Item 1. Business. - ------ --------
The Company
The Company is a diversified holding company engaged in a variety of businesses, including telecommunications, healthcare services, manufacturing, banking and lending, real estate activities, winery operations, development of a copper mine and property and casualty reinsurance. The Company concentrates on return on investment and cash flow to maximize long-term shareholder value. Additionally, the Company continuously evaluates the retention and disposition of its existing operations and investigates possible acquisitions of new businesses in order to maximize shareholder value. In identifying possible acquisitions, the Company tends to seek assets and companies that are troubled or out of favor and, as a result, are selling substantially below the values the Company believes to be present.
Shareholders' equity has grown from a deficit of $7,700,000 at December 31, 1978 (prior to the acquisition of a controlling interest in the Company by the Company's Chairman and President), to a positive shareholders' equity of $2,258,700,000 at December 31, 2004, equal to a book value per common share of the Company (a "common share") of negative $.07 at December 31, 1978 and $20.99 at December 31, 2004. The December 31, 2004 shareholders' equity and book value per share amounts have been reduced by the $811,900,000 special cash dividend paid in 1999.
In November 2003, pursuant to a registered exchange offer and merger agreement, the Company acquired the balance of the outstanding common stock of WilTel Communications Group, Inc. ("WilTel") that it did not already own for 16,734,690 of the Company's common shares. The Company had previously acquired 47.4% of the outstanding common stock of WilTel during 2002 for cash consideration of $353,900,000, including expenses. WilTel is a telecommunications company that owns or leases and operates a nationwide inter-city fiber-optic network providing Internet, data, voice and video services. Upon completion of the exchange offer and merger, WilTel became a consolidated subsidiary of the Company.
SBC Communications Inc. ("SBC"), a major communications provider in the U.S., is WilTel's largest customer, accounting for 70% of the Network segment's 2004 operating revenues. On January 31, 2005, SBC announced that it would buy AT&T Corp., and announced its intention to migrate the services provided by WilTel to the AT&T network. For more information about SBC see Item 1, "Business-Telecommunications" below.
The Company's healthcare services operations are conducted by subsidiaries of Symphony Health Services, LLC ("Symphony"), which was acquired in September 2003. Symphony is engaged in the provision of physical, occupational, speech and respiratory therapy services, healthcare staffing services and Medicare consulting services.
The Company's manufacturing operations manufacture and market lightweight plastic netting used for a variety of purposes including, among other things, building and construction, erosion control, agriculture, packaging, carpet padding, filtration and consumer products. In February 2005, the manufacturing segment increased its product offerings and customer base though the purchase of the assets of NSW, LLC U.S. ("NSW") for approximately $28,000,000.
The Company's banking and lending operations have historically consisted of making instalment loans to niche markets primarily funded by customer banking deposits insured by the Federal Deposit Insurance Corporation (the "FDIC"). However, as a result of increased loss experience and declining profitability, the Company stopped originating subprime automobile loans in September 2001 and all other consumer loans in January 2003. During 2004, the Company sold 97% of its remaining outstanding loans to a third party for aggregate cash proceeds of $149,000,000. Current operating activities at this segment are concentrated on maximizing returns on its investment portfolio, collecting and servicing its remaining loan portfolios and discharging deposit liabilities as they come due. The Company's banking and lending subsidiary intends to ultimately surrender its national bank charter.
The Company's domestic real estate operations include a mixture of commercial properties, residential land development projects and other unimproved land, all in various stages of development and all available for sale.
The Company's winery operations consist of Pine Ridge Winery in Napa Valley, California and Archery Summit in the Willamette Valley of Oregon. These wineries primarily produce and sell wines in the luxury segment of the premium table wine market.
The Company's copper mine development operations consist of its 72.1% interest in MK Resources Company ("MK Resources") (formerly MK Gold Company), a public company traded on the NASD OTC Bulletin Board (Symbol: MKRR).
The Company's property and casualty reinsurance business is conducted through its 19% common stock interest in Olympus Re Holdings, Ltd. ("Olympus"), a Bermuda reinsurance company primarily engaged in the property excess, marine and aviation reinsurance business.
Certain of the Company's subsidiaries have substantial tax loss carryforwards. The amount and availability of the tax loss carryforwards are subject to certain qualifications, limitations and uncertainties as more fully discussed in Note 15 of "Notes to the Consolidated Financial Statements" and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
On December 31, 2004, the Company effected a three-for-two stock split of the Company's common shares in the form of a 50% stock dividend (the "Stock Split"). The stock dividend was paid to holders of record of the Company's common shares at the close of business on December 23, 2004. All amounts in this Report have been adjusted to give retroactive effect to the Stock Split.
As used herein, the term "Company" refers to Leucadia National Corporation, a New York corporation organized in 1968, and its subsidiaries, except as the context otherwise may require.
Investor Information
The Company is subject to the informational requirements of the Securities Exchange Act of 1934 (the "Exchange Act"). Accordingly, the Company files periodic reports, proxy statements and other information with the Securities and Exchange Commission (the "SEC"). Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, D.C. 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding the Company and other issuers that file electronically. In addition, material filed by the Company can be inspected at the offices of the New York Stock Exchange, Inc. (the "NYSE"), 20 Broad Street, New York, NY 10005 and the Pacific Exchange, Inc., 115 Sansome Street, San Francisco, CA 94104, on which the Company's common shares are listed. The Company has submitted to the NYSE a certificate of the Chief Executive Officer of the Company, dated May 11, 2004, certifying that he is not aware of any violations by the Company of NYSE corporate governance listing standards.
The Company's website address is http://www.leucadia.com. The Company makes available, without charge, through its website copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after such reports are filed with or furnished to the SEC.
Financial Information about Segments
The Company's reportable segments consist of its operating units, which offer different products and services and are managed separately. The Company's telecommunications business is conducted by WilTel and contains two segments, Network and Vyvx. Network owns or leases and operates a nationwide fiber optic network over which it provides a variety of telecommunications services. Vyvx transmits audio and video programming over the network and distributes advertising media in physical and electronic form. The Company's other segments include healthcare services, manufacturing, banking and lending and domestic real estate. Healthcare services include the provision of physical, occupational, speech and respiratory therapy services, healthcare staffing services and Medicare consulting services. Manufacturing operations manufacture and market lightweight plastic netting used for a variety of purposes. Banking and lending operations historically made collateralized personal automobile instalment loans to individuals who had difficulty obtaining credit, at interest rates above those charged to individuals with good credit histories. The banking and lending segment has ceased originating any new loans and in 2004 sold 97% of its remaining outstanding loans to a third party. The Company's domestic real estate operations consist of a variety of commercial properties, residential land development projects and other unimproved land, all in various stages of development and all available for sale. Other operations primarily consist of winery operations and development of a copper mine.
Associated companies include equity interests in entities that the Company accounts for on the equity method of accounting. Prior to the acquisition of the outstanding common stock of WilTel that it did not already own in November 2003, the Company accounted for its 47.4% interest in WilTel as an associated company. Other investments in associated companies include Olympus, a Bermuda-based reinsurance company, Berkadia LLC ("Berkadia"), a joint venture formed to facilitate the chapter 11 restructuring of The FINOVA Group Inc. ("FINOVA"), HomeFed Corporation ("HomeFed"), a corporation engaged in real estate activities, Jefferies Partners Opportunity Fund II, LLC ("JPOF II") and EagleRock Capital Partners (QP), LP ("EagleRock"). Both JPOF II and EagleRock are engaged in investing and/or securities transactions activities.
Corporate assets primarily consist of investments and cash and cash equivalents and corporate revenues primarily consist of investment income and securities gains and losses. Corporate assets, revenues, overhead expenses and interest expense are not allocated to the operating units. The Company has a manufacturing facility located in Belgium and an interest, through MK Resources, in a copper deposit in Spain. WilTel owns or has the right to use certain cable systems which connect its U.S. domestic network to foreign countries, and has the right to use wavelengths in Europe which it is currently not using. These are the only entities with non-U.S. revenues or assets that the Company consolidates, and they are not material. In addition to its investment in Bermuda-based Olympus, the Company also owns 36% of the electric utility in Barbados. From time to time the Company invests in the securities of non-U.S. entities or in investment partnerships that invest in non-U.S. securities.
Except for the telecommunications segments of WilTel, the primary measure of segment operating results and profitability used by the Company is income (loss) from continuing operations before income taxes, minority expense of trust preferred securities and equity in income (losses) of associated companies. For WilTel's segments, segment profit from operations is the primary performance measure of segment operating results and profitability. WilTel defines segment profit from operations as income before income taxes, interest expense, investment income, depreciation and amortization expense and other non-operating income and expense.
The following information reconciles segment profit from operations of the Network and Vyvx segments to the most comparable measure under accounting principles generally accepted in the United States ("GAAP"), which is used for all other reportable segments, for the year ended December 31, 2004 and for the period from November 6, 2003 through December 31, 2003 (in millions):
(1) See note (d) to segment information below. (2) If items in these categories cannot be directly attributed to a particular WilTel segment, they are allocated to each segment based upon a formula that considers each segment's revenues, property and equipment and headcount. (3) For 2004, includes income of $18,500,000 related to the settlement of litigation for less than amounts reserved, income of $6,000,000 related to the sale of an equity security which had a zero book value, gains of $3,500,000 related to cash and securities received in excess of the book value of secured claims in customers' bankruptcies and income of $2,300,000 related to the reversal of excess reserves for long-term commitments.
Certain information concerning the Company's segments for 2004, 2003 and 2002 is presented in the following table. Consolidated subsidiaries are reflected as of the date of acquisition, which for WilTel's segments was November 2003 and for Symphony's healthcare services segment was September 2003. Associated Companies are only reflected in the table below under identifiable assets employed.
(a) Revenues and other income for each segment include amounts for services rendered and products sold, as well as segment reported amounts classified as investment and other income and net securities gains (losses) on the Company's consolidated statements of operations.
(b) For 2004 and the period from November 6, 2003 (date of acquisition) through December 31, 2003, includes services provided to SBC of $1,032,800,000 and $141,700,000, respectively.
(c) Net securities gains for Corporate aggregated $123,100,000 during 2004, which primarily resulted from the sale of publicly traded debt and equity securities that had been classified as available for sale securities. For 2004, includes a provision of $4,600,000 to write down investments in certain available for sale securities. For 2003, includes a provision of $6,500,000 to write down investments in certain available for sale securities and an investment in a non-public security. For 2002, includes a provision of $37,100,000 to write down investments in certain available for sale securities and an equity investment in a non-public fund. The write down of the available for sale securities resulted from a decline in market value determined to be other than temporary.
(d) Eliminates intersegment revenues billed from Network to Vyvx. However, the intersegment revenues are included in the calculation to determine segment profit from operations and income (loss) from continuing operations for each of Network and Vyvx.
(e) For the years ended December 31, 2004, 2003 and 2002, income (loss) from continuing operations has been reduced by depreciation and amortization expenses of $235,900,000, $61,400,000 and $18,500,000, respectively; such amounts are primarily comprised of Corporate ($11,400,000, $11,700,000 and $8,700,000, respectively), and amounts related to WilTel's segments, which are disclosed above. Depreciation and amortization expenses for other segments are not material.
(f) For the years ended December 31, 2004, 2003 and 2002, income (loss) from continuing operations has been reduced by interest expense of $96,800,000, $43,000,000 and $33,000,000, respectively; such amounts are primarily comprised of Corporate ($55,300,000, $26,000,000 and $13,100,000, respectively), banking and lending ($2,700,000, $8,800,000 and $18,100,000, respectively), and amounts related to WilTel's segments, which are disclosed above. Interest expense for other segments is not material.
At December 31, 2004, the Company and its consolidated subsidiaries had 5,324 full-time employees.
Telecommunications
Acquisition
During the fourth quarter of 2002, the Company acquired 47.4% of the outstanding common stock of WilTel for an aggregate cash purchase price of $353,900,000, including expenses. In November 2003, the Company consummated an exchange offer and merger pursuant to which WilTel became a wholly-owned subsidiary of the Company and former WilTel public stockholders received an aggregate of 16,734,690 common shares of the Company. The aggregate purchase price for the 2003 acquisition was approximately $425,300,000, consisting of $422,800,000 of the Company's common shares (based on a price of $25.27 per share) and cash expenses of $2,500,000. Following completion of the merger, the Company consolidated the financial condition and results of operations of WilTel, and no longer accounts for its investment in WilTel under the equity method of accounting. In the aggregate, the Company invested $779,200,000 in cash and common shares issued to acquire 100% of WilTel during 2002 and 2003. At December 31, 2004, the Company's consolidated balance sheet includes total WilTel assets of $1,611,700,000 and total WilTel liabilities of $1,118,300,000 (which are non-recourse to the Company), resulting in a net investment of $493,400,000.
Certain telecommunications terms used throughout this section are defined under "Telecommunications Glossary" below.
Network - -------
Business Description
Through its Network segment, WilTel owns or leases and operates a nationwide inter-city fiber-optic network. WilTel has also built a fiber-optic network within certain cities in the U.S. and has the ability to connect to networks outside the U.S. Network provides Internet, data, voice, and video services to companies that use high-capacity and high-speed telecommunications in their businesses. Network sells its products to the wholesale carrier and enterprise market segments, and many of its most significant customers provide retail telecommunications services to consumers and businesses. Historically, Network's fastest growing and largest revenue component is its voice business.
Network also offers rights of use in dark fiber, which is fiber that it installs but for which it does not provide communications transmission services. Purchasers of dark fiber rights install their own electrical and optical transmission equipment. Network also provides space and power to collocation customers at network centers and a variety of professional and managed services including network design and construction, network management and network monitoring or surveillance.
WilTel's network includes ownership interests in or rights to use:
- nearly 30,000 miles of fiber-optic cable in the U.S., of which 27,677 is currently in service; - local fiber-optic cable networks within 40 of the largest U.S. cities; - 118 network centers located in 107 U.S. cities; - fiber-optic cable connecting the U.S. and Mexico in California and Texas, and the U.S. and Canada in Washington, Illinois and New York; - capacity on five major undersea cable systems connecting the continental U.S. with Europe, Asia, Australia, New Zealand, Guam and Hawaii; and - rights to use wavelengths in Europe connecting the UK, France, Germany, Belgium, the Netherlands, Norway, Denmark, Finland, and Sweden. These rights have been exercised and wavelengths are available but not currently in use.
Properties
U.S. Inter-City Network
(1) Network has obtained rights in dark fiber and conduits of approximately 10,884 route miles, all of which have had fiber-optic cable installed. Network manages the transmission equipment on the routes it acquired, and it typically pays for the maintenance of fiber-optic strands and rights of way.
Network also leases capacity from both long-distance and local telecommunications carriers, including its competitors, in order to meet the needs of its customers. Leases of capacity are distinguished from rights in dark fiber in that capacity leases are for only a portion of the fiber capacity and the lessor supplies and operates the equipment to transmit over the fiber. Capacity leases are generally for terms of one month to five years, but can be longer. Network leases from third parties approximately one percent of its U.S. network capacity currently in use. These leases are for areas where Network does not have its own network capacity, or such capacity is not currently sufficient to meet the expected demand.
WilTel commenced construction of its network in 1997, began providing services in 1998 and had substantially completed construction in 2002. The domestic voice network grew to 25 switches as of December 31, 2004, including twenty three domestic switches, four of which are Voice over Internet Protocol capable, and two gateway switches. The gateway switches offer foreign termination and inbound domestic termination to other carrier customers.
Conduit and fiber-optic cable. The WilTel network contains multiple conduits along more than 90% of the routes it constructed. When constructing fiber-optic cable, the manufacturer places fiber-optic strands inside small plastic tubes, wraps bundles of these tubes with plastic, and strengthens them with metal. Network then places these bundles inside a conduit, which is high-density polyethylene hollow tubing one-and-one-half to two inches in diameter. The conduit is generally buried approximately 42 inches underground along pipeline or other rights of way corridors. Network also uses steel casing in high-risk areas, including railroad crossings and high-population areas, thereby providing greater protection for the cable. The first conduit generally contains a cable that has between 96 and 144 fibers, and the second conduit or, where constructed, a third conduit, serves as a spare. The spare conduits allow for future technology upgrades, potential conduit sales, and expansion of capacity. Network generally plans to retain from 8 to 24 fibers throughout the network for its own use, with the remainder made available for leases of dark fiber.
Rights of way. The WilTel network was primarily constructed by digging trenches along rights of way, or rights to use the property of others, which Network obtained throughout the United States from various landowners. Generally, where feasible, Network used the rights of way of pipeline companies that WilTel believed provided greater physical protection of the fiber system and resulted in lower construction costs than systems built over more public rights of way. Almost all of WilTel's rights of way extend through at least 2018. Rights of way are generally for terms of at least 20 years, and most cover distances of less than one mile.
Local Network
As of December 31, 2004, Network was providing services on local networks in 40 U.S. cities. These cities are: Anaheim, CA; Atlanta, GA; Bakersfield, CA; Baltimore, MD; Boston, MA; Buffalo, NY; Chicago, IL; Columbus, OH; Dallas, TX; Denver, CO; Fresno, CA; Houston, TX; Indianapolis, IN; Jersey City, NJ; Kansas City, KS; Laredo, TX; Los Angeles, CA; McAllen, TX; Modesto, CA; Miami, FL; Milwaukee, WI; Minneapolis, MN; New York, NY; Newark, NJ; Oakland, CA; Philadelphia, PA; Phoenix, AZ; Portland, OR; Riverside, CA; Sacramento, CA; San Francisco, CA; San Jose, CA; Santa Clara, CA; Seattle, WA; Secaucus, NJ; St. Louis, MO; Stamford, CT; Tucson, AZ; Tulsa, OK; and Washington, D.C. WilTel also has rights to utilize 30,740 local dark fiber miles in the U.S. through a fiber lease agreement with AboveNet Communications, Inc. ("AboveNet"). In addition, WilTel has the right to lease an additional 54,324 of dark fiber miles anywhere that AboveNet may construct or currently owns dark fiber in the U.S. or Europe.
Products and Services
Network's principal products and services are as follows:
Packet-based data products. These services provide connections for Internet, data, voice, and video networks at variable capacities between two or more points. Specific packet-based data products include ATM, Frame Relay, Ethernet Transparent LAN, Internet Protocol ("IP") transport and IP virtual private networks. These services are billed on a flat rate or usage basis.
Private line products. Network provides customers with fixed amounts of point-to-point capacity at various speeds on a protected or unprotected service level. A protected service level provides restoration on the customer's circuit under a variety of network outage conditions and is priced higher than unprotected service. These services are billed as fixed monthly fees, regardless of usage.
Voice services. Network provides wholesale origination, transport and termination, as well as calling card, directory assistance, operator assistance, toll-free services and international termination to more than 200 countries.
Optical wave services. This service is a point-to-point service which has no protection capacity, and which allows a customer the exclusive use of a portion of the transmission capacity of a fiber-optic strand rather than the entire fiber strand. A purchaser of optical wave services installs its own electrical interface, switching and routing equipment.
Backhaul services. Network has interconnected international cable landing stations on the West and East Coasts with fiber-optic rings capable of terminating cable traffic at specified Network centers. These services are made available to customers that have access to their own undersea cables and require domestic interconnection services only. Network also owns capacity positions on five major undersea cable systems.
Customers
Network offers services to both carrier and enterprise markets, and its customers currently include Regional Bell Operating Companies, ("RBOCs") cable television companies, Internet service providers, application service providers, data storage service providers, managed network service providers, digital subscriber line service providers, long distance carriers, local service providers, utilities, governmental entities, educational institutions, financial institutions, international carriers and other communications services providers who desire high-capacity and high-speed products on a carrier services basis.
SBC
Sales to SBC accounted for 70% of Network's 2004 operating revenues. On January 31, 2005, SBC announced that it would buy AT&T Corp., and announced its intention to migrate the services provided by WilTel to the AT&T network. SBC indicated that it expects to close its acquisition of AT&T in the first half of 2006.
Once SBC completes the migration of its business from WilTel's network to the AT&T network and terminates the existing preferred provider agreements between WilTel and SBC (scheduled to extend until 2019), SBC will be required to pay WilTel up to $200,000,000 for all costs WilTel incurs in connection with such termination, including increased costs of the network facilities remaining with WilTel due to the loss of SBC traffic (defined as "Transition Costs" in the provider agreements). WilTel anticipates that a migration of services from its network to AT&T would not begin until after the appropriate regulatory agencies approve SBC's acquisition of AT&T. WilTel expects it will take anywhere from two to three years from now for SBC to migrate all of its traffic off of WilTel's network, and anticipates that it will continue to provide some level of service to SBC into 2007.
Pursuant to the preferred provider agreements, the price for products and services, determined separately for each product or service, generally will be equal to the lesser of the cost of the product or service plus a specified rate of return, the prices charged to other customers, the current market rate or, in some circumstances, a specific rate. If either party can secure lower prices for comparable services that the other party will not match, then that party is free to utilize the lowest cost provider. WilTel and SBC have agreed to use a fixed price for voice transport services (the substantial majority of WilTel's SBC generated revenue) through April 1, 2005.
WilTel is currently engaged in negotiations with SBC with respect to a transition pricing agreement and other matters that will enable WilTel to continue to provide SBC with a high level of service after April 1, 2005. If the parties fail to reach agreement on pricing, any disputes as to pricing methodology are to be resolved through binding arbitration. The Company is also evaluating the impact of SBC's intended acquisition of AT&T on WilTel's operations and financial condition, including the potential adverse impact on the carrying values of Network's assets. Under GAAP, the SBC announcement is considered to be an event requiring the Company to assess the recoverability of Network's assets (principally property and equipment) during the first quarter of 2005. For more information about the process the Company expects to use to assess the recoverability of Network's assets, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
WilTel plans to modify its operations in light of the anticipated loss of its major customer, including expanding its customer base and evaluating opportunities for consolidation. WilTel expects it will evaluate and implement cost reduction strategies, investigate sales of assets and minimize capital expenditure outlays to help offset the loss of SBC's business. However, given the current economic condition of the telecommunications industry as a whole, where telecommunications capacity far exceeds actual demand and the marketplace is characterized by fierce price competition, and the limited growth of non-SBC business over the past few years, WilTel does not believe it will be able to fully replace the revenues and profits generated by the SBC agreements in the near future, if ever. The Company believes there may be opportunities to increase Network's value through consolidation opportunities, and it is actively investigating those possibilities. However, no assurance can be given that the Company will be successful in these efforts.
Sales and Marketing
Network's sales and marketing organizations target customers that require high volumes of bandwidth to operate their businesses. The successful acquisition of a new customer requires a high degree of technical knowledge about both the product being sold and the customer's operation, since most of Network's products need to be specifically configured to meet the unique needs of each customer.
Network has a centralized marketing organization that has established a segment-wide approach to marketing and product management. The marketing organization is responsible for advanced market planning and segmentation, product planning and development, product marketing, advertising, lifecycle management, product economics, pricing and competitive analysis.
Competition
The telecommunications industry is highly competitive. Some of Network's competitors may have financial, personnel and other resources significantly greater than those of Network. In the market for carrier customers, Network competes primarily with AT&T, MCI, Sprint, Qwest, Level 3, Global Crossing and Broadwing. In the market for enterprise customers, Network competes primarily with AT&T, MCI, and Sprint. Many of these competitors have revenues and customer bases far larger than those of Network. Network also competes with numerous other service providers that focus either on a specific product or set of products or within a geographic region. Network competes primarily on the basis of price, network reliability, customer service and support. Network's services within local markets in the U.S. face additional competitors, including the traditional regional telephone companies and other local telephone companies.
The telecommunications industry has experienced a great deal of instability during the past several years. During the 1990s, forecasts of very high levels of future demand brought a significant number of new entrants and new capital investments into the industry. However, many industry participants have gone through bankruptcy, those forecasts have not materialized, telecommunications capacity now far exceeds actual demand and the resulting marketplace is characterized by fierce price competition as competitors seek to secure market share. Resulting lower prices have eroded margins and have kept many in the industry from attaining positive cash flow from operations. In addition, many larger industry participants (SBC, Verizon and Sprint) have announced agreements to acquire other industry participants in transactions that may further intensify the competitive environment. The Company does not know if and when the current pricing environment will improve or achieve stability.
Vyvx - ----
Business Description
Vyvx transmits audio and video programming for its customers over Network's fiber-optic network and via satellite. It uses Network's fiber-optic network to carry many live traditional broadcast and cable television events from the site of the event to the network control centers of the broadcasters of the event. These events include live sporting events of the major professional sports leagues, including the last sixteen Super Bowls. For live events where the location is not known in advance, such as breaking news stories in remote locations, Vyvx provides an integrated satellite and fiber-optic network based service to transmit the content to its customers. Most of Vyvx's customers for these services contract for the service on an event-by-event basis; however, Vyvx has some customers who have purchased a dedicated point-to-point service which enables these customers to transmit programming at any time.
Vyvx also distributes advertising spots to radio and television stations throughout the U.S., both electronically and in physical form. Customers for these services can utilize a network-based method for aggregating, managing, storing and distributing content for content owners and rights holders.
Products and Services
Vyvx's primary products and services are as follows:
Fiber Optic and Satellite Video Transport Services. Vyvx offers various products to provide audio and video feeds over fiber or satellite for broadcast and production customers. These products vary in capacity provided, frequency of use (i.e., may be provided on an occasional or dedicated basis) and price. In 2004, Super Bowl XXXVIII was the first live broadcast event ever carried using Vyvx's new high definition (HD) transport product.
Advertising Distribution Services. These services include:
Audio Distribution. Vyvx sends radio spots to stations via electronic and physical distribution. Spots are distributed to over 10,500 stations in North America via the Internet using no proprietary hardware.
Video Distribution. Vyvx has the capability to deliver video content electronically and physically to television stations, broadcast networks and cable networks across the United States. Its electronic reach covers more than 1,450 destinations.
Storage. Vyvx offers secure storage of media components in Vyvx's climate-controlled storage facilities located in Burbank, Chicago and Newark, Delaware.
Customers
Vyvx sells to media content service providers and businesses that use media content as a component of their business. It does not compete with its media customers for retail end-users. It has approximately 2,000 customers, including major broadcast and cable television networks, news services, professional and collegiate sports organizations, advertising agencies and their advertisers, television companies and movie production companies. Approximately 62% of Vyvx's 2004 operating revenue was derived from its top 10 customers. Fox Entertainment Group, Inc. and its parent company The News Corporation Limited, through their various news, sports and entertainment businesses, accounted for approximately 18% of Vyvx's operating revenues and TimeWarner, Inc. accounted for 16% of Vyvx's operating revenues.
Sales and Marketing
Vyvx has sales personnel located in eight states and the District of Columbia to provide service to its domestic and international customers. The largest sales offices are in New York, New York and Burbank, California, where many of Vyvx's largest customers are based.
Competition
The Company believes that no single competitor currently exists that offers all of the services being offered by Vyvx. Vyvx encounters smaller competitors in the market place, each of which historically has offered only one or two of Vyvx's products.
Telecommunications Glossary - ---------------------------
Access - a long distance carriers use of local exchange facilities to originate or terminate long distance traffic or of leased lines for dedicated facilities.
Asynchronous transfer mode (ATM) - a Layer 2 high-speed multiplexing and switching protocol that uses fixed cell sizes of 53 bytes each to transport voice, data and video traffic.
Bandwidth - the width of or measure of capacity of a communications channel; analog channel capacity is measured in hertz and digital channel capacity is measured in bits per second.
Capacity - the information carrying ability of a telecommunications facility. The facility determines what measure is appropriate. For example, a private line's capacity could be measured in bits per second. A switch's capacity could be measured in the maximum number of calls per hour.
Carrier - a provider of communications transmission services.
Carrier class customer - a customer who has significant bandwidth capacity requirements that would rival the capacity requirements of a wholesale carrier.
Dark fiber - installed fiber-optic cable which is not connected to transmission equipment and so is not capable of carrying transmission services.
Ethernet - a local area network used for connecting computers, printers, workstations, terminal, servers, etc. within the same building or campus.
Ethernet Transparent LAN - a network with Ethernet interfaces that can carry any Layer 3 protocol, giving the LANs it connects the appearance of complete transparency, as though they were connected directly across an Ethernet cable.
Fiber-optic cable - a transmission medium consisting of a core of glass or plastic which is surrounded by a protective cladding, strengthening material and an outer jacket. Signals are transmitted as light pulses, introduced into the fiber by a light transmitter (a light emitting diode or a laser). Low data loss, high-speed transmission, large bandwidth, small physical size, light weight and freedom from electromagnetic interference and grounding problems are some of the advantages offered by fiber-optic cable.
Frame Relay - a Layer 2 switching and multiplexing protocol that places data in frames of varying size and allows transmission of data with efficient error correction.
Gateway switch - a switch that allows signals to cross from one network to another.
High Definition (HD) - a system standard for transmitting a TV signal with far greater resolution.
Internet Protocol (IP) - the Layer 3 communications protocol standard used for delivering individual data packets to their destinations by tracking the Internet addresses of the sender and receiver.
Layer 2 - a data communications standard (such as ATM, Frame Relay, or Ethernet) that establishes a fixed, pre-determined path for the data stream. In the event of a network outage, the switches work together to re-route traffic to facilities not impacted by the outage.
Layer 3 - a data communications standard (such as IP) that does not create a fixed path through the network, but makes an individual routing decision for each data packet received based upon real-time updates of network congestion. Because of this additional computation burden, Layer 3 networks tend to have more latency that is less predictable, but are also less susceptible to major network outages.
Local area network (LAN) - a data communications network that links together computers and peripherals to serve users within a confined area.
Multiplexing - consolidation of multiple signals into a single, higher speed signal that is transmitted to a receiver. The receiver then decomposes the signal into its original constituent elements.
Network center - an environmentally controlled secure location containing equipment and staff, and space and power for collocation customers, where various network management and control functions are conducted.
Optical wave - see "Wavelengths" below.
Switch - mechanical or electronic device for making, breaking or changing the directional flow of electrical or optical signals.
Transmission - sending electrical signals that carry information over a physical path to a destination.
Virtual private network (VPN) - private, secure switched voice or data network between two or more sites that functions as a dedicated or private line facility while using public network segments.
Voice over IP - telephone calls using IP.
Wavelengths - a portion of the transmission capacity of a fiber-optic cable rather than the entire fiber cable. A purchaser of optical wave or wavelength installs its own electrical interface, switching and routing equipment.
Government Regulation - ---------------------
Overview
WilTel is subject to significant federal, state, local and foreign laws, regulations and orders that affect the rates, terms and conditions of certain of its service offerings, its costs and other aspects of its operations. Regulation of the telecommunications industry varies from state to state and from country to country, and it changes regularly in response to technological developments, competition, government policies and judicial proceedings. Some of these changes and potential changes are discussed below. The Company cannot predict the impact, nor give any assurances about the materiality of any potential impact, that such changes may have on its business or results of operations, nor can it guarantee that domestic or international regulatory authorities will not raise material issues regarding its compliance with applicable laws and regulations.
The Federal Communications Commission ("FCC") has jurisdiction over WilTel's facilities and services to the extent those facilities are used to provide interstate telecommunications services (services that originate and terminate in different states) or international telecommunications services. State regulatory commissions generally have jurisdiction over facilities and services to the extent the facilities are used in intrastate telecommunications services. Foreign laws and regulations apply to telecommunications that originate or terminate in a foreign country. Generally, the FCC and state commissions do not regulate Internet, video conferencing or certain data services, although the underlying telecommunications services components of such offerings may be regulated in some instances.
WilTel's operations also are subject to a variety of environmental, building, safety, health and other governmental laws and regulations.
Federal Regulation
The Communications Act of 1934. The Communications Act of 1934, as amended (the "Communications Act") grants the FCC authority to regulate interstate and foreign communications by wire or radio. The Telecommunications Act of 1996 (the "1996 Act") establishes a framework for fostering competition in the provision of local and long distance telecommunications services. WilTel is regulated by the FCC as a non-dominant carrier and, therefore, is subject to less comprehensive regulation than dominant carriers under the Communications Act. WilTel is subject to certain provisions of Title II of the Communications Act applicable to all common carriers that require WilTel to offer service upon reasonable request and pursuant to just and reasonable charges and practice, and prohibit WilTel from unjustly or unreasonably discriminating in its charges or practices. The FCC has authority to impose more stringent regulatory requirements on non-dominant carriers. The FCC reviews its rules and regulations from time to time, and WilTel may be subject to those new or changed rules.
WilTel has obtained authority from the FCC to provide international services between the U.S. and foreign countries, and has registered with the FCC as a provider of domestic interstate long distance services. WilTel believes that it is in material compliance with applicable federal laws and regulations, but cannot guarantee that the FCC or third parties will not raise issues regarding its compliance with applicable laws or regulations.
Long Distance Regulation. Regulation of other carriers in the communications industry also may affect WilTel. For example, Section 271 of the Communications Act had prohibited RBOCs and their respective affiliates from providing long distance services between so-called Local Access and Transport Areas ("LATAs") in their region, and between their region and other states, until they have demonstrated to the FCC, on a state-by-state basis, that they have satisfied certain procedural and substantive requirements set forth in the 1996 Act. The FCC has granted Section 271 authority to all RBOCs in each of their in-region states.
In a state where a RBOC has received authority to provide long distance telecommunications service, Section 272 of the Communications Act requires the RBOC to maintain a separate affiliate and to comply with certain structural and operational safeguards for its long distance operations, all of which impose on RBOCs significant costs related to maintaining separate equipment, employees and processes. This separate affiliate requirement expires on a state-by-state basis three years after the RBOC first obtained approval to provide long distance service in a given state, unless the FCC extends the three-year period. If an RBOC chooses to provide long distance telecommunications services without a separate affiliate in a state where the separate affiliate requirement has expired, the RBOC currently is subject to heightened regulation of its rates for long distance services. The FCC is considering several options for strengthening or weakening regulation governing the RBOCs' provision of long distance telecommunications services without a separate affiliate.
The Section 272 separate subsidiary requirement for two of WilTel's largest customers, Verizon in New York, Massachusetts, Pennsylvania and Rhode Island and SBC in Texas, Oklahoma, Kansas, Arkansas and Missouri has expired and has not been extended by the FCC. WilTel does not expect the FCC to extend the requirement in any other states as the 3-year period elapses in such states. While the RBOCs' entry into the long distance market could provide opportunities for WilTel to sell dark fiber or lease high-volume long distance capacity to the RBOCs, it could also allow the RBOCs to provide the same services that WilTel currently provides, services which RBOCs currently purchase from WilTel. Increased competition from the RBOCs could have an adverse effect on WilTel's business, as the RBOCs will be able to market integrated local and long distance services and may enjoy significant competitive advantages. Because RBOCs account for approximately 75% of WilTel's Network revenues, the RBOC's ability to offer long distance voice and data services poses risks to WilTel's business in the future. For information about SBC (Network's largest customer) and its plan to acquire AT&T and migrate its traffic to AT&T's network, see Item 1, "Business-Telecommunications" above.
Local Service Regulation. In addition to overseeing the entry of the RBOCs into the long distance market, the FCC was required, pursuant to the 1996 Act, to establish national rules implementing the local competition provisions of the 1996 Act. More specifically, the 1996 Act imposed duties on all local exchange carriers, including incumbent local exchange carriers ("ILECs") and new entrants (sometimes referred to as competitive local exchange carriers, or "CLECs") to provide network interconnection, reciprocal compensation, resale, number portability and access to rights-of-way. Where WilTel provides local telecommunications services, it must comply with these statutory obligations and the FCC's implementing rules.
In March 2004, the U.S. Court of Appeals for the District of Columbia Circuit struck down an FCC rule that required regional telephone companies to open their networks to competitors at reasonable rates. In response, the FCC issued interim rules requiring regional local telephone companies to continue opening their networks to competitors at reasonable rates until the earlier of such time as the FCC issues permanent rules or September 13, 2005 (with increased rates and reduced availability effective March 13, 2005). The FCC released permanent rules on February 3, 2005. As a result, competing telephone companies will be charged higher rates by local telephone companies to use parts of their networks on certain routes, or incur costs to purchase and install their own networks in order to offer local phone service. Although WilTel's wholesale carrier market segment is not likely to be materially affected by these actions, its enterprise market segment could experience a short-term cost disadvantage with competitors who have cheaper access to local telephone company networks. In addition, certain of WilTel's customers could be significantly affected by these changes.
Access Regulation. Federal regulation affects the cost and thus the demand for long distance services through regulation of interstate access charges, which are the local telephone companies' charges for use of their exchange facilities in originating or terminating interstate transmissions. The FCC regulates the interstate access rates charged to long distance carriers by ILECs and CLECs for the local origination and termination of interstate long distance traffic. Those access rates make up a significant portion of the cost of providing long distance traffic. Since the 1996 Act, the FCC has restructured the access charge system, resulting in significant downward changes in access charge rate levels.
On May 31, 2000, the FCC adopted a proposal submitted by a coalition of long distance companies and RBOCs, referred to as "CALLS," pursuant to which ILEC access rates must be decreased in stages over five years. On September 10, 2001, the United States Court of Appeals for the Fifth Circuit upheld most of the FCC's CALLS order, but remanded for further consideration portions of the order that created a new universal service fund and that set a factor applied annually to reduce access rates at a certain pace. The FCC issued an order on July 10, 2003 on remand readopting the substance of the disputed aspects of the CALLS order, and the remand order was not appealed.
On April 27, 2001, the FCC issued a ruling regarding the interstate access charges levied by CLECs on long distance carriers. Effective June 20, 2001, CLEC access charges were required to be reduced over a three-year period to the level charged by ILECs in the competing area. This reduction in CLEC access charge rates has resulted in a substantial reduction in the per-minute rate CLECs charge WilTel for interstate access services.
On April 19, 2001, the FCC adopted a Notice of Proposed Rulemaking seeking to unify its inter-carrier compensation rules. The FCC proposal seeks to address disparities in rates for access charges and reciprocal compensation (the rates that carriers pay each other for completing local calls exchanged between them). The FCC's proposal seeks comments on a transition to a "bill and keep" system pursuant to which carriers would not exchange cash compensation, but would provide call completion services free of charge. Adoption by the FCC of a unified inter-carrier compensation regime that adopts a "bill and keep" regime or that otherwise reduces the rates that carriers may charge for access charges could significantly reduce WilTel's inter-carrier compensation costs and revenues. Several groups of industry participants, seeking to develop an industry consensus to present to the FCC, have submitted proposals for broad reform to the FCC, and on February 10, 2005, the FCC announced the adoption of a further notice of proposed rulemaking in which it would seek comment on these various proposals. WilTel is unable to determine at this time the outcome of the FCC proceeding and the industry effort or the resulting impact, if any, on WilTel's business.
Voice-over-IP. In a 1998 report to Congress, the FCC suggested, but did not conclude, that telephone calls using IP could be considered telecommunications services. The FCC has also been asked to consider the regulatory implications of such "Voice-over-IP" technology. Certain ILECs have asked the FCC to rule that certain transmission services, such as calls made over the Internet, are subject to regulation as telecommunications services including the assessment of interstate switched access charges and universal service fund assessments. On February 5, 2003, pulver.com filed a petition for declaratory ruling that a service offering that uses IP voice communications is neither telecommunications nor a telecommunications service. On February 19, 2004, the FCC held that the specific "IP-to-IP" service offered by pulver.com is an interstate information service and is neither telecommunications nor a telecommunications service.
In a May 2004 ruling, the FCC clarified that whenever traffic originates and terminates on the public switched telephone network, long distance carriers (such as WilTel) that carry such traffic must pay access charges, but the FCC has not yet addressed whether traffic originating on broadband networks is subject to such charges. RBOCs have attempted to recover unpaid access charges from long distance carriers who were following business practices not consistent with the FCC ruling. Although WilTel had been actively seeking clarification from the FCC concerning this matter, WilTel's policy has been to accrue access charges in a manner that it believes is consistent with the FCC's ruling. The FCC's ruling is not expected to have a material impact on WilTel; however, certain of WilTel's customers and competitors may be adversely affected.
On November 12, 2004, the FCC granted the request of Vonage Holdings Corporation to preempt the Minnesota Public Utility Commission from regulating Vonage's broadband-originated services as a telecommunications service subject to full state regulation. WilTel believes that the FCC's ruling provides the FCC with authority to create uniform rules applicable to Voice-over-IP. The FCC's Vonage decision has been appealed by several state public utility commissions.
Several other Voice-over-IP petitions have also been filed. During 2004, both Level 3 Communications and SBC filed petitions seeking FCC rulings on the regulatory framework for Voice-over-IP related offerings. Other local exchange carriers have filed similar petitions, and the FCC has requested comments on developing comprehensive rules to cover Voice-over-IP. Absent FCC action on these matters, some state public utility commissions and private parties (through agreements) have begun addressing important issues such as the amount of compensation companies must pay for termination of Voice-over-IP traffic on the public switched telephone network. Decisions on the Level 3 and SBC petitions are expected during the first or second quarter of 2005. As carriers and their customers migrate to IP and packet-based technologies, the outcome of such proceedings is likely to affect carrier-carrier and carrier-customer relationships. WilTel is unable to determine at this time the outcome of any of these proceedings or the impact, if any, they could have on its business. However, assuming the same volume of voice minutes, WilTel believes that revenues and profitability for Voice-over-IP services may be less than traditional voice transport products.
Universal Service. Pursuant to the 1996 Act, in 1997 the FCC established a significantly expanded universal service regime to subsidize the cost of telecommunications services to high-cost areas, to low-income customers, and to qualifying schools, libraries and rural health care providers. Providers of interstate and international telecommunications services, and certain other entities, must pay for these programs by contributing to a Universal Service Fund (the "Fund"). The rules concerning which services are considered when determining how much an entity is obligated to contribute to the Fund are complex; however, many of the services sold by WilTel are included in the calculation. Current rules require contributors to make quarterly and annual filings reporting their revenues, and the Universal Service Administrative Company issues monthly bills for the required contribution amounts, based on a quarterly contribution factor approved by the FCC. The FCC announced assessments for the first quarter of 2005 of 10.7% have been increased from 8.7% in the fourth quarter of 2004. The contribution factor may be higher in future quarters. A portion of WilTel's gross revenues from the provision of interstate and international services are subject to these assessments. For the year ended December 31, 2004, WilTel was assessed approximately $6,600,000 by the Fund.
On December 13, 2002, the FCC issued revised universal service rules and proposed further changes to the universal service contribution methodology. Under one of the proposed changes, the FCC would begin assessing contributions to the Fund based on working telephone numbers and connections to telephone company customers, as opposed to the existing mechanism that requires contributions based on end user revenues. The FCC is expected to adopt this proposal during 2005. Although any FCC changes to the methodology could result in WilTel paying a larger percentage of its revenues to the Fund, WilTel is unable to determine what changes will occur and what impact those changes will have on its business.
WilTel and other contributors to the federal universal service fund may recover their contributions in any manner that is equitable and nondiscriminatory, but may not mark up their federal universal service recovery above the amount of the contribution factor. Carriers may recover their contribution costs through their end-user rates, or through a line item (stated as a flat amount or percentage), provided that the line item does not exceed the total amount associated with the contribution factor. The recovery rules are the subject of a petition for reconsideration pending before the FCC. The rules also allow contributors to renegotiate contract terms that prohibit the pass-through of universal service recovery charges. Unrecovered assessments will increase WilTel's costs.
Broadband Regulation. The FCC to date has treated Internet service providers as enhanced service providers rather than common carriers. As such, Internet service providers generally have been exempt from various federal and state regulations, including the obligation to pay access charges and contribute directly to universal service funds. On December 20, 2001, the FCC issued a Notice of Proposed Rulemaking seeking comment on whether ILEC broadband offerings are telecommunications services subject to Title II jurisdiction or, as the FCC already has concluded with respect to cable modem service, information services subject only to Title I jurisdiction. In 2003, the United States Court of Appeals for the Ninth Circuit partially vacated the FCC's determination that cable modem service is subject only to Title I jurisdiction, holding that companies providing cable modem services also offer a telecommunications service component that is subject to Title II regulation. The FCC appealed that decision, and the U.S. Supreme Court is scheduled to hear the case during 2005. In a separate Notice of Proposed Rulemaking released February 15, 2002, the FCC sought comment on issues related to broadband access to the Internet over domestic wireline facilities, including whether facilities-based broadband Internet access providers should be required to contribute to support universal service. The FCC has not addressed either of these Notices of Proposed Rulemaking and WilTel cannot determine how the U.S. Supreme Court will rule on the Ninth Circuit decision, and whether such action will impact WilTel's business.
State Regulation
The Communications Act severely restricts state and local governments from enforcing any law, rule or legal requirement that prohibits or has the effect of prohibiting any person from providing any interstate or intrastate telecommunications service. However, states retain substantial jurisdiction over intrastate matters, and generally have adopted regulations intended to protect public safety and welfare, ensure the continued quality of communications services, and safeguard the rights of consumers. Some states impose assessments for state universal service programs and for other purposes. To the extent that WilTel provides intrastate telecommunications services, WilTel is subject to various state laws and regulations.
Most state public utility and public service commissions require some form of certificate of authority or registration before offering or providing intrastate services, including competitive local telecommunications services. Currently, WilTel or its subsidiary, WilTel Local Network, LLC, hold authorizations to provide such services, at least to some extent, in all 50 states and the District of Columbia.
In most states, in addition to the requirement to obtain a certificate of authority, WilTel must request and obtain prior regulatory approval of price lists or tariffs containing rates, terms and conditions for its regulated intrastate services. WilTel is required to update or amend these tariffs when it adjusts its rates or adds new products. WilTel believes that most states do not regulate its provision of dark fiber. If a state did regulate its provision of dark fiber, WilTel could be required to provide dark fiber in that state pursuant to tariffs and at regulated rates.
WilTel is also subject to various reporting and record-keeping requirements in states in which it is authorized to provide intrastate services. Many states also require prior approval for transfers of control of certified providers, corporate reorganizations, acquisitions of telecommunications operations, assignment of carrier assets, carrier stock offerings and undertaking of significant debt obligations. States generally retain the right to sanction a service provider or to condition, modify or revoke certification if a service provider violates applicable laws or regulations. Fines and other penalties also may be imposed for such violations. While WilTel believes that it is substantially in compliance with applicable state laws and regulations that are material to its operations, it cannot guarantee that state regulatory authorities or third parties will not raise issues with regard to its compliance.
State regulatory commissions generally regulate the rates that ILECs charge for intrastate services, including intrastate access services paid by providers of intrastate long distance services. WilTel's intrastate services compete against the regulated rates of these carriers and also utilize certain ILEC services. State regulatory commissions also regulate the rates ILECs charge for interconnection of network elements with, and resale of, services by competitors. State commissions have initiated proceedings that could have the potential to affect the rates, terms and conditions of intrastate services. WilTel, through WilTel Local Network, LLC, has entered into or is in the process of entering into interconnection agreements with various ILECs and the rates, terms and conditions contained in such agreements will be affected by such state proceedings.
Local Regulation
Some jurisdictions require WilTel to obtain street use and construction permits and licenses and/or franchises before installing or expanding its fiber-optic network using municipal rights-of-way. Termination of, or failure by WilTel to renew, its existing franchise or license agreements could have a material adverse effect on its operations. In some municipalities where WilTel has installed or may construct facilities, it is required to pay license or franchise fees based on a percentage of gross revenue, a flat annual fee or a per linear foot basis. WilTel cannot guarantee that fees will remain at their current levels following the expiration of existing franchises. In addition, WilTel could be at a competitive disadvantage if its competitors do not pay the same level of fees as it does. The Communications Act requires municipalities to manage public rights of way in a competitively neutral and non-discriminatory manner and prohibits the imposition of right-of-way fees as a means of raising revenue. A considerable amount of litigation has challenged right-of-way fees on the grounds that such fees violate the Communications Act. The outcome of such litigation may affect WilTel's costs of operations.
Other U.S. Regulation
WilTel's operations are subject to a variety of federal, state and local environmental, safety and health laws and governmental regulations. These laws and regulations govern matters such as the generation, storage, handling, use and transportation of hazardous materials, the emission and discharge of hazardous materials into the atmosphere, the emission of electromagnetic radiation, the protection of wetlands, historic sites and endangered species, and the health and safety of employees. WilTel also may be subject to environmental laws requiring the investigation and cleanup of contamination at sites it owns or operates or at third-party waste disposal sites. Such laws often impose liability even if the owner or operator did not know of, or was not responsible for, the contamination.
WilTel owns or operates numerous sites in connection with its operations. WilTel monitors compliance with environmental, safety and health laws and regulations and believes it is in material compliance; however, it cannot give assurances that it has been or will be in complete compliance with these laws and regulations. WilTel may be subject to fines or other sanctions imposed by governmental authorities if it fails to obtain certain permits or violates their respective laws and regulations.
WilTel has ownership interests in and utilizes certain submarine cable systems for the provision of telecommunications services. WilTel, through its joint ownership interests, is subject to certain state and federal laws and regulations governing the construction, maintenance and use of such facilities. Such laws and regulations may include corridor restrictions, exclusionary zones, undersea cable fees or right-of-way use fees for submerged lands. Increased regulation of cable assets or assessments may affect the cost and ultimately the demand for services provided over such facilities.
Foreign Regulation
The provision of telecommunications services in foreign countries is also regulated and varies from country to country. Telecommunications carriers are generally required to obtain permits, licenses or authorizations to initiate or terminate communications in a country. Many regulatory systems have only recently faced the issues raised by competition and are still in the process of development. Although the services WilTel currently provides outside the U.S. are not currently material, if WilTel expands its foreign operations it will be subject to substantial regulatory requirements. Foreign telecommunications laws and regulations are changing and WilTel cannot determine at this time the impact, if any, that such future regulatory, judicial or legislative activities may have on its business or operations.
International switched long distance traffic between two countries historically is exchanged under correspondent agreements between carriers, each owning network transmission facilities in their respective countries. Correspondent agreements generally provide for, among other things, the termination of switched traffic in, and the return of switched traffic to, the carriers' respective countries at a negotiated accounting rate. Settlement costs, typically one-half of the accounting rate, are reciprocal fees owed by one international carrier to another for transporting traffic on its facilities and terminating that traffic in the other country. The FCC and regulators in foreign countries may regulate agreements and settlements between U.S. and foreign carriers.
Healthcare Services
Business Description
In September 2003, the Company acquired Symphony for approximately $36,700,000, including expenses. Established in 1994, Symphony provides post-acute healthcare services including contract therapy, long-term care consulting and temporary staffing to skilled nursing facilities, hospitals, sub-acute care centers, assisted living facilities, schools and other healthcare providers. Symphony currently operates in 46 states, providing services at approximately 2,000 locations through its employee workforce of approximately 3,200 part-time and full-time skilled healthcare professionals (excluding temporary personnel). The businesses owned by Symphony operate under the names RehabWorks, VTA Management Services, VTA Staffing Services, Symphony Respiratory Services, NurseWorks and Polaris Group. At December 31, 2004, the Company's consolidated balance sheet includes total Symphony assets of $65,600,000 and total Symphony liabilities of $60,200,000 (which are non-recourse to the Company), resulting in a net investment of $5,400,000.
The principal services offered by Symphony are described below.
o Contract Therapy Services - Physical therapy, occupational therapy, speech pathology and respiratory therapy services provided to various health care providers and schools. Services include compliance and clinical training, recruitment, orientation and staffing, management information and reimbursement expertise. o Healthcare Staffing Services - Placement of temporary healthcare professionals in hospitals and skilled nursing facilities generally ranging from one day to 13-week assignments. o Consulting Services - These services assist healthcare providers in managing Medicare reimbursement to ensure that systems and procedures are in place to manage costs and cash flow.
When determining how to meet their rehabilitation therapy and healthcare staffing needs, healthcare providers are faced with an "in-source" or "outsource" decision, to either manage the rehabilitation therapy unit in-house or to contract the service to an outside vendor. As healthcare expenditures in the U.S. have continued to increase, healthcare providers have experienced increased cost reduction pressures as a result of managed care and the implementation of prospective payment systems, where fixed fee schedules are set by the Center for Medicare and Medicaid Services ("CMMS"). Symphony's services give its customers increased flexibility in managing staffing levels and enables them to reduce their overall costs by converting a fixed cost into a variable cost. Contract therapy is available on a full-time, part-time and on-call basis, and can be customized at each location according to the particular needs of a facility or patient. Contract therapy services also include full therapy program management with a full-time program manager who is also a therapist and two to four professionals trained in physical and occupational therapy or speech/language pathology. Symphony generally bills its customers either on the basis of a negotiated patient per diem rate or a negotiated fee schedule based on the type of service rendered. Symphony is also the largest provider of therapy services to the Department of Education of New York City.
Symphony's revenues and growth are affected by trends and developments in healthcare spending, which has been increasing at an accelerated rate over the past five years. Demographic considerations also affect the amount spent on healthcare. Due to the increasing life expectancy of Americans, the number of people aged 65 years or older has been growing and is expected to increase in the future. These trends, combined with the need for healthcare providers to find more cost effective means to deliver their services, may encourage healthcare providers to use the services offered by Symphony and its competitors.
Competition
The contract therapy and healthcare staffing services businesses compete in national, regional and local markets with full-service staffing companies and with specialized staffing agencies. The program management services business competes with companies that may offer one or more of the same services and with hospitals and skilled nursing facilities that do not choose to outsource these services. The managed inpatient units and outpatient programs are in highly competitive markets and compete for patients with other hospitals and skilled nursing facilities.
There is a significant shortage of skilled healthcare professionals who provide Symphony's services, and Symphony's revenues are dependent on its ability to attract, develop and retain qualified therapists and other healthcare personnel who possess the skills, experience and, as required, licensure necessary to meet the specified requirements of customers. Symphony competes for healthcare staffing personnel, with other healthcare companies, as well as actual and potential customers, some of whom seek to fill positions with either regular or temporary employees.
Government Regulation
Healthcare providers are subject to a complex array of federal, state and local regulations which include but are not limited to Medicare and Medicaid regulations, licensure regulations, fraud and abuse regulations, as well as regulations regarding the confidentiality and security of health-related information. If Symphony fails to comply with these laws it can result in civil penalties, criminal penalties and/or exclusion from participation with programs such as Medicare and Medicaid. Failure of Symphony's customers to meet regulatory requirements could have an adverse impact on its business.
Symphony's customers are subject to state licensure and Medicare certification requirements with respect to their facilities and healthcare professionals. Symphony is also subject to these requirements when it is the direct provider of the service. Systems are in place to assure that these requirements are met before Symphony's healthcare professionals treat patients.
In most instances, customers participate in the Medicare and Medicaid programs as do certain of Symphony's outpatient therapy facilities. As such, they are subject to Medicare and Medicaid's regulations regarding quality of care, qualifications of personnel, adequacy of physical plant, as well as billing and payment regulations. These regulations are written, published and administered by the CMMS and are monitored for compliance.
Various federal and state laws prohibit the knowing and willful submission of false claims or fraudulent claims to obtain payment from Medicare, Medicaid or other government programs. The federal anti-kickback statute also prohibits individuals and entities from knowingly and willfully paying, offering, receiving or soliciting money or anything else of value in order to induce the referral of patients or to induce a person to purchase, lease, order, arrange for or recommend services or goods covered by Medicare, Medicaid or other government healthcare programs.
The Balanced Budget Act of 1997 mandated the phase-in of a Medicare Part A prospective payment system for skilled nursing facilities and units based on the category of patient care under resource utilization group classifications established by the CMMS. All of the skilled nursing units to which we provide management services are now fully phased in under the resource utilization group system for skilled nursing facilities. The proposed 2006 federal budget includes a provision to refine the resource utilization group system to more appropriately account for certain high cost cases, but no assurance can be given that such changes will be implemented. Under the Medicare Part B payment system, reimbursement for outpatient therapy services is based on the lesser of the provider's actual charge for such services or the applicable Medicare physician fee schedule amount also established by the CMMS. As part of the Balanced Budget Act of 1997, the outpatient therapy benefit was capped at $1,590 per beneficiary per year, but the implementation of the cap has been delayed a number of times through legislation. Most recently, a two year moratorium expiring on December 31, 2005, was placed on implementation of the cap. Absent specific action by Congress the moratorium will expire and the benefit cap will go into place on January 1, 2006.
The Health Insurance Portability and Accountability Act of 1996 is designed to improve efficiency in healthcare delivery by standardizing electronic data interchange and by protecting the confidentiality and security of an individual's health data by setting and enforcing national standards of practice. Virtually all healthcare providers are affected by the law, which consists of three primary areas, standards for electronic transactions, privacy and security. The privacy rule and the standards for electronic transactions are currently effective and the security rule is scheduled to become effective on April 21, 2005. Symphony is in compliance with the privacy and electronic transmission provisions and believes that it will be in compliance with the security rule.
Manufacturing
Through its plastics division, the Company manufactures and markets lightweight plastic netting used for a variety of purposes including, among other things, building and construction, erosion control, agriculture, packaging, carpet padding, filtration and consumer products. The products are primarily used to add strength to other materials or act as barriers, such as warning fences and crop protection from birds. The plastics division is a market leader in netting products used in carpet cushion, erosion control, nonwoven reinforcement and crop protection. Certain of the division's products are proprietary, protected by patents and/or trade secrets. It markets its products both domestically and internationally, with approximately 16% of its 2004 revenues generated by customers in Europe, Latin America, Japan and Australia. Products are sold primarily through an employee sales force, located in the United States and Europe. Manufacturing revenues were $64,100,000, $53,300,000 and $50,700,000 for the years ended December 31, 2004, 2003 and 2002, respectively. At December 31, 2004, the Company's consolidated balance sheet includes total manufacturing assets of $50,400,000 and total manufacturing liabilities of $21,100,000, resulting in a net investment of $29,300,000.
New product development focuses on market niches where the division's proprietary technology and expertise can lead to sustainable competitive economic advantages. Historically, this targeted product development generally has been carried out in partnership with a prospective customer or industry where the value of the product has been recognized. The plastics division has also begun focusing on developing products which provide an upgrade to a current product used by an existing customer. Over the last several years, the plastics division has spent approximately 2% to 5% of annual sales on the development and marketing of new products and new applications of existing products.
The plastics division is subject to domestic and international competition, generally on the basis of price, service and quality. Additionally, certain products are dependent on cyclical industries, including the construction industry. The cost of the principal raw material used in its products, polypropylene, has increased by approximately 80% since the beginning of 2004. High oil and natural gas prices along with high capacity utilization in the polypropylene industry are expected to keep raw material costs higher than historical levels for the next two years. The division was able to raise prices to its customers during 2004 to offset the increase in polypropylene costs.
The plastics division currently has excess manufacturing capacity, principally in its Belgium facility which became operational in the third quarter of 2001. Utilization of this capacity has taken longer than anticipated primarily due to the loss of a major customer for whom the facility was expected to produce products. A new general manager was hired at the facility in 2004 to develop and implement marketing and sales initiatives directed at generating revenue growth. Operating results at the facility have improved during 2004 as sales grew 20% compared to 2003 and the business achieved positive cash flow. New customer acquisitions must continue in order for the facility to reach profitability.
The Company holds patents on certain improvements to the basic manufacturing processes it uses and on applications thereof. The Company believes that the expiration of these patents, individually or in the aggregate, is unlikely to have a material effect on the plastics division.
As mentioned above, in February 2005 the Company acquired the assets of NSW for approximately $28,000,000, thereby increasing its mix of products and customer base. NSW has a manufacturing and distribution facility in Roanoke, Virginia, and for its year ended December 31, 2004 generated annual sales of approximately $20,000,000. Although the Company plans to integrate certain of NSW's operating activities into its own, principally in the administration and raw materials purchasing areas, NSW's manufacturing facility will continue as a stand-alone operation. Products manufactured by NSW include produce and packaging nets, header label bags, case liners and heavy weight nets for drainage and erosion control purposes.
Banking and Lending
Business Description
Over the past few years, the Company has been shrinking its banking and lending operations. Historically, this segment made collateralized consumer loans consisting principally of personal automobile instalment loans to individuals who had difficulty obtaining credit. The Company's other consumer lending programs primarily consisted of marine, recreational vehicle, motorcycle and elective surgery loans. These lending activities were conducted through American Investment Bank, N.A. ("AIB"), a national bank subsidiary, and American Investment Financial, a Utah industrial loan corporation which merged into AIB in 2004.
The segment's current operating activities are concentrated on maximizing returns on its investment portfolio, collecting and servicing its remaining loan portfolios and discharging deposit liabilities as they come due. In September 2001, the Company stopped originating subprime automobile loans as a result of increasing loss experience and the increasingly difficult competitive environment. In January 2003, the Company stopped originating all consumer loans. In May 2004, the Company sold its subprime automobile and collateralized consumer loan portfolios, which represented 97% of banking and lending's total outstanding loans (net of unearned finance charges). The Company received aggregate cash proceeds of $149,000,000 and reported a pre-tax gain of $8,700,000, which is reflected in investment and other income. In September 2004, the Company sold certain loan portfolios that had been substantially written-off and reported a pre-tax gain of $7,600,000, which is reflected in investment and other income.
Certain information with respect to the Company's banking and lending segment is as follows for the years ended December 31, 2004, 2003 and 2002 (dollars in thousands):
Investments held by the banking and lending segment are primarily U.S. Government agencies and mortgage-back securities.
It is the Company's policy to charge to income an allowance for losses which, based upon management's analysis of numerous factors, including current economic trends, aging of the loan portfolio, historical loss experience and collateral value, is deemed adequate to cover probable losses on outstanding loans. At December 31, 2004, the allowance for loan losses for the Company's entire loan portfolio was $950,000 or 22% of the net outstanding loans, compared to $24,200,000 or 11.8% of net outstanding loans at December 31, 2003.
Government Regulation
The Company's principal banking and lending operations are subject to supervision by federal authorities, as well as federal regulation pursuant to the Federal Consumer Credit Protection Act, the Truth in Lending Act, the Equal Credit Opportunity Act, the Right to Financial Privacy Act, the Community Reinvestment Act, the Fair Credit Reporting Act and regulations promulgated by the Federal Trade Commission and the Board of Governors of the Federal Reserve System. The Company's banking operations are subject to federal regulation and supervision by, among others, the Office of the Comptroller of the Currency (the "OCC") and the FDIC.
In 2003, AIB entered into a formal agreement with the OCC, pursuant to which the OCC approved AIB's strategic plan for exiting its existing lending businesses. AIB also agreed to initiate a regulatory process by January 31, 2005, which would result in the eventual surrender of its national bank charter. In November 2004, AIB submitted an application to the state of Utah to convert its current national charter to a Utah state commercial bank charter. AIB is not able to surrender its national bank charter while it still has deposits outstanding, unless it is able to convert its charter to a Utah state commercial bank charter. However, in January 2005 the state of Utah notified AIB that it was suspending the application to convert AIB's charter until such time as AIB has the operational structure in place that is necessary to begin loan originations. AIB does not intend to make these changes. In February 2005, the OCC denied AIB's prior request to extend the deadline to begin the regulatory process to surrender the national charter, and required AIB to begin the regulatory process to surrender the national charter within 30 days from the date of the OCC's denial. Since AIB's application to convert the charter was not approved, and since the OCC did not approve AIB's request for an extension, AIB will file a plan with the OCC that will ultimately result in the surrender of its national bank charter. No assurance can be given that the OCC will approve AIB's plan of voluntary liquidation or that it will not take other adverse regulatory action.
The Competitive Equality Banking Act of 1987 ("CEBA") places certain restrictions on the operations of AIB and restricts further acquisitions of banks and savings institutions by the Company.
Domestic Real Estate
At December 31, 2004, the Company's domestic real estate assets had a book value of $131,200,000. The real estate operations include a mixture of commercial properties, residential land development projects and other unimproved land, all in various stages of development and all available for sale. The Company's largest domestic real estate investment consists of a 90% interest in 8 acres of unimproved land in Washington, D.C., which was acquired in September 2003 and has a book value of $57,600,000 at December 31, 2004. The land is zoned for a minimum of 2,000,000 square feet of commercial office space that the Company intends to develop in phases once acceptable tenants or purchasers are identified. The Company owns a 716-room hotel located on Waikiki Beach in Hawaii that has a book value of $39,400,000 at December 31, 2004. The hotel was fully renovated during 2001 and 2002, and for 2004 had an occupancy rate of approximately 66% and a net average daily room rate of $109.05. The Company secured non-recourse financing for these two projects, which aggregated $42,400,000 as of December 31, 2004.
The Company owns 30% of the outstanding common stock of HomeFed. In addition, as a result of a 1998 distribution to all of the Company's shareholders, approximately 9.4% and 9.5% of HomeFed is owned by the Company's Chairman and President, respectively. HomeFed is currently engaged, directly and through subsidiaries, in the investment in and development of residential real estate projects in the State of California. Its current development projects consist of two master-planned communities located in San Diego County, California: San Elijo Hills, which it purchased from the Company in 2002, and a portion of the larger Otay Ranch planning area. The Company accounts for its investment in HomeFed under the equity method of accounting. At December 31, 2004 its investment had a carrying value of $39,500,000 which is included in investments in associated companies. HomeFed is a public company traded on the NASD OTC Bulletin Board (Symbol: HOFD).
Certain of the Company's other real estate investments and their respective carrying values as of December 31, 2004 include: approximately 88 acres of land located in Myrtle Beach, South Carolina, which is fully entitled for a large scale mixed-use development of various residential and commercial space ($12,900,000); and an operating shopping center on Long Island, New York that has 60,000 square feet of retail space ($7,100,000).
The real estate development industry is subject to substantial environmental, building, construction, zoning and real estate regulations that are imposed by various federal, state and local authorities. In order to develop its properties, the Company must obtain the approval of numerous governmental agencies regarding such matters as permitted land uses, density, the installation of utility services (such as water, sewer, gas, electric, telephone and cable television) and the dedication of acreage for various community purposes. Furthermore, changes in prevailing local circumstances or applicable laws may require additional approvals or modifications of approvals previously obtained. Delays in obtaining required approvals and authorizations could adversely affect the profitability of the Company's projects.
Other Operations
Wineries
The Company owns two wineries, Pine Ridge Winery in Napa Valley, California and Archery Summit in the Willamette Valley of Oregon. Pine Ridge, which was acquired in 1991, has been conducting operations since 1978, while the Company started Archery Summit in 1993. Since acquisition, the Company's investment in winery operations has grown, principally to fund the acquisition of land for vineyard development and to increase production capacity and storage facilities at both of the wineries. It can take up to five years for a new vineyard property to reach full production and, depending upon the varietal produced, up to three years after grape harvest before the wine can be sold. The Company controls 224 acres of vineyards in the Napa Valley, California and 115 acres of vineyards in the Willamette Valley of Oregon, substantially all of which are owned and producing grapes. The Company believes that its vineyards are located in some of the most highly regarded appellations of the Napa Valley. At December 31, 2004, the Company's combined net investment in these wineries was $58,000,000. During 2004, the wineries sold approximately 63,600 9-liter equivalent cases of wine generating wine revenues of $13,200,000.
These wineries primarily produce and sell wines in the luxury segment of the premium table wine market; however, approximately 7% of the wineries' wine revenues and 19% of case sales were derived from a wine that is not in the luxury segment and is made from purchased grapes. The Company's wines are primarily sold to distributors, who then sell to retailers and restaurants. The distributors used by the Company also offer premium table wines of other companies that directly compete with the Company's products. As permitted under federal and local regulations, the wineries have also been placing increasing emphasis on sales direct to consumers, which they are able to do through the internet, wine clubs and at the wineries' tasting rooms. During 2004, direct sales to consumers represented 21% of case sales and 41% of wine revenues. Sales of the Company's wines in California and Oregon (excluding direct sales to consumers) amounted to approximately 11% of 2004 wine revenues.
The luxury segment of the wine industry is intensely competitive. The Company's wines compete with small and large producers in the U.S., as well as with imported wines. Demand for wine in the luxury market segment can rise and fall with general economic conditions, and is also significantly affected by available supply. At present, there is a worldwide oversupply of luxury wine which may last for a few years. The demand for the Company's wines is also affected by the ratings given the Company's wines in industry publications. During the past year, ratings for some of the Company's wines have increased or stayed substantially the same while ratings for other varietals have declined. Although future ratings are impossible to predict, the Company would not normally expect that all of its wines would be similarly rated at the same time.
In the past year wine sales have declined and inventory levels of the Company's wines held by the Company and its distributors have grown, which resulted in the need to hold, or for certain varietals reduce prices. In particular, Pine Ridge has been producing too much Merlot for its historical sales volume, and it expects to reduce future production through re-budding and re-planting activities. The Company's wineries have also been focused on improving wine quality. Wine quality improvements are principally being made by reducing the amount of grape clusters grown on each grapevine (resulting in yield reduction) to further concentrate flavor, and investing in new winemaking equipment. Luxury wines available for sale in any given year are also dependent upon harvest yields of earlier periods, which can fluctuate from harvest to harvest depending on weather patterns, insects and other non-controllable circumstances.
Certain of the wineries' production, sales and distribution activities are subject to regulation by agencies of both federal and state governments. There is currently a case pending before the U.S. Supreme Court concerning interstate wine shipments that could change the ability of wineries to sell wine directly to consumers in various states. The Company is unable to predict the eventual outcome of this litigation.
MK Resources
The Company has a 72.1% interest in MK Resources, whose principal subsidiary, Cobre Las Cruces, S.A., a Spanish company, holds the exploration and mineral rights to the Las Cruces copper deposit in the Pyrite Belt of Spain. During 2003, a feasibility study for the project was prepared by DMT-Montan Consulting GmbH and Outokumpu Technology Group, which incorporates the requirements of various local regulatory authorities. The feasibility study was reviewed by Pincock, Allen & Holt, an independent engineering company, and includes a proven and probable ore reserve calculation prepared by DMT. Pincock, Allen & Holt made minor adjustments to the ore reserve calculations in connection with its review. Including these adjustments, proven and probable reserves are approximately 16 million metric tons of copper ore at an average grade of 6.62% copper. As of December 31, 2004, the carrying value of the Company's investment in mining properties, plant and mine development was $85,400,000 substantially all of which related to Cobre Las Cruces.
Based on the study, the capital costs to build the project are estimated at 281 million euros ($372,000,000 at exchange rates in effect on March 4, 2005), including working capital, land purchases, and contingencies, but excluding reclamation bonding requirements, inflation, interest during construction, cost overruns and other financing costs. Cash operating costs per pound of copper produced are expected to average 0.33 euros per pound ($.44 per pound) of copper produced. The project's capital and operating costs will be paid for in euros, while copper revenues during the life of the mine will be based on the U.S. dollar. The appreciation of the euro against the U.S. dollar during the past few years has significantly increased the U.S. dollar cost to build the project; however, the price of copper in U.S. dollars has also increased significantly, which would offset the increase in capital costs. However, there can be no assurance that the relationship between the U.S. dollar price of copper and the euro will stay the same in the future.
Development of the Las Cruces project is subject to obtaining required permits, obtaining both debt and equity financing for the project, engineering and construction. Environmental approval of the project has been obtained from the Spanish and Andalusian government agencies. The mining concession was received during 2003, and the four principal water permits that are required were received during 2003 and 2004. The approvals, permits and concessions that have been received to date are significant to the successful development of the project; however, additional licenses and permits will have to be obtained. Cobre Las Cruces has filed applications with the appropriate regulatory authorities seeking approval for certain of these matters, while others cannot be filed until additional engineering work or other steps are completed. Cobre Las Cruces has also been granted government subsidies of 47.5 million euros ($62,900,000); however, the grants require it to make certain capital expenditures by March 27, 2005, a deadline that it will not be able to meet principally because of delays in obtaining permits. Cobre Las Cruces has filed a request to further extend the deadline, but has been informed that the government will not act on the extension request prior to the current expiration. Although MK Resources believes that the extension will be granted, no assurance can be given that an extension will actually be received. A loss of the subsidies would adversely impact the economic viability of the project.
To date, the Company has been the sole source of funding for the Las Cruces project. The amount of equity capital and third party financing that can be obtained for the project and its related cost will be significantly affected by the assessment of potential investors and lenders of the current and expected future market price of copper, as well as current market conditions for this type of investment. MK Resources has not yet determined whether the debt financing for the project will be denominated in euros or dollars or some combination of both. During 2004, MK Resources was unsuccessful in raising equity capital for the project, due to unfavorable market conditions at the time. Assuming required permits and financing are obtained in a timely manner, MK Resources anticipates that final design will begin in 2005, followed by construction and mine development thereafter, with copper production to begin during 2007. Although MK Resources believes the necessary permitting and financing will be obtained, no assurances can be given that MK Resources will be successful, or if successful, when permitting and financing will be obtained. Further, there may be other political and economic circumstances that could prevent or delay development of Las Cruces.
Other Investments
In 2004, the Company invested $75,000,000 in INTL Consilium Emerging Market Absolute Return Fund, LLC ("INTL"), a limited liability company that is invested in a master fund which primarily invests in emerging markets debt and equity securities. INTL and the master fund are managed and controlled by an investment manager who has full discretion over investment and operating decisions. Under GAAP, INTL is considered a variable interest entity and the Company is the primary beneficiary; as a result, the Company accounts for its investment in INTL as a consolidated subsidiary. INTL plans to sell additional membership interests in the future, which if accomplished could result in the Company no longer accounting for INTL as a consolidated subsidiary. The Company can generally withdraw its capital account interest upon 90 days notice, subject to the manager's ability to liquidate security positions in an orderly manner. At December 31, 2004, INTL had total assets of $79,600,000, which are reflected as investments in the Company's consolidated balance sheet, and its liabilities were not material. For the year ended December 31, 2004, the Company recorded $2,200,000 of pre-tax income relating to INTL. The Company has included INTL in its Corporate segment.
In December 2003, the Company purchased all of the debt obligations under the senior secured credit facility of ATX Communications, Inc. and certain of its affiliates (collectively "ATX") for $25,000,000, and also entered into an amendment to the facility pursuant to which the Company agreed to refrain from exercising certain of its rights under the facility, subject to certain conditions. ATX is an integrated communications provider that offers local exchange carrier and inter-exchange carrier telephone, Internet, high-speed data and other communications services to business and residential customers in targeted markets throughout the Mid-Atlantic and Midwest regions of the U.S. For the year ended December 31, 2004, ATX reported total revenues of approximately $251,000,000.
As contemplated at the time of the Company's purchase, in January 2004, ATX commenced a voluntary Chapter 11 case in order to reorganize its financial affairs. During 2004, the Company provided debtor-in-possession financing to ATX of $5,000,000. This financing is secured by liens on substantially all of ATX's assets, and is expected to be repaid upon ATX's emergence from bankruptcy. In January 2005, ATX filed its First Amended Joint Plan of Reorganization (the "Plan") and related disclosure statement. The Plan was filed after agreements were reached with major stakeholders and/or the representatives of major stakeholders in the bankruptcy case. The Plan contemplates that the Company will convert its current investment in the ATX credit facility into 95% of the new common stock of the reorganized ATX and a new $25,000,000 senior secured note which bears interest at 10%. In addition, the Company will provide up to $25,000,000 of exit financing to ATX to fund bankruptcy related payments and working capital requirements, which includes the repayment of the Company's $5,000,000 debtor-in-possession financing. The Plan is subject to the approval of the bankruptcy court and creditors. Assuming that ATX is reorganized as contemplated in the Plan, the Company will consolidate ATX as of the date the Plan becomes effective.
The Company has an investment in Berkadia, an entity jointly owned by the Company and Berkshire Hathaway Inc. ("Berkshire"). In 2001, Berkadia lent $5,600,000,000 on a senior secured basis to FINOVA Capital Corporation (the "Berkadia Loan"), the principal operating subsidiary of FINOVA, to facilitate a chapter 11 restructuring of the outstanding debt of FINOVA and its principal subsidiaries. Berkadia also received newly issued shares of common stock of FINOVA representing 50% of the stock of FINOVA outstanding on a fully diluted basis. In 2001, the Company entered into a ten-year management agreement with FINOVA, for which it receives an $8,000,000 annual fee that it shares equally with Berkshire. FINOVA is a financial services holding company that, prior to its filing for bankruptcy, provided a broad range of financing and capital markets products, primarily to mid-size businesses. Since its chapter 11 restructuring, FINOVA's business activities have been limited to the orderly collection and liquidation of its assets and FINOVA has not engaged in any new lending activities.
Berkadia financed the Berkadia Loan with bank financing that was guaranteed, 90% by Berkshire and 10% by the Company (with the Company's guarantee being secondarily guaranteed by Berkshire). All income related to the Berkadia Loan, after payment of financing costs, was shared 90% to Berkshire and 10% to the Company. In February 2004, FINOVA fully repaid the Berkadia Loan, and Berkadia fully repaid its bank financing, thereby eliminating the Company's guaranty. Pursuant to the management agreement, the Company continues to manage FINOVA, for which it receives the fee described above. Although the term of the Company's management agreement with FINOVA extends until August 2011, the Company cannot provide assurances that the agreement (and the fee the Company receives) will remain in effect after November 2009, at which time FINOVA's bond debt matures.
At December 31, 2004, the book value of the Company's 19% equity interest in Olympus was $124,400,000. Olympus was formed in 2001 to take advantage of the lack of capacity and favorable pricing in the reinsurance market. It has entered into a quota share reinsurance agreement with Folksamerica Reinsurance Company, an affiliate of White Mountains Insurance Group, Ltd. ("WMIG"), and has also entered into reinsurance transactions with other parties. When the market opportunity to underwrite reinsurance business on favorable terms recedes, the by-laws of Olympus include mechanisms to return its capital to its investors, subject to Bermuda insurance regulations and other laws restricting the return of capital. For the years ended December 31, 2004, 2003 and 2002, the Company recorded $9,700,000, $40,400,000 and $24,100,000, respectively, of pre-tax income from this investment under the equity method of accounting. During 2004, Olympus' results, and accordingly, the Company's equity in Olympus' earnings, were adversely affected by property damage claims caused by severe hurricanes.
At December 31, 2004, the book value of the Company's equity investment in JPOF II, a registered broker-dealer, was $116,200,000. JPOF II is managed by Jefferies & Company, Inc., a full service investment bank to middle market companies. JPOF II invests in high yield securities, special situation investments and distressed securities and provides trading services to its customers and clients. For the years ended December 31, 2004, 2003 and 2002, the Company recorded $16,200,000, $14,800,000 and $15,200,000, respectively, of pre-tax income from this investment under the equity method of accounting, all of which was distributed to the Company shortly after the end of each year.
In December 2001, the Company invested $50,000,000 in EagleRock, a limited partnership that invests and trades in securities and other investment vehicles. At December 31, 2004, the book value of the Company's equity investment in EagleRock was $121,100,000. Pre-tax results of $29,400,000, $49,900,000 and $(4,500,000) for the years ended December 31, 2004, 2003 and 2002, respectively, were recorded from this investment under the equity method of accounting. During 2004, EagleRock distributed $3,700,000 to the Company.
The Company owns 375,000 common shares that represent approximately 3.5% of WMIG. WMIG is a publicly traded, Bermuda domiciled financial services holding company, principally engaged through its subsidiaries and affiliates in property and casualty insurance and reinsurance. At December 31, 2004, the Company's investment had a market value of $242,300,000.
The Company owns approximately 36% of the common stock of Light & Power Holdings Ltd., the parent company of The Barbados Light and Power Company Limited, the primary generator and distributor of electricity in Barbados. At December 31, 2004, the Company's investment of $12,100,000 was accounted for on the cost method of accounting, due to currency exchange restrictions and stock transfer restrictions.
The Company beneficially owns equity interests representing more than 5% of the outstanding capital stock of each of the following domestic public companies at March 4, 2005 (determined in accordance with Rule 13d-3 of the Securities Exchange Act of 1934): FINOVA (25%), HomeFed (30%), International Assets Holding Corporation (16.5%), Jordan Industries, Inc. ("JII") (10.1%), and ParkerVision, Inc. (6.2%). The Company also owns 20.3% of JII's Senior Subordinated Discount Debentures due 2009 ($19,300,000 aggregate principal amount, for which the Company paid $9,100,000) and 22.8% of JII Holdings Senior Secured Notes due 2007 ($39,500,000 aggregate principal amount, for which the Company paid $36,500,000).
From 1982 through the fourth quarter of 2002, a subsidiary of the Company has had a partnership interest in The Jordan Company LLC and Jordan/Zalaznick Capital Company, entities that specialized in structuring leveraged buyouts in which the owners are given the opportunity to become equity participants. These equity investments include JII, JZ Equity Partners PLC (a British company traded on the London Stock Exchange in which the Company holds a 6.5% equity interest), and a total of 24 other companies. At December 31, 2004, these investments are carried in the Company's consolidated financial statements at $108,900,000, of which $81,800,000 relates to public companies carried at market value. The Jordan-related partnerships were terminated at the end of 2002.
For further information about the Company's business, including the Company's investments, reference is made to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Report and Notes to Consolidated Financial Statements.
Item 2.
Item 2. Properties. - ------ ----------
The WilTel network and its component assets are the principal properties that WilTel operates and are described in Item 1 herein. WilTel purchased or leased various rights of way to install its network; the majority of its rights of way agreements extend through at least 2018. WilTel owns or leases office space and points of presence sites (point of presence are locations where WilTel has transmission, routing and switching equipment) in approximately 120 U.S. cities and towns. These facilities primarily range in size from 2,000 square feet to 750,000 square feet and total approximately 3,700,000 square feet, including WilTel's 750,000 square foot headquarters building located in Tulsa, Oklahoma, which it owns.
Through its various subsidiaries, the Company owns and utilizes office space in Salt Lake City, Utah for corporate and banking and lending activities (totaling approximately 80,200 square feet). Subsidiaries of the Company own facilities primarily used for manufacturing located in Georgia and Genk, Belgium (totaling approximately 410,300 square feet) and facilities and land in California and Oregon used for winery operations (totaling approximately 123,300 square feet and 396 acres, respectively).
The Company and its subsidiaries lease numerous manufacturing, warehousing, office and headquarters facilities. Symphony also leases facilities in a number of locations that are used for administrative functions and outpatient therapy services. The facilities vary in size and have leases expiring at various times, subject, in certain instances, to renewal options. See Notes to Consolidated Financial Statements.
Item 3.
Item 3. Legal Proceedings. - ------ -----------------
The Company and its subsidiaries are parties to legal proceedings that are considered to be either ordinary, routine litigation incidental to their business or not material to the Company's consolidated financial position. The Company does not believe that any of the foregoing actions will have a material adverse effect on its consolidated financial position, consolidated results of operations or liquidity.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders. - ------ ---------------------------------------------------
Not applicable.
Item 10. Executive Officers of the Registrant. - ------- ------------------------------------
All executive officers of the Company are elected at the organizational meeting of the Board of Directors of the Company held annually and serve at the pleasure of the Board of Directors. As of March 4, 2005, the executive officers of the Company, their ages, the positions held by them and the periods during which they have served in such positions were as follows:
Mr. Cumming has served as a director and Chairman of the Board of the Company since June 1978 and as Chairman of the Board of FINOVA since August 2001. Mr. Cumming has also been a director of Skywest, Inc., a Utah-based regional air carrier, since June 1986 and a director of HomeFed since May 1999.
Mr. Steinberg has served as a director of the Company since December 1978 and as President of the Company since January 1979. In addition, he has served as a director of JII since June 1988, HomeFed since August 1998 (Chairman since December 1999), FINOVA since August 2001 and WMIG since June 2001.
Mr. Mara joined the Company in April 1977 and was elected Vice President of the Company in May 1977. He has served as Executive Vice President of the Company since May 1980 and as Treasurer of the Company since January 1993. In addition, he has served as a director of MK Resources since February 2000 and President of MK Resources since March 2004 and as a director of FINOVA since September 2002 and Chief Executive Officer of FINOVA since September 2002.
Mr. Orlando, a certified public accountant, has served as Chief Financial Officer of the Company since April 1996 and as Vice President of the Company since January 1994.
Ms. Lowenthal, a certified public accountant, has served as Vice President and Comptroller of the Company since April 1996.
Mr. Scruggs joined the Company in 1995, served as Vice President from March 2000 through December 2001, and from August 2002 until the present.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. - ------ ----------------------------------------------------------------------
The common shares of the Company are traded on the NYSE and Pacific Exchange, Inc. under the symbol LUK. The following table sets forth, for the calendar periods indicated, the high and low sales price per common share on the consolidated transaction reporting system, as reported by the Bloomberg Professional Service provided by Bloomberg L.P.
As of March 4, 2005, there were approximately 2,800 record holders of the common shares.
The Company paid cash dividends of $0.25 per common share in 2004 and $.167 per common share in 2003. The payment of dividends in the future is subject to the discretion of the Board of Directors and will depend upon general business conditions, legal and contractual restrictions on the payment of dividends and other factors that the Board of Directors may deem to be relevant.
In connection with the declaration of dividends or the making of distributions on, or the purchase, redemption or other acquisition of common shares, the Company is required to comply with certain restrictions contained in certain of its debt instruments. The Company's regulated subsidiaries are restricted in the amount of distributions that can be made to the Company without regulatory approval. For further information, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in this Report.
Certain subsidiaries of the Company have significant net operating loss carryforwards ("NOLs") and other tax attributes, the amount and availability of which are subject to certain qualifications, limitations and uncertainties. In order to reduce the possibility that certain changes in ownership could impose limitations on the use of the Company's tax attributes, the Company's certificate of incorporation contains provisions which generally restrict the ability of a person or entity from accumulating five percent or more of the common shares and the ability of persons or entities now owning five percent or more of the common shares from acquiring additional common shares. The restrictions will remain in effect until the earliest of (a) December 31, 2024, (b) the repeal of Section 382 of the Internal Revenue Code (or any comparable successor provision) or (c) the beginning of a taxable year of the Company to which certain tax benefits may no longer be carried forward.
Item 6.
Item 6. Selected Financial Data. - ------ -----------------------
The following selected financial data have been summarized from the Company's consolidated financial statements and are qualified in their entirety by reference to, and should be read in conjunction with, such consolidated financial statements and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Report. Amounts have been adjusted to give retroactive effect to the Stock Split.
(a) WilTel is reflected as a consolidated subsidiary as of November 6, 2003, the date the Company acquired the balance of the WilTel shares it did not previously own in exchange for the issuance of 16,734,690 common shares of the Company. In 2002, the Company acquired 47.4% of WilTel for $353,900,000 in cash, including expenses, which was accounted for by the Company under the equity method of accounting. The Company's share of WilTel's losses prior to November 6, 2003 is included in the caption equity in income (losses) of associated companies ($52,087,000 for 2003 and $13,374,000 for 2002). Symphony is reflected as a consolidated subsidiary since its acquisition in September 2003. For additional information, see Note 3 of Notes to Consolidated Financial Statements.
(b) Includes net securities gains (losses) of $142,936,000, $9,953,000, $(37,066,000), $28,450,000 and $124,964,000 for the years ended December 31, 2004, 2003, 2002, 2001 and 2000, respectively.
(c) As a result of the favorable resolution of various state and federal income tax contingencies, the income tax provision reflects a benefit of approximately $27,300,000 for 2004, $24,400,000 for 2003, $120,000,000 for 2002 and $36,200,000 for 2001.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. - ------ -----------------------------------------------------------------------
The purpose of this section is to discuss and analyze the Company's consolidated financial condition, liquidity and capital resources and results of operations. This analysis should be read in conjunction with the consolidated financial statements and related notes which appear elsewhere in this Report.
Liquidity and Capital Resources
Parent Company Liquidity
Leucadia National Corporation (the "Parent") is a holding company whose assets principally consist of the stock of its direct subsidiaries, cash and cash equivalents and other non-controlling investments in debt and equity securities. The Parent continuously evaluates the retention and disposition of its existing operations and investments and investigates possible acquisitions of new businesses in order to maximize shareholder value. Accordingly, while the Parent does not have any material arrangement, commitment or understanding with respect thereto (except as disclosed in this Report), further acquisitions, divestitures, investments and changes in capital structure are possible. Its principal sources of funds are its available cash resources, liquid investments, bank borrowings, public and private capital market transactions, repayment of subsidiary advances, funds distributed from its subsidiaries as tax sharing payments, management and other fees, and borrowings and dividends from its regulated and non-regulated subsidiaries.
As of December 31, 2004, the Parent's readily available cash, cash equivalents and marketable securities, excluding amounts held by its regulated subsidiary and non-regulated subsidiaries that are parties to agreements which restrict the payment of dividends, totaled $1,756,600,000. This amount is comprised of cash and short-term bonds and notes of the United States Government and its agencies of $1,087,800,000 (61.9%), the equity investment in WMIG of $242,300,000 (13.8%) (which can be sold privately or otherwise in compliance with the securities laws and have the benefit of a registration rights agreement), and other publicly traded debt and equity securities aggregating $426,500,000 (24.3%). The investment income realized from these investments is used to meet the Parent company's short-term recurring cash requirements, which are principally the payment of interest on its debt and corporate overhead expenses.
The Parent's only long-term cash requirement is to make principal payments on its long-term debt ($964,000,000 outstanding as of December 31, 2004), of which $40,800,000 is due before 2013, $475,000,000 is due in 2013, $350,000,000 is due in 2014 and $98,200,000 is due in 2027. Historically, the Parent has used its available liquidity to make acquisitions of new businesses and other investments, but the timing of any future investments and the cost can not be predicted. Should the Company require additional liquidity for an investment or any other purpose, the Parent also has an unsecured bank credit facility of $110,000,000 that matures in 2007 and bears interest based on the Eurocurrency Rate or the prime rate. No amounts are currently outstanding under the bank credit facility. In addition, based on discussions with commercial and investment bankers, the Company believes that it has the ability to raise additional funds under acceptable conditions for use in its existing businesses or for appropriate investment opportunities. During 2004, Moody's Investors Services and Standard & Poor's each downgraded the Parent's debt obligations, and in early 2005, the Parent was also downgraded by Fitch Ratings. The Parent's senior debt obligations are rated two levels below investment grade by Moody's Investors Services and Standard & Poor's, and one level below investment grade by Fitch Ratings. Ratings issued by bond rating agencies are subject to change at any time.
In April 2004, the Parent sold $100,000,000 principal amount of its 7% Senior Notes due 2013 in a private placement transaction at 102.191% of the principal amount. The net cash proceeds from the sale of the notes are being used for general corporate purposes. The Parent completed a registered exchange offer pursuant to which each holder of the privately placed senior notes exchanged those notes for publicly registered notes.
Also in April 2004, the Parent sold $350,000,000 principal amount of its 3 3/4% Convertible Senior Subordinated Notes due 2014 in a private placement transaction. The notes are convertible into the Parent's common shares at $45.93 per share at any time before their maturity, subject to certain restrictions contained in the notes, at a conversion rate of 21.7707 shares per each $1,000 principal amount of notes, subject to adjustment (an aggregate of 7,619,745 shares). The net cash proceeds from the sale of the notes are being used for general corporate purposes. The Parent has a currently effective shelf registration statement in respect of the notes and the common shares issuable upon conversion of the notes.
In January 2004, the Company exercised an option to sell two of its older corporate aircraft for total proceeds of $38,800,000. The option was received in connection with the purchase of two new corporate aircraft during 2003. The Company completed the sales in July 2004, and reported a pre-tax gain of $11,300,000.
In 2004, the Company invested $75,000,000 in INTL, a limited liability company that is invested in a master fund which primarily invests in emerging markets debt and equity securities. INTL and the master fund are managed and controlled by an investment manager who has full discretion over investment and operating decisions. Under GAAP, INTL is considered a variable interest entity and the Company is the primary beneficiary; as a result, the Company accounts for its investment in INTL as a consolidated subsidiary. INTL plans to sell additional membership interests in the future, which if accomplished could result in the Company no longer accounting for INTL as a consolidated subsidiary. The creditors of INTL have recourse only to the assets of INTL and do not have recourse to any other assets of the Company. The Company can generally withdraw its capital account interest upon 90 days notice, subject to the manager's ability to liquidate security positions in an orderly manner. At December 31, 2004, all of INTL's assets were classified as investments and its liabilities were not material.
WilTel became a member of the Company's consolidated federal income tax return as of November 6, 2003. WilTel joined the Company's tax return with significant NOLs, substantially all of which are only available to reduce the federal taxable income of WilTel and its subsidiaries, and has substantial other tax attributes and generates substantial deductions (primarily depreciation deductions), some of which are also available to offset the federal taxable income of the Company and its other subsidiaries. Although the amount of these deductions that can be used to offset the federal taxable income of other members of the Company's consolidated tax group is dependent upon a number of factors, including the future taxable income of WilTel and its subsidiaries, the Company does not expect it will have material federal income tax liabilities for the foreseeable future. For more information about WilTel's NOLs and tax attributes, see Note 15 of Notes to Consolidated Financial Statements included in this Report.
The amount and availability of the Company's NOLs and other tax attributes are subject to certain qualifications, limitations and uncertainties. In order to reduce the possibility that certain changes in ownership could impose limitations on the use of the NOLs, the Company's certificate of incorporation contains provisions which generally restrict the ability of a person or entity from accumulating five percent or more of the common shares and the ability of persons or entities now owning five percent or more of the common shares from acquiring additional common shares. The restrictions will remain in effect until the earliest of (a) December 31, 2024, (b) the repeal of Section 382 of the Internal Revenue Code (or any comparable successor provision) or (c) the beginning of a taxable year of the Company to which certain tax benefits may no longer be carried forward.
As of March 4, 2005, the Company is authorized to repurchase 3,733,148 common shares. Such purchases may be made from time to time in the open market, through block trades or otherwise. Depending on market conditions and other factors, such purchases may be commenced or suspended at any time without prior notice. Except in connection with employees using common shares to pay the exercise price of employee stock options, the Company has not repurchased any common shares during the three year period ended December 31, 2004.
At December 31, 2004, no amounts were available to the Parent as dividends from its regulated subsidiary without regulatory approval. Cash and investments aggregating $241,000,000 are held by non-regulated subsidiaries that are parties to agreements which restrict the payment of dividends. For more information concerning the long-term debt of the Company and its subsidiaries, see Note 11 of Notes to Consolidated Financial Statements.
Consolidated Liquidity
In 2004, net cash was provided by operating activities, principally as a result of distributions from associated companies, the pre-funding by SBC of certain of WilTel's capital expenditures, the refund of excess federal income tax payments and an increase in accounts payable due to the timing of payments. In 2003, net cash was used for operating activities, principally due to corporate overhead expenses, reduced investment income, an increase in the investment in the trading portfolio and a $10,000,000 contribution to the Company's defined benefit pension plan. In 2002, net cash was provided by operating activities, principally as a result of a reduction to the Company's investment in the trading portfolio.
At December 31, 2004, WilTel had aggregate cash and investments of $239,700,000 available for use in its operating, investing and financing activities. Substantially all of WilTel's assets have been pledged to secure its outstanding long-term debt, principally to secure its obligations under its credit agreement ($359,400,000 outstanding as of December 31, 2004) and its mortgage debt ($60,300,000 outstanding at December 31, 2004).
In conjunction with a pricing agreement for certain voice services, in January 2004, SBC paid WilTel $25,000,000 for pre-funding of certain capital expenditures. The amount is reflected as a liability on the December 31, 2004 consolidated balance sheet. During 2004, WilTel expended all of these funds for the equipment specified in the pricing agreement. The agreement required that WilTel return the funds to SBC if, prior to January 31, 2005, WilTel and SBC entered into an agreement for voice transport pricing through December 31, 2006. Since such an agreement was not entered into, during the first quarter of 2005 WilTel will recognize the full amount as other income.
In September 2004, WilTel refinanced its existing $375,000,000 credit agreement debt by entering into an amended credit agreement consisting of a $240,000,000 first lien term loan facility, a $120,000,000 second lien term loan facility and a $25,000,000 revolving credit facility (which it can no longer draw upon, as discussed below). WilTel also used $90,000,000 of its cash and investments to repay in full one of the two mortgage notes that was secured by its headquarters building ($54,600,000 including accrued interest), reduce the amount outstanding under its credit agreement ($15,000,000), reduce the amount outstanding under the other note that is secured by its headquarters building ($13,300,000) and pay expenses. The amended credit agreement has not been guaranteed by the Company and is not secured by any of the Company's assets other than the assets of WilTel.
The first lien term loan facility requires quarterly principal payments of approximately $632,000 commencing December 31, 2004 through June 30, 2009, and quarterly principal payments of $57,000,000 thereafter until final maturity on June 30, 2010. The second lien term loan facility matures on December 31, 2010. However, if WilTel does not refinance its obligations under its outstanding mortgage debt prior to October 1, 2009, then the first lien term loan facility will mature on October 1, 2009, and if such mortgage debt is not refinanced by January 1, 2010, then the second lien term loan facility will mature on January 1, 2010. Loans under the credit agreement bear interest at a variable rate based upon either the prime rate or LIBOR, at WilTel's option, plus a specified margin for each loan. WilTel's obligations under its amended credit agreement are secured by substantially all of its assets other than those assets securing its headquarters building, for which the amended credit agreement lenders have a second priority lien, and its aircraft capital leases.
Pursuant to the terms of WilTel's amended credit agreement, SBC's announcement to migrate its IP-based and long distance services to the AT&T network is considered an event which could reasonably be expected to have a "material adverse effect" as defined in the facility, and as a result WilTel can no longer access its $25,000,000 revolving credit facility. WilTel does not anticipate needing the $25,000,000 revolving credit facility to meet its present requirements. The announcement does not have any impact on the $360,000,000 of term loans under WilTel's credit agreement. However, the credit agreement provides for an event of default if there is any amendment, supplement, modification or termination of any WilTel contract or agreement that has had or could reasonably be expected to result in a material adverse effect on WilTel (as defined in the credit agreement). As mentioned above, WilTel is currently engaged in negotiations with SBC with respect to a transition pricing agreement and other matters which, if successfully concluded, may or may not be deemed an event of default under the WilTel credit agreement. WilTel intends to enter into discussions with its lenders before entering into any new definitive agreement with SBC.
WilTel's mortgage debt (which is non-recourse to the Company), has an interest rate of 7% and requires annual principal payments escalating from approximately $700,000 in 2005 to approximately $1,000,000 in 2009; a final payment of approximately $56,000,000 is due at maturity in April 2010.
The WilTel amended credit agreement contains covenants which require WilTel to meet certain operating targets, which it currently meets, and restrictions which limit WilTel's ability to incur additional indebtedness, spend funds on capital expenditures and make certain investments. The agreement also prohibits WilTel from paying dividends to the Company. The Company currently expects that WilTel will be able to meet the operating targets required by its credit agreement through 2006; however, compliance with the operating targets thereafter is uncertain because of SBC's announced intention to migrate its traffic to AT&T's network.
While WilTel has no material contractual commitments for capital expenditures, it may spend significant amounts each year, principally for network expansion, maintenance and product upgrades. In addition, WilTel may also incur additional capital expenditures upon the acquisition of new customers or when providing new products to existing customers. WilTel uses its available cash resources and operating profits to fund its capital expenditure needs. During 2004, WilTel spent approximately $73,200,000 for capital expenditures, including amounts that were pre-funded by SBC and that will be retained by WilTel.
WilTel is a party to various legal actions and claims, and has reserved $21,500,000 for the satisfaction of all litigation. Certain of these actions relate to the rights of way licensed to WilTel in connection with the installation of its fiber-optic cable and seek damages from WilTel for failure to obtain all necessary landowner consents. Additional right of way claims may be asserted against WilTel. The Company does not believe that the ultimate resolution of all claims, legal actions and complaints will have a material adverse effect upon WilTel's results of operations, although unfavorable outcomes could significantly impact WilTel's liquidity. During 2004, WilTel settled litigation for a cash payment of $5,000,000; the $18,500,000 excess of the reserved amount over the amount paid was recognized as other income.
As mentioned above, in February 2005 the Company's manufacturing division acquired the assets of NSW for approximately $28,000,000, thereby increasing its mix of products and customer base. The funds for the acquisition were provided from the Company's readily available cash resources.
The Company's consolidated banking and lending operations had outstanding loans (net of unearned finance charges) of $4,300,000 and $205,500,000 at December 31, 2004 and 2003, respectively. These loans were primarily funded by deposits generated by the Company's deposit-taking facilities and by brokers, which totaled $24,600,000 and $145,500,000 at December 31, 2004 and 2003, respectively. The cash flows generated from the collections on and sales of its loan portfolios have been used to retire these deposits as they matured. During 2004, the Company sold its subprime automobile and collateralized consumer loan portfolios for aggregate cash proceeds of $149,000,000, and sold certain loan portfolios that had been substantially written-off for aggregate cash proceeds of $8,100,000. The banking and lending segment is no longer making loans.
Operating activities at the banking and lending segment are currently concentrated on maximizing returns on its investment portfolio, collecting and servicing its remaining loan portfolios and discharging deposit liabilities as they come due. In 2004, AIB submitted an application to the state of Utah to convert AIB's current national charter to a Utah state commercial bank charter. However, in January 2005 the state of Utah notified AIB that it was suspending the application to convert AIB's charter until such time as AIB has the operational structure in place that is necessary to begin loan originations. AIB does not intend to make these changes. Since AIB's application to convert the charter was not approved, and since the OCC is requiring AIB to begin the regulatory process to surrender its national charter, AIB will file a plan with the OCC that will ultimately result in the surrender of its national bank charter. No assurance can be given that the OCC will approve AIB's plan of voluntary liquidation or that it will not take other adverse regulatory action.
The Company's debt instruments require maintenance of minimum Tangible Net Worth, limit distributions to shareholders and limit Indebtedness and Funded Debt (as such terms are defined in the agreements). In addition, the debt instruments contain limitations on investments, liens, contingent obligations and certain other matters. The Company is in compliance with all of these restrictions, and the Company has the ability to incur additional indebtedness or make distributions to its shareholders and still remain in compliance with these restrictions. Certain of the debt instruments of subsidiaries of the Company also contain restrictions which require the maintenance of financial covenants, impose restrictions on the ability to pay dividends to the Company and/or provide collateral to the lender. For more information, see Note 11 of Notes to Consolidated Financial Statements.
As shown below, at December 31, 2004, the Company's contractual cash obligations totaled $3,030,611,000.
The estimated interest expense on long-term debt includes estimated interest related to variable rate debt which the Company determined using rates in effect at December 31, 2004. Estimated payments related to a currency swap agreement are based on the currency rate in effect at December 31, 2004. Material contractual obligations that are not included in the table above are the Company's deferred revenue obligations ($213,800,000) and the consolidated pension liability ($83,900,000). Deferred revenue obligations do not require the expenditure of material incremental cash; however, they do require WilTel to maintain its network for the benefit of itself and the other contracting party. Except for expected funding of $21,700,000 in 2005, the pension liability is excluded from the table because the timing of cash payments, if any, cannot be predicted.
Off-Balance Sheet Arrangements
At December 31, 2004, the Company's off-balance sheet arrangements consist of guarantees and letters of credit aggregating $73,300,000. Pursuant to an agreement that was entered into before the Company sold CDS Holding Corporation ("CDS") to HomeFed in 2002, the Company agreed to provide project improvement bonds for the San Elijo Hills project. These bonds, which are for the benefit of the City of San Marcos, California and other government agencies, are required prior to the commencement of any development at the project. CDS is responsible for paying all third party fees related to obtaining the bonds. Should the City or others draw on the bonds for any reason, CDS and one of its subsidiaries would be obligated to reimburse the Company for the amount drawn. At December 31, 2004, the amount of outstanding bonds was $28,200,000, $27,700,000 of which expires in 2005, $400,000 in 2006 and the remainder in 2009. Subsidiaries of the Company have outstanding letters of credit aggregating $25,100,000 at December 31, 2004, principally to secure various obligations. All of these letters of credit expire during 2005. The Company's remaining guarantee at December 31, 2004 is a $20,000,000 indemnification given to a lender to a certain real estate property. The amount borrowed under this real estate financing is reflected as long-term debt in the Company's consolidated balance sheet.
Critical Accounting Estimates
The Company's discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires the Company to make estimates and assumptions that affect the reported amounts in the financial statements and disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates all of these estimates and assumptions. The following areas have been identified as critical accounting estimates because they have the potential to have a material impact on the Company's financial statements, and because they are based on assumptions which are used in the accounting records to reflect, at a specific point in time, events whose ultimate outcome won't be known until a later date. Actual results could differ from these estimates.
Income Taxes - The Company records a valuation allowance to reduce its deferred taxes to the amount that is more likely than not to be realized. Historically, if the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment would increase income in such period. Similarly, if the Company were to determine that it would not be able to realize all or part of its net deferred taxes in the future, an adjustment would be charged to income in such period. The Company also records reserves for contingent tax liabilities based on the Company's assessment of the probability of successfully sustaining its tax filing positions.
Subsequent to the acquisition of all of the outstanding common stock of WilTel, WilTel became a member of the Company's consolidated tax return. As discussed above, WilTel has significant tax attributes, some of which are available to offset the future taxable income of other members of the Company's consolidated federal income tax return. The Company established a valuation allowance that fully reserved for all of WilTel's net deferred tax assets, reduced by an amount equal to the Company's current and deferred federal income tax liabilities as of the date of acquisition (see allocation of the purchase price in Note 3 of Notes to Consolidated Financial Statements). Except as discussed in results of operations below, before the Company can recognize a net deferred tax asset, it will need to demonstrate that on a pro forma combined basis with WilTel it will have had positive cumulative pre-tax income over a period of years. At that time, any decrease to the valuation allowance will be based significantly upon the Company's assumptions and projections of its future income, which are inherently uncertain.
During each of the last three years, the Company has adjusted its reserve for contingent tax liabilities and reduced income tax expense upon the conclusion of audits by various taxing jurisdictions or upon the expiration of the statute of limitations for the examination of the Company's tax returns. The adjustments have been material, reflecting the inherent difficulty of accurately estimating and accruing for the ultimate resolution of tax contingencies. The Company expects that adjustments to the valuation allowance for deferred income taxes and contingent tax liabilities could be made in the future and, if such adjustments are made, they could be material.
Impairment of Long-Lived Assets - In accordance with Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), the Company evaluates its long-lived assets for impairment when events or changes in circumstances indicate, in management's judgment, that the carrying value of such assets may not be recoverable. The determination of whether a long-lived asset (or asset group) is recoverable is based on management's estimate of undiscounted future cash flows attributable to the asset as compared to its carrying value. If the carrying amount of the asset (or asset group) is greater than the undiscounted cash flows, the carrying amount of the asset is considered to be not recoverable. The amount of the impairment recognized would be determined by estimating the fair value for the asset (or asset group) and recording a provision for the excess of the carrying value over the fair value.
As of December 31, 2004, the carrying amount of the Company's investment in the mineral rights and mining properties of MK Resources was approximately $85,400,000. The recoverability of this asset is entirely dependent upon the success of MK Resource's mining project at the Las Cruces copper deposit in the Pyrite Belt of Spain. Mining will be subject to obtaining required permits, obtaining both debt and equity financing for the project, engineering and construction. In addition, the actual price of copper, the operating cost of the mine and the capital cost (in U.S. dollars) to build the project and bring the mine into production will affect the recoverability of this asset. The Las Cruces project has been granted government subsidies of 47.5 million euros ($62,900,000); however, the grants require MK Resources to make certain capital expenditures by March 27, 2005, a deadline that it will not be able to meet principally because of delays in obtaining permits. Las Cruces has filed a request to further extend the deadline, but has been informed that the government will not act on the extension request prior to the current expiration.
To date, the Company has been the sole source of funding for the Las Cruces project. The amount of equity capital and third party financing that can be obtained for the project and its related cost will be significantly affected by the assessment of potential investors and lenders of the current and expected future market price of copper, as well as current market conditions for this type of investment. During 2004, MK Resources was unsuccessful in raising equity capital for the project, due to unfavorable market conditions at the time. MK Resources continues to explore financing possibilities. Based on the current status of the project, MK Resource's estimate of future cash flows and its assessment of financing possibilities, the Company believes the carrying amount of its investment is recoverable. However, if the Company is unable to obtain the permits required to begin construction of the mine and commence mining activities, is unable to obtain financing for the project or the capital cost of the project changes significantly, it is likely that this investment will be impaired.
At December 31, 2004, the carrying amount of the Company's investment in its manufacturing facility located in Belgium was approximately $17,900,000. The Belgium facility, which became operational in the third quarter of 2001, has not yet achieved the level of revenues and profitability originally expected by the Company, primarily due to the segment's loss of a major multi-national customer and insufficient demand from other customers. During 2004, a new general manager was hired at the facility to develop and implement marketing and sales initiatives directed at generating revenue growth. Operating results at the facility improved during 2004 as sales grew significantly compared to 2003 and the business achieved positive cash flow. However, new customer acquisitions must continue in order for the facility to reach profitability. Based on the current business plan, which includes estimates of revenue growth, the Company believes that its investment in the Belgium facility is recoverable. However, if the estimated revenue growth is not achieved, the carrying amount of the facility is likely to be impaired.
As discussed above, on January 31, 2005, SBC announced that it would buy AT&T Corp., and announced its intention to migrate the services provided by Network to the AT&T network. Since SBC is WilTel's and Network's largest customer, accounting for 70% of Network's 2004 revenues, the Company concluded that the SBC announcement is an event which requires the Company to assess the carrying value of WilTel's long-lived assets for impairment, principally property and equipment. Since the event which gave rise to the impairment review occurred on January 31, 2005, and is not reflective of a condition that existed as of December 31, 2004, the assessment of impairment will be performed as part of the preparation of the Company's financial statements for the first quarter of 2005, and does not effect the carrying amount of the Company's assets as of December 31, 2004. The carrying value of WilTel's property and equipment is approximately $1,054,700,000 at December 31, 2004.
The Company will have to make numerous assumptions and estimates about the future to prepare its impairment analysis. The process of estimating future cash flows is subjective and inherently inaccurate because precise information about the future is not available, and in this case is exacerbated by the volatility that the telecommunications industry has experienced over the past few years. The economics of WilTel's future relationship with SBC, including its term, is also uncertain, which will be one of the most significant variables in the analysis. WilTel is currently engaged in negotiations with SBC concerning this and other pricing matters. WilTel will also have to make assumptions concerning its ability to retain existing customers, attract new customers, reduce expenses and participate in potential consolidation opportunities as part of the analysis. The Company is not currently able to determine whether the carrying amounts of WilTel's long-lived assets are impaired.
Acquisition of WilTel - In connection with accounting for the acquisition of WilTel, significant judgments and estimates were made to determine the fair values of certain liabilities, including liabilities for net unfavorable long-term commitments and deferred revenue, many of which required the Company to make assumptions about the future. To determine the fair value of deferred revenue, the Company had to assess transactions having limited activity in the current telecommunications market environment. The Company considered market indicators related to pricing, pricing for comparable transactions, as well as the legal obligation of WilTel to provide future services. The Company also assumed WilTel would continue to perform its contractual obligations through the term of its contracts. Revenue is recognized on these contracts as services are performed, typically on a straight-line basis over the remaining length of the contract. In the future, if WilTel settles these obligations or they are otherwise terminated prior to completion of the performance obligation, the Company would likely recognize a gain equal to the carrying amount of the obligation. At December 31, 2004, the amount reflected in the consolidated balance sheet for deferred revenue was $213,800,000.
The Company evaluated the fair value of long-term commitments that were either above or below the current market rates for similar transactions, and the fair value of telecommunications capacity commitments that are not required based on WilTel's current operating plans. These commitments primarily consist of real estate leases and international capacity contracts. In order to determine the fair values of these agreements, the Company made significant assumptions concerning future market prices, future capacity utilization, the ability to enter into subleasing arrangements and that the commitments will not be terminated prior to their expiration dates. The accrued liability is amortized on a straight-line basis over the life of the commitments. Results of operations in the future would be impacted by any subsequent adjustment to this liability, which could result from negotiating a termination or reduction of its contractual obligation with contract counter-parties or sublease activity that is different from the Company's original assumptions. At December 31, 2004, the amount reflected in the consolidated balance sheet for unfavorable long-term commitments was $44,900,000.
Telecommunications Revenue Recognition - Capacity, transmission, video services and other telecommunications services revenues are recognized monthly as the services are provided or revenues are earned. If at the time services are rendered, collection is not reasonably assured either due to credit risk, the potential for billing disputes or other reasons, revenue is not recognized until such contingencies are resolved.
WilTel estimates the amount of services which should not be recognized as revenue at the time the service is rendered based on its collection experience for each type of service. Certain of WilTel's customers represent such a high credit risk due to their difficult financial position that revenue is not recognized until cash is received. In addition, WilTel knows from past experience that a certain percentage of its billings will be disputed and uses that experience to estimate the amount of expected disputes and defers recognition of revenue at the time the service is provided. Revenues that have not been recognized at the time service is provided are subsequently recognized as revenue when the amounts are collected.
Accruals for Access Costs - WilTel's access costs primarily include variable charges paid to vendors to originate and/or terminate switched voice traffic, which are based on actual usage at negotiated or regulated contract rates, and fixed charges for leased lines for dedicated facilities. At the end of each reporting period, WilTel's estimated accrual for incurred but not yet billed costs is based on internal usage reports. The accrual is subsequently reconciled to actual invoices as they are received, which is a process that can take several months to complete. This process includes an invoice validation procedure that normally identifies errors and inaccuracies in rate and/or volume components of the invoices resulting in numerous invoice disputes. It is WilTel's policy to adjust the accrual for the probable amount it believes will ultimately be paid on disputed invoices, a determination which requires significant estimation and judgment. Due to the number of different negotiated and regulated rates, constantly changing traffic patterns, uncertainty in the ultimate resolution of disputes, the period of time required to complete the reconciliation and delays in invoicing by access vendors, changes in these estimates should be expected.
Contingencies - The Company accrues for contingent losses when the contingent loss is probable and the amount of loss can be reasonably estimated. As of December 31, 2004, the Company's consolidated balance sheet includes litigation reserves of $21,500,000, all of which relate to WilTel litigation. Estimating the ultimate outcome of litigation matters is inherently uncertain, in particular because the ultimate outcome will rest on events and decisions of others that may not be within the power of the Company to control. The Company does not believe that any of these matters will have a material adverse effect on its consolidated financial position, consolidated results of operations or liquidity. However, if the amounts ultimately paid at the resolution of a litigation matter are significantly different than the Company's recorded reserve amount, the difference could be material to the Company's consolidated results of operations and, with respect to WilTel, settlement amounts are likely to be material to its liquidity.
Results of Operations
Telecommunications
The following table reconciles WilTel's segment profit from operations to income (loss) from continuing operations before income taxes for the year ended December 31, 2004 and for the period from November 6, 2003 (when WilTel became a consolidated subsidiary) through December 31, 2003. Prior to November 6, 2003, the Company accounted for its 47.4% share of WilTel's results under the equity method of accounting. Audited financial statements of WilTel for the period from January 1, 2003 to November 5, 2003 are filed as financial statement schedules to this Report. For WilTel's segments, segment profit from operations is the primary performance measure of segment operating results and profitability. WilTel defines segment profit from operations as income before income taxes, interest expense, investment income, depreciation and amortization expense and other non-operating income and expense.
(1) Excludes intersegment revenues from amounts billed by Network to Vyvx of $18,400,000 and $4,300,000, respectively, for 2004 and for the 2003 period. (2) If items in these categories can not be directly attributed to a particular WilTel segment, they are allocated to each segment based upon a formula that considers each segment's revenues, property and equipment and headcount.
Network's revenues include services provided to SBC of $1,032,800,000 and $141,700,000 for the 2004 and 2003 periods, respectively, representing approximately 70% and 66%, respectively, of Network's operating revenues. Network's revenues from SBC have continued to grow throughout 2003 and 2004, principally related to voice products, for which SBC and WilTel have agreed to use a fixed price through April 1, 2005. The growth in voice revenue resulted from, in part, SBC's continued growth in long distance services in various states, including California, Michigan, Indiana, Ohio, Illinois and Wisconsin. Revenues attributable to other RBOCs were approximately 6% and 5% of Network's operating revenues for the 2004 and 2003 periods, respectively. Revenues and gross margins for non-SBC related business continue to reflect the excess telecommunications capacity in the marketplace, which has resulted in lower prices for WilTel and others in the industry, and created a very competitive environment for acquiring new business. In 2004, WilTel's Network segment began to sell into the enterprise business market, although revenues have not been material to date.
As discussed above, SBC's announcement to migrate its business from Network to the AT&T network is expected to have a significant impact on WilTel's future revenues and profitability. SBC indicated that it expects to close its acquisition of AT&T in the first half of 2006. WilTel expects it will take anywhere from two to three years from now for SBC to migrate all of its traffic off of WilTel's network, and anticipates that it will continue to provide some level of service to SBC into 2007. WilTel expects it will evaluate and implement cost reduction strategies, investigate sales of assets and minimize capital expenditure outlays to help offset the loss of SBC's business. However, given the current economic condition of the telecommunications industry as a whole, where telecommunications capacity far exceeds actual demand and the marketplace is characterized by fierce price competition, and the limited growth of non-SBC business over the past few years, WilTel does not believe it will be able to fully replace the revenues and profits generated by the SBC agreements in the near future, if ever.
Network's cost of sales has increased in line with revenue growth throughout 2003 and 2004, and is comprised of variable charges paid to access vendors to originate and/or terminate switched voice traffic, and fixed charges for leased facilities and local off-net costs. The price Network pays for these services has been declining, generally in line with declines experienced by Network in its pricing of its own services to customers. Network's gross margin percentage has been adversely affected by a larger mix of voice transport business, principally resulting from SBC's growth, which has a lower gross margin as compared to some of Network's other products and services. In addition, Network cost of sales in 2004 includes a charge of $3,500,000 for international voice access costs, for which no revenue was recognized. WilTel entered into a commitment for these access costs in order to provide services for a specific customer; however, the customer defaulted under its contract, and WilTel accrued the remaining amount of the commitment, but does not expect to be able to recover from its customer.
Network's salaries were $121,000,000 and $16,300,000 for the 2004 and 2003 periods, respectively, and selling, general and other expenses were $155,500,000 and $24,000,000 for the 2004 and 2003 periods, respectively. Selling, general and other expenses in 2004 include a reduction of $4,100,000 to the provision for doubtful accounts, principally due to the collection of previously reserved accounts receivable which had been in dispute. The provision for doubtful accounts also includes a charge of $2,700,000 to fully reserve for another customer's accounts receivable which is not expected to be collected. Selling, general and other expenses in 2004 include $5,000,000 for estimated repair costs for WilTel's headquarters building. The need for repair work arose after the building was damaged in a severe storm. While insurance recovery is deemed probable for some repairs to the building, the accrual relates to repairs for which insurance recovery is not assured, as they are necessitated by underlying design flaws in the building. WilTel will seek to obtain reimbursement from the responsible parties; however, no recovery has been accrued. Network's salaries expense and selling, general and other expenses for 2004 reflect lower headcount, higher costs of performance-based compensation, greater personnel retention costs and greater vendor contract maintenance costs for the network.
Vyvx operating revenues were $120,500,000 and $20,600,000 for the 2004 and 2003 periods, respectively. Revenues in 2004 were slightly lower due in part to fewer hockey game broadcasts due to the National Hockey League labor dispute and customers switching to lower cost Vyvx products. Although the lower priced products result in less revenue, the costs to provide these products and related selling, general and other expenses is also lower, which results in increased segment profits. Approximately 62% of Vyvx's 2004 operating revenue was derived from its top 10 customers. Fox and its parent company, The News Corporation Limited, through their various news, sports and entertainment businesses, accounted for approximately 18% of Vyvx's 2004 revenues and TimeWarner, Inc. accounted for 16% of Vyvx's 2004 revenues. These percentages were not significantly different during the 2003 period. Approximately 65% of Vyvx's 2004 revenues are from the sale of fiber optic and satellite video transport services and the remaining 35% of revenues are from the sale of advertising distribution services.
Vyvx cost of sales reflects the level of revenue and is comprised primarily of amounts billed by Network to Vyvx for transporting content over the WilTel network, costs paid to other providers for local access and other off-net services, transponder expenses and freight and overnight delivery costs. The Company's consolidated statement of operations includes Vyvx salaries expense of $18,600,000 and $3,000,000, respectively, and selling, general and other expenses of $15,900,000 and $3,700,000, respectively, for the 2004 and 2003 periods.
For 2004, WilTel's other non-operating income includes income of $18,500,000 related to the settlement of litigation for less than amounts reserved, income of $6,000,000 related to the sale of an equity security which had a zero book value, gains of $3,500,000 related to cash and securities received in excess of the book value of secured claims in customers' bankruptcies, and income of $2,300,000 related to the reversal of excess reserves for long-term commitments.
Healthcare Services
Pre-tax income (loss) of the healthcare services segment was $5,100,000 for the year ended December 31, 2004 and $(2,300,000) for the four month period from acquisition through December 31, 2003. For the 2004 and 2003 periods, healthcare services revenues were $257,300,000 and $71,000,000, respectively, and cost of sales, which primarily consist of salaries and employee benefits, were $216,300,000 and $61,300,000, respectively.
Since its acquisition in September 2003, Symphony has been focused on profitably growing its business and, because of the nature of its business, attracting and hiring skilled professionals to provide its services. The ability of Symphony to continue to grow its business depends heavily upon its ability to attract, develop and retain qualified therapists. There is a current shortage of qualified therapists industry-wide, and Symphony has open positions to provide service to new customers, provide additional service offerings for existing customers and through normal employee turnover. The tight labor market causes Symphony and others in its industry to hire, at times, independent contractors to perform required services, which may increase costs and reduce margins, and can also result in lost revenue opportunities.
During 2004, Symphony performed an evaluation of its customer base, in order to identify those customers and markets where Symphony can deliver the highest level of service and that should be the focus of customer retention efforts, as well as identifying those customers that should be terminated. In addition, Symphony has restructured its corporate management and field operations organization, resulting in a more efficient organization with reduced costs. Symphony is also seeking to grow its profitable businesses, which includes expanding its service offerings to existing customers. Symphony may look for strategic acquisitions to increase its customer base and pool of professional service providers; however, no assurance can be given that it will be successful in those efforts.
Legislative caps on Part B Medicare therapy, which negatively impacted Symphony's revenues in 2003, have been removed for 2004 and 2005, and the fee schedule for such services has also been increased by 1.5%. As a result, Symphony's average quarterly 2004 revenues for these therapy services increased by approximately 44% as compared to the fourth quarter of 2003, comparing only those locations that were operating during all periods. Symphony also added new customers during 2004; however, certain low margin and non-profitable accounts were cancelled, resulting in a slight decrease in total locations serviced. During 2004, one customer accounted for approximately 16% of Symphony's revenues. Symphony's margins for 2004 also reflect higher hourly wages and benefits paid to attract and retain its therapists, and increased costs to hire independent contractors as a result of hiring needs for both full-time and part-time professionals. In order to maintain and improve margins in the challenging labor market in which Symphony operates, Symphony is focused on obtaining sufficient pricing for new and renewal business, as well as cost effective employee retention programs. Pre-tax results for 2004 also reflect approximately $3,300,000 from the collection of receivables in excess of their carrying amounts, a decrease in estimated liabilities for employee health insurance costs and other third party claims of approximately $1,700,000, and a gain of $1,000,000 from the sale of certain property. In addition, pre-tax results for 2004 reflect approximately $3,900,000 of costs, principally severance for Symphony's former chief executive officer and others due to reorganizing and consolidating certain field operations and closing offices.
The moratorium on legislative caps for Part B Medicare therapy is scheduled to expire on December 31, 2005. While there is some congressional support for an extension of the moratorium, there is also concern regarding the cost of an extension. Symphony is unable to predict what the ultimate outcome will be; however, any re-introduction of the legislative caps or other methodology that reduces fees for Part B Medicare therapy could significantly reduce Symphony's revenues.
Manufacturing
Pre-tax income for the manufacturing segment was $7,900,000, $4,400,000 and $3,100,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Manufacturing revenues were $64,100,000, $53,300,000 and $50,700,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Revenues increased by 20% in 2004 and by 5% in 2003, while they declined by 5% in 2002 as compared to the prior year.
Manufacturing revenues in 2004 increased in substantially all of the division's markets. The Company believes that these increases result from a variety of factors including an improved economy, new product development and the acquisition in the first quarter of 2004 of customer receivables and inventory of a competitor that was exiting certain markets. Although raw material costs increased significantly in 2004, the division increased selling prices in most markets, that along with increased sales and production volumes enabled it to maintain its gross profit margins. The primary raw material in the division's products is a polypropylene resin, which is a byproduct of the oil refining process, whose price tends to increase and decrease with the price of oil. There is relatively little direct labor or other raw material costs in the division's products. In addition to managing resin purchases, the division also has initiatives to reduce and/or reuse scrap thereby increasing raw material utilization.
As a result, the division's gross profit and gross profit margins increased in 2004 as compared to 2003. Pre-tax results for 2004 also reflect greater salaries expense, due to higher bonuses attributable to the division's improved performance. During 2005, the division will seek to gain additional cost efficiencies resulting from its acquisition of NSW, principally in administration and overhead expense and raw material purchasing. In addition, the division will look to make other strategic acquisitions of smaller entities that serve the same markets as NSW, primarily those that supply package netting and filtration products.
The increase in manufacturing revenues in 2003 primarily resulted from increases in the construction and consumer products markets of $6,200,000, although revenues in the carpet padding and agricultural markets declined. However, gross profit declined, as the increase in the price of resin more than offset the revenue increase. Pre-tax results improved due to lower salaries and selling, general and other expenses principally as a result of workforce reductions and other cost reduction programs, cash received from government grants and a gain from the sale of a line of business. In addition, the impairment charge that is discussed below reduced pre-tax results in 2002.
For the year ended December 31, 2002, the division recorded an impairment charge of approximately $1,250,000 to write down the book value of certain production lines that the division did not expect would be utilized over the next several years. These lines were initially purchased to provide additional capacity to produce a specific product for a specific customer; however, the customer discontinued the product in 2001 and the Company determined that the cost of these lines were no longer recoverable from other business.
Banking and Lending
As stated previously, the current activities of the banking and lending segment are concentrated on collecting and servicing its remaining loan portfolio, maximizing returns on its investment portfolio and discharging deposit liabilities as they come due. As a result, revenues and expenses for this segment included in the Company's consolidated statements of operations are reflective of the continuing decrease in the size of the loan portfolio. In addition, as described earlier in this Report, during 2004, the Company sold its subprime automobile and collateralized consumer loan portfolios representing approximately 97% of its total outstanding loans (net of unearned finance charges) and certain loan portfolios that had been substantially written-off for aggregate pre-tax gains of $16,300,000, which is reflected in investment and other income. Pre-tax income for the banking and lending segment was $22,000,000, $8,400,000 and $1,900,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Finance revenues, which reflect both the level and mix of consumer instalment loans, decreased in each of the last two years as compared to the prior period, as average loans outstanding were $57,100,000, $283,000,000 and $440,800,000 during 2004, 2003 and 2002, respectively. Although finance revenues decreased in 2004 as compared to 2003, pre-tax results increased due to gains from the loan portfolios sales, a decline in the provision for loan losses of $24,700,000, reductions in interest expense of $6,000,000 principally resulting from reduced customer banking deposits, less interest paid on interest rate swaps and lower salaries expense and operating costs resulting from the segment's restructuring efforts. All of these changes reflect the ongoing reduction in the amount of loan assets under management, including as a result of the loan portfolios sales.
Although finance revenues decreased in 2003 as compared to 2002 for the reasons described above, pre-tax results increased primarily due to a $9,300,000 reduction in interest expense, due to reduced customer banking deposits and lower interest rates thereon, a decline in the provision for loan losses of $19,600,000, less interest paid on interest rate swaps and lower salaries expense and operating costs resulting from the segment's restructuring efforts. The reduction in the provision for bad debts resulted from the decrease in the size of the consumer loan portfolios. However, the Company increased its allowance during the third quarter of 2003 by $4,000,000 as a result of an increase in delinquency, which shortly followed the outsourcing of loan collection activities.
Pre-tax results for the banking and lending segment include income of $3,100,000 and $3,500,000 for the years ended December 31, 2003 and 2002, respectively, resulting from mark-to-market changes on its interest rate swaps. The Company used interest rate swaps to manage the impact of interest rate changes on its customer banking deposits; all of the segment's interest rate swaps matured in 2003. Although the Company believes that these derivative financial instruments served as economic hedges, they did not meet certain effectiveness criteria under SFAS 133 and, therefore, were not accounted for as hedges.
Domestic Real Estate
Pre-tax income for the domestic real estate segment was $20,700,000, $18,100,000 and $16,300,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Pre-tax results for the domestic real estate segment are largely dependent upon the performance of the segment's operating properties, the current status of the Company's real estate development projects and non-recurring gains or losses recognized when real estate assets are sold. As a result, the results of operations for this segment in the aggregate for any particular year are not predictable and do not follow any consistent pattern.
Revenues and pre-tax results for this segment increased in 2004 as compared to 2003, primarily due to the sale of 92 lots at the Company's 95-lot development project in South Walton County, Florida for aggregate sales proceeds of approximately $50,000,000 for which the Company recognized pre-tax profits of $15,800,000, net of minority interest. The Company will be required under the sale agreements to make significant improvements to the property, including infrastructure and certain amenities, which it expects to complete in 2005. The Company estimates it will recognize additional pre-tax profit of $10,200,000 related to this project. In addition, revenues during 2004 reflect the sale of certain unimproved land for cash proceeds of $8,800,000, which resulted in a pre-tax gain of $7,600,000. Revenues during 2004 also reflect decreased gains from property sales at the Company's other residential and commercial project in the Florida panhandle as the lots have largely been sold, and less amortization of deferred gains from sales of real estate in prior years. Pre-tax results for 2004 also reflect due diligence expenses for a real estate development project that the Company decided not to develop.
Revenues and pre-tax results from domestic real estate increased in 2003 as compared to 2002, primarily as a result of improved operating performance at the Company's Hawaiian hotel. Gains recognized from sales of real estate during 2003 declined by $8,300,000, principally due to the gains on sale of real estate of CDS prior to its sale in 2002. During 2003, the Company also recognized $11,100,000 of deferred gains from sales of real estate in prior years.
During the fourth quarter of 2002, the Company sold one of its real estate subsidiaries, CDS, to HomeFed for a purchase price of $25,000,000, consisting of $1,000,000 in cash and 2,474,226 shares of HomeFed's common stock, which represented approximately 30% of the outstanding HomeFed stock. CDS's principal asset is the master-planned community located in San Diego County, California known as San Elijo Hills, for which HomeFed has served as the development manager since 1998. Prior to the sale to HomeFed, the Company recognized pre-tax gains of $7,800,000 from sales of residential sites at San Elijo Hills during 2002.
Corporate and Other Operations
Investment and other income increased in 2004 as compared to 2003 primarily due to the pre-tax gain from the sale of two of the Company's older corporate aircraft, discussed above, greater dividend and interest income of $12,400,000 and miscellaneous other income. Available corporate cash is generally invested on a short-term basis until such time as investment opportunities require an expenditure of funds. Investment and other income for 2003 included $5,300,000 of income related to a refund of foreign taxes not based on income.
Investment and other income declined in 2003 as compared to 2002, principally as a result of a non-recurring gain of $14,300,000 recognized in 2002 from the sale of the Company's thoroughbred racetrack business. Corporate investment income also declined as a result of lower interest rates in 2003 and foreign exchange gains recorded in 2002. During 2003, income related to accounting for the market values of Corporate's derivative financial instruments increased by $5,600,000, and the Company also recorded $5,300,000 of income related to a refund of foreign taxes not based on income. In addition, revenues from the Company's gas operations increased in 2003 principally due to increased production and prices.
Net securities gains (losses) for Corporate and Other Operations aggregated $136,100,000, $10,600,000 and $(31,300,000) for the years ended December 31, 2004, 2003 and 2002, respectively. During 2004, substantially all of the Company's net securities gains reflect realized gains from the sale of publicly traded debt and equity securities that had been classified as Corporate available for sale securities. Net securities gains (losses) for 2004, 2003 and 2002 include provisions of $4,600,000, $6,500,000 and $37,100,000, respectively, to write down the Company's investments in certain available for sale securities and an investment in a non-public security in 2003 and an equity investment in a non-public fund in 2002. The write down of the securities resulted from a decline in market value determined to be other than temporary.
The Company's decision to sell securities and realize security gains or losses is generally based on its evaluation of an individual security's value at the time and the prospect for changes in its value in the future. The decision can also be influenced by the status of the Company's tax attributes but in recent years has not been influenced by liquidity needs. Therefore, the timing of realized security gains or losses is not predictable and does not follow any pattern from year to year.
The increase in interest expense during 2004 as compared to 2003 primarily reflects interest expense relating to the $375,000,000 aggregate principal amount of the 7% Senior Notes issued during 2003 and 2004, the issuance of $350,000,000 principal amount of its 3 3/4% Convertible Senior Subordinated Notes in 2004 and dividends accrued on its trust issued preferred securities, which commencing July 1, 2003 are classified as interest expense (shown as minority interest in prior periods) as a result of the implementation of Statement of Financial Accounting Standards No. 150. The increase in interest expense during 2003 as compared to 2002 principally results from the issuance of $275,000,000 aggregate principal amount of the 7% Senior Notes that were issued in 2003 and dividends accrued on its trust issued preferred securities.
The increase in selling, general and other expenses of $19,700,000 in 2004 as compared to 2003 primarily reflects greater professional and other fees of $8,500,000, which largely relate to due diligence expenses for potential investments, greater professional fees for existing investments and fees relating to the implementation of the Sarbanes-Oxley Act of 2002, and $3,600,000 of expenses related to the proposed public offering of MK Resources' equity that did not go forward due to unfavorable market conditions. In addition, the increase reflects greater employee benefit expenses, higher insurance costs and greater amortization of debt issuance costs related to the 7% Senior Notes and 3 3/4% Convertible Notes.
Selling, general and other expenses also include additions to cost of goods sold of the winery operations of $3,900,000, $4,300,000 and $2,100,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The winery operations, which account for inventory under the LIFO method of accounting, recorded adjustments to cost of goods sold based upon the results of its annual harvest. The additional expenses recorded in each of the last three years were due primarily to a lower yield than had been previously estimated.
The income tax provision reflects the reversal of tax reserves aggregating $27,300,000, $24,400,000 and $120,000,000 for the years ended December 31, 2004, 2003 and 2002, respectively, as a result of the favorable resolution of various state and federal income tax contingencies. In addition, in 2004 the tax provision reflects a benefit to record a federal income tax carryback refund of $3,900,000.
In 2003, the Company established a valuation allowance that fully reserved for all of WilTel's net deferred tax assets, reduced by an amount equal to the Company's current and deferred federal income tax liabilities as of the date of acquisition. The Company needs the valuation allowance because, on a pro forma combined basis, the Company is not able to demonstrate that it is more likely than not that it will be able to realize the deferred tax asset. Subsequent to the acquisition of WilTel, any benefit realized from WilTel's deferred tax asset reduces the valuation allowance for the deferred tax asset; however, that reduction is first applied to reduce the carrying amount of the acquired non-current intangible assets of WilTel rather than reduce the income tax provision of any component of total comprehensive income.
As a result, the various components of comprehensive income include an aggregate federal income tax provision of $22,300,000 in 2004 and $22,500,000 in 2003 (for the period subsequent to the acquisition of WilTel), even though no federal income tax for those periods was due. During 2004, the effect of recording this tax provision and the resulting reduction to the valuation allowance was to reduce the carrying amount of the acquired non-current intangible assets to zero. Income tax expense for 2003 also includes the Company's actual income tax expense for the period prior to the acquisition of WilTel.
Now that the non-current intangible assets have been reduced to zero, the Company does not expect it will reflect a net federal income tax expense or benefit for total comprehensive income in the aggregate until such time as the Company is able to reduce its valuation allowance and recognize a net deferred tax asset. Each component of other comprehensive income may reflect either a federal income tax provision or benefit in future periods, depending upon the relative amounts of each component; however, in the aggregate for all components the Company does not expect to report any net federal income tax expense or benefit for the foreseeable future.
Associated Companies
Equity in income of associated companies includes the following for the years ended December 31, 2004, 2003 and 2002 (in thousands):
Since the Berkadia loan was fully repaid during the first quarter of 2004, the Company will no longer have any income related to the Berkadia loan in the future. The Company's income from this investment is expected to be limited to its share of the annual management fee received from FINOVA while such fee remains in effect, which is $4,000,000. The Company has received total net cash proceeds of $91,200,000 from this investment since 2001, including the commitment and financing fees, management fees and interest payments related to its share of the Berkadia loan.
The Company's investment in Olympus was made in December 2001, when Olympus commenced its operations as a newly formed Bermuda reinsurance company primarily engaged in the property excess, marine and aviation reinsurance business. The decline in the Company's share of its earnings in 2004 as compared to 2003 reflects the impact of property damage claims caused by severe hurricanes. The Company's share of its earnings increased in 2003 as compared to the prior year, reflecting the growth in Olympus' premium revenues during its second year of operation. As a result of redemptions of other investors' equity interests in the first half of 2004, the Company's percentage interest in Olympus increased from approximately 16% to 19%.
The equity in income (losses) of EagleRock results from both realized and changes in unrealized gains (losses) in its portfolio. In 2004, $3,700,000 was distributed by the partnership to the Company.
In January 2004, the Company invested $50,000,000 in Pershing Square, L.P. ("Pershing"), a limited partnership that is authorized to engage in a variety of investing activities. The Company redeemed its interest as of December 31, 2004, and the total amount due from Pershing of $71,300,000 (which was paid during the first quarter of 2005) is included in trade, notes and other receivables, net in the Company's consolidated balance sheet.
As more fully described above, the Company acquired its investment in HomeFed in the fourth quarter of 2002. During 2004, HomeFed reported lower earnings from sales of real estate as compared to the prior year principally at the San Elijo Hills project.
As discussed above, WilTel became a consolidated subsidiary in November 2003 and the Company ceased applying the equity method of accounting at that time. For 2003, the Company's share of WilTel's results of operations included income from the recognition of non-operating settlement gains related to the termination of various agreements that released WilTel from previously accrued obligations, recoveries of previously written off receivables and a gain on the sale of a subsidiary. The Company's share of these gains was approximately $31,200,000. The Company did not record a deferred tax benefit for its share of WilTel's losses while applying the equity method as its ability to use the capital loss to reduce the tax due on capital gains in the future is uncertain.
Discontinued Operations
Wireless Messaging
In December 2002, the Company entered into an agreement to purchase certain debt and equity securities of WebLink Wireless, Inc. ("WebLink"), for an aggregate purchase price of $19,000,000. WebLink operated in the wireless messaging industry, providing wireless data services and traditional paging services. In the fourth quarter of 2003, WebLink sold substantially all of its operating assets to Metrocall, Inc. for 500,000 shares of common stock of Metrocall, Inc's parent, Metrocall Holdings, Inc. ("Metrocall"), an immediately exercisable warrant to purchase 25,000 shares of common stock of Metrocall at $40 per share, and a warrant to purchase up to 100,000 additional shares of Metrocall common stock at $40 per share, subject to certain vesting criteria. Based upon the market price of the Metrocall stock received and the fair value of the warrants received as of the date of sale, the Company reported a pre-tax gain on disposal of discontinued operations of $11,500,000. The vesting criteria for the remaining warrants were satisfied during 2004, and the Company recorded $2,200,000 as gain on disposal of discontinued operations (net of minority interest), which represented the estimated fair value of the warrants. Due to WebLink's large net operating loss carryforwards, these gains were not reduced for any federal income tax expense.
During the fourth quarter of 2004, WebLink exercised all of its warrants and subsequently tendered all of its Metrocall shares as part of a merger agreement between Metrocall and Arch Wireless, Inc. WebLink received cash of $19,900,000 and 675,607 common shares of the new parent company (USA Mobility, Inc., which had a fair market value of $25,000,000 when received), resulting in a pre-tax gain of $15,800,000 that is included in net securities gains of continuing operations. The Company's investment in the shares of USA Mobility at December 31, 2004 are classified as a non-current investment.
In return for the Company's $19,000,000 investment in WebLink, the Company has received cash and securities aggregating $48,400,000, based on the market price of USA Mobility as of December 31, 2004. Such amount has been reduced for the minority interest and liabilities of WebLink which remain to be paid.
Foreign Real Estate
In 2002, the Company sold its interest in Fidei to an unrelated third party for total proceeds of 70,400,000 Euros ($66,200,000), which resulted in an after tax gain on the sale reflected in results of operations of $4,500,000 (net of income tax expense of $2,400,000) for the year ended December 31, 2002, and an increase to shareholders' equity of $12,100,000 as of December 31, 2002. The Euro denominated sale proceeds were not converted into U.S. dollars immediately upon receipt. The Company entered into a participating currency derivative, which expired later in 2002. Upon expiration, net of the premium paid to purchase the contract, the Company received $67,900,000 in exchange for 70,000,000 Euros and recognized a foreign exchange gain of $2,000,000, which is included in investment and other income for the year ended December 31, 2002.
Domestic Real Estate
In the fourth quarter of 2004, the Company sold a commercial real estate property and classified it as a discontinued operation. During the second quarter of 2004, the Company recorded a non-cash charge of $7,100,000 to reduce the carrying amount of this property to its estimated fair value. The Company recorded an additional pre-tax loss from the sale of $600,000, principally relating to mortgage prepayment penalties incurred upon satisfaction of the property's mortgage at closing. Operating results for this property were not material in prior years.
Other Operations
In the fourth quarter of 2004, the Company sold its geothermal power generation business for $14,800,000, net of closing costs, and recognized a pre-tax gain of $200,000. For the years ended December 31, 2004, 2003 and 2002, the Company recorded pre-tax losses from discontinued operations relating to this business of $1,500,000, $2,300,000 and $2,800,000, respectively.
Recently Issued Accounting Standards
In November 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 151, "Inventory Costs--An Amendment of ARB No. 43, Chapter 4" ("SFAS 151"), which is effective for fiscal years beginning after June 15, 2005. SFAS 151 amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, SFAS 151 requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of "so abnormal" as stated in ARB No. 43. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company is currently evaluating the impact of SFAS 151 on its consolidated financial statements.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, "Share-Based Payment" ("SFAS 123R"), which replaces SFAS 123 and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS 123R requires that the cost of all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. That cost will be recognized as an expense over the vesting period of the award. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. In addition, the Company will be required to determine fair value in accordance with SFAS 123R. SFAS 123R is effective for reporting periods beginning with the first interim or annual period after June 15, 2005, with early adoption encouraged, and requires the application of a transition methodology for stock options that have not vested as of the date of adoption. The Company is currently evaluating the impact of SFAS 123R on its consolidated financial statements.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153, "Exchanges of Nonmonetary Assets--An Amendment of APB Opinion No. 29" ("SFAS 153"), which is effective for fiscal periods beginning after June 15, 2005. SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, "Accounting for Nonmonetary Transactions," and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of SFAS 153 will not have any material effect on the consolidated financial statements; however, SFAS 153 could impact the accounting for future transactions, if any, within its scope.
Cautionary Statement for Forward-Looking Information
Statements included in this Report may contain forward-looking statements. Such statements may relate, but are not limited, to projections of revenues, income or loss, capital expenditures, plans for growth and future operations, competition and regulation, as well as assumptions relating to the foregoing. Such forward-looking statements are made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are inherently subject to risks and uncertainties, many of which cannot be predicted or quantified. When used in this Report, the words "estimates", "expects", "anticipates", "believes", "plans", "intends" and variations of such words and similar expressions are intended to identify forward-looking statements that involve risks and uncertainties. Future events and actual results could differ materially from those set forth in, contemplated by or underlying the forward-looking statements.
The factors that could cause actual results to differ materially from those suggested by any of these statements or which may materially and adversely affect the Company's actual results include, but are not limited to, those discussed or identified from time to time in the Company's public filings, including:
A worsening of general economic and market conditions or increases in prevailing interest rate levels, which may result in reduced sales of our products and services, lower valuations for our associated companies and investments or a negative impact on the credit quality of our assets;
Changes in foreign and domestic laws, regulations and taxes, which may result in higher costs and lower revenue for our businesses, including as a result of unfavorable political and diplomatic developments, currency fluctuations, changes in governmental policies, expropriation, nationalization, confiscation of assets and changes in legislation relating to non-U.S. ownership;
Increased competition and changes in pricing environments, which may result in decreasing revenues and/or margins, increased raw materials costs for our plastics business, loss of market share or significant price erosion;
Continued instability and uncertainty in the telecommunications industry, associated with increased competition, aggressive pricing and overcapacity;
Dependence on key personnel, in particular, our Chairman and President, the loss of whom would severely affect our ability to develop and implement our business strategy;
Inability to attract and retain highly skilled personnel, which would make it difficult to conduct the businesses of certain of our subsidiaries, including WilTel and Symphony;
Adverse legal and regulatory developments that may affect particular businesses, such as regulatory developments in the telecommunications and healthcare industries, or in the environmental area, which could affect the Company's real estate development activities and telecommunications business, as well as the Company's other operations;
WilTel's ability to replace the revenues generated by SBC, which if lost as a result of SBC's proposed acquisition of AT&T will have a significant adverse impact on WilTel's results of operations;
WilTel's ability to acquire or maintain rights of way necessary for the operation of its network, which could require WilTel to find alternate routes or increase WilTel's costs to provide services to its customers;
WilTel's dependence on a small number of suppliers and high-volume customers, the loss of any of which could adversely affect WilTel's ability to generate operating profits and positive cash flows;
Changes in telecommunications laws and regulations, which could adversely affect WilTel and its customers through, for example, higher costs, increased competition and a loss of revenue;
Adverse regulatory developments impacting Medicare, which could materially reduce Symphony's revenues;
Weather related conditions and significant natural disasters, including hurricanes, tornadoes, windstorms, earthquakes and hailstorms, which may impact our wineries, real estate holdings and reinsurance operations;
The inability to insure or reinsure certain risks economically, or the ability to collect on insurance or reinsurance policies, which could result in the Company having to self-insure business risks;
Changes in U.S. real estate markets and real estate collateral values, including the residential market in Southern California and the commercial market in Washington D.C., which are sensitive to mortgage interest rate levels, and the vacation market in Hawaii;
Adverse economic, political or environmental developments in Spain, which could delay or preclude the issuance of permits necessary to develop the Company's copper mineral rights or which could result in increased costs of bringing the project to completion and increased costs in financing the development of the project;
The inability to obtain necessary financing for the Las Cruces copper mining project, which could delay or prevent completion of the project;
Decreases in world wide copper prices or weakening of the U.S. dollar against the euro, which could adversely affect the commercial viability of the Company's mineral rights in Spain;
WilTel's ability to adapt to technological developments or continued or increased pricing competition in the telecommunications industry, which could adversely affect WilTel's ability to generate operating profits and positive cash flows;
WilTel's inability to generate operating profits and positive cash flows, which could result in a default under WilTel's credit agreement, pursuant to which substantially all of its assets are pledged;
Current and future legal and administrative claims and proceedings against WilTel, which may result in increased costs and diversion of management's attention;
Regional or general increases in the cost of living, particularly in the regions in which the Company has operations or sells its products or services, which may result in lower sales of such products and service; and
Risks associated with future acquisitions and investments, including changes in the composition of the Company's assets and liabilities through such acquisitions, diversion of management's attention from normal daily operations of the business and insufficient revenues to offset increased expenses associated with acquisitions.
This list of factors that may affect future performance and the accuracy of forward-looking statements is illustrative, but is not intended to be exhaustive. Therefore, all forward-looking statements should be evaluated with the understanding of their inherent uncertainty. Undue reliance should not be placed on these forward-looking statements, which are applicable only as of the date hereof. The Company undertakes no obligation to revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this Report or to reflect the occurrence of unanticipated events.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk. ------- ----------------------------------------------------------
The following includes "forward-looking statements" that involve risk and uncertainties. Actual results could differ materially from those projected in the forward-looking statements.
The Company's market risk arises principally from interest rate risk related to its investment portfolio, its borrowing activities and the banking and lending activities of certain subsidiaries.
The Company's investment portfolio is primarily classified as available for sale, and consequently, is recorded on the balance sheet at fair value with unrealized gains and losses reflected in shareholders' equity. Included in the Company's available for sale investment portfolio are fixed income securities, which comprised approximately 69% of the Company's total investment portfolio at December 31, 2004. These fixed income securities are primarily rated "investment grade" or are U.S. governmental agency issued or guaranteed obligations. The estimated weighted average remaining life of these fixed income securities was approximately 1.1 years at December 31, 2004. The Company's fixed income securities, like all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase. The Company's investment portfolio also includes its investment in WMIG, carried at its aggregate market value of $242,300,000. This investment is approximately 13% of the Company's total investment portfolio, and its value is subject to change if the market value of the WMIG stock rises or falls. At December 31, 2003, fixed income securities comprised approximately 70% of the Company's total investment portfolio and had an estimated weighted average remaining life of 2.0 years. At December 31, 2004 and 2003, the Company's portfolio of trading securities was not material.
The Company is subject to interest rate risk on its long-term fixed interest rate debt. Generally, the fair market value of debt securities with a fixed interest rate will increase as interest rates fall, and the fair market value will decrease as interest rates rise.
As previously discussed in this Report, the Company's banking and lending operations stopped originating all loans in 2003, and in 2004, sold the vast majority of its outstanding loans. Cash generated from the collections on and sales of its loan portfolios were used to retire customer deposits as they matured. The Company's banking and lending operations currently are not accepting new consumer or brokered deposits. The Company's banking and lending operations are subject to risk primarily resulting from interest rate fluctuations in its investment portfolio, which is classified as available for sale, repurchase agreements and customer deposits. The investment portfolio primarily consists of investments in mortgage-backed securities for which the underlying assets are adjustable rate mortgages with a weighted average repricing of approximately seven months. The Company's banking and lending operations employ leverage to enhance the investment returns; these fixed rate borrowings, comprised by the repurchase agreements, have an average term as of December 31, 2004 of approximately fifteen days. The principal objectives of the Company's banking and lending asset/liability management activities are to provide maximum levels of net interest income while maintaining acceptable levels of interest rate and liquidity risk. The Company utilizes an interest rate sensitivity model as the primary quantitative tool in measuring the amount of interest rate risk that is present. The model quantifies the effects of various interest rate scenarios on the projected net interest margin over the ensuing twelve-month period.
The following table provides information about the Company's financial instruments used for purposes other than trading that are primarily sensitive to changes in interest rates. For investment securities and debt obligations, the table presents principal cash flows by expected maturity dates. For the variable rate notes receivable and variable rate borrowings, the weighted average interest rates are based on implied forward rates in the yield curve at the reporting date. For loans, securities and liabilities with contractual maturities, the table presents contractual principal cash flows adjusted for the Company's historical experience and prepayments of mortgage-backed securities. For banking and lending's variable rate products, the weighted average variable rates are based upon the rates at the reporting date. For money market deposits that have no contractual maturity, the table presents principal cash flows based on management's judgment. For interest rate swaps, the table presents notional amounts by contractual maturity date.
For additional information, see Notes 6, 11 and 20 of Notes to Consolidated Financial Statements.
Item 8.
Item 8. Financial Statements and Supplementary Data. - ------ -------------------------------------------
Financial Statements and supplementary data required by this Item 8 are set forth at the pages indicated in Item 15(a) below.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. - ------ ---------------------------------------------------------------
Not applicable.
Item 9A.
Item 9A. Controls and Procedures. - ------- -----------------------
Evaluation of disclosure controls and procedures ------------------------------------------------
(a) The Company's management evaluated, with the participation of the Company's principal executive and principal financial officers, the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), as of December 31, 2004. Based on their evaluation, the Company's principal executive and principal financial officers concluded that the Company's disclosure controls and procedures were effective as of December 31, 2004.
Changes in internal control over financial reporting ----------------------------------------------------
(b) There has been no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company's fiscal quarter ended December 31, 2004, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
Management's Report on Internal Control Over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934. Internal control over financial reporting is a process designed 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:
o Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and disposition of the assets of the Company;
o 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
o 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 consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The Company's management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2004. In making this assessment, the Company's management used the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on our assessment and those criteria, management concluded that, as of December 31, 2004, the Company's internal control over financial reporting was effective.
Our management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.
Item 9B.
Item 9B. Other Information. - ------- -----------------
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant. - ------- --------------------------------------------------
The information to be included under the caption "Election of Directors" and "Information Concerning the Board and Board Committees" in the Company's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A of the Exchange Act in connection with the 2005 annual meeting of shareholders of the Company (the "Proxy Statement") is incorporated herein by reference. In addition, reference is made to Item 10 in Part I of this Report.
Item 11.
Item 11. Executive Compensation. - ------- ----------------------
The information to be included under the caption "Executive Compensation" in the Proxy Statement is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------- --------------------------------------------------------------
Equity Compensation Plan Information
The following table summarizes information regarding the Company's equity compensation plans as of December 31, 2004. All outstanding awards relate to the Company's common stock.
The information to be included under the caption "Present Beneficial Ownership of Common Shares" in the Proxy Statement is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions. - ------- ----------------------------------------------
The information to be included under the caption "Executive Compensation - - Certain Relationships and Related Transactions" in the Proxy Statement is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services. - -------- --------------------------------------
The information to be included under the caption "Principal Accounting Fees and Services" in the Proxy Statement is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a)(1)(2) Financial Statements and Schedules.
(3) Executive Compensation Plans and Arrangements. See Item 15(b) below for a complete list of Exhibits to this Report.
1999 Stock Option Plan (filed as Annex A to the Company's Proxy Statement dated April 9, 1999 (the "1999 Proxy Statement")).
Form of Grant Letter for the 1999 Stock Option Plan.
Amended and Restated Shareholders Agreement dated as of June 30, 2003 among the Company, Ian M. Cumming and Joseph S. Steinberg (filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003 (the "2003 10-K")).
Leucadia National Corporation 2003 Senior Executive Annual Incentive Bonus Plan (filed as Annex A to the Company's Proxy Statement dated April 17, 2003 (the "2003 Proxy Statement")).
Employment Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming (filed as Exhibit 10.17 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993 (the "1993 10-K")).
Amendment, dated as of May 5, 1999, to the Employment Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming (filed as Exhibit 10.19 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001 (the "2001 10-K")).
Employment Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg (filed as Exhibit 10.18 to the 1993 10-K).
Amendment, dated as of May 5, 1999, to the Employment Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg (filed as Exhibit 10.21 to the 2001 10-K).
Deferred Compensation Agreement between the Company and Thomas E. Mara dated as of December 20, 2001 (filed as Exhibit 10.28 to the 2001 10-K).
(b) Exhibits.
We will furnish any exhibit upon request made to our Corporate Secretary, 315 Park Avenue South, New York, NY 10010. We charge $.50 per page to cover expenses of copying and mailing.
3.1 Restated Certificate of Incorporation (filed as Exhibit 5.1 to the Company's Current Report on Form 8-K dated July 14, 1993).*
3.2 Certificate of Amendment of the Certificate of Incorporation dated as of May 14, 2002 (filed as Exhibit 3.2 to the 2003 10-K).*
3.3 Certificate of Amendment of the Certificate of Incorporation dated as of December 23, 2002 (filed as Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2002 (the "2002 10-K")).*
3.4 Amended and Restated By-laws as amended through March 9, 2004 (filed as Exhibit 3.4 to the 2003 10-K).*
3.5 Certificate of Amendment of the Certificate of Incorporation dated as of May 13, 2004.
4.1 The Company undertakes to furnish the Securities and Exchange Commission, upon written request, a copy of all instruments with respect to long-term debt not filed herewith.
10.1 1999 Stock Option Plan (filed as Annex A to the 1999 Proxy Statement).*
10.2 Articles and Agreement of General Partnership, effective as of April 15, 1985, of Jordan/Zalaznick Capital Company (filed as Exhibit 10.20 to the Company's Registration Statement No. 33-00606).*
10.3(a) Fiber Lease Agreement, dated April 26, 2002, between Williams Communications, LLC ("WCL") and Metromedia Fiber National Network, Inc. ("MFNN") (filed as Exhibit 10.48 to WilTel's Annual Report on Form 10-K for the fiscal year ended December 31, 2002 (the "WilTel 10-K")).*
10.3(b) First Amendment, dated October 10, 2002, to Fiber Lease Agreement, dated April 26, 2002, among WCL, MFNN and Metromedia Fiber Network Services, Inc. ("MFNS") (filed as Exhibit 10.3(b) to the Company's Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003 (the "2003 10-K/A")).*
10.3(c) Second Amendment, dated February 14, 2003, to Fiber Lease Agreement, dated April 26, 2002, among WCL, MFNN and MFNS (filed as Exhibit 10.48 to the WilTel 10-K).*
10.3(d) Colocation and Maintenance Agreement, dated April 26, 2002, between WCL and MFNN (filed as Exhibit 10.48 to the WilTel 10-K).*
10.3(e) First Amendment, dated October 10, 2002, to Colocation and Maintenance Agreement, dated April 26, 2002, among WCL, MFNN and MFNS (filed as Exhibit 10.48 to the WilTel 10-K).*
10.3(f) Second Amendment, dated February 14, 2003, to Colocation and Maintenance Agreement, dated April 26, 2002, among WCL, MFNN and MFNS (filed as Exhibit 10.48 to the WilTel 10-K).*
10.4 Form of Grant Letter for the 1999 Stock Option Plan.
10.5 Amended and Restated Shareholders Agreement dated as of June 30, 2003 among the Company, Ian M. Cumming and Joseph S. Steinberg (filed as Exhibit 10.5 to the 2003 10-K).*
10.6 Form of Amended and Restated Revolving Credit Agreement (the "Revolving Credit Agreement") dated as of March 11, 2003 between the Company, Fleet National Bank as Administrative Agent, The Chase Manhattan Bank, as Syndication Agent, and the Banks signatory thereto, with Fleet Boston Robertson Stephens, Inc., as Arranger (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2003).*
10.7 Amendment, dated as of March 31, 2004, to the Revolving Credit Agreement.
10.8 Amendment, dated as of June 29, 2004, to the Revolving Credit Agreement.
10.9 Leucadia National Corporation 2003 Senior Executive Annual Incentive Bonus Plan (filed as Annex A to the 2003 Proxy Statement).*
10.10 Employment Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming (filed as Exhibit 10.17 to the Company's 1993 10-K).*
10.11 Amendment, dated as of May 5, 1999, to the Employment Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming (filed as Exhibit 10.19 to the 2001 10-K).*
10.12 Employment Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg (filed as Exhibit 10.18 to the 1993 10-K).*
10.13 Amendment, dated as of May 5, 1999, to the Employment Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg (filed as Exhibit 10.21 to the 2001 10-K).*
10.14 Management Services Agreement dated as of February 26, 2001 among The FINOVA Group Inc., the Company and Leucadia International Corporation (filed as Exhibit 10.20 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000).*
10.15 Voting Agreement, dated August 21, 2001, by and among Berkadia LLC, Berkshire Hathaway Inc., the Company and The FINOVA Group Inc. (filed as Exhibit 10.J to the Company's Current Report on Form 8-K dated August 27, 2001).*
10.16 Deferred Compensation Agreement between the Company and Thomas E. Mara dated as of December 20, 2001 (filed as Exhibit 10.28 to the 2001 10-K).*
10.17 Settlement Agreement dated as of July 26, 2002, by and among The Williams Companies Inc. ("TWC"), Williams Communications Group, Inc. ("WCG"), CG Austria, Inc., the official committee of unsecured creditors and the Company (filed as Exhibit 99.2 to the Current Report on Form 8-K of WCG dated July 31, 2002 (the "WCG July 31, 2002 8-K")).*
10.18 Investment Agreement, dated as of July 26, 2002, by and among the Company, WCG and, for purposes of Section 7.4 only, WCL (filed as Exhibit 99.4 to the WCG July 31, 2002 8-K).*
10.19 First Amendment, made as of September 30, 2002, to the Investment Agreement, dated as of July 26, 2002, by and among the Company, WCG and WCL (filed as Exhibit 99.4 to the Current Report on Form 8-K of WCG dated October 24, 2002 (the "WilTel October 24, 2002 8-K")).*
10.20 Second Amendment, made as of October 15, 2002, to the Investment Agreement, dated as of July 26, 2002, as amended on September 30, 2002, by and among the Company, WCG and WCL (filed as Exhibit 99.5 to the WilTel October 24, 2002 8-K).*
10.21 Purchase and Sale Agreement, dated as of July 26, 2002, by and between TWC and the Company (filed as Exhibit 99.5 to the Company's Current Report on Form 8-K dated July 31, 2002).*
10.22 Amendment, made as of October 15, 2002, to the Purchase and Sale Agreement, dated as of July 26, 2002, by and among the Company and TWC (filed as Exhibit 99.2 to the WilTel October 24, 2002 8-K).*
10.23 Escrow Agreement, dated as of October 15, 2002, among the Company, TWC, WilTel and The Bank of New York, as Escrow Agent (filed as Exhibit 99.3 to the WilTel October 24, 2002 8-K).*
10.24 Share Purchase Agreement, dated April 17, 2002 between LUK Fidei L.L.C. and Hampton Trust PLC (filed as Exhibit 10.37 to the 2002 10-K).*
10.25 Reiterative Share Purchase Agreement, dated June 4, 2002, among Savits AB Private, Hampton Trust Holding (Europe) SA, John C. Jones and Herald Century Consolidated SA (filed as Exhibit 10.38 to the 2002 10-K).*
10.26 Agreement and Plan of Merger, dated August 21, 2003, among the Company, Wrangler Acquisition Corp. and WilTel (filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated August 22, 2003).*
10.27 Stock Purchase Agreement, dated as of October 21, 2002, between HomeFed Corporation ("HomeFed") and the Company (filed as Exhibit 10.1 to the Current Report on Form 8-K of HomeFed dated October 22, 2002).*
10.28 Second Amended and Restated Berkadia LLC Operating Agreement, dated December 2, 2002, by and among BH Finance LLC and WMAC Investment Corporation (filed as Exhibit 10.40 to the 2002 10-K).*
10.29 Subscription Agreement made and entered into as of December 23, 2002 by and among the Company and each of the entities named in Schedule I thereto (filed as Exhibit 10.41 to the 2002 10-K).*
10.30 Amended and Restated Alliance Agreement between Telefonos de Mexico, S.A. de C.V. and Williams Communications, Inc., dated May 25, 1999 (filed as Exhibit 10.2 to WCG's Equity Registration Statement, Amendment No. 8, dated September 29, 1999).*
10.31 Master Alliance Agreement between SBC Communications Inc. and Williams Communications, Inc. dated February 8, 1999 (filed as Exhibit 10.10 to WCG's Equity Registration Statement, Amendment No. 1, dated May 27, 1999).*
10.32 Transport Services Agreement dated February 8, 1999, between Southwestern Bell Communication Services, Inc. and Williams Communications, Inc. (filed as Exhibit 10.11 to WCG's Equity Registration Statement, Amendment No. 1, dated May 27, 1999).*
10.33 Copy of WCG's April 22, 2002, agreement with principal creditor group (filed as Exhibit 10.1 to WCG's Current Report on Form 8-K dated April 22, 2002 (the "WCG April 22, 2002 8-K")).*
10.34 Copy of WCG's agreement with TWC (filed as Exhibit 10.2 to the WCG April 22, 2002 8-K). *
10.35 First Amended Joint Chapter 11 Plan of Reorganization of WCG and CG Austria, filed with the Bankruptcy Court as Exhibit 1 to the Settlement Agreement (filed as Exhibit 99.3 to the WCG July 31, 2002 8-K).*
10.36 Real Property Purchase and Sale Agreement among WilTel, Williams Headquarters Building Company, Williams Technology Center, LLC, WCL, and Williams Aircraft Leasing, LLC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 4 to the Settlement Agreement (filed as Exhibit 99.6 to the WCG July 31, 2002 8-K).*
10.37 List of TWC Continuing Contracts, filed with the Bankruptcy Court as Exhibit 5 to the Settlement Agreement (filed as Exhibit 99.7 to the WCG July 31, 2002 8-K).*
10.38 Agreement for the Resolution of Continuing Contract Disputes among WCG, WCL and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 6 to the Settlement Agreement (filed as Exhibit 99.8 to the WCG July 31, 2002 8-K).*
10.39 Tax Cooperation Agreement between WCG and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 7 to the Settlement Agreement (filed as Exhibit 99.9 to the WCG July 31, 2002 8-K).*
10.40 Amendment to Trademark License Agreement between WCG and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit to the Settlement Agreement (filed as Exhibit 99.10 to the WCG July 31, 2002 8-K).*
10.41 Assignment of Rights between Williams Information Services Corporation and WCL, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 9 to the Settlement Agreement (filed as Exhibit 99.11 to the WCG July 31, 2002 8-K).*
10.42 Guaranty Indemnification Agreement between WCG and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 10 to the Settlement Agreement (filed as Exhibit 99.12 to the WCG July 31, 2002 8-K).*
10.43 Declaration of Trust, dated as of October 15, 2002, by and among WCG, WilTel and the Residual Trustee (filed as Exhibit 99.1 to the WilTel October 24, 2002 8-K).*
10.44 Amendment No. 1, dated as of October 15, 2002, to the Real Property Purchase and Sale Agreement, dated as of July 26, 2002, among Williams Headquarters Building Company, WTC, WCL, WCG and Williams Communications Aircraft, LLC (filed as Exhibit 99.15 to the WilTel October 24, 2002 8-K).*
10.45 Pledge Agreement dated as of October 15, 2002, by CG Austria, Inc., as pledgor, to Williams Headquarters Building Company, as pledgee (filed as Exhibit 10.42 to the WilTel 10-K).*
10.46 First Amendment to Master Alliance Agreement between SBC Communications Inc. and Williams Communications, Inc., by and between SBC Communications Inc. and WCL, effective as of September 23, 2002 (filed as Exhibit 10.43 to the WilTel 10-K).*
10.47 First Amendment to Transport Services Agreement among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and Williams Communications, Inc., by and among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and Williams Communications, Inc., dated September 29, 2000 (filed as Exhibit 10.44 to the WilTel 10-K).*
10.48 Second Amendment to Transport Services Agreement, as amended by Amendment No. 1 dated September 29, 2000, by and among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and WCL, effective as of June 25, 2001 (filed as Exhibit 10.45 to the WilTel 10-K).*
10.49 Third Amendment to Transport Services Agreement, as amended by Amendment No. 1 dated September 20, 2000, and Amendment No. 2 dated June 25, 2001, by and among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and WCL, effective as of September 23, 2002 (filed as Exhibit 10.46 to the WilTel 10-K).*
10.50(a) Fiber Lease Agreement, dated April 26, 2002, between Metromedia Fiber Network Services, Inc. ("MFNS") and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(b) First Amendment, dated October 10, 2002, to Fiber Lease Agreement, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.55(b) to the 2003 10-K/A).*
10.50(c) Colocation and Maintenance Agreement, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(d) First Amendment, dated October 10, 2002, to Colocation and Maintenance Agreement, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(e) Lease Agreement #2, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(f) First Amendment, dated October 10, 2002, to Lease Agreement #2, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.55(f) to the 2003 10-K/A).*
10.51 Amendment No. 2 to Master Alliance Agreement and Amendment No. 4 to Transport Services Agreement, dated December 31, 2003, amending the (a) Master Alliance Agreement, effective as of February 8, 1999, as amended by Amendment No. 1 effective September 23, 2002, by and between WCL, and SBC Communications Inc. and (b) Transport Services Agreement, effective as of February 8, 1999, as amended by Amendment No. 1 dated as of September 29, 2000, Amendment No. 2 and Amendment No. 3 dated as of September 23, 2002 by and among WCL, SBC Operations, Inc., and Southwestern Bell Communications Services Inc. (filed as Exhibit 10.56 to the 2003 10-K/A).*
10.52 Third Amended and Restated Credit And Guaranty Agreement, dated as of September 8, 1999, as amended and restated as of April 25, 2001, as further amended and restated as of October 15, 2002, and as further amended and restated as of September 24, 2004, among WilTel, WilTel Communications, LLC, certain of its domestic subsidiaries, as loan parties, the several banks and other financial institutions or entities from time to time parties thereto as lenders, Credit Suisse First Boston, acting through its Cayman Islands branch, as administrative agent, as first lien administrative agent and as second lien administrative agent, and Wells Fargo Foothill, LLC, as syndication agent (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated September 24, 2002 (the "Company's September 24, 2002 8-K")).*
10.53 Second Amended and Restated Security Agreement, dated as of April 23, 2001, as amended and restated as of October 15, 2002, and as further amended and restated as of September 24, 2004, among WilTel, WilTel Communications, LLC, and the additional grantors party thereto in favor of Credit Suisse First Boston, acting through its Cayman Islands branch, as administrative agent, as first lien administrative agent and as second lien administrative agent (filed as Exhibit 99.2 to the Company's September 24, 2002 8-K).*
10.54 Exhibit 1 to the Agreement and Plan of Reorganization between the Company and TLC Associates, dated February 23, 1989 (filed as Exhibit 3 to Amendment No. 12 to the Schedule 13D dated December 29, 2004 of Ian M. Cumming and Joseph S. Steinberg with respect to the Company).*
10.55 Letter Agreement, dated February 3, 2005, between the Company and Jefferies & Company, Inc.
21 Subsidiaries of the registrant.
23.1 Consent of PricewaterhouseCoopers LLP with respect to the incorporation by reference into the Company's Registration Statement on Form S-8 (File No. 2-84303), Form S-8 and S-3 (File No. 33-6054), Form S-8 and S-3 (File No. 33-26434), Form S-8 and S-3 (File No. 33-30277), Form S-8 (File No. 33-61682), Form S-8 (File No. 33-61718), Form S-8 (File No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).
23.2 Consent of PricewaterhouseCoopers, with respect to the inclusion in this Annual Report on Form 10-K the financial statements of Olympus Re Holdings, Ltd. and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).
23.3 Consent of independent auditors from Ernst & Young LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of Berkadia LLC and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).**
23.4 Consent of independent auditors from Ernst & Young LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of The FINOVA Group Inc. and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No.333-122047).**
23.5 Consent of independent auditors from BDO Seidman, LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of EagleRock Capital Partners (QP), LP and EagleRock Master Fund, LP and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).
23.6 Consent of independent auditors from Ernst & Young LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of WilTel Communications Group, Inc. and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333- 122047).
31.1 Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of President pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.3 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ***
32.2 Certification of President pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***
32.3 Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ***
(c) Financial statement schedules.
(1) Berkadia LLC financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002. **
(2) Olympus Re Holdings, Ltd. consolidated financial statements as of December 31, 2004 and 2003 for the years ended December 31, 2004, 2003 and 2002.
(3) The FINOVA Group Inc. and subsidiaries consolidated financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002.**
(4) EagleRock Capital Partners (QP), LP financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002 and EagleRock Master Fund, LP financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004 and 2003 and for the period from May 1, 2002 (commencement of operations) to December 31, 2002.
(5) WilTel Communications Group, Inc. consolidated financial statements as of November 5, 2003 (Successor Company), and for the periods from January 1, 2003 through November 5, 2003, and November 1, 2002 through December 31, 2002 (Successor Company) and the periods January 1, 2002 through October 31, 2002 (Predecessor Company).
-----------------------------
* Incorporated by reference.
** To be filed by amendment pursuant to Item 3 - 09(b) of Regulation S-X.
*** Furnished herewith pursuant to item 601(b) (32) of Regulation S-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.
LEUCADIA NATIONAL CORPORATION
March 14, 2005 By: /s/ Barbara L. Lowenthal ----------------------------- Barbara L. Lowenthal Vice President and Comptroller
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 indicated, on the date set forth above.
Signature Title --------- -----
/s/ Ian M. Cumming Chairman of the Board - ------------------------------------- (Principal Executive Officer) Ian M. Cumming
/s/ Joseph S. Steinberg President and Director - ------------------------------------- (Principal Executive Officer) Joseph S. Steinberg
/s/ Joseph A. Orlando Vice President and Chief - ------------------------------------- Financial Officer Joseph A. Orlando (Principal Financial Officer)
/s/ Barbara L. Lowenthal Vice President and Comptroller - ------------------------------------- (Principal Accounting Officer) Barbara L. Lowenthal
/s/ Paul M. Dougan Director - ------------------------------------- Paul M. Dougan
/s/ Lawrence D. Glaubinger Director - ------------------------------------- Lawrence D. Glaubinger
/s/ Alan J. Hirschfield Director - ------------------------------------- Alan J. Hirschfield
/s/ James E. Jordan Director - ------------------------------------- James E. Jordan
/s/ Jeffrey C. Keil Director - ------------------------------------- Jeffrey C. Keil
/s/ Jesse Clyde Nichols, III Director ------------------------------------ Jesse Clyde Nichols, III
EXHIBIT INDEX
3.1 Restated Certificate of Incorporation (filed as Exhibit 5.1 to the Company's Current Report on Form 8-K dated July 14, 1993).*
3.2 Certificate of Amendment of the Certificate of Incorporation dated as of May 14, 2002 (filed as Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003 (the "2003 10-K")).*
3.3 Certificate of Amendment of the Certificate of Incorporation dated as of December 23, 2002 (filed as Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2002 (the "2002 10-K")).*
3.4 Amended and Restated By-laws as amended through March 9, 2004 (filed as Exhibit 3.4 to the 2003 10-K).*
3.5 Certificate of Amendment of the Certificate of Incorporation dated as of May 13, 2004.
4.1 The Company undertakes to furnish the Securities and Exchange Commission, upon written request, a copy of all instruments with respect to long-term debt not filed herewith.
10.1 1999 Stock Option Plan (filed as Annex A to the Company's Proxy Statement dated April 9, 1999 (the "1999 Proxy Statement")).*
10.2 Articles and Agreement of General Partnership, effective as of April 15, 1985, of Jordan/Zalaznick Capital Company (filed as Exhibit 10.20 to the Company's Registration Statement No. 33-00606).*
10.3(a) Fiber Lease Agreement, dated April 26, 2002, between Williams Communications, LLC ("WCL") and Metromedia Fiber National Network, Inc. ("MFNN") (filed as Exhibit 10.48 to WilTel's Annual Report on Form 10-K for the fiscal year ended December 31, 2002 (the "WilTel 10-K")).*
10.3(b) First Amendment, dated October 10, 2002, to Fiber Lease Agreement, dated April 26, 2002, among WCL, MFNN and Metromedia Fiber Network Services, Inc. ("MFNS") (filed as Exhibit 10.3(b) to the Company's Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003 (the "2003 10-K/A")).*
10.3(c) Second Amendment, dated February 14, 2003, to Fiber Lease Agreement, dated April 26, 2002, among WCL, MFNN and MFNS (filed as Exhibit 10.48 to the WilTel 10-K).*
10.3(d) Colocation and Maintenance Agreement, dated April 26, 2002, between WCL and MFNN (filed as Exhibit 10.48 to the WilTel 10-K).*
10.3(e) First Amendment, dated October 10, 2002, to Colocation and Maintenance Agreement, dated April 26, 2002, among WCL, MFNN and MFNS (filed as Exhibit 10.48 to the WilTel 10-K).*
10.3(f) Second Amendment, dated February 14, 2003, to Colocation and Maintenance Agreement, dated April 26, 2002, among WCL, MFNN and MFNS (filed as Exhibit 10.48 to the WilTel 10-K).*
10.4 Form of Grant Letter for the 1999 Stock Option Plan.
10.5 Amended and Restated Shareholders Agreement dated as of June 30, 2003 among the Company, Ian M. Cumming and Joseph S. Steinberg (filed as Exhibit 10.5 to the 2003 10-K).*
10.6 Form of Amended and Restated Revolving Credit Agreement (the "Revolving Credit Agreement") dated as of March 11, 2003 between the Company, Fleet National Bank as Administrative Agent, The Chase Manhattan Bank, as Syndication Agent, and the Banks signatory thereto, with Fleet Boston Robertson Stephens, Inc., as Arranger (filed as Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2003).*
10.7 Amendment, dated as of March 31, 2004, to the Revolving Credit Agreement.
10.8 Amendment, dated as of June 29, 2004, to the Revolving Credit Agreement.
10.9 Leucadia National Corporation 2003 Senior Executive Annual Incentive Bonus Plan (filed as Annex A to the Company's Proxy Statement dated April 17, 2003).*
10.10 Employment Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming (filed as Exhibit 10.17 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993 (the "1993 10-K")).*
10.11 Amendment, dated as of May 5, 1999, to the Employment Agreement made as of December 28, 1993 by and between the Company and Ian M. Cumming (filed as Exhibit 10.19 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001 (the "2001 10-K")).*
10.12 Employment Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg (filed as Exhibit 10.18 to the 1993 10-K).*
10.13 Amendment, dated as of May 5, 1999, to the Employment Agreement made as of December 28, 1993 by and between the Company and Joseph S. Steinberg (filed as Exhibit 10.21 to the 2001 10-K).*
10.14 Management Services Agreement dated as of February 26, 2001 among The FINOVA Group Inc., the Company and Leucadia International Corporation (filed as Exhibit 10.20 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000).*
10.15 Voting Agreement, dated August 21, 2001, by and among Berkadia LLC, Berkshire Hathaway Inc., the Company and The FINOVA Group Inc. (filed as Exhibit 10.J to the Company's Current Report on Form 8-K dated August 27, 2001).*
10.16 Deferred Compensation Agreement between the Company and Thomas E. Mara dated as of December 20, 2001 (filed as Exhibit 10.28 to the 2001 10-K).*
10.17 Settlement Agreement dated as of July 26, 2002, by and among The Williams Companies Inc. ("TWC"), Williams Communications Group, Inc. ("WCG"), CG Austria, Inc., the official committee of unsecured creditors and the Company (filed as Exhibit 99.2 to the Current Report on Form 8-K of WCG dated July 31, 2002 (the "WCG July 31, 2002 8-K")).*
10.18 Investment Agreement, dated as of July 26, 2002, by and among the Company, WCG and, for purposes of Section 7.4 only, WCL (filed as Exhibit 99.4 to the WCG July 31, 2002 8-K).*
10.19 First Amendment, made as of September 30, 2002, to the Investment Agreement, dated as of July 26, 2002, by and among the Company, WCG and WCL (filed as Exhibit 99.4 to the Current Report on Form 8-K of WCG dated October 24, 2002 (the "WilTel October 24, 2002 8-K")).*
10.20 Second Amendment, made as of October 15, 2002, to the Investment Agreement, dated as of July 26, 2002, as amended on September 30, 2002, by and among the Company, WCG and WCL (filed as Exhibit 99.5 to the WilTel October 24, 2002 8-K).*
10.21 Purchase and Sale Agreement, dated as of July 26, 2002, by and between TWC and the Company (filed as Exhibit 99.5 to the Company's Current Report on Form 8-K dated July 31, 2002).*
10.22 Amendment, made as of October 15, 2002, to the Purchase and Sale Agreement, dated as of July 26, 2002, by and among the Company and TWC (filed as Exhibit 99.2 to the WilTel October 24, 2002 8-K).*
10.23 Escrow Agreement, dated as of October 15, 2002, among the Company, TWC, WilTel and The Bank of New York, as Escrow Agent (filed as Exhibit 99.3 to the WilTel October 24, 2002 8-K).*
10.24 Share Purchase Agreement, dated April 17, 2002 between LUK Fidei L.L.C. and Hampton Trust PLC (filed as Exhibit 10.37 to the 2002 10-K).*
10.25 Reiterative Share Purchase Agreement, dated June 4, 2002, among Savits AB Private, Hampton Trust Holding (Europe) SA, John C. Jones and Herald Century Consolidated SA (filed as Exhibit 10.38 to the 2002 10-K).*
10.26 Agreement and Plan of Merger, dated August 21, 2003, among the Company, Wrangler Acquisition Corp. and WilTel (filed as Exhibit 2.1 to the Company's Current Report on Form 8-K dated August 22, 2003).*
10.27 Stock Purchase Agreement, dated as of October 21, 2002, between HomeFed Corporation ("HomeFed") and the Company (filed as Exhibit 10.1 to the Current Report on Form 8-K of HomeFed dated October 22, 2002).*
10.28 Second Amended and Restated Berkadia LLC Operating Agreement, dated December 2, 2002, by and among BH Finance LLC and WMAC Investment Corporation (filed as Exhibit 10.40 to the 2002 10-K).*
10.29 Subscription Agreement made and entered into as of December 23, 2002 by and among the Company and each of the entities named in Schedule I thereto (filed as Exhibit 10.41 to the 2002 10-K).*
10.30 Amended and Restated Alliance Agreement between Telefonos de Mexico, S.A. de C.V. and Williams Communications, Inc., dated May 25, 1999 (filed as Exhibit 10.2 to WCG's Equity Registration Statement, Amendment No. 8, dated September 29, 1999).*
10.31 Master Alliance Agreement between SBC Communications Inc. and Williams Communications, Inc. dated February 8, 1999 (filed as Exhibit 10.10 to WCG's Equity Registration Statement, Amendment No. 1, dated to May 27, 1999).*
10.32 Transport Services Agreement dated February 8, 1999, between Southwestern Bell Communication Services, Inc. and Williams Communications, Inc. (filed as Exhibit 10.11 to WCG's Equity Registration Statement, Amendment No. 1, dated May 27, 1999).*
10.33 Copy of WCG's April 22, 2002, agreement with principal creditor group (filed as Exhibit 10.1 to WCG's Current Report on Form 8-K dated April 22, 2002 (the "WCG April 22, 2002 8-K")).*
10.34 Copy of WCG's agreement with TWC (filed as Exhibit 10.2 to the WCG April 22, 2002 8-K).*
10.35 First Amended Joint Chapter 11 Plan of Reorganization of WCG and CG Austria, filed with the Bankruptcy Court as Exhibit 1 to the Settlement Agreement (filed as Exhibit 99.3 to the WCG July 31, 2002 8-K).*
10.36 Real Property Purchase and Sale Agreement among WilTel, Williams Headquarters Building Company, Williams Technology Center, LLC, WCL, and Williams Aircraft Leasing, LLC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 4 to the Settlement Agreement (filed as Exhibit 99.6 to the WCG July 31, 2002 8-K).*
10.37 List of TWC Continuing Contracts, filed with the Bankruptcy Court as Exhibit 5 to the Settlement Agreement (filed as Exhibit 99.7 to the WCG July 31, 2002 8-K).*
10.38 Agreement for the Resolution of Continuing Contract Disputes among WCG, WCL and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 6 to the Settlement Agreement (filed as Exhibit 99.8 to the WCG July 31, 2002 8-K).*
10.39 Tax Cooperation Agreement between WCG and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 7 to the Settlement Agreement (filed as Exhibit 99.9 to the WCG July 31, 2002 8-K).*
10.40 Amendment to Trademark License Agreement between WCG and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit to the Settlement Agreement (filed as Exhibit 99.10 to the WCG July 31, 2002 8-K).*
10.41 Assignment of Rights between Williams Information Services Corporation and WCL, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 9 to the Settlement Agreement (filed as Exhibit 99.11 to the WCG July 31, 2002 8-K).*
10.42 Guaranty Indemnification Agreement between WCG and TWC, dated July 26, 2002, filed with the Bankruptcy Court as Exhibit 10 to the Settlement Agreement (filed as Exhibit 99.12 to the WCG July 31, 2002 8-K).*
10.43 Declaration of Trust, dated as of October 15, 2002, by and among WCG, WilTel and the Residual Trustee (filed as Exhibit 99.1 to WilTel's Current Report on Form 8-K dated October 24, 2002 (the "WilTel October 24, 2002 8-K")).*
10.44 Amendment No. 1, dated as of October 15, 2002, to the Real Property Purchase and Sale Agreement, dated as of July 26, 2002, among Williams Headquarters Building Company, WTC, WCL, WCG and Williams Communications Aircraft, LLC (filed as Exhibit 99.15 to the WilTel October 24, 2002 8-K).*
10.45 Pledge Agreement dated as of October 15, 2002, by CG Austria, Inc., as pledgor, to Williams Headquarters Building Company, as pledgee (filed as Exhibit 10.42 to the WilTel 10-K).*
10.46 First Amendment to Master Alliance Agreement between SBC Communications Inc. and Williams Communications, Inc., by and between SBC Communications Inc. and WCL, effective as of September 23, 2002 (filed as Exhibit 10.43 to the WilTel 10-K).*
10.47 First Amendment to Transport Services Agreement among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and Williams Communications, Inc., by and among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and Williams Communications, Inc., dated September 29, 2000 (filed as Exhibit 10.44 to the WilTel 10-K).*
10.48 Second Amendment to Transport Services Agreement, as amended by Amendment No. 1 dated September 29, 2000, by and among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and WCL, effective as of June 25, 2001 (filed as Exhibit 10.45 to the WilTel 10-K).*
10.49 Third Amendment to Transport Services Agreement, as amended by Amendment No. 1 dated September 20, 2000, and Amendment No. 2 dated June 25, 2001, by and among Southwestern Bell Communications Services Inc., SBC Operations, Inc. and WCL, effective as of September 23, 2002 (filed as Exhibit 10.46 to the WilTel 10-K).*
10.50(a) Fiber Lease Agreement, dated April 26, 2002, between Metromedia Fiber Network Services, Inc. ("MFNS") and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(b) First Amendment, dated October 10, 2002, to Fiber Lease Agreement, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.55(b) to the 2003 10-K/A).*
10.50(c) Colocation and Maintenance Agreement, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(d) First Amendment, dated October 10, 2002, to Colocation and Maintenance Agreement, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(e) Lease Agreement #2, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.47 to the WilTel 10-K).*
10.50(f) First Amendment, dated October 10, 2002, to Lease Agreement #2, dated April 26, 2002, between MFNS and WCL (filed as Exhibit 10.55(f) to the 2003 10-K/A).*
10.51 Amendment No. 2 to Master Alliance Agreement and Amendment No. 4 to Transport Services Agreement, dated December 31, 2003, amending the (a) Master Alliance Agreement, effective as of February 8, 1999, as amended by Amendment No. 1 effective September 23, 2002, by and between WCL, and SBC Communications Inc. and (b) Transport Services Agreement, effective as of February 8, 1999, as amended by Amendment No. 1 dated as of September 29, 2000, Amendment No. 2 and Amendment No. 3 dated as of September 23, 2002 by and among WCL, SBC Operations, Inc., and Southwestern Bell Communications Services Inc. (filed as Exhibit 10.56 to the 2003 10-K/A).*
10.52 Third Amended and Restated Credit And Guaranty Agreement, dated as of September 8, 1999, as amended and restated as of April 25, 2001, as further amended and restated as of October 15, 2002, and as further amended and restated as of September 24, 2004, among WilTel, WilTel Communications, LLC, certain of its domestic subsidiaries, as loan parties, the several banks and other financial institutions or entities from time to time parties thereto as lenders, Credit Suisse First Boston, acting through its Cayman Islands branch, as administrative agent, as first lien administrative agent and as second lien administrative agent, and Wells Fargo Foothill, LLC, as syndication agent (filed as Exhibit 99.1 to the Company's Current Report on Form 8-K dated September 24, 2002 (the "Company's September 24, 2002 8-K")).*
10.53 Second Amended and Restated Security Agreement, dated as of April 23, 2001, as amended and restated as of October 15, 2002, and as further amended and restated as of September 24, 2004, among WilTel, WilTel Communications, LLC, and the additional grantors party thereto in favor of Credit Suisse First Boston, acting through its Cayman Islands branch, as administrative agent, as first lien administrative agent and as second lien administrative agent (filed as Exhibit 99.2 to the Company's September 24, 2002 8-K).*
10.54 Exhibit 1 to the Agreement and Plan of Reorganization between the Company and TLC Associates, dated February 23, 1989 (filed as Exhibit 3 to Amendment No. 12 to the Schedule 13D dated December 29, 2004 of Ian M. Cumming and Joseph S. Steinberg with respect to the Company).*
10.55 Letter Agreement, dated February 3, 2005, between the Company and Jefferies & Company, Inc.
21 Subsidiaries of the registrant.
23.1 Consent of PricewaterhouseCoopers LLP with respect to the incorporation by reference into the Company's Registration Statement on Form S-8 (File No. 2-84303), Form S-8 and S-3 (File No. 33-6054), Form S-8 and S-3 (File No. 33-26434), Form S-8 and S-3 (File No. 33-30277), Form S-8 (File No. 33-61682), Form S-8 (File No. 33-61718), Form S-8 (File No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No.333-122047).
23.2 Consent of PricewaterhouseCoopers, with respect to the inclusion in this Annual Report on Form 10-K the financial statements of Olympus Re Holdings, Ltd. and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No.333-122047).
23.3 Consent of independent auditors from Ernst & Young LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of Berkadia LLC and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).**
23.4 Consent of independent auditors from Ernst & Young LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of The FINOVA Group Inc. and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).**
23.5 Consent of independent auditors from BDO Seidman, LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of EagleRock Capital Partners (QP), LP and EagleRock Master Fund, LP and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).
23.6 Consent of independent auditors from Ernst & Young LLP with respect to the inclusion in this Annual Report on Form 10-K of the financial statements of WilTel Communications Group, Inc. and with respect to the incorporation by reference in the Company's Registration Statements on Form S-8 (No. 2-84303), Form S-8 and S-3 (No. 33-6054), Form S-8 and S-3 (No. 33-26434), Form S-8 and S-3 (No. 33-30277), Form S-8 (No. 33-61682), Form S-8 (No. 33-61718), Form S-8 (No. 333-51494), Form S-3 (File No. 333-118102) and Form S-3 (File No. 333-122047).
31.1 Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of President pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.3 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chairman of the Board and Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***
32.2 Certification of President pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***
32.3 Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***
(c) Financial statement schedules.
(1) Berkadia LLC financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002. **
(2) Olympus Re Holdings, Ltd. consolidated financial statements as of December 31, 2004 and 2003 for the years ended December 31, 2004, 2003 and 2002.
(3) The FINOVA Group Inc. and subsidiaries consolidated financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002.**
(4) EagleRock Capital Partners (QP), LP financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002 and EagleRock Master Fund, LP financial statements as of December 31, 2004 and 2003 and for the years ended December 31, 2004 and 2003 and for the period from May 1, 2002 (commencement of operations) to December 31, 2002.
(5) WilTel Communications Group, Inc. consolidated financial statements as of November 5, 2003 (Successor Company), and for the periods from January 1, 2003 through November 5, 2003, and November 1, 2002 through December 31, 2002 (Successor Company) and the periods January 1, 2002 through October 31, 2002 (Predecessor Company).
-----------------------------
* Incorporated by reference.
** To be filed by amendment pursuant to Item 3 - 09(b) of Regulation S-X.
*** Furnished herewith pursuant to item 601(b) (32) of Regulation S-K.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM -------------------------------------------------------
To the Board of Directors and Shareholders of Leucadia National Corporation:
We have completed an integrated audit of Leucadia National Corporation's 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements and financial statement schedules - -------------------------------------------------------------------
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Leucadia National Corporation and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We did not audit the financial statements of WilTel for the period from January 1, 2003 through November 5, 2003. For this period, WilTel was accounted for on the equity method and from January 1, 2003 through November 5, 2003 had a net loss of approximately $109,000,000, of which the Company's 47.4% share was approximately $52,000,000. Those statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for WilTel, is based on the report of other auditors. We conducted our audits of these statements 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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Internal control over financial reporting - -----------------------------------------
Also, in our opinion, management's assessment, included in "Management's Report on Internal Control Over Financial Reporting", in Part II, Item 9A of this Report, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting 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. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed 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 (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) 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 (iii) 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 its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PricewaterhouseCoopers LLP New York, New York March 11, 2005
LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2004 and 2003 (Dollars in thousands, except par value)
The accompanying notes are an integral part of these consolidated financial statements.
LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the years ended December 31, 2004, 2003 and 2002 (In thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 2004, 2003 and 2002 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, continued For the years ended December 31, 2004, 2003 and 2002 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended December 31, 2004, 2003 and 2002 (In thousands, except par value and per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Operations: --------------------
The Company is a diversified holding company engaged in a variety of businesses, including telecommunications, healthcare services, manufacturing, banking and lending, real estate activities, winery operations, and property and casualty reinsurance, principally in markets in the United States, and development of a copper mine in Spain. The Company continuously evaluates the retention and disposition of its existing operations and frequently investigates the acquisition of new businesses. Changes in the mix of the Company's owned businesses and investments should be expected.
The Company's telecommunications operations are conducted through WilTel Communications Group, Inc. ("WilTel"), which owns or leases and operates a nationwide inter-city fiber-optic network providing Internet, data, voice and video services to companies that use high-capacity and high-speed telecommunications in their businesses. WilTel has also built a fiber-optic network within certain cities in the U.S. and has the ability to connect to networks outside the U.S. WilTel operates in two segments, Network and Vyvx.
The Company's healthcare services operations primarily provide contract therapy, long-term care consulting and temporary staffing to skilled nursing facilities, hospitals, sub-acute care centers, assisted living facilities, schools, and other healthcare providers. Healthcare services are provided by subsidiaries of Symphony Health Services, LLC ("Symphony").
The Company's manufacturing operations manufacture and market lightweight plastic netting used for a variety of purposes including, among other things, building and construction, erosion control, agriculture, packaging, carpet padding, filtration and consumer products. In addition to its domestic operations, the manufacturing segment owns and operates a manufacturing and sales facility in Belgium.
The Company's banking and lending operations have historically consisted of making collateralized instalment loans primarily funded by customer banking deposits to individuals who had difficulty obtaining credit. However, as a result of increased loss experience and declining profitability, the Company has ceased originating all loans. The segment's current operating activities are concentrated on maximizing returns on its investment portfolio, collecting and servicing its remaining loan portfolio and discharging deposit liabilities as they come due. The Company's banking and lending subsidiary intends to ultimately surrender its national bank charter.
The Company's domestic real estate operations include a mixture of commercial properties, residential land development projects and other unimproved land, all in various stages of development and all available for sale.
The Company's winery operations consist of two wineries, Pine Ridge Winery in Napa Valley, California and Archery Summit in the Willamette Valley of Oregon, which primarily produce and sell wines in the luxury segment of the premium table wine market. The Company's copper mine development operations consist of its 72.1% interest in MK Resources Company ("MK Resources") (formerly MK Gold Company), a public company traded on the NASD OTC Bulletin Board (Symbol: MKRR).
2. Significant Accounting Policies: -------------------------------
(a) Critical Accounting Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States ("GAAP") requires the Company to make estimates and assumptions that affect the reported amounts in the financial statements and disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates all of these estimates and assumptions. The following areas have been identified as critical accounting estimates because they have the potential to have a material impact on the Company's financial statements, and because they are based on assumptions which are used in the accounting records to reflect, at a specific point in time, events whose ultimate outcome won't be known until a later date. Actual results could differ from these estimates.
2. Significant Accounting Policies, continued: --------------------------------
Income Taxes - The Company records a valuation allowance to reduce its deferred taxes to the amount that is more likely than not to be realized. Historically, if the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment would increase income in such period. Similarly, if the Company were to determine that it would not be able to realize all or part of its net deferred taxes in the future, an adjustment would be charged to income in such period. The Company also records reserves for contingent tax liabilities based on the Company's assessment of the probability of successfully sustaining its tax filing positions.
Subsequent to the acquisition of all of the outstanding common stock of WilTel, WilTel became a member of the Company's consolidated tax return. WilTel has significant net operating loss carryforwards (NOLs) and other tax attributes, some of which are available to offset the future taxable income of other members of the Company's consolidated federal tax return. The Company established a valuation allowance that fully reserved for all of WilTel's net deferred tax assets, reduced by an amount equal to the Company's current and deferred federal income tax liabilities as of the date of acquisition (see allocation of the purchase price in Note 3). Before the Company can recognize a net deferred tax asset, it will need to demonstrate that on a pro forma combined basis with WilTel it will have had positive cumulative pre-tax income over a period of years. At that time, any decrease to the valuation allowance will be based significantly upon the Company's assumptions and projections of its future income, which are inherently uncertain.
Impairment of Long-Lived Assets - The Company evaluates its long-lived assets for impairment when events or changes in circumstances indicate, in management's judgment, that the carrying value of such assets may not be recoverable. The determination of whether a long-lived asset (or asset group) is recoverable is based on management's estimate of undiscounted future cash flows attributable to the asset as compared to its carrying value. If the carrying amount of the asset (or asset group) is greater than the undiscounted cash flows, then the carrying amount of the asset is considered to be not recoverable. The amount of the impairment recognized would be determined by estimating the fair value for the asset (or asset group) and recording a provision for the excess of the carrying value over the fair value.
As of December 31, 2004, the carrying amount of the Company's investment in the mineral rights and mining properties of MK Resources was approximately $85,400,000. The recoverability of this asset is entirely dependent upon the success of MK Resource's mining project at the Las Cruces copper deposit in the Pyrite Belt of Spain. Mining will be subject to obtaining required permits, obtaining both debt and equity financing for the project, engineering and construction. In addition, the actual price of copper, the operating cost of the mine and the capital cost (in U.S. dollars) to build the project and bring the mine into production will affect the recoverability of this asset. The Las Cruces project has been granted government subsidies of 47.5 million euros ($62,900,000); however, the grants require MK Resources to make certain capital expenditures by March 27, 2005, a deadline that it will not be able to meet principally because of delays in obtaining permits. Las Cruces has filed a request to further extend the deadline, but has been informed that the government will not act on the extension request prior to the current expiration.
To date, the Company has been the sole source of funding for the Las Cruces project. The amount of equity capital and third party financing that can be obtained for the project and its related cost will be significantly affected by the assessment of potential investors and lenders of the current and expected future market price of copper, as well as current market conditions for this type of investment. During 2004, MK Resources was unsuccessful in raising equity capital for the project, due to unfavorable market conditions at the time. MK Resources continues to explore financing possibilities. Based on the current status of the project, MK Resource's estimate of future cash flows and its assessment of financing possibilities, the Company believes the carrying amount of its investment is recoverable. However, if the Company is unable to obtain the permits required to begin construction of the mine and commence mining activities, is unable to obtain financing for the project or the capital cost of the project changes significantly, it is likely that this investment will be impaired.
2. Significant Accounting Policies, continued: --------------------------------
As of December 31, 2004, the carrying amount of the Company's investment in its manufacturing facility located in Belgium was approximately $17,900,000. The Belgium facility, which became operational in the third quarter of 2001, has not yet achieved the level of revenues and profitability originally expected by the Company, primarily due to the segment's loss of a major multi-national customer and insufficient demand from other customers. During 2004, a new general manager was hired at the facility to develop and implement marketing and sales initiatives directed at generating revenue growth. Operating results at the facility improved during 2004 as sales grew significantly compared to 2003 and the business achieved positive cash flow. However, new customer acquisitions must continue in order for the facility to reach profitability. Based on the current business plan, which includes estimates of revenue growth, the Company believes that its investment in the Belgium facility is recoverable. However, if the estimated revenue growth is not achieved, the carrying amount of the facility is likely to be impaired.
Acquisition of WilTel - In connection with accounting for the acquisition of WilTel, significant judgments and estimates were made to determine the fair values of certain liabilities, including liabilities for net unfavorable long-term commitments and deferred revenue, many of which required the Company to make assumptions about the future. To determine the fair value of deferred revenue, the Company had to assess transactions having limited activity in the current telecommunications market environment. The Company considered market indicators related to pricing, pricing for comparable transactions, as well as the legal obligation of the Company to provide future services. The Company also assumed it would continue to perform its contractual obligations through the term of its contracts. Revenue is recognized on these contracts as services are performed, typically on a straight-line basis over the remaining length of the contract. In the future, if the Company settles these obligations or they are otherwise terminated prior to completion of the performance obligation, the Company would likely recognize a gain equal to the carrying amount of the obligation. At December 31, 2004, the amount reflected in the consolidated balance sheet for deferred revenue was $213,800,000.
The Company evaluated the fair value of long-term commitments that were either above or below the current market rates for similar transactions, and the fair value of telecommunications capacity commitments that are not required based on WilTel's current operating plans. These commitments primarily consist of real estate leases and international capacity contracts. In order to determine the fair values of these agreements, the Company made significant assumptions concerning future market prices, future capacity utilization, the ability to enter into subleasing arrangements and that the commitments will not be terminated prior to their expiration dates. The accrued liability is amortized on a straight-line basis over the life of the commitments. Results of operations in the future would be impacted by any subsequent adjustment to this liability, which could result from negotiating a termination or reduction of its contractual obligation with contract counter-parties or sublease activity that is different from the Company's original assumptions. At December 31, 2004, the balance relating to those unfavorable long-term commitments was $44,900,000.
Telecommunications Revenue Recognition - Capacity, transmission, video services and other telecommunications services revenues are recognized monthly as the services are provided or revenues are earned. If at the time services are rendered, collection is not reasonably assured either due to credit risk, the potential for billing disputes or other reasons, revenue is not recognized until such contingencies are resolved.
WilTel estimates the amount of services which should not be recognized as revenue at the time the service is rendered based on its collection experience for each type of service. Certain of WilTel's customers represent such a high credit risk due to their difficult financial position that revenue is not recognized until cash is received. In addition, WilTel knows from past experience that a certain percentage of its billings will be disputed and uses that experience to estimate the amount of expected disputes and defers recognition of revenue at the time the service is provided. Revenues that have not been recognized at the time service is provided are subsequently recognized as revenue when the amounts are collected.
2. Significant Accounting Policies, continued: --------------------------------
Accruals for Access Costs - WilTel's access costs primarily include variable charges paid to vendors to originate and/or terminate switched voice traffic, which are based on actual usage at negotiated or regulated contract rates, and fixed charges for leased lines for dedicated facilities. At the end of each reporting period, WilTel's estimated accrual for incurred but not yet billed costs is based on internal usage reports. The accrual is subsequently reconciled to actual invoices as they are received, which is a process that can take several months to complete. This process includes an invoice validation procedure that normally identifies errors and inaccuracies in rate and/or volume components of the invoices resulting in numerous invoice disputes. It is WilTel's policy to adjust the accrual for the probable amount it believes will ultimately be paid on disputed invoices, a determination which requires significant estimation and judgment. Due to the number of different negotiated and regulated rates, constantly changing traffic patterns, uncertainty in the ultimate resolution of disputes, the period of time required to complete the reconciliation and delays in invoicing by access vendors, changes in these estimates should be expected.
Contingencies - The Company accrues for contingent losses when the contingent loss is probable and the amount of loss can be reasonably estimated. As of December 31, 2004, the Company's consolidated balance sheet includes litigation reserves of $21,500,000, all of which relate to WilTel litigation. Estimating the ultimate outcome of litigation matters is inherently uncertain, in particular because the ultimate outcome will rest on events and decisions of others that may not be within the power of the Company to control. The Company does not believe that any of these matters will have a material adverse effect on its consolidated financial position, consolidated results of operations or liquidity. However, if the amounts ultimately paid at the resolution of a litigation matter are significantly different than the Company's recorded reserve amount, the difference could be material to the Company's consolidated results of operations and, with respect to WilTel, settlement amounts are likely to be material to its liquidity.
(b) Consolidation Policy: The consolidated financial statements include the accounts of the Company, all variable interest entities of which the Company or a subsidiary is the primary beneficiary, and all majority-controlled entities that are not variable interest entities. All intercompany transactions and balances are eliminated in consolidation.
Associated companies are investments in equity interests that are accounted for on the equity method of accounting. These include investments in corporations that the Company does not control but has the ability to exercise significant influence and investments in limited partnerships in which the Company's interest is more than minor.
Certain amounts for prior periods have been reclassified to be consistent with the 2004 presentation.
(c) Stock Split: On December 31, 2004, a three-for-two stock split was effected in the form of a 50% stock dividend that was paid to shareholders of record on December 23, 2004. The financial statements (and notes thereto) give retroactive effect to the stock split for all periods presented.
(d) Cash Equivalents: The Company considers short-term investments, which have maturities of less than three months at the time of acquisition, to be cash equivalents. Cash and cash equivalents include short-term investments of $302,900,000 and $79,100,000 at December 31, 2004 and 2003, respectively.
(e) Investments: At acquisition, marketable debt and equity securities are designated as either i) held to maturity, which are carried at amortized cost, ii) trading, which are carried at estimated fair value with unrealized gains and losses reflected in results of operations, or iii) available for sale, which are carried at estimated fair value with unrealized gains and losses reflected as a separate component of shareholders' equity, net of taxes.
Held to maturity investments are made with the intention of holding such securities to maturity, which the Company has the ability to do. Estimated fair values are principally based on quoted market prices.
2. Significant Accounting Policies, continued: --------------------------------
Investments with an impairment in value considered to be other than temporary are written down to estimated fair value. The writedowns are included in Net securities gains (losses) in the Consolidated Statements of Operations. The cost of securities sold is based on average cost.
(f) Property, Equipment and Leasehold Improvements: Property, equipment and leasehold improvements are stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization are provided principally on the straight-line method over the estimated useful lives of the assets or, if less, the term of the underlying lease.
(g) Revenue Recognition:
Telecommunications: Capacity, transmission, video services and other telecommunications services revenues are recognized monthly as the services are provided or revenues are earned. If at the time services are rendered, collection is not reasonably assured either due to credit risk, the potential for billing disputes or other reasons, revenue is not recognized until such contingencies are resolved. Amounts billed in advance of the service month are recorded as deferred revenue. Revenues that have been deferred for long-term telecommunications service contracts are amortized using the straight-line method over the life of the related contract. The Company classifies as current the amount of deferred revenue that will be recognized into revenue over the next twelve months.
Grants of indefeasible rights of use ("IRUs") of constructed but unlit fiber, or dark fiber, in exchange for cash, are accounted for as operating leases, and the cash received is recognized as revenue over the term of the IRU. The Company is obligated under dark fiber IRUs and other capacity agreements to maintain its network in efficient working order and in accordance with industry standards. Customers are obligated for the term of the agreement to pay monthly fees for operating and maintenance costs. The Company recognizes these monthly fees as revenue as services are provided.
Telecommunications cost of sales include leased capacity, right of way costs, access charges, other third party circuit costs, satellite transponder lease costs, and package delivery costs and blank tape media costs related to advertising distribution services. WilTel does not defer installation costs.
Prior to the Company's acquisition, WilTel had entered into transactions such as buying, selling, swapping and/or exchanging capacity, conduit and fiber to complete and compliment its network. Depending upon the terms of the agreement, certain transactions were accounted for as pure asset swaps with no revenue and no cost recognition while certain transactions were accounted for as both revenue and cost over the corresponding length of time for each agreement. If the exchange was not essentially the culmination of an earning process, accounting for an exchange of a nonmonetary asset was based on the recorded amount of the nonmonetary asset relinquished, and therefore no revenue and cost was recorded. Payments received for the installation of conduit under joint build construction contracts were generally recorded as a recovery of the applicable construction costs. Revenues under multiple element contracts were recognized based on the respective fair values of each individual element within the multiple element contract. Revenues from conduit and duct sales were recognized at time of delivery and acceptance and when all significant contractual obligations have been satisfied and collection is reasonably assured. While WilTel applied the accounting policies described in this paragraph to transactions prior to the Company's acquisition of WilTel in 2003, WilTel has had no material transactions of the type described in this paragraph subsequent to its acquisition by the Company.
Other: Healthcare revenues are recognized when the services are provided. Manufacturing revenues are recognized when title passes, which is generally upon shipment of goods. Revenue from loans made by the banking and lending operations is recognized over the term of the loan to provide a constant yield on the daily principal balance outstanding. Revenue from the sale of real estate is generally recognized when title passes;
2. Significant Accounting Policies, continued: --------------------------------
however, if the Company is obligated to make improvements to the real estate subsequent to closing, revenues are deferred and recognized under the percentage of completion method of accounting.
(h) Income Taxes: The Company provides for income taxes using the liability method. The future benefit of certain tax loss carryforwards and future deductions is recorded as an asset. A valuation allowance is provided if deferred tax assets are not considered to be more likely than not to be realized.
(i) Derivative Financial Instruments: On January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended ("SFAS 133"). Under SFAS 133, the Company reflects its derivative financial instruments in its balance sheet at fair value. The Company has utilized derivative financial instruments to manage the impact of changes in interest rates on its customer banking deposits and certain debt obligations, hedge net investments in foreign subsidiaries and manage foreign currency risk on certain available for sale securities. Although the Company believes that these derivative financial instruments are practical economic hedges of the Company's risks, except for the hedge of the net investment in foreign subsidiaries, they do not meet the effectiveness criteria under SFAS 133, and therefore are not accounted for as hedges.
Amounts recorded as income (charges) to investment and other income as a result of accounting for its derivative financial instruments in accordance with SFAS 133 were $3,500,000 and $(1,700,000) for the years ended December 31, 2003 and 2002, respectively, and not material for 2004. Net unrealized losses on derivative instruments were $3,800,000 and $3,400,000 at December 31, 2004 and 2003, respectively.
(j) Translation of Foreign Currency: Foreign currency denominated investments and financial statements are translated into U.S. dollars at current exchange rates, except that revenues and expenses are translated at average exchange rates during each reporting period; resulting translation adjustments are reported as a component of shareholders' equity. Net foreign exchange transaction gains were $2,500,000 for 2002 and not material for 2004 and 2003. Net unrealized foreign exchange translation gains were $14,300,000 and $7,500,000 at December 31, 2004 and 2003, respectively.
(k) Stock-Based Compensation: Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), establishes a fair value method for accounting for stock-based compensation plans, either through recognition in the statements of operations or disclosure. As permitted, the Company applies APB Opinion No. 25 and related Interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized in the statements of operations for its stock-based compensation plans.
Had compensation cost for the Company's stock option plans been recorded in the statements of operations consistent with the provisions of SFAS 123, the Company would have recognized compensation cost of $1,000,000, $800,000 and $600,000 in 2004, 2003 and 2002, respectively.
(l) Recently Issued Accounting Standards: In November 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 151, "Inventory Costs--An Amendment of ARB No. 43, Chapter 4" ("SFAS 151"), which is effective for fiscal years beginning after June 15, 2005. SFAS 151 amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, SFAS 151 requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of "so abnormal" as stated in ARB No. 43. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company is currently evaluating the impact of SFAS 151 on its consolidated financial statements.
2. Significant Accounting Policies, continued: --------------------------------
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, "Share-Based Payment" ("SFAS 123R"), which replaces SFAS 123 and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS 123R requires that the cost of all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. That cost will be recognized as an expense over the vesting period of the award. Pro forma disclosures previously permitted under SFAS 123 (which are shown above) no longer will be an alternative to financial statement recognition. In addition, the Company will be required to determine fair value in accordance with SFAS 123R. SFAS 123R is effective for reporting periods beginning with the first interim or annual period after June 15, 2005, with early adoption encouraged, and requires the application of a transition methodology for stock options that have not vested as of the date of adoption. The Company is currently evaluating the impact of SFAS 123R on its consolidated financial statements.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153, "Exchanges of Nonmonetary Assets--An Amendment of APB Opinion No. 29" ("SFAS 153"), which is effective for fiscal periods beginning after June 15, 2005. SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, "Accounting for Nonmonetary Transactions," and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of SFAS 153 will not have any material effect on the consolidated financial statements; however, SFAS 153 could impact the accounting for future transactions, if any, within its scope.
3. Acquisitions: -------------
In 2002, the Company completed the acquisition of 44% of the outstanding common stock of WilTel for an aggregate purchase price of $333,500,000, including expenses. The WilTel stock was acquired by the Company under the chapter 11 restructuring plan of Williams Communications Group, Inc., the predecessor of WilTel. In October 2002, in a private transaction, the Company purchased 1,700,000 shares of WilTel common stock, on a when issued basis, for $20,400,000. Together, these transactions resulted in the Company acquiring 47.4% of the outstanding common stock of WilTel during 2002.
In November 2003, the Company consummated an exchange offer and merger agreement pursuant to which WilTel became a wholly-owned subsidiary of the Company and former WilTel public stockholders received an aggregate of 16,734,690 common shares of the Company. The merger agreement also provided that WilTel stockholders receive contingent sale rights which entitled WilTel stockholders to additional Leucadia common shares under certain circumstances; such contingent sale rights expired in 2004 without payment of any additional consideration. The 2003 acquisition was wholly unrelated to the initial acquisition in 2002; the Company's decision to acquire the remaining WilTel shares was based upon developments subsequent to the initial 2002 purchase.
The aggregate purchase price for the 2003 acquisition was approximately $425,300,000, consisting of $422,800,000 of Leucadia common shares and cash expenses of $2,500,000. The execution of the merger agreement on August 21, 2003 created a measurement date for accounting purposes that is used to determine the per share value of the Leucadia common shares issued. The Company averaged the closing prices of its common shares for the five business day period commencing two business days before and ending two business days after the merger agreement was executed. That average, $25.27 per share, was used to calculate the aggregate value of the Leucadia common shares issued.
3. Acquisitions, continued: -------------
Following completion of the merger, the Company has consolidated the financial condition and results of operations of WilTel, and no longer accounts for its initial investment in WilTel under the equity method of accounting. The condensed WilTel balance sheet as of the date of acquisition is presented below. It reflects amounts for the acquisition of the WilTel common stock in 2003, and amounts for the acquisition of 47.4% of WilTel's common stock in 2002, all of which were determined based on the estimated fair value of the assets acquired and liabilities assumed as of the date of each acquisition. The carrying amount of the Company's initial 2002 cash investment in WilTel of $353,900,000, including expenses, had been subsequently reduced by $65,400,000, representing the Company's share of WilTel's losses under the equity method of accounting. The aggregate net investment in WilTel shown below of $713,800,000 consists of the carrying amount of the Company's equity investment in WilTel as of November 5, 2003 ($288,500,000) and the aggregate purchase price of the acquisition pursuant to the merger ($425,300,000). All amounts are in thousands.
As of November 6, 2003 ---------------- Assets: Current assets: Cash and cash equivalents $ 97,900 Investments 93,600 Trade, notes and other receivables, net 243,400 Prepaids and other current assets 62,200 ------------- Total current assets 497,100 Non-current investments 30,600 Property and equipment 1,214,900 Intangible assets 47,000 Other assets 38,800 ------------- Total assets 1,828,400 -------------
Liabilities: Current liabilities: Trade payables and expense accruals 235,900 Deferred revenue 47,400 Other current liabilities 119,100 Long-term debt due within one year 4,000 ------------- Total current liabilities 406,400 Long-term deferred revenue 154,500 Other non-current liabilities 138,100 Long-term debt 502,700 ------------- Total liabilities 1,201,700 ------------- 626,700 Allocation to consolidated deferred income taxes 87,100 -------------
Net investment in WilTel $ 713,800 =============
Of the $47,000,000 of acquired intangible assets, $10,100,000 was related to Vyvx's tradename (with a weighted-average useful life of approximately fifteen years) and $36,900,000 was related to customer relationships (with a weighted-average useful life of approximately thirteen years), primarily Vyvx customers. The net carrying amount of these intangible assets increased $8,200,000 during 2004 (which is reflected in the balance sheet above), due to the completion of the analyses used to allocate the purchase price to the individual assets acquired, which also resulted in a reduction in the amount initially allocated to property and equipment. See Note 8 for more information concerning intangible asset activity subsequent to the acquisition.
3. Acquisitions, continued: -------------
Unaudited pro forma operating results for the Company, assuming the acquisition of 100% of WilTel had occurred as of the beginning of each year presented below are as follows (in thousands, except per share amounts):
Pro forma adjustments include an increase to 2003 depreciation expense of $3,100,000 related to the adjustment to fair value of property and equipment at acquisition, which fair value adjustment is assumed amortized over an average life of 15 years and, for the 2002 period, a reduction of $235,000,000 to WilTel's historical depreciation expense, as the historical carrying amount of WilTel's property and equipment as of January 1, 2002 was nearly $3.1 billion more than the amount allocated to property and equipment assumed in the pro forma financial statements. Accordingly, depreciation expense was substantially reduced on a pro forma basis since the actual depreciation expense recorded on a much larger asset would not have been recorded on a pro forma basis.
The pro forma adjustments for 2002 also include the reversal of certain statement of operations activity as a result of WilTel's emergence from bankruptcy, including the reversal of the gain recognized upon the discharge of WilTel's indebtedness ($4.3 billion), the reversal of the net charge recognized upon WilTel's application of fresh start accounting adjustments to the historical carrying amounts of its assets and liabilities ($2.1 billion) and the reversal of historical interest expense related to all debt that was converted to equity under WilTel's bankruptcy plan. For both periods, the pro forma adjustments included an adjustment to reduce the Company's historical federal income tax provision (2003 - $38,200,000 and 2002 - $12,900,000), as losses generated by WilTel reduced or eliminated the Company's historical income, and the reversal of the Company's recognition of its share of WilTel's losses under the equity method of accounting as a result of the pro forma consolidation.
The unaudited pro forma data for WilTel is not indicative of future results of operations or what would have resulted if the acquisitions had actually occurred as of the beginning of the periods presented. Unaudited pro forma data is not included for Symphony as the amounts were not material.
In September 2003, the Company acquired Symphony for approximately $36,700,000, including expenses, of which approximately $29,200,000 was provided by financing that is non-recourse to the Company but is fully collateralized by Symphony's assets. In addition, at acquisition, the lender provided an additional $5,000,000 of working capital financing to Symphony. The Company has consolidated Symphony's financial condition and results of operations since acquisition.
In September 2003, the Company acquired a 90% interest in 8 acres of unimproved land in Washington, D.C. for cash of $53,800,000. Immediately following the acquisition, mortgage financing of $15,000,000 was obtained, which is non-recourse to the Company, that reduced the Company's net cash investment in the property to $38,800,000. Subsequent to the acquisition, the mortgage lender provided an additional $5,000,000 of such non-recourse financing, which further reduced the Company's net cash investment. The land is zoned for a minimum of 2,000,000 square feet of commercial office space, which the Company intends to develop in phases, once acceptable tenants or purchasers are identified.
3. Acquisitions, continued: -------------
In December 2003, the Company purchased all of the debt obligations under the senior secured credit facility of ATX Communications, Inc. and certain of its affiliates (collectively "ATX") for $25,000,000, and also entered into an amendment to the facility pursuant to which the Company agreed to refrain from exercising certain of its rights under the facility, subject to certain conditions. ATX is an integrated communications provider that offers local exchange carrier and inter-exchange carrier telephone, Internet, high-speed data and other communications services to business and residential customers in targeted markets throughout the Mid-Atlantic and Midwest regions of the U.S.
As contemplated at the time of the Company's purchase, in January 2004, ATX commenced a voluntary Chapter 11 case in order to reorganize its financial affairs. During 2004, the Company provided debtor-in-possession financing to ATX of $5,000,000. This financing is secured by liens on substantially all of ATX's assets, and is expected to be repaid upon ATX's emergence from bankruptcy. In January 2005, ATX filed its First Amended Joint Plan of Reorganization (the "Plan") and related disclosure statement. The Plan was filed after agreements were reached with major stakeholders and/or the representatives of major stakeholders in the bankruptcy case. The Plan contemplates that the Company will convert its current investment in the ATX credit facility into 95% of the new common stock of the reorganized ATX and a new $25,000,000 senior secured note which bears interest at 10%. In addition, the Company will provide up to $25,000,000 of exit financing to ATX to fund bankruptcy related payments and working capital requirements, which includes the repayment of the Company's $5,000,000 debtor-in-possession financing. The Plan is subject to approval by the bankruptcy court and creditors. Assuming that ATX is reorganized as contemplated in the Plan, the Company will consolidate ATX as of the date the Plan becomes effective.
In July 2004, the Company invested $50,000,000 in INTL Consilium Emerging Market Absolute Return Fund, LLC ("INTL"), a limited liability company that is invested in a master fund which primarily invests in emerging markets debt and equity securities. INTL and the master fund are managed and controlled by an investment manager who has full discretion over investment and operating decisions. In accordance with FASB Interpretation No. 46R, "Consolidation of Variable Interest Entities", INTL is a variable interest entity and the Company is currently the primary beneficiary; as a result, the Company accounts for its investment in INTL as a consolidated subsidiary. In October 2004, the Company invested an additional $25,000,000 in INTL. INTL plans to sell additional membership interests in the future, which if accomplished could result in the Company no longer accounting for INTL as a consolidated subsidiary. At December 31, 2004, INTL had total assets of $79,600,000, which are reflected as investments in the Company's consolidated balance sheet, and its liabilities were not material. The creditors of INTL have recourse only to the assets of INTL and do not have recourse to any other assets of the Company. The Company can generally withdraw its capital account interest upon 90 days notice, subject to the manager's ability to liquidate security positions in an orderly manner. For the year ended December 31, 2004, the Company recorded $2,200,000 of pre-tax income relating to INTL. The Company has included INTL in its Corporate segment.
4. Investments in Associated Companies: -----------------------------------
The Company has investments in several Associated Companies. The amounts reflected as equity in income of associated companies in the consolidated statements of operations are net of income tax provisions of $15,000,000, $70,100,000 and $36,700,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Included in consolidated retained earnings at December 31, 2004 is approximately $124,000,000 of undistributed earnings of the associated companies.
JPOF II
During 2000, the Company invested $100,000,000 in the equity of a limited liability company, Jefferies Partners Opportunity Fund II, LLC ("JPOF II"), that is a registered broker-dealer. JPOF II is managed by Jefferies & Company, Inc., a full service investment bank to middle market companies. JPOF II invests in high yield securities, special situation investments and distressed securities and provides trading services to its customers and clients. For the years ended December 31, 2004, 2003 and 2002, the Company recorded $16,200,000,
4. Investments in Associated Companies, continued: ------------------------------------
$14,800,000 and $15,200,000, respectively, of pre-tax income from this investment under the equity method of accounting. These earnings were distributed by JPOF II as dividends shortly after the end of each year.
Olympus
In December 2001, the Company invested $127,500,000 for an approximate 25% common stock interest in Olympus Re Holdings, Ltd. ("Olympus"), a newly formed Bermuda reinsurance company primarily engaged in the property excess, marine and aviation reinsurance business. In June 2003, the Company sold 567,574 common shares of Olympus back to Olympus for total proceeds of $79,500,000. The Company recognized a $1,500,000 gain on the sale which is reflected in other income for the year ended December 31, 2003. The shares were sold to Olympus as part of an issuer tender offer available to all of its shareholders. After completion of the tender, the Company's interest in Olympus declined from 25% to 16.1%. Although the Company's equity interest declined below 20%, the Company continued to account for its investment under the equity method of accounting because of its ability to exercise significant influence. As a result of redemptions of other investors' equity interests in the first half of 2004, the Company's percentage interest in Olympus has increased to 19%. For the years ended December 31, 2004, 2003 and 2002, the Company recorded $9,700,000, $40,400,000 and $24,100,000, respectively, of pre-tax income from this investment under the equity method of accounting.
EagleRock
In December 2001, the Company invested $50,000,000 in EagleRock Capital Partners (QP), LP ("EagleRock"), a limited partnership that invests and trades in securities and other investment vehicles. Pre-tax results of $29,400,000, $49,900,000 and $(4,500,000) for the years ended December 31, 2004, 2003 and 2002, respectively, were recorded from this investment under the equity method of accounting. The results reported by the partnership since its inception include both realized and changes in unrealized gains and losses in its portfolio. In 2004, $3,700,000 was distributed by EagleRock to the Company.
HomeFed
In October 2002, the Company sold one of its real estate subsidiaries, CDS Holding Corporation ("CDS"), to HomeFed Corporation ("HomeFed") for a purchase price of $25,000,000, consisting of $1,000,000 in cash and 2,474,226 shares of HomeFed's common stock, which represented approximately 30% of HomeFed's outstanding common stock. At December 31, 2004 and 2003, the deferred gain on this sale was $6,800,000 and $7,900,000, respectively, which is being recognized into income as CDS's principal asset, the real estate project known as San Elijo Hills, is developed and sold. For the years ended December 31, 2004 and 2003, the Company recorded $10,000,000 and $16,200,000 of pre-tax income from this investment under the equity method of accounting. HomeFed is engaged, directly and through subsidiaries, in the investment in and development of residential real estate projects in the State of California. HomeFed is a public traded company traded on the NASD OTC Bulletin Board (Symbol: HOFD).
As a result of a 1998 distribution to all of the Company's shareholders, approximately 9.4% and 9.5% of HomeFed is owned by the Company's Chairman and President, respectively. Both are also directors of HomeFed and the Company's President serves as HomeFed's Chairman.
Pershing
In January 2004, the Company invested $50,000,000 in Pershing Square, L.P. ("Pershing"), a limited partnership that is authorized to engage in a variety of investing activities. The Company redeemed its interest as of December 31, 2004, and the total amount due from Pershing of $71,300,000 (which was paid during the first quarter of 2005) is included in trade, notes and other receivables, net in the Company's consolidated balance sheet.
4. Investments in Associated Companies, continued: ------------------------------------
Other
In November 2002, the Company sold its approximately 40% equity interest in certain thoroughbred racetrack businesses to a third party for net proceeds of $28,000,000. The sale resulted in a pre-tax gain of $14,300,000. As part of the transaction, the Company has an approximately 15% profits interest in a joint venture formed with the buyer of the businesses to pursue the potential development and management of gaming ventures in Maryland, including slot machines and video lottery terminals (if authorized by state law). The Company has no funding obligations for this joint venture.
The following table provides summarized data with respect to the Associated Companies accounted for on the equity method of accounting included in results of operations for the three years ended December 31, 2004, except for Berkadia LLC ("Berkadia") and WilTel which are separately summarized below. (Amounts are in thousands.)
The Company has not provided any guarantees, nor is it contingently liable for any of the liabilities reflected in the above table. All such liabilities are non-recourse to the Company. The Company's exposure to adverse events at the investee companies is limited to the book value of its investment.
Berkadia
In August 2001, Berkadia, an entity jointly owned by the Company and Berkshire Hathaway Inc., loaned $5,600,000,000 on a senior secured basis to FINOVA Capital Corporation (the "Berkadia Loan"), the principal operating subsidiary of The FINOVA Group Inc. ("FINOVA"), to facilitate a chapter 11 restructuring of the outstanding debt of FINOVA and its principal subsidiaries. Berkadia also received 61,020,581 newly issued shares of common stock of FINOVA (the "FNV Shares"), representing 50% of the stock of FINOVA outstanding on a fully diluted basis. Berkadia financed the Berkadia Loan with bank financing that was guaranteed, 90% by Berkshire Hathaway and 10% by the Company (with the Company's guarantee being secondarily guaranteed by Berkshire Hathaway). In February 2004, FINOVA fully repaid the Berkadia Loan, and Berkadia fully repaid its bank financing, thereby eliminating the Company's guaranty.
During 2001, Berkadia was paid a $60,000,000 commitment fee by FINOVA Capital upon execution of the commitment, and a $60,000,000 funding fee upon funding of the Berkadia Loan. The Company's share of these fees, $60,000,000 in the aggregate, was distributed to the Company shortly after the fees were received. In connection with the funding commitment, in February 2001, FINOVA entered into a ten-year management agreement with the Company, for which the Company receives an annual fee of $8,000,000. The management agreement remains in effect even though the Berkadia Loan has been repaid.
4. Investments in Associated Companies, continued: ------------------------------------
Under the agreement governing Berkadia, the Company and Berkshire Hathaway agreed to equally share the commitment fee, funding fee and all management fees. All income related to the Berkadia Loan, after payment of financing costs, was shared 90% to Berkshire Hathaway and 10% to the Company.
In August 2001, Berkadia transferred $5,540,000,000 in cash to FINOVA Capital, representing the $5,600,000,000 loan reduced by the funding fee of $60,000,000, in exchange for a $5,600,000,000 note from FINOVA Capital and the FNV Shares. Under GAAP, Berkadia was required to allocate the $5,540,000,000 cash transferred, reduced by the previously received $60,000,000 commitment fee, between its investment in the Berkadia Loan and the FNV Shares, based upon the relative fair values of the securities received. Further, the fair value of the FNV Shares was presumed to be equal to the trading price of the stock on the day Berkadia received the FNV Shares, with only relatively minor adjustments allowed for transfer restrictions and the inability of the traded market price to account for a large block transfer. The requirement to use the trading price as the basis for the fair value estimate resulted in an initial book value for the FNV Shares of $188,800,000, which was far in excess of the $17,600,000 aggregate book net worth of FINOVA on the effective date of the Plan, and was inconsistent with the Company's view that the FINOVA common stock has a very limited value. Based on this determination of fair value, Berkadia recorded an initial investment in the FNV Shares of $188,800,000 and in the Berkadia Loan of $5,291,200,000. The allocation of $188,800,000 to the investment in the common stock of FINOVA, plus the $120,000,000 of cash fees received, were reflected as a discount from the face amount of the Berkadia Loan. The discount was amortized to income over the life of the Berkadia Loan under the effective interest method.
During 2002, Berkadia gave its consent to FINOVA to use up to $300,000,000 of cash to repurchase certain subordinated notes rather than make mandatory prepayments of the Berkadia Loan. In consideration for its consent, FINOVA and Berkadia agreed that they would share equally in the net interest savings resulting from any repurchase. The Company's share of the net interest savings is reflected in the table below.
Subsequent to acquisition, Berkadia accounted for its investment in the FINOVA common stock under the equity method of accounting. During 2001, Berkadia recorded its share of FINOVA's losses in an amount that reduced Berkadia's investment in FINOVA's common stock to zero. Berkadia's recognition of any future FINOVA losses was suspended at that time. Although the Company had no cash investment in Berkadia, since it guaranteed 10% of the third party financing provided to Berkadia, the Company recorded its share of any losses recorded by Berkadia, up to the amount of the Company's guarantee. For the years ended December 31, 2004, 2003 and 2002, the Company's equity in the income of Berkadia consists of the following (in thousands):
The following table provides certain summarized data with respect to Berkadia at December 31, 2003 and for the years ended December 31, 2004, 2003 and 2002. Since Berkadia has distributed all of its cash to its members and the carrying amount of its investment in FINOVA is zero, it has no assets or liabilities as of December 31, 2004. (Amounts are in thousands.)
4. Investments in Associated Companies, continued: ------------------------------------
WilTel
Prior to its acquisition in 2003 of the remaining shares of WilTel's outstanding common stock, the Company accounted for its 47.4% interest in WilTel under the equity method of accounting. For the period January 1, 2003 through November 5, 2003 (the day before the acquisition was consummated) and for the period from the initial 2002 purchase through December 31, 2002, the Company recorded $52,100,000 and $13,400,000, respectively, of pre-tax losses from this investment under the equity method of accounting. The amounts recorded in 2003 include the Company's share of WilTel's income from the recognition of non-operating settlement gains related to the termination of various agreements that released WilTel from previously accrued obligations, recoveries of previously written off receivables and a gain on the sale of a subsidiary. The Company's share of these gains was approximately $31,200,000, for which no tax provision was recorded.
The following table provides certain summarized data with respect to WilTel for the periods from January 1, 2003 through November 5, 2003, and from the initial 2002 purchase through December 31, 2002. (Amounts are in thousands.)
5. Discontinued Operations: -----------------------
During the second quarter of 2002, the Company sold its interest in Fidei, its foreign real estate subsidiary, to an unrelated third party for total proceeds of 70,400,000 Euros ($66,200,000), which resulted in an after tax gain on the sale reflected in results of operations of $4,500,000 (net of income tax expense of $2,400,000) for the year ended December 31, 2002, and an increase to shareholders' equity of $12,100,000 as of December 31, 2002. The Euro denominated sale proceeds were not converted into U.S. dollars immediately upon receipt. The Company entered into a participating currency derivative, which expired in September 2002. Upon expiration, net of the premium paid to purchase the contract, the Company received $67,900,000 in exchange for 70,000,000 Euros and recognized a foreign exchange gain of $2,000,000, which is included in investment and other income for the year ended December 31, 2002.
In December 2002, the Company entered into an agreement to purchase certain debt and equity securities of WebLink Wireless, Inc. ("WebLink"), for an aggregate purchase price of $19,000,000. WebLink operated in the wireless messaging industry, providing wireless data services and traditional paging services. In the fourth quarter of 2003, WebLink sold substantially all of its operating assets to Metrocall, Inc. for 500,000 shares of common stock of Metrocall, Inc's parent, Metrocall Holdings, Inc. ("Metrocall"), an immediately exercisable warrant to purchase 25,000 shares of common stock of Metrocall at $40 per share, and a warrant to purchase up to 100,000 additional shares of Metrocall common stock at $40 per share, subject to certain vesting criteria.
5. Discontinued Operations, continued: ------------------------
Based upon the market price of the Metrocall stock received and the fair value of the warrants received as of the date of sale, the Company reported a pre-tax gain on disposal of discontinued operations of $11,500,000. The vesting criteria for the remaining warrants were satisfied during 2004, and the Company recorded $2,200,000 as gain on disposal of discontinued operations (net of minority interest), which represented the estimated fair value of the warrants.
During the fourth quarter of 2004, WebLink exercised all of its warrants and subsequently tendered all of its Metrocall shares as part of a merger agreement between Metrocall and Arch Wireless, Inc. WebLink received cash of $19,900,000 and 675,607 common shares of the new parent company (USA Mobility, Inc., which had a fair market value of $25,000,000 when received), resulting in a pre-tax gain of $15,800,000 that is included in net securities gains of continuing operations. The Company's investment in the shares of USA Mobility at December 31, 2004 are classified as a non-current investment.
In October 2004, the Company sold a commercial real estate property and classified it as a discontinued operation. During the second quarter of 2004, the Company recorded a non-cash charge of approximately $7,100,000 to reduce the carrying amount of this property to its estimated fair value. The Company recorded an additional loss of $600,000 in the fourth quarter of 2004 resulting principally from mortgage prepayment penalties incurred upon satisfaction of the property's mortgage at closing. Operating results for this property were not material in prior years.
In the fourth quarter of 2004, the Company sold its geothermal power business and classified it as a discontinued operation. This business had been included in the Company's Other Operations segment. The Company received proceeds of $14,800,000, net of closing costs, and recognized a pre-tax gain of $200,000.
During 2003, the Company settled certain tax payment responsibilities with the purchaser of Colonial Penn Insurance Company. Income from discontinued operations for the year ended December 31, 2003 includes a payment of $1,800,000 from the purchaser to reimburse the Company for tax payments previously made.
A summary of the results of discontinued operations is as follows for the three year period ended December 31, 2004 (in thousands):
6. Investments: -----------
A summary of investments classified as current assets at December 31, 2004 and 2003 is as follows (in thousands):
6. Investments, continued: ------------
A summary of non-current investments at December 31, 2004 and 2003 is as follows (in thousands):
The amortized cost, gross unrealized gains and losses and estimated fair value of non-current investments classified as available for sale at December 31, 2004 and 2003 are as follows (in thousands):
6. Investments, continued: ------------
The amortized cost and estimated fair value of non-current investments classified as available for sale at December 31, 2004, by contractual maturity are shown below. Expected maturities are likely to differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Estimated Amortized Fair Cost Value --------- --------- (In thousands)
Due after one year through five years $ 133,191 $ 173,709 Due after five years through ten years 1,856 2,505 Due after ten years 7,610 7,610 ----------- ----------- 142,657 183,824 Mortgage-backed securities 142,173 141,140 ----------- -----------
$ 284,830 $ 324,964 =========== ===========
The Company owns 375,000 common shares of White Mountains Insurance Group, Ltd. ("WMIG"), for which it paid $75,000,000. WMIG is a publicly traded, Bermuda domiciled financial services holding company, principally engaged through its subsidiaries and affiliates in property and casualty insurance and reinsurance. The Company's president is a director of WMIG. At December 31, 2004 and 2003, the Company's investment in WMIG, which is reflected in non-current investments available for sale, had a market value of $242,300,000 and $172,500,000, respectively. The WMIG shares owned by the Company have the benefit of a registration rights agreement with WMIG.
6. Investments, continued: ------------
Net unrealized gains on investments were $153,200,000, $161,800,000 and $58,000,000 at December 31, 2004, 2003 and 2002, respectively. Reclassification adjustments included in comprehensive income for the three year period ended December 31, 2004 are as follows (in thousands):
The unrealized losses on the securities issued by the United States Government and agencies and the mortgage-backed securities were caused by interest rate increases and were considered to be minor (approximately .2% and .9%, respectively). The unrealized losses on the securities issued by the United States Government and agencies relate to 48 securities which were primarily purchased in 2004 and substantially all of which mature in 2005. The unrealized losses on the mortgage-backed securities relate to 34 securities substantially all of which were purchased in 2004. The unrealized losses related to the corporate bonds are not considered to be an other than temporary impairment. This determination is based on a number of factors, including the length of time and the extent to which the market value has been less than cost and factors specific to the individual investment. The unrealized losses on marketable equity securities primarily relates to one security which the Company has owned since November 2004 and which is in an unrealized gain position subsequent to year-end.
At December 31, 2004, the Company's investments which have been in a continuous unrealized loss position for 12 months or longer had aggregate gross unrealized losses of approximately $50,000 and an aggregate fair value of approximately $16,400,000. All of these securities were either issued by the United States Government agencies or were mortgage-backed securities.
At December 31, 2004 and 2003, securities with book values aggregating $7,100,000 and $26,300,000, respectively, were on deposit with various regulatory authorities. Securities with book values of $12,100,000 and $11,100,000 at December 31, 2004 and 2003, respectively, collateralized certain swap agreements, and securities with a book value of $11,000,000 and $24,200,000 at December 31, 2004 and 2003, respectively, collateralized certain debt obligations and a related letter of credit.
7. Trade, Notes and Other Receivables, Net: -----------------------------------
A summary of trade, notes and other receivables, net at December 31, 2004 and 2003 is as follows (in thousands):
(a) Contractual maturities of instalment loan receivables at December 31, 2004 were as follows (in thousands): 2005 - $2,000; 2006 - $500; 2007 - $400; 2008 - $200; and 2009 and thereafter - $1,200.
8. Other Assets: ------------
A summary of other assets at December 31, 2004 and 2003 is as follows (in thousands):
During 2004, the Company recorded $1,900,000 of customer relationship intangible assets in connection with an acquisition made by its manufacturing segment. The manufacturing segment's customer relationship intangible assets are being amortized on a straight-line basis over an average useful life of approximately three years.
8. Other Assets, continued: -------------
The Company's total comprehensive income in 2004 and 2003 subsequent to the acquisition of WilTel enabled it to realize certain of WilTel's acquired deferred tax assets which had been fully reserved for at acquisition. The resulting reduction in the valuation allowance for deferred tax assets was applied to reduce the recorded amount of WilTel's identifiable intangible assets to zero.
Amortization expense on intangible assets was $2,300,000 for the year ended December 31, 2004. The estimated aggregate future amortization expense for the customer relationship intangible asset for each of the next five years is as follows (in thousands): 2005 - $654; 2006 - $654; 2007 - $164; and thereafter - $0.
As previously disclosed in the 2003 10-K, the Las Cruces mineral rights of MK Resources had been classified as an intangible asset. Effective April 2004, the FASB ratified the Emerging Issues Task Force's consensus that mineral rights should be accounted for as tangible assets and classified as a component of property and equipment. In accordance with this pronouncement, the Company has reclassified this asset in the consolidated balance sheet as of December 31, 2003.
9. Property, Equipment and Leasehold Improvements, Net: ---------------------------------------------------
A summary of property, equipment and leasehold improvements, net at December 31, 2004 and 2003 is as follows (in thousands):
In January 2004, the Company exercised an option to sell two of its corporate aircraft for total proceeds of approximately $38,800,000. The option was received in connection with the purchase of two new corporate aircraft. The Company completed the sales in July 2004, and reported a pre-tax gain of $11,300,000.
10. Trade Payables, Expense Accruals and Other Liabilities: ------------------------------------------------------
A summary of trade payables, expense accruals and other liabilities at December 31, 2004 and 2003 is as follows (in thousands):
(a) In conjunction with a pricing agreement for certain voice services, in January 2004 WilTel's largest customer, SBC Communications, Inc. ("SBC"), paid WilTel $25,000,000 for pre-funding of certain capital expenditures (all the funds were spent during 2004). The agreement required that WilTel return the funds to SBC if, prior to January 31, 2005, WilTel and SBC entered into an agreement for voice transport pricing through December 31, 2006. Since such an agreement was not entered into, during the first quarter of 2005 WilTel will recognize the full amount of this deposit as other income.
The Company's asset retirement obligations relate primarily to two categories of WilTel's assets:
o Fiber and Conduit - The Company has right of way agreements which generally require the removal of fiber and conduit upon the termination of those agreements.
o Technical Sites - The Company leases land for technical sites and leases space at technical sites along its network. Termination of these lease agreements normally requires removal of equipment and other assets, and restoration of the lease property to its original condition.
10. Trade Payables, Expense Accruals and Other Liabilities, continued: -------------------------------------------------------
The Company recorded WilTel's asset retirement obligation of $28,500,000 as of the date the merger was consummated on November 6, 2003. The change in the Company's asset retirement obligation during 2004 was primarily due to additional liabilities incurred of $8,400,000 and accretion expense of $4,500,000.
11. Indebtedness: ------------
The principal amount, stated interest rate and maturity of debt outstanding at December 31, 2004 and 2003 are as follows (dollars in thousands):
Parent Company Debt: At December 31, 2004, the Company had an unsecured bank credit facility of $110,000,000, which bears interest based on the Eurocurrency Rate or the prime rate and matures in 2007. At December 31, 2004, no amounts were outstanding under this bank credit facility.
11. Indebtedness, continued: -------------
In June 2003, the Company sold $200,000,000 principal amount of its newly authorized 7% Senior Notes due 2013 in a private placement at 99.612% of the principal amount. In each of August, November and December 2003, the Company sold $25,000,000 principal amount ($75,000,000 in the aggregate) of its newly authorized 7% Senior Notes due 2013 in private placements at 99.612% of the principal amount. In April 2004, the Company sold $100,000,000 principal amount of its 7% Senior Notes due 2013 in a private placement transaction at 102.191% of the principal amount. The Company has completed a series of registered exchange offers for all of these notes that converted the various issues of privately placed notes into a single issue of publicly registered notes issued under the same indenture.
In April 2004, the Company sold $350,000,000 principal amount of its 3 3/4% Convertible Senior Subordinated Notes due 2014 in a private placement transaction. The notes are convertible into the Company's common shares at $45.93 per share at any time before their maturity, subject to certain restrictions contained in the notes, at a conversion rate of 21.7707 shares per each $1,000 principal amount of notes subject to adjustment (an aggregate of 7,619,745 shares). The Company has a currently effective shelf registration statement in respect of the notes and the common shares issuable upon conversion of the notes.
In January 1997, the Company issued 8.65% trust issued preferred securities ("Trups") of its wholly-owned subsidiary, Leucadia Capital Trust I (the "Trust"). As a result of the implementation of SFAS 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity", the Company began classifying the Trups as liabilities on July 1, 2003, and classifies dividends accrued for these securities as interest expense. SFAS 150 did not permit restatement of prior period amounts to reflect the new classification. In 2004, the Company liquidated the Trust and distributed to the Trups holders the 8.65% Junior Subordinated Deferrable Interest Debentures held by the Trust in exchange for their Trups securities. The distribution had no effect on the total debt of the Company.
Subsidiary Debt: In September 2004, WilTel refinanced its existing $375,000,000 credit agreement debt by entering into an amended credit agreement consisting of a $240,000,000 first lien term loan facility, a $120,000,000 second lien term loan facility and a $25,000,000 revolving credit facility (which it can no longer draw upon, as discussed below). WilTel also used $90,000,000 of its cash and investments to repay in full one of the two mortgage notes that was secured by its headquarters building ($54,600,000 including accrued interest), reduce the amount outstanding under its credit agreement ($15,000,000), reduce the amount outstanding under the other note that is collateralized by its headquarters building ($13,300,000) and pay expenses. The amended credit agreement has not been guaranteed by the Company and is not collateralized by any of the Company's assets other than the assets of WilTel.
The first lien term loan facility requires quarterly principal payments of approximately $632,000 commencing December 31, 2004 through June 30, 2009, and quarterly principal payments of $57,000,000 thereafter until final maturity on June 30, 2010. The second lien term loan facility matures on December 31, 2010. However, if WilTel does not refinance its obligations under the remaining promissory note that is secured by its headquarters building ($60,300,000 outstanding at December 31, 2004) prior to October 1, 2009, then the first lien term loan facility will mature on October 1, 2009, and if such promissory note is not refinanced by January 1, 2010, then the second lien term loan facility will mature on January 1, 2010. Loans under the credit agreement bear interest at a variable rate based upon either the prime rate or LIBOR, at WilTel's option, plus a specified margin for each loan. At December 31, 2004, the amended credit agreement had a weighted average interest rate of 6.7%. WilTel's obligations under its amended credit agreement are secured by substantially all of its assets other than those assets securing its headquarters building, for which the amended credit agreement lenders have a second priority lien, and its aircraft capital lease.
11. Indebtedness, continued: -------------
As discussed in Note 24, in January 2005, SBC announced its intention to migrate its IP-based and long distance services to the AT&T network. Pursuant to the terms of WilTel's amended credit agreement, that announcement is considered an event which could reasonably be expected to have a "material adverse effect" as defined in the facility, and as a result WilTel can no longer access its $25,000,000 revolving credit facility. WilTel does not anticipate needing the $25,000,000 revolving credit facility to meet its present requirements. The announcement does not have any impact on the $360,000,000 of term loans under WilTel's amended credit agreement. However, the credit agreement provides for an event of default if there is any amendment, supplement, modification or termination of any WilTel contract or agreement that has had or could reasonably be expected to result in a material adverse effect on WilTel (as defined in the credit agreement). As discussed above, WilTel is currently engaged in negotations with SBC with respect with a transition pricing agreement and other matters which, if successfully concluded, may or may not be deemed an event of default under the WilTel credit agreement. WilTel intends to enter into discussions with its lenders before entering into any new definitive agreement with SBC.
WilTel's amended credit agreement also permitted WilTel to obtain letters of credit of which $21,000,000 was outstanding at December 31, 2004. However, as a result of the SBC announcement WilTel will no longer be able to obtain new letters of credit.
The WilTel amended credit agreement contains covenants that require WilTel to meet certain operating targets, which it currently meets, and restrictions that limit WilTel's ability to incur additional indebtedness, spend funds on capital expenditures and make certain investments. The agreement also prohibits WilTel from paying dividends to the Company. The Company currently expects that WilTel will be able to meet the operating targets required by its credit agreement through 2006; however, compliance with the operating targets thereafter is uncertain because of SBC's announced intention to migrate its traffic to AT&T's network.
The remaining OTC Note is fully recourse to WilTel, bears interest at 7% and is secured by a first priority mortgage lien and security interest in WilTel's headquarters building (except for network related assets in the building) and other ancillary assets. The note requires annual principal payments escalating from approximately $700,000 in 2005 to approximately $1,000,000 in 2009; a final payment of approximately $56,000,000 is due at maturity in April 2010.
During 2001, a subsidiary of the Company borrowed $53,100,000 secured by certain of its corporate aircraft. This debt bears interest based on a floating rate, requires monthly payments of principal and interest and matures in ten years. The interest rate at December 31, 2004 was 6.4%. The subsidiary has entered into an interest rate swap agreement for this financing, which fixed the interest rate at approximately 5.7%. The subsidiary would have paid $2,300,000 and $3,100,000 at December 31, 2004 and 2003, respectively, if the swap were terminated. Changes in interest rates in the future will change the amounts to be received under the agreement, as well as interest to be paid under the related variable debt obligation. The Parent company has guaranteed this financing.
Capital leases primarily consist of a sale-leaseback transaction related to WilTel's corporate aircraft entered into in May 2003. The aircraft were sold for approximately $21,000,000 in cash and leased back for a period of ten years. Under the terms of the transaction, approximately $5,300,000 from the cash proceeds is held as cash collateral by the owner-lessor for the lease, which is reflected in the balance sheet in other non-current assets. WilTel recorded a capital lease obligation representing the present value of the future minimum lease payments during the lease term.
A subsidiary of the Company obtained loan commitments totaling $25,000,000 to finance the renovation of its Hawaiian hotel. Included in other subsidiary debt are outstanding borrowings under this facility of $22,400,000 and $23,800,000 at December 31, 2004 and 2003, respectively. The financing bears interest at a rate of 8.05% through September 1, 2005, at which time the rate is adjusted based on the three year treasury index to a new fixed rate through maturity. The borrowing matures in 2008 and is secured by the hotel but otherwise is non-recourse to the Company.
11. Indebtedness, continued: -------------
Symphony has a $50,000,000 revolving credit facility, of which $37,700,000 and $34,200,000 was outstanding at December 31, 2004 and 2003, respectively, and is included above in other subsidiary debt. This financing, which is secured by all of Symphony's assets but otherwise is non-recourse to the Company, matures in 2006 and bears interest based on LIBOR plus 3.85%. At December 31, 2004, the interest rate on this facility was 6.25%. At December 31, 2003, Symphony was not in compliance with a financial covenant contained in its $50,000,000 credit facility but had obtained a waiver from the lender that suspended application of the covenant until March 31, 2004. Symphony is currently in compliance with the covenant and expects it will continue to be in compliance in the future.
Included in other subsidiary debt are fixed rate borrowings of the Company's banking and lending operations of $21,300,000 and $16,600,000 at December 31, 2004 and 2003, respectively. These borrowings are primarily comprised of repurchase agreements, that at December 31, 2004 have an average term of approximately 15 days and a weighted average interest rate of 2.4%, and are secured by mortgage-backed securities that have a book value of $22,100,000 at December 31, 2004.
Other subsidiary debt also includes a mortgage financing of $20,000,000 obtained in 2003, which otherwise is non-recourse to the Company, in connection with the acquisition of a 90% interest in 8 acres of unimproved land in Washington, D.C. The financing matures in 2005 and bears interest based on LIBOR plus 3%. At December 31, 2004, the interest rate on this facility was 5.4%.
The Company's debt instruments require maintenance of minimum Tangible Net Worth, limit distributions to shareholders and limit Indebtedness and Funded Debt, all as defined in the agreements. In addition, the debt instruments contain limitations on investments, liens, contingent obligations and certain other matters. As of December 31, 2004, cash dividends of approximately $620,900,000 would be eligible to be paid under the most restrictive covenants.
Substantially all of WilTel's assets (with an aggregate book value of $1,611,700,000) are pledged as collateral under WilTel's debt agreements. All of Symphony's assets (with an aggregate book value of $65,600,000) are pledged as collateral under Symphony's debt agreement. Property, equipment and leasehold improvements of the manufacturing division (with a net book value of $5,400,000) are pledged as collateral for Industrial Revenue Bonds; and $195,800,000 of other assets (primarily property) are pledged for other indebtedness aggregating $112,600,000. In addition, the Industrial Revenue Bond obligation is collateralized by a letter of credit which is fully collateralized by securities with a book value of $11,000,000.
Interest rate swap agreements were used to manage the potential impact of changes in interest rates on customer banking deposits. Under interest rate swap agreements, the Company had agreed with other parties to pay fixed rate interest amounts and receive variable rate interest amounts calculated by reference to an agreed notional amount. The variable interest rate portion of the swaps was a specified LIBOR interest rate. These interest rate swaps expired in 2003.
Counterparties to interest rate and currency swap agreements are major financial institutions, that management believes are able to fulfill their obligations. Management believes any losses due to default by the counterparties are likely to be immaterial.
The aggregate annual mandatory redemptions of debt during the five year period ending December 31, 2009 are as follows (in thousands): 2005 - $68,200; 2006 - $69,400; 2007 - $18,000; 2008 - $24,100; and 2009 - $119,200.
11. Indebtedness, continued: -------------
At December 31, 2004, customer banking deposits include $8,600,000 aggregate amount of time deposits in denominations of $100,000 or more.
The weighted average interest rate on short-term borrowings (consisting of customer banking deposits and subsidiary revolving credit agreements) was 4.6% and 3.4% at December 31, 2004 and 2003, respectively.
12. Common Shares, Stock Options and Preferred Shares: --------------------------------------------------
The Board of Directors from time to time has authorized acquisitions of the Company's common shares. In December 1999, the Company's Board of Directors increased to 6,000,000 the maximum number of shares that the Company is authorized to purchase. During the three year period ended December 31, 2004, the Company acquired 7,371 common shares at an average price of $23.89 per common share, all in connection with employees exercising stock options. At December 31, 2004, the Company is authorized to repurchase 3,733,148 common shares.
In December 2002, the Company completed a private placement of approximately $150,000,000 of equity securities, based on a common share price of $23.50, to mutual fund clients of Franklin Mutual Advisers, LLC, including the funds comprising the Franklin Mutual Series Funds. The Company issued 4,361,399 of the Company's common shares and newly authorized Series A Non-Voting Convertible Preferred Stock, that were converted into 2,021,580 common shares in March 2003.
The Company has a fixed stock option plan which provides for grants of options or rights to non-employee directors and certain employees up to a maximum grant of 450,000 shares to any individual in a given taxable year. The maximum number of common shares which may be acquired through the exercise of options or rights under this plan cannot exceed 1,800,000. The plan provides for the issuance of stock options and stock appreciation rights at not less than the fair market value of the underlying stock at the date of grant. Options generally become exercisable in five equal annual instalments starting one year from date of grant. No stock appreciation rights have been granted.
During the second quarter of 2000, pursuant to shareholder approval, warrants to purchase 600,000 common shares were issued to each of the Company's Chairman and President. The warrants were exercisable through May 15, 2005 at an exercise price of $15.97 per common share (105% of the closing price of a common share on the date of grant). In June 2004, Joseph S. Steinberg, President of the Company, sold all of his warrants to Jefferies & Company, Inc. ("Jefferies") based on the value of $33.33 per Leucadia share. In September 2004, Ian M. Cumming, Chairman of the Board of the Company, and others (principally family members) sold warrants to purchase 361,500 of the Company's common shares to Jefferies based on a value of $36.67 per Leucadia share. Jefferies exercised all of the warrants during 2004. Additionally, in September 2004, Mr. Cumming and others (principally family members) exercised warrants to purchase 238,500 shares at an exercise price of $15.97 per share. During 2004, the Company filed two registration statements covering the shares owned by Jefferies and each were effective for a thirty day period.
12. Common Shares, Stock Options and Preferred Shares, continued: --------------------------------------------------
A summary of activity with respect to the Company's stock options for the three years ended December 31, 2004 is as follows:
The weighted-average fair value of the options granted was $8.29 per share for 2004, $6.29 per share for 2003 and $5.27 per share for 2002 as estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: (1) expected volatility of 19.1% for 2004, 29.9% for 2003 and 30.3% for 2002; (2) risk-free interest rates of 3.3% for 2004, 2.3% for 2003 and 3.5% for 2002; (3) expected lives of 3.7 years for 2004, 4.0 years for 2003 and 3.7 years for 2002; and (4) dividend yields of .4% for 2004, .6% for 2003 and .8% for 2002.
The following table summarizes information about fixed stock options outstanding at December 31, 2004:
12. Common Shares, Stock Options and Preferred Shares, continued: -------------------------------------------------
At December 31, 2004 and 2003, 1,453,005 and 1,618,155, respectively, of the Company's common shares were reserved for stock options, at December 31, 2004, 7,619,745 of the Company's common shares were reserved for the 3 3/4% Convertible Senior Subordinated Notes, and at December 31, 2003, 1,200,000 of the Company's common shares were reserved for warrants.
At December 31, 2004 and 2003, 6,000,000 of preferred shares (redeemable and non-redeemable), par value $1 per share, were authorized and not issued.
13. Net Securities Gains (Losses): -----------------------------
The following summarizes net securities gains (losses) for each of the three years in the period ended December 31, 2004 (in thousands):
(a) Includes a provision to write down investments in certain available for sale securities in 2004, 2003 and 2002, an investment in a non-public security in 2003 and an equity investment in a non-public fund in 2002.
Proceeds from sales of investments classified as available for sale were $1,460,200,000, $683,700,000 and $649,000,000 during 2004, 2003 and 2002, respectively. Gross gains of $142,300,000, $17,700,000 and $20,500,000 and gross losses of $1,600,000, $2,100,000 and $21,000,000 were realized on these sales during 2004, 2003 and 2002, respectively.
14. Other Results of Operations Information: ---------------------------------------
Investment and other income for each of the three years in the period ended December 31, 2004 consists of the following (in thousands):
Taxes, other than income or payroll, amounted to $23,900,000, $6,600,000 and $3,400,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Advertising costs amounted to $5,400,000, $2,100,000 and $1,400,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
15. Income Taxes: ------------
The principal components of deferred taxes at December 31, 2004 and 2003 are as follows (in thousands):
As of December 31, 2004, the Company had consolidated federal NOLs of $356,000,000, none of which expire prior to 2023, that may be used to offset the taxable income of any member of the Company's consolidated tax group. WilTel has $3,549,000,000 of federal NOLs, none of which expire prior to 2019, $45,000,000 of capital loss carryforwards, which expire in 2005 through 2007, and $28,000,000 of foreign NOLs and various state NOLs that expire in various years. The potential benefit from the capital loss carryforwards and the foreign NOLs are not reflected in the table above, since the Company does not expect it will be able to use them before they expire. In addition, at December 31, 2004, WebLink had $140,000,000 of federal NOLs, none of which expire prior to 2023. All of WilTel's and WebLink's NOLs and capital loss carryforwards are only available to offset the federal taxable income of WilTel and WebLink and each of their respective subsidiaries. However, WilTel also has substantial other tax attributes and substantial deductions (primarily depreciation deductions), some of which are also available to offset the federal taxable income of the Company and its other subsidiaries. Uncertainties that may affect the utilization of the Company's tax attributes include future operating results, tax law changes, the amount of WilTel deductions that are available to offset the income of other members of the Company's consolidated tax return, rulings by taxing authorities regarding whether certain transactions are taxable or deductible and expiration of carryforward periods.
The Company established a valuation allowance that fully reserved for all of WilTel's net deferred tax assets, reduced by an amount equal to the Company's current and deferred federal income tax liabilities as of the date of acquisition. The Company needed to establish the valuation allowance because, on a pro forma combined basis, the Company is not able to demonstrate that it is more likely than not that it will be able to realize the deferred tax asset. Subsequent to the acquisition of WilTel, any benefit realized from WilTel's deferred tax asset reduces the valuation allowance for the deferred tax asset; however, that reduction is first applied to reduce the carrying
15. Income Taxes, continued: -------------
amount of the acquired non-current intangible assets of WilTel rather than reduce the income tax provision of any component of total comprehensive income. During 2004, $22,300,000 of the reduction in the valuation allowance reduced the carrying amount of WilTel's non-current intangible assets to zero. The remaining reduction in the valuation allowance results from a federal income tax carryback refund of $3,900,000 and the Company's use of WilTel's tax attributes to offset the federal income tax provision that would have otherwise been recorded during 2004.
In future periods, the Company does not expect it will reflect a net federal income tax expense or benefit for total comprehensive income in the aggregate until such time as the Company is able to reduce its valuation allowance and recognize a net deferred tax asset. Each component of other comprehensive income may reflect either a federal income tax provision or benefit in future periods, depending upon the relative amounts of each component; however, in the aggregate for all components the Company does not expect to report any net federal income tax expense or benefit for the foreseeable future.
Under certain circumstances, the ability to use the NOLs and future deductions could be substantially reduced if certain changes in ownership were to occur. In order to reduce this possibility, the Company's certificate of incorporation includes a charter restriction, which prohibits transfers of the Company's common stock under certain circumstances.
The provision (benefit) for income taxes for each of the three years in the period ended December 31, 2004 was as follows, excluding amounts allocated to equity in associated companies, trust preferred securities and discontinued operations (in thousands):
15. Income Taxes, continued: -------------
Reflected above as recognition of additional tax benefits and resolution of tax contingencies are reductions to the Company's income tax provision for the favorable resolution of certain federal and state income tax contingencies. The Internal Revenue Service has completed its audit of the Company's consolidated federal income tax returns for the years 1996 through 1999, without any material payment required from the Company.
The statute of limitations with respect to all years through 2000 has expired. Prior to May 2001, WilTel was included in the consolidated federal income tax return of its former parent, The Williams Companies Inc. ("Williams"). Pursuant to a tax settlement agreement between WilTel and Williams, WilTel has no liability for any audit adjustments made to Williams' consolidated tax returns; however, adjustments to Williams' prior years tax returns could affect certain of WilTel's tax attributes that impact the calculation of alternative minimum taxable income.
16. Pension Plans and Postretirement Benefits: -----------------------------------------
The information presented below for defined benefit pension plans and postretirement benefits is presented separately for the Company and WilTel. The Company presents the information separately since WilTel still has some active participants in its plan and its investment strategies, assumptions and results are significantly different than those of the Company.
The Company: Prior to 1999, the Company maintained defined benefit pension plans covering employees of certain units who also met age and service requirements. Effective December 31, 1998, the Company froze its defined benefit pension plans. A summary of activity with respect to the Company's defined benefit pension plan for 2004 and 2003 is as follows (in thousands):
(a) Includes charges to expense of $800,000 and $1,100,000 for 2004 and 2003, respectively, relating to discontinued operations obligations.
16. Pension Plans and Postretirement Benefits, continued: ------------------------------------------
As of December 31, 2004 and 2003, $20,700,000 and $15,300,000, respectively, of the net amount recognized in the consolidated balance sheet was reflected as a charge to accumulated other comprehensive income and $10,600,000 and $2,600,000, respectively, was reflected as accrued pension cost. Since the Company froze its defined benefit pension plan, the accumulated benefit obligation is the same as the projected benefit obligation. No contributions are expected to be made in 2005 related to the Company's defined benefit pension plan.
Pension expense related to the defined benefit pension plan charged to operations included the following components (in thousands):
At December 31, 2004, the plan's assets consist of U.S. government and agency bonds (43%), investment grade bonds (28%) and cash equivalents (29%). At December 31, 2003, the plan's assets consisted of U.S. government and agencies bonds (72%), investment grade bonds (26%) and cash equivalents (2%).
The defined benefit pension plan assets are invested in short-term investment grade fixed income investments in order to maximize the value of its invested assets by minimizing exposure to changes in market interest rates. This investment strategy provides the Company with more flexibility in managing the plan should interest rates rise and result in a decrease in the discounted value of benefit obligations. The current investment strategy only permits investments in investment grade securities, and a final average maturity target for the portfolio of one and one-half years and a one year maximum duration.
To develop the assumption for the expected long-term rate of return on plan assets, the Company considered the following underlying assumptions: 2% current expected inflation, 1% real rate of return for risk-free investments (primarily U.S. government and agency bonds) for the target duration and .25% default risk premium for the portion of the portfolio invested in non-U.S. government and agency bonds. The combination of these underlying assumptions resulted in the selection of the 3.25% expected long-term rate of return assumption for 2004. Because pension expense includes the cost of expected plan administrative expenses, the 3.25% assumption is not reduced for such expenses.
Several subsidiaries provide certain health care and other benefits to certain retired employees under plans which are currently unfunded. The Company pays the cost of postretirement benefits as they are incurred. Amounts charged to expense were not material in each of the three years ended December 31, 2004.
16. Pension Plans and Postretirement Benefits, continued: ------------------------------------------
A summary of activity with respect to the Company's postretirement plans for 2004 and 2003 is as follows (in thousands):
The Company expects to spend $400,000 on postretirement benefits during 2005. At December 31, 2004, the assumed health care cost trend rate for 2005 used in measuring the accumulated postretirement benefit obligation is 10% and, at December 31, 2003, such rate for 2004 was 11.5%. At December 31, 2004 and 2003, the assumed health care cost trend rates were assumed to decline to an ultimate rate of 5.0% by 2013. If the health care cost trend rates were increased or decreased by 1%, the accumulated postretirement obligation as of December 31, 2004 would have increased or decreased by $200,000. The effect of these changes on interest cost for 2004 would be immaterial.
The Company uses a December 31 measurement date for its plans. The assumptions used relating to the defined benefit plan and postretirement plans are as follows:
16. Pension Plans and Postretirement Benefits, continued: ------------------------------------------
WilTel:
WilTel maintains defined benefit pension plans and a postretirement plan covering certain employees who met certain age and service requirements. Employees hired subsequent to April 2001 are not eligible to participate in WilTel's defined benefit pension plan. Employees hired subsequent to December 31, 1991 are not eligible to participate in WilTel's postretirement benefits plan. A summary of activity with respect to WilTel's defined benefit pension plan for 2004 and for the period from November 6, 2003 (date of acquisition) through December 31, 2003 is as follows (in thousands):
16. Pension Plans and Postretirement Benefits, continued: ------------------------------------------
WilTel's plans' assets consist of equity securities (71%), debt securities (19%) and cash equivalents (10%) at December 31, 2004. At December 31, 2003, the plans' assets consisted of equity securities (77%), debt securities (17%) and mutual funds (6%).
The investment objectives of WilTel's plan emphasize long-term capital appreciation as a primary source of return and current income as a supplementary source.
WilTel's target allocation is as follows:
Interim Long-term Target Target ------ ------ Equity securities: Large cap stocks 36% 40% Small cap stocks 18% 10% International stocks 21% 20% ----- ----- Total equity securities 75% 70% Fixed income/bonds 25% 30% ----- ----- Total 100% 100% ===== =====
The interim target was established in order to balance speed and caution in transitioning to the long-term allocations, lowering the risk of selling low and buying high and shifting the portfolio to the long-term targets under the right market conditions.
Investment performance objectives are based upon a benchmark index or mix of indices over a market cycle. The investment strategy designates certain investment restrictions for domestic equities, international equities and fixed income securities. These restrictions include the following:
o For domestic equities, there will generally be no more than 5% of any manager's portfolio at market in any one company and no more than 150% of any one sector of the appropriate index for any manager's portfolio. Restrictions are also designated on outstanding market value of any one company at 5% for large to medium equities and 8% for small to medium equities.
o For international equities, there will be no more than 8% in any one company in a manager's portfolio, no fewer than three countries in a manager's portfolio, no more than 10% of the portfolio in countries not represented in the EAFE index, no more than 150% of any one sector of the appropriate index and no currency hedging is permitted.
o Fixed income securities will all be rated BBB- or better at the time of purchase, there will be no more than 8% at market in any one security (U.S. government and agency positions excluded), no more than a 30-year maturity in any one security and investments in standard collateralized mortgage obligations are limited to securities that are currently paying interest, receiving principal, do not contain leverage and are limited to 10% of the market value of the portfolio.
To develop the assumption for the expected long-term rate of return on plan assets, WilTel considered historical returns and future expectations, including a more conservative expectation of future returns and asset allocation targets as WilTel's closed participant population grows closer to retirement age. Based on this information, a 7.0% expected long-term rate of return on plan assets was selected for 2004 and 2003.
A summary of activity with respect to WilTel's postretirement plans for 2004 and for the period from November 6, 2003 (date of acquisition) through December 31, 2003 is as follows (in thousands):
16. Pension Plans and Postretirement Benefits, continued: ------------------------------------------
WilTel's postretirement benefit expense was not material for 2004 and for the period from date of acquisition through December 31, 2003.
WilTel's cash cost for its postretirement plan during 2005 is not expected to be material.
The health care cost trend rate assumed for 2005 is 8.8% to 10.8% and 2004 is 12%, declining to an ultimate rate of 5% by 2013. If the health care cost trend rates were increased or decreased by 1%, WilTel's accumulated postretirement obligation as of December 31, 2004 would have increased or decreased by $300,000 and $200,000, respectively. The effect of these changes on the aggregate of service and interest cost for 2004 would be immaterial.
WilTel uses a December 31 measurement date for its plans. The assumptions used relating to WilTel's defined benefit plan and postretirement plan for 2004 and 2003 are as follows:
The following pension benefit payments, which reflect expected future service, as appropriate, are expected to be paid (in thousands):
2005 $ 2,151 2006 2,555 2007 2,730 2008 2,385 2009 2,881 2010 - 2014 19,601
16. Pension Plans and Postretirement Benefits, continued: ------------------------------------------
The expected benefit payments for its post retirement plan during that ten year period are not expected to be material.
The Company and its consolidated subsidiaries (including WilTel) have defined contribution pension plans covering certain employees. Contributions and costs are a percent of each covered employee's salary. Amounts charged to expense related to such plans were $7,200,000, $2,200,000 and $1,600,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
17. Commitments: -----------
The Company and its subsidiaries rent office space and office equipment under noncancellable operating leases with terms varying principally from one to twenty years. In addition, WilTel enters into noncancellable operating leases for rights of way along its fiber network, network centers and off-network capacity. Rental expense (net of sublease rental income and unfavorable contract amortization) was $85,800,000 in 2004, $14,000,000 in 2003 and $5,200,000 in 2002. Future minimum annual rentals (exclusive of month-to-month leases, real estate taxes, maintenance and certain other charges) under these leases at December 31, 2004 are as follows (in thousands):
2005 $ 60,400 2006 53,500 2007 50,800 2008 44,000 2009 36,200 Thereafter 299,300 ------------ 544,200 Less: sublease income (6,300) ------------ $ 537,900 ============
In connection with the sale of certain subsidiaries and certain non-recourse financings, the Company has made or guaranteed the accuracy of certain representations. No material loss is expected in connection with such matters.
Pursuant to an agreement that was entered into before the Company sold CDS to HomeFed in 2002, the Company agreed to provide project improvement bonds for the San Elijo Hills project. These bonds, which are for the benefit of the City of San Marcos, California and other government agencies are required prior to the commencement of any development at the project. CDS is responsible for paying all third party fees related to obtaining the bonds. Should the City or others draw on the bonds for any reason, CDS and one of its subsidiaries would be obligated to reimburse the Company for the amount drawn. At December 31, 2004, $28,200,000 was outstanding under these bonds, $27,700,000 of which expires in 2005 and the remainder thereafter.
Sales to SBC accounted for 70% of 2004 and 66% of 2003 Network operating revenues included in the Company's consolidated statement of operations. See Note 24 for further information with respect to WilTel's relationship with SBC.
WilTel is prohibited and Symphony is limited by debt agreements in the amount of dividends and other transfers of funds that are available to the Company. The banking and lending subsidiary is limited by regulatory requirements and agreements in the amount of dividends and other transfers of funds that are available to the Company. Principally as a result of such restrictions, the net assets of these subsidiaries which are subject to limitations on transfer of funds to the Company were approximately $599,100,000 at December 31, 2004.
18. Litigation: ----------
The Company and its subsidiaries are parties to legal proceedings that are considered to be either ordinary, routine litigation incidental to their business or not material to the Company's consolidated financial position. The Company does not believe that any of the foregoing actions will have a material adverse effect on its consolidated financial position, consolidated results of operations or liquidity.
WilTel is a party to various legal actions and claims, and has reserved $21,500,000 for the satisfaction of all litigation. Certain of these actions relate to the rights of way licensed to WilTel in connection with the installation of its fiber-optic cable and seek damages from WilTel for failure to obtain all necessary landowner consents. Additional right of way claims may be asserted against WilTel. The Company does not believe that the ultimate resolution of all claims, legal actions and complaints will have a material adverse effect upon WilTel's results of operations, although unfavorable outcomes could significantly impact WilTel's liquidity. During 2004, WilTel settled litigation for a cash payment of $5,000,000; the $18,500,000 excess of the reserved amount over the amount paid was recognized as other income.
19. Earnings (Loss) Per Common Share: --------------------------------
For the year ended December 31, 2004, the numerators for basic and diluted per share computations for income from continuing operations were $152,000,000 and $158,200,000, respectively. The calculation for diluted earnings (loss) per share assumes the 3 3/4% Convertible Notes had been converted into common shares for the periods they were outstanding and earnings increased for the interest on such notes, net of the income tax effect ($6,200,000).
For the years ended December 31, 2003 and 2002, there were no differences in the numerators for the basic and diluted per share computations for income from continuing operations. These numerators were $85,900,000 and $154,100,000 for 2003 and 2002, respectively. The denominators for basic per share computations were 106,692,000, 91,896,000 and 83,501,000 for 2004, 2003 and 2002, respectively. The denominators for diluted per share computations reflect the dilutive effect of 779,000, 656,000 and 524,000 options and warrants for 2004, 2003 and 2002, respectively (the treasury stock method was used for these calculations), and 5,275,000 shares related to the 3 3/4% Convertible Notes for 2004. Due to the nature of their rights and their nominal liquidation value, the Series A Non-Voting Convertible Preferred shares were treated as common shares and were included in the denominator for basic and diluted per share computations for 2002.
20. Fair Value of Financial Instruments: -----------------------------------
The following table presents fair value information about certain financial instruments, whether or not recognized on the balance sheet. Fair values are determined as described below. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The fair value amounts presented do not purport to represent and should not be considered representative of the underlying "market" or franchise value of the Company. The methods and assumptions used to estimate the fair values of each class of the financial instruments described below are as follows:
(a) Investments: The fair values of marketable equity securities, fixed maturity securities and investments held for trading purposes (which include securities sold not owned) are substantially based on quoted market prices, as disclosed in Note 6.
(b) Cash and cash equivalents: For cash equivalents, the carrying amount approximates fair value.
(c) Notes receivables: The fair values of variable rate notes receivable are estimated to be the carrying amount.
20. Fair Value of Financial Instruments, continued: ------------------------------------
(d) Loan receivables of banking and lending subsidiaries: At December 31, 2004, the carrying amount approximates fair value. At December 31, 2003, the fair value of loan receivables of the banking and lending subsidiaries is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings for the same remaining maturities.
(e) Customer banking deposits: The fair value of customer banking deposits is estimated using rates currently offered for deposits of similar remaining maturities.
(f) Long-term and other indebtedness: The fair values of non-variable rate debt are estimated using quoted market prices and estimated rates which would be available to the Company for debt with similar terms. The fair value of variable rate debt is estimated to be the carrying amount.
(g) Derivative instruments: The fair values of the interest rate swap and currency rate swap agreements are based on rates currently available for similar agreements.
The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 2004 and 2003 are as follows (in thousands):
21. Concentration of Credit Risk: ----------------------------
As of December 31, 2004 and 2003, accounts receivable due from SBC, WilTel's largest customer, represented approximately 28.9% and 32.2%, respectively, of the Company's trade receivables. For 2004 and for the period from date of acquisition of WilTel through December 31, 2003, telecommunications revenues relating to SBC represented approximately 46% and 26%, respectively, of the Company's total revenues and other income.
22. Segment Information: -------------------
The Company's reportable segments consist of its operating units, which offer different products and services and are managed separately. The Company's telecommunications business is conducted by WilTel and contains two segments, Network and Vyvx. Network owns or leases and operates a nationwide fiber optic network over which it provides a variety of telecommunications services. Vyvx transmits audio and video programming over the network and distributes advertising media in physical and electronic form. The Company's other segments include healthcare services, manufacturing, banking and lending and domestic real estate. Healthcare services primarily include the provision of physical, occupational, speech and respiratory therapy services, healthcare staffing services and Medicare consulting services. Manufacturing operations manufacture and market lightweight plastic netting used for a variety of purposes. Banking and lending operations historically made collateralized personal automobile instalment loans to individuals who had difficulty obtaining credit, at interest rates above those charged to individuals with good credit histories. The banking and lending segment has ceased originating any new loans and in 2004 sold 97% of its remaining outstanding loans to a third party. The Company's domestic real estate operations consist of a variety of commercial properties, residential land development projects and other unimproved land, all in various stages of development and all available for sale. Other operations primarily consist of winery operations and development of a copper mine.
Associated companies include equity interests in entities that the Company accounts for on the equity method of accounting. Prior to the acquisition of the outstanding common stock of WilTel that it didn't already own in November 2003, the Company accounted for its 47.4% interest in WilTel as an associated company. Other investments in associated companies include Olympus, Berkadia, HomeFed, JPOF II and EagleRock. Both JPOF II and EagleRock are entities engaged in investing and/or securities transactions activities.
Corporate assets primarily consist of investments and cash and cash equivalents and corporate revenues primarily consist of investment income and securities gains and losses. Corporate assets, revenues, overhead expenses and interest expense are not allocated to the operating units. The Company has a manufacturing facility located in Belgium and an interest, through MK Resources, in a copper deposit in Spain. WilTel owns or has the right to use certain cable systems which connect its U.S. domestic network to foreign countries, and has the right to use wavelengths in Europe which it is currently not using. These are the only entities with non-U.S. revenue or assets that the Company consolidates, and they are not material. In addition to its investment in Bermuda-based Olympus, the Company owns 36% of the electric utility in Barbados. From time to time the Company invests in the securities of non-U.S. entities or in investment partnerships that invest in non-U.S. securities.
Except for the telecommunications segments of WilTel, the primary measure of segment operating results and profitability used by the Company is income (loss) from continuing operations before income taxes, minority expense of trust preferred securities and equity in income (losses) of associated companies. For WilTel's segments, segment profit from operations is the primary performance measure of segment operating results and profitability. WilTel defines segment profit from operations as income before income taxes, interest expense, investment income, depreciation and amortization expense and other non-operating income and expense.
The following information reconciles segment profit from operations of the Network and Vyvx segments to the most comparable GAAP measure which is used for all other reportable segment for the year ended December 31, 2004 and for the period from November 6, 2003 through December 31, 2003 (in millions):
22. Segment Information, continued: --------------------
(1) See note (d) to segment information below.
(2) If items in these categories cannot be directly attributed to a particular WilTel segment, they are allocated to each segment based upon a formula that considers each segment's revenues, property and equipment and headcount.
(3) For 2004, includes income of $18,500,000 related to the settlement of litigation for less than amounts reserved, income of $6,000,000 related to the sale of an equity security which had a zero book value, gains of $3,500,000 related to cash and securities received in excess of the book value of secured claims in customers' bankruptcy, and income of $2,300,000 related to the reversal of excess reserves for long-term commitments.
Certain information concerning the Company's segments for 2004, 2003 and 2002 is presented in the following table. Consolidated subsidiaries are reflected as of the date of acquisition, which for WilTel's segments was November 2003 and for Symphony's healthcare services segment was September 2003. Associated Companies are only reflected in the table below under identifiable assets employed.
22. Segment Information, continued: --------------------
22. Segment Information, continued: --------------------
(a) Revenues and other income for each segment include amounts for services rendered and products sold, as well as segment reported amounts classified as investment and other income and net securities gains (losses) on the Company's consolidated statements of operations.
(b) For 2004 and the period from November 6, 2003 (date of acquisition) through December 31, 2003, includes services provided to SBC Communications Inc. of $1,032,800,000 and $141,700,000, respectively, pursuant to long-term preferred provider agreements.
(c) Net securities gains for Corporate aggregated $123,100,000 during 2004, which primarily resulted from the sale of publicly traded debt and equity securities that had been classified as available for sale securities. For 2004, includes a provision of $4,600,000 to write down investments in certain available for sale securities. For 2003, includes a provision of $6,500,000 to write down investments in certain available for sale securities and an investment in a non-public security. For 2002, includes a provision of $37,100,000 to write down investments in certain available for sale securities and an equity investment in a non-public fund. The write down of the available for sale securities resulted from a decline in market value determined to be other than temporary.
(d) Eliminates intersegment revenues billed from Network to Vyvx. However, the intersegment revenues are included in the calculation to determine segment profit from operations and income (loss) from continuing operations for each of Network and Vyvx.
(e) For the years ended December 31, 2004, 2003 and 2002, income (loss) from continuing operations has been reduced by depreciation and amortization expenses of $235,900,000, $61,400,000 and $18,500,000, respectively; such amounts are primarily comprised of Corporate ($11,400,000, $11,700,000 and $8,700,000, respectively), and amounts related to WilTel's segments, which are disclosed above. Depreciation and amortization expenses for other segments are not material.
(f) For the years ended December 31, 2004, 2003 and 2002, income (loss) from continuing operations has been reduced by interest expense of $96,800,000, $43,000,000 and $33,000,000, respectively; such amounts are primarily comprised of Corporate ($55,300,000, $26,000,000 and $13,100,000, respectively), banking and lending ($2,700,000, $8,800,000 and $18,100,000, respectively), and amounts related to WilTel's segments, which are disclosed above. Interest expense for other segments is not material.
23. Selected Quarterly Financial Data (Unaudited): ---------------------------------------------
The Internal Revenue Service has completed the audit of the Company's consolidated federal income tax returns for the years 1996 through 1999, without any material tax payment required from the Company. Income taxes reflect a benefit for the favorable resolution of certain income tax contingencies for which the Company had previously established reserves of $27,300,000 for the third quarter of 2004 and $13,900,000 for the fourth quarter of 2003. In addition, the fourth quarter of 2004 reflects a benefit to record a federal income tax carryback refund of $3,900,000.
In 2004 and 2003, the totals of quarterly per share amounts do not equal annual per share amounts because of changes in outstanding shares during the year.
24. Subsequent Event: ----------------
On January 31, 2005, SBC announced that it would buy AT&T Corp., and announced its intention to migrate the services provided by WilTel to the AT&T network. SBC indicated that it expects to close its acquisition of AT&T in the first half of 2006.
Once SBC completes the migration of its business from WilTel's network to the AT&T network and terminates the existing preferred provider agreements between WilTel and SBC (scheduled to extend until 2019), SBC will be required to pay WilTel up to $200,000,000 for all costs WilTel incurs in connection with such termination, including increased costs of the network facilities remaining with WilTel due to the loss of SBC traffic (defined as "Transition Costs" in the provider agreements). WilTel anticipates that a migration of services from its network to AT&T would not begin until after the appropriate regulatory agencies approve SBC's acquisition of AT&T. WilTel expects it will take anywhere from two to three years from now for SBC to migrate all of its traffic off of WilTel's network, and anticipates that it will continue to provide some level of service to SBC into 2007.
Pursuant to the preferred provider agreements, the price for products and services, determined separately for each product or service, generally will be equal to the lesser of the cost of the product or service plus a specified rate of return, the prices charged to other customers, the current market rate or, in some circumstances, a specific rate. If either party can secure lower prices for comparable services that the other party will not match, then that party is free to utilize the lowest cost provider. WilTel and SBC have agreed to use a fixed price for voice transport services (the substantial majority of WilTel's SBC generated revenue) through April 1, 2005. WilTel is currently engaged in negotiations with SBC with respect to a transition pricing agreement and other matters that will enable WilTel to continue to provide services to SBC after April 1, 2005. If the parties fail to reach agreement on pricing, any disputes as to pricing methodology are to be resolved through binding arbitration.
Since SBC is WilTel's largest customer, accounting for 70% of Network's 2004 operating revenues, the Company concluded that the SBC announcement is an event which requires the Company to assess the carrying value of WilTel's long-lived assets for impairment, principally property and equipment. Since the event which gave rise to the impairment review occurred on January 31, 2005, and is not reflective of a condition that existed as of December 31, 2004, the assessment of impairment will be performed as part of the preparation of the Company's financial statements for the first quarter of 2005. The carrying value of WilTel's property and equipment is approximately $1,054,700,000 at December 31, 2004.
As more fully described in Note 11, SBC's announcement is considered an event which could reasonably be expected to have a "material adverse effect" as defined in WilTel's amended credit facility, and while WilTel can no longer access its $25,000,000 revolving credit facility it has no impact on the $360,000,000 of term loans under the agreement. However, the credit agreement provides for an event of default if there is any amendment, supplement, modification or termination of any WilTel contract or agreement that has had or could reasonably be expected to result in a material adverse effect on WilTel (as defined in the credit agreement). As mentioned above, WilTel is currently engaged in negotiations with SBC with respect to a transition pricing agreement and other matters which, if successfully concluded, may or may not be deemed an event of default under the WilTel credit agreement. WilTel intends to enter into discussions with its lenders before entering into any new definitive agreement with SBC.
Schedule I - Condensed Financial Information of Registrant LEUCADIA NATIONAL CORPORATION BALANCE SHEETS December 31, 2004 and 2003 (Dollars in thousands, except par value)
See notes to this schedule.
Schedule I - Condensed Financial Information of Registrant, continued LEUCADIA NATIONAL CORPORATION STATEMENTS OF OPERATIONS For the years ended December 31, 2004, 2003 and 2002 (In thousands, except per share amounts)
See notes to this schedule.
Schedule I - Condensed Financial Information of Registrant, continued LEUCADIA NATIONAL CORPORATION STATEMENTS OF CASH FLOWS For the years ended December 31, 2004, 2003 and 2002 (In thousands)
See notes to this schedule.
Schedule I - Condensed Financial Information of Registrant, continued LEUCADIA NATIONAL CORPORATION STATEMENTS OF CASH FLOWS, continued For the years ended December 31, 2004, 2003 and 2002 (In thousands)
See notes to this schedule.
Schedule I - Condensed Financial Information of Registrant, continued LEUCADIA NATIONAL CORPORATION NOTES TO SCHEDULE
A. The notes to consolidated financial statements of Leucadia National Corporation and Subsidiaries are incorporated by reference to this schedule.
B. The statements of shareholders' equity are the same as those presented for Leucadia National Corporation and Subsidiaries.
C. Equity in the income of associated companies and subsidiaries is after reflecting income taxes recorded by the subsidiaries. The income tax benefit recorded by the parent company includes benefits for the favorable resolution of certain federal and state income tax contingencies of $27,300,000, $24,400,000 and $120,000,000 for 2004, 2003 and 2002, respectively, and a benefit of $3,900,000 to recognize a federal income tax carryback refund for the year ended December 31, 2004.
D. Federal income taxes payable has not been allocated to the individual subsidiaries.
E. The aggregate annual mandatory redemptions of debt during the five year period ending December 31, 2009 are as follows (in thousands): 2005 - $19,100; 2006 - $21,700; 2007 - $0; 2008 - $0; and 2009 - $0.
Schedule II - Valuation and Qualifying Accounts LEUCADIA NATIONAL CORPORATION AND SUBSIDIARIES For the years ended December 31, 2004, 2003 and 2002 (In thousands)
(a) Principally results from the recognition of acquired tax benefits, of which $22,300,000 was applied to reduce the carrying amount of WilTel's acquired non-current intangible assets to zero, $3,900,000 resulted from a carryback refund claim and $6,500,000 resulted from the use of WilTel's tax attributes to offset the federal income tax provision that would have otherwise been recorded during 2004.
(b) Additions represent acquired tax benefits, principally WilTel's tax benefits, for which the Company established a full valuation allowance at acquisition since the Company was not able to demonstrate that it was more likely than not that it will be able to realize such tax benefits.
(c) Principally results from the recognition of acquired tax benefits of $22,500,000, which was applied to reduce the carrying amount of WilTel's acquired non-current intangible assets and a reclassification to other liabilities.
OLYMPUS RE HOLDINGS, LTD. (Incorporated in Bermuda)
Consolidated Financial Statements
DECEMBER 31, 2004, 2003 AND 2002 (expressed in U.S. dollars)
PRICEWATERHOUSECOOPERS - -------------------------------------------------------------------------------- PriceWaterhouseCoopers Chartered Accountants Dorchester House 7 Church Street Hamilton Bermuda HM 11 Telephone +1 (441) 295 2000 Facsimile +1 (441) 295 1242
January 26, 2005
REPORT OF INDEPENDENT AUDITORS
TO THE SHAREHOLDERS OF OLYMPUS RE HOLDINGS, LTD.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, shareholders' equity, comprehensive income and cash flows present fairly, in all material respects, the financial position of Olympus Re Holdings, Ltd. at December 31, 2004 and 2003, and the results of its operations and its cash flows for the years ended December 31, 2004, 2003 and 2002 in conformity with accounting principles generally accepted in the United States of America. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits of these consolidated statements in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
CHARTERED ACCOUNTANTS
MAILING ADDRESS: PO BOX HM 1171, Hamilton, Bermuda HM EX.
A list of partners can be obtained from the above address
OLYMPUS RE HOLDINGS, LTD. Consolidated Balance Sheets AS OF DECEMBER 31, 2004 AND 2003 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
APPROVED BY THE BOARD OF DIRECTORS
Director Director - ----------------------------- -----------------------------
The accompanying notes are an integral part of these consolidated financial statements
OLYMPUS RE HOLDINGS, LTD. Consolidated Statements of Income FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
The accompanying notes are an integral part of these consolidated financial statements
OLYMPUS RE HOLDINGS, LTD. Consolidated Statements of Shareholders' Equity FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
The accompanying notes are an integral part of these consolidated financial statements
OLYMPUS RE HOLDINGS, LTD. Consolidated Statements of Comprehensive Income FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
The accompanying notes are an integral part of these consolidated financial statements
OLYMPUS RE HOLDINGS, LTD. Consolidated Statements of Cash Flows FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
The accompanying notes are an integral part of these consolidated financial statements
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
1. NATURE OF THE BUSINESS
Olympus Re Holdings, Ltd. and its subsidiaries (the "Company") were incorporated under the laws of Bermuda on December 3, 2001 and commenced operations on January 1, 2002. The Company's principal operating subsidiary is Olympus Reinsurance Company, Ltd. ("Olympus Re"). Olympus Re is registered as a Class 4 insurer under The Insurance Act 1978, amendments thereto and related regulations ("The Act"). The Company's bye-laws provide that the Board of Directors of Olympus Re shall consist of persons who first have been elected as designated directors by a resolution in a general meeting of the shareholders of the Company. The Board of Directors of the Company must then vote all shares of Olympus Re owned by the Company to elect such designated directors as Olympus Re directors. The bye-law provisions with respect to the removal of directors of Olympus Re operate similarly (see note 2(h)).
The Company, through Olympus Re, writes reinsurance business on a global basis with an emphasis on property excess business. During the year ended December 31, 2004, this was through two main sources, quota share reinsurance agreements with a U.S. reinsurance company (see note 6) and two underwriting advisory contracts. The purpose of these quota share agreements is to produce primarily property reinsurance. Olympus Re's underwriting advisory contracts are with non-U.S. advisors (see note 5) to recommend excess property and marine reinsurance business and consult on the quota share agreements. The non-U.S. advisors are related to the previously mentioned U.S. reinsurance company through common ownership.
2. SIGNIFICANT ACCOUNTING POLICIES
These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts of assets and liabilities, as well as disclosure of contingent assets and liabilities as at the balance sheet date. Estimates also affect the reported amounts of income and expenses for the reporting period. Actual results could differ from those estimates.
The following is a summary of the significant accounting policies adopted by the Company:
(a) CONSOLIDATION
The consolidated financial statements include the financial statements of the Company and its wholly-owned subsidiary Olympus Re. All significant inter-company balances and transactions have been eliminated on consolidation.
(b) PREMIUMS AND UNEARNED PREMIUMS
The Company records premiums based on cession statements received. Premiums are earned evenly over the term of the underlying reinsurance contract, in proportion to the risk assumed. The portion of the premium related to the unexpired portion of the contract at the end of the fiscal period is reflected in unearned premiums.
Certain reinsurance premiums assumed are estimated based on information provided by the underlying ceding companies. The information used in establishing these estimates is reviewed and subsequent adjustments are taken into income in the period in which they are determined. These premiums are earned over the terms of the related reinsurance contracts.
(1)
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
(c) DEFERRED ACQUISITION COSTS
The Company records acquisition costs based on cessions statements received, in addition to its own direct acquisition costs.
Policy acquisition costs are comprised of ceding commissions, brokerage, premium taxes and other expenses that relate directly to the acquisition of premiums. These costs are deferred and amortized over the terms of the related contracts. Deferred policy acquisition costs are reviewed to determine if they are recoverable from future underwriting profits, including investment income. If such costs are estimated to be unrecoverable, they are expensed.
(d) LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The Company records loss and loss adjustment expenses based on cessions statements received. The reported amounts for incurred but not reported losses are also separately reviewed by the Company. Loss and loss adjustment expense reserves, including losses incurred but not reported and provisions for settlement expenses, includes amounts determined from losses reported to the Company, and management estimates. Due to limited historical experience, industry data is relied upon in the reserving process.
A significant portion of the Company's business is in the property catastrophe market and programs with higher layers of risks. Reserving for losses in such programs is inherently complicated in that losses in excess of the attachment level of the underlying policies are characterized by high severity and low frequency. This limits the volume of industry claims experience available from which to reliably predict ultimate losses following a loss event.
The Company uses industry data and professional judgment to estimate the ultimate loss from reinsurance contracts exposed to a loss event. Delays in reporting losses to the Company together with the potential for unforeseen adverse developments may result in losses and loss expenses significantly greater or less than the reserve provided at the time of the loss event.
Loss and loss adjustment reserve estimates are regularly reviewed and updated, as new information becomes known to the Company. Any resulting adjustments are included in income in the period in which they become known.
(e) CASH AND CASH EQUIVALENTS
Cash and cash equivalents include debt securities and time deposits with a maturity of three months or less from the date of purchase.
(f) INVESTMENTS
The Company's investments in fixed maturities are classified as "available-for-sale" and are carried at fair value, based on quoted market prices. Unrealized gains and losses are included within accumulated other comprehensive income in shareholders' equity.
Net investment income is stated net of investment management and custody fees. Interest income is recognized on the accrual basis and includes the amortization of premium or discount on fixed interest securities purchased at amounts different from their par value.
(2)
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
Gains and losses on investments are included in investment income when realized. Investments are recorded on a trade date basis and the cost of securities sold is determined on the first-in, first-out basis.
Investments are reviewed periodically to determine if they have sustained an impairment of value that is considered to be other than temporary. The identification of potentially impaired investments involves significant management judgment, which includes the determination of their fair value and the assessment of whether any decline in value is other than temporary. If investments are determined to be impaired, a loss is charged to the income statement in that period.
(g) FOREIGN CURRENCY
Monetary assets and liabilities denominated in foreign currencies have been translated to U.S. dollars at the rates of exchange prevailing at the balance sheet date. Income and expense transactions originating in foreign currencies are translated at the rates of exchange prevailing on the date of the transaction. Gains and losses on foreign currency translation are included in income.
(h) NEW ACCOUNTING PRONOUNCEMENTS
In December 2003, the FASB issued a FASB Interpretation No. 46, Consolidation of variable interest entities - an interpretation of ARB No. 51 (revised December 2003) ("FIN 46R"). FIN 46R clarifies the accounting and reporting for certain entities in which equity investors do not have the characteristics of a controlling financial interest.
Olympus Re's Board of Directors, who are elected as described in note 1, have unilateral authority to manage the affairs of Olympus Re, except for certain actions that require approval by the Company as sole shareholder. Since the Company and Olympus Re are under the common control of the shareholders of the Company, the financial statements of the Company were previously presented on a combined basis, rather than on a consolidated basis, in accordance with ARB No. 51.
The Company adopted FIN 46R during 2004, the impact of which is to present the financial statements as consolidated rather than combined. This has not had any impact on the Company's net income or net shareholders' equity as presented in these financial statements.
3. INVESTMENTS
The estimated fair value of fixed interest securities is based on quoted market values.
The Company did not have any investments in a single corporate security which exceeded 1.6% of total fixed interest securities as of December 31, 2004 and 2003.
The following table sets forth certain information regarding the investment ratings of the company's fixed interest securities portfolio as of December 31, 2004 and 2003.
The amortized cost and estimated fair value amounts for fixed interest securities held at December 31, 2004 are shown by contractual maturity. Actual maturity may differ from contractual maturity because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
(4)
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
The following table shows the unrealized losses and fair value of the Company's investments with unrealized losses that are not deemed to be other than temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004:
The unrealized losses on the Company's investment portfolio are the result of changes in general market conditions and interest rate increases, rather than credit concerns related to these securities. It is believed that the issuers of these securities will continue, to meet the contractual obligations to the Company, including full repayment on principal as contractually obligated. The Company has the ability to hold these securities until a market price recovery, or until maturity, and does not consider these investments to be other than temporarily impaired at December 31, 2004.
(5)
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
The components of net investment income are as follows:
During 2004, 2003 and 2002, proceeds from sales of available-for-sale securities were $610,701,636, $564,819,740 and $483,840,192 respectively. Gross realized gains were $2,990,444, $5,548,574 and $3,361,350 and gross realized losses were $1,985,079, $418,276 and $391,491 for the years end December 31, 2004, 2003 and 2002 respectively.
White Mountain Advisors, LLC, the Company's investment advisors, receive a management fee at an annual rate of 0.1% of net invested assets. In 2003 and 2002 the annual rate was 0.2%.
In the normal course of business, the Company provides collateral in accordance with certain reinsurance agreements. The Company has cash equivalents of $2,840,794 and $54,453 and investments of $287,839,361 and $201,128,202 in trusts, as of December 31, 2004 and 2003, respectively, provided as collateral.
4. LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
Loss and loss adjustment expense reserves are estimates subject to variability, and the variability could be material in the near term. The variability arises because all events affecting the ultimate settlement of claims have not taken place and may not take place for some time. Variability can be caused by receipt of additional claim information, changes in judicial interpretation of contracts or significant changes in the severity or frequency of claims from historical trends. Loss and loss adjustment expenses estimates are based on all relevant information available to the Company. Methods of estimation are used which the Company believes produce reasonable results given current information.
(6)
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
Reserve activity for loss and loss expenses is summarized below:
The December 31, 2004 and 2003 year end balance is comprised of provisions for reported claims of $115,474,945 and $33,300,789 and provisions for claims incurred but not reported of $185,546,783 and $81,016,352, respectively.
5. ADVISORY FEES PAYABLE
Advisory fees payable represents override commission and profit commissions payable, including a 20% profit commission payable to the non-U.S. advisors, White Mountains Underwriting Limited and White Mountains Underwriting (Bermuda) Limited, (collectively White Mountains Underwriting) for all business on which they advise.
6. MAJOR CUSTOMERS
During the years ended December 31, 2004, 2003 and 2002, the Company derived 86%, 90% and 99%, respectively, of its premiums written from Folksamerica Reinsurance Company ("Folksamerica") for which the Company pays an override commission. During the years ended December 31, 2004 and 2003, the Company derived 9% and 8% respectively, of its premiums written from business recommended by White Mountains Underwriting for which the Company pays an override commission. No significant business was written through White Mountains Underwriting in 2002. Folksamerica and White Mountains Underwriting are wholly-owned subsidiaries of White Mountains Insurance Group Ltd., which is a minority shareholder of the Company through a 50% joint venture, and is also the parent of White Mountain Advisors, LLC. Included in premiums receivable for the years ended December 31, 2004 and 2003 were amounts of $166,798,822 and $157,980,421, respectively, due from Folksamerica.
(7)
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
7. CAPITAL STOCK
(a) AUTHORIZED SHARES
The Company's authorized share capital is 20,000,000 common shares of the par value $0.01 each.
(b) COMMON SHARES
At December 31, 2004 and 2003, the total issued and outstanding common shares of the Company were 3,716,378 and 4,385,714, respectively, with a par value of $0.01. The holders of the ordinary shares are entitled to receive dividends and are allocated one vote per share, provided that, if the controlled shares of any shareholder (excluding Leucadia National Corporation) constitute 9.5 percent or more of the outstanding common shares of the Company, only a fraction of the vote will be allowed so as not to exceed 9.5 percent. There are various restrictions on the ability of shareholders to dispose of their shares.
In the period to December 31, 2001, the Company received cash of $509,850,000 in respect of subscriptions of common shares. On January 2, 2002, payment of the remaining outstanding subscriptions totaling $150,000 was received from shareholders. Following receipt of the outstanding subscriptions payments, all issued and outstanding common voting shares were fully paid.
The Company's Bye-laws provide that the shareholders have an annual put option to request that the Company repurchase any or all of their shares. Such repurchase is subject to capital adequacy of the Company under the Act and the approval of the Board of Directors of the Company. At December 31, 2004 the Company had received requests to repurchase 197,088 shares which will cost the Company approximately $34.8 million at year end net asset value. The repurchase of these shares is subject to approval by the Board of Directors at their first meeting in 2005.
In the years ended December 31, 2004 and 2003, the Company used $122,984,606 and $99,999,995 to repurchase a total of 669,336 and 714,286 shares respectively.
8. TAXATION
BERMUDA
The Company has received an undertaking from the Bermuda government exempting it from all local income, withholding and capital gains taxes until March 28, 2016. At the present time no such taxes are levied in Bermuda.
UNITED STATES
The Company does not consider itself to be engaged in trade or business in the United States and, accordingly, does not expect to be subject to United States income tax.
9. STATUTORY REQUIREMENTS
Under The Act, Olympus Re is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Act also requires Olympus Re to meet certain minimum capital and surplus requirements. To satisfy these requirements, Olympus Re was required to maintain a minimum level of statutory capital and surplus of $260,515,704, $261,589,120 and $149,261,044 at December 31, 2004, 2003 and 2002 respectively. Olympus Re's statutory capital and surplus was $602,649,109, $668,937,898 and $593,312,822 at December 31, 2004, 2003 and 2002 respectively.
(8)
OLYMPUS RE HOLDINGS, LTD. Notes to Consolidated Financial Statements DECEMBER 31, 2004, 2003 AND 2002 - --------------------------------------------------------------------------------
(expressed in U.S. dollars)
Statutory capital and surplus as reported under The Act is different from shareholders' equity as determined in conformity with accounting principles generally accepted in the United States of America ("GAAP") due to certain items that are capitalized under GAAP but expensed under The Act.
Olympus Re is also required to maintain a minimum liquidity ratio under the Act, which was met for the years ended December 31, 2004, 2003 and 2002.
(9)
APPENDIX 1
FINANCIAL STATEMENTS CONTROL SHEET
==================================================================== THIS SHEET IS TO REMAIN WITH THE MOST CURRENT COPY. ALL PERSONS TYPING IN THE STATEMENTS - INITIAL AND DATE THIS SHEET. ====================================================================
EAGLEROCK CAPITAL PARTNERS (QP), LP
FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 2004
EAGLEROCK CAPITAL PARTNERS (QP), LP
FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 31, 2004
CONTENTS - --------------------------------------------------------------------------------
EAGLEROCK CAPITAL PARTNERS (QP), LP
INDEPENDENT AUDITORS' REPORT 3
FINANCIAL STATEMENTS: Statements of assets and liabilities 4 Statements of operations 5 Statements of changes in partners' capital 6 Statements of changes in net assets 7 Summary of business and significant accounting policies 8-9 Notes to financial statements 10-13
EAGLEROCK MASTER FUND, LP 14
INDEPENDENT AUDITORS' REPORT 15
FINANCIAL STATEMENTS: Statements of assets and liabilities 16 Condensed schedule of investments - December 31, 2004 17-22 Condensed schedule of investments - December 31, 2003 23-27 Statements of operations 28 Statements of changes in partners' capital 29 Statements of changes in net assets 30 Summary of business and significant accounting policies 31-34 Notes to financial statements 35-38
INDEPENDENT AUDITORS' REPORT
The Partners EagleRock Capital Partners (QP), LP New York, New York
We have audited the accompanying statements of assets and liabilities of EagleRock Capital Partners (QP), LP (a limited partnership) as of December 31, 2004 and 2003, and the related statements of operations, changes in partners' capital, and changes in net assets for the three years then ended. These financial statements are the responsibility of the Partnership's management.. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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, the financial statements referred to above present fairly, in all material respects, the financial position of EagleRock Capital Partners (QP), LP as of December 31, 2004 and 2003, and the results of its operations, changes in partners' capital and its changes in net assets for the three years then ended, in conformity with accounting principles generally accepted in the United States of America.
January 21, 2005
EAGLEROCK CAPITAL PARTNERS (QP), LP
STATEMENTS OF ASSETS AND LIABILITIES - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK CAPITAL PARTNERS (QP), LP
STATEMENTS OF OPERATIONS - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK CAPITAL PARTNERS (QP), LP
STATEMENTS OF CHANGES IN PARTNERS' CAPITAL - --------------------------------------------------------------------------------
Three years ended December 31, 2004
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK CAPITAL PARTNERS (QP), LP
STATEMENTS OF CHANGES IN NET ASSETS - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK CAPITAL PARTNERS (QP), LP
SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES - --------------------------------------------------------------------------------
BUSINESS EagleRock Capital Partners (QP), L.P. ("Partnership") is a Delaware limited partnership organized to invest and trade in securities and other investment vehicles and instruments. The Partnership invests a significant portion of its assets in EagleRock Master Fund, LP. On May 1, 2002, the Partnership contributed all of its net assets to a related entity, EagleRock Master Fund, a Delaware partnership, in exchange for a pro rata share of equity in that partnership. On November 1, 2004, EagleRock Master Fund transferred its net assets and partnership interests to EagleRock Master Fund, LP, a Cayman Islands exempted partnership that became the surviving master partnership. As a result of the transfer, the Partnership received a pro rata share of the Partnership interest in Eagle Rock Master Fund, LP on that date. The financial statements of EagleRock Master Fund, LP are included elsewhere in this report and should be read with the Partnership's financial statements.
SIGNIFICANT ACCOUNTING POLICIES Investment in EagleRock Master Fund, LP
The investment in EagleRock Master Fund, LP is accounted for under the equity method, which reflects the Partnership's proportionate interest in the net assets and net income of EagleRock Master Fund, LP. Valuation of the investments held by EagleRock Master Fund, LP is discussed in the notes to the EagleRock Master Fund, LP financial statements included elsewhere in this report. The percentage of EagleRock Master Fund, LP partners' capital owned by the Partnership at December 31, 2004 and 2003 was approximately 72% and 91%, respectively.
Investment Transactions
The Partnership records all security transactions and related expenses on a trade date basis. Revenues and expenses are recorded on the accrual basis. Dividends are recorded on the ex-dividend date and interest is accrued in the period earned.
EAGLEROCK CAPITAL PARTNERS (QP), LP
SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES - --------------------------------------------------------------------------------
Income Taxes
No income tax provision has been made in the accompanying financial statements since the partners are required to report their respective shares of the Partnership income in their individual income tax returns.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported 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 year. Actual results could differ from those estimates.
Reclassifications
Certain amounts in 2003 and 2002 have been reclassified to conform to the 2004 presentation.
EAGLEROCK CAPITAL PARTNERS (QP), LP
NOTES TO FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
1. ALLOCATION OF NET INCOME (LOSS) AND PERFORMANCE ALLOCATION The net income (loss) for the three years ended December 31, 2004 is allocated to each partner in accordance with the ratio of the capital account of each partner to the total of all capital accounts at the beginning of each fiscal period.
At the end of each performance period, 20% of net income in excess of cumulative loss is reallocated to the capital accounts of Mariel Capital Management, LLC ("General Partner") as a performance allocation. The General Partner may, at its discretion, waive or alter this allocation. For one of the limited partners of the Partnership, a separate agreement exists stating that at the end of each performance period, 10% of net income in excess of cumulative loss is reallocated to the capital account of the General Partner. For the years ended December 31, 2004 and 2003, the performance allocation was $4,427,330 and $4,991,114, respectively. There was no performance allocation for the year ended December 31, 2002.
In consideration of one of the limited partner's contribution, the limited partner is entitled to receive 10% of any performance allocation paid to the General Partner by the Partnership and an affiliated partnership (the "Profit Participation Allocation"). Prior to June 1, 2003, the limited partner was entitled to 5% of any performance allocation paid to the General Partner by the Partnership. The General Partner may, at its discretion, increase this fee. For the years ended December 31, 2004 and 2003, the Profit Participation Allocation was $581,663 and $521,806, respectively. There was no profit participation allocation for the year ended December 31, 2002.
EAGLEROCK CAPITAL PARTNERS (QP), LP
NOTES TO FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
2. DUE TO EAGLEROCK MASTER FUND, LP Management Fees
EagleRock Capital Management, LLC ("Investment Manager") serves as the Investment Manager of the Partnership. The Partnership incurs a quarterly fee payable at the beginning of each quarter equal to .375% of the capital account balance of each limited partner as of the close of the preceding quarter. The General Partner may, at its discretion, reduce or eliminate this fee. Management fees are paid by EagleRock Master Fund, LP and are discussed in the notes to EagleRock Master Fund, LP's financial statements included elsewhere in this report. For one of the limited partners of the Partnership, a separate agreement exists stating that the Partnership incur a quarterly fee payable at the beginning of each quarter equal to .25% of the capital account balance of the limited partner as of the close of the preceding quarter. For the years ended December 31, 2004, 2003 and 2002, the Partnership's management fees were $1,068,296, $584,522 and $489,495, respectively. As of December 31, 2004 and 2003 an aggregate amount of $1,974,347 and $906,051, respectively, was due to EagleRock Master Fund, LP.
EAGLEROCK CAPITAL PARTNERS (QP), LP
NOTES TO FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
3. FINANCIAL HIGHLIGHTS The financial highlights table represents the Partnership's financial performance for the three years ended December 31, 2004 are as follows:
-----------------
The financial highlights disclosed above are calculated based on the following criteria:
(a) Total return is computed based on the change in value during the year of a theoretical investment made at the beginning of the year. The total return is shown net of operating expenses, management fees and the performance allocation, net of profit participation allocation.
EAGLEROCK CAPITAL PARTNERS (QP), LP
NOTES TO FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
-----------------
An individual partner's return may vary from the above returns based on participation in hot issues, different management fee and performance arrangements and the timing of capital transactions.
(b) The operating expense ratio is calculated by dividing the total operating expenses by the net assets of a theoretical investment made at the beginning of the year. The operating expense ratio is based on the expenses allocated to each limited partner prior to the effects of any performance allocation, net of profit participation allocation. For the purpose of this calculation, expenses do not include dividend and interest expense.
The expense ratios attributable to an individual partner's account may vary based on different management fee and performance arrangements and the timing of capital transactions.
(c) The net investment (loss) income ratio is calculated by dividing the net investment (loss) income by the net assets of a theoretical investment made at the beginning of year. The net investment (loss) income ratio is based on the net investment income allocated to a limited partner prior to the effects of a performance allocation, net of profit participation allocation. The net investment (loss) income ratio attributable to an individual partner's account may vary based on timing of capital transactions.
EAGLEROCK MASTER FUND, LP
- -------------------------------------------------------------------------------- FINANCIAL STATEMENTS TWO YEARS ENDED DECEMBER 31, 2004 AND PERIOD FROM MAY 1, 2002 (COMMENCEMENT OF OPERATIONS) TO DECEMBER 31, 2002
INDEPENDENT AUDITORS' REPORT
The Partners EagleRock Master Fund, LP Grand Cayman, Cayman Islands
We have audited the accompanying statement of assets and liabilities, including the condensed schedule of investments, of EagleRock Master Fund LP (formerly, EagleRock Master Fund) as of December 31, 2004 and 2003, and the related statements of operations, changes in partners' capital, and changes in net assets for each of the two years in the period ended December 31, 2004 and the period from May 1, 2002 (commencement of operations) to December 31, 2002. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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, the financial statements referred to above present fairly, in all material respects, the financial position of EagleRock Master Fund LP as of December 31, 2004 and 2003, and the results of its operations, changes in partners' capital and changes in net assets for each of the two years in the period ended December 31, 2004 and the period from May 1, 2002 (commencement of operations) to December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
January 21, 2005
EAGLEROCK MASTER FUND, LP
STATEMENTS OF ASSETS AND LIABILITIES (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK MASTER FUND, LP
CONDENSED SCHEDULE OF INVESTMENTS (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK MASTER FUND, LP
STATEMENTS OF OPERATIONS (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK MASTER FUND, LP
STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK MASTER FUND, LP
STATEMENTS OF CHANGES IN NET ASSETS (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
See accompanying summary of business and significant accounting policies and notes to financial statements.
EAGLEROCK MASTER FUND, LP
SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
BUSINESS EagleRock Master Fund, LP ("Partnership") is a Cayman Islands exempted partnership that invests and trades in securities and other investment vehicles and instruments.
The Partnership is a successor of EagleRock Master Fund, a Delaware partnership, which transferred all of its net assets on November 1, 2004. As a result, the financial statements are presented as if the entities were always the same reporting entity.
In addition, the EagleRock Capital Partners Offshore Fund, Ltd. transferred all of its net assets to the Partnership in exchange for a pro rata share of the Partnership interests based on net assets contributed at that date and became a feeder fund of the Partnership.
EagleRock Capital Partners, LP, EagleRock Capital Partners (QP), LP and EagleRock Capital Partners Offshore Fund, Ltd. (collectively "Feeder Funds") are all entities under common control and are the general and limited partners of the Partnership. Mariel Capital Management, LLC is also a general partner of the Partnership and has no capital balance at December 31, 2004.
SIGNIFICANT ACCOUNTING POLICIES Investment Transactions
The Partnership records all security transactions and related expenses on a trade date basis. Revenues and expenses are recorded on the accrual basis. Dividends are recorded on the ex-dividend date and interest is accrued in the period earned.
EAGLEROCK MASTER FUND, LP
SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
Investment Valuation
Securities and other investments listed or traded on a national securities exchange or on the national market system of NASDAQ are valued at their last sales price on the date of valuation or if there has been no sale on that date, at the mean of the bid (for investments) or ask (for investments sold, not yet purchased) prices supplied by market making broker-dealers at the close of business. Certain long-term debt and other securities for which quotations are not readily available are valued at estimated fair value as determined in good faith by the general partner. The values assigned to such investments are based upon available information and do not necessarily represent amounts which might ultimately be realized. Because of the inherent uncertainty of valuation, those estimated fair values may differ from the values that would have been used had a ready market for the investments existed and those differences could be material. The resulting unrealized gains and losses are reflected in the statements of operations.
Accounting for Derivative Instruments and Hedging Activities
The Partnership recognizes all derivatives as either assets or liabilities in the statement of assets and liabilities and measures those instruments at fair value. Fair values for derivatives traded on a national exchange, principally certain options, are based on quoted market prices.
EAGLEROCK MASTER FUND, LP
SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
The Partnership uses purchased and written option contracts as part of its investment strategy to manage market risk. Option contracts are contractual agreements that give the purchaser the right, but not the obligation, to purchase or sell a financial instrument at a predetermined exercise price. In return for this right, the purchaser pays a premium to the seller of the option. By selling or writing options, the Partnership receives a premium and becomes obligated during the term of the option to purchase or sell a financial instrument at a predetermined exercise price if the option is exercised, and assumes the risk of not being able to enter into a closing transaction if a liquid secondary market does not exist. Option contracts are recorded in the statement of assets and liabilities at fair value as discussed above. Gains and losses on option contracts are recorded in the statement of operations in net realized and unrealized gain/loss on investments.
Foreign Currency
Investment securities and other assets and liabilities denominated in foreign currencies are translated into U.S. dollar amounts at the date of valuation. Purchases and sales of investment securities and income and expense items denominated in foreign currencies are translated into U.S. dollar amounts on the respective dates of such transactions.
The Partnership does not isolate that portion of the results of operations resulting from changes in foreign exchange rates on investments from the fluctuations arising from changes in market prices of securities held. Such fluctuations are included with the net realized and unrealized gain or loss from investments.
Income Taxes
The Partnership is exempt from all forms of taxation in the Cayman Islands including income, capital gains and withholding taxes. In jurisdictions other than the Cayman Islands, foreign taxes may be withheld on dividends and interest received by the Partnership at rates up to 30%. Capital gains derived by the Partnership are generally exempt from foreign income or withholding taxes at source. Dividend income is recorded net of any such withholding taxes.
EAGLEROCK MASTER FUND, LP
SUMMARY OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
Prior to November 1, 2004, there was no income tax provision made in the accompanying financial statements since the partners were required to report their respective shares of the Partnership's income in their individual income tax returns.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported 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.
Reclassifications
Certain amounts in 2003 and 2002 have been reclassified to conform to the 2004 presentation.
EAGLEROCK MASTER FUND, LP
NOTES TO FINANCIAL STATEMENTS (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
1. DUE TO BROKER The Partnership has an agreement with a brokerage firm to carry its customer account. The broker has custody of the Partnership's securities and, from time to time, cash balances, which may be due from this broker.
These securities and/or cash positions serve as collateral for any amounts due to broker as well as collateral for securities sold short or purchased on margin.
The Partnership is subject to credit risk if the broker is unable to repay balances due or deliver securities in its custody.
2. ALLOCATION OF NET INCOME (LOSS) The net income (loss) is allocated to each partner in accordance with the ratio of the capital account of each partner to the total of all capital accounts at the beginning of each fiscal period.
3. MANAGEMENT FEES EagleRock Capital Management, LLC ("Investment Manager") serves as the Investment Manager of the Partnership. The Partnership pays a quarterly management fee on behalf of its three Feeder Funds. As of December 31, 2004 and 2003, due from limited partnerships were $2,302,938 and $954,130, respectively. In addition, the Partnership has a payable to the Investment Manager of $28,686 and $-0- as of December 31, 2004 and 2003, respectively, which is included in accrued expenses and other liabilities.
4. ADMINISTRATION FEES Effective November 1, 2004, Butterfield Fund Services (Cayman) Limited serves as the administrator and registrar for the Partnership and its Feeder Funds. Pursuant to an Administrative and Services Agreement, the Partnership pays an administration fee on a monthly basis, in arrears based on the Partnership's net assets. For the period from November 1 to December 31, 2004, the administration fee was $43,379 which was payable at December 31, 2004 and included in accrued expenses and other liabilities.
EAGLEROCK MASTER FUND, LP
NOTES TO FINANCIAL STATEMENTS (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
5. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Partnership invests in marketable securities and is exposed to market risks resulting from changes in the fair value of their investments. Derivative financial instruments are used by the Partnership to help manage such market risk.
Securities sold, not yet purchased by the Partnership, may give rise to off-balance sheet risk. The Partnership may sell a security it does not own in anticipation of a decline in the fair value of that security. When the Partnership sells a security short, it must borrow the security sold short. A gain, limited to the price at which the Partnership sold the security short, or a loss, unlimited in amount, will be recognized upon the termination of a short sale. The Partnership has recorded this obligation in the financial statements at the December 31, 2004 and 2003 market value of these securities. There is an element of market risk in that, if the securities increase in value, it will be necessary to purchase the securities at a cost in excess of the price reflected in the statement of assets and liabilities. The amounts reflected in investments in securities owned and securities sold, not yet purchased include $22,663,677 and $29,528,151 of identical securities held both long and short at December 31, 2004 and 2003, respectively.
The Partnership is exposed to credit-related losses in the event of nonperformance by counterparties to financial instruments, but it does not expect any counterparties to fail to meet their obligations. The aggregate credit exposure related to the derivative financial instruments of the Partnership is equal to the fair value of the contracts with positive fair values as of December 31, 2004 and 2003.
EAGLEROCK MASTER FUND, LP
NOTES TO FINANCIAL STATEMENTS (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
6. FINANCIAL HIGHLIGHTS The financial highlights table represents the Partnership's financial performance for the years ended December 31, 2004 and 2003 and the period from May 1, 2002 (commencement of operations) to December 31, 2002 are as follows:
-----------------
The financial highlights disclosed above are calculated based on the following criteria:
(a) Total return is computed based on the change in value during the period of a theoretical investment made at the beginning of the period. The total return is shown net of operating expenses. There is no performance fee allocated to the Partnership.
An individual partner's return may vary from the above returns based on participation in hot issues, different fee arrangements and the timing of capital transactions.
(b) The operating expense ratio is calculated by dividing the total operating expenses by the net assets of a theoretical investment made at the beginning of the period. The operating expense ratio is based on the expenses allocated to each limited partner. For the purpose of this calculation, expenses do not include dividend and interest expense on securities sold, not yet purchased.
The expense ratios attributable to an individual partner's account may vary based on different fee arrangements and the timing of capital transactions.
EAGLEROCK MASTER FUND, LP
NOTES TO FINANCIAL STATEMENTS (EXPRESSED IN US DOLLARS) - --------------------------------------------------------------------------------
-----------------
(c) The net investment (loss) income ratio is calculated by dividing the net investment income by the net assets of a theoretical investment made at the beginning of period. The net investment (loss) income ratio is based on the net investment (loss) income allocated to a limited partner. The net investment (loss) income ratio attributable to an individual partner's account may vary based on timing of capital transactions.
7. SUBSEQUENT CAPITAL TRANSACTIONS From January 1, 2005 through January 21, 2005, there were $1,000,000 in capital contributions. There were no capital withdrawals.
Report of Independent Registered Public Accounting Firm
The Stockholder WilTel Communications Group, Inc.
We have audited the accompanying consolidated balance sheet of WilTel Communications Group, Inc. as of November 5, 2003 (Successor Company), and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for the period from January 1, 2003 to November 5, 2003 (Successor Company), the period from November 1, 2002 to December 31, 2002 (Successor Company), and the period from January 1, 2002 to October 31, 2002 (Predecessor Company). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of WilTel Communications Group, Inc. at November 5, 2003 (Successor Company), and the consolidated results of its operations and its cash flows for the period from January 1, 2003 to November 5, 2003 (Successor Company), the period from November 1, 2002 to December 31, 2002 (Successor Company), and the period from January 1, 2002 to October 31, 2002 (Predecessor Company), in conformity with U.S. generally accepted accounting principles.
Ernst & Young LLP
Tulsa, Oklahoma February 20, 2004
WILTEL COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEET
See accompanying notes.
See accompanying notes.
WILTEL COMMUNICATIONS GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
See accompanying notes.
WILTEL COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
WILTEL COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)
See accompanying notes.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Leucadia Exchange Offer -- Basis of Presentation -- Summary of Significant Accounting Policies
Leucadia Exchange Offer
Effective November 6, 2003, WilTel Communications Group, Inc. ("WilTel") and Leucadia National Corporation ("Leucadia") consummated an exchange offer and a merger agreement pursuant to which all WilTel stockholders received 0.4242 of a Leucadia common share for each share of WilTel common stock. Leucadia issued 11,156,460 of its common shares in exchange for all of the WilTel common shares that it did not previously own. Upon completion of the back-end merger, WilTel ceased to be a public company and is consolidated by Leucadia effective November 6, 2003.
The merger agreement also provided that WilTel stockholders receive contingent sale rights, which entitle WilTel stockholders to additional Leucadia common shares if Leucadia sells substantially all of WilTel's assets or outstanding shares of capital stock prior to October 15, 2004, or consummates such a sale at a later date if the sale agreement was entered into prior to August 21, 2004, and in either case, the net proceeds exceed the valuation ascribed to WilTel's equity in the merger transaction.
Basis of Presentation
2003 Presentation
The financial statements presented for 2003 are as of and for the period from January 1, 2003 through November 5, 2003, which represents the financial position and results of operations and cash flows prior to the acquisition by Leucadia.
Emergence from the Chapter 11 Proceedings in October 2002
On April 22, 2002, Williams Communications Group, Inc. ("WCG") and CG Austria, Inc. (collectively, the "Debtors") filed petitions for relief under Chapter 11 of title 11 of the United States Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court"). On September 30, 2002, the Bankruptcy Court entered an order confirming the Second Amended Joint Chapter 11 Plan of Reorganization of the Debtors (the "Plan"), effective on October 15, 2002 (the "Effective Date"). Pursuant to the Plan and the confirmation order, WilTel Communications Group, Inc. ("WilTel" and, together with its direct and indirect subsidiaries, the "Company") emerged on October 15, 2002 as the successor to WCG.
WCG was a non-operating holding company whose principal asset was 100% of the membership interest in Williams Communications, LLC ("WCL"), which changed its name to WilTel Communications, LLC in January 2003. In connection with the consummation of the Plan (as described in Note 19), WCG transferred substantially all of its assets to WilTel on October 15, 2002. WCL is an operating company, which owns or leases and operates a nationwide inter-city fiber-optic network, extended locally and globally, to provide Internet, data, voice and video services. Information on WilTel's operations by segment and geographic area is included in Note 2. In addition, WCL is the direct or indirect parent of all the remaining subsidiaries of the Company, including CG Austria, Inc., a non-operating holding company with direct and indirect interest in certain foreign subsidiaries of the Company. WCL was not included in the chapter 11 proceedings.
The Company became subject to the provisions of Statement of Position ("SOP") 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code," upon commencement of the chapter 11 proceedings. SOP 90-7 required that revenues, expenses, realized gains and losses and provisions for losses resulting from the reorganization and restructuring of the Company be reported separately as reorganization items in the consolidated statement of operations. Interest expense on liabilities subject to compromise and preferred stock dividends ceased to accrue upon commencement of the chapter 11 proceedings.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company emerged from the chapter 11 proceedings in October 2002 and implemented fresh start accounting under the provisions of SOP 90-7 effective October 31, 2002 to coincide with its normal monthly financial closing cycle. Under SOP 90-7, the net reorganization value of the Company was allocated to its assets and liabilities, its accumulated deficit was eliminated and new equity was issued according to the Plan. The Company recorded a $2.2 billion reorganization charge to adjust the historical carrying value of its assets and liabilities to fair value reflecting the allocation of the Company's reorganization value of approximately $1.3 billion. The Company also recorded a $4.3 billion gain on the discharge of debt pursuant to the Plan. In addition, changes in accounting principles that would be required in the financial statements within twelve months following emergence from the chapter 11 proceedings were adopted in the Company's fresh start financial statements. See Note 20 for a presentation of the impact of implementing fresh start accounting on WCG's consolidated balance sheet as of October 31, 2002.
The Company's emergence from the chapter 11 proceedings resulted in a new reporting entity with no retained earnings or accumulated deficit as of October 31, 2002. Accordingly, the Company's consolidated financial statements for the period prior to November 1, 2002 is not comparable to consolidated financial statements presented on or subsequent to October 31, 2002. For periods prior to November 1, 2002, the financial results have been separately presented under the label "Predecessor Company" and for periods subsequent to October 31, 2002 the financial results have been separately presented under the label "Successor Company" as required by SOP 90-7. The Predecessor Company is also referred to as "WCG" and the Successor Company is also referred to as "WilTel".
Prior to April 2001, The Williams Companies, Inc. ("TWC") owned 100% of WCG's outstanding Class B common stock which gave TWC approximately 98% of the voting power of WCG. In March 2001, TWC's Board of Directors approved a tax-free spin-off of WCG to TWC's shareholders. On April 23, 2001, TWC distributed approximately 95% of the WCG common stock it owned to holders of TWC common shares on a pro rata basis (see Note 13).
Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts in the financial statements and disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates all of these estimates and assumptions. Actual results could differ from those estimates.
Principles of consolidation
The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. In addition, the Company also consolidated a subsidiary that it controlled but owned less than 50% of the voting common stock, until it was sold in 2003 (see Note 5).
Revenue Recognition
Network - -------
Capacity, transmission, video services and other telecommunications services revenues are recognized monthly as the services are provided or revenues are earned. If at the time services are rendered collection is not reasonably assured either due to credit risk, the potential for billing disputes, or other reasons, revenue is not recognized until such contingencies
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
are resolved. Amounts billed in advance of the service month are recorded as deferred revenue. Payments received for the installation of conduit under joint build construction contracts are generally recorded as a recovery of the applicable construction costs. Revenues under multiple element contracts are recognized based on the respective fair values of each individual element within the multiple element contract. Revenues from conduit and duct sales are recognized at time of delivery and acceptance and when all significant contractual obligations have been satisfied and collection is reasonably assured.
Grants of indefeasible rights of use, or IRUs, of constructed but unlit fiber, or dark fiber, in exchange for cash, are accounted for as operating leases, since the Company's IRUs generally do not transfer title to the fibers under lease to the lessee. If title is transferred to the lessee, the transaction would be accounted for as a sales-type lease.
Cost of sales includes operating and maintenance costs, leased capacity, right-of-way costs, access charges, other third party circuit costs, satellite transponder lease costs, and package delivery costs and blank tape media costs related to ads distribution services. Operating and maintenance costs include the costs of network management functions and personnel that provide network fault indication, performance information, data and diagnosis functions, field operations, network planning and engineering as well as the cost of contract maintenance. WilTel does not defer installation costs.
The Company has entered into transactions such as buying, selling, swapping and/or exchanging capacity, conduit and fiber to complete and compliment its network. Depending upon the terms of the agreement, certain transactions are accounted for as pure asset swaps with no revenue and no cost recognition while certain transactions are accounted for as both revenue and cost over the corresponding length of time for each agreement. If the exchange is not essentially the culmination of an earning process, accounting for an exchange of a nonmonetary asset is based on the recorded amount of the nonmonetary asset relinquished, and therefore no revenue and cost is recorded in accordance with Accounting Principles Board ("APB") Opinion No. 29. Examples of transactions cited by APB Opinion No. 29 that are not the culmination of the earnings process include exchange of productive assets for similar productive assets or for an equivalent interest in similar productive assets.
Revenues that have been deferred for long-term service contracts are amortized using the straight-line method over the life of the related contract. The Company classifies as current the amount of deferred revenue that will be recognized into revenue over the next twelve months.
Revenues that have been deferred for long-term service contracts that are subsequently terminated or included as part of an overall settlement agreement have been recognized in other operating income for periods prior to November 1, 2002 and other income for periods subsequent to October 31, 2002.
Vyvx - ----
Transmission and video services revenues are recognized monthly as the services are provided. Amounts billed in advance of the service month are recorded as deferred revenue.
Provision for Doubtful Accounts
A provision for doubtful accounts is recorded when the collectibility of a specific customer's receivable balance becomes at risk due to a deterioration in the customer's financial condition or evidence that recovery of the past due receivable balance is unlikely. In addition, the Company maintains a general reserve based on past collection history. An accounts receivable balance is written-off against the allowance for doubtful accounts when reasonable collection efforts have been exhausted and the balance is deemed worthless.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Cash and Cash Equivalents
Cash and cash equivalents include demand and time deposits, certificates of deposit and other marketable securities that are readily convertible to known amounts of cash and so near maturity that it presents insignificant risk of changes in value because of changes in interest rates.
Property, Plant and Equipment
Property, plant and equipment is recorded at cost. Depreciation is computed primarily on the straight-line method over estimated useful lives with the exception of assets acquired through capital leases, which are depreciated over the lesser of the estimated useful lives or the term of the lease. In accordance with fresh start accounting, the book value of property, plant and equipment was adjusted to its fair value and the Company also established new useful lives.
Impairment of Long-Lived Assets
The Company evaluates its long-lived assets, including related intangibles, of identifiable business activities for impairment when events or changes in circumstances indicate, in management's judgment, that the carrying value of such assets may not be recoverable. The determination of whether an impairment has occurred is based on management's estimate of undiscounted future cash flows attributable to the assets as compared to the carrying value of the assets. If an impairment has occurred, the amount of the impairment recognized is determined by estimating the fair value for the assets and recording a provision for loss if the carrying value is greater than fair value.
For assets identified to be disposed of in the future, the carrying value of these assets is compared to the estimated fair value less the cost to sell to determine if an impairment is required. Until the assets are disposed of, an estimate of the fair value is redetermined when related events or circumstances change.
Income Taxes
Prior to the spin-off of WCG from TWC in April 2001, WCG's operations were included in TWC's consolidated federal income tax return. A tax sharing agreement existed between WCG and TWC to allocate and settle among themselves the consolidated federal income tax liability. Deferred income taxes were allocated from TWC using the liability method and were provided on all temporary differences between the financial basis and allocated tax basis of WCG's assets and liabilities. Valuation allowances were established to reduce deferred tax assets to an amount that was more likely than not be realized.
Effective with the spin-off of WCG from TWC in April 2001, the existing tax sharing agreement with TWC was amended to address pre spin-off tax attributes. Under the amendment, TWC retained all rights and obligations with respect to tax attributes of WCG for all periods prior to WCG's initial public offering. In the event of any final determination with respect to a WCG tax attribute that arose from the time of WCG's initial public offering to the date of the spin-off of WCG from TWC, WCG would pay TWC for any determination resulting in a detriment as compared to previous amounts filed and TWC would pay WCG for any determination resulting in favorable tax consequences as compared to amounts filed. Tax attributes of WCG arising subsequent to the spin-off date are rights and obligations of WCG. The tax sharing agreement was further amended in July 2002 by the Tax Cooperation Agreement, which provides that upon emergence from bankruptcy WCG has no responsibility for indemnification of TWC for pre-spinoff tax items.
Earnings (Loss) Per Share
The Company's basic earnings (loss) per share is based on the sum of the average number of common shares outstanding and deferred shares, if any. Diluted earnings (loss) per share includes any dilutive effect of stock options and convertible preferred stock. For WCG, diluted earnings (loss) per common share is the same as the basic calculation as the inclusion of any stock options and convertible preferred stock would be antidilutive. Stock options and convertible preferred stock of 7.6 million shares for the ten months ended October 31, 2002 have been excluded from the computation of diluted earnings (loss) per common share. For WilTel, the basic and diluted earnings (loss) per share is the same as it does not have any dilutive securities outstanding.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock Options
Prior to emergence from bankruptcy, the Company's employee stock-based awards were accounted for under the provisions of APB Opinion No. 25 and related interpretations. The Company's fixed plan common stock options generally did not result in compensation expense because the exercise price of the stock options equaled the market price of the underlying stock on the date of grant. As of November 5, 2003 and December 31, 2002, WilTel did not have any stock-based awards outstanding.
Foreign Currency Translation
The functional currency of the Company is the U.S. dollar. Generally, the functional currency of the Company's foreign operations is the applicable local currency for each foreign subsidiary. Assets and liabilities of foreign subsidiaries are translated at the spot rate in effect at the applicable reporting date, and the combined statements of operations are translated at the average exchange rates in effect during the applicable period. The resulting cumulative translation adjustment is recorded as a separate component of other comprehensive income.
Transactions denominated in currencies other than the functional currency are recorded based on exchange rates at the time such transactions arise. Subsequent changes in exchange rates result in transaction gains and losses, which are reflected in the statement of operations.
Recently Issued Accounting Standards
In December 2003, the Financial Accounting Standards Board issued SFAS No. 132 "Employers' Disclosures about Pensions and Other Postretirement Benefits" ("SFAS 132R"), which is effective for financial statements with fiscal years ending after December 15, 2003. The Company has adopted SFAS 132R, which requires additional disclosures to those required in the original Statement 132.
2. Segment Disclosures
The Company's reportable segments are Network and Vyvx.
Network owns or leases and operates a nationwide inter-city fiber-optic network. Network has also built a fiber-optic network within certain cities in the U.S. and has the ability to connect to networks outside the U.S., including Asia, Australia, Canada, Europe, Guam, Mexico and New Zealand. Network provides Internet, data, voice and video services to companies that use high-capacity and high-speed telecommunications in their businesses. Network sells its products to the wholesale carrier and enterprise market segments, and many of its most significant customers provide retail telecommunications services to consumers and business enterprises. Network also offers rights of use in dark fiber, which is fiber that it installs but for which it does not provide communications transmission services. Network also provides space and power to collocation customers at network centers and a variety of professional and managed services to customers including network design and construction, network management and network monitoring or surveillance.
Vyvx transmits audio and video programming for its customers over Network's fiber-optic network and via satellite. Vyvx transmits live traditional broadcast and cable television events from the site of the event to the network control centers of the broadcasters of the event. In addition, Vyvx provides an integrated satellite and fiber-optic network based service to transmit live content from remote locations to its customers. Vyvx also distributes advertising spots and syndicated programming to radio and television stations throughout the U.S., both electronically and in physical form. Customers for these services can utilize a network-based method for aggregating, managing, storing and distributing content owners and right holders.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other includes certain corporate assets not attributable to a specific segment such as cash and cash equivalents.
The Company evaluates performance based upon segment profit (loss) from operations, which represents earnings before interest, income taxes, depreciation and amortization and other unusual or non-cash items, such as asset impairments and restructuring charges, equity earnings or losses and minority interest. A reconciliation of segment loss from operations to loss from operations is provided below. Intercompany sales are generally accounted for as if the sales were to unaffiliated third parties. The following tables present certain financial information concerning the Company's reportable segments.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Predecessor Company:
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Total Assets ----------------- Successor Company --------------- As of November 5, ----------- (In thousands)
Network.................................. $1,433,578 Vyvx..................................... 54,246 Other.................................... 307,738 ---------- Total assets........................... $1,795,562 ==========
The following geographic area data includes revenues from external customers based on origin of services rendered and long-lived assets based upon physical location for the following periods.
Successor Company -------------- As of November 5, --------------- (In thousands)
Long-lived assets: United States........................$ 1,230,613 Other................................ 6,130 ------------ Total..................................$ 1,236,743 ============
Long-lived assets are comprised of property, plant and equipment.
For the period from January 1, 2003 through November 5, 2003, one of Network's customers exceeded 10% of the Company's revenue with sales of approximately $552 million. In 2002, one of Network's customers exceeded 10% of the Company's revenues with sales of approximately $73 million and $442 million for the two months ended December 31, 2002 and for the ten months ended October 31, 2002, respectively.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3. Other Operating Expense (Income), Net
Transactions included in segment profit (loss)
Other operating income of $6.2 million and $18.8 million for the two months ended December 31, 2002 and the ten months ended October 31, 2002, respectively, consisted primarily of cash settlement gains related to the termination of various agreements.
Transactions excluded from segment profit (loss)
Other operating expense of $38.0 million for the ten months ended October 31, 2002 primarily included a $54.3 million accrual for contingent liabilities partially offset by non-cash settlement gains related to the termination of various agreements of $8.3 million, a $3.6 million credit from the determination that remaining liabilities accrued for exit costs established in previous years related to various business sales and abandonments were no longer required, and income of $2.9 million related to revisions of estimated costs associated with the sale of the single strand of lit fiber in fourth quarter 2001.
4. Investing Income
Predecessor Company
Marketable equity securities
Certain marketable equity securities were sold for proceeds of $7.0 million for the ten months ended October 31, 2002. Gross realized gains of $0.7 million were recognized for the ten months ended October 31, 2002.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Cost-based and equity-method investments
The Company's equity losses were $2.7 million for the ten months ended October 31, 2002.
WCG entered into an agreement with America Movil, S.A. de C.V. in second quarter 2001 to sell its remaining economic interest in ATL. The transaction closed in third quarter 2001 and WCG received $309.6 million in cash with an additional $90.0 million due from America Movil, S.A. de C.V. on May 15, 2002. A gain of $45.1 million was recognized from the sale. In February 2002, America Movil, S.A. de C.V. prepaid its note from the sale of ATL by paying a discounted amount of $88.8 million.
5. Gain on Sale of Consolidated Subsidiary
At the time the Company implemented fresh start accounting, the net assets of PowerTel, a consolidated subsidiary, were assumed to have minimal value based on assessments by management and its financial advisor assisting with the potential sale of the Company's ownership interest in PowerTel. Important elements of that assessment included PowerTel's struggles to maintain compliance with its bank covenants, and the assessment that improvements in market conditions or improved operations during the periods following fresh start, neither which could be predicted with certainty, would be required in order to ascribe a higher value.
In August 2003, market conditions improved such that WilTel successfully entered into agreements to sell its ownership interest in PowerTel. WilTel sold its common and preferred stock interest to TVG Consolidation Holdings SPRL for 20 million Australian dollars (or $13.1 million). In addition, WilTel also settled its intercompany receivable from PowerTel for 10 million Australian dollars (or $6.5 million). The proceeds from the sale of the PowerTel stock were placed in a restricted bank account pursuant to the terms of agreements related to the Company's One Technology Notes outstanding. Accordingly, the Company has classified the restricted investments ($13.1 million as of November 5, 2003) as other noncurrent assets. The sale resulted in a non-recurring gain of $21.1 million. Net loss attributable to PowerTel was $1.6 million for the period ended November 5, 2003.
6. Other Income, Net
Other income, net of $45.3 million for the period from January 1, 2003 through November 5, 2003 includes non-recurring, non-operating settlement gains of $28.5 million related to the termination of various agreements. As a result of the termination of the agreements, the Company will no longer be required to perform the contractual obligations that were the basis for the recording of the deferred revenue performance obligations. In addition, other income, net includes $16.8 million of non-recurring, non-operating gains primarily related to the termination of arrangements previously accrued as unfavorable commitments in fresh start accounting and recoveries of various receivables previously written off.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
7. Benefit (Provision) from Income Taxes
The benefit (provision) from income taxes includes:
The U.S. and foreign components of income (loss) before income taxes are as follows:
The Company's undistributed earnings from non U.S. subsidiaries in 2003 and 2002 have been accounted for as if fully repatriated.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Reconciliations from the benefit (provision) from income taxes at the federal statutory rate to the provision from income taxes are as follows:
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As of November 5, 2003, the Company had $3.3 billion of federal net operating losses, of which $859.9 million, $1.2 billion, $535.2 million and $647.0 million expire in 2019, 2020, 2021 and 2022, respectively, and $402.3 million of estimated capital loss carryforwards, of which $209.3 million, $88.5 million, $0.9 million, $34.0 million and $69.7 million will expire in 2003, 2004, 2005, 2006 and 2007, respectively, and $222.9 million of foreign net operating losses as well as various state net operating losses that expire at various dates. Valuation allowances have been established that fully reserve the net deferred tax assets. Uncertainties that may affect the utilization of the loss carryforwards include future operating results, tax law changes, rulings by taxing authorities regarding whether certain transactions are taxable or deductible and expiration of carryforward periods. The valuation allowance change for the period from January 1, 2003 through November 5, 2003 and the year ended 2002 was an increase of $50.1 million and $964.3 million, respectively.
If the Company had filed a separate federal income tax return for all periods presented, the tax provision would have been unchanged.
8. Employee Benefit Plans
Pension and Other Postretirement Benefit Plans
WilTel provides both funded and unfunded noncontributory defined benefit pension plans to substantially all of its employees who were employed prior to April 24, 2001. The funded pension plan provides defined benefits based on amounts credited to employees on a cash balance formula. The formula takes into account age, compensation, social-security-wage base and benefit service with the company. An additional unfunded, unqualified pension plan is offered to pension plan participants with earnings in excess of $200,000.
WilTel also has an unfunded other postretirement benefit plan covering employees who were employed prior to January 1, 1992. This health care plan is contributory with participants' contributions adjusted annually. Benefits are paid to eligible employees with 10 years of service and aged 55 years or older when leaving the company.
Obligations and Funded Status
The following table presents the changes in benefit obligations and plan assets for pension benefits and other postretirement benefits for the WilTel Plans for the periods indicated. It also presents a reconciliation of the funded status of these benefits to the amount recognized in the accompanying consolidated balance sheet.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The net accrued benefit cost for other postretirement benefits is included in the accompanying balance sheet as accrued employee cost within accrued liabilities.
Components of Net Periodic Benefit Cost
The following tables present net pension expense and other postretirement benefit expense for the WilTel Plans.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Assumptions
The following are the weighted-average assumptions used to determine pension benefit obligations as of the measurement date indicated:
The following are the weighted-average assumptions utilized to determine net periodic pension benefit cost for the period ended indicated:
The general approach for determining the expected long-term rate-of-return-on-assets assumption is to review the asset allocation targets and their corresponding historic weighted-average returns and adjust those rates as necessary to properly reflect capital market expectations. With the aid of a computer model, average returns, average volatility, correlations of asset classes to each other, and minimum and maximum allocation constraints were analyzed over several historic periods (the period 1926-2001, post-war period 1952-2001 and the ten years to December 2001). These historic returns were then adjusted in order to reflect a more conservative expectation of future returns and asset allocation targets reflective of the closed participant population growing closer to retirement age.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following are the weighted-average assumptions used to determine other postretirement benefit obligations as of the period ended indicated:
The following are the weighted-average assumptions utilized to determine net periodic other postretirement benefit cost for the period ended indicated:
The annual assumed rate of increase in the health care cost trend rate for 2004 is 12% which systematically decreases to 5% by 2012.
The various nonpension postretirement benefit plans which WilTel sponsors provide for retiree contributions and contain other cost-sharing features such as deductibles and coinsurance. The accounting for these plans anticipates future cost-sharing changes to the written plans that are consistent with WilTel's expressed intent to increase the retiree contribution rate generally in line with health care cost increases.
The health care cost trend rate assumption has a significant effect on the amounts reported. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Plan Assets
The following table presents WilTel's pension plan asset allocations:
The investment objectives of WilTel's plan emphasize long-term capital appreciation as a primary source of return. Current income is a supplementary source of return. The target allocation was recently approved by the Investment Committee to be as follows:
Interim Long-term Target Target ------ ------ Equity securities: Large cap stocks.............................. 38% 40% Small cap stocks.............................. 22% 10% International stocks.......................... 20% 20% --- --- Total equity securities................... 80% 70% Fixed income/bonds ............................. 20% 30% --- --- Total........ ............................100% 100%
The Investment Committee established the interim target in order to balance speed and caution in transitioning to the long-term allocations, lowering the risk of selling low and buying high and shifting the portfolio to the long-term targets under the right market conditions.
Investment performance objectives are based upon a benchmark index or mix of these indices over a market cycle. The benchmark is as follows:
S&P 500 Index................................................. 25% Russell 2000 Index............................................ 22% EAFE Index.................................................... 33% Merrill Lynch Domestic Master Bond Index ..................... 20% --- Total....................................................100%
Investment performance objectives are based upon a benchmark index or mix of indices over a market cycle. The investment strategy designates certain investment restrictions for domestic equities, international equities and fixed income securities. These restrictions include the following:
o For domestic equities, there will generally be no more than 5% of any manager's portfolio at market in any one company and no more than 150% of any one sector of the appropriate index for any manager's portfolio. Restrictions are also designated on outstanding market value of any one company at 5%.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
o For international equities, there will be no more than 8% in any one company in a manager's portfolio, no fewer than three countries in a manager's portfolio, no more than 10% of the portfolio in countries not represented in the EAFE index, no more than 150% of any one sector of the appropriate index and no currency hedging is permitted.
o Fixed income securities will all be rated BBB- or better at the time of purchase, there will be no more than 8% at market in any one security (US government and agency positions excluded), no more than a 30-year maturity in any one security, and investments in standard collateralized mortgage obligations are limited to 10%.
Pension Plan Contributions
WilTel expects to contribute $5 million to its pension plan in 2004.
Defined Contribution Plan
Beginning January 1, 2001, the Company established and continues to maintain a defined contribution plan for its employees. Prior to January 1, 2001, the Company's employees were included in various defined contribution plans maintained by TWC. The Company's costs related to these plans were $5.3 million, $1.6 million and $9.0 million for the period from January 1, 2003 through November 5, 2003, for the two months ended December 31, 2002 and for the ten months ended October 31, 2002, respectively. These costs fluctuate as a result of changes in the eligible employee base.
9. Property, Plant and Equipment
Property, plant and equipment is summarized as follows:
Depreciation expense of $205.6 million, $43.8 million and $461.0 million was recorded for the period from January 1, 2003 through November 5, 2003, for the two months ended December 31, 2002 and for the ten months ended October 31, 2002, respectively.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
10. Accounts Payable, Accrued Liabilities and Other Noncurrent Liabilities
The Company's cash accounts reflect credit balances to the extent checks written have not been presented for payment. The amount of these credit balances included in accounts payable was $19.5 million as of November 5, 2003.
Accrued liabilities consisted of the following:
11. Asset Retirement Obligations
The Company's asset retirement obligations relate primarily to two categories of assets:
Fiber and Conduit - The Company has right-of-way agreements which generally require the removal of fiber and conduit upon the termination of those agreements.
Technical Sites - The Company leases land for technical sites and leases space at technical sites along its network. Termination of these lease agreements normally requires removal of equipment and other assets, and restoration of the lease property to its original condition.
The estimation of the fair value of asset retirement obligations requires the significant use of estimates regarding the amounts and timing of expected cash flows. The fair value of the asset retirement obligations was calculated using credit-adjusted risk-free rates ranging from 8% to 14%, which were assigned based upon the expected timing of cash flows for each respective obligation.
The fair value of the Company's assets that are legally restricted for purposes of settling asset retirement obligations at November 5, 2003, is $16.5 million, which is classified in property, plant and equipment.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Reconciliation of the asset retirement obligation is as follows:
Successor Company ---------------- As of November 5, ---- (In thousands)
Beginning balance............................ $ 26,270 Liabilities incurred......................... 473 Liabilities settled.......................... (197) Accretion expense............................ 2,886 Revisions in estimated cash flows............ (975) ----------- $ 28,457 ===========
The Company adopted SFAS No. 143 relating to asset retirement obligations as part of implementing fresh start accounting as required by SOP 90-7 and recorded a cumulative effect of change in accounting principle of $8.7 million in 2002 (net of a zero tax provision). The cumulative effect of change in accounting principle represents accretion and depreciation expense the Company would have recorded had the provisions of SFAS No. 143 been in effect on the dates the obligations were incurred.
If the Company had adopted SFAS No. 143 on January 1, 2001, it would have recorded a liability of $20.6 million. Accretion expense for the ten months ended October 31, 2002 would have been $2.5 million.
12. Debt
Long-term debt consisted of the following:
A description of the Company's debt obligations listed in the table above is as follows:
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Exit Credit Agreement
On October 15, 2002, WCL and the credit facility lenders entered into the Exit Credit Agreement. The Exit Credit Agreement combined the term loans under the previous credit facility into one loan repayable in installments of principal beginning in June 2005 through September 2006 and currently bears interest at either the Prime rate plus a margin of 3.50% or LIBOR plus a margin of 4.50%, at the Company's option. In July 2004, the margin, in each case, will increase 1%. In October 2003, WCL locked in a rate of 5.69% for three months based on LIBOR. The Exit Credit Agreement does not provide for revolving loans for WCL. Among other things, the Exit Credit Agreement provides for:
o a security interest in all of the domestic assets of the Company, except for those assets secured under the OTC Notes and the aircraft capital lease in which the lenders have a second priority lien and security interest;
o prepayment of the term loans from cash proceeds received from refinancing all or a portion of the Exit Credit Agreement, a sale leaseback transaction (not otherwise permitted), issuance of debt (not otherwise permitted), or asset sales (not otherwise permitted);
o prepayment of the term loans equal to 100% of excess cash flows and 50% of cash proceeds received from the sale of equity, formation of a joint venture or any other similar transaction;
o the Company meeting certain financial targets, as defined;
o aggregate dollar limitations on certain activities such as indebtedness, investments and capital expenditures;
o the Company making certain representations and warranties, including the existence of no material adverse effect, as defined;
o restrictions on the ability of WCL to transfer funds to WilTel, except for certain payments as outlined in the Exit Credit Agreement; and
o the ability for WCL to request up to $45 million in cash-collateralized letters of credit, less the amount of cash deposits and pledges made to third parties in an amount not to exceed $30 million. The total of cash collateralized letters of credit, plus cash deposits and pledges made to third parties, outstanding as of November 5, 2003 was $37.3 million. Amounts held as collateral for outstanding letters of credit are reflected primarily in other noncurrent assets.
WCL is the obligor under the Exit Credit Agreement and has pledged substantially all of its assets to secure its obligations under that agreement. In addition, WCL's obligations are guaranteed by WilTel and secured by substantially all of the assets of the Company. The Exit Credit Agreement ranks senior to the Company's other debt.
Sale and subsequent leaseback to TWC and the OTC Notes
In September 2001, the Company sold its headquarters building and other ancillary assets to TWC for approximately $276 million in cash. Concurrent with the sale, the Company leased its headquarters building for a period of ten years and other ancillary assets for a period of three to ten years with varying payment terms.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As discussed in Note 19, the sale and subsequent leaseback agreement was terminated and replaced with the OTC Notes of approximately $145 million. The OTC Notes consist of: (1) a $100 million note at a fixed annual interest rate of 7.0%, with monthly payments for the first 90 months (based on a 360 month amortization schedule) and with the entire remaining unpaid principal balance due and payable on April 1, 2010 and (2) a $44.8 million note with accrued interest paid in kind ("PIK Interest") and capitalized once annually, with the original principal balance and all capitalized and accrued PIK Interest (totaling $74.4 million at maturity) due and payable on December 29, 2006. The second note carries a fixed interest rate of 10.0% through 2003, and each year thereafter the interest rate increases 2.0% resulting in an interest rate of 16% in the final year of 2006. The $100 million note was reduced by payments made of $3.1 million during the period from October 15, 2002 to the close of the escrow in December 2002. The OTC Notes are full recourse notes and are secured by the OTC Mortgage, under which TWC was granted a first priority mortgage lien and security interest in the headquarters building and other ancillary assets. In addition, the OTC Notes are secured by a second lien and security interest in the proceeds resulting from the sale of the Company's ownership interest in PowerTel (see Note 5).
The OTC Notes were reduced in third quarter 2003 by the net cash proceeds of $15.1 million from the Aircraft Capital Lease transaction per the terms of the OTC Notes agreement and by $6.5 million related to the final settlement and payment terms pursuant to an agreement for the purchase of the One Technology Center building.
Scheduled Debt Maturities
Scheduled maturities of debt as of November 5, 2003 to November 5th of the year presented below are as follows (in thousands):
2004................................. $ 4,021 2005................................. 85,701 2006................................. 294,041 2007................................ 46,401 2008................................. 1,754 Thereafter............................ 74,849 ------------- $ 506,767 =============
The scheduled maturities table above excludes the payment of the PIK interest of $29.6 million in 2006 from the OTC Notes.
Cash payments for interest, net of amounts capitalized, were $25.8 million, $5.2 million and $115.7 million for the period from January 1, 2003 through November 5, 2003, for the two months ended December 31, 2002 and for the ten months ended October 31, 2002, respectively. These payments include commitment fees relating to the Company's credit facility of $1.1 million, $0.1 million and $6.2 million for the period from January 1, 2003 through November 5, 2003, for the two months ended December 31, 2002, for the ten months ended October 31, 2002 , respectively.
13. Stockholders' Equity
In 2001, TWC's Board of Directors approved a tax-free spin-off of WCG to TWC's shareholders. TWC owned 24,265,892 shares of WCG Class A common stock outstanding and 395,434,965 shares of Class B common stock outstanding which it converted to Class A shares prior to the spin-off. After the close of the market on April 23, 2001, TWC distributed 398,500,000 shares, or approximately 95%, of the WCG common stock it owned, to holders of TWC common shares on a pro rata basis by distributing approximately 0.822399 of a share of WCG Class A common stock as a dividend on each share of TWC common stock outstanding on the record date.
Prior to the spin-off, TWC and WCG entered into an agreement that, among other things, resulted in the transfer of ownership of a building under construction and other assets from TWC to WCG, a commitment to fund the completion of the building, the conversion of the TWC note into paid in capital and the issuance of 24.3 million shares of WCG Class A common stock. WCG's total equity increased by $42.9 million in 2002 as a result of this transaction.
As discussed in Note 19, pursuant to the terms of the Plan, all of WCG's Class A common stock was cancelled and 50 million shares of WilTel common stock was issued upon emergence from the chapter 11 proceedings. In addition, certain transfer restrictions apply to transactions in WilTel common stock as discussed in Note 19.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
14. Accumulated Other Comprehensive Income
The table below presents changes in the components of accumulated other comprehensive income (loss).
15. Leases
Future minimum annual rentals under noncancellable operating leases as of November 5, 2003 are payable as follows (in thousands):
Total -----
2004.................................................... $ 53,444 2005.................................................... 49,999 2006.................................................... 44,850 2007.................................................... 42,516 2008.................................................... 38,025 Thereafter.............................................. 259,233 ----------- Total minimum annual rentals............................ $ 488,067 ===========
Total capacity expense incurred from leasing from a third party's network (off-network capacity expense) was $35.4 million, $11.9 million and $92.1 million for the period from January 1, 2003 through November 5, 2003, the two months ended December 31, 2002 and the ten months ended October 31, 2002, respectively. All other rent expense was $29.2 million, $6.4 million and $42.2 million for the period from January 1, 2003 through November 5, 2003, the two months ended December 31, 2002 and the ten months ended October 31, 2002, respectively.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
16. Related Party Transactions
Transactions with Former Executive Officers
As part of the spin-off from TWC, WCG inherited a long-established loan program from TWC under which TWC extended loans to its executives to purchase TWC stock (the "Executive Loans"). At the time of the spin-off, six WCG executives had outstanding loans with TWC, and as part of the spin-off, the Executive Loans were transferred to WCG. As of December 31, 2001, the outstanding balance of these loans were $19.9 million, all which were considered long-term receivables.
Effective December 31, 2001, the Compensation Committee of the Board of Directors of WCG established a program to award annual retention bonuses over a period of five years in the aggregate amount of $13 million to certain executives to be applied, after deduction of applicable withholding taxes, solely against their respective outstanding principal loan balances. The agreements executed under this program were subsequently amended in conjunction with the Plan.
Under the amended retention bonus agreements, the Company reimbursed interest payments owed by the WCG executives as of January 1, 2002. In addition, the Company became responsible for paying all taxes, limited to an aggregate total of $20 million, associated with interest and principal payments under the retention bonus agreements, as well as any taxes incurred as a result of the payment of taxes by the Company. Under a separate amendment, all retention bonus payments vested upon consummation of the transactions included in the Plan, but still are to be paid out over the first through fourth anniversaries of the Effective Date, unless accelerated as a result of death or disability of the payee. Any officers who were parties to retention bonus agreements were not eligible to participate in the Company's otherwise applicable change in control severance plan. The Company recorded an expense of $23.3 million for the ten months ended October 31, 2002 related to the retention bonus agreements, $10.4 million of this expense was recorded to selling, general and administrative expense for costs prior to WCG commencing chapter 11 proceedings and the remaining $12.9 million was recorded to reorganization expense for costs after WCG commenced chapter 11 proceedings. For the period from January 1, 2003 through November 5, 2003, tax gross-up estimates were reduced by $1 million offsetting selling, general and administrative expense. As of November 5, 2003, the Company has accrued liabilities of $2.5 million and other long-term liabilities of $2.9 million representing taxes to be paid by the Company related to the retention bonus agreements.
On October 10, 2002, the Bankruptcy Court approved a settlement agreement between WCG and John C. Bumgarner, a former officer of WCG who participated in the TWC loan program. The agreement provided that WCG would settle a $6.9 million employee loan plus accrued interest in return for the loan's collateral of 238,083 shares of TWC common stock and 195,798 shares of WCG common stock and approximately $7 million of face value of WCG's Senior Redeemable Notes. As a result of the surrender of the Senior Redeemable Notes by Mr. Bumgarner, no shares of WilTel common stock were distributed under the Plan to Mr. Bumgarner. In addition, Mr. Bumgarner will provide consulting services at no cost to the Company for a period of three years from the date of his retirement. The Company recorded a loss of approximately $7 million to provision for doubtful accounts for the ten months ended October 31, 2002 related to the agreement.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company also recorded $12.1 million to reorganization expense for the ten months ended October 31, 2002 related to an employee incentive program that was adopted to retain employees during the Company's restructuring process, of which $3.9 million and $0.7 million related to former officers of the Company and current officers of the Company, respectively. As of November 5, 2003, the Company had no liabilities related to the employee retention incentive program.
Leucadia
On November 27, 2002, WilTel entered into a one-year Restructuring Services Agreement with Leucadia effective as of October 16, 2002 which later expired in October 2003. Under the terms of this agreement, Leucadia provides restructuring advice to WilTel with respect to management, operations, future business opportunities, and other matters to be mutually determined between Leucadia and WilTel. Leucadia does not receive any compensation for its services rendered under this agreement, but is reimbursed for all expenses incurred in connection with its performance under the agreement.
17. Commitments and Contingencies
Commitments
The Company has historically entered into various telecommunications equipment agreements in connection with its fiber-optic network. As of November 5, 2003, the Company's remaining purchase obligations under its remaining purchase agreements are not significant.
Litigation
The Company is subject to various types of litigation in connection with its business and operations.
Department of Labor Investigation
In April 2003, the Company received written notice from the United States Department of Labor that it is exercising its authority under Section 504 of the Employee Retirement Income Security Act of 1974 ("ERISA") to conduct periodic investigations of employee benefit plans to determine whether such plans conform with the provisions of ERISA and other applicable regulations. The stated scope of the review covers the Williams Communications Investment Plan (a defined contribution plan) for a time period extending from 1998 through the present date. In January 2004, the Company received a subpoena from the United States Department of Labor requiring the production of related documents. The Company is cooperating fully with the Department of Labor. At this time, neither the length of the review nor likely outcome of the investigation can be determined. The Company believes that all of its actions with respect to employee benefit plans have been in full compliance with ERISA and other applicable regulations.
Right of Way Class Action Litigation
A number of suits attempting to achieve class action status seek damages and other relief from the Company based on allegations that the Company installed portions of its fiber-optic cable without all necessary landowner consents. These allegations relate to the use of rights of way licensed by railroads, state departments of transportation and others controlling pre-existing right-of-way corridors. The putative members of the class in each suit are those owning the land underlying or adjoining the right-of-way corridors. Similar actions have been filed against all major carriers with fiber-optic networks. It is likely that additional actions will be filed. The Company believes it obtained sufficient rights to install its cable. It also believes that the class action suits are subject to challenge on procedural grounds.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company and other major carriers are seeking to settle the class action claims referenced above relating to the railroad rights of way through an agreed class action. These companies initially sought approval of a settlement in a case titled Zografos et al. vs. Qwest Communications Corp., et al., filed in the U.S. District Court for the District of Oregon on January 31, 2002. On July 12, 2002, the Oregon Court dismissed the action. Thereafter, on September 4, 2002, an existing case titled Smith, et al., vs. Sprint, et al., pending in the U.S. District Court for the Northern District of Illinois, was amended to join the Company and two other telecommunications companies as defendants. On July 25, 2003, the judge in this case issued an order preliminarily approving a proposed settlement agreement and issued an injunction, which stayed other putative class action railroad rights of way cases against the Company. Two of the intervening plaintiffs filed appeals, which were consolidated. If this settlement withstands potential challenges by plaintiffs' counsel, it will settle the majority of the putative nationwide and statewide class actions related to the railroad right-of-way claims. Based on the Company's estimate of a likely settlement range, the Company has accrued $16.6 million as of November 5, 2003.
Other right of way claims may be asserted against the Company. The Company cannot quantify the impact of all such claims at this time. Thus, WilTel cannot be certain that an unfavorable outcome of other potential right-of-way claims will not have a material adverse effect.
Platinum Equity Dispute
In March 2001, the Company sold its Solutions segment to Platinum Equity LLC ("Platinum Equity") for a sales price that was subject to adjustment based upon a computation of the net working capital of the business as of March 31, 2001. A dispute arose between the companies with respect to the net working capital amount as defined in the agreement. Pursuant to the provisions of the sale agreement, the parties submitted the dispute to binding arbitration before an independent public accounting firm.
In September 2002, Platinum Equity filed suit in the District Court of Oklahoma County, State of Oklahoma, against the Company alleging various breaches of representations and warranties related to the sale of the Solutions segment and requested a ruling that no payment was due under a promissory note issued by Platinum Equity at the time of purchase until all disputes were resolved. Many of the claims alleged by Platinum Equity in this suit are the same claims asserted by Platinum Equity in the net working capital dispute. Discovery in this suit is ongoing, with the trial expected to begin sometime in Spring 2004.
In May 2003, the arbitrator rendered a determination of the adjustment amount under the net working capital dispute, and an order entry of judgment was entered against Platinum Equity in the amount of approximately $38 million, which represented the amount that Platinum Equity owed under the promissory note, offset by the net working capital adjustment determined by the arbitrator. The Company adjusted the carrying amount of the note receivable to $38 million by offsetting amounts previously accrued for the net working capital dispute. In July 2003, the Company collected approximately $39 million, including interest, from Platinum Equity related to the judgment. The receipt of the $39 million does not resolve all of the issues between Platinum Equity and the Company as neither company has waived any of the claims currently pending in the litigation discussed above. The Company continues to believe that it is adequately reserved or accrued with respect to its receivable and payable positions with Platinum Equity.
Thoroughbred Technology and Telecommunications, Inc. vs. WCL
Thoroughbred Technology and Telecommunications, Inc. ("TTTI") filed suit on July 24, 2001, against WCL in a case titled Thoroughbred Technology and Telecommunications, Inc. vs. Williams Communications, LLC f/k/a Williams Communications, Inc., Civil Action No. 1:01-CV-1949-RLV, pending in the U.S. District Court for the Northern District of Georgia, Atlanta Division. TTTI alleged claims that included breach of contract with respect to a fiber-optic installation project that TTTI was constructing for itself and other parties, including WCL, with respect to certain conduit segments including a three-conduit segment between Cleveland, Ohio and Boyce, Virginia. TTTI sought specific performance to require that WCL take title to the Cleveland-Boyce segment and pay TTTI in excess of $36 million plus pre-judgment interest for such purchase. WCL alleged various defenses, including significant warranty and breach of contract claims against TTTI.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On May 9, 2002, the trial court determined that WCL did not have the right to terminate the contract with respect to the Cleveland-Boyce segment, but deferred ruling on TTTI's remedy until a later time. In a series of rulings on January 27, 2003, the court ordered, among other things, (1) that WCL's claims against TTTI for breach of contract and construction deficiencies for certain of the telecommunications routes constructed by TTTI be heard by an arbitration panel; and (2) that WCL close the purchase of the Cleveland-Boyce segment and pay TTTI the sum of $36.3 million plus pre-judgment interest for such purchase. The court denied WCL's motion for a stay of the proceedings while the construction claims against TTTI are adjudicated through arbitration and further denied the Company's request to stay closing on the Cleveland-Boyce segment pending an appeal of the trial court's decision. WCL sought and obtained a stay of the trial court's order compelling a closing of the Cleveland-Boyce segment from the United States Court of Appeals for the 11th Circuit thereby staying WCL's obligation to close the transaction until the appeal is decided. The stay granted by the Court of Appeals was conditioned on the posting of an appropriate supersedeas bond by the Company, which was posted by the Company in March 2003 in the approximate amount of $44.1 million. The Company posted the bond, which was docketed by the trial court on March 13, 2003. WCL prosecuted its appeal of the trial court's decision while pursuing its arbitration claims of construction defects against TTTI. Oral arguments in the appeal were scheduled for November 2003.
Subsequent to November 5, 2003, the parties reached a settlement of their disputes, which resulted in a payment of $37.5 million to TTTI and the transfer of title to WCL of conduits on the Cleveland-Boyce segment. All settlement documents were executed in November 2003, and this matter has been concluded.
StarGuide
On October 12, 2001, StarGuide Digital Networks ("StarGuide") sued WCG in the United States District Court for Nevada for infringement of three patents relating to streaming transmission of audio and video content. Subsequently, StarGuide added WCL as a party to the action. StarGuide seeks compensation for past infringement, an injunction against infringing use, and treble damages due to willful infringement. On July 1, 2002, StarGuide initiated a second patent suit against WCL with respect to a patent that is a continuation of the patents at issue in the prior litigation. The two actions have been consolidated. In July 2003, the parties reached a settlement, and this case was dismissed by joint agreement. The settlement did not have a material impact on the Company's results of operations, financial position or cash flows.
WilTel Shareholder Derivative Lawsuits
On May 15, 2003, the first of several shareholder derivative class actions was filed against WilTel, the nine members of WilTel's Board of Directors and Leucadia National Corporation ("Leucadia"). Currently, the Company has been served with notice of eight (8) shareholder derivative class actions: four (4) in Clark County, Nevada, one (1) in Washoe County, Nevada, two (2) in New York County, New York and one (1) in Tulsa County, Oklahoma. Each of the lawsuits sets forth substantially the same allegations of breach of fiduciary duty in connection with Leucadia's proposed exchange offer announced on May 15, 2003. Amended complaints were filed in each of the lawsuits based upon Leucadia's withdrawal of its initial offer and Leucadia's subsequent offers. On October 15, 2003, subject to approval from directors and officers insurance carriers, the parties in these cases reached an agreement in principle to settle all cases. On February 4, 2004, the proposed settlement in one of the New York County cases was approved by the trial court. The amount of the settlement is $300,000 representing Plaintiffs' attorney fees and expenses and is not material to the financial statements of WilTel. The settlement proceeds will be paid upon the expiration of the time period within which the matter may be appealed.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Summary
The Company is a party to various other claims, legal actions, and complaints arising in the ordinary course of business. In the opinion of management, upon the advice of legal counsel, the ultimate resolution of all claims, legal actions, and complaints, after consideration of amounts accrued, insurance coverage, or other indemnification arrangements, is not expected to have a materially adverse effect upon the Company's future financial position or results of operations, although unfavorable outcomes in the items discussed above could significantly impact the Company's liquidity.
Other
SBC
SBC is the Company's largest customer (comprising 54 percent and 47 percent of Network's revenues for the period from January 1, 2003 through November 5, 2003 and the year ended December 31, 2002, respectively). The Company has entered into preferred provider agreements with SBC that extends until 2019, although the agreements may be terminated prior to then by either party under certain circumstances. The agreements provide that:
o the Company is SBC's preferred provider for domestic voice and data long distance services and select international wholesale services, requiring that SBC seek to obtain these services from the Company before it obtains them from any other provider; and
o SBC is the Company's preferred provider for select local exchange and various other services, including platform services supporting its switched voice services network, requiring that the Company seek to obtain these services from SBC before it obtains them from any other provider.
For the services each party must seek to obtain from the other, the prices, determined separately for each product or service, generally will be equal to the lessor of the cost of the product or service plus a specified rate of return, the prices charged to other customers, the current market rate or, in some circumstances, a specific rate. If either party can secure lower prices for comparable services that the other party will not match, then that party is free to utilize the lowest cost provider. Subsequent to November 5, 2003, the Company and SBC have agreed to use a fixed price for voice transport services (the substantial majority of SBC generated revenue) through January 2005. Although it is difficult to identify a precise market price since the products and services provided to each customer are customized to meet the needs of each customer, the fixed price currently charged to SBC is representative of the current market price for the voice transport service currently provided to SBC.
The methodology that the Company uses to determine the current market rate and to determine the cost of the product or service upon which a specified rate of return applies are complex and subject to different interpretations. If SBC and the Company are unable to agree on the methods used, the agreements with SBC provide that any disputes are resolved through binding arbitration. If SBC successfully challenged the Company's pricing methodology in an arbitration proceeding, resulting in a significant reduction in the voice transport price, the Company may not be able to continue to provide services to SBC. The Company is unable to predict the ultimate outcome of future price discussions with SBC.
SBC has the right to terminate the agreements if the Company begins to offer certain services that are competitive with SBC's services, if the Company materially breaches its agreements or the Company has a change in control without SBC's consent. The Company has the right to terminate the agreements if SBC materially breaches its agreements or SBC has a change in control without the Company's consent. In the event of a termination by either party due to these actions, the terminating party has the right to receive transition costs from the other party, not to exceed $200 million.
Either party may terminate a particular provider agreement if the action or failure to act of any regulatory authority materially frustrates or hinders the purpose of that agreement. There is no monetary remedy for such a termination.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18. Financial Instruments
Fair Value Methods
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts reported in the balance sheet approximate fair value due to the short-term maturity of these instruments.
Notes receivables: The carrying amounts reported in the balance sheet approximate fair value due to the short-term maturity of these instruments.
Long-term debt: The carrying amounts reported in the balance sheet approximate fair value due to the long-term debt outstanding being primarily variable-rate debt.
Concentration of Credit Risk
The Company's cash equivalents include high-quality securities placed with various major financial institutions with high credit ratings. The Company's investment policy limits its credit exposure to any one issuer/obligor.
The Company's customers include numerous corporations. The Company serves a wide range of customers, of which SBC comprises approximately 38% of its net accounts receivable balance as of November 5, 2003. There are no other customers, which are individually significant to its business. While sales to these various customers are generally unsecured, the financial condition and creditworthiness of customers are routinely evaluated.
19. Bankruptcy Proceedings
Overview of the Chapter 11 Proceedings
On April 22, 2002, the Debtors filed petitions for relief under the Bankruptcy Code in the Bankruptcy Court. On September 30, 2002, the Bankruptcy Court entered an order confirming the Second Amended Joint Chapter 11 Plan of Reorganization of the Debtors (the "Plan"), effective on October 15, 2002 (the "Effective Date"). The confirmation order was subject to certain conditions including gaining necessary FCC regulatory approvals to transfer control of licenses from WCG to the Company. Prior to the Effective Date, WCG, WCL, and the Company applied to and received from the FCC special temporary authority to transfer control of all licenses to the Company. The granting of the special temporary authority from the FCC allowed the Company to emerge from the chapter 11 proceedings on the Effective Date subject to an escrow agreement discussed below.
A copy of the Plan was filed as Exhibit A to Exhibit 99.2 to WCG's Current Report on Form 8-K, dated August 13, 2002. Modifications to the Plan were filed as Exhibit 99.3 to WCG's Current Report on Form 8-K, dated September 30, 2002 (the "Confirmation Date 8-K"). A copy of the Confirmation Order was filed as Exhibit 99.1 to the Confirmation Date 8-K.
Described below is a summary of certain significant agreements and important events that have occurred in and following the bankruptcy reorganization. The summary should be read in conjunction with and is qualified in its entirety by reference to the Plan and the material transaction documents discussed herein and made available as exhibits to WCG's and WilTel's public filings, including those filed with the SEC.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Plan of Reorganization
On September 30, 2002, the Bankruptcy Court approved and entered an order confirming the Plan, which had been proposed by the Debtors, the official committee of unsecured creditors (the "Committee") and Leucadia National Corporation ("Leucadia"). The Plan was designed to meet the requirements of the Settlement Agreement (described in greater detail below) and the pre-petition Restructuring Agreement. By implementing both the Settlement Agreement and the Restructuring Agreement, the Plan allowed WCG to raise the $150 million new investment from Leucadia. That additional investment allowed WCG to further reduce its secured debt without sacrificing working capital (see below for a discussion of the Escrow Agreement and the ultimate release from escrow of the $150 million investment).
Settlement Agreement
On July 26, 2002, TWC, the Committee, and Leucadia entered into a settlement agreement (the "Settlement Agreement") that provided for, among other things, (a) the mutual release of each of the parties, (b) the purchase by Leucadia of TWC's unsecured claims against WCG (approximately $2.35 billion face amount) for $180 million, (c) the satisfaction of such TWC claims and a $150 million investment in the Company by Leucadia in exchange for 44% of the outstanding WilTel common stock, and (d) modification of WCG's sale and subsequent leaseback transaction covering the WCG headquarters building and modification of the TWC Continuing Contracts (as defined in the Settlement Agreement). An order approving the Settlement Agreement was issued on August 23, 2002.
TWC's unsecured claims of $2.35 billion related to arrangements between WCG and TWC and primarily consisted of the following:
Senior Reset Note Claim: Approximately $1.4 billion of those claims related to the Trust Notes, which were senior secured notes issued by a WCG subsidiary in March 2001. The proceeds from the sale of the Trust Notes were (i) transferred to WCG in exchange for WCG's $1.5 billion 8.25% senior reset note due 2008 (the "Senior Reset Note") and (ii) contributed by WCG as capital to WCL to provide liquidity following the tax-free spin-off from TWC. Obligations of WCG and its affiliates under the Trust Notes were secured by the Senior Reset Note and were effectively guaranteed by TWC. In July 2002, TWC exchanged $1.4 billion of new senior unsecured notes of TWC (the "New TWC Notes") for all of the outstanding Trust Notes. TWC, as agent under the Trust Notes indenture, had the right to sell the Senior Reset Note to achieve the highest reasonably available market price and the Bankruptcy Court found that the TWC sale of the TWC Assigned Claims to Leucadia met this requirement.
ADP Claims: In 1998, WCG entered into an operating lease agreement covering a portion of its fiber-optic network referred to as an asset defeasance program ("ADP"). The total cost of the network assets covered by the lease agreement was $750 million. Pursuant to the ADP, WCG had the option to purchase title to those network assets at any time for an amount roughly equal to the original purchase price, and TWC was expressly obligated to pay the purchase price under an intercreditor agreement entered into by TWC in connection with the then-existing WCL credit facility. In March 2002, WCG exercised its purchase option, and TWC funded the purchase price of approximately $754 million. In exchange for this payment from TWC, the intercreditor agreement provided that TWC was entitled to either the issuance of WCG equity or WCG unsecured subordinated debt (meaning debt that was subordinate in priority to WCL's pre-petition credit facility), each on terms reasonably acceptable to the lenders under WCL's pre-petition credit facility. On March 29, 2002, WCG tendered an unsecured note to TWC for approximately $754 million that was not accepted by TWC. Any and all causes of action of TWC or any of its direct or indirect subsidiaries against a Debtor relating to the ADP were resolved pursuant to the terms of the Settlement Agreement.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Pre-Spin Services Claims: The terms of the Settlement Agreement also resolved "Pre-Spin Services Claims" of TWC arising from a Services Agreement entered into between WCG and TWC when WCG was a wholly-owned subsidiary of TWC. Pursuant to this agreement, TWC and certain of its affiliates performed payroll, administrative, and related services for WCG and its affiliates. Pre-Spin Services Claims were also resolved pursuant to the Settlement Agreement.
The Settlement Agreement also resolved WCG's defaults under the sale and subsequent leaseback transaction (discussed below) as a result of WCG's bankruptcy filing, thus negating any threat or risk that the Company would be evicted or otherwise lose possession of its headquarters due to the bankruptcy.
SBC Stipulation
On September 25, 2002, the Bankruptcy Court approved a stipulation agreement (the "Stipulation Agreement") between the Company and SBC conditioned upon the consummation of the Plan. The Stipulation Agreement provided for the necessary SBC approval of the Plan and resolved change-of-control issues that SBC had raised regarding WCG's spin-off from TWC. At the same time, SBC and WCL executed amendments to their alliance agreements.
Purchase of Headquarters Building
In connection with the spin-off of WCG by TWC in 2001, TWC and WCG entered into a sale and leaseback transaction for WCG's headquarters building and certain real and personal property, including two corporate aircraft (the "Building Purchase Assets"), as a result of which TWC purchased the Building Purchase Assets and leased them back to WCG. Pursuant to an agreement between WCG and TWC, among others, dated July 26, 2002, (as amended, the "Real Property Purchase and Sale Agreement"), WCG repurchased the Building Purchase Assets from TWC for an aggregate purchase price of approximately $145 million (the "Purchase Price").
The Purchase Price consisted of promissory notes issued by Williams Technology Center, LLC ("WTC"), the Company, and WCL to TWC (the "OTC Notes"). One note for $100 million is due April 1, 2010; the other note for $44.8 million is due December 29, 2006. The obligations of WTC, WilTel, and WCL under the OTC Notes may be subject to reduction, depending on the disposition of certain aircraft leases described in greater detail in the Real Property Purchase and Sale Agreement. Obligations of WTC, WilTel, and WCL under the OTC Notes were secured by, and made pursuant to, a mortgage agreement (the "OTC Mortgage"), under which WTC granted a first priority mortgage lien and security interest to TWC in all of its right, title and interest in, to and under the headquarters building and related real and personal property.
The Settlement Agreement also contemplated that the lenders under the Company's credit facility would receive a second priority mortgage lien and security interest in those same assets. The Real Property Purchase and Sale Agreement also provided that the OTC Notes are secured in part by a second lien and security interest in the Company's interests in PowerTel. See Note 12 for a further discussion of the terms of the OTC Notes.
As described below, consummation of the transactions contemplated by the Real Property Purchase and Sale Agreement were conditioned upon satisfaction of the terms of the Escrow Agreement (as defined below).
Transactions on the Effective Date
On the Effective Date, pursuant to the Plan and the confirmation order, WilTel emerged as the successor to WCG and issued an aggregate of 22,000,000 shares of WilTel common stock to Leucadia and an aggregate of 27,000,000 shares of WilTel common stock to a grantor trust (the "Residual Trust") among WCG, WilTel, and Wilmington Trust Corporation, as trustee (the "Residual Trustee") on behalf of certain creditors of WCG. An additional 1,000,000 shares of WilTel common stock were issued to WCG in connection with a "channeling injunction" that could potentially benefit securities holders involved in a class action proceeding against WCG.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
WilTel issued shares of its common stock to Leucadia under the Plan in two distributions. First, pursuant to a Purchase and Sale Agreement, dated as of July 26, 2002, between Leucadia and TWC (amended on October 15, 2002), Leucadia acquired from TWC certain claims that TWC had against WCG (the "TWC Assigned Claims") for a purchase price of $180 million paid in the form of a letter of credit issued by Fleet Bank (the "TWC Letter of Credit") and WilTel issued 11,775,000 shares of its common stock to Leucadia in satisfaction of such claims in accordance with the Plan.
Second, pursuant to an Investment Agreement by and among Leucadia, WCG, and WCL, dated as of July 26, 2002 (amended on October 15, 2002), on the Effective Date Leucadia invested $150 million in the Company in exchange for 10,225,000 shares of WilTel common stock (the "New Investment"). Leucadia paid $1,000 of the purchase price in cash to WilTel and delivered the remainder, in the form of a letter of credit issued by JP Morgan Chase Bank (the "Company Letter of Credit").
Leucadia delivered the TWC Letter of Credit and the Company Letter of Credit into an escrow account established pursuant to an Escrow Agreement (the "Escrow Agreement") dated as of October 15, 2002, among the Company, Leucadia, TWC, and The Bank of New York as Escrow Agent. The Escrow Agreement provided for the release of the Letters of Credit (and documents related to the Real Property Purchase and Sale Agreement) upon receipt, prior to February 28, 2003, of approval from the FCC for the transfer of control to the Company of the licenses that had been temporarily issued to WCL prior to the Effective Date. Failure to obtain FCC approval by February 28, 2003, in accordance with the terms of the Escrow Agreement would have resulted in an "unwind" of the New Investment and the purchase of the TWC Assigned Claims. However, following receipt of the FCC approval on November 25, 2002, the proceeds of the Company Letter of Credit were paid to the Escrow Agent for disbursement to the Company in accordance with the terms of the Escrow Agreement, and the proceeds of the TWC Letter of Credit were paid to the Escrow Agent for disbursement to TWC.
WCG continues to exist as a separate corporate entity, formed in the State of Delaware, in order to liquidate any residual assets and wind up its affairs. On the Effective Date, WCG transferred substantially all of its assets to WilTel. The other Debtor, CG Austria, continues to exist as a separate corporate entity, incorporated in the State of Delaware, and owned solely by WCL.
The Exit Credit Agreement
On the Effective Date, WCL and the lenders under its credit facility (the "Lenders") entered into a credit agreement (the "Exit Credit Agreement") that combined the term loans under the previous credit facility into one loan for $375 million (paid down throughout the bankruptcy from a pre-petition balance of $975 million). See Note 12 for a further discussion of the terms of the Exit Credit Agreement.
Capitalization, Corporate Governance, and Leucadia Agreements
Pursuant to the Plan and a Stockholders Agreement, dated October 15, 2002, between Leucadia and the Company (the "Stockholders Agreement"), the Company's Board of Directors was comprised of four members designated by Leucadia, four members designated by the Official Committee of Unsecured Creditors of WCG, and the Chief Executive Officer of the Company, Jeff K. Storey, who was elected as Chief Executive Officer of the Company and became a member of the Board of Directors on October 31, 2002. Pursuant to the Stockholders Agreement, so long as Leucadia beneficially owned at least 20% of the outstanding common stock of WilTel, it would be entitled to nominate four members of the Board of Directors. If Leucadia beneficially owned less than 20% but more than 10% of the outstanding common stock of WilTel, it would be entitled to nominate one member to the Board of Directors. In addition, the Stockholders Agreement provided that, until October 15, 2004, Leucadia would vote all of its shares of WilTel common stock in favor of Committee designees to the Board. Until October 15, 2004, any replacement of a Committee designee will occur through a nominating process detailed at Section 3.4 of the Stockholders Agreement.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Pursuant to the Stockholders Agreement, for a period of five years from the Effective Date of the Plan, Leucadia would not acquire or agree to acquire any of the Company's securities except (a) with prior approval by a majority of the members of the Board of Directors that are independent or by holders of a majority of the Company voting securities that are not owned by Leucadia voting together as a single class, (b) in connection with certain other acquisitions, so long as Leucadia would not hold in excess of 49% of the Company's voting securities following such acquisition or (c) a Permitted Investor Tender Offer (as defined in the Stockholders Agreement). The Leucadia exchange offer described in Note 1 was a Permitted Investor Tender Offer approved by WilTel's Board of Directors in August 2003 when the Board approved the merger agreement. In addition, the Stockholders Agreement was terminated upon the consummation of the merger by Leucadia.
The WilTel articles of incorporation (the "Charter") provided that 200 million shares of common stock were authorized for issuance (of which 50 million shares were issued under the Plan and are outstanding), and 100 million shares of preferred stock were authorized for issuance (of which no shares were issued and outstanding).
Leucadia has entered into a Registration Rights Agreement with the Company by which the Company has granted Leucadia certain rights to obligate the Company to register for sale under the Securities Act of 1933, the shares owned by Leucadia or its affiliates, including the shares issued pursuant to the Plan.
Leucadia and the Company have entered into a Stockholder Rights and Co-Sale Agreement (the "Co-Sale Agreement") by which, among other things, certain WilTel holders (any of the approximately 2,500 holders who submitted an affidavit within 90 days after the Effective Date, or their Permitted Transferee under the Co-Sale Agreement, who maintain beneficial ownership of at least 100 shares of common stock received pursuant to the Plan) will be eligible to participate in (i) issuances of Securities (as defined in the Co-Sale Agreement) to Leucadia until the fifth anniversary of the Effective Date and (ii) any transfer (other than transfers to affiliates of Leucadia and Exempt Transactions (as defined in the Co-Sale Agreement)) by Leucadia of shares of WilTel common stock representing 33% or more of the WilTel common stock outstanding. In addition, two such holders each paid $25,000 to the Company (with the submission of the affidavit referred to above) to be eligible to participate in proposed issuances or actual issuances of Other Securities (as defined in the Co-Sale Agreement) to Leucadia until the fifth anniversary of the Effective Date. The Co-Sale Agreement was terminated upon the consummation of the merger by Leucadia.
On October 28, 2002, Leucadia purchased in a private transaction 1.7 million shares of WilTel's common stock as reported on Schedule 13-D filed on October 30, 2002, which brought Leucadia's ownership interest in WilTel to 47.4%.
The "Five-Percent Limitation" on Stock Ownership
As required by the Plan, the Charter imposes certain restrictions on the transfer of "Corporation Securities" (as defined in the Charter, including common stock, preferred stock, and certain other interests) with respect to persons who are, or become, five-percent shareholders of the Company, as determined in accordance with applicable tax laws and regulations (the "Five-percent Ownership Limitation"). The Five-percent Ownership Limitation provides that any transfer of, or agreement to transfer, Corporation Securities prior to the end of the effectiveness of the restriction (as described below) shall be prohibited if either (y) the transferor holds five percent or more of the total fair market value of the Corporation Securities (a "Five-percent Shareholder") or (z) to the extent that, as a result of such transfer (or any series of transfers of which such transfer is a part), either (1) any person or group of persons shall become a Five-percent Shareholder, or (2) the holdings of any Five-percent Shareholder shall be increased, excluding issuances of WilTel common stock under the Plan and certain other enumerated exceptions. Each certificate representing shares of WilTel common stock bears a legend that re-states the applicable provisions of the Charter.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Five-percent Ownership Limitation will not apply to: (i) certain transactions approved by the WilTel Board, (ii) an acquisition by Leucadia of shares of the Corporation Securities that, as a percentage of the total shares outstanding, is not greater than the difference between 49% and the percentage of the total shares outstanding acquired by Leucadia or any of its subsidiaries in the Plan, plus any additional Corporation Securities acquired by Leucadia and its subsidiaries, and (iii) certain other transactions specified in the Charter if, prior to the transaction, the WilTel Board or a duly authorized committee thereof determines in good faith upon request of the transferor or transferee that the transaction meets certain specified criteria. The Five-percent Ownership Limitation did not apply to the merger by Leucadia since the merger agreement was approved by the WilTel Board.
The Charter also prohibits the issuance of non-voting equity securities.
Additional Effective Date Transactions
In addition, the following transactions, among others, occurred on the Effective Date pursuant to the Plan (capitalized terms used but not defined herein have the meaning ascribed to them in the Plan):
o All of the Restated Credit Documents were executed and delivered and became effective, and $350 million was paid to the Lenders thereunder.
o Each of the transactions that comprised the TWC Settlement occurred or were implemented and became binding and effective in all respects (subject to the Escrow Agreement), including:
- documents to effect the sale by Williams Headquarters Building Company of the Building Purchase Assets to WTC pursuant to the Real Property Purchase and Sale Agreement were deposited into escrow with The Bank of New York, as Escrow Agent, and subsequently delivered when the $330 million proceeds of the Leucadia New Investment and purchase of TWC Assigned Claims were released to the Company and TWC, respectively, pursuant to the terms of the Escrow Agreement;
- all of the releases contemplated by the TWC Settlement became binding and effective, including releases whereby WCG, WCG's current and former directors and officers, and the Committee released TWC and its current and former directors, officers, and agents; in addition, TWC released WCG and WCG's current and former directors and officers, including the claims that TWC alleged it had against WCG's non-debtor subsidiaries; and
- all other transactions contemplated under the TWC Settlement were consummated.
o As contemplated by the Settlement Agreement, the confirmation order provided an injunction with respect to (a) channeling all personal claims of WCG's unsecured creditors against TWC and deeming them satisfied from the consideration provided by TWC under the Settlement Agreement; and (b) channeling all remaining securities actions against WCG's officers and directors to a "fund" consisting of up to 2% of WilTel's common stock and the right to collect under WCG's director and officer liability insurance policies.
o Pursuant to the Settlement Agreement, TWC transferred to WCG all of its rights in the "WilTel" and "WilTel Turns Up Worldwide" marks, and in exchange WCG agreed to amend the term of the Trademark License Agreement, dated April 23, 2001, between TWC and WCG, to two years following the Effective Date, at which time the Company would no longer have the right to use the "Williams" mark, the "Williams Communications" mark, and certain other "Williams" related marks. The transfer of these rights was effectuated through an Assignment of Rights Agreement between Williams Information Services Corporation ("WISC") and WCL pursuant to which WISC agreed to grant, sell, and convey to WCL all of its right, title, and interest in the United States and Canada to the trademarks "WilTel" and "WilTel Turns Up Worldwide."
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
o WCG has various administrative service and support contracts with TWC. The Settlement Agreement provides for the continuation of only those contracts between WCG and the TWC entities that WCG views as favorable (the "TWC Continuing Contracts"), as well as modification to certain of those TWC Continuing Contracts to waive any rights to an unfavorable alteration of contract terms due to the New Investment or the transactions contemplated by the Plan.
All other payments, deliveries and other distributions to be made pursuant to the Plan or the Restated Credit Documents on or as soon as practicable after the Effective Date were made or duly provided for.
20. Adoption of Fresh Start Accounting
As discussed in Note 19, the Company emerged from bankruptcy on October 15, 2002. Pursuant to the provisions of SOP 90-7, the Company adopted the provisions of fresh start accounting on October 31, 2002 to coincide with its normal monthly financial closing cycle. Under fresh start accounting, the net reorganization value of the Company was allocated among the Company's individual assets and liabilities based upon their relative fair values, which were primarily based upon independent appraisals.
In conjunction with formulating the Plan, the Company was required to estimate its post-confirmation reorganization value. The Company's financial advisors assisted in the valuation utilizing methodologies that were based upon the cash flow projections and business plan as contemplated by the Predecessor Company. These methodologies incorporated discounted cash flow techniques, a comparison of the Company and its projected performance to market values of comparable companies and a comparison of the Company and its projected performance to values of past transactions involving comparable entities. The cash flow valuations utilized five-year projections discounted at a weighted average cost of capital of approximately 27.5%, including a terminal value equal to a multiple of projected fifth year operating results, together with the net present value of the five-year projected cash flows. Based upon these analyses, upon emergence from the chapter 11 proceedings, the reorganization value for the Company was estimated to be approximately $1.3 billion, which was within the range of reorganization values contained in the Company's disclosure statement filed in the chapter 11 proceedings. This reorganization value was reflected in the Company's consolidated balance sheet upon emergence from the chapter 11 proceedings as post-emergence debt of approximately $573 million and an equity value of $750 million. The Company's post-emergence debt was valued at the present value of amounts expected to be paid, which was principally the face amount. The Company's total common equity value was determined by reference to the implied value of the equity derived from Leucadia's purchase of 44% of the Company for $330 million.
The reorganization value was allocated to the Company's net assets in relation to their fair values similar to the procedures specified in SFAS 141, "Business Combinations." The Company recorded $2.2 billion in reorganization items to record its net assets to fair value primarily consisting of the following:
o an adjustment to property, plant and equipment of approximately $2.4 billion to reflect its fair value;
o an adjustment to deferred revenue of approximately $210 million to reflect the estimated value of such contracts as if they were entered into on the Effective Date;
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
o a liability for long-term commitments not representative of current market conditions of approximately $84 million for commitments that were either above current market rates or for capacity not required based on the Company's business plans primarily related to real estate leases and domestic and international capacity contracts; and
o an adjustment in the benefit obligation of approximately $40 million to record unrecognized prior service costs and actuarial gains (losses) through October 31, 2002.
The allocation of net reorganization value to assets and liabilities required significant judgment and assumptions. For example, the Company engaged an independent appraiser to assist in its determination that the fair value of its long-lived assets was approximately $1.5 billion and in its allocation of the fair value to the various asset classes. The Company and the appraiser considered several factors, such as local market conditions; the size and character of the property; the estimated cost to acquire comparable property (if comparable property was available); the estimated cost to acquire new property, less the loss of value (depreciation) resulting from physical, functional and economic obsolescence; contractual relationships; the remaining expected useful life of the assets and estimates of future network capacity utilization. To the extent actual results are different than the assumptions the Company made, future results of operations could be impacted either positively or negatively.
The aggregate replacement cost of new property, plant and equipment was estimated to be approximately $6 billion. This estimate was comprised of a significant network construction cost element of approximately $3 billion (including rights of way, conduit and fiber) and equipment that is part of the network of approximately $1.5 billion. The network construction and related equipment are both industry specific. The remaining balance of the estimate was comprised of buildings and other equipment, which are not necessarily industry specific. Functional and economic obsolescence factors reduced the aggregate value of the property, plant and equipment by approximately $4 billion and primarily reflected the current abundance of capacity in the telecommunications industry for network-related assets. Estimates of fair values were further reduced to account for the age of the Company's assets. If the assumptions used by the Company were changed to result in a different estimate of fair value, the Company's financial position and results of operations could be materially different. For example, if upon using different assumptions the estimate of fair value was lowered, the Company would have likely recognized some amount of goodwill and less property, plant and equipment upon emergence from its chapter 11 proceedings in its statement of financial position, which would have also resulted in lower depreciation expense in the future. Conversely, if upon using different assumptions the estimate of fair value was greater than the amount determined, there would have been minimal impact on the Company's current financial position or future results of operations, since any such increase in value would reduce the Company's initial estimated value of its long-term assets, which in this case was property, plant and equipment.
In addition, the net assets of PowerTel were assumed to have minimal value based on assessments by management and its financial advisor assisting with the potential sale of the Company's ownership interest in PowerTel. An important element of that assessment included PowerTel's struggles to maintain compliance with its bank covenants. In August 2003, market conditions improved such that the Company sold its ownership interest in PowerTel resulting in a gain of $21.1 million as discussed in Note 5.
The fair value adjustment to reflect the new carrying value for deferred revenue of approximately $253 million required a determination of fair value for transactions having limited activity in the current telecommunications market environment. The fair value adjustment considered market indicators related to pricing, quotes from third parties, pricing for comparable transactions as well as the legal obligation of the Company to provide future services in accordance with EITF 01-3, "Accounting in a Purchase Business Combination for Deferred Revenue of an Acquiree." The Company also assumed it would continue to perform its contractual obligations through the term of its contracts. Revenue will be recognized on these contracts as services are performed, typically on a straight-line basis over the remaining length of the contract. Future results of operations could be impacted by the early termination of the Company's obligations to the extent the contracts are rejected through a customer bankruptcy proceeding or otherwise settled prior to completing the Company's performance obligation.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
An $84 million liability, on a net present value basis, was recorded for unfavorable long-term commitments that are either above the current market rates for similar transactions (net of certain contracts that are below current market rates) or for telecommunications capacity that is not required based on the Company's revised business plans. These commitments primarily consist of real estate leases and domestic and international capacity contracts. The accrual for these unfavorable commitments includes significant assumptions pertaining to future market prices, future capacity utilization, the ability to enter into subleasing arrangements and that the commitments will not be terminated prior to their expiration dates. The accrued liability will be amortized on a straight-line basis over the life of the commitments. However, future results of operations could be impacted by a subsequent adjustment to the accrued liability as a result of the Company terminating or reducing its contractual obligation as a result of subsequent agreements with contract counter-parties or sublease activity different from the Company's original assumptions.
The impact of the Plan and fresh start accounting on the Predecessor's consolidated balance sheet as of October 31, 2002 is as follows:
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Explanations of the adjustment columns in the consolidated balance sheet are as follows:
(a) To record the $150 million investment by Leucadia as a subscription receivable until the proceeds placed in escrow were released.
(b) To reflect the $350 million prepayment on the credit facility, the discharge of liabilities subject to compromise, the replacement of the sale and subsequent leaseback debt with the OTC Notes and issuance of WilTel common stock upon consummation of the Plan resulting in a gain on the reorganization of $4.3 billion.
(c) To reflect the fair value of net assets as of October 31, 2002.
(d) To reflect the cancellation of WCG's Class A common stock and the 6.75% redeemable cumulative convertible preferred stock and the elimination of accumulated deficit and other comprehensive loss.
(e) To reflect the release of the $150 million Leucadia investment from escrow in December 2002.
21. Reorganization Items, Net
Reorganization items, which consist of items incurred by WCG as a result of reorganization under the Bankruptcy Code, are as follows for the ten months ended October 31, 2002:
Predecessor (In thousands)
Reorganization items, net: Gain on the discharge of liabilities (a) $ 4,339,342 Fresh start adjustments to fair value (b)............... (2,154,464) Gain on forgiveness of interest (c).................... 73,898 Write-off of deferred financing costs (d).............. (92,391) Write-off of debt discounts (d)........................ (10,055) Retention bonus agreements with former officers (e).... (12,926) Retention incentive expense (e)........................ (12,108) Professional fees and other (f)....................... (68,109) Interest income (g)................................... 2,845 ----------- $ 2,066,032 ===========
Explanations of the reorganization items in the table above are as follows:
(a) The gain on the discharge of liabilities subject to compromise primarily included the Senior Redeemable Notes of approximately $2.4 billion, the Trust Notes of $1.4 billion, the ADP Claims of approximately $754 million, the Pre-Spin Services Claims of $100 million, the replacement of the sale and subsequent leaseback debt with the OTC Notes of approximately $97 million and accrued interest of approximately $137 million, partially offset by the issuance of $600 million of WilTel common stock.
(b) See Note 20 for a discussion of the adjustments to record net assets to fair value in fresh start accounting.
(c) As discussed in Note 19, in March 2002, certain provisions of the indenture related to the Trust Notes were amended. The amendment, among other things, provided that TWC would make the required March and September 2002 interest payments on behalf of WCG to WCG Note Trust, and WCG would not be required to reimburse TWC for these interest payments. Since the interest accrued on these notes through March 2002 was not a claim in the chapter 11 proceedings, WCG recognized a gain of $73.9 million ($0.15 per share) for the ten months ended October 31, 2002 in accordance with SOP 90-7.
WILTEL COMMUNICATIONS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(d) For the ten months ended October 31, 2002, the Company wrote off deferred financing costs and debt discounts associated with liabilities subject to compromise and a portion of the deferred financing costs associated with the Company's credit facility to reorganization items in accordance with SOP 90-7 since the deferred financing costs and debt discounts do not have a remaining useful life as a result of the chapter 11 proceedings.
(e) As discussed in Note 16, the Company has recorded $12.9 million in reorganization expense for the ten months ended October 31, 2002 primarily related to taxes on the retention bonus agreements with former officers in place, inasmuch as the Company committed to pay pursuant to those agreements an aggregate of up to $20 million for taxes incurred by the beneficiaries of those agreements. In addition, the Company recorded $12.1 million for the ten months ended October 31, 2002 pursuant to an employee incentive program that was adopted to retain employees during the Company's restructuring process.
(f) Professional fees and other primarily consists of professional fees for legal and financial advisory services in connection with the reorganization.
(g) The Company recognized interest income of $2.8 million for the ten months ended October 31, 2002 on accumulated cash that the Company did not disburse as a result of the chapter 11 proceedings.
22. Asset Impairments and Restructuring Charges
Asset impairments and restructuring charges of $8.6 million for the two months ended December 31, 2002 included $8.4 million for severance related expenses. Asset impairments and restructuring charges of $28.5 million for the ten months ended October 31, 2002 included $21.6 million for severance related expenses and $4.0 million related to the early termination or settlement of lease agreements. The Company had workforce reductions of approximately 1,400 employees in 2002 and paid out approximately $26 million relating to severance in 2002.
During the first three quarters of 2002, the Company compared estimated future net cash flows associated with its long-lived assets with the remaining basis of such long-lived assets on a going concern basis, and determined its remaining basis in its long-lived assets was recoverable through future cash flows. Estimates of future net cash flows used for potential impairment analysis were consistent with estimates used by the Company's financial advisors to arrive at the Company's reorganization value and included assumptions regarding decreased prices for the Company's products and services, significant increases in sales quantities in periods beyond 2002 and that the Company would continue to have adequate liquidity. It was determined that no impairment was necessary for the ten months ended October 31, 2002. The adoption of fresh start accounting resulted in a reduction in the Company's carrying value of long-lived assets by approximately $2.4 billion and is reported as a reorganization item. The reorganization value was based on a discounted cash flow methodology, as required, whereas the impairment tests utilized undiscounted cash flows, as required. This is the primary reason no impairment was necessary during the first three quarters of 2002, and a reduction in the carrying value of long-lived assets was necessary at the adoption of fresh start accounting.