ITEM 1. Business
Company Overview
Iowa Telecommunications Services, Inc. (“Iowa Telecom”) and its subsidiaries provide wireline local exchange telecommunications services to residential and business customers in rural Iowa, Minnesota and Missouri. We currently operate 294 telephone exchanges serving 423 communities as the incumbent or “historical” local exchange carrier and are the sole telecommunications company providing wireline services in approximately 67% of these communities. In addition, we provide service to residential and business customers throughout Iowa and Minnesota as a competitive local exchange carrier. In total, we provide services to approximately 242,100 access lines.
Our core business is the provision of local telephone service and network access to other telecommunications carriers for calls originated or terminated on our network. In addition to these core activities, which generated 65% of our total revenues for the year ended December 31, 2008, we provide long distance service, dial-up and DSL Internet access, and other communications services. We provide services as the incumbent local exchange carrier through Iowa Telecom and its wholly-owned subsidiaries; Lakedale Telephone Company and Montezuma Mutual Telephone Company. As part of our strategy of pursuing growth beyond our current service area, we compete for customers in Iowa in mostly adjacent markets through our competitive local exchange carrier subsidiaries, Iowa Telecom Communications, Inc. (“ITC”) and IT Communications, LLC (“IT Communications”). Additionally, Lakedale Link, Inc. and EN-TEL Communications LLC (“EN-TEL”) are competitive local exchange carriers that provide local and long distance service in Minnesota. Together, ITC, IT Communications, Lakedale Link, Inc. and EN-TEL are referred to as the “CLEC” or our “CLEC Operations.”
Our History
We were incorporated under the laws of the State of Iowa in 1999. In the late 1990’s, several of the Regional Bell Operating Companies and other large telecommunications companies, such as GTE Midwest Incorporated, decided to sell many of their rural assets. We began business on June 30, 2000, when we acquired the Iowa operations of GTE Midwest Incorporated. Our common stock began trading on the New York Stock Exchange on November 18, 2004, under the trading symbol “IWA.”
On July 18, 2008, we acquired Bishop Communications Corporation (“Bishop Communications”). As of September 30, 2008, Bishop Communications and its consolidated subsidiaries provided telecommunications services to 11,600 access lines as the incumbent local exchange carrier, to 4,600 access lines as a competitive local exchange carrier, to 9,700 long distance subscribers, and provides Internet access service to more than 6,600 subscribers in Minnesota.
Over 99% of the customers we serve are located in rural Iowa or Minnesota communities. Virtually all of our services are offered in an area that is approximately 20,000 square miles in size, and each of our switching centers is within 30 miles of another of our switching centers.
On November 21, 2008, the Company announced a definitive agreement to acquire, subject to regulatory approvals, substantially all of the assets of Sherburne Tele Systems, Inc. (“Sherburne”) for a total purchase price of $80.6 million, subject to certain adjustments. Sherburne is a closely held telecommunications company headquartered in Big Lake, Minnesota, less than 30 miles from the headquarters of Bishop Communications, which we acquired on July 18, 2008. As of December 31, 2008, Sherburne served 15,500 access lines as the incumbent local exchange carrier, and 10,200 access lines as a competitive local exchange carrier, and provides service to 13,900 DSL high-speed Internet customers and 3,700 video customers, primarily in communities and rural areas near the Minnesota/St. Paul Metropolitan Area. Sherburne’s operations include its incumbent local exchange carrier services, marketed as Connections, Etc., and competitive local exchange carrier services provided through its wholly-owned subsidiary, Northstar Access.
Our Strategy
Our objective is to continue to strengthen our position as a leading provider of telecommunications services, focusing primarily on non-metropolitan markets in the Midwest. To achieve this goal, we intend to pursue the following strategies:
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Maintain Stable Cash Flows from Operations and Disciplined Capital Spending. We have a diverse residential and business customer base that produces a recurrent revenue stream and relatively predictable cash flows. We intend to maintain our financial performance by growing revenue and improving operating efficiency throughout our businesses. We make disciplined capital expenditure decisions, focusing on investments made for maintaining high quality service, cost structure improvement and cash flow generation.
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Leverage and Enhance Local Presence and Customer Loyalty. We have a strong commitment to local presence and customer relationships. We have created a community relations staff dedicated to maintaining relationships with local leaders and civic organizations. As a result of this and other initiatives, we believe our companies have developed brand identities as responsive, locally oriented service providers. We intend to use these identities to maintain our competitive market position, cross-sell additional services to our current subscribers and expand our existing customer base.
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Increase Revenue per Access Line by Selling Additional and Enhanced Services. We actively market long distance service, dial-up and DSL Internet access service, satellite and cable video service and enhanced local services (such as call waiting, caller ID and voice mail) to our local customers as bundled services billed on the same monthly statement the customer receives for basic local service.
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Prudent Expansion of Our Service Area Through our Competitive Local Exchange Carrier Subsidiaries. We intend to leverage our strong local presence, superior customer service and economies of scale to pursue customers in markets in close proximity to our rural local exchange carrier markets through our competitive local exchange carrier subsidiaries, ITC, IT Communications, Lakedale Link, Inc. and EN-TEL. We plan to continue this strategy by seeking growth opportunities on a low-cost, selective basis, focusing primarily on business customers.
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Grow Through Selective Strategic Acquisitions. We intend to continue pursuing a disciplined process of evaluating select acquisitions of access lines from Regional Bell Operating Companies and other rural local exchange carriers, as well as evaluating acquisitions of providers of businesses complementary to ours. Over the past several years, Regional Bell Operating Companies have divested a significant number of access lines nationwide and are expected to continue these divestitures in order to focus on larger markets. We also believe there may be attractive opportunities to acquire rural local exchange carriers, which we believe will likely consolidate as competitive pressures intensify. In Iowa and Minnesota, there are approximately 230 rural local exchange carriers serving a fragmented market representing approximately 580,000 access lines. One of our key acquisition criteria will be the potential of any proposed transaction to increase our free cash flow per share.
Products, Services and Revenue Sources
We provide wireline local exchange telecommunications services as the incumbent local exchange carrier to residential and business customers in 423 communities in Iowa, Minnesota and Missouri. Our wholly owned CLEC’s, ITC, IT Communications and Lakedale Link, Inc. are certified to provide service in all areas served by Qwest in Iowa and Minnesota and certain Embarq and Frontier exchanges in Minnesota. EN-TEL, our majority owned CLEC subsidiary, is a certified reseller in Qwest, Embarq and Frontier exchanges and a certified facility-based provider in certain Qwest exchanges in Minnesota. Approximately 70% of our access lines serve residential customers and 30% serve business customers. We generate revenues by providing our customers:
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local services, which include basic local telephone service and enhanced local services like voice mail, caller ID and call forwarding;
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network access services to interexchange carriers for the origination and termination of interstate and intrastate long distance phone calls on our network and special access services to carriers and others;
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toll (also known as long distance) services;
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data and Internet services, including dial-up and DSL Internet access service and other enhanced data services; and
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other services and sales, including the sale, installation and maintenance of customer premise voice and data equipment, satellite and cable video, inside line care and the leasing of office space.
We complement our basic local telephone services by actively marketing products under our local brands. We believe that our ability to cross-sell to our customer base in this way is bolstered by the fact that we are currently the sole local wireline telecommunications provider in approximately 67% of the communities we serve as the incumbent carrier. The following table shows our revenues and sales for each of the years ended December 31, 2006, 2007 and 2008, by category of service:
Local Services
Basic local services enable end user customers to make and receive telephone calls within a defined local calling area for a flat monthly fee. We also provide extended area service, a mandatory expanded calling service to select nearby communities charged at a flat monthly rate, which is also considered a basic monthly service.
In addition to subscribing to basic local telephone services, our customers may choose from a variety of enhanced or non-basic communications services which are also classified as local services. These include call waiting, call forwarding, caller ID, voice mail and three-way calling, and are billed on the customer’s monthly bill for basic local service. Offering such services to local customers through bundled service packages is an important part of our strategy to increase average revenue per subscriber.
Network Access Services
We bill access charges to other carriers for the use of our facilities to terminate or originate long distance calls on our network. These fees relate to interexchange long distance, or toll calls, that involve more than one company in the provision of the service. Network access charges compensate us for the services we provide to other carriers for completing toll calls for our customers.
The rates for our network access revenues are determined under two jurisdictions. We generate intrastate access revenues for providing either switched or special access services when a long distance call is placed or received by a customer in one of our exchanges to or from another party located within the same state. The toll carrier pays us an intrastate access charge, the level of which is regulated and approved by either the Iowa Utilities Board or the Minnesota Public Utilities Commission. We generate interstate access revenues for providing either switched or special access services when a long distance call is originated or terminated by a
customer calling from one state to a customer in another state and one of the parties is a local service customer of ours. We bill interstate access charges in the same manner as we bill intrastate access charges. Interstate access charges are regulated and approved by the FCC.
Additionally, we bill subscriber line charges (“SLC’s”) to substantially all of our end user customers for access to the public switched network. The monthly subscriber line charges are regulated and approved by the FCC.
We bill wireless and landline carriers for use of our transit services and for transport and termination services unrelated to intrastate or interstate access service. These charges are governed by interconnection agreements with the wireless or landline carriers.
Toll Services
We began offering toll, or long distance, services in July 2000 through sales to our established customer base. We have leveraged our customer relationships and single billing approach to increase our penetration for toll service with minimal need for additional capital expenditures. The following table shows our number of toll service subscribers:
(1) Penetration rate is computed by dividing the subscribers of our toll services by the total access lines served at the end of the period.
We market long distance service under our local brand names, but we provide service through resale arrangements we have with a variety of carriers. Long distance revenues are earned as our long distance customers place calls, with charges generally based on the length of the call and the applicable per-minute rate. Some customers pay a fixed minimum monthly charge for our long distance service independent of calls actually made. In order to offer attractively priced options to our customers, we often bundle long distance service with our local services, dial-up and DSL Internet access offerings.
Data and Internet Services
Data and Internet services consist largely of revenues generated by our dial-up and DSL Internet access services as well as for providing enhanced data solutions to customers. We began offering dial-up Internet access service in 2000, and DSL Internet access service in a few markets in late 2001. We currently have DSL equipment installed in all of our 294 incumbent exchanges. We estimate that we are capable of providing DSL Internet access service to over 80% of our access lines. Approximately 38% of our access line customers subscribe to our dial-up or DSL Internet service. The following table shows our number of dial-up and DSL Internet access service subscribers:
(1) Penetration rate is computed by dividing the total of our dial-up and DSL Internet access subscribers by the total access lines served at the end of the period.
Other Services and Sales
Other services and sales consists largely of revenues generated by the sale, installation and maintenance of the customer premise voice and data equipment, satellite and cable video, inside line care and leasing of office space. The following table shows our number of satellite and cable video subscribers:
(1) Penetration rate is computed by dividing the total of our video subscribers by the total residential access lines served at the end of the period.
Competitive Local Exchange Carrier Services
We currently provide competitive local exchange carrier services through our wholly-owned subsidiaries, ITC, IT Communications and Lakedale Link, Inc and our majority owned subsidiary EN-TEL. ITC, IT Communications and Lakedale Link, Inc. primarily provide services utilizing either an unbundled network element or resale platform on which we resell services to end customers. Our interest in EN-TEL was acquired as a part of the acquisition of Bishop Communications and is primarily a facilities-based provider. Our CLEC currently offers a broad range of traditional and enhanced wireline communications services to business and residential customers. Between ITC, IT Communications and Lakedale Link, Inc., our wholly owned CLEC subsidiaries are certified in all markets served by Qwest in Iowa and Minnesota and certain Embarq and Frontier markets in Minnesota. Our majority owned CLEC subsidiary, EN-TEL, is a certified reseller in Embarq, Frontier and Qwest exchanges and is a certified facility-based provider in certain Qwest exchanges in Minnesota. As of December 31, 2008, our CLEC Operations served approximately 17,000 business and 15,400 residential access lines and accounted for 13% of our total access lines. We view our competitive local exchange carrier business as a cost-effective way to leverage our corporate infrastructure and, in Iowa, our Iowa Telecom brand into markets in close proximity to those served by our incumbent local exchange carrier operations. Our primary strategy has been to target contiguous markets that historically have been underserved and subject to minimal competition. In these markets, we can compete cost effectively through our interconnection agreements with the incumbent provider, pursuant to which we may lease lines on a “wholesale” basis.
We have historically entered selected exchanges by utilizing a low-risk unbundled network element platform. This entry strategy permitted us to use the incumbent carrier’s existing loop and switches and thus required minimal upfront capital investment on our part. Although the FCC has revised the rules that govern the availability of the unbundled network element platform, we believe we can continue to profitably provide competitive local exchange services as a result of contractual arrangements entered into with the incumbent provider for switching services and leased lines. The majority of the customers served utilizing the unbundled network element platform are in exchanges in which Qwest is the incumbent local exchange carrier. Our current contracted monthly rates with Qwest, which include volume discounts and are effective until December 2009, range from $12.55 to $29.34 per line for residential customers and $15.91 to $38.04 per line for business customers. Our agreements with Qwest expire in 2011. We intend to consider installing owned communications equipment in these communities only after we have achieved sufficient scale and we believe such investment can be cost effective. The cost to expand our competitive local exchange carrier operations is predominantly comprised of variable expenses such as marketing and sales expenses, which allows us to more readily control the level of cash flow required to support expansion of this business and provides the opportunity to lower spending levels if necessary. In 2009, we plan to maintain this limited investment approach as we continue to grow our competitive local exchange carrier business, focusing primarily on business customers.
Sales and Marketing
We have established sales and marketing organizations that centralize marketing strategies and deploy sales and customer service resources locally. We have a dedicated sales force for business customers and have 21 local offices at which customers can contact us in person to address their needs.
We believe that customers in rural communities are concerned that historically they have had access to less sophisticated telecommunications products and services than consumers in urban locations. We believe these concerns have increased in recent years as advanced telecommunications services, such as readily available broadband Internet access, have come to be seen as essential to economic growth. We believe that residential and business end-users will be more likely to increase the use of our products and services if we are perceived as a locally managed provider, committed to delivering advanced telecommunications services to the communities we serve.
To address our customers’ needs, we have established in-state support operations, including 21 customer offices and three customer contact centers. These customer offices and contact centers provide us with a significant degree of customer contact, thereby affording us an opportunity to offer and sell additional and enhanced services to our subscribers. In addition, we have created a community relations department whose purpose is to maintain an ongoing relationship with community leaders and organizations throughout our service area, with a view to continue developing our brand identities as responsive, locally-oriented providers. We believe this reputation also enhances our potential to cross-sell additional services to our existing subscriber base.
We also offer local telephone services in bundled packages including long distance, enhanced local services, dial-up and DSL Internet access services, satellite and cable video services. We believe bundled services are popular with customers because they permit the purchase of a number of services at a discount to the pricing that would be available on an individual service basis. We intend to continue to expand this marketing strategy, which we expect will increase average revenue per access line. We also believe that integrated packages of quality services result in a more loyal and satisfied customer base, thereby reducing subscriber turnover.
Competition
Local Service. We currently face competition from other providers of local services in approximately 138 of the 423 communities our incumbent local exchange carriers serve. Of these 138 communities, we believe 109 communities have some voice service offered by Mediacom’s telephony affiliates, MCC Telephony of Iowa, Inc. and MCC Telephony of Minnesota, LLC. (“MCC”), which initiated service in most of these markets during the second quarter of 2007. Additionally, we believe that in approximately 40 of these communities, independent local exchange carriers operating in mostly adjacent exchanges and municipal utilities have constructed networks to provide competitive local exchange carrier services to customers in our exchanges.
MCC is offering voice services through a business arrangement with Sprint Communications L.P. (“Sprint”). On June 23, 2006, we filed a complaint against the Iowa Utilities Board and Sprint in the U.S. District Court for the Southern District of Iowa asking the court to rule that the Iowa Utilities Board acted unlawfully when it required us to enter into an interconnection agreement with Sprint and asking the court to invalidate the agreement. On April 15, 2008, the court issued a ruling in favor of the Iowa Utilities Board and Sprint, therefore maintaining the status quo in which we are obligated to enter into an interconnection agreement with Sprint. We appealed this decision to the U.S. Court of Appeals for the Eighth Circuit on May 14, 2008, and oral argument was held on December 12, 2008. We cannot predict how or when this litigation will be resolved.
Notwithstanding the period in which our complaint was under consideration, we have negotiated, mediated and litigated with Sprint and, at times, with MCC to resolve issues relating to interpretation and implementation of the interconnection agreement. On January 22, 2007, we filed a second complaint against the Iowa Utilities Board and Sprint in U.S. District Court asking the court to rule that the Iowa Utilities Board acted unlawfully
when it interpreted the interconnection agreement to require Iowa Telecom to provide certain services to Sprint, particularly in the manner requested by Sprint. Briefing on this complaint concluded on August 11, 2008. We cannot predict how or when this litigation will be resolved.
In addition to the disputes pending in federal district court and before the Iowa Utilities Board, we are also defending a complaint filed by MCC on July 31, 2006, in the Iowa District Court for Polk County alleging that our refusal to accede to Sprint’s negotiation demands improperly interfered with MCC’s contracts and prospective customer relationships. The state court complaint seeks unspecified damages and costs and additional relief as warranted. This state court proceeding had been stayed pending the result of our first federal complaint. On September 9, 2008, the state court refused to lift the stay due to the pending appeal of the federal district court’s decision on the first complaint to the Eighth Circuit. This stay will remain effective until the Eighth Circuit rules, subject to reconsideration by the state court if the Eighth Circuit has not ruled by March 9, 2009. We cannot predict how long this stay will last nor how this state court litigation will be resolved.
Wireless and Emerging Technology Competition. We estimate that wireless service providers served approximately 5.9 million subscribers in Iowa and Minnesota, as of June 2007, based on the most recent FCC data available. We expect that wireless providers will continue to provide services that compete with ours. Technological developments in cellular telephone features, personal communications services, telephone services over cable television systems, satellite, voice over Internet protocol, high-speed fiber optic networks and other technologies will continue to provide our customers with alternatives to the traditional local telephone services we provide.
Iowa Communications Network. The Iowa Communications Network is a state-owned communications network consisting of more than 3,000 miles of fiber optic cable extending into all 99 Iowa counties and capable of providing a variety of voice, data and video communications services. The Iowa Communications Network currently provides certain voice, data and video communications services to authorized educational and governmental institutions, including accredited public and private schools and colleges, public libraries, state and federal agencies, the United States Post Office and to authorized hospitals and physician clinics. Current state law does not allow the Iowa Communications Network to provide its services to other public or private entities, and prohibits the sale, lease or other disposition of the Iowa Communications Network without prior authorization of a majority of each house of the Iowa legislature and approval by the governor. The Iowa legislature has previously considered modifying state law to allow for sale of the Iowa Communications Network to a private party but has not done so.
Our Competitive Local Exchange Carrier Subsidiaries. We have four competitive local exchange carrier subsidiaries-ITC, IT Communications, Lakedale Link, Inc. and EN-TEL. Our wholly owned CLEC subsidiaries, ITC, ITC Communications and Lakedale Link, Inc., are authorized to provide services in all of Qwest’s Iowa and Minnesota exchanges as well as certain Embarq and Frontier exchanges in Minnesota, and generally offer the same local exchange services as those offered by the local incumbent provider. Our wholly owned CLEC subsidiaries also provide DSL Internet access service in all exchanges in which they operate, using either Qwest’s, Embarq’s or Frontier’s wholesale service or owned facilities. Our majority owned CLEC subsidiary, EN-TEL, is an authorized reseller in Embarq, Frontier and Qwest exchanges in Minnesota, and generally offers the same local exchange services as those offered by the local incumbent provider. EN-TEL is also an authorized facility based provider in certain Qwest exchanges and offers cable video and high-speed broadband services in these exchanges.
Long Distance. We face significant competition in the long distance market. AT&T, Sprint and Verizon Business currently are the other major long distance providers in our service territory. We believe that wireless service also competes with the traditional wireline long distance service that we provide. Although the long distance market is competitive, we believe we are in a good position relative to our competitors given our local presence, strong brand and ability to offer both long distance and local services in a single bill. Approximately 60% of our local access lines also subscribe to one of our long distance services.
Dial-up and DSL Internet Access. In many markets we face competition from other dial-up and broadband Internet access service providers. Many dial-up competitors are neighboring incumbent local exchange carriers, small proprietors with service in only a few communities or, in some circumstances, near larger Midwest communities, national providers such as America Online and the Microsoft Network. In some of our markets, broadband competition exists from cable television providers (principally Mediacom), wireless broadband providers using non-licensed spectrum and competitive local exchange carriers that either have their own facilities or have collocated DSL equipment in our central offices. We believe our ability to sell dial-up or broadband services on a bundled basis with local and long distance service enhances our competitive position for continued growth in sales of Internet access service.
Customers
Our incumbent local exchange carriers currently operate 294 local telephone exchanges in 423 rural communities. Our business is largely concentrated in the eastern and southern portions of Iowa and the central portion of Minnesota. According to the 2000 U.S. Census, our service area includes four communities with a population over 9,000; ten communities with a population between 5,001 and 9,000; 27 communities with a population between 2,000 and 5,000; and 382 communities with a population under 2,000. The largest five communities in our service area are (2000 population figures in parentheses): Newton, Iowa (15,579); Pella, Iowa (9,832); Fairfield, Iowa (9,509); Grinnell, Iowa (9,105); and Mount Pleasant, Iowa (8,751). These five communities represent approximately 11% of the access lines we serve.
Approximately 74% of our incumbent local exchange carrier access lines serve residential customers. We also provide services to several large businesses in our service area including, Pella Corporation and Vermeer Manufacturing Company, both headquartered in Pella, Iowa. In addition, Grinnell and Pella are each home to four-year colleges, namely Grinnell College and Central College. No single local service customer represented more than 5% of our revenues from 2006 to 2008.
As a competitive local exchange carrier, we are authorized to provide services in all Iowa and Minnesota local telephone exchanges served by Qwest, and to certain Embarq and Frontier telephone exchanges in Minnesota. Our majority owned CLEC subsidiary, EN-TEL, is an authorized reseller in Embarq, Frontier and Qwest Minnesota exchanges and is an authorized facility based provider in certain Qwest exchanges. Approximately 52% of the access lines in our competitive local exchange carrier markets serve business customers and approximately 48% serve residential customers.
Network access charges historically have been one of our largest sources of revenues. During 2006, the Company had one carrier customer that represented approximately 11% of total revenue and sales. During 2007 and 2008, the Company did not have an access carrier customer that represented more than 10% of total revenue and sales.
Network Facilities
All of our exchanges in which we are the incumbent local exchange carrier are served by digital switches that we own and are capable of providing one-plus equal access for long distance service. The switches are linked through a combination of aerial, underground and buried cable, including approximately 3,700 miles of fiber optic cable. Most of our primary network routes utilize fiber optic cable. The majority of our switches in Iowa were manufactured by Nortel Networks. Our network operations and monitoring services for our Iowa properties are provided on a contract basis by a third party, which also provides those services for its own network and for other local exchange carriers in Iowa. Our switches in Minnesota were manufactured by various entities. Our network operations and monitoring services for our Minnesota properties are provided by company personnel. Automated alarm systems are in place to alert us to problems with our facilities, and our own technicians are available to make any necessary repairs to the network.
The network facility upgrades we have completed in recent years include the following:
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We have deployed DSL Internet access service to all of our exchanges. Over 80% of our access lines are now DSL eligible.
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We have built a data network to support our dial-up and DSL Internet access services customers.
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We have reduced the number of access lines utilizing analog carrier technology to less than 1% of total access lines. Analog carrier lines are not fully compatible with advanced telephone services such as high-speed Internet.
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We have deployed voice-mail services to additional exchanges and are now able to offer voice-mail services to all exchanges.
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We have entered into a long-term lease to acquire fiber transport facilities between Chicago and Omaha, utilizing facilities which cross the state of Iowa. This network was put in to service in the second quarter of 2008.
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Existing fiber network routes have received upgrades to the electronics that provide greater redundancy and traffic capacity.
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Additional backup generator capacity has been added within our network to enhance our ability to provide a stable network in the event of commercial power interruptions.
Employees
We employ approximately 720 full-time employees, of which 629 are based in Iowa. We have a collective bargaining agreement with the Communications Workers of America, or CWA, which covers 176 of our employees and expires in May 2012. We also have a collective bargaining agreement with the International Brotherhood of Electrical Workers, or IBEW, which covers 22 of our employees and expires in June 2009. There have been no work stoppages or strikes by our IBEW or CWA employees in the past 8 years, and we consider our labor relations to be good.
Intellectual Property
We believe we have the trademarks, trade names and licenses that are necessary for the operation of our business. The Iowa Telecom logo is a registered trademark in the United States. We do not consider our trademarks, trade names or licenses to be material to the operation of our business.
Regulation
The following summary does not describe all present and proposed federal, state and local legislation and regulations affecting us or the telecommunications industry. Some laws and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proceedings that could change the manner in which our company or our industry operates. We cannot predict the outcome of any of these developments or their potential impact on us. Regulation can change rapidly in the telecommunications industry, and such changes may adversely affect us in the future. Our business is subject to extensive regulation that could change in a manner adverse to us.
Overview
We are subject to federal, state and local government regulation. We hold various authorizations for our service offerings. At the federal level, the FCC has jurisdiction over common carriers, such as us, to the extent that their facilities are used to originate, terminate or provide interstate and international telecommunications services. The Iowa Utilities Board and the Minnesota Public Utilities Commission exercise jurisdiction over our
intrastate telecommunications services within Iowa and Minnesota, respectively. The Missouri Public Service Commission exercises similar jurisdiction over the intrastate telecommunications services we provide to a small number of customers in Missouri. In addition, under the Telecommunications Act of 1996, or “the Telecom Act,” federal and state regulators share responsibility for regulating such matters as interconnection between carriers. Municipalities and other local government agencies regulate certain aspects of our business, such as our use of public rights-of-way, and by requiring that we obtain construction permits and comply with building codes.
The following description discusses some of the major telecommunications related regulations that affect us, but numerous other substantive areas of regulation not discussed here may influence our business. When we refer to “our incumbent local exchange carrier,” we mean Iowa Telecommunications Services, Inc., and when we refer to “our independent incumbent local exchange carriers,” we mean our incumbent local exchange carrier operations other than those of Iowa Telecommunications Services, Inc. such as Lakedale Telephone Company and Montezuma Mutual Telephone Company which are subsidiaries of Iowa Telecommunication Services Inc. When we refer to “our competitive local exchange carriers,” we mean our Iowa Telecom Communications, Inc., IT Communications, LLC, Lakedale Link, Inc. and subsidiaries as well as our interest in EN-TEL Communications, LLC.
Federal Regulation
We are subject to, and must comply with, the federal Communications Act of 1934, as amended by, among other things, the Telecom Act (the “Communications Act”). Under the Communications Act, we must obtain FCC approval before we transfer control of our company, assign, acquire, or transfer licenses or authorizations issued by the FCC or before we discontinue our interstate service in any area.
Access Charges. The FCC regulates the prices that incumbent local exchange carriers charge for the use of their local networks in originating or terminating interstate and international transmissions. State regulatory commissions, such as the Iowa Utilities Board, regulate prices for access provided in connection with the origination and termination of intrastate transmissions. The prices that we and other incumbent local exchange carriers charge for use of local telephone networks to complete interexchange calls-access services-are called “access charges.”
We provide two types of access services: special access and switched access. The rates for special access, which is provided via dedicated circuits connecting long distance carriers, other carriers and certain end users to our network, are structured as flat-rate monthly charges. Rates for switched access are structured as a combination of flat-rate monthly charges, which are paid by end users, and per-minute traffic sensitive charges, which are paid by long distance carriers. A significant amount of our revenues come from access charges derived from intrastate, interstate and international transmissions.
Since 1991, the FCC has administered a system of price cap regulation for interstate access charges applicable to the largest incumbent local exchange carriers, as well as for any other, smaller incumbent local exchange carriers that choose to be subject to price cap regulation. Our incumbent local exchange carrier has operated under the price cap regime since July 2000 as a result of our acquiring GTE Midwest Incorporated’s Iowa exchanges and succeeding to GTE’s obligations to price its access charges in accordance with price cap regulation. We believe our incumbent local exchange carrier is the smallest carrier in the nation operating under the FCC’s price cap rules.
Since July 1, 2000, our incumbent local exchange carrier’s interstate access charges have been established in accordance with an order adopted by the FCC in response to a proposal put forth by members of The Coalition for Affordable Local and Long Distance Service (“CALLS Order”). The CALLS Order reformed access charge regulation for carriers subject to price caps. It implemented a system for reducing per-minute traffic sensitive rates for switched access services to specific target levels that the FCC believed more closely approximated the cost of providing those services. We met the target rates for switched access in our access charge filings made
with the FCC in July 2001. In September 2003, the FCC permitted our incumbent local exchange carrier to increase our rates for switched access to more closely reflect our forward-looking economic costs.
The CALLS Order also permitted us to recover a greater proportion of our local costs by increasing the subscriber line charge levied on end users. In June 2002, the FCC adopted an order that permitted all price cap-regulated carriers, including us, to increase subscriber line charges to their current levels.
Our incumbent local exchange carrier files tariffs for its interstate access charges with the FCC annually. Our 2008 filing became effective on June 30, 2008, without objection.
In addition to the access charge system, our incumbent local exchange carrier also is subject to the requirements of the Communications Act and the FCC that impose on local telecommunications carriers a duty to establish reciprocal compensation arrangements for the transport and termination of non-toll telecommunications between telecommunications carriers. See “Interconnection with Local Telephone Companies and Access to Other Facilities.” Under these rules, the calling party’s carrier must compensate the called party’s carrier for costs associated with transporting and terminating the call. At present, we only charge interconnecting wireless carriers for the transport and termination of calls bound for our network because Iowa Utilities Board rules impose a “bill-and-keep” regime for local traffic transport and termination when exchanged traffic is at least roughly balanced, as is the case for exchanged wireline traffic.
Our competitive local exchange carriers also charge for interstate access in accordance with FCC requirements. These rules allow ITC and EN-TEL to set their rates at the current National Exchange Carrier Association rates for switched access. IT Communications, by the nature of the larger markets it serves, is required to mirror the interstate access rates of the ILEC with which it competes (Qwest). Lakedale Link, Inc., through its use of total service resale, does not assess access charges.
In April 2001, the FCC released a Notice of Proposed Rulemaking to determine whether to adopt a unified regime that would apply to all of these intercarrier compensation arrangements; such a regime could be a successor to the five-year transitional access charge system established by the CALLS Order, as well as the rules applicable to non-price-cap ILECs (such as our independent incumbent local exchange carriers-see Regulation of Our Independent Incumbent Local Exchange Carriers) and by competitive local exchange carriers (such as ITC, IT Communications, Lakedale Link, Inc. and EN-TEL).
Intercarrier compensation reform, and, to a lesser degree, universal service reform, were intensely debated at the FCC during the third and fourth quarters of 2008. Most proposals entailed reducing intrastate access rates to interstate levels over a period of years with some sort of funding mechanism to meet a substantial amount of the revenue shortfall created by such a reduction. Some proposals also included reform of universal service distribution that could lead to our ILEC becoming eligible for high-cost funding. We cannot predict when the FCC will take global action to reform intercarrier compensation and universal service or how the FCC may do so. There is also a potential for Congress to legislate in such areas, the likelihood, timing, and nature of which we cannot predict.
The Telecommunications Act of 1996. The Telecom Act changed the regulatory and competitive landscape in which we operate. The most important of these changes were: removing most legal barriers to market entry into local telephone services; requiring that incumbent local exchange carriers, such as our incumbent local exchange carrier, interconnect with competitors and offer unbundled network elements; establishing procedures for the Regional Bell Operating Companies to provide long distance services within their home regions; and creating greater opportunities for competitive providers, such as our competitive local exchange carriers, to compete with other incumbent local exchange carriers. These changes are discussed below:
Removal of Entry Barriers. Following the passage of the Telecom Act, the level of competition in the local markets served by our incumbent local exchange carrier has increased and is expected to increase. See
“Business-Competition.” The requirements of the Telecom Act also effectively remove or prevent legal barriers to market entry, and thereby permit our competitive local exchange carriers to provide competitive local exchange service in areas in which we are not the incumbent provider.
Interconnection with Local Telephone Companies and Access to Other Facilities. The Telecom Act imposes several requirements on all local exchange carriers, including competitive local exchange carriers, with additional requirements imposed on incumbent local exchange carriers. These requirements are intended to promote competition in the local exchange market by, in part, ensuring that a carrier seeking interconnection will have access to the interconnecting carrier’s network functionalities under reasonable rates, terms and conditions.
All local exchange carriers, including both our incumbent local exchange carrier and our competitive local exchange carriers, must comply with the following requirements:
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Resale. Local exchange carriers generally may not prohibit or place unreasonable restrictions on the resale of their local services at retail rates.
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Telephone Number Portability. Local exchange carriers must provide for telephone number portability, allowing a customer to keep the same telephone number even when switching service providers.
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Dialing Parity. Local exchange carriers must provide dialing parity, which allows customers to route their calls to another local service provider without having to dial special access codes.
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Access to Rights-of-Way. Local exchange carriers must provide access to their poles, ducts, conduits and rights-of-way on a reasonable, nondiscriminatory basis.
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Reciprocal Compensation. Each local exchange carrier on whose network a call originates must reasonably compensate each telecommunications carrier on whose network the call terminates.
Under the Telecom Act, all incumbent local exchange carriers, including our incumbent local exchange carrier, but excluding certain exempt “rural telephone companies,” must comply with the following additional requirements:
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Duty to Negotiate. Negotiate in good faith with any carrier requesting interconnection.
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Interconnection. Provide interconnection for the transmission and routing of telecommunications at any technically feasible point in the network, equal to interconnection provided to an affiliate or other party, and on just, reasonable and nondiscriminatory rates, terms and conditions.
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Unbundling of Network Elements. Provide nondiscriminatory access to unbundled network elements or combinations of unbundled network elements at cost-based rates.
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Resale. Offer its retail local telephone services to resellers at a wholesale rate that is less than the retail rate charged to end users.
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Notice of Changes. Provide notice of changes in information needed for another carrier to transmit and route services using the incumbent local exchange carrier’s facilities.
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Collocation. Provide physical collocation, which allows competitive local exchange carriers to install and maintain their own network termination equipment in incumbent local exchange carriers’ central offices, or to obtain functionally equivalent forms of interconnection.
Our incumbent local exchange carrier is a “rural telephone company,” as defined by the Communications Act. In 1997, however, the Iowa Utilities Board removed the rural telephone company exemption applicable to what were then GTE Midwest Incorporated’s Iowa exchanges, which we later acquired. As a result, this exemption does not apply to Iowa Telecommunications Services, Inc., our incumbent local exchange carrier.
The Telecom Act affords small local exchange carriers (those with less than two percent of the nation’s access lines) the opportunity to petition the state regulatory agency for suspension or modification of any of the
requirements imposed on local exchange carriers. In March 2004, we filed with the Iowa Utilities Board a request for permission to delay implementation of thousand block number pooling in certain switch locations. On September 17, 2004, the Iowa Utilities Board extended the deadline for Iowa Telecom to complete its implementation of thousand block number pooling to May 2008, which we met. We believe we are otherwise in compliance with all other interconnection requirements of the Telecom Act.
As of December 31, 2008, our incumbent local exchange carrier and our independent incumbent local exchange carriers had interconnection agreements with 42 of the competitive local exchange carriers authorized to offer local service in our service area, and 17 active interconnection agreements in force with wireless carriers. We are currently negotiating one additional interconnection agreement with a wireless carrier. We are currently negotiating one additional interconnection agreement with a CLEC. Thirty-nine CLEC agreements and ten wireless agreements are with firms operating in Iowa. The remainder operate in Minnesota.
Unbundling of Network Elements. To implement the interconnection requirements of the Telecom Act, incumbent local exchange carriers, including our incumbent local exchange carrier (See Regulation of our Independent Incumbent Local Exchange Carriers for discussion of Lakedale and Montezuma Telephone), are required to provide unbundled network elements to competitors based on forward-looking economic costs, using the total element long-run incremental cost, or TELRIC, methodology. Our incumbent local exchange carrier is in compliance with these requirements and is meeting its obligations to unbundle its network. Our competitive local exchange carriers entered some local markets where Qwest is the incumbent local exchange carrier by initially obtaining a combination of unbundled network elements, including unbundled switching and local loops (known as the unbundled network platform), from Qwest.
Under the FCC’s current unbundled network element rules, which became effective March 11, 2005, an incumbent local exchange carrier’s obligation to provide access to high capacity loops and dark fiber is eliminated immediately, and the obligation to provide access to unbundled switching and, by implication, to the unbundled network element platform was phased-out. The new rules, however, continue to impose an obligation to provide unbundled access to DS-1 loops and certain forms of dedicated transport, although carriers may seek exemption from such obligations in particular geographic areas based on the presence of competition, relief that Qwest is currently seeking before the Iowa Utilities Board.
In light of the phase-out of incumbent local exchange carrier obligations to provide access to the unbundled network element platform, we entered into arrangements with Qwest in which our Iowa CLECs have continuing access to equivalent Qwest products for current and new customers regardless of future FCC or judicial action regarding the availability of unbundled network elements. However, the rates we must pay under the agreements are somewhat higher than before we entered into the agreements. The agreements with Qwest expire in 2011.
The FCC may, in the future, reconsider various aspects of its local competition rules, such as rules for seeking exemption from certain unbundling requirements, the manner in which UNEs are priced, and the rate for terminating local interconnected traffic, such as certain wireless traffic. Congress may consider legislation that would affect local competition and these rules. We cannot predict the outcome of any of these proceedings, or of any action or decision taken by the FCC, the Iowa Utilities Board, Minnesota Public Utilities Commission, any legislative body or court concerning the rules regarding local competition, and how any changes would affect either our incumbent local exchange carrier, our independent incumbent local exchange carrier or our competitive local exchange carriers.
Bell Operating Company Entry into Long Distance Services. Qwest is our competitive local exchange carriers’ principal competitor in regions in which Qwest is the incumbent local exchange carrier. Pursuant to provisions of the Telecom Act, in December 2002, the FCC authorized Qwest to provide in-region long distance services, a line of business from which Qwest was previously prohibited from entering. Now that Qwest, a Regional Bell Operating Company, is authorized to provide long distance services, it competes more directly with providers of integrated communications services, such as our competitive local exchange carriers.
Regulation of Interstate and International Services. The Communications Act requires that we offer interstate and international common carrier services at just and reasonable rates and on terms and conditions that
are not unreasonably discriminatory. In general, our interstate and international long distance services are not subject to rate regulation but are subject to the FCC’s complaint procedures. Pursuant to the FCC’s rules, we disclose the terms and conditions of our long distance services on our web site.
Universal Service. Pursuant to federal statute, the FCC maintains a “universal service” program, to ensure that affordable, quality telecommunications services are available to all Americans. The program at the federal level has several components, including one that pays support to “high cost” areas, including certain areas served by rural local exchange carriers for which the costs of providing basic telephone service are significantly higher than the national average. The Telecom Act altered the framework for providing and funding universal service by:
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requiring the FCC to make implicit subsidies explicit;
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expanding the types of telecommunications carriers that are required to pay universal service; support; and
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allowing telecommunications carriers to apply to state regulators for, and be eligible for, universal service support, including where they serve customers formerly served by an incumbent local exchange carrier.
These and other provisions were intended to make the provision of and contributions to universal service compatible with a competitive market.
Universal service funds are only available to carriers designated as eligible telecommunications carriers by the state regulatory commission. Although our incumbent local exchange carrier is certified as an eligible communications carrier by the Iowa Utilities Board with respect to the exchanges that we operate, under current FCC rules it is not eligible to receive any high-cost support because the historical cost of relevant portions of our network, largely based on the recorded amounts that transferred with our acquisition of exchanges from GTE Midwest Incorporated, are lower than the national average. Under the FCC’s rules, support for rural carriers, such as our incumbent local exchange carrier, is only available to carriers with historical loop costs above the national average.
On May 8, 2006, the Company filed with the FCC forbearance and waiver petitions asking it to allow the Company to become eligible to qualify for high-cost support from the non-rural high cost support program of the Universal Service Fund. On August 6, 2007, the FCC issued an order denying our petition for forbearance. The FCC has not yet ruled on our petition for waiver and there is no statutory deadline for issuing a ruling. We cannot predict whether the FCC will deny or approve the waiver petition, and the amount, if any, of high cost support funds that we may receive in the future. Furthermore, because our use of any high cost support program funds that we may receive as a result of our waiver petition would be limited to the provision, maintenance, and upgrading of facilities and services for which the support is intended, we cannot predict the extent to which receipt of such funds would affect our liquidity or earnings.
The CALLS Order also provided for a phase-out of implicit universal service support mechanisms (which had, in part, relied on setting rates for interstate access above cost), to be replaced with more explicit subsidy mechanisms. The CALLS Order created an Interstate Access Support fund as part of the Universal Service Fund to accomplish this objective. For 2008, our incumbent local exchange carrier received approximately $5.2 million in universal service support from this portion of the fund. Because of the substantially different origin and basis for Interstate Access Support, we do not include such support when discussing high-cost universal service support, despite the fact that Interstate Access Support is part of such program.
Our Iowa competitive local exchange carriers are certified to offer service in all Iowa exchanges served by Qwest and have been certified as eligible telecommunications carriers in all such areas by the Iowa Utilities Board. ITC receives no high-cost or Interstate Access Support for the Qwest markets it has entered because Qwest currently receives no high cost support and only nominal Interstate Switched Access Support for the exchanges served by ITC. Qwest receives no high cost support and no Interstate Switched Access Support for the exchanges served by IT Communications, and therefore IT Communications receives no universal service support. Neither Lakedale Link, Inc. nor EN-TEL operate as eligible telecommunications carriers.
Our incumbent local exchange carrier, independent incumbent local exchange carriers and competitive local exchange carriers are required to make contributions to the federal universal service program based on methodologies and procedures established by the FCC. Contributions to the federal universal service fund are based on revenues from interstate and international services. In accordance with FCC rules, we recover our contributions from our customers through a surcharge on interstate and international revenues. The surcharge is adjusted each quarter and, in the first quarter of 2009, decreased to below 10% of interstate and international revenues for the first time in two years. In 2008, our incumbent local exchange carrier and competitive local exchange carriers collected and contributed to the universal service fund approximately $2.4 million and $231,000, respectively.
As of October 1, 2004, the Universal Service Administrative Company (“USAC”) has been subject to the federal Anti-Deficiency Act (“ADA”), the effect of which could have caused delays in payments to Universal Service Fund (“USF”) program recipients from high-cost programs, including Interstate Access Support (to our incumbent local exchange carrier), Interstate Common Line Support (to our independent incumbent local exchange carriers), Local Switching Support (to Lakedale Telephone and Montezuma Telephone) and High-Cost Loop Support (to Montezuma Telephone), as well as significantly increased the amount of USF regulatory fees charged to consumers. In April 2005, the FCC tentatively concluded that the high-cost and low-income universal service programs of the Universal Service Fund were compliant with ADA requirements, and asked the Office of Management and Budget (“OMB”) to make a final determination on this issue, which has not yet occurred. In September 2008, Congress passed legislation to exempt the USF from ADA requirements until March 6, 2009. We cannot predict whether and for how long USF payments might be delayed or suspended or how actions to address this problem may affect us.
In 2000, the FCC implemented new rules requiring the high-cost universal service support received by non-rural telephone companies to be based on forward-looking costs. In May 2001, the FCC adopted a proposal from the Rural Task Force to reform universal service support for rural areas. Although the rules adopted in response to the Rural Task Force proposal were to expire July 1, 2006, no replacement rules have been established, leaving the current regime temporarily in place. Under the currently-effective rules, eligible rural carriers continue to receive support based on a modified embedded cost mechanism.
The FCC continues to consider various proposals for changing the manner in which universal service funds are distributed, some in the context of intercarrier compensation reform and some independently. The FCC also continues to consider the extent to which its universal service programs should be more targeted at broadband deployment. The FCC has a variety of proposals before it on which it could act and others on which it may seek comment. We cannot predict if, when, or how the FCC will change its non-rural or rural universal service programs, which may include combining such programs. Congressional action in this area is also a possibility. We cannot predict if, when, or how Congress may change the universal service program.
Internet. We provide Internet access services as an Internet service provider (“ISP”). Historically, the FCC has regulated wireline carrier provision of broadband Internet service as comprising two components-a “telecommunications” component representing the transmission function that is subject to common carrier regulation, including contributing to the Universal Service Fund, and an “information service” component, which is not regulated (either with respect to price or the terms and conditions of service). The FCC concluded in an order effective November 16, 2005, that wireline carrier provision of broadband Internet access service comprises only “information service” and does not include a regulated telecommunications component. Therefore, pursuant to a regulatory election by our incumbent local exchange carrier, effective November 16, 2005, all portions of our DSL service are now deregulated and detariffed, which provides us with enhanced pricing flexibility. We cannot predict the outcome or the effect of FCC or judicial decisions on our ISP, our incumbent local exchange carrier or competitive local exchange carrier businesses. Our ISP business is, and may become, subject to a variety of other legal requirements relating to privacy, copyrights, the conveyance of obscenity, indecent speech, unsolicited electronic messages and taxation.
In February 2004, the FCC determined that a particular type of entirely Internet-based voice over Internet protocol service also is an information service and exempt from such regulatory obligations, and in November 2004, determined that another, more widely used, version of voice over Internet protocol service is an interstate service, and therefore, outside the jurisdiction of state telecommunications regulations. Certain aspects of the FCC’s determination have been challenged in judicial proceedings. The FCC is currently considering the regulatory status of a variety of voice over Internet protocol service configurations in the context of a comprehensive proceeding launched in February 2004, as well as in several other application and issue-specific proceedings. These proceedings concern, among other things, what, if any, intercarrier compensation must be paid by providers of such service and what, if any, universal service contributions must be made by such providers. We cannot predict the outcome of these proceedings or the effect of FCC or judicial decisions on any of our ISP, incumbent local exchange carrier or competitive local exchange carrier businesses.
Customer Information. Companies such as our incumbent local exchange carrier and competitive local exchange carriers are subject to statutory and regulatory limitations on the use of customer information we acquire by virtue of providing telecommunications services, including information related to the quantity, technical configuration, type, destination and amount of a customer’s use of services. Under these rules, we may not use such information acquired through one of our service offerings to market other service offerings without the approval of the affected customers. New FCC rules requiring carriers to take additional measures to protect customer data became effective on December 6, 2007. We believe that we are in compliance with these obligations, which may affect our incumbent local exchange carrier’s ability to market some services to our customers.
Communications Assistance for Law Enforcement Act. Under the Communications Assistance for Law Enforcement Act (“CALEA”) and related federal statutes, we are required to provide law enforcement officials with call content and call identifying information under a valid electronic surveillance warrant and to reserve a sufficient number of circuits for use by law enforcement officials in executing court-authorized electronic surveillance. We believe we are in compliance with the laws and regulations, including those relating to broadband service with which we have been required to comply since May 14, 2007. We cannot predict whether and when the FCC might modify such regulations or any other rules, or what compliance with new rules might cost.
Preferred Carrier Selection Changes. A customer may change his or her preferred long distance carrier at any time, but the FCC, Iowa Utilities Board and Minnesota Public Utilities Commission regulate this process and require that specific procedures be followed. The FCC, Iowa Utilities Board and Minnesota Public Utilities Commission have levied substantial fines for unauthorized changes and have recently increased the penalties for such conduct. We believe we are in compliance with the required processes and procedures, and no such fines have been assessed against us.
Service Outage Reporting. On August 4, 2004, the FCC adopted rules requiring certain telecommunications carriers to begin reporting additional information to the FCC in the event of selected service outages and related events affecting some fiber rings. On December 20, 2004, the FCC stayed the rules’ effectiveness pending agency reconsideration of their merits, in part due to concerns about the substantial expenditures required of telecommunications carriers in order to comply with the new reporting obligations. At this time, we cannot predict the consequences of the FCC’s reconsideration or the financial or operational impacts any final rules may have on us.
Emergency Back-up Power. In response to the Independent Panel Reviewing the Impact of Hurricane Katrina on Communications Networks, the FCC adopted rules on May 31, 2007, requiring incumbent local exchange carriers, competitive local exchange carriers and wireless carriers to, among other things, maintain emergency back-up power for a minimum of eight hours for cell sites, remote switches and digital loop carrier system remote terminals that normally are powered from local AC commercial power. Five days prior to the new rules taking effect, the FCC on October 4, 2007, released an order amending some of these new requirements to
provide greater compliance flexibility. After having its back-up power reporting requirements rejected by the Office of Management and Budget, effectively staying the FCC’s rules, the FCC has indicated that it will conduct a proceeding in 2009 to reconsider its not-yet-effective rules so as to provide greater flexibility.
Regulation of Our Independent Incumbent Local Exchange Carriers. Our independent incumbent local exchange carriers, Lakedale Telephone and Montezuma Telephone, which for regulatory purposes are treated as independent of our incumbent local exchange carrier, are generally subject to the same federal regulation as our incumbent local exchange carrier, with certain exceptions. First, their interstate access charges are subject to historical investment-based regulation applicable to non-price-cap carriers, that is, rate-of-return regulation. Montezuma Telephone, in particular, falls into the category of non-price-cap carriers known as “average schedule” companies, whose historic costs are simulated through formulae, individual company data and pooled data from companies nationwide. Lakedale Telephone, on the other hand, is known as a “cost” company, whose historic costs are based on actual accounting figures. Second, Montezuma Telephone, but not Lakedale Telephone, continues to maintain the rural exemption from certain interconnection obligations. Third, because, as a general matter, rate-of-return carriers have been unable to remove the assets and expenses attributable to DSL transmission from their rate bases, our independent incumbent local exchange carriers, like most other rate-of-return carriers, continue to offer DSL transmission on a regulated common carrier basis.
Lakedale Telephone (through its affiliates) and Montezuma Telephone provide commercial mobile radio service in their incumbent local exchange carrier service territories and are subject to provisions of the Communications Act and FCC concerning wireless carriers. Lakedale Telephone provides service through a resale agreement. Montezuma, through a management agreement with Iowa Wireless Services, LLC (“Iowa Wireless”), provides mobile wireless service in its incumbent local exchange carrier service territory. Lakedale Telephone (either directly or through its affiliates) and Montezuma Telephone also provide television service in all of their incumbent local exchange carrier service territories. EN-TEL also provides television service in its CLEC territory. Neither Lakedale Telephone, EN-TEL or Montezuma Telephone’s mobile wireless nor television service are subject to federal rate regulation.
Just as we are unable to predict the outcome of pending and potential proceedings affecting the federal regulation of our incumbent local exchange carrier, we are unable to predict the outcome of such proceedings, such as intercarrier compensation reform, on our independent incumbent local exchange carriers and competitive local exchange carrier subsidiaries.
Regulation Applicable to our Advanced Wireless Service and 700 Band MHz Licenses
We currently hold 15 FCC Advanced Wireless Service and three 700 MHz Band licenses in Iowa. Our ownership of these licenses subjects us to FCC regulation of the wireless services we may choose to provide and the technical operating characteristics of the network equipment we may utilize. In addition, our right to renew these licenses depends on our compliance with build-out requirements promulgated by the FCC. For the 700 MHz licenses, we must begin meeting such requirements in stages prior to the expiration of the initial 10 year license term. For our Advanced Wireless Service licenses, we must meet the FCC’s build-out requirements by the end of such licenses’ 15 year initial term. We cannot predict changes that may occur in the FCC’s regulation of our Advanced Wireless Services or 700 MHz licenses, the network we may build or the services we may provide over the period of time we may hold the licenses.
Environmental Regulation
We are subject to federal, state and local laws and regulations governing the use, storage, disposal of, and exposure to, hazardous materials, the release of pollutants into the environment and the remediation of contamination. As an owner or operator of property and a generator of hazardous wastes, we could be subject to certain environmental laws that impose liability for the entire cost of cleanup at a contaminated site, regardless of fault or the lawfulness of the activity that resulted in contamination. We believe, however, that our operations are in substantial compliance with applicable environmental laws and regulations.
State Regulation
Incumbent Local Exchange Carrier. The Iowa Utilities Board is responsible for regulating the rates, terms and conditions pursuant to which our incumbent local exchange carrier provides basic intrastate local telephone service and switched access service for intrastate transmissions within Iowa. The Iowa Utilities Board also has jurisdiction over the service quality of the incumbent local exchange carrier’s intrastate services and relationships with our customers. As required by the Iowa Utilities Board, our incumbent local exchange carrier files and receives approval of tariffs for local telephone and switched access service. These tariff filings are available on our web site. The Iowa Utilities Board does not regulate the rates our incumbent local exchange carrier charges for any service other than, arguably, extended area service.
The Iowa Utilities Board has granted a certificate of public convenience and necessity to our incumbent local exchange carrier to provide local telephone service in Iowa. We may not transfer our certificate, transfer control of our company or discontinue providing local services in any of the exchanges we serve without first obtaining the Iowa Utilities Board’s approval. The Iowa Utilities Board has the power to penalize us or revoke our certificate if we are in material violation of any law or regulation. We also must obtain the Iowa Utilities Board’s approval to acquire the whole or any substantial part of the assets or the controlling capital stock of any public utility in Iowa, or to sell or otherwise dispose of the whole or any substantial part of our assets. In addition, the Iowa Utilities Board is responsible for implementing some of the state and federal laws and regulations intended to promote competition. It also has authority under the Telecom Act to establish the rates and terms on which competitive local exchange carriers can interconnect with and obtain unbundled access to incumbent local exchange carrier networks.
The jurisdiction of the Iowa Utilities Board over our local retail rates changed dramatically as a result of state deregulatory legislation that became effective on July 1, 2005. Pursuant to this legislation, each telephone utility then subject to rate regulation, such as Iowa Telecom, was permitted to elect to deregulate its charges for all of its retail business and residential local exchange services except single line flat-rated residential and business service and extended area service, which remained rate-regulated until June 30, 2008, after which such authority was scheduled to sunset. The Iowa Utilities Board could have extended such sunset to no later than June 30, 2010, but determined in a June 27, 2008 order not to impose such an extension based on the level of competition in local telecommunications markets. The Iowa Utilities Board, through its jurisdiction to deregulate services based on the existence of effective competition, had already deregulated all of our rates for local exchange in 14 exchanges pursuant to a December 23, 2004 order, and after the July 1, 2005, legislation took effect, another 14 exchanges pursuant to a December 5, 2005, order, the latter order focusing only on single-line flat-rated service.
We believe that the rates, terms and conditions governing our incumbent local exchange carrier’s provision of intrastate switched access service, which is not a local retail service, continue to be regulated by the Iowa Utilities Board in the same manner as prior to July 1, 2005. That is, intrastate switched access service is provided subject to a statutory price regulation plan that applied to the GTE Midwest Incorporated exchanges at the time we acquired them on June 30, 2000. Under the terms of the price regulation plan, intrastate switched access service is provided pursuant to a tariff approved by the Iowa Utilities Board containing rates described in the statute that authorized GTE Midwest Incorporated to elect price regulation. In accordance with the price regulation statute, our local incumbent exchange carrier may not increase its intrastate switched access service rates and cannot be required to decrease them.
The Iowa Utilities Board took the position in the fourth quarter of 2008 that our incumbent local exchange carrier’s intrastate access rates have ceased to be subject to the intrastate switched access rate freeze since July 1, 2005, and are subject to challenge. The Board is currently considering such a challenge based on a February 20, 2008, MCImetro Transmission Access Transmission Services LLC, d/b/a Verizon Access Transmission Services and MCI Communications Services, Inc. d/b/a Verizon Business Services complaint filed with the Iowa Utilities Board against our local incumbent exchange carrier, our Iowa competitive local exchange carriers, Frontier
Communication of Iowa, Inc., and Citizens Mutual Telephone Company alleging that such companies’ tariffed originating and terminating intrastate switched access rates of each are not just and reasonable and should be lowered by the Iowa Utilities Board to “mirror” the rates contained in Qwest Corporation’s Iowa tariff. The complaint appears to be similar to others asserted by these or related entities against the intrastate access charges of mid-sized incumbent local exchange companies in several other states. We filed a motion to dismiss the complaint in light of our legislated price plan, and believe the substance of the complaint to be without merit given the absence of any rationale for the proposed decrease. The Iowa Utilities Board denied our motion to dismiss on November 14, 2008, a decision we cannot appeal until the Board issues a decision on the merits. The final round of testimony will be filed by Verizon on April 2, 2009, with a hearing to be held starting during the first week of May 2009. We cannot predict when this proceeding will conclude and what the outcome may be.
The new law that became effective July 1, 2005 also gives the Iowa Utilities Board jurisdiction to entertain a complaint by certain local exchange carriers that other carriers have engaged in activity that is inconsistent with the antitrust laws and the policies underlying them, and allows the Iowa Utilities Board to punish such behavior by adjusting retail rates in an amount sufficient to correct the antitrust activity, ordering the local exchange carrier engaging in such activity to pay costs incurred by the complainant in pursuing the complaint, imposing civil penalties against the local exchange carrier engaging in such activity, and ordering either the complainant or the other local exchange carrier to pay the costs of the complaint proceeding including the other party’s reasonable attorney fees.
On September 12, 2008, the Iowa Utilities Board issued an order commencing an inquiry into whether the Board should create an Iowa universal service fund (“USF”). At this point, the Board is seeking comment on preliminary issues, such as how it should determine whether an Iowa USF is needed, and on certain policy and implementation issues assuming that an Iowa USF will be established. Comments were filed on October 27, 2008. Eventually the Board may issue an order commencing rulemaking. We cannot predict whether the Board will establish a rulemaking as a result of its pending inquiry or, assuming it does, the result of such rulemaking.
Iowa Competitive Local Exchange Carriers. We have two Iowa competitive local exchange carrier subsidiaries-ITC and IT Communications. ITC and IT Communications offer services in all of Qwest’s Iowa exchanges and generally offer the same local exchange services as those offered by Qwest, using unbundled network facilities provided by Qwest pursuant to our commercial agreements with them, and provides DSL Internet access service in all the exchanges in which it operates, using either Qwest’s wholesale service or owned facilities. IT Communications began operations in January 2006. IT Communications operates similarly to ITC, but is focused on larger markets in Iowa. The Iowa Utilities Board does not have jurisdiction over the rates for local basic communications service of our competitive local exchange carriers, but ITC and IT Communications do file tariffs regarding the terms and conditions for such service with the Iowa Utilities Board.
The Iowa Utilities Board has jurisdiction over our Iowa competitive local exchange carriers’ switched access rates. The Iowa Utilities Board rules allow our competitive local exchange carriers to adopt the tariffs of any other carrier providing switched access service in Iowa. Our Iowa competitive local exchange carriers, like a majority of competitive local exchange carriers in the state, have adopted the switched access rates contained in the access tariff of the Iowa Telecommunications Association. See discussion of Montezuma Telephone below for developments regarding such access rates. The Iowa Utilities Board also has jurisdiction over the service quality of our competitive local exchange carriers’ intrastate services and relationships with their customers.
Minnesota Competitive Local Exchange Carriers. We have two Minnesota competitive local exchange carrier subsidiaries: Lakedale Link, Inc., which is engaged in total service resale of Qwest, Frontier, and Embarq products in certain of their respective exchanges and EN-TEL, a majority owned subsidiary that provides facility-based service in certain Qwest exchanges. Competitive local exchange carriers in Minnesota are not subject to rate-of-return regulation or earnings investigation, and their retail rates are generally subject to investigation only to prevent unreasonable discrimination. The intrastate access rates of Minnesota competitive local exchange carriers remain subject to regulation and adjustment by the Minnesota Public Utilities Commission. The
Minnesota Public Utilities Commission also has jurisdiction over the service quality of competitive local exchange carriers’ intrastate services and relationships with their customers.
Independent Incumbent Local Exchange Carriers. Lakedale Telephone has made an election of alternative regulation under Minnesota statute that is available to a local exchange telephone company with fewer than 50,000 subscribers. Pursuant to this election, Lakedale Telephone is not subject to rate-of-return regulation or earnings investigation, but its retail rates remain subject to review and adjustment upon petition or complaint under certain conditions. Lakedale Telephone’s intrastate access rates also remain subject to regulation and adjustment by the Minnesota Public Utilities Commission. The Minnesota Public Utilities Commission also has jurisdiction over the service quality of Lakedale Telephone’s intrastate services and relationships with its customers.
Montezuma Telephone, as an Iowa provider of fewer than 15,000 access lines, is not subject to the retail and, arguably, access rate regulation of the Iowa Utilities Board, although it is subject to the Board’s complaint jurisdiction. Montezuma Telephone and our Iowa competitive local exchange carriers concur in the Iowa Telecommunications Association (“ITA”) intrastate access charge tariff. On May 30, 2008, the Iowa Utilities Board issued an order rejecting ITA’s proposed tariff revision, and requiring ITA to make certain significant changes to its tariff by June 30, 2008. These changes include lowering the originating and terminating local switching rate from 4.04 to 2.44 cents-per-minute and removing the separate 1.5 cent-per-minute Transport Interconnection Charge. ITA filed a request for stay pending rehearing on a variety of issues, including the appropriate transition period for implementation. Sprint also filed a rehearing request regarding the Board’s decision not to issue refunds back to September 1, 2007, the date of Sprint’s objection. Following granting ITA’s request for stay, the Board, on January 8, 2009, denied all requests for reconsideration and required ITA to implement the ordered tariff revisions effective February 9, 2009, a requirement with which ITA complied. The Board’s May 30, 2008, order also indicated that it might institute a proceeding that could lead to removal of the three cents-per-minute carrier common line charge in the ITA tariff, which would apply to Montezuma but not to our CLEC because our CLEC does not assess the originating and terminating carrier common line (“CCL”) charge. We cannot predict the result of either the rehearing on the ITA tariff or of any proceeding regarding ITA’s CCL rate. Montezuma and perhaps our Iowa CLECs could also be affected by any Iowa universal service fund program.
Neither Lakedale Telephone’s or Montezuma Telephone’s mobile wireless, television, or data services are subject to state rate regulation.
Other
Our incumbent local exchange carrier provides local exchange services from three exchanges in Iowa that include approximately 100 access lines that serve customers physically located in Missouri. With regard to these access lines, our incumbent local exchange carrier is subject to the jurisdiction of the Missouri Public Service Commission, which is responsible for granting operating certificates to local service providers and regulating the intrastate access service, local service, the service quality and relationships with customers of incumbent local exchange carriers operating in Missouri. Our incumbent local exchange carrier is certified to operate in Missouri and, as such, has approved tariffs on file with the Missouri Public Service Commission. Our incumbent local exchange carrier contributes to the Missouri universal service fund and also files service quality and financial monitoring reports with the Missouri Public Service Commission on an annual and quarterly basis.
Neither the Iowa Utilities Board, Minnesota Public Utilities Commission, nor the Missouri Public Service Commission regulate dial-up Internet access or, high-speed Internet access services to customers of either our incumbent local exchange carrier or our competitive local exchange carriers. Further, none of the regulatory agencies regulates the intrastate long distance rates of any carrier.
Local Government Authorizations
In some communities, our incumbent local exchange carriers are required to obtain certain authorizations from municipal authorities, such as permits, licenses or easements to install and maintain the facilities and equipment necessary to provide telecommunications services. We believe we are in compliance with all such requirements. Some jurisdictions where we may provide service may require license or franchise fees based on criteria established by Iowa statute. These amounts are not material to our incumbent local exchange carrier operations.
To the extent our competitive local exchange carriers provide service through facilities or services purchased from Qwest, no local government authorizations are required. If our competitive local exchange carriers were to construct their own facilities, they may be subject to the requirements of local governments in such markets. Currently, our competitive local exchange carriers pay no local license or franchise fees.
Lakedale Telephone, Montezuma Telephone, and EN-TEL provide cable television service pursuant to franchise agreements which include certain operational requirements.
ITEM 1A.
ITEM 1A. Risk Factors
Set forth below are risks and uncertainties that could cause actual future results to differ materially from those described herein.
Risk Related to Our Capital Structure and Ownership
Our dividend policy may limit our ability to pursue growth opportunities.
Our board of directors adopted a dividend policy, effective upon closing of our initial public offering in November 2004, which reflects an intention to distribute a substantial portion of the cash generated by our business in excess of operating needs, interest and principal payments on our indebtedness and capital expenditures as regular quarterly dividends to our shareholders. As a result, we may not retain a sufficient amount of cash to finance a material expansion of our business, or to fund our operations consistent with past levels of funding in the event of a significant business downturn. In addition, because a significant portion of cash available to pay dividends will be distributed to holders of our common stock under our dividend policy, our ability to pursue any material expansion of our business, through acquisitions or increased capital spending, will depend more than it otherwise would on our ability to obtain third party financing. We cannot assure you that such financing will be available to us at all, or at an acceptable cost.
Our equity owners may not receive any dividends.
We are not obligated to pay dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. Future dividends with respect to shares of our common stock, if any, will depend on, among other things, our results of operations, working capital requirements, financial condition, contractual restrictions, business opportunities, anticipated cash needs, provisions of applicable law and other factors that our board of directors may deem relevant. In addition, we have reported a loss from continuing operations in the past.
We might not generate sufficient cash from operations in the future to pay dividends on our common stock in the intended amounts or at all. Our board of directors may decide not to pay dividends at any time and for any reason. Our dividend policy is based upon our directors’ current assessment of our business and the environment in which we operate, and that assessment could change based on competitive or technological developments (which could, for example, increase our need for capital expenditures), new growth opportunities or other factors. If our cash flows from operations for future periods were to fall below our minimum expectations, we would need either to reduce or eliminate dividends or, to the extent permitted under the terms of our credit facilities, fund a portion of our dividends with borrowings or from other sources. If we were to use working capital or permanent borrowings to fund dividends, we would have less cash and/or borrowing capacity available for future dividends and other purposes, which could negatively affect our financial condition, our results of operations, our liquidity and our ability to maintain or expand our business. Our board is free to depart from or change our dividend policy at any time and could do so, for example, if it were to determine that we had insufficient cash to take advantage of growth opportunities. In addition, our credit facilities contain limitations on our ability to pay dividends. See “Dividend Policy and Restrictions” in Item 5 of this report. The reduction or elimination of dividends may negatively affect the market price of our common stock.
We have substantial indebtedness and may incur additional indebtedness in the future, which could restrict our ability to pay dividends.
Our ability to make distributions, pay dividends or make other payments will be subject to applicable law and contractual restrictions contained in the instruments governing any indebtedness of ours and our subsidiaries, including our credit facilities. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of our common stock, including the following:
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our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited;
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a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our common stock;
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we may be more vulnerable to economic downturns and be limited in our ability to withstand competitive pressures; and
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we may have limited flexibility to plan for and react to changes in our business or strategy.
In addition, we may incur substantial additional indebtedness in the future. Any additional debt incurred by us could increase the risks associated with our substantial leverage.
We are subject to restrictive debt covenants and other requirements related to our outstanding debt that limit our business flexibility by imposing operating and financial restrictions on us.
Covenants in our credit facilities impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things:
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the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock;
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the payment of dividends on, and purchase or redemption of, capital stock;
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a number of other restricted payments, including investments and acquisitions;
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specified sales of assets;
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specified transactions with affiliates;
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the creation of liens on our assets;
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consolidations, mergers and transfers of all or substantially all of our assets;
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our ability to change the nature of our business; and
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our ability to make capital expenditures.
These restrictions could limit our ability to obtain future financing, make acquisitions, fund capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the credit facilities also require us to maintain specified total leverage and fixed charge coverage ratios, to satisfy specified financial condition tests and may require us to make annual mandatory prepayments with a portion of our available cash. See “Long-Term Debt and Revolving Credit Facilities” in Item 7 of this report. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions.
A breach of any of these covenants, ratios or tests could result in a default under the credit facilities. Upon the occurrence of an event of default under the credit facilities, the lenders could elect to declare all amounts outstanding under the credit facilities to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the credit facilities, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness.
We may not be able to refinance our credit facilities at maturity on favorable terms or at all.
Our credit facilities will mature in full on November 23, 2011. We may not be able to renew or refinance the credit facilities, or any renewal or refinancing may occur on less favorable terms. If we are unable to refinance or renew our credit facilities, our failure to repay all amounts due on the maturity date would cause a default under the credit facilities. In addition, given the current credit environment, our ability to access the capital markets may be restricted and our interest expense may increase significantly if we refinance our credit facilities on terms that are less favorable to us than the terms of our existing credit facilities, which could impair our ability to pay dividends.
Due to the severe contraction in the global financial markets, we may seek funding under our revolving credit facility or a commitment to lend incremental term loans and learn that our lenders cannot fulfill our request for cash.
We have an agreement with the Rural Telephone Finance Cooperative, which we depend upon for our revolving credit needs along with a commitment from them to fund a $75 million incremental term loan. In spite of the contractual obligation of the institution to perform under the financing agreement, and in spite of our attempts to remain informed of the capability of any institution to perform their functions for us, we may learn that our request for cash on any given day cannot be fulfilled.
We will require a significant amount of cash, which may not be available to us, to service our debt, pay dividends and fund our other liquidity needs.
Our ability to make payments, refinance or repay our debt, to fund planned capital expenditures, pay dividends and to expand our business will depend largely upon our future operating performance. Our future operating performance is subject to general economic, financial, competitive, legislative and regulatory factors, as well as other factors that are beyond our control. Our business may not generate enough cash flow and future borrowings may not be available to us under our credit facilities or otherwise, sufficient to enable us to pay our debt, pay dividends or fund our other liquidity needs. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our credit facilities. We may not be able to refinance any of our debt, including the credit facilities, under such circumstances, on commercially reasonable terms or at all. If we were unable to refinance our debt or obtain new financing under these circumstances, we would have to consider other options, including:
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sales of certain assets to meet our debt service requirements;
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sales of equity; and
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negotiations with our lenders to restructure the applicable debt.
Our credit facilities could restrict our ability to do some of these things. If we are forced to pursue any of the above options under distressed conditions, our business and/or the value of our common stock could be adversely affected.
There may be volatility in the trading price of our common stock, which could negatively affect the value of an investment in our common stock.
The market price of our common stock may fluctuate widely as a result of various factors, such as period-to-period fluctuations in our operating results, sales of our common stock by significant shareholders, developments in the telecommunications industry, the failure of securities analysts to cover our common stock or changes in financial estimates or opinions by analysts, competitive factors, regulatory developments, economic and other external factors, interest rates, general market conditions and market conditions affecting the stock of telecommunications companies in particular. Telecommunications companies have in the past experienced extreme volatility in the trading prices and volumes of their securities, which has often been unrelated to operating performance. Any such market volatility may have a significant adverse effect on the market price of our common stock.
Future sales, or the possibility of future sales, of a substantial amount of our common stock may depress the price of the shares of our common stock.
Future sales, or the availability for sale in the public market, of substantial amounts of our common stock could adversely affect the prevailing market price of our common stock, and could impair our ability to raise capital through future sales of equity securities.
Members of our management and other employees hold fully vested options to purchase a total of 677,579 shares of our common stock as of December 31, 2008, all of which have been registered under the Securities Act of 1933 and may be exercised and sold at any time.
We may issue shares of our common stock, or other securities, from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock, or the number or aggregate principal amount, as the case may be, of other securities that we may issue, may in turn be significant. We may also register, or grant registration rights covering, those shares or other securities in connection with any such acquisitions and investments.
Our organizational documents could limit another party’s ability to acquire us and therefore could deprive our investors of the opportunity to obtain a takeover premium for their shares.
A number of provisions in our articles of incorporation and bylaws will make it difficult for another company to acquire us and, therefore, for investors to receive any related takeover premium for their shares. For example, our articles of incorporation provide for a classified board of directors, prohibit removal of directors without cause and authorize the issuance of preferred stock without shareholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future.
We are also subject to laws that may have a similar effect. For example, federal and state telecommunications laws and regulations generally prohibit a direct or indirect transfer of control over our business without prior regulatory approval. Section 490.1110 of the Iowa Business Corporation Act prohibits us from engaging in a business combination with an interested shareholder for a period of three years from the date the person became an interested shareholder unless certain conditions are met. The Iowa Business Corporation Act also provides that only shareholders representing at least 50% of our shares entitled to vote may request that our board of directors call a special meeting of shareholders and that, in evaluating any acquisition offer, our board of directors may consider the interests of our employees, suppliers, creditors and customers, the interests of the communities in which we operate, and the long-term interests of our company and the shareholders, in addition to the financial interests of shareholders.
Factors requiring us to pay cash taxes in future periods may affect our ability to pay dividends.
We currently are able to take deductions of approximately $41 million from taxable income associated with the amortization of intangibles through June 2015. In addition, as of December 31, 2008, we have net operating losses to offset taxable income of $149.0 million which will expire in 2021 through 2024. Consequently, in the future we may be required to pay cash income taxes because all of our net operating losses have been used or have expired, or because our intangible assets have been fully amortized. Any of the foregoing would have the effect of increasing our taxable income and potentially reducing our after-tax cash flow available for payment of dividends in future periods, and may require us to reduce dividend payments on our common stock in such future periods.
Risks Relating to Our Business and Industry
Competition in the telecommunications industry could result in access line losses or reduce our customer base, possibly requiring that we lower our rates, increase marketing expenditures, invest in new technologies or capabilities or use discounting and promotional campaigns that adversely affect our margins.
We face actual or potential competition from other telecommunications service providers, including wireless service providers, who have entered and may continue to enter our service areas. Such competition has resulted in access line losses. In general, when we lose a customer to a competitor for local service we also lose that customer for all related services, such as long distance and Internet service, and may also lose the access charge revenues for that customer. We have interconnection agreements with 42 of the competitive local exchange carriers authorized to offer local service in our service area.
Six of the 42 competitive local exchange carriers are municipal telephone utilities, and other communities we serve may in the future evaluate the establishment of a municipal telephone utility. We cannot predict the likelihood of further competition from municipal telecommunications utilities on our business.
MCC is offering voice services through a business arrangement with Sprint Communications L.P. (“Sprint”). On June 23, 2006, we filed a complaint against the Iowa Utilities Board and Sprint in the U.S. District Court for the Southern District of Iowa asking the court to rule that the Iowa Utilities Board acted unlawfully when it required us to enter into an interconnection agreement with Sprint and asking the court to invalidate the agreement. On April 15, 2008, the court issued a ruling holding against us, therefore maintaining the status quo in which we are obligated to enter into an interconnection agreement with Sprint. We appealed this decision to the U.S. Court of Appeals for the Eighth Circuit on May 14, 2008 and oral argument was held on December 12, 2008. We cannot predict how and when this litigation will be resolved.
Notwithstanding the period in which our complaint was under consideration, we have negotiated, mediated and litigated with Sprint and, at times, with MCC to resolve issues relating to interpretation and implementation of the interconnection agreement. On January 22, 2007, we filed a second complaint against the Iowa Utilities Board and Sprint in U.S. District Court asking the court to rule that the Iowa Utilities Board acted unlawfully when it interpreted the interconnection agreement to require Iowa Telecom to provide certain services to Sprint, particularly in the manner requested by Sprint. Briefing on this complaint concluded on August 11, 2008. We cannot predict how and when this litigation will be resolved.
In addition to the disputes pending in federal district court and before the Iowa Utilities Board, we are also defending a complaint filed by MCC on July 31, 2006, in the Iowa District Court for Polk County alleging that our refusal to accede to Sprint’s negotiation demands improperly interfered with MCC’s contracts and prospective customer relationships. The state court complaint seeks unspecified damages and costs and additional relief as warranted. This state court proceeding had been stayed pending the result of our first federal complaint. On September 9, 2008, the state court refused to lift the stay due to the pending appeal of federal district court’s decision on the first complaint to the Eighth Circuit. This stay will remain effective until the Eighth Circuit rules, subject to reconsideration by the state court if the Eighth Circuit has not ruled by March 9, 2009. We cannot predict how long this stay will last nor how this state court litigation will be resolved.
We also face competition from sources other than wireline competition and wireline competitive local exchange carriers. Wireless providers for example, currently compete in most of our markets. We expect this competition to continue, and likely become more acute, in the future. We also compete, or may in the future compete, with companies that provide other close substitutes for the traditional telephone services we provide, like cable television, voice over Internet protocol, high-speed fiber optic networks or satellite telecommunications services, and companies that might provide traditional telephone services over nontraditional network infrastructures, like electric utilities. We are subject to regulations, like those requiring us to provide number portability for wireless carriers, that reduce the barriers to entry faced by some providers of substitute services, and may be subject to other regulations favoring substitute services in the future.
We may lose access lines due to general economic conditions and competition.
Our business generates revenue by delivering voice and data services over access lines. In the past, we have experienced net access line loss due to challenging economic conditions and increased competition. Our total access line count decreased by 4.5% during 2007 and increased 0.6% during 2008. Access lines decreased 6.1% for 2007, and 7.5% for 2008, if we exclude lines served by our competitive local exchange carrier and access lines acquired during 2008. We are affected both by the economic effects of general demographic trends in the rural Midwest as well as, to some extent, more general economic downturns. Continued access line losses could adversely affect our revenues and earnings.
The recent severe contraction in the global financial markets may have an impact on our business and financial condition
Diminished availability of credit and liquidity due to the recent severe contraction in the global financial markets may impact the financial health of the Company’s customers, vendors and partners, which in turn may negatively impact the Company’s revenues and operating expenses.
We may lose access lines due to the economic conditions and a declining population in many rural Midwest communities.
Virtually all of our customers and operations are located in Iowa and Minnesota. Due to our geographic concentration, the successful operation and growth of our businesses is dependent on economic conditions in Iowa and Minnesota. The Iowa and Minnesota economies, in turn, are dependent upon many factors, including the strength of the agricultural economy along with the manufacturing and service industries.
Furthermore, the economies of rural communities, such as those that we serve, are affected by many of the same factors as the Iowa and Minnesota economies in general. In addition, rural communities face additional challenges to their economic stability and growth. The populations of many rural communities in Iowa and Minnesota, particularly smaller towns, have been declining. Any deterioration in general economic conditions in Iowa and Minnesota are likely to result in lower demand for our services, which would reduce our revenues.
We may in the future compete with the Iowa Communications Network or with a future purchaser of the assets now owned by the Iowa Communications Network.
The Iowa Communications Network, a state-owned limited use network with more than 3,000 miles of fiber optic cable extending into all 99 Iowa counties, and capable of providing a variety of voice, data and video communication services, currently is prohibited by state law from providing telephone service to parties other than school districts, higher education institutions, state and federal agencies, the United States Post Office, hospitals, physicians’ clinics and public libraries. The assets now owned by the Iowa Communications Network could be used to provide voice, data and video communications to other users. The State of Iowa has previously considered modifying state law to remove some of the usage restrictions applicable to the Iowa Communications Network or permit the sale of the Iowa Communications Network to a private party. A sale of the Iowa Communications Network or its assets, or a change in the law permitting broader use of the Iowa Communications Network, could provide additional competition for us.
We may not be able to integrate future technologies, respond effectively to customer requirements or provide new services.
The communications industry is subject to rapid and significant changes in technology, frequent new service introductions and evolving industry standards. We cannot predict the effect of these technological changes on our business. New technologies and products may not be compatible with our existing technologies and systems. In addition, our existing technologies and systems may not be competitive with new superior technologies and products, which may reduce service prices. These developments could require us to incur costs for equipment upgrades or to procure additional products that could be expensive. If we do not adequately replace or upgrade our technology and equipment that becomes obsolete, we may not be able to compete effectively. Technological changes in the communications industry may have a material adverse effect on our business or financial results. We may not be able to obtain timely access to new technology on satisfactory terms or incorporate new technology into our systems in a cost effective manner, or at all.
In addition to technological advances, other factors could require us to further expand or adapt our network, including an increasing number of customers, demand for greater data transmission capacity, failure of our technology and equipment to support operating results anticipated in our business plan and changes in our customers’ service requirements. Expanding or adapting our network could require substantial additional financial, operational and managerial resources, any of which may not be available to us.
Network failures and other disruptions could adversely affect our operating results.
To be successful, we will need to continue providing our customers with a high capacity, reliable and secure network. Some of the risks to our network and infrastructure and the networks and infrastructures of our third party service providers include:
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physical damage to access lines, central offices, central office equipment, or equipment used in our underlying voice and data networks or to our corporate headquarters;
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power loss from, among other things, adverse weather conditions;
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capacity limitations;
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software and hardware defects and malfunctions;
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breaches of security, including sabotage, tampering, computer viruses and break-ins; and
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other disruptions that are beyond our control.
Disruptions or system failures may cause interruptions in service or reduced capacity for customers. If service is not restored in a timely manner, agreements with our customers or service standards set by the Iowa Utilities Board may obligate us to provide credits or other remedies, which would reduce our revenues or increase our costs. Service disruptions could also damage our reputation with customers, causing us to lose existing customers or have difficulty attracting new ones.
We may not be able to maintain the necessary rights-of-way for our network.
We are dependent on rights-of-way and other permits from railroads, utilities, state highway authorities, local governments and transit authorities to install conduit and related telecommunications equipment for any expansion of our network. We may need to renew current rights-of-way for our network and cannot assure you that we would be successful in renewing these agreements on acceptable terms. Some of our agreements may be short-term, revocable at will or subject to termination upon customary default provisions, and we may not have access to existing rights-of-way after they have expired or terminated. If any of these agreements were terminated or could not be renewed, we may be required to remove our existing facilities from existing locations such as under the streets or be forced to abandon our networks. Similarly, we may not be able to obtain right-of-way agreements on favorable terms, or at all, in new service areas, and, if we are unable to do so, our ability to expand our network, if we decide to do so, could be impaired. In addition, we may be required to relocate our facilities to comply with state or local laws or to allow for public infrastructure changes. Such relocations may require significant expenditures by us that are not reimbursed.
Our competitive local exchange carrier strategy may adversely affect our profitability.
We intend to expand our operations in both telephone and Internet services through our four competitive local exchange carrier subsidiaries into areas in close proximity to our incumbent local exchange carrier territory. As of December 31, 2008, we had approximately 32,400 competitive local exchange carrier access lines focusing primarily on business customers. Competitive local exchange carrier profitability is contingent on obtaining customers in competition with the incumbent local exchange service provider in a cost-effective manner. Our wholly owned CLEC subsidiaries utilize wholesale contracts with Qwest, Embarq and Frontier to purchase certain services from these providers. CLEC profitability could be negatively impacted if such wholesale contracts were either not available, or available only at a higher cost than we incur today. Either an incumbent provider or another competitive local exchange carrier may diminish our profitability by expanding its marketing efforts or offering additional products. Furthermore, as a result of the recently enacted statutory provisions regarding deregulation of basic local services in some markets, the incumbent provider will have greater flexibility to respond to competition from our competitive local exchange carriers, which may reduce our margins and have other negative impacts on our profitability.
We face risks associated with the planned acquisition of Sherburne Tele Systems, Inc. and with our strategy of growth through acquisitions.
Any future acquisitions will depend on our ability to identify suitable acquisition candidates, negotiate acceptable terms for their acquisition and finance those acquisitions. In addition, future acquisitions by us could result in the incurrence of indebtedness or contingent liabilities, which could have a material adverse effect on our business, and our ability to achieve sufficient cash flow, provide adequate working capital and service our indebtedness. Any future acquisitions could also expose us to increased risks, including:
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the difficulty of integrating the acquired personnel, network, operations and other support systems;
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the potential disruption of our ongoing business and diversion of resources and management time;
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the inability to generate revenues from acquired businesses sufficient to offset acquisition costs;
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the inability of management to maintain uniform standards, controls, procedures and policies;
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the risks of entering markets in which we have little or no direct prior experience;
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the difficulty in enhancing our customer support resources to adequately service our existing customers and acquired customers; and
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the impairment of relationships with suppliers, employees or unions as a result of changes in management of the acquired company.
Any future acquisitions of access lines will likely be subject to prior approvals from the Federal Communications Commission, the Iowa Utilities Board, the Minnesota Public Utilities Commission and other applicable state and federal agencies. We may not be able to obtain such approvals, in which case the acquisition could be delayed or not consummated.
We may not be able to raise the capital to grow through acquisitions.
We may need additional capital to continue growing through acquisitions. Such additional capital may be in the form of additional debt, which would increase our leverage or equity, which would increase our dividends paid. We may not be able to raise sufficient additional capital at all or on terms that we consider acceptable.
We may not be successful in efficiently managing the growth of our business.
Our business plan will, if successfully implemented, result in growth of our operations, which may place a significant strain on our management, financial and other resources. To achieve and sustain growth we must, among other things, monitor operations, control costs, maintain regulatory compliance, maintain effective quality controls and maintain adequate internal management, technical, provisioning, information, billing, customer service and accounting systems. We may not be able to successfully integrate, obtain and use the employee, management, operational and financial resources necessary to manage a developing and expanding business in an evolving, regulated and increasingly competitive industry.
Our relationships with other telecommunications companies are material to our operations and their financial difficulties may affect our business.
We originate and terminate calls for long distance carriers and other interexchange carriers over our network and for that service we receive payments called access charges. Some of the carriers that pay us these access charges are our largest customers in terms of revenues. Several such carriers have declared bankruptcy in recent years. Our inability to collect access charges from these bankrupt or financially distressed carriers has had a negative effect on our financial results and cash flows, as would any subsequent bankruptcies or disruptions in the businesses of these or other interexchange carriers. Our ability to collect past due amounts of access billings from carriers is hampered by federal and state regulations governing business relationships of these bankrupt or financially distressed carriers.
We use many vendors and suppliers that derive significant amounts of business from customers in the telecommunications business. Associated with the difficulties facing many service providers, some of these vendors and suppliers recently have experienced substantial financial difficulties, in some cases leading to bankruptcies and liquidations. Any disruptions experienced by these vendors and suppliers as a result of their own financial difficulties may affect their ability to deliver products or services to us on a timely basis or at all, which could have an adverse affect on our business.
We face risks associated with our reliance on third party telecommunications service providers.
We currently rely on a combination of interexchange carriers to provide long distance service and local exchange carriers to provide service in the communities served by our CLEC. These third party service providers could cancel or not renew our current agreements or require significant price increases to continue providing services. Any increase in costs from these carriers or an inability to obtain service from these carriers could have an adverse impact on our business.
We face risks associated with our reliance on our information and billing systems.
We currently rely on a combination of internal systems and licenses with third party vendors for our information and billing systems. These systems are vital to our growth and our ability to monitor and control costs, bill customers, process orders, and provide customer service. If our information and billing systems fail or do not perform as expected, our ability to collect revenues, provide adequate customer service and accurately track our expenses and revenues would be impaired, with potentially materially adverse effects on our business and operations. In addition, if our third party vendors cancel or do not renew our license agreements, we could face disruption in our operations, as well as unforeseen expense for obtaining suitable replacement services from other vendors.
Labor disputes with our employees could interrupt our operations and adversely affect our business.
We have a collective bargaining agreement with the Communications Workers of America, or CWA, which covers 176 of our employees and expires in May 2012. We also have a collective bargaining agreement with the International Brotherhood of Electrical Workers, or IBEW, which covers 22 of our employees and expires in June 2009. If we negotiate acceptable terms with the CWA or IBEW at the expiration of the current agreements, our operating costs could increase as a result of higher wages or benefits paid to union members, and if we fail to reach an agreement with the unions our operations could be disrupted. Also, we may experience labor disputes over recognition of types of work performed or additional organizing efforts. Any of these events could have a material adverse effect on our business, results of operations or financial condition.
We depend on key members of our senior management team.
Our success depends largely on the skills, experience and performance of key members of our senior management team, including Alan L. Wells, our President, CEO and Chairman. Competition for senior management in our industry is intense, and we may have difficulty retaining our current managers or attracting new managers in the event of termination or resignation.
Risks Related to Our Regulatory Environment
Our business is subject to extensive regulation that could change in a manner adverse to us.
We operate in a heavily regulated industry, and most of our revenues come from providing services regulated by the Federal Communications Commission, or FCC, the Iowa Utilities Board, and the Minnesota Public Utilities Commission. Federal and state communications laws and regulations may be amended in the future, and other laws or regulations may be enacted which will affect our business. The FCC, Iowa Utilities Board and Minnesota Public Utilities Commission may add new rules, amend their rules or change the interpretation of their rules at any time. Laws and regulations applicable to us and our competitors may be, and
have been, challenged in the courts, and could be changed at any time. We cannot predict future developments or changes to the regulatory environment, or the impact such developments or changes would have on us.
FCC, Iowa Utilities Board and Minnesota Public Utilities Commission decisions concerning telecommunications policy and judicial review of such decisions may adversely affect our business.
Federal telecommunications policy continues to evolve through further proposed statutory amendments, changing and implementing new regulations, and judicial review. These continuing potential and actual changes make it difficult to predict what effect such changes will have on us, our operations and our competitors. For example, as discussed in more detail under Regulation-Federal Regulation, the FCC has recently been considering changes to intercarrier compensation applicable to local exchange carriers and wireless providers that could adversely affect the access revenues of our incumbent local exchange carrier and competitive local exchange carrier operations, and the manner in which we will be compensated for terminating calls originating on other carriers’ networks and will compensate other carriers for handling calls that originate on our network. The FCC is also examining its universal service policies, including policies with respect to both contribution and disbursement that could have an effect on the amount and timing of our receipt of universal service funds. Further, many FCC telecommunications decisions are subject to substantial judicial review and delay. These delays and related litigation create uncertainty over federal policies and rules, and may affect our business plans, investments and operations. The Iowa Utilities Board and Minnesota Public Utilities Commission establish state telecommunications policies, including in the area of discretionary deregulation, both on a service type and geographic basis, and the consequences thereof. Orders of the Iowa Utilities Board and Minnesota Public Utilities Commission are also subject to judicial review.
New regulations and changes in existing regulations may force us to incur significant expenses.
Our business may be adversely affected by laws and regulations that impose new or greater obligations related to assisting in law enforcement, bolstering homeland security, reducing environmental impacts or other aspects of our business. For example, existing provisions of the Communications Assistance for Law Enforcement Act and FCC regulations implementing the Communications Assistance for Law Enforcement Act require telecommunications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance. We cannot predict whether and when the FCC or other state or federal agencies might modify such regulations or any other rules, or what compliance with new rules might cost. Similarly, we cannot predict whether or when federal or state legislators or regulators might impose new security, environmental or other obligations on our business. Such new obligations include FCC outage reporting obligations, stayed by the FCC on December 20, 2004, but pending reconsideration that may, if enacted, require substantial compliance expenditures.
As the incumbent local exchange carrier in our service areas, we are subject to regulation that is not applicable to our competitors.
Federal and state rules impose obligations and limitations on us, as an incumbent local exchange carrier, that are not imposed on some of our competitors. Federal obligations require us to, among other things, share facilities, allow unbundled access to our network and resale of our services purchased at wholesale rates, file tariffs for access charges, maintain certain types of accounts and file certain types of reports. Similarly, Iowa and Minnesota law impose, among other things, accounting and reporting requirements and service obligations on us that do not exist for our competitors. As our business becomes increasingly competitive, these regulatory disparities could impede our incumbent local exchange carrier businesses and our ability to compete in the marketplace, which, in turn, could have a material adverse effect on our business.
Changes to existing regulations may reduce the revenue we receive from network access charges.
Network access charges, which include charges that we assess carriers for originating, terminating or transporting services for their interchange calls on our local network (governed by tariffs), as well as charges for
transit services and transport and termination services billed to wireless and landline carriers (governed by interconnection agreements) accounted for approximately 36% of our revenues in 2008.
Large long distance providers have advocated in the past, and continue to advocate, that access charges they are required to pay should be reduced and the revenues replaced, perhaps only in part, by raising the fees charged to business and residential customers or by receipts from a universal service fund. Large long-haul network providers have also argued and continue to argue that access charges do not apply to specific types of traffic. The combined or individual results of these long distance carrier efforts could reduce the amount of access charge revenue we receive. Access charge reform is a key element of the universal service and intercarrier compensation issues under review by state and federal regulators and legislators. We cannot predict whether or when action may be taken on any of these issues, or what effect any action may have on revenues and costs of our incumbent local exchange carrier and competitive local exchange carrier operations.
To the extent that services that compete with ours are subject to different regulatory regimes, our revenues, particularly from network access charges, may be reduced.
The emerging technology known as voice over Internet protocol can be used to carry user-to-user voice communications over dial-up or broadband service. The FCC has determined that a particular type of entirely Internet-based voice over Internet protocol service also is an information service and exempt from such regulatory obligations, but that another, more widely-used, version of voice over Internet protocol service is an interstate service, and therefore, outside the jurisdiction of state telecommunications regulations. Certain aspects of the FCC’s determination have been challenged in judicial proceedings. The FCC is currently considering the regulatory status of a variety of voice over Internet protocol service configurations in the context of a comprehensive proceeding launched in February 2004 as well as several more application and issue-specific proceedings. These proceedings concern, among other things, what, if any, intercarrier compensation must be paid by providers of such service and what, if any, universal service contributions such providers must make. Expanded use of voice over Internet protocol technology could reduce the access revenues received by local exchange carriers like us. We cannot predict the outcome of these proceedings or the effect of FCC or judicial decisions on any of our incumbent local exchange carrier or competitive local exchange carrier businesses, or on our Internet operations.
Because we are subject to extensive laws and regulations relating to the protection of the environment, natural resources and worker health and safety, we may face significant liabilities or compliance costs in the future.
Our operations and properties are subject to federal, state and local laws and regulations relating to protection of the environment, natural resources and worker health and safety, including laws and regulations governing and creating liability relating to the management, storage and disposal of hazardous materials, asbestos, petroleum products and other regulated materials. As a result, we face several risks, including but not limited to the following:
•
Under certain environmental laws, we could be held liable, jointly and severally and without regard to fault, for the costs of investigating and remediating any actual or threatened environmental contamination at currently and formerly owned or operated properties, and those of our predecessors, and for contamination associated with disposal by us or our predecessors of hazardous materials at third party disposal sites. Hazardous materials may have been released at certain current or formerly owned properties as a result of historic operations.
•
The presence of contamination can adversely affect the value of our properties and our ability to sell any such affected property or to use it as collateral.
•
We could be held responsible for third party property damage claims, personal injury claims or natural resource damage claims relating to any such contamination.
•
The cost of complying with existing environmental requirements could be significant.
•
Adoption of new environmental laws or regulations or changes in existing laws or regulations or their interpretations could result in significant compliance costs or as yet unidentified environmental liabilities.
•
Future acquisitions of businesses or properties subject to environmental requirements or affected by environmental contamination could require us to incur substantial costs relating to such matters.
•
In addition, environmental laws regulating wetlands, endangered species and other land use and natural resource issues may increase costs associated with future business or expansion opportunities, delay, alter or interfere with such plans, or otherwise adversely affect such plans.
As a result of the above, we may face significant liabilities and compliance costs in the future.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments
None.
ITEM 2.
ITEM 2. Properties
We own most of our administrative and maintenance facilities, central offices and remote switching platforms, and transport and distribution network facilities. Our corporate headquarters is located in Newton, Iowa in a complex consisting of 11 buildings with approximately 518,300 square feet of office space that we own. We are currently using approximately half of the space for our corporate headquarters, including our customer contact centers, and intend to lease the remainder to third parties. We also own a 41,600 square foot facility in Newton, Iowa, a 63,100 square foot building in Grinnell, Iowa, of which approximately 20% is leased to a third party, a 35,900 square foot warehouse and distribution center in Grinnell, Iowa and a 41,000 square foot combined office and warehouse in Annandale, Minnesota.
Our transport and distribution network facilities include a fiber optic and copper wire backbone, and a distribution network that connects customers both to remote switch locations or the central office in their exchange and to network points of presence or interconnections with interexchange carriers. These facilities are located on land either owned by us or used by us pursuant to permits, rights-of-way, easements or other authorizations.
ITEM 3.
ITEM 3. Legal Proceedings
We currently, and from time to time, are involved in litigation and regulatory proceedings incidental to the conduct of our business. See “Business-Regulation.” We are not a party to any lawsuit or proceeding that, in the opinion of our management, is likely to have a material adverse effect on us.
The Iowa Utilities Board took the position in the fourth quarter of 2008 that our incumbent local exchange carrier’s intrastate access rates have ceased to be subject to the intrastate switched access rate freeze since July 1, 2005, and are subject to challenge. The Board is currently considering such a challenge based on a February 20, 2008, MCImetro Transmission Access Transmission Services LLC, d/b/a Verizon Access Transmission Services and MCI Communications Services, Inc. d/b/a Verizon Business Services complaint filed with the Iowa Utilities Board against our local incumbent exchange carrier, our Iowa competitive local exchange carriers, Frontier Communication of Iowa, Inc., and Citizens Mutual Telephone Company alleging that such companies’ tariffed originating and terminating intrastate switched access rates of each are not just and reasonable and should be lowered by the Iowa Utilities Board to “mirror” the rates contained in Qwest Corporation’s Iowa tariff. The complaint appears to be similar to others asserted by these or related entities against the intrastate access charges of mid-sized incumbent local exchange companies in several other states. We filed a motion to dismiss the complaint in light of our legislated price plan, and believe the substance of the complaint to be without merit given the absence of any rationale for the proposed decrease. The Iowa Utilities Board denied our motion to dismiss on November 14, 2008, a decision we cannot appeal until the Board issues a decision on the merits. The final round of testimony will be filed by Verizon on April 2, 2009, with a hearing to be held starting during the first week of May 2009. We cannot predict when this proceeding will conclude and what the outcome may be.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
PART II.
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for Common Stock
Our Common Stock is listed on the New York Stock Exchange and is traded under the symbol “IWA.” As of February 17, 2009, we had approximately 147 shareholders of record. Because many of our shares are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. The high and low reported sales prices per share of our common stock are set forth in the following table for the periods indicated.
Dividend Policy and Restrictions
Our board of directors has adopted a dividend policy which reflects an intention to distribute, as regular quarterly dividends to our shareholders, a substantial portion of the cash generated by our business in excess of operating needs, interest and principal payments on our indebtedness and capital expenditures, rather than retaining all of such cash for other purposes.
We believe that our dividend policy may limit, but not preclude, our ability to pursue growth. If we continue paying dividends at the level currently anticipated under our dividend policy, we expect that we would need additional financing to fund significant acquisitions or to pursue growth opportunities requiring capital expenditures significantly beyond our current expectations. However, we intend to retain sufficient cash after the distribution of dividends to permit the pursuit of growth opportunities that do not require material capital investment.
The table below reflects the dividends declared or paid by the Company during 2007 and 2008:
Dividends on our common stock are not cumulative.
Despite our dividend policy, our shareholders may not receive dividends in the future for reasons that may include any of the following factors:
•
we may not have enough cash to pay dividends due to changes in our operating earnings, working capital requirements and anticipated cash needs;
•
while the dividend policy adopted by our board of directors contemplates the distribution of a substantial portion of our cash available to pay dividends, our board could modify or revoke this policy at any time;
•
even if our dividend policy is not modified or revoked, the actual amount of dividends distributed under the policy and the decision to make any distribution will remain at all times entirely at the discretion of our board of directors;
•
the amount of dividends that we may distribute is limited by restricted payment and leverage covenants in our credit facilities and, potentially, the terms of any future indebtedness that we may incur;
•
the amount of dividends that we may distribute is subject to restrictions under Iowa law; and
•
our shareholders have no contractual or other legal right to dividends.
Equity Compensation Plan Information
The following table sets forth information, as of December 31, 2008, concerning compensation plans previously approved by security holders and not previously approved by security holders.
(1) Excludes 471,150 shares of common stock that have been issued as restricted stock, subject to certain vesting requirements.
(2) The number of securities noted represents the remaining shares available for future issuance under the Company’s 2005 Stock Incentive Plan. Although the 2002 Stock Incentive Plan permits the issuance of options to purchase 32,354 additional shares, the board has determined that no further options will be granted under the 2002 Plan.
2008 Performance Graph
Recent Sales of Unregistered Securities
None.
Repurchase of Equity Securities by the Issuer and Affiliated Purchasers
None.
ITEM 6.
ITEM 6. Selected Financial Data
The following selected financial data for the years ended December 31, 2004 through 2008 has been derived from our consolidated financial statements. The following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Item 7
Item 7 and our consolidated financial statements for 2006, 2007 and 2008 and the related notes thereto contained under Item 8. The figures in the table below reflect rounding adjustments.
(a) Includes the recognition, as a result of our rate settlement agreement with the Iowa Utilities Board in April 2004, of $7.1 million of revenues that we had collected in prior periods subject to refund pending such agreement. In addition, Other, net includes $22.4 million of costs associated with our initial public offering and related debt refinancing.
(b) Includes a pension settlement charge of $3.0 million.
(c) Includes $5.8 million of revenue from a non-recurring network access billing matter with connecting carriers.
(d) Includes a $2.5 million curtailment gain resulting from changes to our postretirement welfare plan obligations.
(e) We present Adjusted EBITDA because we believe it is a useful indicator of our historical debt capacity and our ability to service debt and pay dividends. We also present Adjusted EBITDA because covenants in our credit facilities contain ratios based on Adjusted EBITDA.
Adjusted EBITDA is defined in our credit facilities as: (1) consolidated net income, as defined therein; plus (2) the following items, to the extent deducted from consolidated net income: (a) interest expense; (b) provision for income taxes; (c) depreciation and amortization; (d) transaction expenses related to our initial public offering and the related debt refinancing and other limited expenses related to permitted securities offerings, investments and acquisitions incurred after the closing date of the our initial public offering, to the extent not exceeding $5.0 million; (e) unrealized losses on financial derivatives recognized in accordance with SFAS No. 133; (f) non-cash stock-based compensation expense; (g) extraordinary or unusual losses (including extraordinary or unusual losses on permitted sales of assets and casualty events); (h) losses on sales of assets other than in the ordinary course of business; and (i) all other non-cash charges that represent an accrual for which no cash is expected to be paid in the next twelve months; minus (3) the following items, to the extent any of them increases consolidated net income: (w) extraordinary or unusual gains (including extraordinary or unusual gains on permitted sales of assets and casualty events); (x) gains on asset disposals not in the ordinary course of business; (y) unrealized gains on financial derivatives recognized in accordance with SFAS No. 133; and (z) all other non-cash income (including the non-cash portion of any RTFC patronage capital allocation). If our Adjusted EBITDA were to decline below certain levels, covenants in our new credit facilities that are based on Adjusted EBITDA, including our fixed charge coverage and total leverage ratio covenants, may be violated and could cause, among other things, a default or mandatory prepayment under our credit facilities, or result in our inability to pay dividends. We believe that net income is the most directly comparable financial measure to Adjusted EBITDA under generally accepted accounting principles. Adjusted EBITDA should not be considered in isolation or as a substitute for consolidated statement of operations and cash flows data prepared in accordance with GAAP. Adjusted
EBITDA is not a complete measure of an entity’s profitability because it does not include costs and
expenses identified above; nor is Adjusted EBITDA a complete net cash flow measure because it does not include reductions for cash payments for an entity’s obligation to service its debt, fund its working capital, make capital expenditures and make acquisitions or pay its income taxes and dividends.
The following table sets forth a reconciliation of Net Income to Adjusted EBITDA:
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in combination with the selected financial data and the consolidated financial statements and notes thereto included in Items 6 and 8 herein.
Overview
General
Iowa Telecommunications Services, Inc. (“Iowa Telecom”) and its subsidiaries provide wireline local exchange telecommunications services to residential and business customers in rural Iowa, Minnesota and Missouri. We currently operate 294 telephone exchanges serving 423 communities as the incumbent or “historical” local exchange carrier and are the sole telecommunications company providing wireline services in approximately 67% of these communities. In addition, we provide service to residential and business customers throughout Iowa and Minnesota as a competitive local exchange carrier. In total, we provide services to approximately 242,100 access lines.
Our core business is the provision of local telephone service and network access to other telecommunications carriers for calls originated or terminated on our network. In addition to these core activities, which generated 65% of our total revenues for the year ended December 31, 2008, we provide long distance service, dial-up and DSL Internet access, and other communications services. We provide services as the incumbent local exchange carrier through Iowa Telecom and its wholly-owned subsidiaries; Lakedale Telephone Company and Montezuma Mutual Telephone Company. As part of our strategy of pursuing growth beyond our current service area, we compete for customers in Iowa in mostly adjacent markets through our competitive local exchange carrier subsidiaries, Iowa Telecom Communications, Inc. (“ITC”) and IT Communications, LLC (“IT Communications”). Additionally, Lakedale Link, Inc. and EN-TEL Communications LLC (“EN-TEL”) are competitive local exchange carriers that provide local and long distance service in Minnesota. Together, ITC, IT Communications, Lakedale Link, Inc. and EN-TEL are referred to as the “CLEC” or our “CLEC Operations.”
Factors Affecting Our Operating Performance
We believe that a number of industry and company-specific factors have affected and will continue to affect our results of operations. These factors include the following:
•
the effect on our revenues of declining numbers of access lines resulting from competition and other factors and our strategic response to this trend, which includes efforts to introduce enhanced local services and additional services like dial-up and DSL Internet access and long distance service and to cross-sell these services to our subscriber base;
•
the effect on our revenues of our rate and pricing structure, including recent and potential future changes in rate regulation at the state and federal levels;
•
our ability to control our variable operating expenses, such as sales and marketing expense;
•
the development of our competitive local exchange carrier strategy; and
•
our success in integrating acquired operations.
Access Line Trends
The number of access lines served is a factor that can affect a telecommunications provider’s revenues. Consistent with a general trend in the local exchange carrier industry in the past few years, the number of access lines we serve as an incumbent local exchange carrier has been decreasing. We expect that this trend will continue. Because substantially all of our revenues result from our relationships with customers who utilize our access lines and the level of activity recorded on those lines, the access line trend has an adverse impact on our revenues. Our response to this trend will have an important impact on our future revenues. Our primary strategy to respond to this trend is to leverage our strong incumbent market position to increase our revenue by selling additional services to our customer base and to promote our DSL Internet access service offering, which is often used in lieu of additional access lines devoted to Internet usage. In addition, we expect to add new access lines as we pursue expansion of our service area through our competitive local exchange carrier subsidiaries and, potentially, through selected acquisitions of other telecommunications companies or lines from other telecommunications companies. However, we believe that the number of access lines served is not the sole meaningful indicator of our operating prospects and that, given our relatively stable subscriber base and ability to offer additional services, the number of long distance, and dial-up and DSL Internet subscribers are also meaningful indicators for us.
The table below indicates the total number of access lines we serve and the number of customers subscribing to the indicated types of service as of the dates and for the periods shown:
(1) Includes lines subscribed by our incumbent local exchange carrier retail customers and lines subscribed by our “wholesale” customers who are competing local exchange carriers. Wholesale access lines include: lines subscribed by our local exchange carrier competitors pursuant to interconnection agreements on an unbundled network element basis, for which the competitive local exchange carrier pays us a monthly fee; lines that we provide to competitive local exchange carriers for resale to their subscribers, for which the
competitive local exchange carrier pays us a monthly fee equal to what we would charge our customers for local service less an agreed discount; and shared lines, for which a competitive local exchange carrier pays us a monthly fee to provide DSL service to its customers. We had 2,300 wholesale lines subscribed at December 31, 2008; 2,900 at December 31, 2007; and 3,100 at December 31, 2006.
(2) Access lines subscribed by retail customers of our competitive local exchange carrier subsidiaries.
(3) Includes units acquired from Bishop Communications.
(4) Includes subscribers served via our facilities as well as subscribers of satellite service which we resell.
The following is a discussion of the major factors affecting our access line counts:
Competition. We currently face competition from other providers of local services in approximately 138 of the 423 incumbent local exchange communities our incumbent local exchange carrier serves. Of these 138 communities, we believe 109 communities have some voice service offered by Mediacom’s telephony affiliates, MCC Telephony of Iowa, Inc. and MCC Telephony of Minnesota, LCC. (“MCC”), which initiated service in most of these markets during the second quarter of 2007. Additionally, we believe that in approximately 40 of these communities, independent local exchange carriers operating in mostly adjacent exchanges and municipal utilities have constructed networks to provide competitive local exchange carrier services to customers in our exchanges.
In addition, we have experienced and expect to continue experiencing some line losses due to competition from wireless providers, but cannot precisely quantify the effect of this competition on us. We are responding proactively to wireless competition by offering bundled service packages that include blocks of long distance minutes. These packages are designed to meet the demand of our customers who wish to purchase both local and long distance services in a package, as is typically offered by wireless providers.
The jurisdiction of the Iowa Utilities Board over our local retail rates changed dramatically as a result of state deregulatory legislation that became effective on July 1, 2005. Pursuant to this legislation, each telephone utility then subject to rate regulation, such as Iowa Telecom, was permitted to elect to deregulate its charges for all of its retail business and residential local exchange services except single line flat-rated residential and business service and Extended Area Services, which remained rate-regulated until June 30, 2008, after which such authority sunset. The Iowa Utilities Board could have extended such sunset to no later than June 30, 2010, but determined on June 27, 2008, not to impose such an extension based on the level of competition in local telecommunications markets. The Iowa Utilities Board, through its jurisdiction to deregulate services based on the existence of effective competition, had already deregulated all of our rates for local exchange in 14 exchanges pursuant to a December 23, 2004 order, and after the July 1, 2005, legislation took effect, another 14 exchanges pursuant to a December 5, 2005, order, the latter order focusing only on single-line flat-rated service due to the July 1, 2005, deregulation of all other local exchange service rates statewide.
MCC is offering voice services through a business arrangement with Sprint Communications L.P. (“Sprint”). On June 23, 2006, we filed a complaint against the Iowa Utilities Board and Sprint in the U.S. District Court for the Southern District of Iowa asking the court to rule that the Iowa Utilities Board acted unlawfully when it required us to enter into an interconnection agreement with Sprint and asking the court to invalidate the agreement. On April 15, 2008, the court issued a ruling in favor of the Iowa Utilities Board and Sprint, therefore maintaining the status quo in which we are obligated to enter into an interconnection agreement with Sprint. We appealed this decision to the U.S. Court of Appeals for the Eighth Circuit on May 14, 2008 and oral argument was held on December 12, 2008. We cannot predict how or when this litigation will be resolved.
Notwithstanding the period in which our complaint was under consideration, we have negotiated, mediated and litigated with Sprint and, at times, with MCC to resolve issues relating to interpretation and implementation of the interconnection agreement. On January 22, 2007, we filed a second complaint against the Iowa Utilities Board and Sprint in U.S. District Court asking the court to rule that the Iowa Utilities Board acted unlawfully when it interpreted the interconnection agreement to require Iowa Telecom to provide certain services to Sprint, particularly in the manner requested by Sprint. Briefing on this complaint concluded on August 11, 2008. We cannot predict how or when this litigation will be resolved.
In addition to the disputes pending in federal district court and before the Iowa Utilities Board, we are also defending a complaint filed by MCC on July 31, 2006, in the Iowa District Court for Polk County alleging that our refusal to accede to Sprint’s negotiation demands improperly interfered with MCC’s contracts and prospective customer relationships. The state court complaint seeks unspecified damages and costs and additional relief as warranted. This state court proceeding had been stayed pending the result of our first federal complaint. On September 9, 2008, the state court refused to lift the stay due to the pending appeal of the federal district court’s decision on the first complaint to the Eighth Circuit. This stay will remain effective until the Eighth Circuit rules, subject to reconsideration by the state court if the Eighth Circuit has not ruled by March 9, 2009. We cannot predict how long this stay will last nor how or when this state court litigation will be resolved.
Business Acquisitions. We completed the purchase of Bishop Communications on July 18, 2008. As of September 30, 2008, Bishop Communications and its consolidated subsidiaries provided telecommunications services to 11,600 access lines as the incumbent local exchange carrier, 4,600 access lines as a competitive local exchange carrier, served 9,700 long distance subscribers, and provided Internet access service to more than 6,600 subscribers.
Ancillary Effects of our Data Businesses. Part of our decreasing line count has been an ancillary effect of our strategic focus on growing our Internet access service business. As our Internet service provider business expanded, some competitors offering dial-up internet service have cancelled their connections to our network. These connections had historically been counted as access lines. Moreover, as we increase DSL Internet access service penetration, customer demand for second lines for dial-up Internet access service decreases accordingly because DSL Internet access service often replaces a second line dedicated to Internet usage. We believe that the revenue generated by our dial-up and DSL Internet access services outweighs the effect of these types of access line losses.
Our Retail Local Rate and Pricing Structure
As described under “Overview-Competition” above, effective July 1, 2005, the rates for all of our Iowa retail local exchange service except for single line flat-rated business and residential service and EAS were deregulated. Beginning July 1, 2005, monthly rates for single line services remaining under price regulation could be adjusted annually by one dollar for residential lines and two dollars for business lines, plus an inflation increment, up to a monthly rate cap of $19.00 for residential lines and $38.00 for business lines. These rate caps did not, however, include charges for EAS. The remaining retail local exchange service rate regulation in our then-rate-regulated exchanges, with the arguable exception of EAS, expired effective July 1, 2008. The Iowa Utilities Board had an opportunity to extend such remaining rate regulation until July 1, 2010, but, in a June 27, 2008 order, found that an extension of rate regulation was not in the public interest.
Our Ability to Control Operating Expenses
We strive to control expenses in order to maintain our operating margins. We anticipate that operating expenses generally will remain stable and in line with revenue growth. Because some of our operating expenses, such as those relating to sales and marketing, are variable, we believe we can calibrate expenses to growth in the business to a significant degree.
Development of our Competitive Local Exchange Carrier Strategy
Part of our business strategy is to use our CLEC Operations to pursue customers in markets in close proximity to our rural local exchange carrier markets. We plan to continue this strategy by seeking growth opportunities on a low-cost, selective basis, focusing primarily on business customers.
As of December 31, 2008, our CLEC Operations served 32,400 access lines. Our CLEC Operations accounted for 13.4% of Iowa Telecom’s total access lines as of December 31, 2008. Throughout 2009, we plan to maintain a limited investment approach as we continue to grow our competitive local exchange carrier business.
Revenues
We derive our revenues from five sources:
Local Services. We receive revenues from providing local exchange telephone services. These revenues include monthly subscription charges for basic service, as well as charges for extended area service (mandatory expanded calling service to select nearby communities at a flat monthly rate), local private line services and enhanced calling features, such as voice mail, caller ID and 3-way calling.
Network Access Services. We receive revenues from charges established to compensate us for the origination, transport and termination of calls generated by the customers of long distance carriers and for calls transported and terminated for the customers of wireless carriers. These include subscriber line charges imposed on end users, and switched and special access charges paid by carriers and others. We receive federally administered universal service support, representing approximately 2% of our total revenue in 2008, as a result of the interstate switched access support provisions of the FCC’s CALLS Order to which the Company became subject in 2000. In addition, Montezuma Telephone received high cost loop universal service support amounting to less than 1% of our revenue. Our incumbent local exchange carrier and our independent incumbent local exchange carriers switched access charges are based on rates approved by applicable state regulatory agencies. Our incumbent local exchange carrier and our independent incumbent local exchange carriers switched and special access charges for interstate and international services are based on rates approved by the FCC. The transport and termination charges paid by wireless carriers to our incumbent local exchange carriers are specified in interconnection agreements negotiated with each individual wireless carrier.
Toll Services. We receive revenues for providing toll, or long distance, services to our customers. This revenue category also includes fees relating to our provision of directory assistance, operator assistance and long distance private lines.
Data and Internet Services. We receive revenues from monthly recurring charges for dial-up and DSL Internet access services, as well as for providing enhanced data services to our customers.
Other Services and Sales. We receive revenues from directory publishing, inside line care, satellite and cable video, and the sale, installation and maintenance of customer premise voice and data equipment (“CPE”), and the lease of office space to third parties.
The following table summarizes our revenues and sales from these sources:
Operating Expenses
Our operating expenses are categorized as cost of services and sales; selling, general and administrative expense; gain on sale of properties; and depreciation and amortization.
Cost of services and sales. This includes expense for salaries and wages relating to plant operations and maintenance; other plant operations, maintenance and administrative costs; network access costs paid to other carriers; bad debt expense; operating tax expense and cost of sales for our dial-up and DSL Internet access services, video services and customer premise equipment products and services.
Selling, general and administrative expense. This includes expense for salaries, wages and benefits and contract service payments (e.g., legal fees) relating to customer and corporate operations; recruiting costs; expenses for travel, lodging and meals; internal communications costs; insurance premiums; and supplies and postage.
Gain on sale of properties. This includes gains recorded when properties are sold.
Depreciation and amortization. This includes depreciation of our telecommunications network and equipment, and amortization of intangible assets.
Results of Operations
The following table sets forth certain items reflected in our consolidated statements of income for the periods indicated, expressed as a percentage of total revenues and sales:
Year ended December 31, 2008 compared to year ended December 31, 2007
Revenues and Sales
The table below sets forth the components of our revenues and sales for 2008 as compared to 2007:
Local Services. Local services revenues decreased $2.8 million, or 3.8%, for 2008 as compared to 2007. The decrease was primarily due to a decline in average access lines. From December 31, 2007 to December 31, 2008, total access lines, excluding lines acquired in the Bishop Communications transaction, decreased by 14,500, including the loss of 16,000 incumbent local exchange carrier lines partially offset by an increase in lines served by our competitive local exchange carriers of 1,500. Inclusive of the lines acquired in the Bishop Communication transaction, total access lines decreased by 1,400, comprised of a decrease in incumbent local exchange carrier lines of 4,600 and an increase in competitive local exchange carrier lines of 6,000. The decrease in revenue resulting from the access line loss was partially offset by local rate increases combined with higher revenue from enhanced calling features due to greater bundled offering sales.
Network Access Services. Our network access services revenues decreased $11.2 million, or 11.1%, for 2008 as compared to 2007. The decrease was primarily due to $5.8 million of revenue from certain non-recurring network access billing matters with connecting carriers recorded in 2007, while 2008 included a $1.5 million unfavorable impact due to similar items. Also contributing to the decrease was the decline in access lines, lower minutes of use per line and slightly lower revenue per minute.
Toll Services. Our toll services revenues increased by $1.8 million, or 8.5%, for 2008 as compared to 2007. The increase in revenue was due to higher customer connection charges and the acquisition of Bishop Communications.
Data and Internet Services. Data and Internet services revenues increased by $5.7 million, or 19.1%, for 2008 as compared to 2007. The increase was primarily a result of growth in our DSL Internet access service revenue of $4.8 million excluding Bishop Communications, growth in our enhanced data services products revenue of $1.2 million and revenue from Bishop Communications. This increase was partially offset by a decrease in dial-up Internet revenue of $1.7 million. We believe the decline in dial-up Internet access service customers primarily was the result of customer migration to broadband products such as our DSL Internet service.
Other Services and Sales. Other services and sales revenues increased by $2.1 million, or 8.1%, for 2008 as compared to 2007. The revenue increase was primarily due to a $2.9 million growth in our CPE business and the acquisition of Bishop Communications, partially offset by a $1.9 million decrease in rental income.
Operating Costs and Expenses
The table below sets forth the components of our operating costs and expenses for 2008 as compared to 2007:
Cost of Services and Sales. Cost of services and sales decreased $155,000, or 0.2%, for 2008 as compared to 2007. During the fourth quarter of 2008, the Company obligation for postretirement benefits was modified. This resulted in a one-time curtailment gain of $2.5 million which reduced expenses. Exclusive of the benefit plan obligation changes, costs of services and sales increased by $2.4 million. The increase was principally due to growth of our CPE and data business and costs attributable to the acquisition of Bishop Communications.
Selling, General and Administrative. Selling, general and administrative expenses increased $2.5 million for 2008 as compared to 2007. The increase in expenses was primarily due to increased costs from Bishop Communications partially offset by lower salary, wages, benefits and insurance costs.
Depreciation and Amortization. Depreciation and amortization increased $4.7 million, or 9.6%, for 2008 as compared to 2007. The increase was primarily due to higher plant balances for the Iowa properties and depreciation and amortization expense for Bishop Communications.
Other Income (Expense)
The table below sets forth other income (expense) for 2008 as compared to 2007:
Interest and Dividend Income. Interest and dividend income increased $10,000, or 1.1% for 2008 as compared to 2007, primarily due to higher dividend income.
Interest Expense. Interest expense decreased $441,000, or 1.4%, for 2008 as compared to 2007 principally as a result of lower interest rates on our variable rate debt.
Other, Net. Other, net was a net income of $429,000 for 2008, compared to a net expense of $719,000 in 2007, primarily due to lower earnings before income tax. This was principally from the ineffectiveness and subsequent termination of an interest rate swap agreement during 2008. The $719,000 of expense in 2007 resulted from the ineffective portion of our interest rate swap agreements.
Income Tax Expense
Income tax expense decreased $3.6 million to $17.3 million for 2008 as compared to 2007.
At December 31, 2008, we had unused tax net operating loss carryforwards of approximately $149.0 million which expire in 2021 to 2024. Furthermore, we expect that we will continue to be able to take deductions related to the amortization of intangibles in excess of the amount recorded for book purposes in the amount of approximately $41 million annually through June 2015. We determined that, based upon the evidence available as of December 31, 2008, the combination of the continued generation of taxable income and the taxable income generated from reversing temporary differences will, more likely than not, be sufficient to utilize the entire deferred tax asset. As such, we determined that no valuation allowance was required for our deferred tax assets. During the years ended December 31, 2007 and 2008, cash income taxes paid were $633,000, and $399,000, respectively, and primarily relate to payments of alternative minimum tax (AMT).
Year ended December 31, 2007 compared to year ended December 31, 2006
Revenues and Sales
The table below sets forth the components of our revenues and sales for 2007 as compared to 2006:
Local Services. Local services revenues decreased $2.5 million, or 3.3%, for 2007 as compared to 2006. The decrease was primarily attributable to the loss of access lines. From December 31, 2006 to December 31, 2007, total access lines decreased by 11,300, including the loss of 13,900 incumbent local exchange carrier lines offset by an increase in lines served by our competitive local exchange carriers of 2,600. The decrease in revenue resulting from the access line loss was partially offset by local rate increases combined with higher revenue from enhanced calling features due to greater bundled offering sales.
Network Access Services. Our network access services revenues increased $4.4 million, or 4.6%, for 2007 as compared to 2006. The increase was primarily due to $5.8 million of revenue from certain non-recurring network access billing matters with connecting carriers. This was partially offset by a decrease in minutes of use resulting from the loss of access lines.
Toll Services. Our toll services revenues decreased by $591,000, or 2.7%, for 2007 as compared to 2006. The number of long distance customers decreased by approximately 3,000, or 2.0%. In addition, average minutes of use per access line decreased.
Data and Internet Services. Data and Internet Services revenues increased by $4.5 million, or 18.0%, for 2007 as compared to 2006, primarily as a result of growth in our DSL Internet access service of $5.8 million. This increase was partially offset by decreases in dial-up Internet revenue of $1.9 million. We believe the decline in dial-up Internet access service customers was the result of customer migration to broadband products such as our DSL service.
Other Services and Sales. Other services and sales revenues increased by $11.5 million, or 78.7%, for 2007 as compared to 2006. The revenue increase was in part due to growth of our CPE and data business, primarily as a result of our acquisition of Baker Communications in August 2006. Also contributing to the increase was $3.5 million of revenue from the lease of office space to another entity during 2007.
Operating Costs and Expenses
The table below sets forth the components of our operating costs and expenses for 2007 as compared to 2006:
Cost of Services and Sales. Cost of services and sales increased $11.7 million, or 17.6%, for 2007 as compared to 2006. The increase was principally due to growth of our CPE and data business, primarily as a result of our acquisition of Baker Communications in August 2006. Additionally, the operating costs for the newly acquired corporate headquarters facilities contributed to the increase in cost of services and sales.
Selling, General and Administrative. Selling, general and administrative expenses decreased $4.1 million, or 8.9%, for 2007 as compared to 2006. The 2006 period included a pension settlement charge of approximately $3.0 million. During the second quarter of 2007, the Company amended its postretirement welfare plan. The amendment reduced expense $1.1 million compared to 2006.
Gain on sale of Properties. The 2006 period included a $4.2 million gain on the sale of exchanges.
Depreciation and Amortization. Depreciation and amortization increased $1.3 million, or 2.6%, for 2007 as compared to 2006. The increase was primarily due to depreciation and amortization related to Montezuma Mutual Telephone Company and Baker Communications, which were acquired in July 2006 and August 2006, respectively.
Other Income (Expense)
The table below sets forth other income (expense) for 2007 as compared to 2006:
Interest and Dividend Income. Interest and dividend income decreased $25,000, or 2.6% for 2007 as compared to 2006, primarily due to lower dividend income.
Interest Expense. Interest expense increased $177,000, or 0.6%, for 2007 as compared to 2006 principally as a result of higher interest rates on our variable rate debt.
Other, Net. Other, net was a net expense of $719,000 for 2007, compared to $572,000 in 2006.
Income Tax Expense
Income tax expense increased $8.6 million to $20.9 million for 2007 as compared to 2006.
A valuation allowance had been recorded at December 31, 2005 for our deferred tax assets that expire over time to the extent that they exceeded the net deferred tax assets and liabilities resulting from reversing temporary differences. We determined that no valuation allowance was required for our deferred tax assets as of December 31, 2006 and thereafter. We determined that, based upon the evidence available as of December 31, 2007, the combination of the continued generation of taxable income and the taxable income generated from reversing temporary differences will more likely than not, be sufficient to utilize the entire deferred tax asset. During the years ended December 31, 2006 and 2007, cash income taxes paid were $964,000, and $633,000, respectively, and relate to payments of alternative minimum tax (AMT).
At December 31, 2007, we had unused tax net operating loss carryforwards of approximately $159.8 million which expire in 2021 to 2024. Furthermore, we expect that we will continue to be able to take deductions related to the amortization of intangibles in excess of the amount recorded for book purposes in the amount of approximately $41 million annually through June 2015.
Liquidity and Capital Resources
Our short-term and long-term liquidity requirements arise primarily from: (i) interest and principal payments related to our credit facilities; (ii) capital expenditures; (iii) working capital requirements; (iv) dividend payments on our common stock and (v) potential acquisitions as described below.
The table below reflects the dividends declared or paid by the Company during 2008:
Our intention is to distribute a substantial portion of the cash generated by our business to our shareholders in regular quarterly dividends to the extent we generate cash in excess of operating needs, interest and principal payments on our indebtedness, and capital expenditures.
We intend to fund our operations, interest expense, capital expenditures, working capital requirements and dividend payments on our common stock with cash from operations. For 2008 and 2007, cash provided by operating activities was $88.6 million and $100.2 million, respectively.
To fund any significant future acquisitions, we intend to use borrowings under our revolving credit facility or, subject to the restrictions in our credit facilities, to arrange additional funding through the sale of public or private debt and/or equity securities, including common stock, or to obtain additional senior bank debt.
On November 21, 2008, the Company announced a definitive agreement to acquire substantially all of the assets of Sherburne Tele Systems, Inc. (“Sherburne”) for a total purchase price of $80.6 million, subject to certain adjustments and regulatory approvals. Sherburne is a closely held telecommunications company headquartered in Big Lake, Minnesota, less than 30 miles from the headquarters of Bishop Communications, which we acquired on July 18, 2008. The Company intends to fund the acquisition of Sherburne with the
proceeds of $75.0 million of new term debt issued under our existing credit facilities, borrowings on our revolving credit facility and cash on hand. The new term debt is expected to bear interest per annum at a LIBOR rate plus 2.0% and will mature in November 2011.
Our ability to service our indebtedness will depend on our ability to generate cash in the future. We are not required to make any scheduled principal payments on Term Loans B, C and D, which will mature in 2011. However, we may be required to make annual mandatory prepayments under our credit facilities with a portion of our available cash. We will need to refinance all or a portion of our indebtedness on or before maturity in 2011. Debt issued by EN-TEL, of approximately $13.0 million, required principal payments of $599,000 in 2008, and will have principal payments of $1.2 million in 2009, $1.3 million in 2010, $1.4 million in 2011, $1.5 million in 2012, $1.6 million in 2013 and $5.3 million thereafter.
The dividend policy adopted by our board of directors calls for us to distribute a substantial portion of our cash flow to our shareholders. As a result, we may not have significant cash available to meet any large unanticipated liquidity requirements, other than through available borrowings, if any, under our revolving credit facility. Therefore, we may not have a sufficient amount of cash to finance growth opportunities, including acquisitions, to fund unanticipated capital expenditures or to fund our operations. If we do not have sufficient cash for these purposes, our financial condition and our business could suffer. However, our board of directors may, in its discretion, amend or repeal this dividend policy to decrease the level of dividends provided for under the policy, or discontinue entirely the payment of dividends.
We have historically funded our operations and capital expenditure requirements primarily with cash from operations and our revolving line of credit. The following table summarizes our short-term liquidity and Adjusted Total Debt and Adjusted EBITDA, as defined in our credit agreement, as of December 31, 2007 and 2008:
The reductions in current assets and increase in current liabilities from December 31, 2007 to December 31, 2008 were primarily due to the use of cash and cash equivalents and borrowings on the revolving credit facility to acquire Bishop Communications, and to acquire our wireless licenses.
The following table summarizes our sources and uses of cash for the years ended December 31, 2006, 2007 and 2008:
Cash Provided by Operating Activities
For the years ended December 31, 2006, 2007, and 2008, cash provided by operating activities was $89.5 million, $100.2 million, and $88.6 million, respectively. The increase of $10.7 million for 2007 as compared to 2006 was primarily attributable to the funds received related to the resolution of certain network access disputes in 2007 and a pension contribution in 2006. The decrease of $11.6 million for 2008 as compared to 2007 was primarily attributable to funds received related to the resolution of certain network access disputes in 2007.
Cash Used in Investing Activities
The table below sets forth the components of cash used in investing activities for the years ended December 31, 2006, 2007, and 2008:
In April 2004, our incumbent local exchange carrier reached a rate settlement agreement with the Iowa Utilities Board and other parties. Pursuant to the settlement agreement, we were obligated to invest substantially all additional revenues generated by the allowed increase in our regulated rates, except for revenues resulting from inflation adjustments, on capital improvements identified in our network improvement plan. Because deregulated services were excluded from the agreement, the retail local exchange service rate deregulation that became effective July 1, 2008 eliminated our continuing obligation to invest any incremental revenue from the regulated rate increase.
We expect that total capital expenditures, excluding those associated with the Sherburne acquisition, will be between approximately $25.0 million to $27.0 million in fiscal 2009. We expect to fund all of these capital expenditures through cash generated by our operations. Our capital expenditures can fluctuate from quarter to quarter, and are impacted to some extent by factors beyond our control, such as customer demand, the level of construction activity in our region, and weather.
On July 18, 2008, we completed the purchase of Bishop Communications for a total purchase price of $33.1 million net of cash received and assumed debt of $13.0 million, subject to potential working capital adjustments.
During the first quarter of 2008, we participated in the FCC’s auction of 700 MHz Band licenses (Auction No. 73) after depositing $1.9 million with the FCC. We were the high bidder on three Cellular Market Area licenses in the 704-710 MHz, and 734-740 MHz bands. We submitted the balance of our $5.9 million total winning bids on April 17, 2008. The FCC issued the licenses during the second quarter of 2008.
We currently hold 15 FCC Advanced Wireless Service licenses and hold three 700 MHz licenses in Iowa. Our ownership of these licenses subjects us to FCC regulation of the wireless services we may choose to provide and the technical operating characteristics of the network equipment we may utilize. In addition, our right to renew these licenses depends on our compliance with build-out requirements promulgated by the FCC. For the 700 MHz licenses, which were acquired in 2008, we must begin meeting such requirements in stages prior to the expiration of the initial 10 year license term. For our Advanced Wireless Service licenses, which were acquired in 2006, we must meet the FCC’s build-out requirements by the end of such licenses’ 15 year initial term. We cannot predict changes that may occur in the FCC’s regulation of our Advanced Wireless Services of 700 MHz licenses, the network we may build or the services we may provide over the period of time we may hold the licenses.
Cash Used in Financing Activities
For the year ended December 31, 2008, net cash used in financing was $31.7 million, consisting primarily of dividends on common stock of $51.7 million offset by an increase in the balance outstanding on the revolving credit facility of $21.0 million. For the year ended December 31, 2007, net cash used in financing was $65.0 million, consisting primarily of dividends on common stock of $51.5 million and a reduction in the balance
outstanding on the revolving credit facility of $13.0 million. For the year ended December 31, 2006, net cash used in financing was $58.2 million, consisting primarily of dividends on common stock of $51.0 million and a reduction in the balance outstanding on the revolving credit facility of $9.0 million.
Long-Term Debt and Revolving Credit Facilities
Iowa Telecom Credit Facilities
As of December 31, 2008, we had outstanding $477.8 million of senior debt under the term facilities, and had $39.0 million drawn under the $100.0 million revolving credit facility. The details of the credit facilities are as follows:
The revolving credit facility will expire in November 2011 and permits borrowings up to the aggregate principal amount of $100.0 million (less amounts reserved for letters of credit up to a maximum amount of $25.0 million). As of December 31, 2008, $39.0 million was outstanding on the revolving credit facility and $61.0 million was available. Borrowings under the revolving credit facility bear interest per annum at either (a) the London inter-bank offered rate, or LIBOR, plus 2.0% or (b) a base rate plus 1.0%. As of December 31, 2008, we had $39.0 million outstanding under LIBOR elections at an average all-in rate of 2.6%.
Term Loan B is a $400.0 million senior secured term facility maturing in November 2011, bearing interest per annum at either (a) a LIBOR rate plus an applicable rate adder of 1.75% per annum or (b) a base rate election plus an applicable rate adder of 0.75% per annum. As of December 31, 2008, $350.0 million was outstanding under Term Loan B based upon a LIBOR election effective through March 30, 2009, at an all-in rate of 3.22%. We have entered into interest rate swap agreements to fix the rate on $350.0 million of Term Loan B as more fully described below. As of December 31, 2008, the interest rate on the remaining $50.0 million was based upon a LIBOR election effective through January 12, 2009 at an all-in rate of 3.19%.
Term Loan C is a $70.0 million senior secured term facility maturing in November 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. The interest rate on Term Loan C was fixed at 6.65% until November 2007. Effective August 1, 2007 we elected a new all-in fixed interest rate of 6.95% through June 2011 on Term Loan C. Upon the expiration of the fixed interest rate period, the term loan will convert to the Rural Telephone Finance Cooperative base variable rate plus 0.85%.
Term Loan D is a $7.8 million senior secured term facility maturing in November 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. The interest rate on Term Loan D was fixed at 6.65% until November 2007. Effective August 1, 2007 we elected a new all-in fixed interest rate of 6.95% through June 2011 on Term Loan D. Upon the expiration of the fixed interest rate period, the term loan will convert to the Rural Telephone Finance Cooperative variable rate plus 0.85%.
As a condition of borrowing under Term Loans C and D, we are required to invest $7.8 million, representing 10% of the total amounts of Term Loans C and D, in Subordinated Capital Certificates (“SCCs”) of the Rural Telephone Finance Cooperative. SCCs are non-interest bearing but, as a member of the Rural Telephone Finance Cooperative, we share proportionately in the institution’s net earnings. The Rural Telephone Finance Cooperative will redeem the SCCs in proportion to our principal repayments on Term Loans C and D.
The credit facilities are secured by substantially all of our tangible and intangible assets, properties and revenues. The credit facilities are guaranteed by all of our wholly owned subsidiaries.
The credit facilities permit us to pay dividends to holders of our common stock; however, they contain significant restrictions on our ability to do so. The Iowa Telecom credit facilities contain certain negative covenants that, among other things, limit or restrict our ability (as well as those of our subsidiaries) to: create liens and encumbrances; incur debt, issue preferred stock, or enter into leases and guarantees; enter into loans, investments and acquisitions; make asset sales, transfers or dispositions; change lines of business; enter into hedging agreements; pay dividends, redeem stock, or make certain restricted payments; amend material debt agreements or other material contracts; engage in certain transactions with affiliates; enter into sale/leaseback or synthetic lease transactions; grant negative pledges or agree to such other restrictions relating to subsidiary dividends and distributions; make changes to our fiscal year; and engage in mergers and consolidations.
The Iowa Telecom credit facilities require us, subject to certain exceptions, to prepay outstanding loans under the credit facilities to the extent of net cash proceeds received from the following: issuance of certain indebtedness; proceeds of certain asset sales; and casualty insurance proceeds. The credit facilities further require us, subject to certain exceptions, to make prepayments under the credit facilities equal to 50% of any net increase in the following: distributable cash during a dividend suspension period, as defined; and cumulative distributable cash, as defined, during the fiscal year less the cumulative reductions of revolving loans (adjusted to exclude the effects of borrowings to fund permitted acquisitions) through such period, with reductions to the percentage to be determined based on improvements in certain credit ratios. As of December 31, 2008, no prepayment amounts were due under these provisions.
The Iowa Telecom credit facilities generally permit voluntary prepayments of the term loans and reductions of commitments without penalty or premium, other than standard breakage costs.
In addition, the financial covenants under the Iowa Telecom credit facilities specify, among other things, certain fixed charge coverage ratios and a maximum total leverage ratio, as defined, all of which we were in compliance with as of December 31, 2008.
EN-TEL Debt
On July 18, 2008, the Company acquired Bishop Communications Corporation (“Bishop Communications”). As part of the acquisition, the Company assumed debt issued by EN-TEL, a majority owned subsidiary of Bishop Communications, of $13.0 million. The EN-TEL debt consists of promissory notes payable to the Rural Telephone Finance Cooperative which have quarterly installments of principal and interest. The notes currently bear interest at an average all-in fixed rate of 7.19%. The notes have a fixed interest rate for specific periods of time ranging from December 2008 through December 2013 and will thereafter be either at a variable interest rate or renegotiated at a fixed rate at the end of the specified period. The notes mature in 2015 and 2018. Principal payments of $599,000 were made in 2008. The remaining scheduled payments are $1.2 million in 2009, $1.3 million in 2010, $1.4 million in 2011, $1.5 million in 2012, $1.6 million in 2013 and $5.3 million thereafter.
The notes are secured by the assets of EN-TEL, a majority owned subsidiary of Bishop Communications. The debt agreements restrict dividends paid by EN-TEL, and no amounts are currently available for dividends.
Interest Rate Swaps
On August 26, 2005, the Company amended the swap arrangement that was originally entered into on November 4, 2004. The amended swap arrangement resulted in two identical swap agreements which each fixed the interest rate that we will pay on $175.0 million of indebtedness under Term Loan B, for a total swap notional value of $350.0 million. Effective September 26, 2008, we terminated one of our swap agreements which we had designated as a hedge against the variability in future interest payments due on $175.0 million of Term Loan B. We entered into a new swap agreement effective September 30, 2008 to replace the terminated swap agreement. The amended terms of the new swap agreement and the remaining swap agreement effective August 31, 2005, effectively convert the variable rate interest payments due on $350.0 million of Term Loan B to a fixed rate of 5.87% through maturity of November 23, 2011.
Other Items
On August 4, 2004, the FCC adopted rules requiring certain telecommunications carriers to begin reporting additional information to the FCC in the event of selected service outages and related events affecting some fiber facilities. On December 20, 2004, the FCC stayed the rules’ effectiveness pending agency reconsideration of their merits, in part due to concerns about the substantial expenditures required of telecommunications carriers in order to comply with the new reporting obligations. At this time, we cannot predict the consequences of the FCC’s reconsideration or the financial or operational impacts any final rules may have on us.
In response to the Independent Panel Reviewing the Impact of Hurricane Katrina on Communications Networks, the FCC adopted rules on May 31, 2007, requiring incumbent local exchange carriers, competitive local exchange carriers, and wireless carriers to, among other things, maintain emergency back-up power for a minimum of eight hours for cell sites, remote switches, and digital loop carrier system remote terminals that normally are powered from local AC commercial power. Five days prior to the new rules taking effect, the FCC on October 4, 2007, released an order amending some of these new requirements to provide greater compliance flexibility. We do not anticipate incurring significant costs in complying with the FCC’s requirements.
On May 8, 2006, the Company filed with the FCC forbearance and waiver petitions asking it to allow the Company to become eligible to qualify for high-cost support from the non-rural high cost support program of the Universal Service Fund. On August 6, 2007, the FCC issued an order denying our petition for forbearance. The FCC has not yet ruled on our petition for waiver and there is no statutory deadline for issuing a ruling. We cannot predict whether the FCC will deny or approve the waiver petition, and the amount, if any, of high cost support funds that we may receive in the future. Furthermore, because our use of any high cost support program funds that we may receive as a result of our waiver petition would be limited to the provision, maintenance, and upgrading of facilities and services for which the support is intended, we cannot predict the extent to which receipt of such funds would affect our liquidity or earnings.
The Iowa Utilities Board took the position in the fourth quarter of 2008 that our incumbent local exchange carrier’s intrastate access rates have ceased to be subject to the intrastate switched access rate freeze since July 1, 2005, and are subject to challenge. The Board is currently considering such a challenge based on a February 20, 2008, MCImetro Transmission Access Transmission Services LLC, d/b/a Verizon Access Transmission Services and MCI Communications Services, Inc. d/b/a Verizon Business Services complaint filed with the Iowa Utilities Board against our local incumbent exchange carrier, our Iowa competitive local exchange carriers, Frontier Communication of Iowa, Inc., and Citizens Mutual Telephone Company alleging that such companies’ tariffed originating and terminating intrastate switched access rates of each are not just and reasonable and should be lowered by the Iowa Utilities Board to “mirror” the rates contained in Qwest Corporation’s Iowa tariff. The complaint appears to be similar to others asserted by these or related entities against the intrastate access charges of mid-sized incumbent local exchange companies in several other states. We filed a motion to dismiss the complaint in light of our legislated price plan, and believe the substance of the complaint to be without merit given the absence of any rationale for the proposed decrease. The Iowa Utilities Board denied our motion to
dismiss on November 14, 2008, a decision we cannot appeal until the Board issues a decision on the merits. The final round of testimony will be filed by Verizon on April 2, 2009, with a hearing to be held starting during the first week of May 2009. We cannot predict when this proceeding will conclude and what the outcome may be.
On September 12, 2008, the Iowa Utilities Board issued an order commencing an inquiry into whether the Board should create an Iowa universal service fund (“USF”). At this point, the Board is seeking comment on preliminary issues, such as how it should determine whether an Iowa USF is needed, although the Board is also inquiring into certain broad policy and implementation issues assuming that an Iowa USF will be established. Comments were due October 27, 2008. The Board has scheduled an initial informal workshop on March 25, 2009 to discuss issues. This workshop may be followed by other workshops and/or an order commencing rulemaking. At this time, the Board has yet to state formally whether its Iowa USF inquiry is tied to potential reductions in intrastate access charges. We cannot predict whether the Board will establish a rulemaking as a result of its pending inquiry and, if assuming it does, the result of such rulemaking or its potential impact on our operations.
In June 2008, record flooding damaged a few of the 423 ILEC communities served by Iowa Telecom. Through December 31, 2008, we believe that we have lost approximately 250 access lines that can be directly attributed to the flooding. Additionally, we believe that our operating results for the twelve months ended December 31, 2008 were negatively impacted by approximately $400,000, which is comprised of lost revenues, increased labor costs from overtime and a shift of capital efforts into repair efforts, along with other repair and prevention costs. We estimate that we have also incurred approximately $1.0 million of capital expenditures related to the flooding through December 31, 2008. However, we expect that amount may increase over time as the infrastructure is rebuilt in the impacted communities. We believe that we will recover a portion of the costs and expenditures described from our insurance carrier, but have not finalized an insurance claim. No insurance recovery has been recorded in the financial statements.
During the second quarter of 2007, we amended our postretirement welfare plan. The amendment eliminated medical benefits for certain retirees and reduced benefits for others. Life insurance benefits were eliminated for most retirees covered under the agreement. At the time of the plan amendment, approximately 58% of employees covered under the plan chose to opt out of the postretirement welfare plan. The significant change in the number of plan participants required a re-measurement of both the plan assets and benefit obligations. The re-measurement resulted in a one time curtailment gain of $247,000 and a reduction in the liability recorded for prior service costs of $5.6 million which will be amortized over 5.31 years as a component of the annual cost.
During the fourth quarter of 2008, the Company modified the agreement with the Communications Workers of America. The modification resulted in 26 employees opting out of the retiree medical plan effective November 30, 2008. This in turn triggered a plan curtailment under FAS 106 which required the immediate recognition of a portion of the remaining $3.8 million unrecognized prior service credit that was being amortized over 5.31 years. This resulted in a curtailment service ratio of 66.2% and a curtailment gain of $2.5 million in the fourth quarter of 2008.
Obligations and Commitments
Our ongoing capital commitments include capital expenditures and debt service requirements. For 2008, our capital expenditures were $28.2 million; see “-Liquidity and Capital Resources-Cash Used in Investing Activities.”
The following table sets forth our contractual obligations as of December 31, 2008, together with cash payments due in each period indicated:
(1) Advances on the line of credit mature in periods within one year. The terms of the line of credit are a component of our senior debt agreement which expires in November 2011.
(2) Excludes interest payments on variable rate long-term debt that has not been fixed through hedging arrangements. Amounts include the impact of hedging arrangements.
(3) Excludes commitments for Sherburne of $80.6 million, subject to certain future adjustments and regulatory approvals.
As of December 31, 2008, no letters of credit were outstanding.
We currently project that cash provided by operations will be adequate to meet our foreseeable operational liquidity needs for the next 12 months. However, our actual cash needs and the availability of required funding may differ from our expectations and estimates, and those differences could be material. Our future capital requirements will depend on many factors, including, among others, the demand for our services in our existing markets and regulatory, technological and competitive developments.
Critical Accounting Policies
The process of preparing financial statements requires the use of estimates on the part of management. The estimates used by management are based on our historical experiences combined with management’s understanding of current facts and circumstances. Certain of our accounting policies are considered critical, as they are both important to the portrayal of our financial statements and require significant or complex judgments on the part of management. The following is a summary of certain policies considered critical by management:
Impairment of Long-Lived Assets (Including Property, Plant and Equipment), Goodwill and Identifiable Intangible Assets. We reduce the carrying amounts of long-lived assets, goodwill and identifiable intangible assets to their fair values when the fair value of such assets is determined to be less than their carrying amounts. Fair value is typically estimated using a discounted cash flow analysis, which requires us to estimate the future cash flows anticipated to be generated by the particular asset being tested for impairment, and to select a discount rate to measure the present value of the anticipated cash flows. When determining future cash flow estimates, we consider historical operating results, as adjusted to reflect current and anticipated operating conditions. Estimating future cash flows requires significant judgment by us in such areas as future economic conditions, industry specific conditions and necessary capital expenditures. The use of different assumptions or estimates for future cash flows could produce different impairment amounts (or none at all) for long-lived assets, goodwill and identifiable intangible assets.
We performed an annual impairment review of goodwill and indefinite-lived intangible assets as required by Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, as of August 31, 2008, primarily using discounted cash flow and market value of debt methodologies. No impairment of goodwill or other long-lived assets resulted from the annual valuation.
Revenue Recognition. Revenues are recorded based upon services provided to customers. We record unbilled revenue representing the estimated amounts customers will be billed for services rendered since the last billing date through the end of a particular month. The unbilled revenue estimate is reversed in the following month when actual billings are made. All revenues are recorded net of applicable taxes assessed by governmental authorities.
Allowance for Doubtful Accounts. Our allowance for doubtful accounts reflects reserves for customer receivables to reduce receivables to amounts expected to be collected. In estimating uncollectible amounts, management considers factors such as current overall economic conditions, industry-specific economic conditions, historical customer payment trends and anticipated customer payment trends. While we believe our process effectively addresses our exposure for doubtful accounts, changes in economic, industry or specific customer conditions may require adjustment to the allowance for doubtful accounts recorded by us.
Income Taxes. Management calculates the income tax provision, current and deferred income taxes, along with the valuation allowance based upon various complex estimates and interpretations of income tax laws and regulations. Deferred tax assets are reduced by a valuation allowance to the extent that it is more likely than not they will not be realized.
Interest Rate Swap Agreements. The Company has entered into interest rate swap agreements which the Company designated as a hedge against the variability in future interest payments due on $350.0 million of Term Loan B. The purpose of the swap agreements is to adjust the interest rate profile of the Company’s debt obligations and to achieve a targeted mix of floating and fixed rate debt.
The swap agreements are accounted for in accordance with Statement of Financial Accounting Standard SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and qualify for cash flow hedge accounting of a variable-rate debt. In accordance with this standard, all changes in fair market value of the swap instruments attributable to hedge ineffectiveness are reported currently in earnings and are recorded in the Other Income (Expense) section of the Company’s Consolidated Statements of Income. Changes in fair market value of the swap instruments attributable to hedge effectiveness are recorded, net of income tax effects, in the Accumulated Other Comprehensive Income section of the Company’s Consolidated Statements of Stockholders’ Equity and Comprehensive Income.
In the event that the swap agreements no longer qualify for cash flow hedge accounting treatment, all changes in fair market value would be reported currently in earnings and would be recorded in the Other Income (Expense) section of the Company’s Consolidated Statements of Income. Additionally, the net gain or loss remaining in accumulated other comprehensive income would be reclassified into earnings over the remainder of the term of the swap agreements. For the period ended December 31, 2008, the Company would have recognized in earnings a loss of $18.1 million, had the interest rate swaps ceased to qualify for hedge accounting.
The fair value of the Company’s interest rate swap has been calculated by discounting the future cash flows of both the fixed rate and variable rate interest payments. The discount rate was derived from a yield curve created by a nationally recognized financial institution. The fair value of the interest rate swap is recorded in the Other Long-Term Liabilities section of the Company’s Consolidated Balance Sheets.
Off-Balance Sheet Risk and Concentration of Credit Risk
The Company has no known off-balance sheet exposure or risk.
Certain financial instruments potentially subject us to concentrations of credit risk. These financial instruments consist primarily of trade receivables, interest rate swap agreements, cash and cash equivalents.
We place our cash and temporary cash investments with high credit quality financial institutions. We also periodically evaluate the credit-worthiness of the institutions with which we invest. We have entered into interest rate swap agreements to adjust the interest rate profile of our debt obligations and to achieve a targeted mix of floating and fixed rate debt. The floating rate payers under the interest rate swap agreements are nationally recognized counterparties. While we may be exposed to losses due to non-performance of the counterparties or the calculation agents, we consider the risk remote and do not expect the settlement of these transactions to have a material adverse effect on our financial condition or results of operations.
New Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS 109”). Guidance is provided on derecognition, classification, interest and penalties accounting in interim periods, disclosure and transition. FIN 48 requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 were effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Adoption of FIN 48 on January 1, 2007, had no effect on our financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Adoption of SFAS 157 on January 1, 2008, did not have a material impact on the Company’s financial position, results of operations or cash flows.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose, at specified election dates, to measure eligible items at fair value and to report in earnings unrealized gains and losses on those items for which the fair value option has been elected. SFAS 159 also requires entities to display the fair value of those assets and liabilities on the face of the balance sheet. SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS 157. The Company evaluated the provisions of this statement and did not elect to adopt the fair value option on any financial instruments or other items held by the Company on January 1, 2008.
In May 2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1, Definition of Settlement in FASB Interpretation No. 48, which provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. The amendment had no impact on our financial position, results of operations or cash flows.
In June 2007, the Emerging Issues Task Force (“EITF”) reached consensus on Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards. EITF Issue No. 06-11 requires that the tax benefit related to dividend equivalents paid on restricted stock units that are expected to vest be recorded as an increase to additional paid-in capital. The Company currently accounts for this tax benefit as a reduction to its income tax provision. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007. Adoption of EITF Issue No. 06-11 on January 1, 2008, did not have a material impact on the Company’s financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 160, Non-controlling Interest in Consolidated Financial Statements (“SFAS 160”), an amendment of ARB No. 51. SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the non-controlling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding their interest of the parent and its non-controlling interest. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. The Company does not except adoption of this pronouncement to have a material impact on its financial position, results of operations and cash flows.
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS 141(R)”). SFAS 141(R) requires an acquiring entity to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value, with limited exceptions, and also includes a substantial number of new disclosure requirements. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption is prohibited. SFAS 141(R) requires acquisition related costs to be expensed as incurred. Acquisition related costs of $868,000 deferred pursuant to Statement of Financial Accounting Standard No. 141 (“SFAS 141”) on acquisitions that will not close until after SFAS 141(R) is adopted will be expensed upon adoption of SFAS 141(R) during the first quarter of 2009. Other than expensing acquisition costs deferred pursuant to SFAS 141 as discussed above, the Company does not expect the adoption of this pronouncement to have a material impact on its financial position, results of operations and cash flows.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”)-an amendment of FASB Statement No. 133. The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial condition, financial performance and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. SFAS 161 will impact disclosures only and will not have an impact on the Company’s consolidated financial condition, results of operations and cash flows.
ITEM 7A.
ITEM 7A. Quantitative And Qualitative Disclosures About Market Risk
Our short-term excess cash balance, if any, is typically invested in short-term commercial paper. We do not invest in any derivative or commodity type instruments. Accordingly, we are subject to minimal market risk on our investments.
Under the terms of our credit facilities, as amended, our long-term secured debt facilities will mature November 2011. Our $400.0 million of indebtedness under Term Loan B, maturing in 2011, bears interest per year at either (a) LIBOR plus 1.75% or (b) a base rate plus 0.75%. On August 26, 2005, we entered into two identical interest rate swap agreements with nationally recognized counterparties for the purpose of fixing the interest on a portion of these borrowings. On September 26, 2008, we terminated one of our swap
agreements and entered in to a new replacement swap agreement effective September 30, 2008. Pursuant to the current swap agreements, we will pay a fixed rate of interest of 5.87% on a $350.0 million notional amount of Term Loan B from September 30, 2008 through November 23, 2011.
We pay interest at a fixed rate on all borrowings under Term Loans C and D through June 2011. Thereafter, we expect our interest rates under Term Loans C and D to convert to the Rural Telephone Finance Cooperative variable rate then in effect, as provided in the credit facilities.
We are exposed to interest rate risk, resulting primarily from fluctuations in LIBOR, with respect to $50.0 million of borrowings under Term Loan B through November 2011. Similarly, changes in LIBOR will be the primary source of interest rate risk we face with respect to the $39.0 million of borrowings drawn under the revolving credit facility at December 31, 2008. With respect to our $77.8 million of borrowings under Terms Loan C and D, we are exposed to interest rate risk, resulting primarily from fluctuations in the Rural Telephone Finance Cooperative’s variable rate, from July 2011 through maturity in November 2011.
With respect to our $12.4 million of borrowings at our EN-TEL subsidiary, we are exposed to interest rate risk, resulting primarily from fluctuations in the Rural Telephone Finance Cooperation variable rate. The interest rate risk from the dates of the current interest rate locks, which have expiration dates from 2009 through 2013, until the notes mature in 2018.
A one percent change in the underlying interest rates for the variable rate debt that was outstanding on December 31, 2008 would have an impact of approximately $890,000 per year on our interest expense while our fixed rates and swaps are in place.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Iowa Telecommunications Services, Inc. and subsidiaries
Newton, Iowa
We have audited the accompanying consolidated balance sheets of Iowa Telecommunications Services, Inc. and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and of cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Iowa Telecommunications Services, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, as of December 31, 2006.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2009 expressed an unqualified opinion on the Company’s internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Des Moines, Iowa
February 27, 2009
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2007 AND 2008
(Dollars in Thousands, Except Per Share Amounts)
See notes to consolidated financial statements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
(Dollars in Thousands, Except Per Share Amounts)
See notes to consolidated financial statements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
(Dollars in Thousands, Except Per Share Amounts)
See notes to consolidated financial statements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
(Dollars in Thousands)
SUPPLEMENTAL NONCASH INVESTING AND FINANCING ACTIVITIES:
•
Dividends on common stock of $12,846 were declared on December 15, 2006 for shareholders of record as of December 29, 2006 and paid on January 16, 2007.
•
Dividends on common stock of $12,887 were declared on December 14, 2007 for shareholders of record as of December 31, 2007 and paid on January 15, 2008.
•
Dividends on common stock of $12,949 were declared on December 15, 2008 for shareholders of record as of December 31, 2008 and paid on January 15, 2009.
•
Includes the assumption of EN-TEL debt of $13,021 in consideration with the acquisition of Bishop Communications.
See notes to consolidated financial statements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
1. ORGANIZATION
Business Description-Iowa Telecommunications Services, Inc. and subsidiaries (“Iowa Telecom” or the “Company”) is an integrated telecommunications network serving approximately 242,100 total access lines in the Iowa, Minnesota and Missouri. Iowa Telecom provides local, long distance and Internet access and communications equipment primarily to rural residential and business customers, and provides access services to interexchange carriers (“IXCs”) and other communications companies. The company’s retail rates are primarily deregulated on a federal and state level. The vast majority of the Company’s interstate wholesale revenue is derived from access services provided to IXCs that are regulated on a price cap basis at the federal level. At the state level the vast majority of similar revenue is regulated on a basis currently under determination by the Iowa Utilities Board although we believe it to be a price cap basis and retain the right to litigate this matter. The Company manages its business as one operating segment.
Basis of Consolidation-The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Iowa Telecommunications Services, Inc., the parent company, is an operating company. For 2008, the parent company represents approximately 80% of total revenues, approximately 94% of net income and approximately 90% of total assets of the consolidated company. The subsidiaries, individually and in the aggregate represent less than 20% of consolidated revenue, earnings and total assets.
Revenue Recognition-Revenue is recognized when evidence of an arrangement exists, the earning process is complete and collectability is reasonably assured. The prices for regulated services are filed in tariffs with the appropriate regulatory bodies that exercise jurisdiction over the various services.
Local Services-Monthly recurring local line charges are billed to end users in advance. Revenue is recognized during the period these services are rendered. Billed but unearned revenue is deferred and recorded as a current liability included in advanced billings and customer deposits.
Network Access Services-Network access revenue primarily consists of switched access revenue billed to other carriers. Switched access revenue is billed in arrears based on originating and terminating minutes of use. Earned but unbilled switched access revenue is included in receivables. Network access revenue also contains special access revenue. Special access revenue is billed in advance based on recurring fees and recognized in revenue during the period services are provided. Network access revenue and special access revenue is recognized in the month services are provided.
Toll Services-Toll services are typically billed to end users in arrears based on actual usage. Earned but unbilled toll services are included in receivables. Toll service revenue is recognized in the month services are provided.
Data and Internet Sales-Monthly recurring charges for dial-up and DSL Internet access services are billed to end users in advance. Revenue is recognized during the period these services are provided. Billed but unearned revenue is included in advanced billings and customer deposits
Other Services and Sales-Other services and sales consist primarily of revenues from the sale, installation and maintenance of customer premise voice and data equipment (“CPE”), directory publishing, inside line care, providing satellite and cable video services, and the lease of office space. The Company recognizes directory
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
services revenue on a straight-line basis over the twelve month period in which the corresponding directory is distributed. The monthly recurring charges for inside line care are billed to end users in advance. Revenue is recognized during the period these services are provided. Billed but unearned revenue is included in advanced billings and customer deposits. The Company recognizes the revenue from the sale and maintenance of CPE in the period the sale or service is rendered. Rent is recognized on a straight-line basis over the term of the lease agreement.
Cash and Cash Equivalents-Cash and cash equivalents include cash and temporary investments with maturities of three months or less from the acquisition date of the instrument.
Estimating Valuation Allowances-The Company must make estimates of the uncollectability of its accounts receivables. The Company specifically analyzes accounts receivables and historic bad debts, customer concentrations, customer creditworthiness, current economic trends and changes in its customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.
Inventories-Inventories, which consist mainly of cable, supplies and replacement parts, are stated at the lower of cost, determined principally by the average cost method, or net realizable value.
Property and Depreciation-Property, plant and equipment are carried at cost. Depreciation has been calculated primarily using the composite remaining life methodology and straight-line depreciation rates. This method depreciates the remaining net investment in telephone plant, less anticipated net salvage value, over remaining economic asset lives by asset category. This method requires the periodic review and revision of depreciation rates. The economic asset lives used are as follows: buildings-35 years; cable and wire-18-25 years; conduit systems-40 years; switching and circuit equipment-12-13 years; and other property-5-15 years. When depreciable telephone plant is retired in the normal course of business, the amount of such plant is deducted from the respective plant and accumulated depreciation accounts with no gain or loss recognized.
The Company completed its most recent review of the depreciation rates during 2006. The composite depreciation rate is 9.6%.
Goodwill and Other Intangible Assets-Goodwill and indefinite-lived intangible assets are not amortized but are reviewed annually (or more frequently under various conditions) for impairment in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 142, Goodwill and Other Intangible Assets. Impairment occurs when the fair value of the asset is less than its carrying value. The Company performs its annual goodwill and other indefinite-lived-intangible asset impairment test during the third quarter, primarily using discounted cash flow and market value of equity and debt methodologies. Intangible assets with definite lives include the value assigned to customer base and easements at the date of acquisition, which are being amortized using a straight-line method over 6 to 20 years.
While our wireless licenses are issued for only a fixed time, such licenses are subject to renewal by the FCC. Renewals of licenses occur routinely, subject to meeting certain build out requirements, and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful life of our wireless licenses. As a result, we treat the wireless licenses as an indefinite-lived intangible asset under the provisions of SFAS No. 142 and test for impairment using the “Greenfield” approach.
Impairment of Long-Lived Assets-The Company assesses the recoverability of long-lived assets, including property, plant and equipment and definite-lived intangible assets, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In such cases, if the sum of
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
the expected cash flows (undiscounted and without interest) resulting from the use of the asset are less than the carrying amount, an impairment loss is recognized based on the difference between the carrying amount and the fair value of the assets. No impairment loss has been recognized to date.
Debt Issuance Costs-Deferred financing costs are amortized over the term of the related debt issuance.
Income Taxes-Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities at each balance sheet date using enacted tax rates expected to be in effect in the year the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance to the extent that it is unlikely they will be realized. See footnote 10, Income Taxes, for further discussion.
Stock-Based Compensation-The Company applies SFAS No. 123 (Revised), Share-Based Payment (“SFAS 123(R)”) to stock based compensation. This statement requires companies to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees and to record compensation cost for all stock awards granted after the required effective date and for awards modified, repurchased or cancelled after that date.
The Company recognizes compensation cost related to awards of restricted stock on a straight-line basis over the requisite service period for the entire award.
Fair Value of Financial Instruments-The estimated fair value of accounts receivable, accounts payable, and short-term notes payable approximate their carrying values unless otherwise indicated. The carrying value of receivables and accounts payable approximate fair value based on their short-term nature.
Interest Rate Swap Agreements-The Company has entered into interest rate swap agreements which the Company designated as hedges against the variability in future interest payments due on $350.0 million of Term Loan B. The purpose of the swap agreements is to adjust the interest rate profile of the Company’s debt obligations, and to achieve a targeted mix of floating and fixed rate debt.
The swap agreements are accounted for in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and qualify for cash flow hedge accounting of variable-rate debt. In accordance with this standard, all changes in fair market value of the swap instruments attributable to hedge ineffectiveness are reported currently in earnings and are recorded in the Other Income (Expense) section of the Company’s Consolidated Statements of Income. Changes in fair market value of the swap instruments attributable to hedge effectiveness are recorded, net of income tax effects, in the Accumulated Other Comprehensive Income section of the Company’s Consolidated Statements of Stockholders’ Equity and Comprehensive Income. Accordingly, in the event that the swap agreements no longer qualify for cash flow hedge accounting treatment, all changes in fair market value would be reported currently in earnings and recorded in the Other Income (Expense) section of the Company’s Consolidated Statements of Income.
The fair value of the Company’s interest rate swaps were determined based on the present value of the expected future cash flows using discount rates appropriate with consideration given to the Company’s non-performance risk. The fair value of the interest rate swaps is recorded in the Other Long-Term Liabilities section of the Company’s Consolidated Balance Sheets.
Use of Estimates-The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
affect amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Recently Issued Accounting Pronouncements-In September 2006, the Financial Accounting Standards Board (“FASB”) released SFAS No.158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements 87, 88, 106, and 132 (“SFAS 158”). SFAS 158 requires that the Company recognize the over-funded or under-funded status of its defined benefit and retiree medical plans as an asset or liability in its 2006 year-end balance sheet, with changes in the funded status recognized through comprehensive income in the year in which they occur. The Company has adopted the recognition and disclosure provisions of SFAS 158 as of December 31, 2006. See footnote 13, Employee Benefit Plans, for further discussion.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS 109”). Guidance is provided on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 requires that the Company recognize in its financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of the Company’s 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Adoption of FIN 48 on January 1, 2007, had no effect on the Company’s financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Adoption of SFAS 157 on January 1, 2008, did not have a material impact on the Company’s financial position, results of operations or cash flows.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose, at specified election dates, to measure eligible items at fair value and to report in earnings unrealized gains and losses on those items for which the fair value option has been elected. SFAS 159 also requires entities to display the fair value of those assets and liabilities on the face of the balance sheet. SFAS 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of SFAS 157. The Company evaluated the provisions of this statement and did not elect to adopt the fair value option on any financial instruments or other items held by the Company on January 1, 2008.
In May 2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1, Definition of Settlement in FASB Interpretation No. 48, which provides guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. The amendment had no impact on the Company’s financial position, results of operations or cash flows.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
In June 2007, the EITF reached consensus on Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards. EITF Issue No. 06-11 requires that the tax benefit related to dividend equivalents paid on restricted stock units that are expected to vest be recorded as an increase to additional paid-in capital. The Company currently accounts for this tax benefit as a reduction to its income tax provision. EITF Issue No. 06-11 is to be applied prospectively for tax benefits on dividends declared in fiscal years beginning after December 15, 2007. Adoption of EITF Issue No. 06-11 on January 1, 2008, did not have a material impact on the Company’s financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 160, Non-controlling Interest in Consolidated Financial Statements (“SFAS 160”), an amendment of ARB No. 51. SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the non-controlling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding their interest of the parent and its non-controlling interest. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. The Company does not expect adoption of this pronouncement to have a material impact on its financial position, results of operations and cash flows.
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS 141(R)”). SFAS 141(R) requires an acquiring entity to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value, with limited exceptions and also includes a substantial number of new disclosure requirements. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption is prohibited. SFAS 141(R) requires acquisition related costs to be expensed as incurred. The Company anticipates that acquisition related costs deferred pursuant to Statement of Financial Accounting Standard No. 141 (“SFAS 141”) on acquisitions that will not close until after SFAS 141(R) is adopted of $868,000 will be expensed upon adoption of SFAS 141(R) during the first quarter of 2009. Other than expensing acquisition costs deferred pursuant to SFAS 141 as discussed above, the Company does not expect the adoption of this pronouncement to have a material impact on its financial position, results of operations and cash flows.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”) - an amendment of FASB Statement No. 133. The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial condition, financial performance and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. SFAS 161 will impact disclosures only and will not have an impact on the Company’s consolidated financial condition, results of operations and cash flows.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
2. EARNINGS PER SHARE
Basic earnings per share is computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed based on the weighted average common shares outstanding plus equivalent shares assuming exercise of stock options and vesting of unvested compensatory shares. The dilutive effect of stock options and unvested compensatory shares is computed by application of the treasury stock method. The following is a reconciliation between basic and diluted weighted average shares outstanding:
As of December 31, 2006, 2007 and 2008, total options outstanding were 682,579, 677,579 and 677,579, respectively.
3. REVENUES
The table below sets forth the components of our revenues and sales for the years ended December 31, 2006, 2007 and 2008:
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
4. ACCOUNTS RECEIVABLE
Accounts receivable consisted of the following at December 31:
The following is a summary of activity for the allowance for doubtful accounts during each of the three years ended December 31:
(1) Includes an addition to the reserve of $737,000 due to the acquisition of Bishop on July 18, 2008.
The Company grants credit to its customers in the normal course of business. At December 31, 2007 and 2008, the Company had outstanding trade receivables from telecommunications companies which totaled $5.1 million and $7.3 million, respectively. During 2006, the Company had one customer that represented approximately 11% of total revenue and sales. During 2007 and 2008, the Company did not have any customers that represented more than 10% of total revenue and sales.
5. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consisted of the following at December 31:
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
6. GOODWILL, INTANGIBLE ASSETS AND OTHER
The Company performed its annual impairment review of goodwill and indefinite-lived intangible assets as required by SFAS No. 142, Goodwill and Other Intangible Assets, as of August 31, 2007 and 2008.
Total goodwill at December 31, 2006 and 2007 was $466.6 million. During 2008, the purchase of Bishop Communications Corporation increased goodwill by $7.4 million and intangibles and other assets by $7.7 million on the acquisition date, which resulted in a goodwill balance of $474.0 million at December 31, 2008. The allocation of the purchase price for Bishop Communications is preliminary as of December 31, 2008.
Intangible assets and other consisted of the following at December 31:
Amortization expense for definite-lived intangible assets was $2.1 million, $1.7 million and $1.9 million for the years ended December 31, 2006, 2007 and 2008, respectively. Amortization expense is calculated on the straight-line method unless there is a method that more accurately reflects the consumption of the benefit provided by the intangible asset. Estimated annual amortization expense for definite-lived-intangible assets for each of the next five years and cumulative thereafter is as follows (in thousands):
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
7. ACCRUED AND OTHER CURRENT LIABILITIES
Accrued and other current liabilities consisted of the following at December 31:
8. LONG-TERM DEBT
Long-term debt obligations consisted of the following at December 31:
The aggregate maturities of long-term obligations for each of the next five years and thereafter subsequent to December 31, 2008 are as follows:
Iowa Telecom Long-Term Debt and Revolving Credit Facilities
As of December 31, 2008, the Company had outstanding $477.8 million of senior debt under the term facilities, and had $39.0 million drawn under the $100 million revolving credit facility. The details of the credit facilities are as follows:
The revolving credit facility will expire in November 2011 and permits borrowings up to the aggregate principal amount of $100 million (less amounts reserved for letters of credit up to a maximum amount of
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
$25 million). As of December 31, 2008, $39.0 million was outstanding on the revolving credit facility and $61.0 million was available. Borrowings under the revolving credit facility bear interest per annum at either (a) the London inter-bank offered rate, or LIBOR, plus 2.0% or (b) a base rate plus 1.0%. As of December 31, 2008, the Company had $39.0 million outstanding under LIBOR elections at an all-in rate of 2.6%. As of December 31, 2007, the Company had $18.0 million outstanding under a base rate election at an all-in rate of 8.25%.
Term Loan B is a $400.0 million senior secured term facility maturing in November 2011, bearing interest per annum at either (a) a LIBOR rate plus an applicable rate adder of 1.75% per annum or (b) a base rate election plus an applicable rate adder of 0.75% per annum. As of December 31, 2008, $350.0 million was outstanding under Term Loan B based upon a LIBOR election effective through March 30, 2009, at an all-in rate of 3.22%. The Company entered into interest rate swap agreements to fix the rate on $350.0 million of Term Loan B as more fully described below. As of December 31, 2008, the interest rate on the remaining $50.0 million was based upon a LIBOR election effective through January 12, 2009, at an all-in rate of 3.19%.
Term Loan C is a $70.0 million senior secured term facility maturing in November 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. The interest rate on Term Loan C was fixed at 6.65% until November 2007. Effective August 1, 2007, the Company elected a new all-in fixed interest rate of 6.95% through June 2011 on Term Loan C. Upon the expiration of the fixed interest rate period, the term loan will convert to the Rural Telephone Finance Cooperative base variable rate plus 0.85%.
Term Loan D is a $7.8 million senior secured term facility maturing in November 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. The interest rate on Term Loan D was fixed at 6.65% until November 2007. Effective August 1, 2007, the Company elected a new all-in fixed interest rate of 6.95% through June 2011 on Term Loan D. Upon the expiration of the fixed interest rate period, the term loan will convert to the Rural Telephone Finance Cooperative variable rate plus 0.85%.
As a condition of borrowing under Term Loans C and D, the Company is required to invest $7.8 million, representing 10% of the total amounts of Term Loans C and D, in Subordinated Capital Certificates (“SCCs”) of the Rural Telephone Finance Cooperative. The Rural Telephone Finance Cooperative will redeem the SCCs in proportion to principal repayments on Term Loans C and D. SCCs are non-interest bearing but, as a member of the Rural Telephone Finance Cooperative, the Company shares proportionately in the institution’s net earnings. The Company holds $5.5 million in Patronage Capital Certificates from the Rural Telephone Finance Cooperative.
The Company’s share of Rural Telephone Finance Cooperative net earnings, included in interest and dividend income was $740,000, $543,000 and $501,000 for the years ended December 31, 2006, 2007 and 2008, respectively.
The Iowa Telecom credit facilities are secured by substantially all of the Company’s tangible and intangible assets, properties and revenues. The credit facilities are guaranteed by all of the Company’s wholly owned subsidiaries.
The Iowa Telecom credit facilities permit the Company to pay dividends to holders of its common stock; however, they contain significant restrictions on the ability to do so. The credit facilities contain certain negative covenants that, among other things, limit or restrict the Company’s ability (as well as those of its subsidiaries) to: create liens and encumbrances; incur debt, issue preferred stock, or enter into leases and guarantees; enter into loans, investments and acquisitions; make asset sales, transfers or dispositions; change lines of business; enter into hedging agreements; pay dividends, redeem stock, or make certain restricted payments; amend material debt agreements or other material contracts; engage in certain transactions with affiliates; enter into sale/leaseback or synthetic lease transactions; grant negative pledges or agree to such other restrictions relating to subsidiary dividends and distributions; make changes to its fiscal year; and engage in mergers and consolidations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
The Iowa Telecom credit facilities require the Company, subject to certain exceptions, to prepay outstanding loans under the credit facilities to the extent of net cash proceeds received from the following: issuance of certain indebtedness; proceeds of certain asset sales; and casualty insurance proceeds. The credit facilities further require the Company, subject to certain exceptions, to make prepayments under the credit facilities for equal to 50% of any net increase in the following: distributable cash during a dividend suspension period, as defined; and cumulative distributable cash, as defined, during the fiscal year less the cumulative reductions of revolving loans (adjusted to exclude the effects of borrowings to fund permitted acquisitions) through such period, with reductions to the percentage to be determined based on improvements in certain credit ratios. As of December 31, 2008, no prepayment amounts were due under these provisions.
The Iowa Telecom credit facilities generally permit voluntary prepayments of the term loans and reductions of commitments without penalty or premium, other than standard breakage costs.
In addition, the financial covenants under the credit facilities specify, among other things, certain fixed charge coverage ratios and a maximum total leverage ratio, as defined, all of which the Company was in compliance with as of December 31, 2008.
EN-TEL Communications LLC (“EN-TEL”) Debt
On July 18, 2008, the Company acquired Bishop Communications Corporation (“Bishop Communications”). As part of the acquisition, the Company assumed debt of $13.0 million issued by EN-TEL, a majority owned subsidiary of Bishop Communications. The EN-TEL debt consists of promissory notes payable to the Rural Telephone Finance Cooperative which have quarterly installments of principal and interest. The notes currently bear interest at an average all-in fixed rate of 7.19%. The notes have a fixed interest rate for specific periods of time ranging from December 2008 through December 2013 and will thereafter be either at a variable interest rate or renegotiated at a fixed rate at the end of the specified period. The promissory notes mature in 2015 and 2018. Principal payments of $599,000 were made in 2008.
The notes are secured by the assets of EN-TEL. The debt agreements restrict dividends paid by EN-TEL, and no amounts are currently available for dividends.
Interest Rate Swap
On August 26, 2005, the Company amended the interest rate swap agreement that was originally entered into on November 4, 2004. The amended swap agreement resulted in two identical swap agreements which each fixed the interest rate the Company will pay on $175.0 million of indebtedness under Term Loan B, for a total swap notional value of $350.0 million. Effective September 26, 2008, the Company terminated one of its swap agreements which the Company had designated as a hedge against the variability in future interest payments due on $175.0 million of Term Loan B. The Company entered into a new swap agreement effective September 30, 2008, to replace the terminated swap agreement. The amended terms of the new swap agreement and the remaining swap agreement effective August 31, 2005, effectively convert the variable rate interest payments due on $350.0 million of Term Loan B to a fixed rate of 5.87% through maturity of November 23, 2011.
9. COMMON AND PREFERRED STOCK
Common Stock-The Company is authorized to issue 100,000,000 shares of common stock, $0.01 par value. Holders of common stock have one vote per share. As of December 31, 2008, the Company had 31,500,687 shares of common stock issued and outstanding.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
Preferred Stock-The Company’s Board of Directors is authorized to issue up to 50,000,000 shares of preferred stock, $0.01 par value, in one or more series, from time to time, with such designations, preferences and relative, participating, optional or other special rights and qualifications, limitations or restrictions thereof as may be provided in a resolution or resolutions adopted by the Board of Directors. The authority of the Board of Directors includes, but is not limited to, the determination of the following with respect to any such series: (i) the number of shares; (ii) the dividend rate and time of payment, if any, whether such dividends are cumulative, and if so, from which date; (iii) whether shares are to be redeemable and, if so, the terms and amount of any sinking fund providing for the purchase or redemption of such shares; (iv) whether shares shall be convertible and, if so, the terms and provisions thereof; (v) the rights of the shares in the event of voluntary or involuntary liquidation, dissolution or winding up affairs of the Company; (vi) whether the shares will have priority over or be on a parity with or be junior to any other class or series in any respect; and (vii) whether the shares will have voting rights.
10. INCOME TAXES
The Company’s provision for income taxes for the years ended December 31, 2006, 2007 and 2008 differed from the amounts determined by applying the statutory federal income tax rate of approximately 35% to income before taxes for the following reasons:
Income tax expense (benefit) consisted of the following for the years ended December 31:
Current income tax expense (benefit) for 2006, 2007 and 2008 was primarily due pursuant to alternative minimum tax requirements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
The Company’s deferred income tax asset (liability) consisted of the following temporary differences at December 31:
The Company files income tax returns in the U.S. federal jurisdiction and five state jurisdictions. The Company has been notified by the Minnesota Department of Revenue that an acquired subsidiary will be audited. The periods to be audited are prior to Iowa Telecom’s ownership and the Company is fully indemnified for any tax obligations resulting from such matters. The Company is not currently under income tax examination in any other jurisdiction. For federal and state tax purposes, the Company’s 2001 through 2008 tax years remain open for examination by the tax authorities due to net operating losses remaining to be utilized.
The Company had no unrecognized tax benefits at the time of adoption of FIN 48 on January 1, 2007, or as of December 31, 2007 and 2008.
The following is a summary of activity for the valuation allowance of deferred tax assets for the years ended December 31, 2006, 2007 and 2008:
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
A valuation allowance had been provided at December 31, 2005, for the deferred tax assets that expire over time to the extent that they exceeded the net deferred tax assets and liabilities resulting from reversing temporary differences. The Company determined that, based upon the evidence available as of June 30, 2006, and as of the end of each period thereafter, the combination of the continued generation of taxable income and the taxable income generated from reversing temporary differences will be, more likely than not, sufficient to utilize the entire deferred tax asset. As such, the Company determined that no valuation allowance was required for its deferred tax assets and reversed the remaining valuation allowance during 2006.
At December 31, 2008, the Company had unused tax net operating loss carryforwards of approximately $149.0 million which expire in 2021 to 2024.
11. OTHER COMPREHENSIVE INCOME (LOSS)
Accumulated other comprehensive income (loss) was comprised of the following components as of December 31:
Components of other comprehensive income (loss) for the twelve months ended December 31 were:
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
12. LEASES
The Company leases property in various locations throughout its service area. Future minimum rental payments required under operating leases that have initial or remaining lease terms in excess of one year are as follows as of December 31, 2008:
Rental expense for the years ended December 31, 2006, 2007 and 2008 was $403,000, $415,000, and $402,000, respectively.
13. EMPLOYEE BENEFIT PLANS
SFAS
In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. The Company adopted SFAS 158 prospectively on December 31, 2006. SFAS 158 requires that the Company recognize all obligations related to defined benefit pensions and other postretirement benefits. This statement requires that the Company quantify the plans’ funding status as an asset or a liability on its consolidated balance sheet.
SFAS 158 requires that the Company measure the plans’ assets and obligations that determine its funded status as of the end of the fiscal year. The Company was also required to recognize as a component of other comprehensive income the changes in funded status that occurred during the year that was not recognized as part of net periodic benefit cost as explained in SFAS No. 87, Employers’ Accounting for Pensions, or SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
Retirement Pension Plan
The Company sponsors the Iowa Telecom Pension Plan (the “Plan”), a defined benefit pension plan, that covers many former GTE Midwest Incorporated (“GTE”) employees. The provisions of the Plan were assumed by the Company in connection with the GTE Acquisition in 2000. The Plan generally provides for employee retirement at age 65 with benefits based upon length of service and compensation. The Plan provides for early retirement, lump-sum benefits and various annuity options.
During the second quarter of 2005, the Company amended the Plan to freeze the accrued benefit for all salaried participants and for certain hourly participants, and permit certain other hourly participants to elect to discontinue further benefit accruals. As a result of the amendment, the benefits to be paid to salaried participants at their normal retirement age of 65 in the form of a life annuity are fixed. The accrued benefits for hourly employees subject to the mandatory benefit freeze and for those who elected to discontinue further benefit accruals were transferred to a separate plan (the “Spin-Off Plan”). The Spin-Off-Plan was terminated during the third quarter of 2006, with almost all benefits distributed in the fourth quarter of 2006. As a result of the Plan amendment and Spin-Off Plan termination, the number of employees accruing further benefits under the defined benefit pension plan has been reduced to approximately 40 from 175.
Components of pension benefit costs and weighted average actuarial assumptions at December 31, were:
During 2006, the lump-sum distributions from the Plan exceeded the settlement threshold equal to the sum of the service cost and interest cost components of net periodic pension cost resulting in an additional charge to income of $3.0 million. Lump-sum distributions during 2007 and 2008 did not exceed the settlement threshold and therefore no settlement loss was recorded and income was not impacted by a settlement loss.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
The change in projected benefit obligation, change in plan assets, and funded status of the plan at December 31 were:
The estimated net loss and prior service cost that will be amortized from accumulated other comprehensive income (loss) into the net periodic benefit cost over the next fiscal year are $232,000 and $27,000, respectively.
The discount rate the Company used is based on the yield of a portfolio of high quality, fixed income debt instruments matched against the timing and amounts of projected future benefits. The expected return on plan assets is based on the Company’s asset allocation mix and historical returns, taking into account current and expected market conditions. The actual return on pension plan assets, net of trust paid expenses, was (10.4%) in 2008, and 6.9% in 2007.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets at December 31 were:
Cash Contributions
The following table details the Company’s cash contributions for the years ended December 31, 2007 and 2008, and the expected contributions for 2009 (in thousands):
The Company’s policy with respect to funding the qualified plans is to fund at least the minimum required by the Employee Retirement Income Security Act of 1974, as amended, and not more than the maximum amount deductible for tax purposes.
Benefit Payments
The following table details expected benefit payments for the years 2009 through 2018 (in thousands):
Asset Allocation Strategy
The Company’s pension plan asset allocation at December 31, 2007 and 2008, and target allocation for 2009 were as follows:
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
The investment strategy for pension plan assets is to maintain a broadly diversified portfolio designed to achieve the Company’s target of an average long-term rate of return of 7.0% to 8.0%. While the Company believes achievement of a long-term average rate of return of 7.0% to 8.0% is possible, the Company cannot be certain that the portfolio will perform to these expectations. Assets are strategically allocated between equity and debt securities in order to achieve a diversification level that mitigates wide swings in investment returns. The majority of the plan’s assets are invested in debt securities because debt portfolios have historically provided less volatility than equity portfolios. Correspondingly, debt portfolios also entail lower returns than equity portfolios based on historical information. The risk of loss in the plan’s portfolio is mitigated by investment in a broad range of corporate bonds and equity types.
The investment of pension plan assets in securities of the Company is specifically prohibited for both the equity and debt portfolios other than through index fund holdings.
Defined Contribution Plan
The Company participates in two 401(k) savings plans for salaried and hourly employees that allow for voluntary contributions into designated investment funds. The Iowa Telecom Savings Plan covers all full-time salaried and hourly employees, with the Company matching employees’ contributions at the rate of either 75% or 66% of the first 6% of earnings deferred. The Company makes an annual non-elective contribution in the amount of 3% of eligible compensation on behalf of eligible employees. Company contributions to the plans were $1.5 million; $1.9 million and $2.0 million for the years ended December 31, 2006, 2007 and 2008, respectively.
The Company is in the process of merging assets of a third 401(k) plan acquired through the Bishop Communications acquisition in which these assets will be merged into Iowa Telecom salaried Savings Plan by July 1, 2009.
Postretirement Benefits
The Company assumed a postretirement benefit obligation plan for employees who qualified for benefits at the date of the GTE Acquisition. This plan provides for certain medical and life insurance benefits to select employees who satisfy the requirements for an early or normal pension under the defined benefit pension plan.
During the second quarter of 2007, the Company amended its post retirement welfare plan. The amendment eliminated medical benefits for certain retirees and reduced benefits for others. Life insurance benefits were eliminated for most retirees covered under the plan. At the time of the plan amendment, approximately 58% of employees covered under the plan chose to opt out of the postretirement welfare plan. The significant change in the number of plan participants required a re-measurement of the benefit obligations. The re-measurement resulted in a one time curtailment gain of $247,000 and reduction in the liability recorded for prior service costs of $5.6 million, which was to be amortized over 5.31 years as a component of the annual cost.
During the fourth quarter of 2008, the Company modified the agreement with the CWA. The modification resulted in another 26 employees opting out of the retiree medical plan effective November 30, 2008. This triggered a plan curtailment under FAS 106 which required the immediate recognition of a portion of the remaining $3.8 million unrecognized prior service credit that was being amortized over 5.31 years. Although the 26 opt-out employees represented only 29% of the plan participants, they were on the average younger than the other participants. This resulted in a curtailment service ratio of 66.2% and a curtailment gain of $2.5 million in the fourth quarter of 2008.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
Components of postretirement benefit costs and weighted average actuarial assumptions at December 31, were:
The change in accumulated benefit obligation, change in plan assets, and funded status of the plans at December 31 were:
The estimated net loss and prior service cost (credit) that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are $0 and ($438,000), respectively.
The health care cost trend rate used in determining the accumulated postretirement benefit obligation at December 31, 2007 and 2008 was assumed to be 9.5%, decreasing incrementally until reaching an ultimate rate of 5.0% in 2016 and 2017, respectively.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
Assumed health care cost trend rates have a minor effect on the amount reported for health care plans. A one percentage point change in the assumed health care cost trend rates would have no impact on total service, interest cost components or accumulated postretirement benefit obligations for the year ended December 31, 2008.
Cash Contributions and Benefit Payments
The Company’s postretirement benefits are unfunded, and therefore cash contributions for postretirement benefits are equal to the benefit payments.
The following table details the cash contributions and benefit payments for the years ended December 31, 2006, 2007 and 2008, and the expected cash contributions and benefit payments for 2009 through 2018 (in thousands):
All benefit payments for other postretirement benefits are voluntary, as the postretirement plans are not funded, and are not subject to any minimum regulatory funding requirements. Benefit payments for each year represent claims paid for medical and life insurance, and the Company anticipates the 2009 postretirement benefit payments will be made from cash generated from operations.
14. STOCK INCENTIVE PLANS
2002 Stock Incentive Plan
The Iowa Telecommunications, Inc. 2002 Stock Incentive Plan (the “2002 Incentive Plan”) allows for the issuance of incentive stock options or nonqualified stock options. Under the 2002 Incentive Plan, options have been granted for the purchase of 2,227,714 shares, of which 1,031,795 were redeemed for cash in 2004 in conjunction with the Company’s initial public offering, 518,340 have been exercised and 677,579 remained outstanding as of December 31, 2008. No new options will be granted under the 2002 Incentive Plan. The term of each option did not exceed 10 years from the date of grant. Options granted to employees vested over 3 to 5 years from the date of the grant. All unvested options outstanding at the time of the closing of the Company’s initial public offering vested pursuant to the terms of the 2002 Incentive Plan. The exercise price for unexercised options is automatically decreased by the amount of dividends that would have been paid on the shares issuable upon exercise.
The Company recorded $1.1 million, $1.0 million and $1.1 million of stock-based compensation expense during 2006, 2007 and 2008, respectively, to reflect the change in the fair value of the options from the reduction of the exercise price resulting from the declaration of cash dividends.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
The fair value of each option grant and subsequent modification is estimated using the Black-Scholes option-pricing model. The table below depicts the weighted-average assumptions used in determining the options’ fair value at the time of the exercise price reductions.
(1) Because the Company’s stock had not been publicly traded long enough to establish a reliable historical volatility rate, the average historical volatility rate for a pool of similar entities was used.
A summary of the status of options granted under the 2002 Incentive Plan as of December 31, 2007 and 2008, and the changes during the years then ended, is presented below:
The following table summarizes information about stock options outstanding at December 31, 2008:
The weighted average exercise price of options exercisable at December 31, 2008, reflects the reductions required by the plan as a result of the declaration of cash dividends. Pursuant to the 2002 Incentive Plan, all options became fully vested on November 23, 2004, as a result of the change in share ownership resulting from the Company’s initial public offering of common stock.
The total intrinsic value of options exercised during 2006 and 2007 was $4.0 million and $93,000, respectively. There were no options exercised during 2008. The Company received total cash proceeds of $1.7 million and $21,000, respectively, related to the exercise of options during 2006 and 2007. The income tax benefit realized as a result of options exercised was $48,000 and $7,000 during 2006 and 2007, respectively.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
2005 Stock Incentive Plan
The Iowa Telecommunications Services, Inc. 2005 Stock Incentive Plan (the “2005 Incentive Plan”) allows for the issuance of up to an aggregate of 1.5 million shares of restricted or unrestricted stock, of which 634,800 shares of restricted stock, net of forfeitures and cancellations, have been awarded to various officers and employees of the Company and 8,757 shares of unrestricted stock have been issued to members of the Company’s Board of Directors.
A summary of the status of the restricted shares awarded pursuant to the 2005 Incentive Plan as of December 31, 2007 and 2008, and the changes during the years then ended, is presented below:
(1) Weighted average vesting period at grant date for shares granted is 59 months.
(2) Weighted average vesting period at grant date for shares granted is 61 months.
The Company recognizes compensation cost related to awards of restricted stock on a straight-line basis over the requisite service period for the entire award. The Company recorded $1.2 million, $1.7 million and $2.4 million of stock-based compensation expense related to the 2005 Incentive Plan during 2006, 2007 and 2008, respectively. The remaining amount to be charged to expense for unvested awards over the remaining service periods of 4.25 years is $6.2 million. The Company also recorded $13,000, $13,000 and $93,000 respectively, of expense during 2006, 2007 and 2008 related to the unrestricted shares issued to members of its Board of Directors. The total fair value of shares vested during 2007 and 2008 was $1.7 million and $1.5 million, respectively. No shares vested during 2006.
The Company has a policy that permits the repurchase of a portion of vested shares from participants upon their vesting in order to satisfy tax withholding obligations. The aggregate fair market value of such repurchases may not exceed the participant’s minimum statutory tax withholding obligation due upon vesting. During 2007 and 2008, the Company reacquired 26,902 shares and 27,353 shares, respectively, for this purpose. No shares were reacquired by the Company during 2006.
During 2006, the Company recognized $831,000 of income tax benefit related to all stock-based compensation arrangements, excluding the effects related to the reversal of our income tax valuation allowance. During 2007 and 2008, the Company recognized $1.0 million and $1.1 million, respectively, of income tax benefit related to all stock-based compensation arrangements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
15. RELATED PARTY TRANSACTIONS
During 2006 the Company sold network and special access services to a significant stockholder. The Company also purchased certain services including switch monitoring and telecommunication circuits from the related party and resold certain products obtained from the related party. During 2006, the significant stockholder reduced its holdings of the Company’s common stock, and therefore, as of December 31, 2006, is no longer considered a related party. During 2007, there were no material related party transactions. In 2008, the Company leased fiber both to and from certain entities that are accounted for using the equity method. The following table summarizes the amounts included in the accompanying financial statements related to these services:
In 2008, the Company was reimbursed $387,000 for labor, management and other services provided to certain entities that are accounted for using the equity method.
16. COMMITMENTS AND CONTINGENCIES
The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.
On November 21, 2008, the Company announced a definitive agreement to acquire substantially all of the assets of Sherburne Tele Systems, Inc. (“Sherburne”) for a total purchase price of $80.6 million, subject to certain adjustments and regulatory approvals. The Company intends to fund the acquisition of Sherburne with the proceeds of $75.0 million of new term debt issued under existing credit facilities, borrowings on the revolving credit facility and cash on hand.
Sherburne is a closely held telecommunications company headquartered in Big Lake, Minnesota, less than 30 miles from the headquarters of Bishop Communications, which we acquired on July 18, 2008. As of December 31 2008, Sherburne served 15,500 incumbent local exchange carrier access lines, 10,200 competitive local exchange carrier lines, 13,900 DSL high-speed Internet customers and 3,700 video customers, primarily in communities and rural areas adjacent to the Minnesota/St. Paul Metropolitan Area. Sherburne’s operations include its incumbent local exchange carrier services, marketed as Connections, Etc., and competitive local exchange carrier services provided through its wholly-owned subsidiary, Northstar Access.
17. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair Value of Derivative Financial Instruments
Effective January 1, 2008, the Company adopted the provisions of SFAS No. 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.
SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.
Interest Rate Swaps-These included the Company’s interest rate swap derivative instruments. The fair value of the interest rate swaps were determined based on the present value of expected future cash flows using discount rates appropriate with consideration given to the Company’s non-performance risk utilizing inputs that are readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized these swap contracts as Level 2. Deducted from the December 31, 2008, interest rate swap fair value calculation was a $2.2 million adjustment in consideration of the Company’s non-performance risk. The Company’s non-performance risk is assessed based on the current trading discount of its Term Loan B debt as the swap agreements are secured by the same collateral. The fair value of the interest rate swaps is recorded in the Other Long-Term Liabilities section of the Company’s Consolidated Balance Sheets.
Cash equivalents consist of funds invested in bank accounts and money market funds that have daily liquidity. Therefore, cash and cash equivalents are categorized as Level 1. The following table presents fair value of the Company’s cash and cash equivalents and interest rate swaps:
See footnote 18 for additional information regarding the fair value of the Company’s interest rate swap agreements.
Carrying Amount and Fair Value of Other Financial Instruments
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and Cash Equivalents-The carrying amount approximates fair value because of the short maturity of these instruments.
Long-Term Investments-Long-term investments consist primarily of Rural Telephone Finance Cooperative (“RTFC”) Subordinated Capital Certificates. It is not practicable to estimate the fair value of the RTFC Subordinated Capital Certificates because there is no quoted market price for these instruments. Therefore, the RTFC Subordinated Capital Certificates are recorded at cost. Ownership of RTFC Subordinated Capital Certificates is a requirement of the Company’s debt agreement with the RTFC.
Debt-The fair value of the Term Loan C, Term Loan D and EN-TEL debt was estimated using discounted cash flow calculations and current market interest rates. The fair value of the Term Loan B debt was estimated based upon recent observable transactions for the Term Loan B debt. For 2007, the Term Loan B debt was considered to be equal to the carrying value because the interest payments are based on LIBOR rates that are
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
reset every three months and the Company did not believe its credit risk had changed materially from the date the applicable LIBOR rate adder of 1.75% per annum was set. See footnote 8 for additional information regarding the Company’s long-term debt.
The estimated fair value of the Company’s financial instruments as of December 31, 2007 and 2008, was as follows:
Certain financial instruments potentially subject the Company to concentrations of credit risk. These financial instruments consist primarily of trade receivables, cash and temporary cash investments and interest rate swaps.
The Company places its cash and cash equivalents with high credit quality financial institutions. The Company also periodically evaluates the credit-worthiness of the institutions with which it invests.
18. DISCLOSURES ABOUT FAIR VALUE OF INTEREST RATE SWAPS
On August 26, 2005, the Company amended the interest rate swap agreement that was originally entered into on November 4, 2004. The amended swap agreement resulted in two identical swap agreements, which each fixed the interest rate the Company will pay on $175.0 million of indebtedness under Term Loan B, for a total swap value of $350.0 million.
The guarantor of a floating rate payer under one of the interest rate swap agreements declared bankruptcy during the third quarter of 2008 resulting in a default of the agreement. In accordance with the agreement, the Company elected to terminate the agreement effective September 26, 2008. The swap agreement had been designated as a hedge against the variability in future interest payments due on $175.0 million of Term Loan B. The termination of the swap resulted in a credit to income of $1.8 million and the change in fair value attributable to hedge ineffectiveness resulted in an expense of $676,000. The net expense reduction of $1.2 million was recorded in the Other Income (Expense) section of the Company’s Consolidated Statements of Income for the year ended December 31, 2008. Other Comprehensive Income of $870,000 related to the terminated hedge recorded in the Company’s Consolidated Statements of Stockholders’ Equity will be amortized as an expense in the Other Income (Expense) section of the Company’s Consolidated Statements of Income throughout the remaining term of the terminated hedge transaction until November 23, 2011. The Company recorded $129,000 of expense related to the amortization of Accumulated Other Comprehensive Income (loss)
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
for the year-ended December 31, 2008 in the Other Income (Expense) section of the Company’s Consolidated Statements of Income.
The Company entered in to a new interest rate swap agreement effective September 30, 2008, which the Company designated as a hedge against the variability in future interest payments due on $175.0 million of Term Loan B. The new swap agreement, coupled with the remaining August 2005 interest rate swap agreement, effectively converts the variable rate interest payments due on $350.0 million of Term Loan B to a fixed rate of 5.87% through maturity of November 23, 2011. The purpose of the swap agreements is to adjust the interest rate profile of the Company’s debt obligations and to achieve a target mix of floating and fixed rate debt.
During 2008, the fair market value of the swap instruments decreased by $20.3 million. The portion of the change in fair value attributable to hedge ineffectiveness, which for 2008 was a loss of $1.4 million inclusive of $676,000 of hedge ineffectiveness from the terminated swap discussed above, is recorded in the Other Income (Expenses) section of the Company’s Consolidated Statements of Income. The portion of the change in fair value attributable to hedge effectiveness is recorded, net of income tax effects, in the Accumulated Other Comprehensive Income (loss) section of the Company’s Consolidated Statements of Stockholder’s Equity. In assessing hedge effectiveness, no portion of the gain or loss from the swap is excluded.
During 2007, the fair market value of the swap instruments decreased by $15.4 million. The portion of the change in fair value attributable to hedge ineffectiveness, which for 2007 was a loss of $522,000, is recorded in the Other Income section of the Company’s Consolidated Statements of Income. The portion of the change in fair value attributable to hedge effectiveness is recorded, net of income tax effects, in the Accumulated Other Comprehensive Income (loss) section of the Company’s Consolidated Statements of Stockholders’ Equity. In assessing hedge effectiveness, no portion of the gain or loss from the swap is excluded.
During 2006, the fair market value of the swap instruments increased by $1.4 million. The portion of the change in fair value attributable to hedge ineffectiveness, which for 2006 was a loss of $368,000, is recorded in the Other Income (loss) section of the Company’s Consolidated Statements of Income. The portion of the change in fair value attributable to hedge effectiveness is recorded, net of income tax effects, in the Accumulated Other Comprehensive Income section of the Company’s Consolidated Statements of Stockholders’ Equity. In assessing hedge effectiveness, no portion of the gain or loss from the swap is excluded.
The fair value of the Company’s interest rate swaps has been calculated by discounting the future cash flows of both the fixed rate and variable rate interest payments using discount rates appropriate with consideration given to the Company’s non-performance risk. The fair value of the interest rate swaps was in a liability position of $1.9 million and $22.2 million, respectively as of December 31, 2007 and 2008, and was recorded in the Other Long-Term Liabilities section of the Company’s Consolidated Balance Sheets.
19. SALE OF EXCHANGES
The Company closed on the sale of three exchanges representing approximately 600 access lines on April 28, 2006, and received proceeds of approximately $4.8 million. As part of the transaction, the Company retired net plant of $1.5 million and goodwill and other intangible assets of $2.0 million and recorded a gain of approximately $1.3 million, which is included in gain on sale of properties in the Consolidated Statements of Income. On July 1, 2006, the Company completed the sale of four exchanges representing approximately 2,000 access lines and received net proceeds of approximately $8.4 million. As part of the transaction, the Company retired net plant of $1.8 million and goodwill and other intangible assets of $3.7 million, and recorded a gain of approximately $2.9 million, which is included in gain on sale of properties in the Consolidated Statements of Income.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
20. BUSINESS ACQUISITIONS
Montezuma Telephone. On July 1, 2006, the Company acquired Montezuma Mutual Telephone Company, a provider of telecommunications, cable television and Internet services to customers in rural Iowa. The acquisition of Montezuma Telephone expanded the Company’s local exchange service area. The purchase price was $11.9 million and consisted of $11.7 million in cash consideration and $222,000 of direct transaction costs.
The allocation of the purchase price of Montezuma Mutual Telephone Company was as follows:
Baker Communications. On August 1, 2006, the Company acquired Baker Communications, Inc. Baker Communications designs, develops and provides ongoing support of technology solutions for clients. The acquisition of Baker Communications provided growth beyond our local exchange service area. The purchase price was $8.8 million and consisted of $8.6 million in cash consideration and $148,000 of direct transaction costs.
The allocation of the purchase price of Baker Communications was as follows:
Bishop Communications. On July 18, 2008, the Company acquired 100% of the outstanding stock of Bishop Communications, a provider of telecommunications, cable video and high speed Internet services to customers in portions of rural Minnesota. The acquisition of Bishop Communications expanded the Company’s service area and customer base. The purchase price was $33.1 million in cash, net of cash received, and assumed debt of $13.0 million, subject to potential working capital adjustments. The transaction did not result in a tax basis step-up, as such, the goodwill acquired is not deductible for tax purposes.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008
The preliminary allocation of the purchase price of Bishop Communications is as follows:
The purchase price allocation for this acquisition is preliminary and subject to revision as more detailed analyses are completed and additional information on the fair value of acquired assets and liabilities is developed. The preliminary allocation of the purchase price of Bishop Communications includes amortizable intangible assets consisting primarily of customer relationship intangibles which have a weighted average useful life of 11.6 years.
The results of operations for the acquired company are included in the Consolidated Statements of Income beginning on the acquisition date. The proforma impact of the acquisition was not material to the results of operations.
21. CONSOLIDATED QUARTERLY OPERATING INFORMATION (UNAUDITED)
(1) Operating revenues included $4.8 million of revenue from certain non-recurring network access billing matters with connecting carriers.
(2) Operating revenues included a $1.5 million unfavorable impact due to non-recurring network access billing matters.
(3) Operating income included a pension curtailment gain of approximately $2.5 million.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A. Controls And Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of December 31, 2008 (the “Evaluation Date”)). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective to provide reasonable assurance to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Changes in Internal Controls
There was no significant change in the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting.
Internal Control over Financial Reporting.
(a) Management’s Report on Internal Control Over Financial Reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting is a process designed by, or under the supervision of, our chief executive and chief financial officers and effected by our board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorizations of our management and directors; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.
Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we assessed the effectiveness of our internal control over financial reporting as of December 31, 2008. In making this assessment, management used the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As allowed by SEC guidance, management excluded from its assessment the 2008 acquisition of Bishop Communications, which accounted for approximately seven percent of consolidated total assets and approximately three percent of consolidated net sales. Based on this assessment, our management concluded that our internal control over financial reporting was effective as of December 31, 2008.
Our independent registered public accounting firm, Deloitte & Touche LLP, independently assessed the effectiveness of our internal control over financial reporting as stated in their report that follows.
(b) Attestation Report of the Independent Registered Public Accounting Firm.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Iowa Telecommunications Services, Inc. and subsidiaries
Newton, Iowa
We have audited the internal control over financial reporting of Iowa Telecommunications Services, Inc. and subsidiaries (the “Company”) as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in Management’s Report on Internal Control Over Financial Reporting, management excluded from its assessment the internal control over financial reporting at Bishop Communications Corporation and subsidiaries, which was acquired on July 18, 2008 and whose financial statements constitute 19.4% and 6.8% of net and total assets, respectively, 3.5% of revenues, and 0.4% of net income of the consolidated financial statement amounts as of and for the year ended December 31, 2008. Accordingly, our audit did not include the internal control over financial reporting at Bishop Communications Corporation and subsidiaries. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2008 of the Company and our report dated February 27, 2009 expressed an unqualified opinion on those financial statements and included an explanatory paragraph relating to the Company’s adoption of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, as of December 31, 2008.
/s/ DELOITTE & TOUCHE LLP
Des Moines, Iowa
February 27, 2009
******
ITEM 9B.
ITEM 9B. Other Information
None.
PART III.
ITEM 10.
ITEM 10. Directors, Executive Officers of the Registrant and Corporate Governance
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders.
ITEM 11.
ITEM 11. Executive Compensation
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions and Director Independence
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders.
ITEM 14.
ITEM 14. Principal Accountant Fees and Services
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders.
PART IV.
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
(a) Index to Financial Statements
1. Financial Statements: The consolidated financial statements and supplementary data are set forth under Item 8 of this Form 10-K.
2. Financial Statement Schedules: All schedules are inapplicable or the required information is included elsewhere herein.
(b) Exhibits
Reference is made to the Index to Exhibits, immediately preceding the exhibits to this Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 2, 2009.
IOWA TELECOMMUNICATIONS SERVICES, INC.
/s/ ALAN L. WELLS
Alan L. Wells
President, Chief Executive Officer and Director
Principal Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
* Previously filed as exhibits to Iowa Telecom’s Registration Statement on Form S-1 (File No. 333-114349) and incorporated herein by reference thereto.
# Management agreement or compensatory plan or arrangement.