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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q

[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

[     ] TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-556

SUREWEST COMMUNICATIONS

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code  (916) 786-6141 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  X    No      

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  X    No      

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of November 1, 2004, 14,588,326 shares of the registrant’s Common Stock were outstanding.

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SUREWEST COMMUNICATIONS
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Amounts in thousands, except per share amounts)

See accompanying notes.

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SUREWEST COMMUNICATIONS
CONDENSED CONSOLIDATED BALANCE SHEETS
Unaudited)
(Amounts in thousands)

See accompanying notes.

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SUREWEST COMMUNICATIONS
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
(Unaudited)
(Amounts in thousands)

See accompanying notes.

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Amounts in thousands, except share and per share amounts)

1.     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The condensed consolidated financial statements of SureWest Communications (the “Company”) have been prepared in accordance with United States generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, all adjustments (consisting only of normal recurring adjustments, except as disclosed below) considered necessary for a fair presentation of the results for the interim periods shown have been included. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such SEC rules and regulations and accounting principles applicable for interim periods. Management believes that the disclosures made are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2003 Annual Report on Form 10-K filed with the SEC.

The Company is a holding company with wholly-owned subsidiaries that provide integrated communications services in Northern California. The Company’s principal operating subsidiary is SureWest Telephone (formerly known as Roseville Telephone Company). SureWest Directories, SureWest Long Distance (formerly known as Roseville Long Distance Company), SureWest Broadband and SureWest Wireless are each subsidiaries of the Company. The Company expects that the sources of its revenues and its cost structure may be different in future periods, both as a result of its entry into new communications markets and competitive forces in each of the markets in which the Company has operations.

Stock-based Compensation

The Company has two stock-based compensation plans. Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.” Under the prospective method of adoption selected by the Company under the provisions of SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” the fair value method of accounting was applied to all employee awards granted, modified, or settled after January 1, 2003. The Company’s prospective adoption of the fair value recognition provisions’ of SFAS No. 123 during 2003 did not have a material effect on the Company’s condensed consolidated financial statements for the quarter and nine months ended September 30, 2003. Stock-based compensation associated with employee stock options is recognized over the vesting periods (which range from 1 to 5 years) using the graded vesting method.

The fair values of the Company’s employee stock options were estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for the nine months ended September 30, 2003 (no options were granted during the quarter ended September 30, 2003 or the quarter and nine months ended September 30, 2004):

The Black-Scholes option pricing model includes assumptions regarding dividend yields, expected volatility, expected lives and risk-free interest rates. These assumptions reflect management’s best estimates, but these items involve inherent uncertainties based on market conditions generally outside of the control of the Company. As a result, if other assumptions had been used in the current period, actual and pro forma stock-based compensation expense could have been materially different. If management uses different assumptions in future periods, stock-based compensation expense could be materially impacted in future periods.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

The expense related to stock-based employee compensation included in the determination of net income is less than that which would have been recognized if the fair value method had been applied to all awards granted after the original effective date of SFAS No. 123. If the Company had elected to adopt the fair value recognition provisions of SFAS No. 123 as of its original effective date, pro forma net income (loss) and earnings (loss) per share would be as follows:

There were no options granted to employees during the quarter or nine months ended September 30, 2004 and during the quarter ended September 30, 2003. The weighted-average grant date fair value of options granted to employees was $8.75 per share during the nine months ended September 30, 2003.

Other Comprehensive Income (Loss)

The Company’s consolidated net income (loss) equaled its consolidated comprehensive income (loss) for the quarters and nine-month periods ended September 30, 2004 and 2003.

As of September 30, 2004 and 2003, the accumulated other comprehensive loss was $261 and $1,637, respectively, which consisted of minimum pension and post-retirement benefit liability adjustments, net of income taxes.

Cumulative Effect of Change in Accounting Principle

The Company adopted SEC Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,” effective January 1, 2000, which requires non-recurring revenues associated with service and activation charges to be deferred. The cumulative effect of this change in accounting principle was $3,273, net of tax, ($0.21 per share) in 2000.

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

For the three-month periods ended March 31, June 30, and September 30, 2004 and 2003, the Company recognized the following revenues that were included in the cumulative effect adjustment as of January 1, 2000:

The net effect of these revenues in 2004 was to increase net income or decrease the net loss in the three-month periods ended March 31, June 30, and September 30 by $32 (no effect on earnings per share), $23 (no effect on earnings per share) and $16 (no effect on loss per share), respectively.

The net effect of these revenues in 2003 was to increase net income in the three-month periods ended March 31, June 30, and September 30 by $75 ($0.01 per share), $68 (no effect on earnings per share) and $57 (no effect on earnings per share), respectively.

Adjustments and Reclassifications

During the Company’s financial statement closing process for the quarter ended December 31, 2003, certain matters were identified related to prior financial reporting periods that necessitated the recording of adjustments to the Company’s condensed consolidated financial statements. Such adjustments pertained principally to: (i) property, plant and equipment and (ii) cash, and management believes that weaknesses in the Company’s internal controls caused the errors that resulted in these adjustments. The Company does not believe any of the aforementioned amounts are material, individually or in the aggregate, to the respective prior interim periods based on both quantitative and qualitative factors, including the trend of operating results. Accordingly, the Company prospectively corrected these errors during the fourth quarter of 2003. Certain of the aforementioned amounts relating to prior periods would have reduced the Company’s consolidated net income by $1,250, or $0.09 per basic and diluted share, and $1,592, or $0.11 per basic and diluted share, during the quarter and nine months ended September 30, 2003, respectively, had such errors been corrected in the periods in which they originated.

During the Company’s financial statement closing process for the quarter ended September 30, 2004, certain matters were identified related to prior financial reporting periods that necessitated the recording of adjustments to the Company’s condensed consolidated financial statements for the three months ended September 30, 2004. Such adjustments increased depreciation expense by $822 and decreased cost of sales by $39 in the quarter ended September 30, 2004. Management believes that weaknesses in the Company’s internal controls caused the errors that resulted in these adjustments. The Company does not believe the aforementioned amounts are material, individually or in the aggregate, to the respective prior quarterly periods based on both quantitative and qualitative factors, including the trend of operating results, nor does it believe the prospective correction of such amounts during the quarter ended September 30, 2004 is material to the Company’s consolidated results of operations based on both quantitative and qualitative factors, including the trend of operating results. The prospective correction of the aforementioned amounts relating to prior periods increased the Company’s consolidated net loss by $468, or $0.03 per basic and diluted share, for the quarter ended September 30, 2004. Such amounts would have reduced the Company’s quarterly consolidated net income by $239, or $0.02 per basic and diluted share, and $272, or $0.02 per basic and diluted share, for the quarters ended March 31, 2004 and June 30, 2004, respectively, had such errors been corrected in the periods in which they originated.

Certain amounts in the Company’s 2003 condensed consolidated financial statements have been reclassified to conform to the presentation of the Company’s 2004 condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

2.     CORPORATE TREASURY INVESTIGATION

In December 2003, the Company discovered certain irregular bank transactions and deposits in a routine investigation following the abrupt resignation of an employee in the Company’s Corporate Finance Department. Immediately following the Company’s initial review that uncovered suspect transfers, the Company broadened its review of the investment and cash operations, and a special corporate investigation was launched by the Audit Committee of the Board of Directors, which engaged outside counsel and forensic auditors. The investigations revealed concealed illegal transfers in violation of the Company’s investment and cash management policies. The Company believes that the irregularities were limited to the 2003 calendar year. The investigation suggests that as much as $25,000 may have been involved in the scheme. Nearly all of the funds have been recovered; however, approximately $1,828 remained outstanding and was reflected as a non-operating loss in the Company’s 2003 consolidated financial statements. On October 26, 2004, the Company executed a release and partial assignment of claims with the insurance company and received an insurance recovery in the amount of $1,803. The recovery will be recognized in the fourth quarter of 2004 as a non-operating gain in the Company’s consolidated financial statements. In January 2004, the Federal Bureau of Investigation (“FBI”) launched its own probe into the illegal funds transfer. On February 5, 2004, the FBI made three arrests, including a former employee of the Company’s Corporate Finance Department, on charges of mail fraud, conspiracy and money laundering. The Company has been advised that one of the individuals has entered a plea of guilty. The Company has filed a civil lawsuit seeking to recover the misappropriated funds and other costs from five individuals and a private company allegedly associated with the fraudulent scheme to illegally transfer the Company’s funds to outside accounts. The Company will recognize additional recoveries of funds, if any, in future periods to the extent of its litigation recoveries.

3.     CHANGE IN ESTIMATE

In January 2004, the Company revised its long-term network operating plan for its Telecommunications (“Telecom”) and Wireless segments as a result of the successful adoption of certain new technologies that enable the Company to maximize the return on existing network facilities and migrate to other new technologies at the point in time in which the benefit to do so exceeds the cost of conversion. As a result of this change in strategic direction, which was formally approved by the Company’s Board of Directors in December 2003, the Company has evaluated the appropriateness of its estimated useful lives of certain property, plant and equipment at both the Telecom and Wireless segments. Based on this evaluation, the Company increased the estimated useful lives of Telecom’s digital switching, circuit and cable equipment by one to three years and Wireless’ base stations, towers and network software by one to eight years. The Company also decreased the estimated useful lives of certain other Telecom assets, including certain other switching and voicemail equipment. These changes were made effective January 1, 2004. The Company’s revisions have been supported by an assessment and report from an independent third party with expertise in this area that found the revisions to be reasonable in light of the Company’s plan and useful life estimates in comparable businesses.

During the quarter and nine months ended September 30, 2004, this change in estimate decreased consolidated depreciation expense by $2,451 and $8,407, respectively, and increased consolidated net income or decreased consolidated net loss by $1,466 ($0.10 per share) and $4,481 ($0.31 per share), respectively. This change in accounting estimate decreased Telecom depreciation expense and increased Telecom income from operations by $1,104 and $4,392 for the quarter and nine months ended September 30, 2004, respectively. In addition, Wireless depreciation expense and loss from operations decreased by approximately $1,347 and $4,015, respectively, for the quarter and nine months ended September 30, 2004 as a result of this change in accounting estimate.

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

4.     BUSINESS SEGMENTS

The Company has three reportable business segments: Telecom, Broadband and Wireless. The Telecom segment includes SureWest Telephone, SureWest Directories and SureWest Long Distance, which provide landline telecommunications services, directory advertising, Digital Subscriber Line (“DSL”) service, long distance services and certain non-regulated services. SureWest Telephone, which is the principal operating subsidiary of the Telecom segment, provides local and toll telephone services, network access services and certain non-regulated services. SureWest Directories publishes and distributes SureWest Telephone’s directory, including the sale of yellow pages advertising. SureWest Directories is also engaged in the business of producing, publishing and distributing directories in other Northern California communities outside of SureWest Telephone’s service area. SureWest Long Distance is a reseller of long distance services.

The Broadband segment includes the Company’s subsidiaries SureWest Broadband and SureWest Broadband Business Services. SureWest Broadband Business Services is comprised of a division of SureWest Telephone operating as a Competitive Local Exchange Carrier. The Broadband segment provides various services, including high-speed and dial-up Internet, digital video, local, network access, toll telephone and managed services in the greater Sacramento area, principally to customers residing outside of SureWest Telephone’s service area. The Company offers high-speed Internet, digital video and local and long distance phone service as a bundled package referred to as fiber-to-the-premise (“FTTP”) (previously referred to as “Triple Play”). In December 2003, SureWest Broadband began offering digital video services to customers inside SureWest Telephone’s service area.

The Wireless segment consists of the Company’s subsidiary SureWest Wireless, which provides wireless services. SureWest Wireless derives its revenue from the provision of wireless voice services, sales of handsets and related communication equipment, long distance service, handset insurance, roaming service and custom calling features. Wireless services are provided on a month-to-month basis and are generally billed in advance for non-contract subscribers and in arrears for contract subscribers.

In accordance with the provisions of SFAS No 131, “Disclosure About Segments of an Enterprise and Related Information,” the Company has aggregated certain of its operating units within the Telecom and Broadband segments because it believes that such operating units share similar economic characteristics.

Corporate Operations are allocated to the appropriate segments, except for cash, investments, certain property, plant, and equipment and miscellaneous other assets. However, the investment income associated with cash and investments held by Corporate Operations is included in the results of the operations of the Company’s segments. The Company evaluates the performance of its segments based on income (loss) from operations.

These segments are strategic business units that offer different products and services. The Company accounts for intersegment revenues and expenses at prevailing market rates. The Company’s business segment information is as follows:

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

        *Exclusive of depreciation and amortization

5.     ESTIMATED SHAREABLE EARNINGS OBLIGATIONS AND OTHER REGULATORY MATTERS

Certain of the Company’s rates are subject to regulation by the Federal Communications Commission (“FCC”) and the California Public Utilities Commission (“CPUC”). Pending and future regulatory actions may have a material impact on the Company’s consolidated financial position and results of operations.

Revenues from certain telephone services are affected by rates authorized by various regulatory agencies. Intrastate service rates are subject to regulation by the CPUC. With respect to toll calls initiated by interexchange carriers’ customers, the interexchange carriers are assessed access charges based on tariffs filed by SureWest Telephone. Interstate access rates and resultant earnings are subject to regulation by the FCC. With respect to interstate services, SureWest Telephone has filed its own tariff with the FCC for all elements of access services except carrier common line charges, for which SureWest Telephone concurs with tariffs filed by the National Exchange Carrier Association (“NECA”).

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

In 1999, SBC expressed interest in entering into a new, permanent compensation arrangement for extended area service (“EAS”). At that time, SBC had been paying SureWest Telephone approximately $11,500 per year for EAS pursuant to a Settlement Transition Agreement. In November 2000, the CPUC authorized SBC to terminate its annual EAS payments to SureWest Telephone effective November 30, 2000. The CPUC authorized replacement funding to SureWest Telephone on an interim basis using funds from the California High Cost Fund (“CHCF”). The CHCF is a program designed by the CPUC to establish a fair and equitable local rate structure and to reduce any disparity in the rates charged by telephone companies serving high-cost areas. This interim funding was due to expire on January 1, 2005. However, on September 28, 2004, the Governor of California signed SB1276 into law, which amended the existing legislation and extended the expiration date to January 1, 2009. In addition, the CPUC opened an Order Instituting Investigation (“OII”) for the purpose of determining whether future recovery of all, none, or a portion of the approximate $11,500 annual payments previously received from SBC should come from SureWest Telephone’s ratepayers or other regulatory recovery mechanisms. This proceeding began in 2001, evidentiary hearings were held during 2002, and briefing was completed in February 2003. In this proceeding, the CPUC’s Office of Ratepayer Advocates (“ORA”) recommended that the CPUC discontinue SureWest Telephone’s present interim EAS funding from the CHCF without replacement revenues from ratepayers. The CPUC has made no indication as to what, if any, changes will be forthcoming relating to EAS revenues. The results of these proceedings and their potential effects on SureWest Telephone cannot yet be determined.

In 1996, the CPUC issued a decision in connection with SureWest Telephone’s general rate proceeding, which authorized SureWest Telephone to implement a New Regulatory Framework (“NRF”) for services furnished within SureWest Telephone’s service area in order to accommodate market and regulatory movement toward competition and greater pricing flexibility. Under the NRF, SureWest Telephone is subject to ongoing monitoring and reporting requirements, including a sharing mechanism, whereby SureWest Telephone is required to share earnings with customers through reductions of revenues if its earned annual rate-of-return exceeds that authorized by the CPUC.

In accordance with the requirements of its general rate case order, SureWest Telephone filed an application for review of its NRF in 1999. In connection with this proceeding, the ORA undertook a verification audit of SureWest Telephone’s non-regulated and affiliated transactions pursuant to the general rate case and other CPUC orders. In June 2001, the CPUC adopted its decision in this matter (the “Decision”). The Decision did not suspend the sharing mechanism as SureWest Telephone had requested, and the CPUC ruled that SureWest Telephone must change the method used to allocate costs for services provided by SureWest Telephone to its affiliates, the treatment of certain directory revenues and the treatment of internal-use software costs.

The Company has been involved in a proceeding at the CPUC that has considered the continued need for certain sharing requirements in the intrastate jurisdiction and, in connection with that review, has also considered the issue of whether the Company overearned in the intrastate jurisdiction in recent monitoring periods and, if so, the amount of such overearnings that should be shared with customers. On July 27, 2004, the Company entered into a settlement agreement with the other parties in the proceeding, the ORA and The Utility Reform Network (“TURN”), which is intended to resolve all issues in the proceeding. Among other things, the settlement agreement addresses and resolves all earnings issues for the monitoring periods 2000 through 2004, puts into place a surcredit mechanism for the amount of the settlement, and suspends the requirement for any intrastate sharing for monitoring periods from January 1, 2005 through at least December 31, 2010. The Company expects a draft decision during the fourth quarter of 2004. Further, the Company anticipates that the draft decision may be approved by the CPUC during the fourth quarter of 2004. When and if the settlement agreement is approved by the CPUC, the Company will reassess its estimated intrastate shareable earnings obligations.

The FCC monitors SureWest Telephone’s interstate earnings through the use of annual cost separation studies prepared by SureWest Telephone, which utilize estimated cost information and projected demand usage. The FCC establishes rules that carriers must follow in the preparation of the annual studies. Additionally, under current FCC rules governing rate making, SureWest Telephone is required to establish interstate rates based on projected demand usage for its various services and determine the actual earnings from these rates once actual volumes and costs are known.

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

During the quarter ended March 31, 2004, SureWest Telephone changed its estimates for a portion of its interstate and intrastate shareable earnings obligations as a result of periodic cost separation studies. These changes in accounting estimates increased the Company’s consolidated revenues by $539 and net income by $310 ($0.02 per share) for the nine months ended September 30, 2004.

As a result of periodic cost separation studies, the Company changed its estimates for a portion of SureWest Telephone’s interstate and intrastate shareable earnings obligations and certain National Exchange Carrier Association (“NECA”) Carrier Common Line (“CCL”) accounts receivable balances during the first and third quarters of 2003. These changes in accounting estimates decreased the Company’s consolidated revenues by $277 and net income by $166 ($0.01 per share) during the first quarter of 2003 and increased the Company’s consolidated revenues and net income by $246 and $145 ($0.01per share), respectively, during the third quarter of 2003. For the nine months ended September 30, 2003, these changes in accounting estimates decreased the Company’s consolidated revenues by $31 and net income by $21, respectively.

During the year ended December 31, 2001, SureWest Telephone made payments to certain telecommunications companies aggregating $6,800 related to interstate shareable earnings obligations for the monitoring period 1999-2000. No similar payments were made during the quarter or nine-month periods ended September 30, 2004 or 2003. On June 26, 2003, the Company entered into an agreement to recover $1,950 of the amount paid to a telecommunications company in 2001. Therefore, the Company recognized a receivable from this telecommunications company in the amount of $1,950 as of June 30, 2003 through a credit to network access service revenues for the three months ended June 30, 2003. The Company received the funds on July 8, 2003. The Company is currently seeking a similar refund from another telecommunications company. However, the recoverability of the remaining funds cannot presently be determined because the bankruptcy proceeding relating to the telecommunications company from which the Company is seeking a refund has not been completed.

Beginning in January 2002, SureWest Telephone began paying a customer refund for intrastate overearnings relating to the years 1998 and 1999. A portion of the consumer’s intrastate service charges was returned in the form of a surcredit beginning in January 2002 and ending in January 2003, totaling approximately $4,605 (of which $294 was returned during January 2003). Such refunds were recorded as a reduction of the Company’s estimated intrastate shareable earnings obligations.

Beginning in November 2003, SureWest Telephone began paying a customer refund for intrastate overearnings relating to the year 2002. A portion of the consumer’s intrastate service charges was returned to the consumers in the form of a surcredit beginning in November 2003 and ending in February 2004, totaling $483 (of which $208 was returned during the first quarter of 2004). Such refunds were recorded as a reduction of the Company’s estimated intrastate shareable earnings obligations.

As of September 30, 2004, the Company’s condensed consolidated balance sheet reflected aggregate liabilities of $12,642 relating to SureWest Telephone’s estimated interstate and intrastate shareable earnings obligations. The calculations supporting these liabilities are very complex and involve a variety of estimates prior to the ultimate settlement of such obligations. In addition, SureWest Telephone’s interstate shareable earnings obligations lapse over time if SureWest Telephone’s interexchange carrier and other customers do not claim the amounts ascribed to them. Further, should a final decision be approved by the CPUC that adopts the settlement agreement, described above, the decision would settle the Company’s existing estimated intrastate shareable earnings obligations and eliminate the exposure of the Company to sharing of any intrastate overearnings for the immediate future and promote decision making that is focused more on competitive market needs rather than these regulatory considerations. Accordingly, it is reasonably possible that management’s estimates of the Company’s liabilities for interstate and intrastate shareable earnings obligations could change in the near term, and the amounts involved could be material.

6.     PENSION AND OTHER POST-RETIREMENT BENEFITS

Components of Net Periodic Benefit Cost

Net periodic pension costs recognized in the condensed consolidated statements of income for the quarters and nine-month periods ended September 30, 2004 and 2003 under the defined benefit pension plan (“Pension Plan”), Supplemental Executive Retirement Plan (“SERP”) and post-retirement benefits other than pension (“Other Benefits”) plan included the following components:

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

Employer Contributions

The Company expects to contribute $5,000 and $447 to the Pension Plan and Other Benefits plan, respectively, in 2004. As of September 30, 2004, the Company has contributed $5,000 to the Pension Plan (no contributions have been made during 2004 to the Other Benefits plan).

7.     LINE OF CREDIT

In March 2000, the Company entered into a business loan agreement with a bank for a $30,000 line of credit with a term of three years. In July 2002, the bank amended the credit facility increasing the borrowing capacity from $30,000 to $50,000. In March 2004, the bank further amended the credit facility extending the expiration date until June 1, 2005 and revising certain covenants. Interest on this credit facility is based on a LIBOR-based pricing formula. While the Company has borrowed previously under this credit facility, there were no amounts outstanding under this credit facility as of September 30, 2004, nor since the issuance of the Company’s Series B Notes in March 2003. In anticipation that the Company would be unable to meet the interest coverage ratio covenant (the “Covenant”) related to this business loan agreement for the period ending September 30, 2004, the Company obtained a waiver with respect to the Covenant for the periods ended September 30, 2004 and ending December 31, 2004 prior to September 30, 2004.

The Company’s primary credit facilities contain financial and operating covenants that restrict, among other things, the payment of cash dividends, repurchase of the Company’s capital stock, the making of certain other restricted payments and the incurrence of additional indebtedness. The covenants also require the Company to maintain certain financial ratios and minimum levels of tangible net worth. At September 30, 2004, approximately $19,165 was available for the payment of cash dividends, stock payments or other restricted payments under the terms of the Company’s covenants.

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SUREWEST COMMUNICATIONS
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)

8.     COMMITMENTS AND CONTINGENCIES

The Company has entered into various cable television franchise agreements with associated letters of credit totaling $150 in the aggregate as of September 30, 2004.

The Company is subject to certain legal and regulatory proceedings and examinations, Internal Revenue Service examinations and other tax exposures, and other claims arising in the ordinary course of its business. In the opinion of management, the ultimate outcome of these matters will not materially affect the consolidated financial position, results of operations, or cash flows of the Company.

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PART I

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

        (Amounts in thousands, except selected operating metrics and per share amounts)

Certain information included in the Company’s quarterly report on Form 10-Q, including that which relates to the impact on future revenue sources and potential sharing obligations of pending and future regulatory orders, continued expansion of the telecommunications network and expected changes in the sources of the Company’s revenue and its cost structure resulting from its entrance into new communications markets, are forward looking statements and are made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. Such forward looking statements are subject to a number of risks, assumptions and uncertainties that could cause the Company’s actual results to differ from those projected in such forward looking statements.

Important factors that could cause actual results to differ from those set forth in the forward looking statements include, but are not limited to: advances in telecommunications technology, changes in the telecommunications regulatory environment, changes in the financial stability of other telecommunications providers who are customers of the Company, changes in competition in markets in which the Company operates, adverse circumstances affecting the economy in California in general, and in the Sacramento, California Metropolitan area in particular, the availability of future financing, changes in the demand for services and products, new product and service development and introductions, pending and future litigation, internal control weaknesses and unanticipated changes in the growth of the Company’s emerging businesses including the wireless, Internet, digital video and Competitive Local Exchange Carrier operating entities.

Corporate Structure

SureWest Communications (the “Company”) is a holding company with wholly-owned subsidiaries operating in the Telecommunications (“Telecom”), Broadband and Wireless segments.

The Telecom segment includes SureWest Telephone (formerly known as Roseville Telephone Company), SureWest Directories, and SureWest Long Distance (formerly known as Roseville Long Distance Company), which provide landline telecommunications services, directory advertising, Digital Subscriber Line (“DSL”) service, long distance services and certain non-regulated services. SureWest Telephone, which is the principal operating subsidiary of the Telecom segment, provides local and toll telephone services, network access services and certain non-regulated services. SureWest Directories publishes and distributes SureWest Telephone’s directory, including the sale of yellow pages advertising. SureWest Directories is also engaged in the business of producing, publishing and distributing directories in other Northern California communities outside of SureWest Telephone’s service area. SureWest Long Distance is a reseller of long distance services.

The Broadband segment includes the Company’s subsidiaries SureWest Broadband and SureWest Broadband Business Services. SureWest Broadband Business Services is comprised of a division of SureWest Telephone operating as a Competitive Local Exchange Carrier. The Broadband segment provides various services including: high-speed and dial-up Internet, digital video, local and network access, toll telephone and managed services in the greater Sacramento area, principally to customers residing outside of SureWest Telephone’s service area. The Company offers high-speed Internet, digital video and local and long distance phone service as a bundled package referred to as fiber-to-the-premise (“FTTP”) (previously referred to as “Triple Play”). In December 2003, SureWest Broadband began offering digital video services to customers inside SureWest Telephone’s service area.

The Wireless segment consists of the Company’s subsidiary SureWest Wireless, which provides wireless services. SureWest Wireless derives its revenue from the provision of wireless voice services, sales of handsets and related communication equipment, long distance service, handset insurance, roaming service and custom calling features. Wireless services are provided on a month-to-month basis and are generally billed in advance for non-contract subscribers and in arrears for contract subscribers.

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The Company expects that the sources of its revenues and its cost structure may be different in future periods, both as a result of its entry into new communications markets and competitive forces in each of the markets in which the Company has operations.

Treasury Investigation and Internal Control Matters

In January 2004, the Audit Committee of the Board of Directors launched a formal investigation, and retained the law firm of Reed Smith LLP as independent legal counsel to conduct the investigation with the assistance of forensic accountants (the firm of Deloitte & Touche LLP was retained by Reed Smith LLP). The investigation resulted from a preliminary investigation by Company management, (commenced approximately December 15, 2003 and concluded December 26, 2003) triggered by the abrupt resignation of an employee in the Company’s Corporate Finance Department, indicating irregularities by the former employee in the Company’s cash management and investment functions, and violations of the Company’s investment policies. At the time of the commencement of the special investigation, approximately $1,828 of Company funds were outstanding without proper documentation. On October 26, 2004, the Company executed a release and partial assignment of claims with the insurance company and received an insurance recovery in the amount of $1,803. The recovery will be recognized in the fourth quarter of 2004 as a non-operating gain in the Company’s consolidated financial statements.

The independent legal counsel, with the assistance of the forensic accountants, undertook an extensive process to (i) investigate the facts and circumstances giving rise to the misappropriation of Company funds, (ii) determine whether there were any similar or related transactions and any Company employees involved in the previously-identified transactions other than those known to the Company at the commencement of the investigation, (iii) determine the underlying mechanics in the origination of the transactions and the circumstances under which detection failed to occur and (iv) evaluate internal controls relating to the affected portion of the Company’s business.

The Audit Committee of the Board of Directors has been advised by independent legal counsel that:

The independent legal counsel further reported to the Audit Committee (i) its view that existing Company control procedures prior to the discovery of the unauthorized transactions were either circumvented or ignored, and the control procedures existing at the time of the unauthorized transactions were not adequate and (ii) the Company, subsequent to the discovery of the unauthorized transactions, had developed and implemented a number of key internal controls. In addition, the independent legal counsel provided additional control recommendations to the Audit Committee for review and consideration.

In connection with the audit of the Company’s consolidated financial statements for the year ended December 31, 2003, Ernst & Young LLP, the Company’s independent registered public accounting firm, advised the Audit Committee on March 12, 2004, and delivered a formal letter to the Audit Committee on March 26, 2004, that it had concluded that material weaknesses in the Company’s internal control existed, including with respect to certain of the issues identified as a result of the Audit Committee’s special investigation. Other than the material weakness described in their letter, Ernst & Young LLP did not advise the Company of any other reportable conditions. The Company has performed substantial additional procedures designed to ensure that the internal control deficiencies did not lead to material misstatements in its consolidated financial statements, notwithstanding the presence of the noted internal control weaknesses.

During 2004, the Company instituted additional processes and procedures to improve internal control. Subsequent to the discovery of the unauthorized wire transactions, the Company implemented a number of internal controls with respect to cash and investment activities.

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The Audit Committee made a number of additional recommendations to the Company’s Board of Directors for further review and consideration, which were formally acted upon beginning early in the second quarter of 2004, and contemplate additional actions in 2004. Such initiatives relate to:

The Company has previously taken actions that it believes have improved internal controls, including:

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On April 15, 2004, Michael D. Campbell, the Company’s Executive Vice President and Chief Financial Officer retired from the Company. Brian H. Strom, President and Chief Executive Officer of the Company, served as interim Chief Financial Officer while the Company undertook the search for a new Chief Financial Officer. Effective October 4, 2004, Philip A. Grybas joined the Company as Senior Vice President and Chief Financial Officer. Mr. Grybas has more than 20 years of finance and accounting experience in the telecommunications industry.

The Company filed an insurance claim to recover the missing funds, and for which payment has been received in the amount of $1,803 in October 2004 and has filed a civil lawsuit seeking to recover its losses and other costs from five individuals and a private company allegedly associated with the fraudulent scheme to illegally transfer the Company’s funds to outside accounts. The Company has been advised that one of the individuals has pleaded guilty. The Company will recognize a recovery of funds, if any, in future periods to the extent of additional litigation recoveries.

The Company, in early 2004, has engaged in informal discussion with the SEC, which has possession of certain background information, regarding the facts and circumstances of the unauthorized funds transfers. The Company provided supplemental information to the SEC regarding the results of the investigation, including with respect to the report by independent legal counsel to the Audit Committee, and it will provide additional information in response to any future requests.

The Company anticipates completing enhancements and testing to assess the related internal controls to certain of the modules of its enterprise resource planning system relating to property, plant and equipment during the fourth quarter of 2004. It is the Company’s current view that the testing of the internal controls relating to property, plant and equipment, in view of the short time period before the end of the 2004 fiscal year, will require manual processes to increase the liklihood of Management’s favorable assessment with respect to such internal controls. Such processes include (i) the performance of detailed reviews on a monthly basis of all open construction projects by the appropriate project manager to validate the results generated by the Company’s systens, and (ii) the review of systematic routines which generate and transfer data between modules within the enterprise resource planning system as necessary to generate accurate reports. The Company believes that it is reasonably likely that the material wekaness related to property, plant and equipment may not be remediated until the second quarter of 2005.

In the third quarter of 2004, the Company identified certain deficiencies related to its Information Technology general and application controls in its enterprise planning and accounting software. In response to these deficiencies, during the third quarter of 2004 the Company engaged an outside consulting firm to design and implement changes to the controls in an effort to remediate the identified deficiencies. Although the Company has made progress in its remediation effort, it is reasonably likely that it will not be fully complete by December 31, 2004.

The Company performed a number of procedures to compensate for the identified material weaknesses in internal controls to permit its certifying officers to state that the Company’s financial statements fairly presented in all material respects the Company’s financial condition, results of operation, and cash flows. Specifically, with respect to the control of cash and investments, the Company performed a comprehensive reconciliation of all cash and investment accounts for each month during fiscal year 2003 and each month during 2004 through and including September, 2004 (in addition to procedures performed in connection with prior years in connection with the Audit Committee’s special investigation).

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Results of Operations

Consolidated Overview

The tables below reflect certain financial data (on a consolidated and segment basis) and selected operating metrics for each reportable segment as of and for the quarter and nine months ended September 30, 2004 and 2003. Both the financial data and the selected operating metrics demonstrate the increasing importance of the Company’s Broadband and Wireless segments.

Financial Data

(1) External customers only

Selected Operating Metrics

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The Company’s consolidated operating revenues increased $4,384 and $10,461 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003 primarily due to an increase in the number of subscribers and services within the Broadband and Wireless segments.

Broadband segment operating revenues increased $2,564 and $7,863 during the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. This segment experienced an 11% increase in the aggregate number of DSL subscribers at September 30, 2004, as compared to September 30, 2003. More significantly, this segment reported 14,690 FTTP subscribers and 34,306 Revenue-generating units, representing increases of 56% and 57%, respectively, at September 30, 2004 as compared to September 30, 2003, within the broadband residential services business. While continuing to produce significant revenue increases, the expansion of the broadband residential services has and will continue to require significant capital and expense commitments. Accordingly, the Broadband segment incurred larger quarter-over-quarter and year-over-year operating and net losses.

The Wireless segment reported increases in operating revenues of $1,126 and $2,986 during the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. The number of wireless subscribers increased to 49,072 at September 30, 2004, representing a 9% increase from September 30, 2003. SureWest Wireless established its market share in the Sacramento market in large part by promoting an unlimited flat rate regional calling plan. Throughout 2003 and during the first nine months of 2004, SureWest Wireless initiated a number of new service options for customers, including additional regional plans, an unlimited national plan, a family plan and new vertical services (such as wireless data capabilities), which have attracted new customers. Evolution of the marketplace has prompted SureWest Wireless to open four retail stores in its service area, with plans to open a fifth and sixth store in late 2004 and early 2005, respectively. SureWest Wireless is also seeking to expand its service penetration among major accounts in 2004, while seeking to reduce customer turnover (“churn”) and increase revenues from its existing customer base.

Operating revenues in the Telecom segment increased $694 and decreased $388 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. While the Company continues to experience growth from the Broadband and Wireless segments, the Telecom segment continues to be subject to the competitive and regulatory challenges faced by incumbent local exchange carriers (“ILECs”) both nationally and in California. As a result of competitive pressures, this segment experienced decreases in network access revenues due to decreases in (i) access lines of approximately 3%, resulting from increased competition from wireless and wireline competitors, (ii) zone and toll calls and (iii) switched and special access rates. While the Telecom segment continues to generate a majority of the Company’s revenues and yield significant cash flows and net income, the Company believes that the results of the Telecom segment in recent years support the Company’s decision to enter and commit significant resources to newer businesses, particularly in the Broadband segment.

The Company’s consolidated operating expenses increased $9,270 and $19,319 during the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003 due to an increase in cost of services and products expense (exclusive of depreciation and amortization) associated with a larger number of subscribers and services within the Broadband and Wireless segments. Customer operations and selling expenses increased due to additional advertising activity in the current year in the Broadband segment offset in part from internal efficiencies resulting from integrated customer support systems and productivity gains. General and administrative expenses increased as a result of increases in (i) consulting and legal fees due to the treasury investigation, audit services and Sarbanes-Oxley implementation and compliance and (ii) the size of the Company’s workforce, resulting in increases to salaries and wages, worker’s compensation and medical insurance costs.

The Company’s consolidated depreciation and amortization expense increased $308 and decreased $1,721 during the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. As discussed in greater detail below in the Adjustments and Reclassifications section, the increase in depreciation expense during the quarter ended September 30, 2004 was due primarily to the identification and recording of out of period adjustments which increased depreciation expense by $822 during the quarter ended September 30, 2004. The decrease in depreciation expense during the nine month period was due primarily to a change in accounting estimate during the first quarter of 2004, resulting from the successful adoption of certain new technologies that enable the Company to maximize the return on existing network facilities and migrate to other new technologies at the point in time in which the benefit to do so exceeds the cost of conversion. As a result of this change in strategic direction, which was formally approved by the Company’s Board of Directors in December 2003, the Company has evaluated the appropriateness of its estimated useful lives of certain property, plant and equipment at both the Telecom and Wireless segments. Based on this evaluation, the Company increased the estimated useful lives of Telecom’s digital switching, circuit and cable equipment by one to three years and Wireless’ base stations, towers and network software by one to eight years. The Company also decreased the estimated useful lives of certain other Telecom assets, including certain other switching and voicemail equipment. The changes were made effective January 1, 2004. The Company’s revisions have been supported by an assessment and report from an independent third party with expertise in this area that found the revisions to be reasonable in light of the Company’s plans and useful life estimates in comparable businesses.

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During the quarter and nine months ended September 30, 2004, this change in estimate decreased consolidated depreciation expense by $2,451 and $8,407, respectively, and increased consolidated net income by $1,466 ($0.10 per share) and $4,481 ($0.31 per share), respectively. This change in accounting estimate decreased Telecom depreciation expense and increased Telecom income from operations by $1,104 and $4,392 for the quarter and nine months ended September 30, 2004, respectively. In addition, Wireless depreciation expense and loss from operations decreased by approximately $1,347 and $4,015, respectively, for the quarter and nine months ended September 30, 2004 as a result of this change in accounting estimate.

        Adjustments and Reclassifications

During the Company’s financial statement closing process for the quarter ended December 31, 2003, certain matters were identified related to prior financial reporting periods that necessitated the recording of adjustments to the Company’s condensed consolidated financial statements. Such adjustments pertained principally to (i) property, plant and equipment and (ii) cash, management believes that weaknesses in the Company’s internal controls caused the errors that resulted in these adjustments. The Company does not believe any of the aforementioned amounts are material, individually or in the aggregate, to the respective prior interim periods based on both quantitative and qualitative factors, including the trend of operating results. Accordingly, the Company prospectively corrected these errors during the fourth quarter of 2003. Certain of the aforementioned amounts relating to prior periods would have reduced the Company’s consolidated net income by $1,250, or $0.09 per basic and diluted share, and $1,592, or $0.11 per basic and diluted share, during the quarter and nine months ended September 30, 2003, respectively, had such errors been corrected in the periods in which they originated.

During the Company’s financial statement-closing process for the quarter ended September 30, 2004, certain matters were identified related to prior financial reporting periods that necessitated the recording of adjustments to the Company’s condensed consolidated financial statements for the three months ended September 30, 2004. Such adjustments increased depreciation expense by $822 and decreased cost of sales by $39 in the quarter ended September 30, 2004. Management believes that weaknesses in the Company’s internal controls caused the errors that resulted in these adjustments. The Company does not believe the aforementioned amounts are material, individually or in the aggregate, to the respective prior quarterly periods based on both quantitative and qualitative factors, including the trend of operating results, nor does it believe the prospective correction of such amounts during the quarter ended September 30, 2004 is material to the Company’s consolidated results of operations based on both quantitative and qualitative factors, including the trend of operating results. The prospective correction of the aforementioned amounts relating to prior periods increased the Company’s consolidated net loss by $468, or $0.03 per basic and diluted share, for the quarter ended September 30, 2004. Such amounts would have reduced the Company’s quarterly consolidated net income by $239, or $0.02 per basic and diluted share, and $272,or $0.02 per basic and diluted share, for the quarters ended March 31, 2004 and June 30, 2004, respectively, had such errors been corrected in the periods in which they originated.

Certain amounts in the Company’s 2003 condensed consolidated financial statements have been reclassified to conform to the presentation of the Company’s 2004 condensed consolidated financial statements.

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Segment Results of Operations

Telecom

        *Exclusive of depreciation and amortization

        Operating Revenues

Operating revenues from external customers in the Telecom segment increased $694 and decreased $388 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. The Telecom segment is encountering the competitive and regulatory challenges faced by ILECs both nationally and in California. As a result of competitive pressures, the Telecom segment experienced decreases in network access revenues due to decreases in (i) access lines of approximately 3%, resulting from increased competition from wireless and wireline competitors, (ii) zone and toll calls and (iii) switched and special access rates.

Revenues within the Telecom segment are also affected by SureWest Telephone’s shareable earnings obligations. As a result of a decrease in revenues subject to regulation and increased operating expenses during 2004, as described below, SureWest Telephone’s provision related to its estimated interstate and intrastate shareable earnings obligations decreased, which resulted in increased revenues of $1,044 and $2,890 during the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. In addition, SureWest Telephone had changes in estimates for shareable earnings obligations as a result of periodic cost separation studies. For the nine months ended September 30, 2004, changes in estimates, which were recorded during the quarter ended March 31, 2004, pertaining to the Company’s estimated interstate and intrastate shareable earnings obligations increased the Telecom segments’ revenues and net income by $539 and $310 ($0.02 per share), respectively. For the nine months ended September 30, 2003, changes in estimates, pertaining to the Company’s estimated interstate and intrastate shareable earnings obligations and certain National Exchange Carrier Association (“NECA”) Carrier Common Line (“CCL”) accounts receivable balances decreased the Telecom segments’ revenues and net income by $31 and $21 (no effect on earnings per share), respectively. In addition, the decrease in operating revenues in the Telecom segment was due to an agreement SureWest Telephone entered into during 2003. As discussed in greater detail in the Regulatory Matters section, the agreement provided for a $1,950 refund from another telecommunications company for a payment made by SureWest Telephone in 2001 related to interstate shareable earnings obligations.

The Company adopted SEC Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,” effective January 1, 2000, which requires non-recurring revenues associated with service and activation charges to be deferred. The cumulative effect of this change in accounting principle was $3,273, net of tax, ($0.21 per share) in 2000.

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For the three-month periods ended March 31, June 30, and September 30, 2004 and 2003, the Company recognized the following revenues that were included in the cumulative effect adjustment as of January 1, 2000:

The net effect of these revenues in 2004 was to increase net income in the three-month periods ended March 31, June 30, and September 30 by $32 (no effect on earnings per share), $23 (no effect on earnings per share) and $16 (no effect on earnings per share), respectively.

The net effect of these revenues in 2003 was to increase net income in the three-month periods ended March 31, June 30, and September 30 by $75 ($0.01 per share), $68 (no effect on earnings per share) and $57 (no effect on earnings per share), respectively.

Directory advertising revenues increased $359 and $857 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003 due to an increase in advertising sales.

        Operating Expenses

Operating expenses for the Telecom segment increased $3,640 and $5,306 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. Cost of services and products (exclusive of depreciation and amortization) increased $1,628 and $2,405 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. This increase was primarily due to increases in (i) SureWest Directories outside sales as well as a two-month delay in the release of the 2003 Sacramento Directory, (ii) labor expense due to an increase in headcount, (iii) allocation of resources to the Telecom segment due to increased maintenance, engineering and administrative expenses related to the in-territory network and (iv) change in revenue base used to calculate Universal Service Fund expense. Customer operations and selling expense increased $473 and $245 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003 due primarily to a reorganization of the customer service department. General and administrative expenses increased $1,539 and $2,656 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. This increase was due primarily to increases in (i) consulting and legal fees due to the treasury investigation, audit services and Sarbanes-Oxley implementation and compliance and (ii) the size of the Company’s workforce, resulting in increases to salaries and wages, worker’s compensation and medical insurance costs.

Depreciation and amortization decreased $1,619 and $4,542 for the quarter and nine months ended September 30, 2004, respectively, compared to the same periods in 2003. This decrease was due primarily to a change in accounting estimate during the first quarter of 2004, resulting from the adoption of certain new technologies which increased the estimated useful lives of Telecom’s switching, circuit and cable equipment by one to three years and decreased the estimated useful lives of certain other Telecom assets, including certain switching and voicemail equipment. This change in accounting estimate decreased depreciation expense by $1,104 and $4,392 for the quarter and nine months ended September 30, 2004, respectively. This decrease was partially offset by the effects of continuing additions of circuit equipment, cable and wire facilities and internal-use software.

Certain of the Company’s customers filed for bankruptcy protection in 2002, the most notable of which was WorldCom, Inc. (“WorldCom”), which, together with its affiliates, filed for bankruptcy protection on July 21, 2002. With respect to post-petition obligations, WorldCom had proposed, pursuant to a provision of the Bankruptcy Code, and the Bankruptcy Court has agreed, that utilities are entitled to “adequate assurances” that WorldCom will satisfy its obligations for post-petition services. In its original filings, WorldCom proposed its own set of assurances to utilities, but such assurances did not include either deposits or advance payments. Although the Bankruptcy Court did not require WorldCom to provide any deposits or advance payments as adequate assurance of payment, it did provide, with respect to any post-petition services provided after August 14, 2002, that all utilities will have a junior superiority administrative claim senior to other administrative claims and junior only to the claims of WorldCom’s post-petition lenders. If WorldCom fails to pay for post-petition services, a utility can either take appropriate action under any applicable tariff or regulation, or seek, on an expedited basis, an order from the Bankruptcy Court requiring immediate payment or other relief. On April 20, 2004, WorldCom emerged from federal bankruptcy. Settlement(s) of the Company’s pending pre-bankruptcy claims against WorldCom will remain subject to the distribution terms, applicable to creditors, contained in WorldCom’s plan of reorganization. As of September 30, 2004 the amount of any settled pre-bankruptcy claims cannot be determined. Through September 30, 2004, obligations owed by WorldCom to the Company for post-petition services have been paid on a timely basis.

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        Regulatory Matters

Revenues from services subject to regulation which include local and network access services constituted approximately 54% and 55%, of the Company’s total operating revenues for the quarter and nine-month period ended September 30, 2004, respectively. In the same periods in 2003, revenues from services subject to regulation constituted approximately 57% and 59%, respectively, of the Company’s total operating revenues. Such revenues are derived from various sources, including:

Revenues from certain telephone services are affected by rates authorized by various regulatory agencies. Intrastate service rates are subject to regulation by the CPUC. With respect to toll calls initiated by interexchange carriers’ customers, the interexchange carriers are assessed access charges based on tariffs filed by SureWest Telephone. Interstate access rates and resultant earnings are subject to regulation by the Federal Communications Commission (“FCC”). With respect to interstate services, SureWest Telephone has filed its own tariff with the FCC for all elements of access services except carrier common line charges, for which SureWest Telephone concurs with tariffs filed by NECA.

The FCC monitors SureWest Telephone’s interstate earnings through the use of annual cost separation studies prepared by SureWest Telephone, which utilize estimated cost information and projected demand usage. The FCC establishes rules that carriers must follow in the preparation of the annual studies. Additionally, under current FCC rules governing rate making, SureWest Telephone is required to establish interstate rates based on projected demand usage for its various services and determine the actual earnings from these rates once actual volumes and costs are known.

In January 2001, the FCC issued a Memorandum Opinion and Order to another telephone company in which it clarified how Internet traffic, which the FCC had prior to that date characterized as largely interstate in nature, should be treated. During 2000 and 2001, Internet traffic and DSL service grew substantially, far exceeding SureWest Telephone’s estimates, which resulted in actual earnings exceeding the levels allowed by the FCC. Based on preliminary cost studies, the Company recognized liabilities relating to SureWest Telephone’s estimated interstate shareable earnings obligations of $86 and $257, respectively, for the quarter and nine months ended September 30, 2003 through reductions of revenues. The Company did not identify any interstate shareable earnings obligations at SureWest Telephone during the quarter and nine months ended September 30, 2004.

During the year ended December 31, 2001, SureWest Telephone made payments to certain telecommunications companies aggregating $6,800 related to interstate shareable earnings obligations for the monitoring period 1999-2000. No similar payments were made during the quarter or nine-month periods ended September 30, 2004 or 2003. On June 26, 2003, the Company entered into an agreement to recover $1,950 of the amount paid to a telecommunications company in 2001. Therefore, the Company recognized a receivable from this telecommunications company in the amount of $1,950 as of June 30, 2003 through a credit to network access service revenues for the three months ended June 30, 2003. The Company received the funds on July 8, 2003. The Company is currently seeking a similar refund from another telecommunications company. However, the recoverability of the remaining funds cannot presently be determined because the bankruptcy proceeding relating to the telecommunications company from which the Company is seeking a refund has not been completed.

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In 1999, SBC expressed interest in entering into a new, permanent compensation arrangement for extended area service (“EAS”). At that time, SBC had been paying SureWest Telephone approximately $11,500 per year for EAS pursuant to a Settlement Transition Agreement. In November 2000, the CPUC authorized SBC to terminate its annual EAS payments to SureWest Telephone effective November 30, 2000. The CPUC authorized replacement funding to SureWest Telephone on an interim basis using funds from the CHCF. The CHCF is a program designed by the CPUC to establish a fair and equitable local rate structure and to reduce any disparity in the rates charged by telephone companies serving high-cost areas. This interim funding was due to expire on January 1, 2005. However, on September 28, 2004, the Governor of California signed SB1276 into law, which amended the existing legislation and extended the expiration date to January 1, 2009. In addition, the CPUC opened an Order Instituting Investigation (“OII”) for the purpose of determining whether future recovery of all, none, or a portion of the approximate $11,500 annual payments previously received from SBC should come from SureWest Telephone’s ratepayers or other regulatory recovery mechanisms. This proceeding began in 2001, evidentiary hearings were held during 2002, and briefing was completed in February 2003. In this proceeding, the CPUC’s Office of Ratepayer Advocates (“ORA”) recommended that the CPUC discontinue SureWest Telephone’s present interim EAS funding from the CHCF without replacement revenues from ratepayers. The CPUC has made no indication as to what, if any, changes will be forthcoming relating to EAS revenues. The results of these proceedings and their potential effects on SureWest Telephone cannot yet be determined.

In 1996, the CPUC issued a decision in connection with SureWest Telephone’s general rate proceeding, which authorized SureWest Telephone to implement a New Regulatory Framework (“NRF”) for services furnished within SureWest Telephone’s service area in order to accommodate market and regulatory movement toward competition and greater pricing flexibility. Under the NRF, SureWest Telephone is subject to ongoing monitoring and reporting requirements, including a sharing mechanism, whereby SureWest Telephone is required to share earnings with customers through reductions of revenues if its earned annual rate-of-return exceeds that authorized by the CPUC.

In accordance with the requirements of its general rate case order, SureWest Telephone filed an application for review of its NRF in 1999. In connection with this proceeding, the ORA undertook a verification audit of SureWest Telephone’s non-regulated and affiliated transactions pursuant to the general rate case and other CPUC orders. In June 2001, the CPUC adopted its decision in this matter (the “Decision”). The Decision did not suspend the sharing mechanism as SureWest Telephone had requested, and the CPUC ruled that SureWest Telephone must change the method used to allocate costs for services provided by SureWest Telephone to its affiliates, the treatment of certain directory revenues and the treatment of internal-use software costs. In accordance with the provisions of the Decision, the Company recorded liabilities and reductions of revenues of $959 and $2,633, respectively, relating to its estimated intrastate shareable earnings obligations during the quarter and nine months ended September 30, 2003. The Company did not identify any intrastate shareable earnings obligations at SureWest Telephone for the quarter and nine months ended September 30, 2004. The decrease in the provision for its estimated intrastate shareable earnings obligation is primarily due to decreased revenues subject to regulation and increased expenses.

The Company has been involved in a proceeding at the CPUC that has considered the continued need for certain sharing requirements in the intrastate jurisdiction and, in connection with that review, has also considered the issue of whether the Company overearned in the intrastate jurisdiction in recent monitoring periods and, if so, the amount of such overearnings that should be shared with customers. On July 27, 2004, the Company entered into a settlement agreement with the other parties in the proceeding, the ORA and The Utility Reform Network (“TURN”), which is intended to resolve all issues in the proceeding. Among other things, the settlement agreement addresses and resolves all earnings issues for the monitoring periods 2000 through 2004, puts into place a surcredit mechanism for the amount of the settlement, and suspends the requirement for any intrastate sharing for monitoring periods from January 1, 2005 through at least December 31, 2010. The Company expects a draft decision during the fourth quarter of 2004. Further, the Company anticipates that the draft decision may be approved by the CPUC during the fourth quarter of 2004. When and if the settlement agreement is approved by the CPUC, the Company will reassess its estimated intrastate shareable earnings obligations.

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Beginning in January 2002, SureWest Telephone began paying a customer refund for intrastate overearnings relating to the years 1998 and 1999. A portion of the customers’ intrastate service charges was returned in the form of a surcredit beginning in January 2002 and ending in January 2003, totaling approximately $4,605 (of which $294 was returned during 2003). Such refunds were recorded as a reduction of the Company’s estimated intrastate shareable earnings obligations.

Beginning in November 2003, SureWest Telephone began paying a customer refund for intrastate overearnings relating to the year 2002. A portion of the consumer’s intrastate service charges was returned to the consumers in the form of a surcredit beginning in November 2003 and ending in February 2004, totaling $483 (of which $208 was returned during the first quarter of 2004). Such refunds were recorded as a reduction of the Company’s estimated intrastate shareable earnings obligations.

During the quarter ended March 31, 2004, SureWest Telephone changed its estimates for a portion of its interstate and intrastate shareable earnings obligations as a result of periodic cost separations studies. These changes in accounting estimates increased the Company’s consolidated revenues by $539 and net income by $310 ($0.02 per share) for the nine months ended September 30, 2004.

As a result of periodic cost separation studies, the Company changed its estimates for a portion of SureWest Telephone’s interstate and intrastate shareable earnings obligations and certain National Exchange Carrier Association (“NECA”) Carrier Common Line (“CCL”) accounts receivable balances during the first and third quarters of 2003. These changes in accounting estimates decreased the Company’s consolidated revenues by $277 and net income by $166 ($0.01 per share) during the first quarter of 2003 and increased the Company’s consolidated revenues and net income by $246 and $145 ($0.01per share), respectively, during the third quarter of 2003. For the nine months ended September 30, 2003, these changes in accounting estimates decreased the Company’s consolidated revenues by $31 and net income by $21, respectively.

As of September 30, 2004, the Company’s condensed consolidated balance sheet reflected aggregate liabilities of $12,642 relating to SureWest Telephone’s estimated interstate and intrastate shareable earnings obligations. The calculations supporting these liabilities are very complex and involve a variety of estimates prior to the ultimate settlement of such obligations. In addition, SureWest Telephone’s interstate shareable earnings obligations lapse over time if SureWest Telephone’s interexchange carrier and other customers do not claim the amounts ascribed to them. Further, should a final decision be approved by the CPUC that adopts the settlement agreement, described above, the decision would settle the Company’s existing estimated intrastate shareable earnings obligations and eliminate the exposure of the Company to sharing of any intrastate overearnings for the immediate future and promote decision making that is focused more on competitive market needs rather than these regulatory considerations. Accordingly, it is reasonably possible that management’s estimates of the Company’s liabilities for interstate and intrastate shareable earnings obligations could change in the near term, and the amounts involved could be material.

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Broadband