UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

(Mark One)

☒ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2015

or

☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________ to ____________________.

Commission File Number:  000-35180

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

☐ Yes   ☒ No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

☐ Yes   ☒  No

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   ☐ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  ☒ Yes   ☐ No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10‑K or any amendment to this Form 10‑K.  ☒

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ☐ Yes  ☒ No

As of June 30, 2015, the aggregate market value of the Registrant’s common stock was $329,427,269.

There were 23,211,325 shares of the registrant’s common stock outstanding as of the close of business on March 4, 2016.  

 

 

 

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LUMOS NETWORKS CORP.
2015 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

 

 

 

 

 

 

 

 

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Part I

FORWARD-LOOKING STATEMENTS

Any statements contained in this report that are not statements of historical fact, including statements about our beliefs and expectations, are forward-looking statements and should be evaluated as such.  The words “anticipates,” “believes,” “expects,” “intends,” “plans,” “estimates,” “targets,” “projects,” “should,” “may,” “will” and similar words and expressions are intended to identify forward-looking statements. These forward-looking statements are contained throughout this report, for example in “Business,” “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  Such forward-looking statements reflect, among other things, our current expectations, plans and strategies, and anticipated financial results, all of which are subject to known and unknown risks, uncertainties and factors that may cause our actual results to differ materially from those expressed or implied by these forward-looking statements.  Many of these risks are beyond our ability to control or predict.  All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this report.  Because of these risks, uncertainties and assumptions, you should not place undue reliance on these forward-looking statements.  These risks and other factors include those listed under “Risk Factors” and elsewhere in this report.  Furthermore, forward-looking statements speak only as of the date they are made.  We do not undertake any obligation to update or review any forward-looking information, whether as a result of new information, future events or otherwise.

Item 1.  Business. 

Lumos Networks Corp. Overview

Lumos Networks Corp. (“Lumos Networks,” the “Company,” “we,” “us” or “our”) is a fiber-based bandwidth infrastructure and service provider in the Mid-Atlantic region.  We provide services to carrier and enterprise customers, including healthcare providers, local government agencies, financial institutions, educational institutions, and other enterprises over our approximately 8,600 route-mile fiber network.  Our principal products and services include Multiprotocol Label Switching (“MPLS”) based Ethernet, Metro Ethernet (“Metro E”), Fiber to the Cell site (“FTTC”) wireless backhaul and data transport services, wavelength transport services and IP services. 

We became an independent, publicly traded company on October 31, 2011, as a result of our spin-off from NTELOS Holdings Corp. (“NTELOS”).  Our common stock has been publicly traded on The NASDAQ Stock Market LLC (“NASDAQ”) under the ticker symbol “LMOS” since November 1, 2011.  We conduct all of our business through our wholly-owned subsidiary Lumos Networks Operating Company and its subsidiaries.  Our principal executive offices are located at One Lumos Plaza, Waynesboro, Virginia 22980.  The telephone number at that address is (540) 946-2000. 

Business Strategy

Our overall strategy is to transition into a pure-play fiber bandwidth infrastructure company through pursuit of expansion opportunities, both organic and inorganic. To achieve organic growth, our objective is to leverage and expand our fiber assets to capture the growing demand for data and mobility services among our carrier and enterprise customers in our marketplace. Our operating strategy is to (i) leverage our fiber network to expand to new fiber to the cell opportunities; (ii) monetize our approximately 8,600 route-mile fiber optic network by selling bandwidth infrastructure services to new and existing carrier and enterprise customers while maintaining a ratio of approximately 80% of our data revenue from on-net traffic;  (iii) use our “expansion” and "edge-out” strategies to expand into new markets and markets adjacent to our existing footprint to increase our addressable market size; (iv) proactively manage our churn through several initiatives including upgrading existing customers from legacy technologies to carrier Ethernet services and continually improving network and operational performance; (v) focus on managing resources from the declining legacy voice products into our faster growing and more profitable data products; and (vi) execute our success-based investment strategy to maintain our capital efficiency and expand margins.

Our data segment, which provided approximately 56% of our total revenue in 2015, represents the main growth opportunity and is the key focal point of our strategy and includes our enterprise data, transport and FTTC product groups.  Given our focus on on-net customers, our data services typically carry higher gross margins than many of our other services.  A significant majority of our capital expenditures and sales force are dedicated to increasing revenue and profit from our data segment.  We believe that a balanced split between enterprise and carrier revenue results in the most effective capital allocation and resulting profitability.  We are focused on taking advantage of increased carrier bandwidth demand, particularly for long-term FTTC contracts from wireless carriers that are deploying long-term evolution (“LTE”) data services, selling into our expansion and edge-out markets, maximizing the use of our carrier end user distribution channel, connecting our enterprise customers to data centers and improving penetration in existing markets.

Our residential and small business (“R&SB”) and RLEC access segments provided approximately 33% and 11% of our total revenue in 2015, respectively.  Our R&SB segment includes legacy voice and IP services products targeted to our residential and small business customers.  Our RLEC access segment provides other carriers access to our network within our RLEC territories, primarily

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through switched access services.  These segments require limited incremental capital to maintain the underlying assets and deliver reasonably predictable cash flows.  Despite declining revenues as a result of regulatory actions taken to reduce intra-state tariffs, access line loss resulting from residential wireless substitution, technology changes and product replacement of voice service offerings from cable operators in our markets, we expect the cash flows from these legacy businesses to continue to significantly contribute to funding the capital investment in our growing data segment.  Alternatively, we could explore the separation of these assets in order to monetize them more expediently through a sale or some other transaction.

The key imperatives for our data growth initiatives are as follows:

Enhance Carrier Ethernet Network and Grow FTTC Revenues 

As demand for FTTC services, greater data transport bandwidth and guaranteed network stability continues, there is an increasing demand to provide carrier Ethernet networks to our wireless carrier customers and select large data transport customers. In 2014, we completed the core construction of an approximately 850-mile carrier network within our existing fiber network to provide FTTC solutions to multiple large wireless communication providers and select large enterprise customers who operate in our markets and connected the first FTTC sites to this carrier network. This migration continued through 2015 and we expect to have substantially all existing FTTC traffic transitioned early in 2016. Additionally, new traffic has been and will continue to be added directly to this network. As of December 31, 2015, we provided FTTC connectivity to 1,099 cell sites.  We intend to significantly increase FTTC connectivity to cell sites in close proximity to our fiber network over the next several years to capitalize on the growth opportunity in our footprint.  In addition to our initiatives centered on enhancing our network and improving operational performance, we will continue to deliberately and proactively manage our carrier customers with legacy services to our Ethernet-based services with the intent of reducing churn and improving the customer experience. 

Enhance Legacy Enterprise Networks and Grow Enterprise Revenues

As demand for greater data bandwidth and guaranteed network stability continues to grow within enterprise services, we continue to invest capital in expanding and enhancing our enterprise networks to accommodate our customer needs. Growing our enterprise revenues using a success-based expansion approach is critical to ensuring the desired returns on invested capital are met.  As of December 31, 2015, our 8,600 route-mile fiber network was connected to approximately 1,732 buildings.  We believe there is significant prospect to compete for opportunities to connect to additional buildings and data centers in close proximity to our existing fiber network.  Our primary sales channels are enterprise-direct and carrier end user.  Our carrier end user channel facilitates the sale of enterprise data services for national carrier customers that are within our footprint.  Through use of this sales channel we are able to leverage our existing fiber infrastructure to grow revenue and reduce the likelihood of being overbuilt within our markets.  In addition to our initiatives centered on enhancing our network and improving operational performance, we will continue to deliberately and proactively manage our enterprise customers with legacy services to our Ethernet-based services, and appropriately incent our sales force to focus on renewal of long-term contracts with the intent of reducing churn and improving the customer experience.

Monetize our Expansion Markets and Edge-Out into Key Markets Adjacent to Our Existing Network Footprint

Driven by demand from existing enterprise and carrier customers, our expansion strategy grows our fiber network into new contiguous markets by leveraging existing and new assets.  Our current expansion markets are Richmond, VA and Norfolk, VA (including the nearby City of Petersburg and the Hampton Roads area).  In 2015, we added 785 route miles of new fiber to our network, which includes our partially completed fiber network expansion of approximately 822 route miles in the Richmond and Norfolk area. This expansion is underpinned by a long-term FTTC contract with a national U.S. wireless carrier, which will connect a total of 250 new cell sites to our fiber network by early 2016.  We expect the build out to be substantially complete by March 31, 2016. As we expand into these new markets we are significantly increasing our addressable market size, thus allowing us to bring new FTTC carrier customers and enterprise customers onto our fiber networks.    Our edge-out strategy, which focuses on incrementally adding network assets and new customers in markets in close proximity to our existing footprint, is complementary to our expansion strategy in the Richmond, VA and Norfolk, VA area.

Drive Incremental On-Net Data Traffic

Our on-net strategy focuses on driving traffic through our network, thereby increasing profitability.  As our network footprint grows and the bandwidth demand increases, we are able to drive incremental revenue through our existing network with minimal increase in operating expenses or incremental capital expenditures.  We evaluate this on-net approach and the associated capital expenditure against the revenue opportunity and have determined that maintaining approximately 80% of our data revenue from on-net traffic is the most effective use of capital.

Use Disciplined, Success-Based Capital Investment Strategy

We seek to maximize our capital expenditure efficiency by requiring that a significant percentage of our capital investment be tied to specific revenue generating products based on customer commitments, which we refer to as “success-based projects”.  Our success-based capital investment strategy involves maximizing capital expenditure efficiency by pursuing on-net and near-net customer

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opportunities and maintaining a balanced mix of carrier (including FTTC) and enterprise business.  Our capital investment strategy targets a greater than 15% return on investment and a less than four year payback, along with other strategic considerations.

Business Segments 

We have three reportable business segments, as follows:

Data 

Our data segment includes our enterprise data, transport and FTTC product groups.  We market and sell these services primarily to carriers and enterprise customers, including healthcare providers, state and local government agencies, financial institutions, and educational institutions.  Revenues from our data segment accounted for 56.0%, 52.9% and 50.2% of our total revenue for the years ended December 31, 2015,  2014 and 2013, respectively.  Data product lines are growing at a pace that significantly exceeds our legacy product lines and in aggregate, they also provide a higher gross margin.  The objective of our data segment is to leverage the ever increasing data bandwidth demands from our enterprise and carrier customers in our existing and expanding addressable markets.

Our data segment operations are based upon our expansion, edge-out and on-net strategies that seek to capitalize on new markets by maximizing the use of our fiber assets while optimizing capital efficiency and profitability.  In 2015, we continued to re-deploy capital and personnel resources away from our declining legacy product lines towards our growth businesses within our data segment.  Our strategy requires disciplined use of capital expenditures on success-based projects to grow our fiber assets and reach an increasing number of both carrier and enterprise customers.

In addition to the higher gross margins that are characteristic of the data business and our on-net expansion, we have also been able to deliver other enterprise services, such as metro Ethernet transport as a direct result of our expanding network.  We believe our expansion, edge-out and on-net strategies, combined with our commitment to customer service, will continue to attract larger customers in our key vertical markets.

We generate growth within our data segment through new long-term FTTC contracts with wireless carriers deploying LTE services and bandwidth upgrades on existing contracts, improving enterprise penetration within our existing and new markets and providing greater Ethernet bandwidth to enterprise customers.  In 2015, we added 241 FTTC sites, representing a year-over-year increase of approximately 28.1%, and 255 on-net buildings, representing an increase of approximately 17.3% year-over-year.  Our sales force is organized into carrier and enterprise teams to effectively pursue the respective opportunities.  Our ability to sustain or accelerate revenue growth in our data segment depends on our ability to obtain and effectively deploy capital to upgrade and expand our fiber network and implement our FTTC and edge-out plans in a timely and disciplined manner, attract new customers and successfully manage churn downwards through customer retention programs, including upgrading existing customers from legacy technologies to carrier Ethernet services.

R&SB

Our R&SB segment includes the following voice products:  local lines, primary rate interface (“PRI”), long distance, toll and directory advertising and other voice services (excluding voice over IP (“VoIP”) services which are typically provided to enterprise customers and are included in our data segment) and the following IP services products: fiber-to-the-premise broadband XL, DSL, integrated access and IPTV video.  These products are sold to residential and small business customers through our competitive local exchange carrier (“CLEC”) and rural local exchange carrier (“RLEC”) networks.  Revenues from our R&SB segment accounted for 32.9%,  35.8% and 38.9% of our total revenue for the years ended December 31, 2015,  2014 and 2013, respectively.  Despite declining revenues, we expect the cash flows from our legacy businesses to continue to significantly contribute to funding the capital investment in our growing data segment.  As of December 31, 2015, we operated approximately 73,705 CLEC lines and approximately 25,516 RLEC telephone access lines, a portion of which are fiber-fed and have IPTV-based video services and broadband Internet access offering speeds of up to 1 Gigabit.  We also provide high-speed DSL bundled services to customers within this segment.  This segment also includes revenues from switched access and reciprocal compensation services provided to other carriers in our competitive markets.

RLEC Access

Our RLEC access segment provides carrier customers access to our network within our RLEC footprint and primarily includes switched access services.  Revenues from our RLEC access segment accounted for 11.1%, 11.3% and 10.9% of our total revenue for the years ended December 31, 2015,  2014 and 2013, respectively.  A significant portion of our RLEC access segment revenues are derived from programs funded by regulatory agencies for recovery of revenue loss resulting from intercarrier compensation reform.  We anticipate continuing declines in RLEC access revenues primarily resulting from regulatory actions taken by applicable regulatory authorities as described in the Regulation section below and also due to network grooming activities by carriers. 

For detailed financial information about our business segments, see Note 4 in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report on Form 10-K, and for a detailed review of our financial performance and results of operations by business

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segment, see Part II, Item 7.  Managements’ Discussion and Analysis of Financial Condition and Results of Operations of this Annual Report on Form 10-K.

Products and Services

Data Services:

We provide data services to carriers and enterprise customers including healthcare providers, local government agencies, financial institutions, educational institutions, and other enterprises over our fiber network.  Our key data service offerings include the following:

 

 

Residential and Small Business:

 

We provide fiber-to-the-premise Broadband XL and DSL Internet, voice, video and IP services to our residential and small business customers.  Our voice service offerings include local lines, PRI, long distance, toll and directory advertising and other voice services.  Our customers have the option of bundling our voice, broadband and video service offerings.  Our IP-enabled product offerings combine voice and data services over dedicated broadband facilities utilizing VoIP protocols allowing customers dynamically allocated bandwidth to maximize voice and data transmission. VoIP technology also enables advanced voice features such as simultaneous ring, remote office, SIP trunks and business continuity.  Our IPTV-based video services offer over 300 channels, including approximately 86 high definition channels, video-on-demand, TV Everywhere and DVR capability.

 

Carrier Access:

 

In addition to our data services, we also provide carrier customers with access to our network within our footprint which primarily includes switched access services.

 

Sales, Marketing and Customer Care

Sales.  We serve our carrier and enterprise customers with our suite of fiber-based data products, which include carrier Ethernet, MPLS, VPN, wavelength and dedicated Internet access.  We have continued to see increased demand for these products across our customer base, particularly as demand for data transport and mobility services grow.  The mission of our sales team is to capitalize on this growing demand by offering customized solutions to our carrier and enterprise customers with a continued focus on expanding within our key vertical markets, which include healthcare, education, financial services and government.  Our technical team plays a significant role in our sales approach in order to focus on selling customized, long-term and secure networking and data solutions. 

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Our overall strategy of deliberately and strategically shifting resources to our data business also extends to our sales and sales engineering teams.  Our specialized sales force is organized into carrier and enterprise teams to effectively pursue opportunities with the focus on capitalizing on the increased bandwidth demand through new long-term FTTC contracts and bandwidth upgrades in our expansion and edge-out markets and to improve enterprise penetration within our existing markets.  Our carrier sales team uses the carrier end user sales channel to reach new enterprise customers through strategic partnerships with national carriers to provide fiber bandwidth solutions over our network.  We expect an increasing portion of new enterprise sales over time will be initiated through this sales channel.

Our current expansion markets include Richmond, VA and Norfolk, VA (including the City of Petersburg and the Hampton Roads area).  We employ in-market sales teams to drive revenue growth in these markets.  In 2015, we completed a portion of our expansion of approximately 822-route miles to our fiber network in the Richmond metropolitan area and eastward to the key metropolitan areas in and around Norfolk, VA, which is expected to be substantially complete by March 31, 2016.  Our expansion in these markets significantly increases our addressable market for FTTC and enterprise data and our carrier and enterprise sales teams are rapidly mobilizing to sell into these new markets.  We expect to generate significant revenue from this expansion in 2016.

Marketing.  Our marketing team is primarily focused on driving revenue growth in our data business, particularly in our expansion markets of Richmond, VA and Norfolk, VA, revenue retention in our residential and small business segment and enhancing the overall customer experience.  During 2015, we completed a robust market analysis in our existing, expansion and edge-out markets which provided further visibility into our data business growth opportunities. We have developed and will implement a comprehensive outreach and lead generation strategy across our footprint. We also continue to implement a multi-phase customer experience enhancement plan that provides deeper customer data visibility internally and enables proactive management of our top customers’ experience.

Customer Care.  We differentiate our customer care teams so our customer care representatives can provide the highest level of service by specializing in servicing and supporting data customers and residential and small business customers.  We continue to implement our Elite Care and Platinum Care programs, which are designed to provide a higher level of service to our top wireless carrier and enterprise data customers, respectively. Each customer is assigned a dedicated Client Program Manager who assists in proactively managing the customers’ experience and addresses customer issues and opportunities using a cross functional team approach that engages sales, network, service delivery and customer care teams. The Client Program Manager is assisted by a Technical Support Manager who focuses on support of network performance.

Our Network and Platform

We have developed a fiber optic network of long-haul fiber, carrier Ethernet and Ethernet rings located primarily in Virginia and West Virginia, and portions of Pennsylvania, Maryland, Ohio and Kentucky.  As of December 31, 2015, our fiber network spanned approximately 8,600 route miles.

Our integrated fiber transport network allows us to offer a suite of advanced next-generation communications services, including, but not limited to, 100Gbps wavelength services, which provides greater throughput and superior latency performance, multi-site networking, dedicated Internet and MEF 2.0 certified Ethernet solutions, high-speed Internet and VoIP services.  We use a multi-vendor approach, including Cisco, Alcatel-Lucent and Ciena, among others, to deliver high-bandwidth wavelength services directly to end customers as infrastructure for the MPLS Ethernet and high-speed Internet backbone.  Network-to-network interconnection points allow us to engage carrier partners to provide end to end service for carrier and enterprise customers.  We continue to invest in our fiber network to support the deployment of next-generation products and services, expand our addressable market and bring new customers on-net.

In 2015, we completed several significant network enhancement and upgrade projects including the construction of a new MEF certified Carrier Ethernet MPLS/IP fiber overlay network designed to handle FTTC traffic within our network.  This overlay network, totaling approximately 850 route miles, connects four key markets in our footprint (Pittsburgh, PA, Charleston, WV, Roanoke, VA and Ashburn, VA) and meets carrier class requirements for fast-rerouting, full redundancy and low latency performance.  Our second network operations center located in Pittsburgh, PA, opened in 2014, is compatible with our FTTC all-IP network overlay.  Now fully operational, the new network operations center provides replication of all traditional functions of our existing network operations center located in Waynesboro, VA, including performance surveillance, repair, upgrade and maintenance of our fiber network and redundancy of our business continuity and disaster recovery functions.  Our parallel network operations centers provide technical surveillance of our network using industry leading network management systems. 

Our local networks consist of central office digital switches, routers, loop carriers and virtual and physical collocations interconnected primarily with fiber facilities. A mix of fiber optic and copper facilities connect our customers with the core network.

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Competition

We compete with incumbent local exchange carriers (“ILECs”), broadband service providers, incumbent cable operators, and fiber providers and to a lesser extent, CLECs.  We also face competition from potential future market entrants.  In the last several years, we have seen increasing competition from the cable operators and ILECs for metro-Ethernet services to mid-size businesses.  To remain competitive, we position our company as a customer-focused, leading edge provider with a full portfolio of broadband and IP-based services and a differentiation strategy centered on customizable data solutions.

As a result of the rapid growth in demand for broadband data transport, we expect that our competition will increase from market entrants offering FTTC, metro Ethernet solutions and other high-speed data services, including cable and wireless access.  Our competition includes:

 

As the RLEC for the western Virginia cities of Waynesboro, Clifton Forge and Covington and portions of the Virginia counties of Alleghany, Augusta and Botetourt, we have competition from cable companies and are subject to competition from wireless carriers.  A portion of residential customers moving into our service area do not purchase landline phone service.  Although CLECs have not entered our incumbent markets to compete with us, it is possible that one or more may enter our markets.  To minimize potential competition in the RLEC markets, we offer fiber-to-the-premise, DSL, video over copper and a variety of bundled services for broadband, voice and video.

We believe our competitive strengths include our advanced fiber network; our footprint, including contiguous markets, which we believe provides opportunities for growth with a favorable competitive environment relative to first-tier markets; our robust and expanding products and services, including FTTC and metro Ethernet; our disciplined, success-based capital investment strategy aimed at optimizing our capital efficiency and delivering attractive returns; our diverse customer base, our future cash flow visibility from our legacy businesses; and our experienced management team, with deep industry experience and a strong track record of operating and scaling bandwidth infrastructure assets.    

Employees

As of December 31, 2015, we employed 591 full-time and two part-time employees. Of these employees, 43 are covered by a collective bargaining agreement that expires June 30, 2017.  We believe that we have good relations with our employees.

Access to Public Filings

We routinely post important information on our website at www.lumosnetworks.com.  Information contained on our website is not incorporated by reference into this annual report on Form 10-K.  We provide public access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports filed with the U.S. Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934.  These documents may be accessed free of charge on our website at the following address: http://ir.lumosnetworks.com.    These reports are available as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

Regulation

The following summary does not describe all present and proposed federal and state legislation and regulations affecting the telecommunications industry.  Some legislation and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals which could change the manner in which this industry operates.  Neither the outcome of any of these developments, nor their potential impact on us, can be predicted at this time.  Regulation can change rapidly in the telecommunications industry, and such changes may have an adverse effect on us in the future.  See “Risk Factors” elsewhere in this report.

Regulation Overview

Our communications services are subject to varying degrees of federal, state and local regulation.  Under the federal Communications Act, the Federal Communications Commission (“FCC”) has jurisdiction over interstate and international common carrier services.  Under the Telecommunications Act of 1996, the FCC has jurisdiction over certain aspects of local interconnection terms and rates between carriers.

In addition to FCC regulation, our communications services are regulated to different degrees by state public service commissions and by local authorities.  Such local authorities have jurisdiction over public rights-of-way and video and telecommunications franchises.

Our operations are subject to various federal and state laws intended to protect the privacy of customers who subscribe to our services.  The FCC has regulations that place restrictions on the permissible uses that we can make of customer-specific information, known as

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Customer Proprietary Network Information (“CPNI”), received from subscribers and that govern procedures for release of such information and the Federal Trade Commission’s “Red Flag” rules require that companies develop and implement written Identity Theft Prevention programs.

Federal Regulation of Interconnection and Interexchange Services

The Communications Act requires all common carriers to interconnect on a non-discriminatory basis with other carriers, imposes additional requirements on incumbent local exchange carriers (such as our RLEC’s), and imposes even more comprehensive requirements on the largest ILECs.  The large ILECs are required to provide competitors with physical collocation to allow competitors to place qualifying equipment in ILEC central offices; to unbundle some of their services into unbundled network elements (“UNE”) at “forward looking” rates, permit resale of some of their services, provide access to poles, ducts, conduits and rights-of-way, and to establish reciprocal compensation for the transport and termination of local traffic.  The obligations of the large ILECs to provide these network facilities and services could be altered or removed by new legislation, regulations or court order.

ILEC operating entities that serve fewer than 50,000 lines are defined as “rural telephone companies” under the Communications Act and are exempt from the additional requirements applicable to the large ILECs unless and until such exemption is removed by the state regulatory body.  Each of our RLEC operations is considered separately and each has this rural telephone company exemption.   

Intercarrier Compensation Reform    

Intercarrier compensation includes regulated interstate and intrastate access charges that we and other RLECs and CLECs receive from long distance carriers for the origination and termination of long distance calls and reciprocal compensation that interconnected local carriers pay to each other for terminating interconnected local wireline calls.

In 2011, the FCC released a significant order on intercarrier compensation reform.  In the order, the FCC adopted a uniform national bill-and-keep framework (in which carriers do not collect or pay access charges or reciprocal compensation) as the ultimate end state for all telecommunications traffic exchanged between carriers.  The FCC established the $2 billion Connect America Fund (CAF) for RLECs and RLECs now receive support principally through the CAF rather than through intercarrier compensation.  The FCC order permitted ILECs to implement a new charge on end users to partially offset the loss in access charge revenues, the Access Recovery Charge (“ARC”), effective July 1, 2012.  The maximum ARC for residential customers is $3 per month after six years.  Multi-line business customers have their Subscriber Line Charge and ARC combined capped at $12.20 per line. On May 23, 2014, the Tenth District Court of Appeals affirmed the FCC’s order, including the establishment of the CAF and the reform of intrastate access and reciprocal compensation.

Our RLECs began charging the ARC and began receiving funding from the CAF on July 1, 2012.  Effective July 1, 2013, our RLECs and CLECs took their rates for most intrastate access to interstate rates. Effective July 1, 2014 and July 1, 2015, our RLECs and CLECS further reduced interstate and intrastate access charges as required by the FCC.

Net Neutrality. 

On March 12, 2015, the FCC released an order re-classifying Internet service providers as common carriers under Title II of the Federal Communications Act and stating its intention to forbear from much of Title II regulation at this time. These new rules took effect on June 12, 2015. At this early stage, it is uncertain what portions of Title II the FCC might apply and the FCC has not yet adjudicated any complaints under the new rules. Rules that increase the regulation of Internet services could limit our ability to efficiently manage our network and to respond to competitive challenges and could cause us to incur additional administrative costs. While it is uncertain what impact the new rules will have on us,  we do not currently expect that the new rules will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

State Regulation of RLEC, CLEC and Interexchange Services

Most states require wireline telecommunications providers to obtain authority from state regulatory commissions prior to offering common carrier services.  State regulatory commissions generally regulate RLEC rates for intrastate services and RLECs must file tariffs setting forth the terms, conditions and prices for their intrastate services.  Our RLECs are subject to regulation in Virginia by the State Corporation Commission (“SCC”). 

We are certificated as a CLEC in Virginia, West Virginia, Pennsylvania, Maryland, Ohio and Kentucky.  Although we file tariffs covering our CLEC services, our rates for such CLEC services generally fluctuate based on market conditions.

Local Government Authorizations

Certain governmental authorities require permits to open streets for construction and/or telecommunications franchises to install or expand facilities.  Video franchises are also required for our video services.  We obtain such permits and franchises as required.  We hold video franchises in the City of Waynesboro, Botetourt County, City of Lynchburg, City of Staunton (for the Gypsy Hill Development only), Bedford County, Alleghany County, City of Covington, Town of Clifton Forge, and Town of Iron Gate.  All of these localities are in the Commonwealth of Virginia.

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Item 1A.  Risk Factors.    

RISK FACTORS

The following risk factors and other information included in this Form 10-K should be carefully considered.  The risks and uncertainties described below are not the only ones we face.  Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may adversely impact our business operations.  Our business, financial condition or results of operations could be materially adversely affected by any or all of these risks.

Risks Relating to Our Business: 

Adverse economic conditions may harm our business. 

Economic uncertainty or a lack of economic growth could negatively impact our business results.  Unfavorable economic conditions, including a return to recession or disruptions to the credit and financial markets, could cause customers to slow or delay spending.  If demand for our services decreases, our revenues would be adversely affected and churn may increase.  In addition, during challenging economic times our customers may face issues gaining timely access to sufficient credit, which may impair the ability of our customers to pay for services they have purchased.  Any of the above could have a material effect on our business, financial position, results of operations and cash flows. 

We are also susceptible to risks associated with the potential financial instability of the vendors and third parties on which we rely to provide services or to which we outsource certain functions.  The same economic conditions that may affect our customers could also adversely affect vendors and third parties and lead to significant increases in prices, reduction in quality or the bankruptcy of our vendors or third parties upon which we rely.  Any interruption in the services provided by our vendors or by third parties could adversely affect our business, financial position, results of operations and cash flows.  

We may not be able to successfully implement our strategy to grow our data business and thereby sustain our revenue and cash flow growth.

We must grow our data business and manage the decline in our legacy businesses in order to sustain our revenue and cash flow growth.  We have pursued several growth initiatives including:

Our ability to manage this expansion depends on many factors, including our ability to:

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We may be unable to successfully divest legacy businesses on a timely basis, which would hinder our strategy of accelerating our transformation to a pure play fiber bandwidth infrastructure company, and divestitures we do complete could adversely affect our results of operations.

From time to time, we consider the divestiture of legacy businesses based on management's assessment of their strategic value to our business. Divesting certain of our products or assets would be complex operationally due to their interrelationships with products and assets we would desire to retain. Any divestiture also would have implications under our Credit Facility and 8% Notes. The inability to divest legacy businesses on a timely basis would hinder our strategy of accelerating our transformation to a pure play fiber bandwidth infrastructure company. Additionally, decisions to divest certain business operations could involve realization of losses, transition and wind-up expenses and the elimination of revenues along with associated costs, any of which could adversely affect our results of operations and cash flows, and may fail to yield the expected benefits.

We may require additional capital to fund our strategic growth plan, and if we fail to obtain this capital, we may experience a material adverse effect on our business.  

Our strategic growth plans require a significant amount of capital investment in fiber operations through organic and/or inorganic growth.  Additionally, to remain competitive, we will need to continue to upgrade the technical requirements of our existing network infrastructure and build out our network with advanced fiber technology within our territories which will require a significant investment of capital resources.  Additionally, the cost or extent of the work required for organic growth projects could be more significant than anticipated.  Any such unplanned capital expenditures may adversely affect our business, financial condition and operating results. 

We expect that the cash we generate from operations combined with our cash on hand and marketable securities will be sufficient to satisfy our working capital requirements, capital expenditures and debt service requirements for the foreseeable future.  Additionally, we have access to a revolving credit facility, which is currently undrawn. However,  if our assumptions prove incorrect or if there are other factors that increase our need for additional liquidity, such as material unanticipated losses, loss of customers or a significant reduction in demand for our services or other factors, or if we are successful in obtaining additional major FTTC contracts or we make acquisitions, we would expect to seek additional sources of funds through refinancing or other means including additional equity financing.  There is no assurance that we could obtain such additional financing on acceptable terms, if at all.  If available, additional equity financing may dilute our stockholders and debt financing may restrict our ability to raise future capital.

We may not be able to complete acquisitions and acquisitions we do complete could result in operating difficulties, dilution and other adverse consequences, which could adversely affect our results of operations.

We evaluate potential strategic transactions in order to pursue our strategy. At any given time, we may be engaged in discussions with respect to one or more of such transactions that may be material to our financial condition and results of operations. There can be no assurance that any such discussions will result in the consummation of any transaction or that we will identify appropriate transactions on terms acceptable to us. Adverse capital markets and volatility in our stock price could also negatively impact our ability to make acquisitions.

Future acquisitions may result in the dilutive issuances of equity securities, use of our cash resources and incurrence of debt or contingent liabilities. Acquisitions also may result in significant costs and expenses and charges to earnings, including those related to employee costs, integration costs, unexpected liabilities and legal, accounting and financial advisory fees. Any of these items could adversely affect our business, results of operations and cash flows.

We face substantial competition in our markets; our competitors may have substantial business advantages over us and we may not be able to compete successfully.

We compete with ILECs, broadband service providers, incumbent cable operators, fiber companies and to a lesser extent, CLECs.  As a result of the rapid growth in demand for broadband data, we expect that our competition will increase from market entrants offering FTTC, metro Ethernet solutions and other high-speed data services, including cable and wireless access. Our competition includes ILECs, such as AT&T, Verizon, Frontier, Windstream and Centurylink; national fiber service providers and CLECs, including Level 3 and Zayo, and national and regional cable operators, such as Comcast, Shentel, Cox, Time Warner Cable and Suddenlink.  In addition, due to consolidation and strategic alliances within the telecommunications industry, we cannot predict the number of competitors that will emerge.    Such increased competition from existing and new entities could lead to price reductions, loss of customers, reduced operating margins and/or loss of market share.

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Many of our competitors have financial resources, corporate backing, customer bases, marketing programs and brand names that are greater than ours.  Additionally, competitors may charge less than we do for services, causing us to reduce, or preventing us from raising, our fees. 

Network delays or interruptions of service could cause us to lose customers.  

To be successful, we must provide our customers reliable network service.  Some of the risks to our network and infrastructure include:  physical damage to outside plant facilities, power surges or outages; network equipment failures due to aging or other factors; software defects; human error; disruptions beyond our control, including disruptions caused by terrorist activities or severe weather; and failures in operational support systems.

Furthermore, as the demand for increased bandwidth from our customers has grown and as it continues to grow, our fiber optic network could experience greater data loads that may also result in network interruptions in service and reduced capacity for our customers.  Service interruptions and lack of redundancy could cause us to incur additional expenses and/or issue network outage credits to our customers and may cause us to lose customers.

The telecommunications industry is generally characterized by rapid development and introduction of new technologies; if we are unable to adapt to these rapid changes, we could suffer price reductions, customer losses, reduced operating margins and/or loss of market share. 

The telecommunications industry continues to experience rapid and significant changes in technologies and architectures to deliver new services to customers and to deliver existing services more cost-effectively.  We expect that new technologies will continue to enable advances in our customers’ environments that create new demand drivers.  We believe that our future success will depend in part on our ability to anticipate and respond to the rapidly changing needs and demands of our customers on a timely basis and to compete with our competitors' offerings.  Our failure to obtain and integrate new technologies and applications, and develop new service offerings to meet those customer needs or to keep pace with or exceed the service capabilities of our competitors could impact the breadth of our service portfolio, resulting in less competitive and compelling offerings that could impair our ability to attract and retain customers.  We may be unable to keep pace with competitive offerings without making significant additional capital investments or adversely affecting our margins.

 

Revenue from certain of our more traditional products such as dedicated network services and certain voice services is growing slowly or is declining.  As a result, our overall revenue growth is driven primarily by our Ethernet services and we must continue to develop those and other next generation services in order to continue to grow our revenue.  New product development may be capital intensive and may pressure margins until the new products begin to generate substantial revenue.  New products that are largely software based are increasingly complex and may require more customer support and additional systems development.  In addition to investing in new technologies, we must replace equipment that supports our traditional services as that equipment ages or becomes redundant.  If we do not properly manage this process, including the migration of customers to our newer technologies, we may lose customers and market share, and our margins and returns could be adversely affected.

Losses or a decrease in usage from certain key customers may result in lower revenues or higher expenses.  

We generated approximately 32% of our operating revenue from our six largest carrier customers in the year ended December 31, 2015. No single customer currently represents more than 10% of our operating revenues.  If we were to lose one or more of these carrier customers, our revenues would decline, which could have a material adverse effect on our business, financial condition and operating results.    

We may have to undertake further restructuring plans which would require additional charges.

From time to time we have incurred restructuring charges as a result of changes in our business strategy, most recently in the first quarter of 2016. We plan to continue to evaluate our business, which may result in additional restructuring activities. We may choose to implement workforce reductions, outsource certain functions or consolidate or close certain facilities. Decisions to engage in future restructuring activities could involve realization of losses, wind-up expenses, workforce reductions, impairment of assets and the elimination of revenues along with associated costs, any of which could adversely affect our results of operations and cash flows.

 

We have substantial indebtedness, which could have a negative impact on our financing options and liquidity position.    

Lumos Networks Operating Company, our wholly-owned subsidiary, has a credit facility (the “Credit Facility”) which consists of senior secured term loans and a senior secured revolving credit facility.  Our indebtedness under the Credit Facility was $348.4 million at December 31, 2015 and it carries interest expense of approximately $12 million annually.    

On August 6, 2015, we issued $150 million in aggregate principal amount of 8% Notes due 2022 (the “8% Notes”) to an entity formed by Pamplona Capital Management, LLP (together with another entity formed by Pamplona Capital Management, LLP that acquired

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warrants to purchase our common stock, the “Pamplona Entities”).  Our 8% Notes carry interest expense of approximately $12 million annually.

Our indebtedness could adversely affect our financial health and business and future operations by, among other things: 

The ability to make payments on our debt will depend upon our future operating performance, which is subject to general economic and competitive conditions and to financial, business and other factors, many of which we cannot control.  If the cash flows from our subsidiaries’ operating activities are insufficient to service our debt obligations, we may take actions, such as delaying or reducing capital expenditures, attempting to restructure or refinance our debt, selling assets or operations or seeking additional equity capital.  Any or all of these actions may not be sufficient to allow us to service our debt obligations.  Further, we may be unable to take any of these actions on satisfactory terms, in a timely manner or at all. 

Our Credit Facility and our 8% Notes impose certain operating and financial restrictions, which may prevent us from capitalizing on business opportunities and taking some corporate actions.  

Our Credit Facility imposes certain operating and financial restrictions on our subsidiaries.  These restrictions generally:

Our 8% Notes also impose certain financial and operating restrictions.  These restrictions generally:

We cannot provide assurance that these covenants will not adversely affect our ability to finance our future operations or capital needs or pursue available business opportunities.  A breach of any of these covenants could result in a default with respect to the Credit Facility or the 8% Notes, as applicable.  If a default occurs, our indebtedness under the Credit Facility or the 8% Notes, as applicable, could be declared immediately due and payable.

Our RLEC subsidiaries are subject to competition and to regulatory regimes at the state and federal level and consequently face substantial regulatory burdens and uncertainties; regulatory developments will further reduce revenues that we receive from access charges and/or from the federal Universal Service Fund, the Connect America Fund or other fund allocations. 

Our RLECs qualify as rural local telephone companies under the Telecommunications Act and are, therefore, exempt from many of the most burdensome obligations of the Telecommunications Act, such as the obligation to sell unbundled elements of our network to our competitors at “forward-looking” prices that the Telecommunications Act places on larger carriers.  Nevertheless, our RLECs face significant competition, particularly from competitors that do not need to rely on access to our network to reach their customers.  Wireless carriers, cable companies and other VoIP providers are able to compete with our RLECs even though the “rural exemption”

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under the Telecommunications Act is in place.  If our rural exemption were removed, CLECs could more easily enter our RLECs’ markets.  Moreover, the regulatory environment governing wireline local operations has been, and we believe will likely continue to be, very liberal in its approach to promoting competition and network access. 

Over time, FCC and state regulations have resulted in reducing the switched access and reciprocal compensation revenue of our RLECs.  In 2011, the FCC released an order comprehensively reforming interstate and intrastate intercarrier compensation systems.  In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time.  These FCC pricing reductions commenced on July 1, 2012 and continue through July 1, 2020.  A portion of the access revenue previously received by our RLECs from carriers is being recovered through payments from the FCC’s “Connect America Fund” (“CAF”) and from increases in charges to end user subscribers in the form of rate increases and the FCC’s “Access Recovery Charge.”  Regulatory changes could impact the amount and timing of the revenues received from these funds in the future.  There is no guarantee that we will recover all or a portion of lost revenues resulting from intercarrier compensation system reform or that we will not be subject to further rate reductions in the future.  Furthermore, by accepting government funding, we are subject to audit by the FCC or certain other government agencies that administer the funds and our methodologies or approaches taken to determine the amounts of eligible access revenues or costs, as applicable, could be called into question during an audit. Although we believe our methodologies and approaches are compliant and reasonable, there is no assurance that an audit would not result in a demand for a partial refund or nonpayment of future funding by the respective government agency. 

Lumos Networks and other industry participants are frequently involved in disputes over issues that, if decided adversely to us, could harm our financial and operational prospects. 

We anticipate that we will continue to be subject to risks associated with the resolution of various disputes, lawsuits, arbitrations and proceedings affecting our business.  These issues may include, among other things, the administration and enforcement of existing interconnection agreements and tariffs, the terms of new interconnection agreements, operating performance obligations and intercarrier compensation.  We also may be included in proceedings and arbitrations before state and regulatory commissions, private arbitration organizations, and courts over many issues that will be important to our financial and operation success.  While we believe we have adequate reserves for the probable and estimable losses related to the expected outcomes of our current disputes, the results of these disputes are inherently unpredictable.

The implementation of our business strategy is dependent upon our ability to maintain, expand and update our information technology infrastructure in response to growth and changing business needs.

Our business relies on our data, billing and other operational and financial reporting and business systems.  To effectively implement our business strategy, we will need to continue to maintain and, in some cases, make upgrades to modernize our information technology systems and infrastructure, which can be costly.  Our inability to maintain, expand or upgrade our technology infrastructure could have adverse consequences, which could include service or billing interruptions, the diversion of critical resources and inhibiting our growth plans due to an inability to scale effectively.

We are dependent on third-party vendors for our information and billing systems.  Any significant disruption in our relationship with these vendors could increase our costs and affect our operating efficiencies.  

Sophisticated information and billing systems are vital to our ability to monitor and control costs, bill customers, process customer orders, provide customer service and achieve operating efficiencies.  We currently rely on a mix of internal systems and third-party supported applications and systems to provide all of our information and data processing needs.  Some of our billing, customer service and management information systems have been developed by third parties and may not perform as anticipated or the third parties may experience interruptions or other problems delivering these systems.  In addition, our plans for developing and implementing our information and billing systems rely to some extent on the delivery of products and services by third-party vendors.  Our right to use these systems is dependent upon license agreements with third-party vendors.  Some of these agreements are cancelable by the vendor, and the cancellation or nonrenewable nature of these agreements could impair our ability to process customer information and/or bill our customers.  Since we rely on third-party vendors to provide some of these services, any switch in vendors could be costly and affect operating efficiencies.

We rely on a limited number of key suppliers and vendors for timely supply of equipment and services relating to our network infrastructure.  If these suppliers or vendors experience problems or favor our competitors, we could fail to obtain sufficient quantities of the products and services we require to operate our businesses successfully.  

We depend on a limited number of key suppliers and vendors for equipment and services relating to our network infrastructure.  If these suppliers experience interruptions or other problems delivering these network components and related software on a timely basis, our subscriber growth and operating results could suffer significantly.  Our initial choice of a network infrastructure supplier can, where proprietary technology of the supplier is an integral component of the network, cause us effectively to be locked into one or a few suppliers for key network components.  As a result, we have become reliant upon a limited number of network equipment

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manufacturers, including Cisco, Alcatel-Lucent, Ciena and others.  If alternative suppliers and vendors become necessary, we may not be able to obtain satisfactory and timely replacement supplies on economically attractive terms, or at all.

If we fail to extend or renegotiate our collective bargaining agreements with our labor union when they expire, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.  

We are a party to collective bargaining agreements with our labor union, which represented 43 employees as of December 31, 2015.  Although we believe that relations with our employees are satisfactory, no assurance can be given that we will be able to successfully extend or renegotiate our collective bargaining agreements when they expire.  If we fail to extend or renegotiate our collective bargaining agreements, if disputes with our union arise, or if our unionized workers engage in a strike or a work stoppage, we could experience a significant disruption of operations or incur higher ongoing labor costs, either of which could have an adverse effect to the business.  Our collective bargaining agreements are generally renegotiated every three years and the current agreements expire June 30, 2017.

If we cannot obtain and maintain necessary construction permits, rights-of-way and access to pole attachments for our network, our operations may be interrupted, customer installations may be delayed and we would likely face increased costs.  

We need to obtain and maintain the necessary rights-of-way for our network from governmental and quasi-governmental entities and third parties, such as railroads, utilities, state highway authorities, local governments, transit authorities and private landowners.  Additionally, in many cases we require construction permits to complete fiber installations. We may not be successful in obtaining and maintaining these rights-of-way or construction permits or obtaining them on acceptable terms.  Some agreements relating to rights-of-way may be short-term or revocable at will, and we cannot be certain that we will continue to have access to existing rights-of-way after the governing agreements are terminated or expire.  If any of our right-of-way agreements were terminated or could not be renewed, we may be forced to remove our network facilities from the affected areas, relocate or abandon our networks.  This would interrupt our operations and force us to find alternative rights-of-way and make unexpected capital expenditures.  If we are unable to obtain construction permits in a timely manner, or at all, we could face delays in fiber installations, incur unexpected cost for network redesign work, or default on customer contracts. In addition, our failure to maintain the necessary rights-of-way, franchises, easements, licenses and permits may result in an event of default under our credit agreement and may subject us to legal complaints or claims.  We may also incur costs resulting from a disruption of service or the relocation of equipment for other carriers that use our network under Indefeasible Rights to Use (“IRU”) arrangements granted by us.

Under federal law, we have a right to use the poles, ducts, and conduits of investor-owned utilities (electric and telephone) at regulated rates for our cables, including fiber optic facilities.  Some of the poles we use are exempt from federal regulation because they are owned by utility cooperatives and municipal entities.  If the rates, terms and conditions imposed by utilities are unreasonable, or if the utilities do not allow us access to the poles, ducts, and conduits in a timely manner, our business, financial results or financial condition could suffer.   

Our rights to the use of fiber that are part of our network may be affected by the ability to continue long term contracts and the financial stability of our IRU fiber providers. 

A portion of our services are provided on network fiber facilities licensed or leased from other network service providers through IRUs or similar arrangements.  The facilities under these agreements have remaining terms generally ranging from less than 1 year to 24 years.  In these agreements, the network owner is responsible for network maintenance for which we pay such network owners.  If our network provider under IRU agreements has financial troubles, it could adversely affect our costs, especially maintenance costs and ability to deliver service.  Also, if our network providers under IRU agreements are unable to obtain and maintain necessary rights-of-way and access to pole attachments for their fiber networks or if they fail to renew or extend our IRUs, our operations may be interrupted and/or we could incur material expenses if we were required to relocate to alternative network assets.

We are dependent upon interconnection agreements with other carriers to reach some of our customer locations.

We have interconnection agreements with ILECs  in the competitive markets we serve.  Based on existing customers and our assessment of growth opportunities in these markets, we purchase wholesale voice lines, data circuits and access to collocation facilities under these agreements.  From time to time, we are required to negotiate amendments to, extensions of, or replacements for these agreements.  Additionally, we may be required to negotiate new interconnection agreements in order to enter new markets in the future.  We may not be able to successfully negotiate amendments to existing agreements, negotiate new interconnection agreements, renew our existing interconnection agreements, opt in to new agreements or successfully arbitrate replacement agreements for interconnection on terms and conditions acceptable to us.  Our inability to do so would adversely affect our existing operations and opportunities to expand our business in existing and new markets.  If rates became unfavorable or we could no longer access collocation facilities, we could be forced to alter our service delivery which could reduce our customer base.  As the FCC modifies and implements rules related to unbundling of ILEC network elements and collocation of competitive facilities at ILEC central offices, we generally have to renegotiate our interconnection agreements to implement those new or modified rules.

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If interest rates increase, our net income could be negatively affected.

Our Credit Facility exposes us to adverse changes in interest rates.  We cannot predict whether interest rates for long-term debt will increase, and thus we cannot assure you that our future interest expense will not have a material adverse effect on our business, financial condition, operating results and cash flows.  Our interest rate swap contracts, which partially mitigated this exposure, expired on December 31, 2015. 

Security breaches to our physical facilities, computer networks, and informational databases, and unauthorized use of, or interference with, our network could disrupt services and result in loss of customer data and customers, and increase our costs.  

The nature of our business necessitates that parts of our network remain in the public domain and as a result it is possible that unauthorized use, interference with, or malicious or unintentional disruptions of our network may occur. In addition, computer viruses, theft, attacks by hackers, or similar disruptive problems may occur.  If hackers gain improper access to our databases, they may be able to steal, publish, delete or modify confidential personal information concerning our subscribers. 

In addition, misuse of our customer information could result in more substantial harm perpetrated by third parties.  This could damage our business and reputation, and result in a loss of customers.  Misuse of our customer information would also subject us to fines by the FCC.  We may incur costs associated with the unauthorized use of our network including administrative and capital costs associated with detecting, monitoring and reducing the incidence of malice and fraud.  Malicious and fraudulent use of our network may impact interconnection costs, capacity costs, legal and administrative costs, fraud prevention costs and payments to other carriers for fraudulent use.  

Our physical facilities may be vulnerable to physical break-ins which may also result in the misuse of our customer information, malicious and fraudulent use of our networks that may impact interconnection costs, capacity costs, legal and administrative costs, fraud prevention costs and payments to other carriers for fraudulent use.

If or when we lose a member or members of our senior management, our business may be adversely affected.  

The success of our business is largely dependent on our senior management team, as well as on our ability to attract and retain other highly qualified technical and management personnel, including talented sales and technical personnel. 

We believe that there is, and will continue to be, intense competition for qualified personnel in the telecommunications industry, and we cannot assure you that we will be able to attract and retain the personnel necessary for the development of our business.  The unexpected loss of key personnel or the failure to attract additional personnel as required could have a material adverse effect on our business, financial condition and operating results.  

Any significant impairment of our goodwill or intangible assets would lead to a decrease in our assets and a reduction in net income. 

As of December 31, 2015, we had goodwill and other intangible assets of approximately $111.4 million (approximately 14.9% of total assets).  If the impact or the timing of ongoing regulatory reform actions is significantly different than what we anticipate or if there are other regulatory or operating changes to our business, we may be forced to record an impairment charge, which would lead to a decrease in our assets and reduction in net income.  We test goodwill and other indefinite-lived intangible assets for impairment annually or more frequently if events or changes in circumstances indicate an impairment may have occurred.  If the testing performed indicates that impairment has occurred, we are required to record an impairment charge for the difference between the carrying value of the goodwill or indefinite-lived intangible asset and the implied fair value of the asset in the period in which the determination is made.  The testing of goodwill and indefinite-lived intangible assets for impairment requires us to make significant estimates about the fair values of our reporting units. These estimates can be affected by numerous factors, including changes in economic, industry or market conditions, changes in underlying business operations, future reporting unit operating performance, existing or new product market acceptance, changes in competition or changes in technologies.  Any changes in key fair value assumptions, or actual performance compared with those assumptions, about our business and our future prospects or other assumptions could affect the fair value of one or more of the indefinite-lived intangible assets or of the reporting units, resulting in an additional impairment charge.  

Risks Related to Our Common Stock: 

Outstanding warrants may cause dilution to existing shareholders.

On August 6, 2015, we issued to a Pamplona entity a warrant to purchase up to 5,500,000 shares of our common stock (the “Warrant”).  The Warrant is exercisable on a cashless basis at an initial exercise price of $13.99 per share and may be net-share settled only.  Exercise of the Warrant may cause dilution to the interests of other stockholders as a result of the additional common stock that would be issued.  Additionally, the Warrant contains anti- dilution provisions that could result in further dilution to our stockholders.

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The Pamplona Entities have influence over our business and their interests may not always coincide with the interests of the holders of our common stock.

Two of our 11 current directors that serve on our board of directors (and two of the nine directors who will be nominated for election at our 2016 Annual Meeting) are representatives or designees of the Pamplona Entities pursuant to an Investors Rights Agreement between a Pamplona Entity and us. By virtue of the Investors Rights Agreement and such representation on the board of directors, the Pamplona Entities have influence over corporate and management policies and matters submitted to our stockholders, including the election of the directors.

The interest of the Pamplona Entities may not always coincide with the interests of our stockholders. Accordingly, because the Pamplona Entities have influence over our business, they could seek to influence us to enter into transactions or agreements adverse to the interests of our stockholders or to forego entering into transactions or agreements that may be beneficial to our stockholders.

In addition, the Pamplona Entities are in the business of making investments in companies and may, from time to time, acquire and hold interests in business that compete directly or indirectly with us. The Pamplona Entities may also pursue, for their own account, acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. Additionally, we have specifically renounced any interest or expectancy that the Pamplona Entities will offer to us any investment or business opportunity of which they are aware.

Provisions in our charter documents and the General Corporation Law of Delaware could discourage potential acquisition proposals, could delay, deter or prevent a change in control and could limit the price certain investors might be willing to pay for our common stock. 

Certain provisions of the General Corporation Law of Delaware, the state in which we are organized, and our certificate of incorporation and bylaws may inhibit a change of control not approved by our board of directors or changes in the composition of our board of directors, which could result in the entrenchment of current management.  These provisions include:

Our stock price may be volatile.    

The trading price of our common stock is subject to fluctuations in response to certain events and factors, such as quarterly variations in results of operations; entry into major transactions; changes in our business strategy; changes in financial guidance; changes in recommendations or reduced coverage by securities analysts; the operating and stock price performance of other companies that investors may deem comparable to us; industry or stock market trends unrelated to our performance; and general economic conditions.

Our certificate of incorporation designates the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain litigation that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with the Company.

Our certificate of incorporation provides that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of fiduciary duty owed by any of our directors, officers or other employees or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim governed by the internal affairs doctrine.  Our certificate of incorporation further provides that any person or entity purchasing or acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to the provisions described above.  This forum selection provision in our certificate of incorporation may limit our stockholders’ ability to obtain a favorable judicial forum for disputes with the Company. 

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Item 1B.  Unresolved Staff Comments.

None.

Item 2.  Properties.

We are headquartered in Waynesboro, Virginia and own offices and facilities in a number of locations within our operating markets.  Our offices and facilities are generally shared by our operating segments. We believe that our current facilities are adequate to meet our needs in our existing markets for the foreseeable future.  The table below provides the location, description and approximate square footage of our significant owned properties.

 

We also lease the following significant properties:

Item 3.  Legal Proceedings.

We are involved in routine litigation in the ordinary course of our business,  including litigation involving disputes relating to our billings to other carriers for access to our network (see Note 13 in Part II, Item 8. Financial Statements and Supplementary Data).  We do not believe that any pending or threatened litigation of which we are aware will have a material adverse effect on our financial condition, results of operations or cash flows.

Item 4.  Mine Safety Disclosures.

Not applicable.

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Part II 

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. 

Market Information

Our common stock is traded on the NASDAQ Global Market under the symbol “LMOS.”  On March 4, 2016, the last reported sale price for our common stock was $12.52 per share.

Our common stock has been traded on the NASDAQ Global Market under the symbol “LMOS” since November 1, 2011.  Prior to that time, there was no established public trading market for our common stock.  The following table sets forth the high and low prices per share of our common stock and the cash dividends declared per common share for each of the quarters in 2015 and 2014, which correspond to our quarterly fiscal periods for financial reporting purposes:

 

 

 

 

 

Stock Performance Graph

The following indexed line graph indicates our total return to stockholders from November 1, 2011 (the first day our Common Stock began trading on the NASDAQ Global Market) to December 31, 2015, as compared to the total return for the NASDAQ Composite Index and the NASDAQ Telecommunications Index for the same period.  The calculations in the graph assume that $100 was invested on November 1, 2011 in our Common Stock and each index and also assume dividend reinvestment.

Cumulative Total Shareholder Return

Lumos Networks, NASDAQ Composite Index
and NASDAQ Telecommunications Index
(11/1/11 - 12/31/15) 

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Holders

There were approximately 3,000 holders of our common stock on March 4, 2016.

Dividends

Cash dividends of $0.14 per share were declared and subsequently paid for each of the four quarters in 2014.  On March 4, 2015, our board of directors terminated our quarterly dividend in favor of allocating capital to growth opportunities.    

Issuer Purchases of Equity Securities

The Company does not currently have a share repurchase program in effect.  However, from time to time the Company repurchases shares of common stock from employee plan participants for settlement of tax withholding obligations in connection with the vesting of restricted stock grants issued pursuant to the Company’s 2011 Equity and Cash Incentive Plan.  The number of shares repurchased and the average price paid per share for each month in the three-months ended December 31, 2015 are as follows:

 

 

Credit Agreement

Amounts that can be made available to pay dividends or to repurchase shares are limited by a restricted payment basket in our Credit Agreement.

 

 

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Item 6.  Selected Financial Data

SELECTED HISTORICAL FINANCIAL INFORMATION(1)

 

 

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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion of our financial condition in conjunction with our consolidated financial statements and the related notes included herein (Item 8).  This discussion contains forward looking statements that involve risks and uncertainties.  For additional information regarding some of these risks and uncertainties that affect our business and the industry in which we operate, please see “Risk Factors” and “Forward-Looking Statements” elsewhere in this report.

Overview

Lumos Network Corp. (“Lumos Networks,” the “Company,” “we,” “us,” or “our”) is a fiber-based bandwidth infrastructure and service provider in the Mid-Atlantic region.  We provide services to carrier and enterprise customers, including healthcare providers, local government agencies, financial institutions and educational institutions over our approximately 8,600 route-mile fiber network.  Our principal products and services include Multiprotocol Label Switching (“MPLS”) based Ethernet, Metro Ethernet (“Metro E”), Fiber to the Cell site (“FTTC”) wireless backhaul and data transport services, wavelength transport services and IP services.  

Our overall strategy is to transition into a pure-play fiber bandwidth infrastructure company through pursuit of expansion opportunities, both organic and inorganic. To achieve organic growth, our objective is to leverage and expand our fiber assets to capture the growing demand for data and mobility services among our carrier and enterprise customers in our marketplace. Our operating strategy is to (i) leverage our fiber network to expand to new fiber to the cell opportunities; (ii) monetize our approximately 8,600 route-mile fiber optic network by selling bandwidth infrastructure services to new and existing carrier and enterprise customers while maintaining a ratio of approximately 80% of our data revenue from on-net traffic;  (iii) use our expansion and "edge-out” strategies to expand into new markets and markets adjacent to our existing footprint to increase our addressable market size; (iv) proactively manage our churn through several initiatives including upgrading existing customers from legacy technologies to carrier Ethernet services and continually improving network and operational performance; (v) focus on managing resources from the declining legacy voice products into our faster growing and more profitable data products; and (vi) execute our success-based investment strategy to maintain our capital efficiency and expand margins.

Business Segments

Our operating segments generally align with our major product and service offerings and coincide with the way that our chief operating decision makers measured performance and allocated resources during 2015.  Our current reportable operating segments are data, residential and small business (“R&SB”) and RLEC access.  Financial information concerning our reportable segments presented below includes restated segment results for the year ended December 31, 2013 to be consistent with the classification and presentation of our operating segments in 2014 and 2015.

Our data segment provided 56.0%,  52.9% and 50.2% of our total revenue for the years ended December 31, 2015,  2014 and 2013, respectively.  Revenue for our data segment increased 7.2% for the year ended December 31, 2015, as compared to 2014.  This segment, which includes our enterprise data, transport and FTTC product and service groups, represents the main growth opportunity and the key focal point of our strategy.  We market and sell these services primarily to carrier and enterprise customers, including healthcare providers, local government agencies, financial institutions and educational institutions.  These businesses, in the aggregate, typically carry higher gross margins than many of our other product lines.  A majority of our capital expenditures and the focus of our sales force are dedicated to expanding revenue and profit from our data products.  We believe that a balanced split between carrier and enterprise revenue results in the most effective capital allocation and resulting profitability.  Our ability to successfully implement our strategy and thereby sustain our revenue growth in our data segment depends on our ability to obtain capital on acceptable terms and implement our network expansion plans in a timely manner, upgrade and enhance our network, attract new customers and expand our relationships with existing customers, manage our churn through customer retention programs, including upgrading existing customers from legacy technologies to Ethernet-based services and respond to competition from other data service providers in existing and our expansion markets.      

The 7.2% growth in our data segment revenues in 2015 was achieved primarily through increases in long-term contracts with large U.S. wireless carriers, as reflected in the addition of 241 FTTC sites in 2015, the addition of second tenants to existing connected cell towers,  bandwidth upgrades, new enterprise contracts and improved rates of renewal with existing enterprise customers.    Our marketing and sales efforts are focused on taking advantage of increased carrier bandwidth demand, particularly for long-term FTTC contracts from wireless carriers that are deploying long-term evolution (“LTE”) data services, selling into our expansion and edge out markets (with an emphasis on targeting large enterprises in our expansion markets of Richmond, VA and Norfolk, VA), maximizing the use of our carrier end user distribution channel, connecting our enterprise customers to data centers and improving penetration in existing markets.    As of December 31, 2015, we had 1,099 cell towers and 1,732 buildings connected to our fiber network, including 34 data centers.  Our FTTC revenue increased $8.5 million, or 42.8%, as a result of the growth in connected towers as well as the addition of second tenants and bandwidth upgrades on existing towers.  Revenues from our enterprise data products increased $3.5 million, or  8.2%, due to growth in our metro Ethernet and dedicated Internet product lines.  The growth in FTTC and enterprise data revenues was partially offset by the year-over-year decline in our revenue from data transport products, which have been negatively impacted by network grooming as existing customers redesign their networks and upgrade from time division multiplexing (“TDM”)

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technology to Ethernet products to improve efficiency.    As we continue to implement our data growth strategy, which includes completing the extension of our fiber optic network in the key Virginia markets of Richmond and Norfolk, we believe that the effect of churn on legacy product lines will continue to be more than offset by revenues from carrier Ethernet products, long-term FTTC contracts and new enterprise customers.

Our R&SB segment provided 32.9%,  35.8% and 38.9% of revenue for the years ended December 31, 2015,  2014 and 2013, respectively.  This segment includes legacy voice and IP services products targeted at our residential and small business customers.  Revenue declined 6.7% for our R&SB segment in 2015 as compared to 2014 primarily due to the decline in revenues from legacy voice products. This decline is attributable to voice line loss resulting from residential wireless substitution, technology changes and product replacement by competitive voice service offerings from cable operators in our markets. We currently expect aggregate revenue from these businesses will continue to decline.

Our RLEC access segment provided 11.1%,  11.3% and 10.9% of revenue for the years ended December 31, 2015,  2014 and 2013, respectively.  This business requires limited incremental capital to maintain the underlying assets and delivers reasonably predictable cash flows.  However, revenue decline over time is expected due to access line loss and regulatory actions taken to reduce intra-state tariffs by applicable regulatory authorities, principally the FCC and the SCC.  In 2011, the FCC released an order comprehensively reforming its Universal Service Fund (“USF”) and intercarrier compensation systems.  In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time.  These FCC pricing reductions commenced on July 1, 2012 and continue through July 1, 2020.  However, a portion of the access revenue previously received from carriers is being recovered through payments from the FCC’s “Connect America Fund” (“CAF”) and from increases in charges to end user subscribers in the form of rate increases and the FCC’s “Access Recovery Charge”.  These new payments and revenues were also effective July 1, 2012.  These actions directly impact the access rates charged by our RLECs, which provide service to the rural Virginia cities of Waynesboro and Covington, and portions of the Virginia counties of Alleghany, Augusta and Botetourt.  Our total revenues derived from cost recovery mechanisms, including the USF and the CAF, were $21.4 million, $22.5 million and $16.6 million for the years ended December 31, 2015,  2014 and 2013, respectively, most of which are reported in our RLEC access segment.

Our operating income margins were 17.9%, 25.1% and 22.1% for the years ended December 31, 2015,  2014 and 2013, respectively.  Excluding a $10.8 million curtailment gain recognized in 2014 as a result of the discontinuance of certain postretirement medical benefits, our operating income margins were 19.7% in 2014.  Our Adjusted EBITDA margins, as defined below, were 45.0%,  50.0% and 46.4% for the years ended December 31, 2015,  2014 and 2013, respectively.  Excluding the curtailment gain, our Adjusted EBITDA margin was 44.6% for 2014.  Our Adjusted EBITDA margin for 2015 is essentially flat as compared to 2014 as the increase in operating revenues and lower network access costs we experienced were offset by higher selling, general and administrative expenses.  Our operating income margins are also impacted by increased depreciation expense resulting from our capital investments in our fiber optic network and internal business systems as well as restructuring charges incurred during the first quarter of 2015. 

Operating Revenues

Our revenues are generated from the following segments: 

Operating Expenses

Our operating expenses are incurred from the following categories: 

Adjusted EBITDA

Adjusted EBITDA, as defined by us, is net income attributable to Lumos Networks Corp. before interest, income taxes, depreciation and amortization and accretion of asset retirement obligations, net income attributable to noncontrolling interests, other (income) expenses, net, equity-based compensation, amortization of actuarial losses, employee separation charges, restructuring charges and gain (loss) on interest rate swap derivatives. Adjusted EBITDA margin is calculated as the ratio of Adjusted EBITDA, as defined above, to operating revenues.

Adjusted EBITDA is a non-GAAP financial performance measure.  It should not be considered in isolation, as an alternative to, or more meaningful than measures of financial performance determined in accordance with GAAP.  Management believes that Adjusted EBITDA is a standard measure of operating performance and liquidity that is commonly reported in the telecommunications and high speed data transport industry and provides relevant and useful information to investors for comparing performance period to period and for comparing financial performance of similar companies.   Management utilizes Adjusted EBITDA internally to assess its ability to meet future capital expenditure and working capital requirements, to incur indebtedness if necessary, and to fund continued growth.  Management also uses Adjusted EBITDA to evaluate the performance of its business for budget planning purposes and as factors in our employee compensation programs.

Note 4 – in Part II, Item 8. Financial Statements and Supplementary Data Disclosures, provides a reconciliation of Adjusted EBITDA to net income attributable to Lumos Networks Corp.  

Other Income (Expenses)

Our other income (expenses) are generated (incurred) from interest expense on debt instruments and capital lease obligations, including amortization of debt discounts and issuance costs, gains or losses on interest rate swap derivatives and other income or expense, which includes interest income and fees, expenses related to our senior secured credit facility and, as appropriate under the circumstances,  secondary public offering and stock registration costs and write-off of unamortized debt issuance costs. 

Income Taxes

Our income tax expense and effective tax rate increases or decreases based upon changes in a number of factors, including primarily the amount of our pre-tax income or loss, state minimum tax assessments and non-deductible expenses. 

Noncontrolling Interests in Earnings of Subsidiaries

We have a  partnership through our RLEC with a 46.3% noncontrolling interest that owns certain signaling equipment and provides services to a number of small RLECs and to TNS (an inter-operability solution provider). 

Results of Operations

Year ended December 31, 2015 compared to year ended December 31, 2014

Operating revenues increased  $2.8 million, or 1.4%, from 2014 to 2015 resulting from an increase in data segment revenues of $7.7 million, partially offset by decreases in R&SB segment revenues of $4.8 million and RLEC access segment revenues of $0.1 million.   The growth in data segment revenues was primarily driven by increases in FTTC revenue of $8.5 million and enterprise data revenue of $3.5 million, which was partially offset by declines in transport revenues.    The $4.8 million decline in R&SB segment revenues is due primarily to line loss from legacy voice products. For further information regarding these revenue fluctuations, see “Operating Revenues” below.

Operating income decreased $14.0 million from $50.5 million in 2014 to $36.5 million in 2015 due primarily to the $10.8 million curtailment gain recognized in 2014 related to discontinuance of benefits under the postretirement medical plan referenced above, a  $4.6 million increase in other selling, general and administrative expenses,  a  $2.3 million increase in depreciation and amortization expense, and $0.6 million in restructuring charges.  These were partially offset by a $4.3 million increase in gross margin (operating revenues less network access costs).  Variances in the individual line items on the consolidated statements of income are described in the “Operating Expenses” section below.

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Adjusted EBITDA was $92.0 million in 2015 compared to Adjusted EBITDA of $100.6 million in 2014.  Excluding the curtailment gain for the postretirement medical plan, Adjusted EBITDA was $89.9 million for 2014.  The year-over-year increase in Adjusted EBITDA, excluding the curtailment gain in 2014, is primarily attributable to the increase in total operating revenues, as described above and in further detail below.

Net income attributable to Lumos Networks decreased $11.5 million from 2014 to 2015. Reflected in these results was a $14.0 million decrease in operating income and an increase in interest expense of $4.2 million (net of changes in the fair value of interest rate swap derivatives), partially offset by a decrease in income tax expense of $7.3 million.

OPERATING REVENUES

The following table identifies our operating revenues by major product group for the years ended December 31, 2015 and 2014:

 

Data.    Data revenues increased $7.7 million, or 7.2%, in 2015.  The overall increase in data revenues is due to growth in contracts with wireless carriers for FTTC services, new enterprise data contracts and increased services with existing customers, partially offset by churn in data transport revenues due to network grooming activities as described below:

R&SB.  Revenue from residential and small business products declined 6.7% in 2015 as compared to 2014.  This decline was primarily due to the continuing churn of legacy voice products due to the increasing use of wireless devices and competition from cable operators in our markets as well as our shift in focus to VoIP services (which is included in data segment revenues).  As of December 31, 2015, we operated approximately 25,516  RLEC telephone access lines and approximately 73,705 competitive voice lines, compared to approximately 27,250 and 83,400, respectively, as of December 31, 2014.  This represents a 6.4% year-over-year decline in RLEC telephone access lines and an 11.6% year-over-year decline in competitive voice lines.  Growth in fiber-to-the-premise products within our IP services product group such as Broadband XL and IP video was more than offset by declines in revenue from legacy DSL products.  Our total video subscribers increased from 5,352 at December 31, 2014 to 5,904 at December 31, 2015.

RLEC Access.  Revenue from RLEC access was essentially flat year-over-year as declines in revenues due to the decrease in telephone access lines and intrastate access rate reductions mandated by regulatory rate reform was offset by recovery of certain additional intrastate access charges from the FCC’s CAF and other support as discussed in the overview section above.

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OPERATING EXPENSES

The following table identifies our operating expenses for the years ended December 31, 2015 and 2014:

 

 

Network Access Costs.  Network access costs decreased $1.6 million, or 3.8%, from the prior year primarily due to the overall decrease in voice access lines and network grooming, partially offset by increases in collocation costs as we expand and enhance our fiber network.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased $15.4 million, or 23.8%, in 2015 as compared to 2014 primarily as a result of a net curtailment gain of approximately $10.8 million recognized in 2014 due to the discontinuance of certain medical benefits under our postretirement medical plan, in addition to a $2.6 million increase in salaries, wages and benefit related costs due to increased headcount in our data business, partially offset by reduced headcount in our R&SB segment, and increases in retirement benefit plan costs, a $1.5 million increase in equity-based compensation primarily due to grant activity, and increases in operating taxes and other general and administrative costs.  These increases were partially offset by decreases in advertising and marketing costs, professional fees and contracted services.  

Depreciation and Amortization.  Depreciation and amortization increased $2.3 million, or 5.1%, over 2014.  This net increase is attributable to a $6.7 million increase in depreciation expense, partially offset by a $4.4 million decrease in amortization expense.  The increase in depreciation costs is a result of the year-over-year increase in our depreciable base of assets primarily from capital investment in our fiber network including infrastructure upgrades and FTTC site installations.  The decrease in amortization cost is attributable to run off of amortization for customer intangible assets under an accelerated amortization method based on these assets’ estimated patterns of benefit.

 

Restructuring Charges.    We incurred $0.6 million in restructuring charges in 2015, which consisted of separation benefits associated with an employee reduction-in-force, primarily in our legacy businesses, that was completed in March 2015.

The following table identifies our operating expenses by segment for the years ended December 31, 2015 and 2014 and provides a reconciliation from total segment operating expenses to consolidated operating expenses for each period.

 

 

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Data.  Total operating expenses attributed to our data segment increased $7.9 million, or 14.4%, from 2014 to 2015 due to a $0.7 million increase in network access costs, a $6.6 million increase in network operating and engineering costs and a $0.5 million increase in other selling, general and administrative expenses.   The increases in network access and operating costs are directly attributable to our investment of resources in our network operations to support the growth in this segment in 2015 and drive future growth.  The increase in selling, general and administrative costs is primarily attributable to the increase in allocated corporate expenses as the data segment grows in relation to the other segments and the continued redirection of our customer service, engineering, service delivery, and other resources to support and grow the data business. 

 

R&SB.  The $6.5 million, or 12.4%, decrease in total operating costs attributed to our R&SB segment is primarily due to a $2.3 million decrease in network access costs, a $2.8 million decrease in network operating and engineering costs and a $1.4 million decrease in other selling, general and administrative expenses.  The decrease in network access costs and network operating costs is due to an approximate 10.3% year-over-year decrease in voice lines, as reflected in the decline in segment revenues, network grooming activities and internal reorganization to shift resources away from the legacy businesses to our data segment.  The decrease in selling, general and administrative costs is primarily attributable to the decrease in allocated corporate expenses as the data segment grows and we redirect  resources to support and grow the data business.

RLEC Access.  Operating costs for the RLEC access segment decreased $0.8 million, or 17.1%, primarily attributable to a $0.5 million decrease in network operating and engineering costs and a $0.3 million decrease in other selling, general and administrative expenses. 

 

OTHER INCOME (EXPENSES) AND INCOME TAXES

The following table summarizes our other income (expenses) and income taxes for the years ended December 31, 2015 and 2014:

 

Interest Expense.  Interest expense in 2015 and 2014 primarily consists of incurred interest costs associated with our Credit Facility as well as amortization of debt issuance costs, and beginning in the third quarter of 2015, interest incurred on the 8% Notes as well as amortization of associated debt discounts and debt issuance costs.  The year-over-year increase in interest expense of $4.3 million is attributable to the 8% Notes,  partially offset by reduced interest costs on the Credit Facility due to lower interest rates and a partial prepayment using proceeds from the 8% Notes (see Note 5 in Part II, Item 8. Financial Statements and Supplementary Data).

Gain on Interest Rate Swap Derivatives.  We recognized a gain on interest rate swap derivatives of $0.7 million and $0.5 million for the years ended December 31, 2015 and 2014, respectively.  These gains are reflective of mark-to-market adjustments to record the liability associated with the interest rate swap derivatives at fair value on the consolidated balance sheets, which is impacted by fluctuations in interest rates and other market factors.  The interest rate swap derivatives expired on December 31, 2015 and were not replaced or renewed.

Other Income, net.  Other income primarily consists of interest income earned on marketable securities during 2015 and 2014, which was partially offset by costs incurred for the secondary public stock offering (see Note 1 in Part II, Item 8. Financial Statements and Supplementary Data) for 2015. 

Income Tax Expense.  Income tax expense for the years ended December 31, 2015 and 2014 was $7.1 million and $14.4 million, respectively, which represents the federal statutory tax rate applied to pre-tax income and the effects of state income taxes and certain non-deductible charges for each period.  Our recurring non-deductible expenses relate primarily to certain non-cash equity-based compensation and, beginning in the third quarter of 2015, non-deductible interest on the 8% Notes, which are treated as applicable high yield discount obligations (“AHYDO”) within the meaning of Section 163(i)(1) of the Internal Revenue Code, as amended.  The decrease in income tax expense was primarily due to a decrease in income before taxes.  Our effective tax rate was 41.2% in 2015 as compared to 40.0% in 2014.    

At December 31, 2015, we had unused federal net operating losses (“NOLs”) of approximately $48.0 million, net of adjustments for unrecognized income tax benefits.  Our NOLs, if not utilized to reduce taxable income in future periods, will expire in varying

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amounts from 2022 through 2035.  We believe that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

Year ended December 31, 2014 compared to year ended December 31, 2013

Operating revenues decreased $6.0 million, or 2.9%, from 2013 to 2014 resulting from a decrease in R&SB segment revenues of $8.6 million, partially offset by an increase in data segment revenues of $2.5 million.  The growth in data segment revenues was primarily driven by an increase in FTTC revenue of $5.7 million, which increase was partially offset by declines in transport revenues.  The $8.6 million decline in R&SB segment revenues is due primarily to line loss from legacy voice products. For further information regarding these revenue fluctuations, see “Operating Revenues” below.

Operating income increased $4.6 million from $45.8 million in 2013 to $50.5 million in 2014 due primarily to the $10.8 million curtailment gain related to discontinuance of benefits under the postretirement medical plan referenced above, partially offset by a $4.5 million decrease in gross margin (operating revenues less network access costs) and a $2.9 million increase in depreciation and amortization costs due to capital investment primarily in our fiber network assets.  Variances in the individual line items on the consolidated statements of income are described in the operating expenses section below.

Adjusted EBITDA was $100.6 million in 2014 compared to Adjusted EBITDA of $96.3 million in 2013.  Excluding the curtailment gain for the postretirement medical plan, Adjusted EBITDA was $89.9 million for 2014.  The year-over-year decrease in Adjusted EBITDA is primarily attributable to the decline in total operating revenues, as described above and in further detail below.

Net income attributable to Lumos Networks increased $3.8 million from 2013 to 2014. Reflected in these results was a $4.6 million increase in operating income and decrease in other expenses due to the non-recurrence of secondary offering costs and costs associated with the debt refinancing in 2013, offset by an increase in interest expense of $0.7 million (net of changes in the fair value of interest rate swap derivatives) and increase in income tax expense of $2.4 million. 

OPERATING REVENUES

The following table identifies our external operating revenues by business segment for years ended December 31, 2014 and 2013:

 

 

Data.  Data revenues increased $2.5 million, or 2.4%, in 2014.  The overall increase in data revenues is due to growth in contracts with wireless carriers for fiber to the cell site services, partially offset by churn in data transport revenues due to network grooming activities as described below:

 

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R&SB.  Revenue from residential and small business products declined 10.7% in 2014 as compared to 2013.  This decline was primarily due to the continuing churn of legacy voice products due to the increasing use of wireless devices and competition from cable operators in our markets as well as our shift in focus to VoIP services (which is included in data segment revenues).  As of December 31, 2014, we operated approximately 27,250 RLEC telephone access lines and approximately 83,400 competitive voice lines, compared to approximately 28,900 and 95,700, respectively, as of December 31, 2013.  This represents a 5.7% year-over-year decline in RLEC telephone access lines and a 12.9% year-over-year decline in competitive voice lines.  Growth in fiber-to-the-premise products within our IP services product group such as Broadband XL and IP video was more than offset by declines in revenue from legacy DSL products.  Our total video subscribers increased from 5,034 at December 31, 2013 to 5,352 at December 31, 2014.

RLEC Access.  Revenue from RLEC access increased slightly year-over-year primarily as a result of the recovery of certain additional intrastate access charges from the FCC’s Connect America Fund (“CAF”) discussed in the overview section above, offset by declines in revenues due to the decrease in telephone access lines and intrastate access rate reductions mandated by regulatory rate reform.

OPERATING EXPENSES

The following table identifies our operating expenses for the years ended December 31, 2014 and 2013:

 

 

Network Access Costs.  Network access costs decreased $1.5 million, or 3.7%, from the prior year primarily due to network grooming and the overall decrease in voice access lines, partially offset by increases in collocation costs as we expand and enhance our fiber network.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses decreased $12.0 million, or 15.6%, in 2014 as compared to 2013 primarily as a result of a net curtailment gain of approximately $10.8 million recognized in 2014 due to the discontinuance of certain medical benefits under our postretirement medical plan and other reductions in personnel-related costs such as non-cash and incentive compensation and pension-related costs, partially offset by increased salaries and wages.  We also incurred lower rent, repairs and maintenance and operating taxes, which decreases were partially offset by increased advertising and marketing costs and professional fees.

Depreciation and Amortization.  Depreciation and amortization increased $2.9 million, or 6.8%, over 2013.  This net increase is attributable to a $3.5 million increase in depreciation expense, partially offset by a $0.6 million decrease in amortization expense related to customer intangibles for which an accelerated amortization method is applied based on these assets’ estimated pattern of benefits.  The increase in depreciation expense is a result of the year-over-year increase in our depreciable base of assets primarily from capital investment in our network including infrastructure upgrades and fiber to the cell site installations and internal business systems.

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The following table identifies our operating expenses by segment for the years ended December 31, 2014 and 2013 and provides a reconciliation from total segment operating expenses to consolidated operating expenses for each period.

 

 

Data.  Total operating expenses attributed to our data segment increased $4.3 million, or 8.5%, from 2013 to 2014 due to a $0.2 million increase in network access costs, a $2.2 million increase in network operating and engineering costs and a $1.9 million increase in other selling, general and administrative expenses.   The increases in network access and operating costs are directly attributable to our investment of resources in our network operations to support the growth in this segment in 2014 and drive future growth.  The increase in selling, general and administrative costs is primarily attributable to the increase in allocated corporate expenses as the data segment grows in relation to the other segments and the redirection of our sales, marketing, customer service, engineering and other resources to support and grow the data business. 

 

R&SB.  The $3.9 million, or 6.9%, decrease in total operating costs attributed to our R&SB segment is primarily attributable to a $1.7 million decrease in network access costs and a $2.2 million decrease in network operating and engineering costs.  The decrease in network access costs and network operating costs is due to an approximate 11.2% year-over-year decrease in voice lines, as reflected in the decline in segment revenues, network grooming activities and internal reorganization to shift resources away from the legacy businesses to our data segment.  The decrease in selling, general and administrative costs is primarily attributable to the decrease in allocated corporate expenses as the data segment grows and we redirect our sales, marketing, customer service, engineering and other resources away from the legacy businesses to support and grow the data business.

RLEC Access.  Operating costs for the RLEC access segment remained materially consistent with the prior year.

 

OTHER INCOME (EXPENSES) AND INCOME TAXES

The following table summarizes our other income (expenses) and income taxes for the years ended December 31, 2014 and 2013:

 

N/M – not meaningful

 

 

Interest Expense.  Interest expense in 2014 and 2013 primarily consists of incurred interest costs associated with our Credit Facility as well as amortization of debt issuance costs.  The year-over-year increase in interest expense of $1.4 million is attributable to the debt refinancing in April 2013, which resulted in a higher outstanding principal balance and a $0.2 million increase in amortization of debt issuance costs in 2014 as compared to 2013 (see Note 5 in Part II, Item 8. Financial Statements and Supplementary Data).

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Gain (Loss) on Interest Rate Swap Derivatives.  We recognized a gain on interest rate swap derivatives of $0.5 million in 2014 and a loss of $0.1 million for 2013.  These gains and losses are reflective of mark-to-market adjustments to record the liability associated with the interest rate swap derivatives at fair value on the consolidated balance sheets, which is impacted by fluctuations in interest rates and other market factors.

Other Income (Expenses).  Other income of $0.7 million in 2014 primarily consists of interest income earned on marketable securities. Other expenses of $1.6 million for 2013 includes approximately $0.9 million of expense related to unamortized debt issuance costs that were written off in connection with the April 2013 debt refinancing transaction and $0.8 million of administrative, legal and accounting costs associated with the secondary offering of our common stock in November 2013 (see Note 1 in Part II, Item 8. Financial Statements and Supplementary Data).

Income Tax Expense.  Income tax expense for the years ended December 31, 2014 and 2013 was $14.4 million and $12.0 million, respectively, which represents the federal statutory tax rate applied to pre-tax income and the effects of state income taxes and certain non-deductible charges for each period.  Our recurring non-deductible expenses relate primarily to certain non-cash equity-based compensation for 2014 and 2013 and limitations on certain officer compensation for 2013.  The increase in income tax expense was primarily due to an increase in income before taxes.  Our effective tax rate was 40.0% in 2014 as compared to 40.2% in 2013. 

Quarterly Results

The following table sets forth selected unaudited consolidated quarterly statement of operations data for each of the quarters in 2015 and 2014.  This unaudited quarterly information has been prepared on substantially the same basis as our consolidated financial statements appearing elsewhere in this report and includes all adjustments (consisting of normal recurring adjustments) we believe necessary for a fair statement of the unaudited consolidated quarterly data.  The unaudited consolidated quarterly statement of income data should be read together with the consolidated financial statements and related notes thereto included elsewhere in this report.  The results for any quarter are not necessarily indicative of results for any future period, and you should not rely on them as such.