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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, 2005
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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____
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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-2 of 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, 2005
----- -----------------------------
Common Stock, $.0001 par value 2,752,251
INDEX
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LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
----------------------------------------------
PART I. FINANCIAL INFORMATION
- -----------------------------
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets:
- March 31, 2005
- December 31, 2004
- March 31, 2004
Condensed Consolidated Statements of Operations:
- Three months ended March 31, 2005 and 2004
Consolidated Statements of Shareholders' Equity
Condensed Consolidated Statements of Cash Flows:
- Three months ended March 31, 2005 and 2004
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
- --------------------------
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits and Reports on Form 8-K
SIGNATURE
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CERTIFICATIONS
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-1-
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
--------------------
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
March 31, December 31, March 31,
2005 2004 2004
------------ ------------ ----------
Unaudited) (Audited) Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ...... $ 29,698 $ 27,214 $ 29,572
Receivables, less allowances of
$255, $260 and $270,respectively .. 7,573 8,225 7,923
Material and supplies .......... 2,502 2,314 2,736
Prepaid expenses and other current
assets ........................ 1,175 1,685 1,110
-------- --------- ---------
Total current assets ................ 40,948 39,438 41,341
Property, plant and equipment:
Land ........... .................. 983 983 840
Buildings and improvements ........ 17,712 17,640 13,336
Machinery and equipment ........... 220,496 216,429 216,855
-------- --------- ---------
239,191 235,052 231,031
Accumulated depreciation .......... (119,252) (114,724) (107,683)
--------- --------- ---------
119,939 120,328 123,348
Excess of cost over fair value of
net assets acquired, net (goodwill) . 60,501 60,042 60,580
Other intangibles .................... 10,763 10,026 10,321
Investments in and advances to
affiliated entities ................ 11,416 12,340 5,310
Other assets ......................... 15,167 14,906 13,176
--------- --------- ---------
Total assets ........;;;;;;;.......... $ 28,734 $ 257,080 $ 254,076
========= ========= =========
See accompanying Notes to Consolidated Financial Statements
-2-
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
March 31, December 31, March 31,
2005 2004 2004
---------- ----------- -----------
(Unaudited) (Audited) (Unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Notes payable to banks ................. $ 5,980 $ 4,793 $ 3,535
Trade accounts payable ................. 3,125 4,326 4,457
Accrued interest payable ............... 822 825 696
Accrued liabilities .................... 15,100 11,238 10,925
Current maturities of long-term debt ... 14,295 14,364 13,071
--------- --------- ---------
Total current liabilities ........... 39,322 35,546 32,684
Long-term debt ........................... 153,593 154,602 160,388
Deferred income taxes .................... 16,080 17,549 15,812
Other liabilities ........................ 3,431 3,268 2,976
--------- --------- ---------
Total liabilities ................... 212,426 210,965 211,860
Minority interests ....................... 11,313 11,543 10,297
Commitments and contingencies (Note 12)
Shareholders' equity
Common stock, $0.0001 par value-10,000,000
shares authorized; 2,824,766 issued;
2,752,251, 2,757,951 and 2,774,651
outstanding ......................... -- -- --
Additional paid-in capital ............. 21,406 21,406 21,406
Retained earnings ...................... 14,430 13,735 10,872
Accumulated other comprehensive income . 1,495 1,588 1,253
Treasury stock, 72,515, 66,815 and
50,115 shares, at cost ............... (2,336) 2,157) (1,612)
--------- --------- ---------
34,995 34,572 31,919
--------- --------- ---------
Total liabilities and shareholders' equity. $ 258,734 $ 257,080 $ 254,076
========= ========= =========
See accompanying Notes to Consolidated Financial Statements.
-3-
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)
Three Months Ended
March 31,
-----------------------------
2005 2004
-----------------------------
Revenues ......................................... $ 21,618 $ 21,424
Costs and expenses:
Cost of revenue .................................. 7,651 7,203
General and administrative costs at operations ... 3,423 3,139
Corporate office expenses ........................ 2,091 973
Depreciation and amortization .................... 5,195 5,221
-------- --------
Total Expense ................................ 18,360 16,536
-------- --------
Operating profit ................................. 3,258 4,888
Other income (expense):
Investment income ............................. 793 728
Interest expense .............................. (2,823) (2,819)
Equity in earnings of affiliated companies .... 711 712
-------- --------
(1,319) (1,379)
-------- --------
Income before income taxes and minority interests 1,939 3,509
Provision for income taxes ...................... (767) (1,449)
Minority interests .............................. (477) (457)
-------- ------
Net income ...................................... $ 695 $ 1,603
======== ========
Basic and diluted weighted average shares o
utstanding ........................................ 2,754 2,777
Basic and diluted earnings per share ............. $ 0.25 $ 0.58
See accompanying Notes to Condensed Consolidated Financial Statements.
-4-
LYNCH INTERACTIVE CORPORATION AND SUBSIDIAIRES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited)
(in thousands, except share data)
Shares of Accumulated
Common Additional Other
Stock Common Paid-in Retained Comprehensive Treasury
Out-standing Stock Capital Earnings Income Stock Total
------------ --------- --------- ----------- ------------- ---------- ----------
Balance at December 31, 2004 2,757,951 $ 0 $ 21,406 $ 13,735 $ 1,588 $ (2,157) $ 34,572
Net income for the period .. -- -- -- 695 -- -- 695
Unrealized loss on available -- -- -- -- (93) -- (93)
for sale securities, net
-------
Comprehensive income ... 602
-------
Purchase of Treasury Stock . (5,700) -- -- -- -- (179) (179)
--------- -------- --------- --------- -------- ---------- -------
Balance at March 31, 2005 2,752,251 $ 0 $ 21,406 $ 14,430 $ 1,495 $ (2,336) $34,995
=========== =========== =========== =========== =========== ===========
See accompanying Notes to Consolidated Financial Statements.
-5-
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)
Three Months Ended
March 31,
-------------------------
2005 2004
-------------------------
Operating activities:
Net Income $ 695 $ 1,603
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 5,195 5,221
Equity in earnings of affiliated compani (711) (712)
Minority interests 477 457
Changes in operating assets and liabilities:
Receivables 712 307
Accounts payable and accrued liabilitie 400 1,324
Other 619 (189)
--------------------------
Net cash provided by operating activities 7,387 8,011
--------------------------
Investing activities:
Capital expenditures (1,915) (2,614)
Acquisition of business (3,524) (377)
Acquisition of subscrib (22) (91)
Acquisition of spectrum (500) --
Investment in and advances to affiliated entities (62) (63)
Distributions received from investments 1,714 821
Other 183 30
---------------------------
Net cash used in investing activities (4,126) (2,294)
---------------------------
Financing activities:
Issuance of long term debt 2,272 949
Repayments of long term debt (3,350) (3,273)
Net proceeds (repayments) on lines of credit 1,187 79
Purchase of treasury stock (179) (138)
Other (707) (318)
---------------------------
Net cash used in financing activities (777) (2,701)
---------------------------
Net increase in cash and cash equivalents 2,484 3,016
Cash and cash equivalents at beginning of period 27,214 26,556
---------------------------
Cash and cash equivalents at end of period $ 29,698 $ 29,572
===========================
Cash paid for:
Interest expense $ 2,764 $ 2,826
===========================
Income taxes $ 676 $ 175
===========================
See accompanying Notes to Condensed Consolidated Financial Statements.
-6-
LYNCH INTERACTIVE CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
A. Basis of Presentation
- --------------------------
Lynch Interactive Corporation ("Interactive" or the "Company") consolidates the
operating results of its subsidiaries (81%-100% owned at March 31, 2005,
December 31, 2004 and March 31, 2004). All material intercompany transactions
and balances have been eliminated. Investments in affiliates in which the
Company does not have a majority voting control, but has the ability to
significantly influence management decisions, 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, 2005, December 31, 2004 and March 31, 2004), Capital
Communications Company, Inc. (49% owned at March 31, 2005, December 31, 2004 and
March 31, 2004; we note, however, that Interactive owns a convertible preferred
stock which, if converted, would increase its ownership in Capital
Communications to 50%), two cellular partnership operations in New Mexico (both
33% owned at March 31, 2005, December 31, 2004 and March 31, 2004), KMG Holdings
Group (37% owned since May 2004) and telecommunications operations in North
Dakota, Iowa and New York (5% to 14% owned).
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, 2004. 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, 2005 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 2005. 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. Certain prior period amounts in the
accompanying consolidated financial statements have been reclassified to conform
to current period presentation.
B. Recently Issued Accounting Pronouncements
- ----------------------------------------------
In December 2004, the FASB issued SFAS No.153, "Exchanges of Nonmonetary
Assets", which eliminates the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. SFAS No.153 will be
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005. The Company does not believe the adoption of SFAS No.153
will have a material impact on its consolidated financial statements.
In December 2004, the FASB issued SFAS No.123(R), "Share-Based Payment", which
establishes standards for transactions in which an entity exchanges its equity
instruments for goods or services. This standard requires a public entity to
measure the cost of employee services received in exchange for an award of
equity instruments based on the grant-date fair value of the award. This
eliminates the exception to account for such awards using the intrinsic method
previously allowable under APB Opinion No.25. SFAS No.123(R) will be effective
for interim or annual reporting periods beginning on or after June 15, 2005. The
Company is currently evaluating the impact of the adoption of SFAS No.123(R)
will have on its consolidated financial statements.
-7-
In March 2005, the FASB issued Interpretation No. 47, "Accounting for
Conditional Asset Retirement Obligations" ("FIN47"), which clarifies that
conditional asset retirement obligations are within the scope of SFAS No. 143,
"Accounting for Asset Retirement Obligations." FIN 47 requires the Company to
recognize a liability for the fair value of conditional asset retirement
obligations if the fair value of the liability can be reasonably estimated. The
Company does not believe that the adoption of FIN 47 will have a material impact
on its financial statements.
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. On May 5, 2005,
the California Public Utilities Commission approved the transaction subject to
various conditions that the Company expects to meet, at which point the
acquisition will close.
In February 2005, Lynch 3G participated in Auction 58 for PCS Spectrum and was
high bidder for two licenses, Marquette, MI and Klamath Falls, OR, for a total
cost of $0.5 million.
On March 18, 2005, a subsidiary of the Company, Central Telcom Services, LLC,
closed on an agreement with Precis Communications, LLC, to acquire a cable
television assets for a purchase price of $3.5 million. The system has 2,411
cable subscribers located in Sanpete and Sevier Counties, Utah. The preliminary
allocation of the purchase price included $0.4 million of goodwill and $0.4
million for subscriber lists and other intangibles.
D. Investments in Affiliated Companies
- ----------------------------------------
Interactive has equity investments in both broadcasting and telecommunications
companies.
Summarized financial information for broadcasting companies accounted for by the
equity method as of and for the three months ended March 31, 2005 and 2004 and
as of December 31, 2004, is as follows:
Broadcasting Combined
-------- ----------- --------
March 31, December 31, March 31,
2005 2004 2004
-------- ------------ ----------
(in thousands)
Current assets ................................ ... $ 5,273 $ 6,896 $ 5,213
Property, plant & equipment, intangibles & other .. 10,181 9,558 9,187
-------- -------- --------
Total Assets ...................................... $ 15,454 $ 16,454 $ 14,400
======== ======== ========
Current liabilities ............................... $ 2,636 $ 3,383 $ 3,115
Long term liabilities ............................. 16,587 16,751 15,857
Equity ........................................... (3,769) (3,680) (4,572)
-------- -------- --------
Total liabilities & equity ........................ $ 15,454 $ 16,454 $ 14,400
======== ======== ========
Revenues .......................................... $ 3,055 $ 3,490
Gross profit ...................................... 750 1,256
Net income ....................................... (99) 354
-8-
A wholly owned subsidiary of the Company has a 20% investment in Coronet
Communications Company ("Coronet"), which operates television station WHBF-TV, a
CBS affiliate in Rock Island, Illinois. A
second wholly owned subsidiary of the Company has a 49% investment in Capital
Communications Company, Inc. ("Capital"), which operates television station
WOI-TV, an ABC affiliate in Des Moines, Iowa. At March 31, 2005, December 31,
2004 and March 31, 2004, the investment in Coronet was carried at a negative
$0.6 million, $0.6 million and $0.8 million, respectively, due to the
subsidiary's guarantee of $3.8 million of Coronet's third party debt. 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. Long-term debt of Coronet, at March
31, 2005, totaled $9.4 million payable quarterly through December 31, 2005 to a
third party lender.
At March 31, 2005, December 31, 2004 and March 31, 2004, the investment in
Capital is carried at zero as its share of net losses recognized to date have
exceeded its net investment and the Company has no further commitment to
Capital. The Company's shares in Capital have been pledged as security for
Capital's long term debt.
Summarized financial information for telecommunications companies which includes
the cellular telephone providers, spectrum license holders, and other
telecommunication operations accounted for by the equity method as of and for
the three months ended March 31, 2005 and 2004 and as of December 31, 2004 is as
follows (in thousands):
Telecommunications Combined
---------------------------
March 31, December 31, March 31,
2005 2004 2004
------------------------------------
(in thousands)
Current assets ......................................... $33,330 $36,080 $29,425
Property, plant & equipment, intangibles & other ....... 34,349 33,087 26,856
------------------------------------
Total Assets ........................................... $67,679 $69,167 $56,281
====================================
Current liabilities .................................... $22,812 $22,745 $22,322
Long term liabilities .................................. 7,028 5,900 8,938
Equity ................................................ 37,839 40,522 25,021
------------------------------------
Total liabilities & equity ............................. $67,679 $69,167 $56,281
====================================
Revenues ............................................... $16,196 $12,306
Gross profit ........................................... 7,139 5,475
Net income ............................................. 3,945 3,295
Interactive owns a one-third interest in two cellular telephone providers in New
Mexico: New Mexico RSA #3 and RSA #5. The Company's net investment in these
partnerships was $5.4 million, $6.5 million and $4.8 million at March 31, 2005,
December 31, 2004 and March 31, 2004, respectively and included in Investment in
and advances to affiliated entities.
E. Indebtedness
- -----------------
Interactive maintains a short-term line of credit facility totaling $10.0
million through October 2004, which was reduced in steps to $5 million at March
31, 2005. Borrowings under this facility, included in Notes payable to banks,
were $1.8 million, $1.1 million and zero at March 31, 2005, December 31, 2004
and March 31, 2004, respectively. Long-term debt consists of (all interest rates
are at March 31, 2005) (in thousands):
-9-
March 31, December 31, March 31,
2005 2004 2004
----------------------------------------------
Rural Electrification Administration ("REA") and
Rural Telephone Bank (`RTB") notes payable due
quarterly through 2027 at fixed interest rates
ranging from 2% to 7.5%. (5.1% weighted average,
secured by assets of the telephone companies with
a net book value of $150 million) $56,100 $57,129 $59,892
Bank Credit facilities utilized by certain
telephone and telephone holding companies due from
2005 to 2016, $8.8 million at fixed interest
rates averaging 8.3% and $61.7 million at
variable interest rates averaging 5.7%. 70,497 70,402 76,601
Unsecured notes issued in connection with
acquisitions through 2008, at fixed interest rates 38,983 38,983 34,389
averaging 9.4%
Other 2,308 2,452 2,577
----------------------------------------------
167,888 168,966 173,459
Current maturities (14,295) (14,364) (13,071)
----------------------------------------------
$ 153,593 $ 154,602 $ 160,388
==============================================
In March 2005, in conjunction with the acquisition of cable assets in Utah, a
subsidiary of the Company borrowed $2.2 million from a bank at variable interest
rates included in Bank Credit facilities above.
In April 2005, Interactive received a commitment letter for a new $10 million
unsecured revolving credit facility , at 1.5% over prime, expiring in 2008, to
replace the existing short-term line of credit facility. Such facility is
subject to negotiation of terms and there can be no assurance that it will be
completed.
F. Comprehensive Income
- -------------------------
Other comprehensive income, net of tax, which consists of unrealized gains
(losses) on available for sale securities, as of March 31, 2005, December 31,
2004 and March 31, 2004 are as follows (in thousands):
Unrealized Gain
(Loss) Tax Effect Net
--------------------------------------------
(in thousands)
Balance at December 31, 2004 .......................... $ 2,410 $ (822) $ 1,588
Unrealized losses on available for sale securities, net (140) 47 (93)
------- ------- -------
Balance at March 31, 2005 ............................. $ 2,270 $ (775) $ 1,495
======= ======= =======
Balance at March 31, 2004 ............................. $ 1,901 $ (648) $ 1,253
======= ======= =======
G. Treasury Stock Purchases
- ---------------------------------
During the three months ended March 31, 2005, the Company purchased 5,700 shares
of its common stock for treasury at an average investment of $31.53 per share.
-10-
H. Litigation
- -------------------
Taylor Litigation. -------------------------------------- Interactive and
several other parties, including Interactive's CEO, and Fortunet Communications,
L.P., which was Sunshine PCS Corporation's predecessor-in-interest, have been
named as defendants in a lawsuit originally brought by Rufus C. Taylor, III
("Taylor" or the "relator") 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 in February 2001. At
the initiative of one of the defendants, the seal was lifted in January 2002.
Under the False Claims Act, a private plaintiff called 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 ("FCC") 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 report prepared for the relator in February 2005 alleges damages of
approximately $91 million in respect of bidding credits, approximately $70
million in respect of government loans and approximately $206 million in respect
of subsequent sales of licenses, in each case prior to trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's damage computations are 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 in July 2002. In September
2002, the defendants 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. In September 2003, the
Court granted our motion to transfer the action. A scheduling conference was
held in February 2004, at which time the judge approved a scheduling order and
discovery commenced. In July 2004, the judge denied in part and granted in part
our motion to dismiss. Interactive and its subsidiaries remain parties to the
litigation.
In December 2004, the defendants filed a motion in the United States District
Court for the District of Columbia to compel the FCC to provide certain
information subpoenaed by defendents in order to enable them to conduct their
defense. This motion was denied in May 2005 and defendants are considering
appropriate responses. The preparation and filing of dispositive motions is
expected to begin shortly. See "History of Lynch's "C" Block Activities" below.
History of Lynch's "C" Block Activities.
- ---------------------------------------
As part of the Omnibus Budget Resolution of 1993, Congress authorized the FCC to
employ competitive bidding procedures to select among mutually exclusive
applicants for certain spectrum licenses. Initially the FCC had an initiative to
include, among others, African Americans, Native Americans, Asian Americans and
women. As a result of this, the FCC conducted auctions beginning in 1995 to
allocate spectrum in a competitive manner. Interactive was a participating
investor and/or service provider to various entities in this "C-Block" auction.
-11-
By December 18, 1995, Interactive (through its predecessor Lynch Corporation)
had investments in five entities that participated in the FCC 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,
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. Interactive'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, among other reasons, in order to obtain some economies of scale, such
as financing, the five entities merged into Fortunet Communications, Inc. The
FCC, in partial response to actions by Nextwave and others, promoted a plan for
refinancing the "C" block licenses. 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 President of Fortunet, Karen Johnson, participated
in an FCC sponsored forum on this issue on June 30, 1997. 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. Another option, amnesty, was to return all licenses and forgo
any amounts deposited in exchange for forgiveness of the FCC debt. Other options
included: disaggregation, splitting a 30 MHz license into two 15 MHz licenses
and forgoing 50% of the amount deposited; and prepayment, return of certain
licenses and utilizing 70% of the amount deposited to acquire other licenses,
with the other 30% of the deposits to be forfeited.
On June 8, 1998, Fortunet elected 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
its government obligations, including 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 this FCC process, disaggregation resulted in a reduction
of the bidding credits to $5.3 million. Fortunet also lost $6.0 million of its
down payment. As a result of this decision, during 1997, Interactive recorded a
$7.0 million write down of its investment in Fortunet. As a lawyer who worked on
many applications for FCC licenses, Taylor (the relator in this case) is
doubtless aware of the details of these FCC initiated alternatives for the "C"
Block, as presumably are his law firms.
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 appropriate corporate and regulatory
steps, 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 $21.9 million initially invested in the original five
entities in 1992.
Other Litigation. 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
-12-
litigation, either individually or in the aggregate, will have a material effect
on its financial condition and results of operations.
I. Potential MCI/WorldCom Recovery
- ------------------------------------
During 2002, the Company wrote off all receivables associated with MCI/WorldCom
("MCI"), which had declared bankruptcy at that time. While Interactive has not
received settlement from the bank of claims, it is currently estimated that
Interactive could receive $0.3 million. Such amounts have not been included in
the attached financial statements and income will only be recorded to the extent
received.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
-------------
This discussion should be read together with the Consolidated Financial
Statements of Interactive and the notes thereto included elsewhere in this
Annual Report.
RESULTS OF OPERATIONS
- ---------------------
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 the current reporting period,
Interactive (and its predecessor corporation) 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 dependent 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. The Company
expects to recover settlements from MCI in 2005.
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.
-13-
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 to
residential lines, 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 All of our RLECs participate in the National Exchange Carrier
Association ("NECA") access pools. 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 nine cost-based
carriers directly correlate to the rate-of-return on regulated net
investment earned by the NECA access pools plus the amount of
regulated operating expenses including taxes. The revenues of the
Company's five average schedule subsidiaries correlate to usage based
measurements such as access lines, interstate minutes-of-use, and the
number and mileage of different types of circuits. The average
schedule formulas are 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 certain 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 it is
providing the long distance service to the end user customer as the
toll provider. For unaffiliated IXCs who contract with Interactive for
billing services, the Company provides billing services and receives
an administrative handling fee.
The following are material opportunities, challenges and risks that
Interactive's executives are currently focused on, as well as actions that are
being taken to address the concerns:
o Universal Service Reform: Efforts to modify universal service
mechanisms are currently underway at the FCC. In June 2004, the FCC
asked the Federal-State Joint Board on Universal Service ("Joint
Board") to review the rules relating to the high-cost universal
service support mechanisms for rural carriers and to determine the
appropriate rural mechanism to succeed the five-year plan adopted in
the Rural Task Force Order. In particular, the FCC asked the Joint
Board to make recommendations on a long-term universal service plan
that ensures that support is specific, predictable, and sufficient to
preserve and advance universal service. The FCC asked the Joint Board
to ensure that its recommendations are consistent with the goal of
ensuring that consumers in rural, insular, and high-cost areas have
access to telecommunications and information services at rates that
are affordable and reasonably comparable to rates charged for similar
services in urban areas. The FCC also asked the Joint Board to
consider how support can be effectively targeted to rural telephone
companies serving the highest cost areas, while protecting against
excessive fund growth. In
-14-
conducting its review, the Joint Board is supposed to take into
account the significant distinctions among rural carriers, and between
rural and non-rural carriers and consider all options for determining
appropriate universal service support. The Company participated with
the RLEC industry in comments to the FCC regarding 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.
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. VoIP traffic currently does not pay access charges or
contribute to universal service. The FCC has several proceedings
underway to determine whether VoIP traffic should contribute for the
use of the network and contribute to USF. The Company is participating
in the RLEC industry efforts to have VoIP traffic contribute for use
of the underlying network on which the VoIP call travels. To offset
revenue losses from traditional voice services, Interactive is
installing more broadband services and is exploring how to best
incorporate VoIP into its business model.
o Intrastate revenue and operating income at our Michigan telephone company
will be substantially reduced in the future due to a state requirement to
expand the local calling area. The Company intends to file with the state
commission to recover a portion of the revenue deficiency, by increasing
local access rates, however, there is no assurance that it will be
successful.
Three months ended March 31, 2005 compared to 2004
- ---------------------------------------------------
The following is a breakdown of revenues and operating costs and expenses:
Three months ended March 31, Increase
(Decrease)
2005 2004
----------------------------------------------
(Unaudited)
Revenues:
Local access ...................... $ 2,858 $ 2,889 (31)
Interstate access ................. 9,695 9,338 357
Intrastate access ................. 3,697 4,121 (424)
Other business .................... 5,368 5,076 292
------- ------- -------
------- ------- -------
Total ........................... 21,618 21,424 194
------- ------- -------
------- ------- -------
Operating Cost and Expense:
Cost of revenue ................... 7,651 7,203 448
General and administrative costs at
operations ...................... 3,423 3,139 284
Corporate office expenses ......... 2,091 973 1,118
Depreciation and amortization ..... 5,195 5,221 (26)
------- ------- -------
------- ------- -------
Total ........................... 18,360 16,536 1,824
------- ------- -------
------- ------- -------
Operating profit ................ $ 3,258 $ 4,888 $(1,630)
======= ======= =======
Total revenues in the 2005 first quarter increased $0.2 million, or 0.9%, to
$21.6 million compared to $21.4 million in 2004. Local access revenue decreased
by $31,000 resulting from a 3.4% decrease in access lines partially offset by
the sale of additional features. The decrease in access lines is due to the
increase in cell phone usage and reduction in second lines as customers switch
from dial-up internet service to DSL. Interstate access revenue increased $0.4
million in 2005 primarily due to infrastructure development
-15-
undertaken in 2002 and 2003, which entitled the Company to increased network
access and USF support primarily at the Haviland Telephone Company in Kansas,
and to a lesser extent, at our Michigan telephone company. Intrastate network
access revenue decreased $0.4 million due to a loss of toll revenue for dial-up
access to the internet at our Michigan telephone company, the gradual phase-out
of a New York pool for small carriers, and a reduction of minutes of use at
several of our companies. Other business revenues increased $0.3 million due to
increased DSL penetration, and revenues from a small cable company in Utah that
the Company acquired in February 2004.
Total costs and expenses increased by $1.8 million to $18.4 million in 2005.
Costs of revenue increased $0.4 million, or 6.2%, due to additional operating
costs related to the infrastructure development in Haviland and costs generated
by the cable television operation acquired in February 2004. General and
administrative costs incurred at the operations increased $0.3 million primarily
due to professional fees with regard to local area calling in Michigan and
increased audit and Sarbanes - Oxley implementation fees. Corporate office
expenses increased $1.1 million resulting from $1.2 million of legal costs
incurred defending the "qui tam" litigation in 2005 compared to $0.4 million in
2004. In addition, the Company incurred legal and consulting costs in
conjunction with a shareholder proposal to deregister as a public company.
Depreciation and amortization was relatively consistent in the two periods.
As a result of the above, operating profit in 2005 decreased by $1.6 million to
$3.3 million compared to 2004.
EBITDA
- ------
EBITDA represents the Company's earnings from continuing operations 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 an indicator of the Company's operating
performance or to cash flows as a measure of liquidity, in each case as
determined in accordance with generally accepted accounting principles. EBITDA
from operations is presented herein because it is a commonly used metric in the
communications industry to analyze companies on the basis of operating
performance and liquidity. The Company's senior management believes it
facilitates a standardized comparison among companies in the telecommunications
industry, while minimizing differences among those companies based on
depreciation, financial leverage and tax policies. 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).
Three months ended March 31, Increase
(Decrease)
2005 2004
--------------------------------------
(Unaudited)
EBITDA from operations .................... $ 10,544 $ 11,082 $ (538)
Corporate office expenses:
Taylor litigation ....................... (1,201) (382) (819)
Other ...................... .......... (890) (591) (299)
-------- -------- --------
Corporate office expenses: ....... ..... (2,091) (973) (1,118)
-------- -------- --------
Total EBITDA ............................ 8,453 10,109 (1,656)
Depreciation and amortization ............. (5,195) (5,221) 26
-------- -------- --------
Operating profit ........................ 3,258 4,888 (1,630)
Investment income ......................... 793 728 65
Interest expense ...................... ... (2,823) (2,819) (4)
Equity in earnings of affiliates .......... 711 712 (1)
-------- -------- --------
Income before income taxes and ..........
minority interest ..................... $ 1,939 $ 3,509 (1,570)
======== ======== ========
-16-
Other Income (Expense)
- ----------------------
In 2005, investment income increased by $0.1 million primarily due to an
increase in CoBank patronage refunds and a $0.1 million retroactive dividend
from Iowa Network Services. Such increases were offset by a $0.2 million gain on
the sale of an investment in the 2004 period.
Interest expense was unchanged due primarily to lower average outstanding
borrowings partially offset by higher interest rates.
Equity in earnings of affiliates was $0.7 million in both 2005 and 2004
reflecting consistent earnings of the Company's New Mexico cellular investments
(RSA 3 and 5) in both periods.
Income Tax Provision
- --------------------
The income tax provision includes federal, as well as state and local taxes. The
tax provision for 2005 and 2004, represent effective tax rates of 45.7% and
41.3%, 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 in both 2005 and 2004
reflecting the consistent earnings of the Company's New Mexico cellular
investments.
Net Income
- ----------
Net income in 2005 was $0.7 million, or $0.25 per share (basic and diluted),
compared to a net income last year of $1.6 million, or $0.58 per share (basic
and diluted). The Company has no dilutive instruments outstanding.
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------
Liquidity
- ---------
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 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 Parent Company's short-term line of credit facility, which expires August
31, 2005, has a maximum availability totaling $5.0 million, $3.2 million of
which was available at March 31, 2005. In April 2005, Interactive received a
commitment letter for a new $10 million unsecured revolving credit facility, at
1.5% over prime, expiring in 2008, to replace the existing short-term line of
credit facility. Such facility is subject to negotiation of terms and there can
be no assurance that it will be completed. If such new facility is not
completed, management believes that it has various alternative means to obtain
adequate resources to fund operations over the next twelve months.
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
-17-
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, 2005 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 After 5
Total 1 year 1 - 3 years 4 - 5 years years
---------- --------- ----------- ----------- ---------
Long-term debt (a) ............... $167,888 $ 14,295 $ 65,666 $ 36,449 $ 51,478
Operating leases ................. 1,275 277 469 225 304
Notes payable to banks ........... 5,980 5,980
Guarantees ....................... 3,750 3,750
-------- -------- ----------- ------------ --------
Total contractual cash obligations
and commitments .................. $178,893 $ 24,302 $ 66,135 $ 36,674 $ 51,782
======== ======== ======== ======== ========
(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 $9.4 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.
At March 31, 2005, total debt (including notes payable to banks) was $173.9
million, an increase of $0.1 million from December 31, 2004. At March 31, 2005,
there was $105.0 million of fixed interest rate debt outstanding averaging 7.0%
and $68.9 million of variable interest rate debt averaging 5.8%. The debt at
fixed interest rates includes $39.0 million of subordinated notes at interest
rates averaging 9.4% 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, 2005,
December 31, 2004 and March 31, 2004, substantially all of the subsidiaries' net
assets are restricted.
Interactive has a high degree of financial leverage. As of March 31, 2005, the
ratio of total debt to equity was 5.0 to 1. 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, 2005, Interactive had current assets of $40.9 million and
current liabilities of $39.3 million resulting in a working capital surplus of
$1.6 million, compared to a surplus of $2.7 million at December 31, 2004.
Sources and Uses of Cash
- ------------------------
Cash at March 31, 2005, was $29.7 million, an increase of $2.5 million compared
to December 31, 2004. The majority of the cash is restricted by debt covenant to
the subsidiary that generated it and is generally not available for transfer to
the Parent Company. In 2005, net cash provided by operations of $7.4 million was
used to invest in plant and equipment and to repay debt. The acquisition of
cable assets in March 2005 was primarily funded with new borrowings.
Capital expenditures were $1.9 million in the first quarter of 2005, compared to
$2.6 million in 2004 which is predominantly spent at the RLECs and will be
included in their rate bases for rate setting purposes. Capital expenditures in
2005 are expected to be approximately $11 million, most of which will be added
to the RLEC rate bases.
-18-
On March 18, 2005, a subsidiary of the Company, Central Telcom Services, LLC,
closed on an agreement with Precis Communications, LLC, to acquire a cable
television assets for a purchase price of $3.5 million of which $2.2 million was
financed with secured bank debt.
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, 2005, 72,700 shares had been purchased at an
average cost of $32.26 per share.
President Bush's proposed Budget for Fiscal Year 2006 establishes the process
and terms to implement the dissolution of the Rural Telephone Bank ("RTB").
Under RTB's By-Laws, on dissolution, the holders of its Class B and Class C
stock would be paid the par value of their stock. As of March 31, 2005, the
total par value of RTB Class B and Class C stock at the Company's subsidiaries
was $11.3 million. The net book value and tax basis of this stock, at that date,
was $1.1 million. The dissolution of the RTB and payments to the stockholders is
subject to numerous approvals and actions, including Congressional approval of
President Bush's proposed Budget for Fiscal Year 2006 and actions by RTB's Board
of Directors. Therefore, the Company cannot predict whether, or when, such
payments will actually be made to the Company's subsidiaries.
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 and does not expect to pay cash dividends on its common
stock in the foreseeable future. Interactive currently intends to retain its
earnings, if any, for use in its business. Further financing may limit or
prohibit the payment of dividends.
Contingencies
- -------------
Taylor Litigation. --------------------------------------- Interactive and
several other parties, including Interactive's CEO, and Fortunet Communications,
L.P., which was Sunshine PCS Corporation's predecessor-in-interest, have been
named as defendants in a lawsuit brought by Taylor 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
in February 2001. At the initiative of one of the defendants, the seal was
lifted in January 2002. Under the False Claims Act, a private plaintiff called 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 FCC 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 report prepared for the relator in
February 2005 alleges damages of approximately $91 million in respect of bidding
credits, approximately $70 million in respect of government loans and
approximately $206 million in respect of subsequent sales of licenses, in each
case prior to trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's initial damage computations are 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
-19-
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 in July 2002. In September
2002, the defendants 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. In September 2003, the
Court granted our motion to transfer the action. A scheduling conference was
held in February 2004, at which time the judge approved a scheduling order and
discovery commenced. In July 2004, the judge denied in part and granted in part
our motion to dismiss. Interactive and its subsidiaries remain parties to the
litigation.
In December 2004, the defendants filed a motion in the United States District
Court for the District of Columbia to compel the FCC to provide certain
information subpoenaed by defendants in order to enable them to conduct their
defense. This motion was denied in May 2005 and defendants are considering
appropriate responses. The preparation and filing of dispositive motions is
expected to begin shortly.
See also "H. Litigation - History of Lynch's C-Block Activities" above for a
history of our involvement in Auction 5.
Other Litigation.
- -----------------
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.
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.
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 fourteen 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.
-20-
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
- -----------------------------------------
In December 2004, the FASB issued SFAS No.153, "Exchanges of Nonmonetary
Assets", which eliminates the exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. SFAS No.153 will be
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005. The Company does not believe the adoption of SFAS No.153
will have a material impact on its consolidated financial statements.
In December 2004, the FASB issued SFAS No.123(R), "Share-Based Payment", which
establishes standards for transactions in which an entity exchanges its equity
instruments for goods or services. This standard requires a public entity to
measure the cost of employee services received in exchange for an award of
equity instruments based on the grant-date fair value of the award. This
eliminates the exception to account for such awards using the intrinsic method
previously allowable under APB Opinion No.25. SFAS No.123(R) will be effective
for interim or annual reporting periods beginning on or after June 15, 2005. The
Company is currently evaluating the impact of the adoption of SFAS No.123(R)
will have on its consolidated financial statements.
In March 2005, the FASB issued Interpretation No. 47, "Accounting for
Conditional Asset Retirement Obligations" ("FIN47"), which clarifies that
conditional asset retirement obligations are within the scope of SFAS No. 143,
"Accounting for Asset Retirement Obligations." FIN 47 requires the Company to
recognize a liability for the fair value of conditional asset retirement
obligations if the fair value of the liability can be reasonably estimated. The
Company does not believe that the adoption of FIN 47 will have a material impact
on its financial statements.
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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 $29.7 million at March 31, 2005 and $27.2 million at December 31,
2004). 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, 2005, the fair value of debt was approximately equal to its carrying
value.
At March 31, 2005 and December 31, 2004, approximately $68.9 million and $67.2
million, respectively, or 40% and 39% 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 2005 average interest rate under these borrowings, it is estimated
that Interactive's interest expense in the first quarter of 2005 would have
changed by approximately $0.2 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, 2005, if
the Company were to convert a significant portion of its variable interest rate
debt into fixed interest rates, such conversion could have increased interest
expense for the three month period by $0.5 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 have
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.
During the period covered by this report, there have been no changes in our
internal control over financial reporting that have materially affected, or is
reasonably likely to materially affect, our financial statements.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Taylor Litigation. Interactive and several other parties, including
Interactive's CEO, and Fortunet Communications, L.P., which was Sunshine PCS
Corporation's predecessor-in-interest, have been named as defendants in a
lawsuit originally brought by Taylor 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 in
February 2001. At the initiative of one of the defendants, the seal was lifted
in January 2002. Under the False Claims Act, a private plaintiff called 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
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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 FCC 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 report prepared for the relator in February 2005 alleges
damages of approximately $91 million in respect of bidding credits,
approximately $70 million in respect of government loans and approximately $206
million in respect of subsequent sales of licenses, in each case prior to
trebling.
Interactive strongly believes that this lawsuit is completely without merit and
that relator's damage computations are 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 in July 2002. In September
2002, the defendants 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. In September 2003, the
Court granted our motion to transfer the action. A scheduling conference was
held in February 2004, at which time the judge approved a scheduling order and
discovery commenced. In July 2004, the judge denied in part and granted in part
our motion to dismiss. Interactive and its subsidiaries remain parties to the
litigation.
In December 2004, the defendants filed a motion in the United States District
Court for the District of Columbia to compel the FCC to provide certain
information subpoenaed by defendants in order to enable them to conduct their
defense. This motion was denied in May 2005 and defendants are considering
appropriate responses. The preparation and filing of dispositive motions is
expected to begin shortly. See "History of Lynch's "C" Block Activities" below.
History of Lynch's "C" Block Activities.
As part of the Omnibus Budget Resolution of 1993, Congress authorized the FCC to
employ competitive bidding procedures to select among mutually exclusive
applicants for certain spectrum licenses. Initially the FCC had an initiative to
include, among others, African Americans, Native Americans, Asian Americans and
women. As a result of this, the FCC conducted auctions beginning in 1995 to
allocate spectrum in a competitive manner. Interactive was a participating
investor and/or service provider to various entities in this "C-Block" auction.
By December 18, 1995, Interactive (through its predecessor Lynch Corporation)
had investments in five entities that participated in the FCC 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,
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. Interactive's investments in these entities totaled $21 million.
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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, among other reasons, in order to obtain some economies of scale, such
as financing, the five entities merged into Fortunet Communications, Inc. The
FCC, in partial response to actions by Nextwave and others, promoted a plan for
refinancing the "C" block licenses. 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 President of Fortunet, Karen Johnson, participated
in an FCC sponsored forum on this issue on June 30, 1997. 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. Another option, amnesty, was to return all licenses and forgo
any amounts deposited in exchange for forgiveness of the FCC debt. Other options
included: disaggregation, splitting a 30 MHz license into two 15 MHz licenses
and forgoing 50% of the amount deposited; and prepayment, return of certain
licenses and utilizing 70% of the amount deposited to acquire other licenses,
with the other 30% of the deposits to be forfeited.
On June 8, 1998, Fortunet elected 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
its government obligations, including 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 this FCC process, disaggregation resulted in a reduction
of the bidding credits to $5.3 million. Fortunet also lost $6.0 million of its
down payment. As a result of this decision, during 1997, Interactive recorded a
$7.0 million write down of its investment in Fortunet. A lawyer who worked on
many applications for FCC licenses, Taylor (the relator in this case) is
doubtless aware of the details of these FCC initiated alternatives for the "C"
Block, as presumably are his law firms.
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 appropriate corporate and regulatory
steps, 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 $21.9 million initially invested in the original five
entities in 1992.
Other Litigation. 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.
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Item 2. Issuer Purchases of Equity Securities
Maximum Number of (or
Approximate Dollar
Total Number of Value) of Shares that
Total Number of Shares Purchased as May Yet Be Purchased
Shares (or Average Price Paid Part of Publicly Under the Plans or
Period Units) Purchased per Share (or Unit) Announced Plans or
Programs(1)
------ -------------- ------------------- ------------------- ----------------------
1/1/05 to 1/31/05 5,700 31.53 5,700 27,300
2/1/05 to 2/28/05 -- -- -- 27,300
3/1/05 to 3/31/05 -- -- -- 27,300
------ ------ ------
Total ........... 5,700 31.53 5,700
====== ====== ======
(1) In September 1999, the Board of Interactive approved a stock repurchase
program providing for the purchase of up to 100,000 shares of Common Stock
in such manner, at such times and at such prices as the Chief Executive
Officer or his designee determines.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
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.
(b) Reports on Form 8-K during the quarter reported on:
- Current Report on Form 8-K filed January 19, 2005, under Item 5.02
announcing the election of Lawrence R. Moats to the Board of
Directors.
- Current Report on Form 8-K filed March 1, 2005, under Item 8 reporting
on the results of FCC Auction 58.
- Current Report on Form 8-K filed March 11, 2005, under Item 8
reporting the issuance of a press release to consider Going Dark.
- Current Report on Form 8-K filed March 22, 2005, under Item 8
reporting the issuance of a press release regarding the acquisition of
a cable system in Utah and to provide additional information on Going
Dark.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LYNCH INTERACTIVE CORPORATION
(Registrant)
/s/ Robert E. Dolan
Robert E. Dolan
Chief Financial Officer
May 16, 2005
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