March 31, 2004, as compared to $0.2 million for the three months ended March 31,
2003. The change was due to higher earnings from the Company's New Mexico
cellular investments.
-14-
Net Income
- ----------
Net income for the three months ended March 31, 2004, was $1.6 million, or $0.58
per share (basic and diluted), compared to a net income for the same period last
year of $1.4 million, or $0.51 per share (basic and diluted). The Company has no
dilutive instruments outstanding.
Cash Requirements
- -----------------
The debt at each of Interactive's subsidiary companies contains restrictions on
the amount of funds that can be transferred to their respective parent
companies. The Interactive parent company ("Parent Company") needs cash
primarily to pay corporate expenses, federal income taxes and to invest in new
opportunities, including spectrum licenses. The Parent Company receives cash to
meet its obligations primarily through management fees charged to its
subsidiaries, a tax sharing agreement with its subsidiaries, usage of a $10
million line of credit facility, and has obtained additional liquidity by
refinancing certain subsidiary debt. In addition, the Parent Company considers
various alternative long-term financing sources: debt, equity, or sale of
investments and other assets.
The Company's RLECs and other businesses need cash to fund their current
operations, as well as future long-term growth initiatives. Each RLEC and other
business finances its cash needs with cash generated from operations, by
utilizing existing borrowing capacity or by entering into new long-term debt
agreements. New business acquisitions are generally financed with a combination
of new long-term debt, secured by the acquired assets, as well as cash from the
Parent. While management expects that both Parent and the operating subsidiaries
will be able to obtain adequate financing resources to enable the Company to
meet its obligations, there is no assurance that such can be readily obtained or
at reasonable costs. The Company is obligated under long-term debt provisions
and lease agreements to make certain cash payments over the term of the
agreements. The following table summarizes, as of March 31, 2004 for the periods
shown, these contractual obligations and certain other financing commitments
from banks and other financial institutions that provide liquidity:
Payments Due by Period
(In thousands)
Less than
Total 1 year 1-3 years 4-5 years After 5 years
---------------------------------------------------------
Long-term debt (a) ................... $173,459 $ 13,071 $ 52,274 $ 46,058 $ 62,056
Operating leases ..................... 2,259 504 919 510 326
Notes payable to banks ............... 3,535 3,535 -- -- --
Guarantees ........................... 3,750 -- 3,750 -- --
-------- -------- -------- -------- --------
Total contractual cash obligations and
commitments ........................ $183,003 $ 17,110 $ 56,943 $ 46,568 $ 62,382
======== ======== ======== ======== ========
(a) Does not include interest payments on debt.
A subsidiary of the Company has guaranteed $3.8 million of an equity investees'
total debt of $9.9 million. The guarantee is in effect for the duration of the
loan which expires on December 31, 2005 and would be payable if the equity
investee fails to make such payment in accordance with the terms of the loan.
The Parent Company has a short-term line of credit facility, which expires
August 31, 2004, with maximum availability totaling $10.0 million, all of which
was available at both March 31, 2004 and December 31, 2003. The Company is
pursuing various financing alternatives including renewal of the line of credit,
refinancing substantially all or individual pieces of its currently outstanding
debt, and sale of certain investments. The Company expects that this line of
credit facility will be renewed in August 2004. While it is management's
-15-
belief that the Company will have adequate resources to fund operations over the
next twelve months, there can be no assurance that the Company will obtain
financing on terms acceptable to management. The renewal of the line of credit
is a critical element of the Company's financing strategy.
At March 31, 2004, total debt (including notes payable to banks) was $177.0
million, a decrease of $2.2 million from December 31, 2003. At March 31, 2004,
there was $122.0 million of fixed interest rate debt outstanding averaging 6.9%
and $55.1 million of variable interest rate debt averaging 4.2%. The debt at
fixed interest rates includes $34.4 million of subordinated notes at interest
rates averaging 9.6% issued to sellers as part of acquisitions. The long-term
debt facilities at certain subsidiaries are secured by substantially all of such
subsidiaries assets, while at other subsidiaries it is secured by the common
stock of such subsidiaries. In addition, the debt facilities contain certain
covenants restricting distribution to Lynch Interactive. At March 31, 2004 and
December 31, 2003, substantially all of the subsidiaries' net assets are
restricted.
Interactive has a high degree of financial leverage. The ratio of total debt to
equity was 5.5 to 1 as of March 31, 2004 and 6.0 to 1 as of December 31, 2003.
Certain subsidiaries also have high debt to equity ratios. Management believes
that it is currently more beneficial to hold excess cash at certain of our
subsidiaries rather than utilizing the cash to pay-down existing credit
facilities.
As of March 31, 2004, Interactive had current assets of $41.3 million and
current liabilities of $32.7 million resulting in a working capital surplus of
$8.7 million compared to a surplus of $7.2 million at December 31, 2003.
Sources and Uses of Cash
- ------------------------
Cash at March 31, 2004, was $29.6 million, an increase of $3.0 million compared
to December 31, 2003. During the first quarter of 2004, net cash provided by
operations of $8.0 million were primarily used to invest in plant and equipment
and repay debt.
Capital expenditures were $2.6 million in the first quarter of 2004 and $4.2
million in 2003 which is predominantly spent at the RLECs and will be included
in their rate bases for rate setting purposes. Capital expenditures in 2004 are
expected to be approximately $21 million, most of which will be added to the
RLEC rate bases. External financing is currently in place for approximately $7
million of these expenditures. The remainder will be financed from internal
sources.
The Company has initiated an effort to monetize certain of its assets, including
selling a portion or all of its investment in certain of its operating entities
and equity investments. These initiatives may include the sale of certain
telephone operations where growth opportunities are not readily apparent. There
is no assurance that all or any part of this program can be effectuated on
acceptable terms.
Subsequent to the spin-off by Lynch Corporation, the Board of Directors of Lynch
Interactive Corporation authorized the purchase of up to 100,000 shares of
common stock. Through March 31, 2004, 50,300 shares had been purchased at an
average cost of $32.22.
Lynch Corporation, the Company's predecessor, has not paid any cash dividends on
its common stock since 1989. The Company has not paid any cash dividends since
its inception in 1999. The Company may consider paying dividends in the future
depending upon the needs of its businesses. Further financing may limit or
prohibit the payment of dividends.
-16-
Contingencies
- -------------
Interactive and several other parties, including the CEO, and Fortunet
Communications, L.P., which was Sunshine PCS Corporation's
predecessor-in-interest, have been named as defendants in a lawsuit brought
under the so-called "qui tam" provisions of the federal False Claims Act in the
United States District Court for the District of Columbia. The complaint was
filed under seal with the court on February 14, 2001. At the initiative of one
of the defendants, the seal was lifted on January 11, 2002. Under the False
Claims Act, a private plaintiff, termed a "relator," may file a civil action on
the U.S. government's behalf against another party for violation of the statute.
In return, the relator receives a statutory bounty from the government's
litigation proceeds if he is successful.
The main allegation in the case is that the defendants participated in the
creation of "sham" bidding entities that allegedly defrauded the federal
Treasury by improperly participating in certain Federal Communications
Commission spectrum auctions restricted to small businesses, as well as
obtaining bidding credits in other spectrum auctions allocated to "small" and
"very small" businesses. While the complaint seeks to recover an unspecified
amount of damages, which would be subject to mandatory trebling under the
statute, a document filed by the relator with the Court on February 24, 2004,
discloses an initial computation of damages of not less than $88 million
resulting from bidding credits awarded to the defendants in FCC auctions and
$120 million of unjust enrichment through the sale or assignment of licenses
obtained by the defendants in FCC auctions, in each prior to trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's initial damage computation is without basis, and intends to
defend the suit vigorously. The U.S. Department of Justice has notified the
court that it has declined to intervene in the case. Nevertheless, we cannot
predict the ultimate outcome of the litigation, nor can we predict the effect
that the lawsuit or its outcome will have on our business or plan of operation.
Interactive does not have any insurance to cover its cost of defending this
lawsuit, which costs will be material. Interactive does have a directors and
officers liability policy but the insurer has reserved its rights under the
policy and, as a result, any coverage to be provided to any director or officer
of Interactive in connection with a judgment rendered in this action is unclear
at this time.
Interactive was formally served with the complaint on July 10, 2002. On
September 19, 2002, Interactive filed two motions with the United States
District Court for the District of Columbia: a motion to dismiss the lawsuit and
a motion to transfer the action to the Southern District of New York. On
November 25, 2002, the relator filed an opposition reply to our motion to
dismiss and on December 5, 2002, Interactive filed a reply in support of its
motion to dismiss. On September 30, 2003, the Court granted our motion to
transfer the action to the Southern District of New York. A scheduling
conference was held on February 10, 2004, at which the judge approved a
scheduling order. Discovery has now commenced as the parties await a ruling on
the defendants' motion to dismiss the case.
Critical Accounting Policies and Estimates
- ------------------------------------------
The preparation of consolidated financial statements requires Interactive's
management to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an ongoing basis, Interactive evaluates its
estimates, including those related to revenue recognition, carrying value of its
investments in spectrum entities and long-lived assets, purchase price
allocations, and contingencies and litigation. Interactive bases its estimates
on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. Interactive believes the
following critical accounting policies affect its more significant judgments and
estimates used in the preparation of its consolidated financial statements.
-17-
We believe that revenue from interstate access is based on critical accounting
estimates and judgment. Such revenue is derived from settlements with the
National Exchange Carrier Association ("NECA"). NECA was created by the FCC to
administer interstate access rates and revenue pooling on behalf of small local
exchange carriers who elect to participate in a pooling environment. Interstate
settlements are determined based on the various subsidiaries' cost of providing
interstate telecommunications service. Interactive recognizes interstate access
revenue as services are provided based on an estimate of the current year cost
of providing service. Estimated revenue is adjusted to actual upon the
completion of cost studies in the subsequent period.
Interactive's business development strategy is to expand its existing operations
through internal growth and acquisition. From 1989 through 2001, the Company has
acquired twelve telephone companies. Significant judgments and estimates are
required to allocate the purchase price of acquisitions to the fair value of
tangible assets acquired and identifiable intangible assets and liabilities
assumed. Any excess purchase price over the above fair values is allocated to
goodwill. Additional judgments and estimates are required to determine if
identified intangible assets have finite or indefinite lives.
Annually, the Company tests goodwill and other intangible assets with indefinite
lives for impairment. The Company screens for potential impairment by
determining fair value for each reporting unit. We estimate the fair value of
each reporting unit based on a number of subjective factors, including: (a)
appropriate weighting of valuation approaches (income approach, market approach
and comparable public company approach), (b) estimates of our future cost
structure, (c) discount rates for our estimated cash flows, (d) selection of
peer group companies for the public company approach, (e) required level of
working capital, (f) assumed terminal value and (g) time horizon of cash flow
forecasts.
We consider the estimate of fair value to be a critical accounting estimate
because (a) a potential goodwill impairment could have a material impact on our
financial position and results of operations and (b) the estimate is based on a
number of highly subjective judgments and assumptions, the most critical of
which is that the regulatory environment will continue in its current form.
Interactive tests its investments and other long-term non-regulated assets
annually whenever events or changes in circumstances indicate that the carrying
value of such assets may not be recoverable. Significant judgment is required to
determine if an impairment has occurred and whether such impairment is "other
than temporary."
The calculation of depreciation and amortization expense is based on the
estimated economic useful lives of the underlying property, plant and equipment
and intangible assets. Although Interactive believes it is unlikely that any
significant changes to the useful lives of its tangible or intangible assets
will occur in the near term, rapid changes in technology, the discontinuance of
accounting under SFAS No. 71 by the Company's wireline subsidiaries, or changes
in market conditions could result in revisions to such estimates that could
materially affect the carrying value of these assets and the Company's future
consolidated operating results.
Recently Issued Accounting Pronouncements
- -----------------------------------------
The Financial Accounting Standards Board (FASB" issued Financial Interpretation
No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB
No. 51" (FIN 46) in January 2003 and revised it in December 2003 (FIN 46R). FIN
46 requires certain variable interest entities to be consolidated by the primary
beneficiary of the entity if the equity investors in the entity do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. The provisions of FIN 46R
must be applied for the first interim or annual period ending after March 15,
2004 for both new and existing variable interest entities. Certain less than 50%
owned investments in limited liability companies, which were considered to be
variable interest entities, needed to be consolidated as a result of the
implementation of FIN 46. The effect of consolidating such operations resulted
in increasing intangible assets and decreasing investments in and advances to
affiliated companies by approximately $2 million and had no other significant
effect on the
-18-
Company's consolidated financial statements.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
The Company is exposed to market risks relating to changes in the general level
of U.S. interest rates. Changes in interest rates affect the amount of interest
earned on the Company's cash equivalents and short-term investments
(approximately $29.6 million at March 31, 2004 and $26.6 million at December 31,
2003). The majority of the Company's debt is fixed rate and the Company
generally finances the acquisition of long-term assets by borrowing on a fixed
long-term basis. The Company does not use derivative financial instruments for
trading or speculative purposes. Management does not foresee any significant
changes in the strategies used to manage interest rate risk in the near future,
although the strategies may be reevaluated as market conditions dictate. As of
March 31, 2004, the fair value of debt was approximately equal to its carrying
value.
At March 31, 2004 and December 31, 2003, approximately $55.1 million and $56.4
million, respectively, or 31% and 34% of Interactive's long-term debt and notes
payable bears interest at variable rates. Accordingly, the Company's earnings
and cash flows are affected by changes in interest rates. Assuming the current
level of borrowings for variable rate debt and assuming a one percentage point
change in the 2004 average interest rate under these borrowings, it is estimated
that Interactive's interest expense for the three months ended March 31, 2004
would have changed by approximately $0.1 million. In the event of an adverse
change in interest rates, management would likely take actions to further
mitigate its exposure. However, due to the uncertainty of the actions that would
be taken and their possible effects, no such actions are assumed. As of March
31, 2004, if the Company were to convert a significant portion of its variable
interest rate debt into fixed interest rates, such conversion could increase
interest expense for the three months ended March 31, 2004 by $0.4 million
assuming that variable rates remain constant. Further, such analysis does not
consider the effects of the change in the level of overall economic activity
that could exist in such an environment.
Item 4. Controls and Procedures
Our Chief Executive Officer and Chief Financial Officer have evaluated the
effectiveness of the Company's disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the
"Act")) as of the end of the period covered by this report. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Company's disclosure controls and procedures as of the end of the
period covered by this report were designed and were functioning effectively to
provide reasonable assurance that the information required to be disclosed by
the Company in reports filed under the Act is recorded, processed, summarized
and reported within the time periods specified in the SEC's rules and forms. The
Company believes that a controls system, no matter how well designed and
operated, cannot provide absolute assurance that the objectives of the controls
system are met, and no evaluation of controls can provide absolute assurance
that all control issues and instances of fraud, if any, within a company have
been detected.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Interactive and several other parties, including the CEO, and Fortunet
Communications, L.P., which was Sunshine PCS Corporation's
predecessor-in-interest, have been named as defendants in a lawsuit brought
under the so-called "qui tam" provisions of the federal False Claims Act in the
United States District Court for the District of Columbia. The complaint was
filed under seal with the court on February 14, 2001. At the initiative of one
of the defendants, the seal was lifted on January 11, 2002. Under the False
Claims Act, a private plaintiff, termed a "relator," may file a civil action on
the U.S. government's behalf against another party for violation of the statute.
In return, the relator receives a statutory bounty from the government's
-19-
litigation proceeds if he is successful.
The main allegation in the case is that the defendants participated in the
creation of "sham" bidding entities that allegedly defrauded the federal
Treasury by improperly participating in certain Federal Communications
Commission spectrum auctions restricted to small businesses, as well as
obtaining bidding credits in other spectrum auctions allocated to "small" and
"very small" businesses. While the complaint seeks to recover an unspecified
amount of damages, which would be subject to mandatory trebling under the
statute, a document filed by the relator with the Court on February 24, 2004,
discloses an initial computation of damages of not less than $88 million
resulting from bidding credits awarded to the defendants in FCC auctions and
$120 million of unjust enrichment through the sale or assignment of licenses
obtained by the defendants in FCC auctions, in each prior to trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's initial damage computation is without basis, and intends to
defend the suit vigorously. The U.S. Department of Justice has notified the
court that it has declined to intervene in the case. Nevertheless, we cannot
predict the ultimate outcome of the litigation, nor can we predict the effect
that the lawsuit or its outcome will have on our business or plan of operation.
Interactive does not have any insurance to cover its cost of defending this
lawsuit, which costs will be material. Interactive does have a directors and
officers liability policy but the insurer has reserved its rights under the
policy and, as a result, any coverage to be provided to any director or officer
of Interactive in connection with a judgment rendered in this action is unclear
at this time.
Interactive was formally served with the complaint on July 10, 2002. On
September 19, 2002, Interactive filed two motions with the United States
District Court for the District of Columbia: a motion to dismiss the lawsuit and
a motion to transfer the action to the Southern District of New York. On
November 25, 2002, the relator filed an opposition reply to our motion to
dismiss and on December 5, 2002, Interactive filed a reply in support of its
motion to dismiss. On September 30, 2003, the Court granted our motion to
transfer the action to the Southern District of New York. A scheduling
conference was held on February 10, 2004, at which the judge approved a
scheduling order. Discovery has now commenced as the parties await a ruling on
the defendants' motion to dismiss the case.
In addition to the litigation described above, Interactive is a party to routine
litigation incidental to its business. Based on information currently available,
Interactive believes that none of this ordinary routine litigation, either
individually or in the aggregate, will have a material effect on its financial
condition and results of operations.
History of Lynch's "C" Block Activities
- ---------------------------------------
On December 18, 1995, Lynch Interactive Corporation (through its predessor Lynch
Corporation) had investments in five entities that participated in the Federal
Communications Commission Auction for Broadband PCS "C" Block Spectrum (Auction
5). When the auction closed, on May 6, 1996, these five entities, on a combined
basis, were the higher bidders for thirty-one 30 MHz licenses at a gross cost of
$288.2 million. These entities were initially put together under the FCC's
initiative to include, among others, qualified women, African Americans, Native
Americans and Asian Americans. As a result of changes in these initiatives,
these same individuals were qualified as small businesses and remained eligible
as bidders. These entities received $72 million of bidding credits, and
accordingly the net cost was $216.2 million. The federal government provided
financing for 90% of the cost of these licenses, or $194.6 million. Lynch's
investments in these entities totaled $21 million.
Events during and subsequent to Auction 5, made financing these licenses through
the capital markets much more difficult than originally anticipated. On April
18, 1997, in order to obtain some economies of scale, the five entities merged
into Fortunet Communications, Inc. The FCC, in partial response to actions by
Nextwave
-20-
and others, promoted a plan of refinancing of "C" block. In 1997, many of the
license holders from Auction 5, including Fortunet, petitioned the FCC for
relief in order to afford these small businesses the opportunity to more
realistically restructure and build out their systems. The response from the
FCC, which was announced on September 26, 1997 and modified on March 24, 1998,
afforded license holders four options. One of these options was the resumption
of current debt payments, which had been suspended earlier in 1997 for all such
license holders.
On June 8, 1998, Fortunet selected to apply its eligible credits relating to its
original down payment to the purchase of three licenses for 15 MHz of PCS
spectrum in Tallahassee, Panama City and Ocala, Florida. Consistent with an FCC
promulgated disaggregation alternative, Fortunet surrendered all the remaining
licenses and forfeited 30% of its original down payment in full satisfaction of
the government debt and the forgiveness of all accrued interest. Accordingly,
Fortunet retained 15 MHz of spectrum in the three Florida markets covering a
population of approximately 962,000 at a net auction cost of $15.8 million. As a
result of following this FCC process, Fortunet lost $6.0 million of its down
payment. The disaggregation also resulted in a reduction of the bidding credits
to $5.3 million. Yet, the attorneys for the plaintiff continue to state that the
"C" Block entities were involved in receiving $72 million of bidding credits.
Either they didn't do their homework or choose deliberately to ignore the fact
of the disaggregation. A lawyer for many applications for FCC licenses, Mr.
Taylor is intimately aware of the details of these FCC initiated alternatives to
the "C" Block, as was and should be his law firm. As a result of this decision,
during 1997, Interactive recorded a $7.0 million write down of its investment in
Fortunet.
On April 15, 1999, the FCC completed a reauction of all the C-Block licenses
that were surrendered, including the 15 MHz of spectrum that Fortunet returned
to the FCC on June 8, 1998 in respect of the Tallahassee, Panama City and Ocala,
Florida markets. In that reauction, the successful bidders paid a total of $2.7
million for those three 15 MHz licenses returned by Fortunet versus the $15.8
million paid by Fortunet. As a result of this auction, Interactive recorded a
further write down of its investment of $15.4 million, including capitalized
costs, to reflect the amount bid for the similar licenses in the reauction.
In February 2000, Fortunet merged with Sunshine PCS Corporation, which by way of
a spin-off from Lynch Interactive became a public company. It traded under the
symbol SUNPA.
On December 31, 2003, Sunshine, after undergoing appropriate corporate and
regulatory processes, sold its three 15 MHz licenses to Cingular Wireless for
$13.75 million. Interactive received $7.6 million as part of the sale
transaction versus its cash investment of $21 million it initially invested in
the original five entities in 1992.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit 31.1 - Chief Executive Officer Section 302 Certification
Exhibit 31.2 - Chief Financial Officer Section 302 Certification
Exhibit 32.1 - Chief Executive Officer Section 906
Certification.
Exhibit 32.2 - Chief Financial Officer Section 906 Certification.
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SIGNATURE
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LYNCH INTERACTIVE CORPORATION
(Registrant)
/s/ Robert E. Dolan
--------------------
Robert E. Dolan
Chief Financial Officer
May 17, 2004
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