ITEM 1. Business
Company Overview
We are the largest provider of wireline local exchange telecommunications services to residential and business customers in rural Iowa, serving over 440 communities across the state. We are the second largest local exchange carrier in Iowa and estimated to be in the top 20 largest in the United States. We currently operate 288 telephone exchanges as the incumbent or “historical” local exchange carrier and are currently the sole telecommunications company providing wireline services in approximately 85% of these exchanges. Together with our competitive local exchange carrier subsidiaries, we provide services to approximately 252,000 access lines in Iowa.
Our core businesses are local telephone service and the provision of network access to other telecommunications carriers for calls originated or terminated on our network. These businesses generated 74% of our total revenues for the year ended December 31, 2006.
In addition to our basic local service and network access businesses, we provide long distance service, dial-up and DSL Internet access and other communications services. Our strong incumbent market position gives us a platform to cross-sell these additional services to our customers. In 2002, as part of our strategy of pursuing low-cost growth beyond our current service area, we began to compete for customers in adjacent markets in Iowa through our competitive local exchange carrier subsidiary, Iowa Telecom Communications, Inc. (“ITC”). In late 2005, IT Communications, LLC (“IT Communications”) was formed to operate similarly to ITC but with a focus on larger communities in Iowa.
We believe we are building strong consumer loyalty and brand recognition by providing superior, locally focused customer service and maintaining strong ties to our rural communities. Our stable customer base, combined with the higher costs of offering competitive wireline services, leads to limited competition in the rural regions we serve as compared to most urban areas.
Our History
In the late 1990’s, several of the Regional Bell Operating Companies and other large telecommunications companies, such as GTE Midwest Incorporated, decided to sell many of their rural assets. Many of these large providers had decided to focus investment capital and resources on their urban markets and national wireless and business service operations, rather than on their rural markets, which we believe were historically underserved by the large providers. We concluded that GTE Midwest Incorporated’s divestiture of its rural Iowa operations presented an attractive opportunity to improve the financial performance of this business by improving existing networks, offering customers additional services and providing high quality, locally focused customer service. We were incorporated under the laws of the State of Iowa in 1999. We began business on June 30, 2000 when we acquired the Iowa operations of GTE Midwest Incorporated. Our common stock began trading on the New York Stock Exchange on November 18, 2004 under the trading symbol “IWA.”
We are the largest provider of wireline telecommunications services to rural communities in Iowa. We are the sole telecommunications company currently providing wireline services in approximately 85% of our incumbent local exchanges. Our incumbent market position has allowed us to pursue increased revenues per access line by cross-selling additional services to existing subscribers, including offering integrated packages, or bundles, of local, long distance and Internet service on a single monthly customer bill. Since the GTE Midwest Incorporated acquisition, we have expanded our toll, or long distance, services and have introduced dial-up and DSL Internet access as profitable new businesses.
Virtually all of our services are offered in an area that is 20,000 square miles in size, and each of our switching centers is within 30 miles of another of our switching centers. This geographic concentration allows us
to efficiently manage our network operations and to cost-effectively generate a local brand identity, and also leads to a higher degree of customer contact. Over 99% of the customers we serve are located in rural communities in the state of Iowa. Our single-state focus also raises our profile in Iowa and spares us the complexity, cost and unpredictability of operating under multiple state regulatory regimes.
On July 1, 2006, we completed the purchase of the Montezuma Mutual Telephone Company (“Montezuma Telephone”). Montezuma Telephone provides telecommunications services to 2,100 access lines, cable television service to approximately 1,350 subscribers and Internet access service to more than 950 subscribers, most of which are located in Montezuma, Iowa.
On August 1, 2006, we completed the purchase of Baker Communications, Inc. (“Baker Communications”). Baker Communications designs, develops, and provides ongoing support of technology solutions for clients. Areas of specialization include enterprise voice solutions, Internet protocol (“IP”) communications and data networking. Baker Communications is headquartered in Des Moines, Iowa, with additional offices in Cedar Rapids, Iowa and Omaha, Nebraska.
Our Strategy
Our objective is to continue to strengthen our position as a leading provider of telecommunications services, focusing primarily on non-metropolitan markets in the Midwest. To achieve this goal, we intend to pursue the following strategies:
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Maintain Stable Cash Flows from Operations and Disciplined Capital Spending. We have a diverse residential and business customer base that produces a recurrent revenue stream and relatively predictable cash flows. We intend to maintain our financial performance by continuing to grow revenue and improve operating efficiency throughout our businesses. We make disciplined capital expenditure decisions, focusing on investments made for maintaining high quality service, cost structure improvement, and cash flow generation.
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Leverage and Enhance Local Presence and Customer Loyalty. We have a strong commitment to local presence and customer relationships. We have created a community relations staff dedicated to maintaining relationships with local leaders and civic organizations. As a result of this and other initiatives, we believe Iowa Telecom has developed a brand identity as a responsive, locally oriented service provider. We intend to use this strong reputation to maintain our competitive market position, cross-sell additional services to our current subscribers and expand our existing customer base.
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Increase Revenue per Access Line by Selling Additional and Enhanced Services. We actively market long distance service, dial-up and DSL Internet access service, satellite video service and enhanced local services (such as call waiting, caller ID and voice mail) to our local customers as bundled services billed on the same monthly statement the customer receives for basic local service. We have demonstrated success in cross-selling these services to our customer base. The following table shows the average revenue per access line from some of these additional services for the years ended December 31, 2004, 2005 and 2006:
(1) Average revenue per access line is computed by dividing the total revenue for the specified service for the period by the average of the access lines at the beginning of the period and the end of the period.
We intend to pursue increased sales of these services to our existing customers and, where appropriate, to introduce ancillary services to our customers.
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Prudent Expansion of Our Service Area Through our Competitive Local Exchange Carrier Subsidiaries. We intend to leverage our strong local presence, superior customer service and economies of scale to pursue customers in markets adjacent to our rural local exchange carrier markets through our competitive local exchange carrier subsidiaries, ITC and IT Communications. We plan to continue this strategy by seeking growth opportunities on a low-cost, selective basis. In 2007, we plan to maintain this limited investment approach as we continue to grow our competitive local exchange carrier business.
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Grow Through Selective Strategic Acquisitions. We intend to continue pursuing a disciplined process of evaluating select acquisitions of access lines from Regional Bell Operating Companies and other rural local exchange carriers, as well as evaluating acquisitions of providers of businesses complementary to ours. Over the past several years, Regional Bell Operating Companies have divested a significant number of access lines nationwide and are expected to continue these divestitures in order to focus on larger markets. We also believe there may be attractive opportunities to acquire rural local exchange carriers, which we believe will likely consolidate as competitive pressures intensify. In Iowa alone, there are approximately 150 rural local exchange carriers serving a fragmented market representing approximately 230,000 access lines. One of our key acquisition criteria will be the potential of any proposed transaction to increase our free cash flow per share.
Products, Services and Revenue Sources
We provide wireline local exchange telecommunications services to residential and business customers in over 440 communities throughout Iowa through our incumbent local exchange carrier and our competitive local exchange carrier subsidiaries. Approximately 74% of our access lines serve residential customers and 26% serve business customers. We generate revenues by providing our customers:
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local services, which include basic local telephone service and enhanced local services like voice mail, caller ID and call forwarding;
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network access services to interexchange carriers for the origination and termination of interstate and intrastate long distance phone calls on our network;
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toll (also known as long distance) services; and
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other services and sales, including dial-up and DSL Internet access service, satellite video and the sale, installation and maintenance of customer premise voice and data equipment.
We complement our basic local telephone services by actively marketing products under the Iowa Telecom brand. We believe that our ability to cross-sell to our customer base in this way is bolstered by the fact that we are currently the sole local telecommunications provider in approximately 85% of the exchanges we serve as the incumbent carrier. The following table shows our revenues and sales for each of the years ended December 31, 2004, 2005 and 2006 by category of service:
(1) Local services revenue for the year ended December 31, 2004 includes the recognition, as a result of our rate settlement agreement with the Iowa Utilities Board in April 2004, of $7.1 million of revenue that we
had collected in prior periods subject to refund. Excluding the prior period revenue, the percent of total revenues and sales for the year ended December 31, 2004 attributable to local services, network access services, toll services and other services and sales was 34%, 43%, 11%, and 12%, respectively.
Local Services
Basic local services enable end user customers to make and receive telephone calls within a defined local calling area for a flat monthly fee. The maximum amount that we may charge for basic local service for residential and single line business customers is determined by the Iowa price regulation plan under which we operate. We also provide Extended Area Services, a mandatory expanded calling service to selected nearby communities at a flat monthly rate, which is also considered to be a basic monthly service.
In addition to subscribing to basic local telephone services, our customers may choose from a variety of enhanced or non-basic communications services which are also classified as local services. These include call waiting, call forwarding, caller ID, voice mail and three-way calling and are billed on the customer’s monthly bill for basic local service. Offering such services to local customers through bundled service packages is an important part of our strategy to increase average revenue per subscriber.
Network Access Services
We bill access charges to other carriers for the use of our facilities to terminate or originate long distance calls on our network. These fees relate to interexchange long distance, or toll calls, that involve more than one company in the provision of the service. Network access charges compensate us for the services we provide to other carriers for completing toll calls for our customers.
We generate network access revenues under two jurisdictions. We generate intrastate access revenues for providing either switched or special access services when a long distance call is placed or received by a customer in one of our exchanges, to or from another party located in Iowa. The toll carrier pays us an intrastate access charge, the level of which is regulated and approved by the Iowa Utilities Board. We generate interstate access revenues for providing either switched or special access services when a long distance call is originated or terminated by a customer calling from one state to a customer in another state and one of the parties is a local service customer of ours. We bill interstate access charges in the same manner as we bill intrastate access charges. Interstate access charges are regulated and approved by the FCC.
Additionally, we bill subscriber line charges, or SLC’s, to substantially all of our end user customers for access to the public switched network. The monthly subscriber line charges are regulated and approved by the FCC.
We also bill wireless carriers for certain traffic transport and termination services unrelated to intrastate or interstate access service. These charges are governed by interconnection agreements with the wireless carriers.
Toll Services
We began offering toll, or long distance, services in July 2000 through sales to our established customer base. We have leveraged our customer relationships and single billing approach to achieve revenue growth for toll service with minimal need for additional capital expenditures. The following table shows our number of toll service subscribers as of the date shown:
We market long distance service under our Iowa Telecom brand name, but we provide service through resale arrangements we have with a variety of carriers. Long distance revenues are earned as our long distance customers place calls, with charges generally based on the length of the call and the applicable per-minute rate. Some customers pay a fixed minimum monthly charge for our long distance service independent of calls actually made. In order to offer attractively priced options to our customers, we often bundle long distance service with our local services, dial-up and DSL Internet access offerings.
Other Services and Sales
Other services and sales consists largely of revenues generated by our dial-up and DSL Internet access services and the sale, installation and maintenance of the customer premise voice and data equipment. We began offering dial-up internet access service in 2000, and DSL Internet access service in a few markets in late 2001. We currently have DSL equipment installed in all of our 288 incumbent exchanges. We estimate that we are currently capable of providing DSL Internet access service to approximately 75% of our access lines. Approximately 32% of our access line customers subscribe to our dial-up or DSL Internet service. The following table shows our number of dial-up and DSL Internet access service subscribers as of the dates shown.
Competitive Local Exchange Carrier Services
We currently provide competitive local exchange carrier services through our wholly-owned subsidiaries, ITC and IT Communications (sometimes referred to together as “the CLEC”). The CLEC currently offers a broad range of traditional and enhanced wireline communications services to business and residential customers in 21 exchanges throughout Iowa. As of December 31, 2006, the CLEC served approximately 23,800 total access lines. We view our competitive local exchange carrier business as a cost-effective way to leverage our Iowa Telecom brand and corporate infrastructure into markets adjacent to those served by our incumbent local exchange carrier operations. Our primary strategy has been to target contiguous markets that historically have been underserved and subject to minimal competition. In these markets, we can compete cost effectively through our interconnection agreements with the incumbent provider, pursuant to which we may lease lines on a “wholesale” basis.
We have historically entered selected exchanges by utilizing a low-risk unbundled network element platform. This entry strategy permitted us to use the incumbent carrier’s existing loop and switches and thus required minimal upfront capital investment on our part. Although the FCC has revised the rules that govern the availability of the unbundled network element platform, we believe we can continue to profitably provide competitive local exchange services as a result of a contractual arrangement entered into in January 2005 with the incumbent provider for switching services and leased lines. Our contracted rates ranged from $17.46 to $18.99 per line per month during 2005. Beginning January 1, 2006, the range for our rates increased to $17.71 to $20.02 per line per month. We intend to consider installing owned communications equipment in a community only after we have achieved sufficient scale and we believe such investment can be cost effective.
ITC began operations in February 2002. IT Communications began operations in January 2006 in Iowa City, Iowa and has since expanded to Ames and Cedar Rapids, Iowa. As of December 31, 2006, the CLEC served approximately 9,100 business and 14,700 residential access lines and currently accounts for 9% of Iowa Telecom’s total access lines. The cost to expand our competitive local exchange carrier operations is predominantly comprised of variable expenses such as marketing and sales expenses, which allows us to more
readily control the level of cash flow required to support expansion of this business and provides the opportunity to lower spending levels if necessary. In 2007, we plan to maintain this limited investment approach as we continue to grow our competitive local exchange carrier business.
Sales and Marketing
We have established a sales and marketing organization that centralizes marketing strategies and deploys sales and customer services resources locally. We have a dedicated sales force for business customers and have 19 local offices at which customers can contact us in person to address their needs.
We believe that customers in rural communities are concerned that historically they have had access to less sophisticated telecommunications products and services than consumers in urban locations. We believe these concerns have increased in recent years as advanced telecommunications services, such as readily available broadband Internet access, have come to be seen as essential to economic growth. We believe that residential and business end-users will be more likely to increase the use of our products and services if we are perceived as a locally managed provider, committed to delivering advanced telecommunications services to the communities we serve.
To address our customers’ needs, we have established in-state support operations, including 19 customer offices and three customer contact centers. These customer offices and contact centers provide us with a significant degree of customer contact, thereby affording us an opportunity to offer and sell additional and enhanced services to our subscribers. In addition, we have created a community relations department whose purpose is to maintain an ongoing relationship with community leaders and organizations throughout our service area, with a view to developing Iowa Telecom’s brand identity as a responsive, locally oriented provider. We believe this reputation also enhances our potential to cross-sell additional services to our existing subscriber base.
We also offer local telephone services in attractively priced bundled packages including long distance, enhanced local services, dial-up and DSL Internet access services and video services. We believe bundled services are popular with customers because they permit the purchase of a number of services at a discount to the pricing that would be available on an individual service basis. We intend to continue to expand this marketing strategy, which we expect will increase average revenue per access line. We also believe that integrated packages of quality services result in a more loyal and satisfied customer base, thereby reducing subscriber turnover.
Competition
Local Service. We currently face measurable competition from other providers of local services in approximately 44 of the 418 communities our incumbent local exchange carrier serves. We believe that in approximately 36 of these communities, independent local exchange carriers operating in adjacent exchanges and municipal utilities have constructed networks to provide competitive local exchange carrier services to customers in our exchanges. In other communities, competitive local exchange carriers are reselling our services or using their own facilities in combination with ours to provide telecommunications services. We estimate that our largest competitive local exchange carrier competitor serves approximately 9,300 lines in six of the exchanges in which we are the incumbent local exchange carrier. We estimate that our second largest competitive local exchange carrier competitor serves approximately 3,600 lines in three of the exchanges in which we are the incumbent local exchange carrier, and that our remaining competitive local exchange carrier competitors (none of which serve more than four exchanges in which we are the incumbent local exchange carrier) serve an average of fewer than 500 lines per exchange.
MCC Telephony of Iowa, Inc., the telecommunications affiliate of Mediacom, the dominant cable television provider in Iowa, is certificated to provide competitive local telecommunications service in approximately 100 Iowa Telecom exchanges. MCC’s stated business plan is to use Sprint Communications Company L.P. (“Sprint”) as an intermediary in interconnecting with incumbent local exchange carriers throughout Iowa, including Iowa
Telecom, while MCC would retain the retail customer relationship. MCC has already entered the Des Moines market, but has yet to provide traditional wireline local exchange services in non-Qwest markets in Iowa, which we believe is at least partially due to the timing of MCC or Sprint obtaining and implementing agreements with us and certain other incumbent carriers. MCC’s ability to enter non-Qwest markets in Iowa, including Iowa Telecom’s, without its own interconnection agreement with such incumbent carriers remains a contested issue in federal court, although, for the time being, Iowa Telecom and certain other incumbent carriers are subject to Iowa Utilities Board-approved interconnection agreements with Sprint. Further, Iowa Telecom is subject to an Iowa Utilities Board order, also currently on appeal in federal court, requiring us to provide certain interconnection services pursuant to these interconnection agreements. Iowa Telecom is required to provide certain interconnection services while these appeals are pending. We cannot predict the outcome of the pending appeals.
In November 2004, an organization called “Opportunity Iowa” was formed to encourage municipalities to build their own “fiber-to-the-home” communications networks. Opportunity Iowa referendums were held in the November 2005 general election cycle in seven Iowa Telecom exchanges and were rejected by voters in all seven. We cannot predict whether Opportunity Iowa or similar initiatives will lead to additional future competition from municipal telecommunications utilities.
Wireless and Emerging Technology Competition. We estimate that wireless service providers served approximately 1.82 million subscribers in Iowa as of June 2006, based on the most recent FCC data available. We expect that wireless providers will continue to provide services that compete with ours. Technological developments in cellular telephone features, personal communications services, telephone services over cable television systems, satellite, voice over Internet protocol, high-speed fiber optic networks and other technologies will continue to provide our customers with alternatives to the traditional local telephone services we provide.
Iowa Communications Network. The Iowa Communications Network is a state-owned communications network consisting of more than 3,000 miles of fiber optic cable extending into all 99 Iowa counties and capable of providing a variety of voice, data and video communications services. The Iowa Communications Network currently provides certain voice, data and video communications services to authorized educational and governmental institutions, including accredited public and private schools and colleges, public libraries, state and federal agencies and the United States Post Office, and to authorized hospitals and physician clinics. Current state law does not allow the Iowa Communications Network to provide its services to other public or private entities and prohibits the sale, lease, or other disposition of the Iowa Communications Network without prior authorization of a majority of each house of the Iowa legislature and approval by the governor. The Iowa legislature has previously considered modifying state law to allow for sale of the Iowa Communications Network to a private party but has not done so.
Our Competitive Local Exchange Carrier Subsidiaries. We have two competitive local exchange carrier subsidiaries-ITC and IT Communications. The CLEC provides services in 21 of Qwest’s Iowa exchanges. ITC generally offers the same local exchange services as those offered by Qwest and provides DSL Internet access service in all exchanges in which it operates, using either Qwest’s wholesale service or owned facilities. IT Communications was formed in late 2005 to focus on larger markets in Iowa, and now serves Iowa City, Ames and Cedar Rapids.
Long Distance. We face significant competition in the long distance market. The FCC lists approximately 500 interexchange (toll) carriers in Iowa, a substantial number of which are, or are affiliated with, providers of local exchange services in Iowa. AT&T, Sprint, and MCI currently are the other major long distance providers in our service territory. We believe that wireless service also competes with the traditional wireline long distance service that we provide. Although the long distance market is competitive, we believe we are in a good position relative to our competitors given our local presence, strong brand and ability to offer both long distance and local services in a single bill. Approximately 58% of our local access lines also subscribe to one of our long distance services.
Dial-up and DSL Internet Access. In many markets we face competition from other dial-up and broadband Internet access service providers. Many dial-up competitors are neighboring incumbent local exchange carriers, small proprietors with service in only a few communities or, in some circumstances near larger Iowa communities, national providers such as America Online and the Microsoft Network. In some of our markets, broadband competition exists from cable television providers (principally Mediacom Communications), wireless broadband providers using non-licensed spectrum and competitive local exchange carriers that either have their own facilities or have collocated DSL equipment in our central offices. We believe our ability to sell dial-up or broadband services on a bundled basis with local and long distance service enhances our competitive position for continued growth in sales of dial-up and DSL Internet access service.
Customers
Our incumbent local exchange carrier currently operates 288 local telephone exchanges in 418 largely rural communities. Our business is largely concentrated in the eastern and southern portions of Iowa. According to the 2000 U.S. Census, our service area includes four communities with a population over 9,000; ten communities with a population between 5,001 and 9,000; 25 communities with a population between 2,000 and 5,000; and 379 communities with a population under 2,000. The largest five communities in our service area in Iowa are (2000 population figures in parentheses): Newton (15,579); Pella (9,832); Fairfield (9,509); Grinnell (9,105); and Mount Pleasant (8,751). These five communities represent approximately 14% of the access lines we serve.
Approximately 75% of our incumbent local exchange carrier access lines serve residential customers. We also provide services to several large businesses in our service area, including, Pella Corporation (headquartered in Pella) and Vermeer Manufacturing Company (also headquartered in Pella). In addition, Grinnell and Pella are each home to a four-year university, namely Grinnell College and Central College. No single local service customer represented more than 5% of our revenues from 2004 to 2006.
As a competitive local exchange carrier, we currently operate in 21 local telephone exchanges which provide service to 24 communities with an aggregate population of 525,000. According to the 2000 U.S. Census, our CLEC service area includes fifteen communities with a population over 10,000, eight communities with a population between 5,001 and 10,000, and one community with a population below 5,000. The largest five communities served by the CLEC are (2000 population figures in parentheses): Cedar Rapids (120,758); Iowa City (62,220); Ames (50,731); Clinton (27,772); and Ankeny (27,117). These five communities represent approximately 20% of the total access lines in our competitive local exchange carrier markets. Approximately 62% of the access lines in our competitive local exchange carrier markets serve residential customers.
Network access charges historically have been one of our largest sources of revenues. Of the carriers paying these charges, AT&T is our single largest customer and represented approximately 11% of our revenue in 2006 and 12% in 2005, while no other customer has accounted for more than 10% of our revenue during the past three years.
Network Facilities
All of our exchanges are served by digital switches that we own, the majority of which were manufactured by Nortel Networks. All of our switches are capable of providing one-plus equal access for long distance service and are linked through a combination of aerial, underground and buried cable, including more than 3,100 miles of fiber optic cable. Most of our primary network routes have been upgraded from copper to fiber optic cable. The advantages of fiber optic cable compared to copper facilities are greater capacity and flexibility and enhanced transmission quality and reliability. Our network operations and monitoring services are provided on a contract basis by Iowa Network Services, Inc., which also provides those services for its own network and for other local exchange carriers in Iowa. Automated alarm systems are in place to alert us to problems with our facilities, and our own technicians are on call to make any necessary repairs to the network.
The network facility upgrades we have completed since the GTE Midwest Incorporated acquisition in June 2000 include the following:
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we have deployed DSL Internet access service to all 288 exchanges, including those of Montezuma Mutual Telephone Company. We believe approximately 75% of our access lines are now DSL eligible.
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we have built a widespread data network to support our dial-up and DSL Internet access services customers.
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we have migrated most of the interexchange communications traffic originating from or terminating to our switches onto our own network facilities, reducing costs paid to third parties and increasing our network access charge revenues.
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we have reduced the number of access lines utilizing analog carrier technology from approximately 4,600 to approximately 950. Analog carrier lines are not fully compatible with advanced telephone services such as high-speed Internet.
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we have deployed voice-mail services to additional exchanges and are now able to offer voice-mail services to 259 exchanges and approximately 211,000 customers.
Our network improvement plan for 2005 through 2007 became effective on January 30, 2005. The additional revenues made available by the settlement of our rate proceeding in April 2004 will help fund our network improvement plans and will allow us to accelerate the rate at which we deploy DSL and other broadband services, replace analog carrier technology, upgrade switching platforms, install fiber, and otherwise support and deploy new voice and data services.
Employees
We employ approximately 644 full-time employees, of which 638 are based in Iowa and 6 are based in Nebraska. A total of approximately 363 employees are located at our headquarters in Newton, Iowa and our operations center in Grinnell, Iowa.
We have a collective bargaining agreement with the Communications Workers of America, or CWA, which covers approximately 184 of our employees and expires in May 2007. We also have a collective bargaining agreement with the International Brotherhood of Electrical Workers, or IBEW, which covers approximately 24 of our employees and expires in June 2009. There have been no work stoppages or strikes by our IBEW or CWA employees in the past 10 years, and we consider our labor relations to be good.
Intellectual Property
We believe we have the trademarks, trade names and licenses that are necessary for the operation of our business as we currently conduct it. The Iowa Telecom logo is a registered trademark in the United States. We do not consider our trademarks, trade names or licenses to be material to the operation of our business.
Regulation
The following summary does not describe all present and proposed federal, state and local legislation and regulations affecting us or the telecommunications industry. Some laws and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proceedings that could change the manner in which our company or our industry operates. We cannot predict the outcome of any of these developments or their potential impact on us. Regulation can change rapidly in the telecommunications industry, and such changes may adversely affect us in the future. Our business is subject to extensive regulation that could change in a manner adverse to us.
Overview
We are subject to federal, state and local government regulation. We hold various authorizations for our service offerings. At the federal level, the FCC has jurisdiction over common carriers, such as us, to the extent
that their facilities are used to originate, terminate or provide interstate and international telecommunications services. The Iowa Utilities Board exercises jurisdiction over our intrastate telecommunications services within Iowa. The Missouri Public Service Commission exercises similar jurisdiction over the intrastate telecommunications services we provide to a small number of customers in Missouri. In addition, under the Telecommunications Act of 1996, or the Telecom Act, federal and state regulators share responsibility for regulating such matters as interconnection between carriers. Municipalities and other local government agencies regulate certain aspects of our business, such as our use of public rights-of-way, and by requiring that we obtain construction permits and comply with building codes.
The following description discusses some of the major telecommunications-related regulations that affect us, but numerous other substantive areas of regulation not discussed here may influence our business. When we refer to “our incumbent local exchange carrier,” we mean Iowa Telecommunications Services, Inc., and, when we refer to “our independent local exchange carrier,” we mean our incumbent local exchange carrier operations other than those of Iowa Telecommunications Services, Inc. - i.e., Montezuma Mutual Telephone Company. When we refer to “our competitive local exchange carriers,” we mean our Iowa Telecom Communications, Inc. and IT Communications, LLC subsidiaries.
Federal Regulation
We are subject to, and must comply with, the federal Communications Act of 1934, as amended by, among other things, the Telecom Act (the “Communications Act”). Under the Communications Act, we must obtain FCC approval before we transfer control of our company, assign, acquire, or transfer licenses or authorizations issued by the FCC or before we discontinue our interstate service in any area.
Access Charges. The FCC regulates the prices that incumbent local exchange carriers charge for the use of their local networks in originating or terminating interstate and international transmissions. State regulatory commissions, such as the Iowa Utilities Board, regulate prices for access provided in connection with the origination and termination of intrastate transmissions. The prices that we and other incumbent local exchange carriers charge for use of local telephone networks to complete interexchange calls-access services-are called “access charges.”
We provide two types of access services, special access and switched access. The rates for special access, which is provided via dedicated circuits connecting long distance carriers, other carriers and certain end users to our network, are structured as flat-rate monthly charges. Rates for switched access are structured as a combination of flat-rate monthly charges, which are paid by end users, and per-minute traffic sensitive charges, which are paid by long distance carriers. A significant amount of our revenues come from access charges derived from intrastate, interstate and international transmissions.
Since 1991, the FCC has administered a system of price cap regulation for interstate access charges applicable to the largest incumbent local exchange carriers, as well as for any other, smaller incumbent local exchange carriers that choose to be subject to price cap regulation. Our incumbent local exchange carrier has operated under the price cap regime since July 2000 as a result of our acquiring GTE Midwest Incorporated’s Iowa exchanges and succeeding to GTE’s obligations to price its access charges in accordance with price cap regulation. We believe our incumbent local exchange carrier is the smallest carrier in the nation operating under the FCC’s price cap rules.
Since July 1, 2000, our incumbent local exchange carrier’s interstate access charges have been established in accordance with an order adopted by the FCC in response to a proposal put forth by members of The Coalition for Affordable Local and Long Distance Service (“CALLS Order”). The CALLS Order reformed access charge regulation for carriers subject to price caps. It implemented a system for reducing per-minute traffic sensitive rates for switched access services to specific target levels that the FCC believed more closely approximated the cost of providing those services. We met the target rates for switched access in our access charge filings made
with the FCC in July 2001. In September 2003, the FCC permitted our incumbent local exchange carrier to increase our rates for switched access to more closely reflect our forward-looking economic costs.
The CALLS Order also permitted us to recover a greater proportion of our local costs by increasing the subscriber line charge levied on end users. In June 2002, the FCC adopted an order that permitted all price cap-regulated carriers, including us, to increase subscriber line charges to their current levels.
Our incumbent local exchange carrier files tariffs for its interstate access charges with the FCC annually. Our 2006 filing became effective on July 1, 2006 without objection.
In addition to the access charge system, our incumbent local exchange carrier also is subject to the requirements of the Communications Act and the FCC that impose on local telecommunications carriers a duty to establish reciprocal compensation arrangements for the transport and termination of non-toll telecommunications between telecommunications carriers. See “-Interconnection with Local Telephone Companies and Access to Other Facilities.” Under these rules, the calling party’s carrier must compensate the called party’s carrier for costs associated with transporting and terminating the call. At present, we only charge interconnecting wireless carriers for the transport and termination of calls bound for our network as Iowa Utilities Board rules impose a “bill-and-keep” regime for local traffic transport and termination when exchanged traffic is at least roughly balanced, as is the case for exchanged wireline traffic.
In April 2001, the FCC released a Notice of Proposed Rulemaking to determine whether to adopt a unified regime that would apply to all of these intercarrier compensation arrangements; such a regime could be a successor to the five-year transitional access charge system established by the CALLS Order. We are currently a party to one of the major industry intercarrier compensation reform proposals under consideration by the FCC - the proposal known as the Missoula Plan, filed with the FCC on July 24, 2006. The FCC received comments on the Missoula Plan in December 2006 and February 2007. The outcome of the FCC’s proceedings is uncertain, but it could result in significant changes to the way in which we receive compensation from other carriers and our end users. At this time, we cannot predict whether the FCC or Congress will change the current system and, if so, whether and to what extent any changes will affect our incumbent local exchange carriers’ or our competitive local exchange carriers’ access charge revenues and other reciprocal compensation receipts and payments.
Our competitive local exchange carriers also charge for interstate access in accordance with FCC requirements. These rules allow us to set our competitive local exchange carriers’ rates at the current National Exchange Carrier Association rates for switched access, excluding the rate for carrier common line charges.
The Telecommunications Act of 1996. The Telecom Act, which amended the Communications Act, changed and will continue to change the regulatory and competitive landscape in which we operate. The most important of these changes are removing most legal barriers to market entry into local telephone services; requiring that incumbent local exchange carriers, such as our incumbent local exchange carrier, interconnect with competitors and offer unbundled network elements; establishing procedures for the Regional Bell Operating Companies to provide long distance services within their home regions; and creating greater opportunities for competitive providers, such as our competitive local exchange carriers, to compete with other incumbent local exchange carriers. Each of these changes is discussed below.
Removal of Entry Barriers. Following the passage of the Telecom Act, the level of competition in the local markets served by our incumbent local exchange carrier has increased and is expected to increase. See “Business-Competition.” The requirements of the Telecom Act also effectively remove or prevent legal barriers to market entry and thereby permit our competitive local exchange carriers to provide competitive local exchange service in areas in which we are not the incumbent provider.
Interconnection with Local Telephone Companies and Access to Other Facilities. The Telecom Act imposes several requirements on all local exchange carriers, including competitive local exchange carriers, with additional requirements imposed on incumbent local exchange carriers. These requirements are intended to
promote competition in the local exchange market by, in part, ensuring that a carrier seeking interconnection will have access to the interconnecting carrier’s network functionalities under reasonable rates, terms and conditions.
All local exchange carriers, including both our incumbent local exchange carrier and our competitive local exchange carriers, must comply with the following requirements:
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Resale. Local exchange carriers generally may not prohibit or place unreasonable restrictions on the resale of their local services at retail rates.
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Telephone Number Portability. Local exchange carriers must provide for telephone number portability, allowing a customer to keep the same telephone number even when switching service providers.
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Dialing Parity. Local exchange carriers must provide dialing parity, which allows customers to route their calls to another local service provider without having to dial special access codes.
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Access to Rights-of-Way. Local exchange carriers must provide access to their poles, ducts, conduits and rights-of-way on a reasonable, nondiscriminatory basis.
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Reciprocal Compensation. Each local exchange carrier on whose network a call originates must reasonably compensate each telecommunications carrier on whose network the call terminates.
Under the Telecom Act, all incumbent local exchange carriers, including our incumbent local exchange carrier, but excluding certain exempt “rural telephone companies,” must comply with the following additional requirements:
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Duty to Negotiate. Negotiate in good faith with any carrier requesting interconnection.
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Interconnection. Provide interconnection for the transmission and routing of telecommunications at any technically feasible point in the network, equal to interconnection provided to an affiliate or other party, and on just, reasonable and nondiscriminatory rates, terms and conditions.
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Unbundling of Network Elements. Provide nondiscriminatory access to unbundled network elements or combinations of unbundled network elements at cost-based rates.
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Resale. Offer its retail local telephone services to resellers at a wholesale rate that is less than the retail rate charged to end users.
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Notice of Changes. Provide notice of changes in information needed for another carrier to transmit and route services using the incumbent local exchange carrier’s facilities.
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Collocation. Provide physical collocation, which allows competitive local exchange carriers to install and maintain their own network termination equipment in incumbent local exchange carriers’ central offices, or to obtain functionally equivalent forms of interconnection.
Our incumbent local exchange carrier is a “rural telephone company,” as defined by the Communications Act. In 1997, however, the Iowa Utilities Board removed the rural telephone company exemption applicable to what were then GTE Midwest Incorporated’s Iowa exchanges, which we later acquired. As a result, this exemption does not apply to our incumbent local exchange carrier.
The Telecom Act affords small local exchange carriers (those with less than two percent of the nation’s access lines) the opportunity to petition the state regulatory agency for suspension or modification of any of the requirements imposed on local exchange carriers. In March 2004, we filed with the Iowa Utilities Board a request for permission to delay implementation of local number portability and thousand block number pooling in certain switch locations. On September 17, 2004, the Iowa Utilities Board extended the deadline for Iowa Telecom to complete its implementation of local number portability to December 31, 2007 and extended the deadline for Iowa Telecom to complete its implementation of thousand block number pooling to May 2008. Our incumbent local exchange carrier has not otherwise requested any suspension or modification of, and we believe we are otherwise in compliance with, all other interconnection requirements of the Telecom Act.
As of December 31, 2006, our incumbent local exchange carrier had interconnection agreements with 36 of the competitive local exchange carriers authorized to offer local service in our service area, and 12 active interconnection agreements in force with wireless carriers. We are currently negotiating five additional interconnection agreements with wireline competitors.
Unbundling of Network Elements. To implement the interconnection requirements of the Telecom Act, incumbent local exchange carriers, including our incumbent local exchange carrier, are required to provide unbundled network elements to competitors based on forward-looking economic costs, using the total element long-run incremental cost, or TELRIC, methodology. Our incumbent local exchange carrier is in compliance with these requirements and is meeting its obligations to unbundle its network. Our competitive local exchange carriers entered some local markets where Qwest is the incumbent local exchange carrier by initially obtaining a combination of unbundled network elements, including unbundled switching and local loops (known as the unbundled network platform), from Qwest.
Under the FCC’s current unbundled network element rules, which became effective March 11, 2005, an incumbent local exchange carrier’s obligation to provide access to high capacity loops and dark fiber is eliminated immediately, and the obligation to provide access to unbundled switching and, by implication, to the unbundled network element platform will be phased-out over an 18-month period. The new rules, however, will continue to impose an obligation to provide unbundled access to DS-1 loops and certain forms of dedicated transport. These rules are currently subject to appeal. We are unable to predict what impact, if any, such proceedings may have on our incumbent local exchange carrier or on our competitive local exchange carriers.
In light of the phase-out of incumbent local exchange carrier obligations to provide access to the unbundled network element platform, we entered into arrangements with Qwest in which our CLECs will have continuing access to an equivalent Qwest product for current and new customers regardless of future FCC or judicial action regarding the availability of unbundled network elements. However, the rates we must pay under the agreements are somewhat higher than before we entered into the agreements. The agreements with Qwest expire in 2008.
The FCC is also examining its TELRIC pricing rules, which apply generally to all unbundled network elements. The FCC may, in the future, reconsider other aspects of its local competition rules. Congress may consider legislation that would affect local competition and these rules. We cannot predict the outcome of any of these proceedings, or of any action or decision taken by the FCC, the Iowa Utilities Board, any legislative body or court concerning the rules regarding local competition, and how any changes would affect either our incumbent local exchange carrier or our competitive local exchange carriers.
Bell Operating Company Entry into Long Distance Services. Qwest is our competitive local exchange carriers’ principal competitor in regions in which Qwest is the incumbent local exchange carrier. Pursuant to provisions of the Telecom Act, in December 2002, the FCC authorized Qwest to provide in-region long distance services, a line of business from which Qwest was previously prohibited from entering. Now that Qwest, a Regional Bell Operating Company, is authorized to provide long distance services, it competes more directly with providers of integrated communications services, such as our competitive local exchange carriers.
Regulation of Interstate and International Services. The Communications Act requires that we offer interstate and international common carrier services at just and reasonable rates and on terms and conditions that are not unreasonably discriminatory. In general, our interstate and international long distance services are not subject to rate regulation but are subject to the FCC’s complaint procedures. Pursuant to the FCC’s rules, we disclose the terms and conditions of our long distance services on our web site.
Universal Service. Pursuant to Federal statute, the FCC maintains a “universal service” program, to ensure that affordable, quality telecommunications services are available to all Americans. The program at the federal level has several components, including one that pays support to “high cost” areas, including certain areas served by rural local exchange carriers for which the costs of providing basic telephone service are significantly higher
than the national average. The Telecom Act altered the framework for providing and funding universal service by:
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requiring the FCC to make implicit subsidies explicit;
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expanding the types of telecommunications carriers that are required to pay universal service support; and
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allowing telecommunications carriers to apply to state regulators for, and be eligible for, universal service support, including where they serve customers formerly served by incumbent local exchange carriers.
These and other provisions were intended to make the provision of and contributions to universal service compatible with a competitive market.
Universal service funds are only available to carriers designated as eligible telecommunications carriers by the state regulatory commission. Although our incumbent local exchange carrier is certified as an eligible communications carrier by the Iowa Utilities Board with respect to the exchanges that we operate, under current FCC rules it is not eligible to receive any high-cost support because the historical cost of relevant portions of our network, largely based on the recorded amounts that transferred with our acquisition of exchanges from GTE Midwest Incorporated, are lower than the national average. Under the FCC’s rules, support is available only for rural carriers with historical loop costs above the national average.
The CALLS Order also provided for a phase-out of implicit universal service support mechanisms (which had, in part, relied on setting rates for interstate access above cost), to be replaced with more explicit subsidy mechanisms. The CALLS Order created an Interstate Access Support fund as part of the Universal Service Fund to accomplish this objective. For 2006, our incumbent local exchange carrier received approximately $3.3 million in universal service support from this portion of the fund.
Our competitive local exchange carriers serving 21 competitive local exchange carrier exchanges have been certified as eligible telecommunications carriers in Iowa by the Iowa Utilities Board. ITC receives no high-cost or Interstate Access Support for the Qwest markets it has entered because Qwest currently receives no high cost support and only nominal Interstate Switched Access Support for the exchanges served by ITC. Qwest receives no high cost support and no Interstate Switched Access Support for the three exchanges served by IT Communications, and therefore IT Communications receives no universal service support.
Our incumbent local exchange carrier and competitive local exchange carriers are required to make contributions to the federal universal service program based on methodologies and procedures established by the FCC. Contributions to the federal universal service fund are based on revenues from interstate and international services. In accordance with FCC rules, we recover our contributions from our customers through a surcharge on interstate and international revenues. The surcharge is adjusted each quarter and has increased in recent quarters. In 2006, our incumbent local exchange carrier and competitive local exchange carriers collected and contributed to the universal service fund approximately $3.4 million and $151,000, respectively. While suspensions of some universal service fund payments to schools and libraries pursuant to the Federal Anti-Deficiency Act in the Fall of 2004 were thought by industry experts to foreshadow potential related delays or suspensions of payments from other support programs administered by the Universal Service Administrative Company, perhaps including Interstate Access Support payments received by our incumbent local exchange carrier, Congress has prevented any suspensions of such payments through at least December 31, 2007. We cannot predict whether and for how long Interstate Access Support payments might be delayed or suspended or how actions to address this problem may affect us.
In 2000, the FCC implemented new rules requiring the high cost universal service support received by non-rural telephone companies to be based on forward-looking costs. In May 2001, the FCC adopted a proposal from the Rural Task Force to reform universal service support for rural areas. Although the rules adopted in
response to the Rural Task Force proposal were to expire July 1, 2006, no replacement rules have been established, leaving the current regime temporarily in place. Under the currently-effective rules, eligible rural carriers will continue to receive support based on a modified embedded cost mechanism. The FCC has indicated that, upon replacement of the rules adopted in response to the Rural Task Force proposal, it will develop a comprehensive plan for high-cost support mechanisms for rural and non-rural carriers, which may rely on forward-looking cost estimates. The FCC referred these issues to the Federal-State Joint Board on Universal Service, which, in August 2004, requested comment on future federal universal service support mechanisms for rural carriers and, in August 2005, sought further comment on more detailed proposals. Some of these proposals include moving significantly more carriers (including mid-sized carriers such as our incumbent local exchange carrier) to support based on forward-looking cost. We do not expect the Joint Board to issue a recommendation until at least the second quarter of 2007, which would then likely be followed by FCC consideration of the Joint Board’s recommendation.
Internet. We provide Internet access services as an Internet service provider (“ISP”). Historically, the FCC has regulated wireline carrier provision of broadband Internet service as comprising two components-a “telecommunications” component representing the transmission function that is subject to common carrier regulation, including contributing to the Universal Service Fund, and an “information service” component, which is not regulated (either with respect to price or the terms and conditions of service). The FCC concluded in an order effective November 16, 2005 that wireline carrier provision of broadband Internet access service comprises only “information service” and does not include a regulated telecommunications component. Therefore, pursuant to a regulatory election by our incumbent local exchange carrier, effective November 16, 2005, all portions of our DSL service are now deregulated and detariffed, which provides us with enhanced pricing flexibility. However, wireline carriers must continue to contribute to the universal service fund. The FCC order that became effective on November 16, 2005 is currently subject to appeal. We cannot predict the outcome of these proceedings or the effect of FCC or judicial decisions on our ISP, incumbent local exchange carrier or competitive local exchange carrier businesses. Our ISP business is, and may become, subject to a variety of other legal requirements relating to privacy, copyrights, the conveyance of obscenity, indecent speech, unsolicited electronic messages and taxation.
In February 2004, the FCC determined that a particular type of entirely Internet-based voice over Internet protocol service also is an information service and exempt from such regulatory obligations, and in November 2004 determined that another, more widely used, version of voice over Internet protocol service is an interstate service and therefore outside the jurisdiction of state telecommunications regulations. Certain aspects of the FCC’s determination have been challenged in judicial proceedings. The FCC is currently considering the regulatory status of a variety of voice over Internet protocol service configurations in the context of a comprehensive proceeding launched in February 2004, as well as in several other application and issue-specific proceedings. These proceedings concern, among other things, what, if any, intercarrier compensation must be paid by providers of such service and what, if any, universal service contributions must be made by such providers. We cannot predict the outcome of these proceedings or the effect of FCC or judicial decisions on any of our ISP, incumbent local exchange carrier or competitive local exchange carrier businesses.
Customer Information. Companies such as our incumbent local exchange carrier and competitive local exchange carriers are subject to statutory and regulatory limitations on the use of customer information we acquire by virtue of providing telecommunications services, including information related to the quantity, technical configuration, type, destination and amount of a customer’s use of services. Under these rules, we may not use such information acquired through one of our service offerings to market other service offerings without the approval of the affected customers. We believe that we are in compliance with these obligations, which may affect our incumbent local exchange carrier’s ability to market some services to our customers. On February 10, 2006, the FCC adopted a notice of proposed rulemaking seeking comment on potential additional measures regarding carrier protection of customer data. We cannot predict the outcome of these proceedings or the effect of FCC or judicial decisions on our incumbent local exchange carrier or competitive local exchange carrier businesses.
Communications Assistance for Law Enforcement Act. Under the Communications Assistance for Law Enforcement Act (“CALEA”) and related federal statutes, we are required to provide law enforcement officials with call content and call identifying information under a valid electronic surveillance warrant and to reserve a sufficient number of circuits for use by law enforcement officials in executing court-authorized electronic surveillance. We believe we are in compliance with the laws and regulations, as currently applied. On September 23, 2005, the FCC released an order determining that facilities-based broadband providers and providers of interconnected voice over Internet Protocol (“VoIP”) services must be prepared to accommodate law enforcement wiretaps pursuant to the “CALEA” by May 14, 2007. On May 12, 2006, the FCC released a follow-up order further detailing compliance obligations, although uncertainty remains regarding technical aspects of such compliance. We cannot predict whether and when the FCC might modify such regulations or any other rules, or what compliance with new rules might cost.
Preferred Carrier Selection Changes. A customer may change his or her preferred long distance carrier at any time, but the FCC and the Iowa Utilities Board regulate this process and require that specific procedures be followed. The FCC and Iowa Utilities Board have levied substantial fines for unauthorized changes and have recently increased the penalties for such conduct. We believe we are in compliance with the required processes and procedures, and no such fines have been assessed against us.
Service Outage Reporting. On August 4, 2004, the FCC adopted rules requiring certain telecommunications carriers to begin reporting additional information to the FCC in the event of selected service outages and related events affecting some fiber rings. On December 20, 2004, the FCC stayed the rules’ effectiveness pending agency reconsideration of their merits, in part due to concerns about the substantial expenditures required of telecommunications carriers in order to comply with the new reporting obligations. At this time, we cannot predict the consequences of the FCC’s reconsideration or the financial or operational impacts any final rules may have on us.
Regulation of Our Independent Incumbent Local Exchange Carrier. Our independent incumbent local exchange carrier, Montezuma Telephone, which for regulatory purposes is treated as independent of our incumbent local exchange carrier, is generally subject to the same federal regulation as our incumbent local exchange carrier, with certain exceptions. First, Montezuma Telephone continues to maintain the rural exemption from certain interconnection obligations. Second, Montezuma Telephone’s interstate access charges are subject to historical investment-based rate regulation applicable to non-price-cap carriers. Montezuma Telephone, in particular, falls into the category of non-price-cap carriers known as “average schedule” companies, whose historic costs are simulated through formulae, individual company data and pooled data. Montezuma Telephone, through a management agreement with Iowa Wireless Services, LLC (“Iowa Wireless”), provides commercial mobile radio (mobile wireless) service in its incumbent local exchange carrier service territory and is subject to provisions of the Communications Act and FCC rules concerning wireless carriers. Montezuma Telephone also provides cable television service in Montezuma, Deep River, and Barnes City, an activity also subject to provisions of the Communications Act and FCC rules. Neither Montezuma Telephone’s mobile wireless nor cable television service are subject to federal rate regulation. Just as we are unable to predict the outcome of pending and potential proceedings affecting the federal regulation of our incumbent local exchange carrier, we are unable to predict the outcome of such proceedings, such as intercarrier compensation reform, on our independent incumbent local exchange carrier subsidiary.
Regulation Applicable to our Advanced Wireless Service Licenses
We currently hold 15 FCC Advanced Wireless Services licenses in Iowa. Our ownership of these licenses subjects us to FCC regulation of the wireless services we may choose to provide and the technical operating characteristics of the network equipment we may utilize. In addition, our rights to renew these licenses at the end of their initial 15-year terms will depend, at least in part, on our compliance with build-out requirements promulgated by the FCC. We cannot predict changes that may occur in the FCC’s regulation of our Advanced Wireless Services licenses, the network we may build or the services we may provide over the period of time we may hold the licenses.
Environmental Regulation
We are subject to federal, state and local laws and regulations governing the use, storage, disposal of, and exposure to, hazardous materials, the release of pollutants into the environment and the remediation of contamination. As an owner or operator of property and a generator of hazardous wastes, we could be subject to certain environmental laws that impose liability for the entire cost of cleanup at a contaminated site, regardless of fault or the lawfulness of the activity that resulted in contamination. We believe, however, that our operations are in substantial compliance with applicable environmental laws and regulations.
In 2004 we discovered that groundwater near the underground diesel fuel storage tank located at our Mount Pleasant, Iowa facility contained levels of Total Extractable Hydrocarbons (“TEH”) for diesel and waste oil that exceeded the Tier 1 target levels established by the Iowa Department of Natural Resources. Subsequent testing has confirmed the presence of diesel and waste oil TEH and also revealed the presence of free diesel product. As a result of a Tier 2 evaluation and free product assessment conducted in 2005, the site has been assigned a “No Action Required” classification by the Iowa Department of Natural Resources. We continue, however, to maintain a monitoring well and expect to do so until groundwater samples reveal essentially no free diesel product for 24 months. We do not believe that any expense relating to the Mount Pleasant underground storage tank will result in a material adverse effect on our financial condition.
State Regulation
Incumbent Local Exchange Carrier. The Iowa Utilities Board is responsible for regulating the rates, terms and conditions pursuant to which our incumbent local exchange carrier provides basic intrastate local telephone service and switched access service for intrastate transmissions within Iowa. The Iowa Utilities Board also has jurisdiction over the service quality of the incumbent local exchange carrier’s intrastate services and relationships with our customers. As required by the Iowa Utilities Board, our incumbent local exchange carrier files and receives approval of tariffs for local telephone and switched access service. These tariff filings are available on our web site. The Iowa Utilities Board does not regulate the rates our incumbent local exchange carrier charges for other services, including intrastate long distance, intrastate special access, directory assistance, voicemail and local private line services, or for services provided to multi-line business customers.
The Iowa Utilities Board has granted a certificate of public convenience and necessity to our incumbent local exchange carrier to provide local telephone service in Iowa. We may not transfer our certificate, transfer control of our company or discontinue providing local services in any of the exchanges we serve without first obtaining the Iowa Utilities Board’s approval. The Iowa Utilities Board has the power to penalize us or revoke our certificate if we are in material violation of any law or regulation. We also must obtain the Iowa Utilities Board’s approval to acquire the whole or any substantial part of the assets or the controlling capital stock of any public utility in Iowa, or to sell or otherwise dispose of the whole or any substantial part of our assets. In addition, the Iowa Utilities Board is responsible for implementing some of the state and federal laws and regulations intended to promote competition. It also has authority under the Telecom Act to establish the rates and terms on which competitive local exchange carriers can interconnect with and obtain unbundled access to incumbent local exchange carrier networks.
The jurisdiction of the Iowa Utilities Board over our local retail rates changed dramatically as a result of state deregulatory legislation that became effective on July 1, 2005. Pursuant to this legislation, each telephone utility then subject to rate regulation, such as Iowa Telecom, was permitted to elect to deregulate its charges for all of its retail business and residential local exchange services except single line flat-rated residential and business service and Extended Area Services, which will remain rate regulated until at least June 30, 2008. We exercised this option effective July 1, 2005. For services that remain rate-regulated, monthly rates may be adjusted annually by one dollar for residential lines and two dollars for business lines, plus an inflation increment, up to a monthly rate cap of $19.00 for residential lines and $38.00 for business lines. Pursuant to a January 25, 2007 interpretation by the Iowa Utilities Board, the $19.00 and $38.00 limits are inclusive of any
incremental inflationary adjustments and, therefore, once met, do not permit further inflationary adjustments. Upon request by a utility, however, rates may be modified by the Iowa Utilities Board to reflect exogenous factors beyond the control of the utility. These rates do not include charges for Extended Area Services, which, to the extent that it is offered in conjunction with single line flat-rate service, remains regulated by the Iowa Utilities Board. Single line flat-rated business and residential service and EAS will also be deregulated as of July 1, 2008 unless the Iowa Utilities Board determines that the public interest requires it to extend its jurisdiction over such services to July 1, 2010. If the Iowa Utilities Board decides to continue price regulation to 2010, both residential and business monthly rates may be increased up to two dollars during each twelve-month period of the extension and the overall rate caps of $19.00 and $38.00 will be eliminated.
Pursuant to Iowa Telecom’s election, all retail offerings other than single line flat-rate residential and business service (and associated Extended Area Services), such as calling features, second residential lines, Centrex, and bundled packages, were deregulated effective July 1, 2005.
Our intrastate switched access rates continue to be rate-regulated as they were prior to July 1, 2005 - capped at the level set in 1998. The prohibition on changes in our incumbent local exchange carrier’s intrastate access charges did not apply to the intrastate carrier common line rate, which the Iowa Utilities Board set at $0.03 per intrastate minute of use.
In April 2004, our incumbent local exchange carrier reached a settlement agreement with the Iowa Utilities Board and other parties. Pursuant to the settlement agreement, we are obligated to invest substantially all additional revenues generated by the allowed increase in our rates, except for revenues resulting from inflation adjustments, on capital improvements identified in our network improvement plan. This investment is in addition to our baseline level of network capital expenditures, which was assumed to be $16 million per year during the initial period of the plan. The initial period continued until we had spent $38.9 million of cumulative capital expenditures in excess of our assumed baseline investment level. This requirement was satisfied in 2006. Beginning in 2007, both the baseline and the incremental investment levels will increase or decrease consistent with access line changes and further deregulation. We expect that a minimum annual capital investment of approximately $18 million will satisfy the ongoing commitments.
The new law that became effective July 1, 2005 also gives the Iowa Utilities Board jurisdiction to entertain a complaint by certain local exchange carriers that other carriers have engaged in activity that is inconsistent with the antitrust laws and the policies underlying them, and allows the Iowa Utilities Board to punish such behavior by adjusting retail rates in an amount sufficient to correct the antitrust activity, ordering the local exchange carrier engaging in such activity to pay costs incurred by the complainant in pursuing the complaint, imposing civil penalties against the local exchange carrier engaging in such activity, and ordering either the complainant or the other local exchange carrier to pay the costs of the complaint proceeding including the other party’s reasonable attorney fees.
Iowa law authorizes the Iowa Utilities Board to deregulate communications services or facilities if the Iowa Utilities Board determines a service or facility is subject to effective competition. On December 23, 2004, the Iowa Utilities Board issued an order deregulating all rates charged by Iowa Telecom for local exchange service in 14 Iowa Telecom exchanges in which we face facilities-based competition. We began to offer local exchange service at deregulated rates in these deregulated exchanges later in 2005. In addition, on December 5, 2005, the Iowa Utilities Board deregulated an additional 14 exchanges where we face facilities-based competition.
Competitive Local Exchange Carriers. We have two competitive local exchange carrier subsidiaries-ITC and IT Communications. The CLEC provides services in 21 of Qwest’s Iowa exchanges. ITC generally offers the same local exchange services as those offered by Qwest, using unbundled network facilities provided by Qwest pursuant to our agreement with them, and provides DSL Internet access service in all the exchanges in which it operates, using either Qwest’s wholesale service or owned facilities. IT Communications began operations in January 2006. IT Communications operates similarly to ITC, but is focused on larger markets in Iowa, presently
Iowa City, Cedar Rapids and Ames. The Iowa Utilities Board does not have jurisdiction over the rates for local basic communications service of our competitive local exchange carriers, but our competitive local exchange carriers do file tariffs regarding the terms and conditions for such service with the Iowa Utilities Board.
The Iowa Utilities Board has jurisdiction over our competitive local exchange carriers’ switched access rates. The Iowa Utilities Board rules allow our competitive local exchange carriers to adopt the tariffs of any other carrier providing switched access service in Iowa. Our competitive local exchange carriers, like a majority of competitive local exchange carriers in the state, have adopted the switched access rates contained in the access tariff of the Iowa Telecommunications Association. The Iowa Utilities Board also has jurisdiction over the service quality of our competitive local exchange carriers’ intrastate services and relationships with their customers.
Independent Incumbent Local Exchange Carrier. As a provider of fewer than 15,000 access lines, our independent incumbent local exchange carrier, Montezuma Telephone, is not subject to the retail and access rate regulation of the Iowa Utilities Board, although it is subject to the Board’s complaint jurisdiction regarding intrastate access rates. Neither Montezuma Telephone’s mobile wireless nor cable television service is subject to state rate regulation. Montezuma Telephone provides cable television service pursuant to franchise agreements with the cities of Barnes City, Deep River and Montezuma which include certain operational requirements.
Other
Our incumbent local exchange carrier provides local exchange services from three exchanges in Iowa that include approximately 100 access lines that serve customers physically located in Missouri. With regard to these access lines, our incumbent local exchange carrier is subject to the jurisdiction of the Missouri Public Service Commission, which is responsible for granting operating certificates to local service providers and regulating the intrastate access service, local service, the service quality and relationships with customers of incumbent local exchange carriers operating in Missouri. Our incumbent local exchange carrier is certified to operate in Missouri and, as such, has approved tariffs on file with the Missouri Public Service Commission. Our incumbent local exchange carrier contributes to the Missouri universal service fund and also files service quality and financial monitoring reports with the Missouri Public Service Commission on an annual and quarterly basis.
Neither the Iowa Utilities Board nor the Missouri Public Service Commission regulates dial-up Internet access or high-speed Internet access services to customers of either our incumbent local exchange carrier or our competitive local exchange carriers.
Local Government Authorizations
In some communities, our incumbent local exchange carrier is required to obtain certain authorizations from municipal authorities, such as permits, licenses or easements to install and maintain the facilities and equipment necessary to provide telecommunications services. We believe we are in compliance with all such requirements. Some jurisdictions where we may provide service may require license or franchise fees based on criteria established by Iowa statute. These amounts are not material to our incumbent local exchange carrier operations.
To the extent our competitive local exchange carriers provide service through facilities or services purchased from Qwest, no local government authorizations are required. If our competitive local exchange carriers were to construct their own facilities, they may be subject to the requirements of local governments in such markets. Currently, our competitive local exchange carriers pay no local license or franchise fees.
ITEM 1A.
ITEM 1A. Risk Factors
Set forth below are risks and uncertainties that could cause actual future results to differ materially from those described herein.
Risk Related to Our Capital Structure and Ownership
Our dividend policy may limit our ability to pursue growth opportunities.
Our board of directors adopted a dividend policy, effective upon closing of our initial public offering in November 2004, which reflects an intention to distribute a substantial portion of the cash generated by our business in excess of operating needs, interest and principal payments on our indebtedness and capital expenditures as regular quarterly dividends to our shareholders. As a result, we may not retain a sufficient amount of cash to finance a material expansion of our business, or to fund our operations consistent with past levels of funding in the event of a significant business downturn. In addition, because a significant portion of cash available to pay dividends will be distributed to holders of our common stock under our dividend policy, our ability to pursue any material expansion of our business, including through acquisitions or increased capital spending, will depend more than it otherwise would on our ability to obtain third party financing. We cannot assure you that such financing will be available to us at all, or at an acceptable cost.
You may not receive any dividends.
We are not obligated to pay dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. Future dividends with respect to shares of our common stock, if any, will depend on, among other things, our results of operations, working capital requirements, financial condition, contractual restrictions, business opportunities, anticipated cash needs, provisions of applicable law and other factors that our board of directors may deem relevant. In addition, we have reported a loss from continuing operations in the past.
We might not generate sufficient cash from operations in the future to pay dividends on our common stock in the intended amounts or at all. Our board of directors may decide not to pay dividends at any time and for any reason. Our dividend policy is based upon our directors’ current assessment of our business and the environment in which we operate, and that assessment could change based on competitive or technological developments (which could, for example, increase our need for capital expenditures), new growth opportunities or other factors. If our cash flows from operations for future periods were to fall below our minimum expectations, we would need either to reduce or eliminate dividends or, to the extent permitted under the terms of our credit facilities, fund a portion of our dividends with borrowings or from other sources. If we were to use working capital or permanent borrowings to fund dividends, we would have less cash and/or borrowing capacity available for future dividends and other purposes, which could negatively affect our financial condition, our results of operations, our liquidity and our ability to maintain or expand our business. Our board is free to depart from or change our dividend policy at any time and could do so, for example, if it were to determine that we had insufficient cash to take advantage of growth opportunities. In addition, our credit facilities contain limitations on our ability to pay dividends. See “Dividend Policy and Restrictions” in Item 5 of this report. The reduction or elimination of dividends may negatively affect the market price of our common stock.
We have substantial indebtedness and may incur additional indebtedness in the future, which could restrict our ability to pay dividends.
Our ability to make distributions, pay dividends or make other payments will be subject to applicable law and contractual restrictions contained in the instruments governing any indebtedness of ours and our subsidiaries, including our credit facilities. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of our common stock, including the following:
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our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited;
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a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our common stock;
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we may be more vulnerable to economic downturns and be limited in our ability to withstand competitive pressures; and
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we may have limited flexibility to plan for and react to changes in our business or strategy.
In addition, we may incur substantial additional indebtedness in the future. Any additional debt incurred by us could increase the risks associated with our substantial leverage.
We are subject to restrictive debt covenants and other requirements related to our outstanding debt that limit our business flexibility by imposing operating and financial restrictions on us.
Covenants in the credit facilities impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things:
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the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock;
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the payment of dividends on, and purchase or redemption of, capital stock;
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a number of other restricted payments, including investments and acquisitions;
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specified sales of assets;
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specified transactions with affiliates;
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the creation of a number of liens on our assets;
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consolidations, mergers and transfers of all or substantially all of our assets;
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our ability to change the nature of our business; and
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our ability to make capital expenditures.
These restrictions could limit our ability to obtain future financing, make acquisitions or fund capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the credit facilities also require us to maintain specified total leverage and fixed charge coverage ratios and satisfy specified financial condition tests, and may require us to make annual mandatory prepayments with a portion of our available cash. See “Long-Term Debt and Revolving Credit Facilities” in Item 7 of this report. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions.
A breach of any of these covenants, ratios or tests could result in a default under the credit facilities. Upon the occurrence of an event of default under the credit facilities, the lenders could elect to declare all amounts outstanding under the credit facilities to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the credit facilities, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness.
We may not be able to refinance our credit facilities at maturity on favorable terms or at all.
Our credit facilities will mature in full in 2011. We may not be able to renew or refinance the credit facilities, or any renewal or refinancing may occur on less favorable terms. If we were unable to refinance or renew our credit facilities, our failure to repay all amounts due on the maturity date would cause a default under the credit facilities. In addition, our interest expense may increase significantly if we refinance our credit
facilities on terms that are less favorable to us than the terms of our existing credit facilities, which could impair our ability to pay dividends.
We will require a significant amount of cash, which may not be available to us, to service our debt, pay dividends and fund our other liquidity needs.
Our ability to make payments on, or to refinance or repay, our debt, to fund planned capital expenditures, to pay dividends and to expand our business will depend largely upon our future operating performance. Our future operating performance is subject to general economic, financial, competitive, legislative and regulatory factors, as well as other factors that are beyond our control. Our business may not generate enough cash flow, or future borrowings may not be available to us under the credit facilities or otherwise, in an amount sufficient to enable us to pay our debt, pay dividends or fund our other liquidity needs. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our credit facilities. We may not be able to refinance any of our debt, including the credit facilities, under such circumstances on commercially reasonable terms or at all. If we were unable to refinance our debt or obtain new financing under these circumstances, we would have to consider other options, including:
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sales of certain assets to meet our debt service requirements;
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sales of equity; and
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negotiations with our lenders to restructure the applicable debt.
Our credit facilities could restrict our ability to do some of these things. If we are forced to pursue any of the above options under distressed conditions, our business and/or the value of our common stock could be adversely affected.
There may be volatility in the trading price of our common stock, which could negatively affect the value of an investment in our common stock.
The market price of our common stock may fluctuate widely as a result of various factors, such as period-to-period fluctuations in our operating results, sales of our common stock by significant shareholders, developments in the telecommunications industry, the failure of securities analysts to cover our common stock or changes in financial estimates or opinions by analysts, competitive factors, regulatory developments, economic and other external factors, interest rates, general market conditions and market conditions affecting the stock of telecommunications companies in particular. Telecommunications companies have in the past experienced extreme volatility in the trading prices and volumes of their securities, which has often been unrelated to operating performance. Any such market volatility may have a significant adverse effect on the market price of our common stock.
Future sales, or the possibility of future sales, of a substantial amount of our common stock may depress the price of the shares of our common stock.
Future sales, or the availability for sale in the public market, of substantial amounts of our common stock could adversely affect the prevailing market price of our common stock, and could impair our ability to raise capital through future sales of equity securities.
Certain investors that held shares of our common stock prior to our initial public offering in November 2004, continue to hold 943,907 shares of common stock as of December 31, 2006. These shares are eligible for resale pursuant to Rule 144(k) under the Securities Act. In addition, members of our management and other employees hold fully vested options to purchase a total of 682,579 shares of our common stock as of December 31, 2006, all of which have been registered under the Securities Act of 1933 and may be exercised and sold at any time.
We may issue shares of our common stock, or other securities, from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. We may also register, or grant registration rights covering, those shares or other securities in connection with any such acquisitions and investments.
Your interests may conflict with those of our current shareholders with whom we conduct significant business.
One of our shareholders that held shares of our common stock prior to our initial public offering, Iowa Network Services, Inc., as of December 31, 2006 held approximately 3.0% of our outstanding common stock through one of its subsidiaries, Pine Island Capital Corporation. Iowa Network Services, Inc. is in the telecommunications business and provides long distance, wireless, dial-up and DSL Internet access and other services throughout Iowa that compete with certain aspects of our business to the extent permitted by the terms of non-competition arrangements between Iowa Network Services, Inc. and us. We anticipate that Iowa Network Services, Inc. will continue to compete with us in the future, and such competition may intensify following any reduction in Iowa Network Services, Inc.’s equity interest in us.
Iowa Network Services, Inc. is owned by approximately 127 independent incumbent local exchange carriers, which we believe each own less than 5% of Iowa Network Services, Inc. These incumbent local exchange carriers provide telecommunications services in exchanges adjacent to or nearby our exchanges, sometimes in competition with services we provide. Competition with these incumbent local exchange carriers could intensify following any reduction in Iowa Network Services, Inc.’s equity interest in us.
Our organizational documents could limit another party’s ability to acquire us and therefore could deprive our investors of the opportunity to obtain a takeover premium for their shares.
A number of provisions in our articles of incorporation and bylaws will make it difficult for another company to acquire us and, therefore, for investors to receive any related takeover premium for their shares. For example, our articles of incorporation provide for a classified board of directors, prohibit removal of directors without cause and authorize the issuance of preferred stock without shareholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future.
We are also subject to laws that may have a similar effect. For example, federal and Iowa telecommunications laws and regulations generally prohibit a direct or indirect transfer of control over our business without prior regulatory approval. Section 490.1110 of the Iowa Business Corporation Act prohibits us from engaging in a business combination with an interested shareholder for a period of three years from the date the person became an interested shareholder unless certain conditions are met. The Iowa Business Corporation Act also provides that only shareholders representing at least 50% of our shares entitled to vote may request that our board of directors call a special meeting of shareholders and that, in evaluating any acquisition offer, our board of directors may consider the interests of our employees, suppliers, creditors and customers, the interests of the communities in which we operate, and the long-term interests of our company and the shareholders, in addition to the financial interests of shareholders.
Limitations on usage of our net operating losses, and other factors requiring us to pay cash taxes in future periods, may affect our ability to pay dividends to you.
Our initial public offering resulted in an “ownership change” for purposes of Section 382 of the Internal Revenue Code. As a result, our ability to use our substantial net operating losses to offset taxable income for taxable periods ending after the date of the offering are limited. In addition, we currently are able to take deductions of approximately $40.0 million from taxable income associated with the amortization of intangibles
through 2014. Consequently, in the future we may be required to pay cash income taxes because of limitations on using our net operating losses, or because all of our net operating losses have been used or have expired, or because our intangible assets have been fully amortized. Any of the foregoing would have the effect of increasing our taxable income and potentially reducing our after-tax cash flow available for payment of dividends in future periods, and may require us to reduce dividend payments on our common stock in such future periods.
Risks Relating to Our Business and Industry
Competition in the telecommunications industry could result in access line losses or reduce our customer base, possibly requiring that we lower our rates, increase marketing expenditures, invest in new technologies or capabilities or use discounting and promotional campaigns that adversely affect our margins.
We face actual or potential competition from other telecommunications service providers, including wireless service providers, who have entered and may continue to enter our service areas. Such competition has resulted in access line losses. In general, when we lose a customer to a competitor for local service we also lose that customer for all related services, such as long distance and Internet service, and may also lose the access charge revenues for that customer. We have interconnection agreements with 36 of the competitive local exchange carriers authorized to offer local service in our service area, of which four are authorized to provide service statewide and 32 are authorized to provide service only in specific exchanges or regions.
In addition, six municipal telephone utilities operate as competitive local exchange carriers in some of our markets, and other communities we serve may in the future evaluate the establishment of a municipal telephone utility. In particular, in November 2004, an organization called “Opportunity Iowa” was formed to encourage municipalities to build their own fiber to the home communications networks. Opportunity Iowa referendum votes were held in the November 2005 general election cycle in seven Iowa Telecom exchanges. The Opportunity Iowa referendums were defeated in all seven communities. We cannot predict the likelihood of further competition from municipal telecommunications utilities on our business.
MCC Telephony of Iowa, Inc., the telecommunications affiliate of Mediacom, the dominant cable television provider in Iowa, is certificated to provide competitive local telecommunications service in approximately 100 Iowa Telecom exchanges. MCC’s stated business plan is to use Sprint Communications Company L.P. (“Sprint”) as an intermediary in interconnecting with incumbent local exchange carriers throughout Iowa, including Iowa Telecom, while MCC would retain the retail customer relationship. MCC has already entered the Des Moines market, but has yet to provide traditional wireline local exchange services in non-Qwest markets in Iowa, which we believe is at least partially due to the timing of MCC or Sprint obtaining and implementing agreements with us and certain other incumbent carriers. MCC’s ability to enter non-Qwest markets in Iowa, including Iowa Telecom’s service area, without its own interconnection agreement with incumbent carriers remains a contested issue in federal court, although, for the time being, Iowa Telecom and certain other incumbent carriers are subject to Iowa Utilities Board-approved interconnection agreements with Sprint. Further, Iowa Telecom is subject to an Iowa Utilities Board order, also currently on appeal in federal court, requiring us to provide certain interconnection services pursuant to these interconnection agreements. Iowa Telecom is required to provide certain interconnection services while these appeals are pending. We cannot predict the outcome of the pending appeals.
Wireless providers also currently compete in most of our rural markets. We expect this competition to continue, and likely become more acute, in the future. We also compete, or may in the future compete, with companies that provide other close substitutes for the traditional telephone services we provide, like cable television, voice over Internet protocol, high-speed fiber optic networks or satellite telecommunications services, and companies that might provide traditional telephone services over nontraditional network infrastructures, like electric utilities. We are subject to regulations, like those requiring us to provide number portability for wireless carriers, that reduce the barriers to entry faced by some providers of substitute services, and may be subject to other regulations favoring substitute services in the future.
We may continue to lose access lines due to economic conditions and competition.
Our business generates revenue by delivering voice and data services over access lines. In the past, we have experienced net access line loss due to challenging economic conditions and increased competition. Our total access line count decreased by 3.1% during 2005, and 2.6% during 2006. Access lines decreased 5.5% for 2005, and 4.1% for 2006, if we exclude lines served by our competitive local exchange carrier. We may continue to experience net access line losses in our markets for an unforeseen period of time. Continued access line losses could adversely affect our revenues and earnings.
We may in the future compete with the Iowa Communications Network or with a future purchaser of the assets now owned by the Iowa Communications Network.
The Iowa Communications Network, a state-owned limited use network with more than 3,000 miles of fiber optic cable extending into all 99 Iowa counties, and capable of providing a variety of voice, data and video communication services, currently is prohibited by state law from providing telephone service to parties other than school districts, higher education institutions, state and federal agencies, the United States Post Office, hospitals and physicians’ clinics and public libraries. The assets now owned by the Iowa Communications Network could be used to provide voice, data and video communications, and the state of Iowa has previously considered modifying state law to remove some of the usage restrictions applicable to the Iowa Communications Network or permit the sale of the Iowa Communications Network to a private party. A sale of the Iowa Communications Network or its assets, or a change in the law permitting broader use of the Iowa Communications Network, could provide additional competition for us.
We may not be able to integrate future technologies, respond effectively to customer requirements or provide new services.
The communications industry is subject to rapid and significant changes in technology, frequent new service introductions and evolving industry standards. We cannot predict the effect of these technological changes on our business. New technologies and products may not be compatible with our existing technologies and systems. In addition, our existing technologies and systems may not be competitive with new superior technologies and products, which may reduce service prices. These developments could require us to incur unbudgeted upgrades or to procure additional products that could be expensive. If we do not adequately replace or upgrade our technology and equipment that becomes obsolete, we may not be able to compete effectively. Technological changes in the communications industry may have a material adverse effect on our business or financial results. We may not be able to obtain timely access to new technology on satisfactory terms or incorporate new technology into our systems in a cost effective manner, or at all.
In addition to technological advances, other factors could require us to further expand or adapt our network, including an increasing number of customers, demand for greater data transmission capacity, failure of our technology and equipment to support operating results anticipated in our business plan and changes in our customers’ service requirements. Expanding or adapting our network could require substantial additional financial, operational and managerial resources, any of which may not be available to us.
Network disruptions could adversely affect our operating results.
To be successful, we will need to continue providing our customers with a high capacity, reliable and secure network. Some of the risks to our network and infrastructure include:
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physical damage to access lines, central offices, central office equipment, or equipment used in our underlying voice and data networks;
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power loss from, among other things, adverse weather conditions;
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capacity limitations;
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software and hardware defects and malfunctions;
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breaches of security, including sabotage, tampering, computer viruses and break-ins; and
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other disruptions that are beyond our control.
Disruptions or system failures may cause interruptions in service or reduced capacity for customers. If service is not restored in a timely manner, agreements with our customers or service standards set by the Iowa Utilities Board may obligate us to provide credits or other remedies, and this would reduce our revenues or increase our costs. Service disruptions could also damage our reputation with customers, causing us to lose existing customers or have difficulty attracting new ones.
We may not be able to maintain the necessary rights-of-way for our network.
We are dependent on rights-of-way and other permits from railroads, utilities, state highway authorities, local governments and transit authorities to install conduit and related telecommunications equipment for any expansion of our network. We may need to renew current rights-of-way for our network and cannot assure you that we would be successful in renewing these agreements on acceptable terms. Some of our agreements may be short-term, revocable at will, or subject to termination upon customary default provisions, and we may not have access to existing rights-of-way after they have expired or terminated. If any of these agreements were terminated or could not be renewed, we may be required to remove our existing facilities from under the streets or abandon our networks. Similarly, we may not be able to obtain right-of-way agreements on favorable terms, or at all, in new service areas, and, if we are unable to do so, our ability to expand our network, if we decide to do so, could be impaired.
The successful operation and growth of our business are dependent on economic conditions and population stability in Iowa.
Virtually all of our customers and operations are located in Iowa. Due to our geographical concentration, the successful operation and growth of our businesses is dependent on economic conditions in Iowa. The Iowa economy, in turn, is dependent upon many factors, including the strength of the agricultural economy and continued growth in manufacturing and service industries.
The economies of rural communities, such as those that we serve, are affected by many of the same factors as the Iowa economy in general. In addition, rural communities face additional challenges to their economic stability and growth. The populations of many rural communities in Iowa, particularly smaller towns, have been declining. Limited capital availability may hinder the growth of rural businesses. Any deterioration in general economic conditions in Iowa is likely to result in lower demand for our services, which would reduce our revenues.
Our competitive local exchange carrier strategy may adversely affect our profitability and Adjusted EBITDA.
We intend to expand our operations in both telephone and Internet services through our two competitive local exchange carrier subsidiaries into areas adjacent to our incumbent local exchange carrier territory. As of December 31, 2006, we had approximately 23,800 competitive local exchange carrier access lines in 21 exchanges. We expanded into additional markets and have a net investment of approximately $1.1 million in our competitive local exchange carrier operations cumulative though December 31, 2006, principally to fund operating losses during this expansion phase. Our competitive local exchange carrier business incurred losses through most of this expansion period and may require additional funding for capital expenditures and potential operating losses in the future. Competitive local exchange carrier profitability is contingent on obtaining customers from the incumbent local exchange service provider in a cost-effective manner. Either an incumbent provider or another competitive local exchange carrier may diminish our profitability by expanding its marketing efforts or offering additional products. Furthermore, as a result of the recently enacted statutory provisions
regarding deregulation of basic local services, the incumbent provider will have greater flexibility to respond to competition from our competitive local exchange carriers, which may reduce our margins and have other negative impacts on our profitability.
We face risks associated with our strategy of growth through acquisitions.
Any future acquisitions will depend on our ability to identify suitable acquisition candidates, negotiate acceptable terms for their acquisition and finance those acquisitions. In addition, future acquisitions by us could result in the incurrence of indebtedness or contingent liabilities, which could have a material adverse effect on our business and our ability to achieve sufficient cash flow, provide adequate working capital and service our indebtedness. Any future acquisitions could also expose us to increased risks, including:
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the difficulty of integrating the acquired personnel, network, operations and other support systems;
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the potential disruption of our ongoing business and diversion of resources and management time;
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the inability to generate revenues from acquired businesses sufficient to offset acquisition costs;
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the inability of management to maintain uniform standards, controls, procedures and policies;
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the risks of entering markets in which we have little or no direct prior experience;
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the difficulty in enhancing our customer support resources to adequately service our existing customers and acquired customers; and
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the impairment of relationships with suppliers, employees, or unions as a result of changes in management of the acquired company.
Any future acquisitions of access lines will likely be subject to prior approvals from the Federal Communications Commission and the Iowa Utilities Board or other applicable state regulatory commissions. We may not be able to obtain such approvals, in which case the acquisition could be delayed or not consummated.
We may not be successful in efficiently managing the growth of our business.
Our business plan will, if successfully implemented, result in growth of our operations, which may place a significant strain on our management, financial and other resources. To achieve and sustain growth we must, among other things, monitor operations, control costs, maintain regulatory compliance, maintain effective quality controls and maintain adequate internal management, technical, provisioning, information, billing, customer service and accounting systems. We may not be able to successfully integrate and use the employee, management, operational and financial resources necessary to manage a developing and expanding business in an evolving, regulated and increasingly competitive industry.
Our relationships with other telecommunications companies are material to our operations and their financial difficulties may affect our business.
We originate and terminate calls for long distance carriers and other interexchange carriers over our network and for that service we receive payments called access charges. Some of the carriers that pay us these access charges are our largest customers in terms of revenues. Several such carriers have declared bankruptcy in recent years, and others are experiencing substantial financial difficulties. Our inability to collect access charges from these bankrupt or financially distressed carriers has had a negative effect on our financial results and cash flows, as would any subsequent bankruptcies or disruptions in the businesses of these or other interexchange carriers. Our ability to collect past due amounts of access billings from carriers is hampered by federal and state regulations governing business relationships of these bankrupt or financially distressed carriers.
We use many vendors and suppliers that derive significant amounts of business from customers in the telecommunications business. Associated with the difficulties facing many service providers, some of these
vendors and suppliers recently have experienced substantial financial difficulties, in some cases leading to bankruptcies and liquidations. Any disruptions experienced by these vendors and suppliers as a result of their own financial difficulties may affect their ability to deliver products or services to us, and delays in such deliveries could have an adverse affect on our business.
We face risks associated with our reliance on our information and billing systems.
We currently rely on a combination of internal systems and licenses with third party vendors for our information and billing systems. These systems are vital to our growth and our ability to monitor and control costs, bill customers, process orders, and provide customer service. If our information and billing systems fail or do not perform as expected, our ability to collect revenues, provide adequate customer service and accurately track our expenses and revenues would be impaired, with potentially materially adverse effects on our business and operations. In addition, if our third party vendors cancel or do not renew our license agreements, we could face disruption in our operations, as well as unforeseen expense for obtaining suitable replacement services from other vendors.
Labor disputes with our employees could interrupt our operations and adversely affect our business.
We have a collective bargaining agreement with the Communications Workers of America, or CWA, which covers approximately 184 of our employees and expires in May 2007. We also have a collective bargaining agreement with the International Brotherhood of Electrical Workers, or IBEW, which covers approximately 24 of our employees and expires in June 2009. If we negotiate acceptable terms with the CWA or IBEW at the expiration of the current agreement, our operating costs could increase as a result of higher wages or benefits paid to union members, and if we fail to reach an agreement with the unions our operations could be disrupted. Either event could have a material adverse effect on our business, results of operations or financial condition.
We depend on key members of our senior management team.
Our success depends largely on the skills, experience and performance of key members of our senior management team, including Alan L. Wells, our President, CEO and Chairman. Competition for senior management in our industry is intense, and we may have difficulty retaining our current managers or attracting new managers in the event of termination or resignation.
Risks Related to Our Regulatory Environment
Our business is subject to extensive regulation that could change in a manner adverse to us.
We operate in a heavily regulated industry, and most of our revenues come from providing services regulated by the Federal Communications Commission, or FCC, and the Iowa Utilities Board. Federal and state communications laws and regulations may be amended in the future, and other laws or regulations may be enacted which will affect our business. The FCC and the Iowa Utilities Board may add new rules, amend their rules or change the interpretation of their rules at any time. Laws and regulations applicable to us and our competitors may be, and have been, challenged in the courts, and could be changed at any time. We cannot predict future developments or changes to the regulatory environment, or the impact such developments or changes would have on us.
FCC and Iowa Utilities Board decisions concerning telecommunications policy and judicial review of such decisions may adversely affect our business.
The Telecom Act provides for significant changes and increased competition in the telecommunications industry. This federal statute and its related regulations remain subject to judicial review and additional rulemakings of the FCC, thus making it difficult to predict what effect this actually will have on us, our operations and our competitors. For example, as discussed in more detail under Regulation-Federal Regulation,
the FCC is considering changes to intercarrier compensation applicable to local exchange carriers and wireless providers that could adversely affect the access revenues of our incumbent local exchange carrier and competitive local exchange carrier operations, and the manner in which we will be compensated for terminating calls originating on other carriers’ networks and compensate other carriers for handling calls that originate on our network. The FCC is also examining its universal service policies, including policies with respect to both contribution and disbursement, that could have an effect on the amount and timing of our receipt of universal service funds. Further, many FCC telecommunications decisions are subject to substantial judicial review and delay. These delays and related litigation create uncertainty over federal policies and rules, and may affect our business plans, investments and operations. The Iowa Utilities Board establishes state telecommunications policy, particularly in the areas of discretionary deregulation, both on a service type and geographic basis, and the consequences thereof. Orders of the Iowa Utilities Board are also subject to judicial review.
New regulations and changes in existing regulations may force us to incur significant expenses.
Our business may be adversely affected by laws and regulations that impose new or greater obligations related to assisting in law enforcement, bolstering homeland security, reducing environmental impacts, or other aspects of our business. For example, existing provisions of the Communications Assistance for Law Enforcement Act and FCC regulations implementing the Communications Assistance for Law Enforcement Act require telecommunications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance. As discussed in Item 1 under “Regulation-Federal Regulation”, the FCC has concluded that facilities-based broadband providers and providers of interconnected voice over Internet protocol services must be prepared to accommodate law enforcement wiretaps by May 14, 2007, although uncertainty remains regarding technical aspects of compliance. We cannot predict whether and when the FCC might modify such regulations or any other rules, or what compliance with new rules might cost. Similarly, we cannot predict whether or when federal or state legislators or regulators might impose new security, environmental or other obligations on our business. Such new obligations include FCC outage reporting obligations, stayed by the FCC on December 20, 2004, pending reconsideration, that may, if enacted, require substantial compliance expenditures.
As the incumbent local exchange carrier in our service areas, we are subject to regulation that is not applicable to our competitors.
Federal and state rules impose obligations and limitations on us, as an incumbent local exchange carrier, that are not imposed on some of our competitors. Federal obligations require us to, among other things, share facilities, allow unbundled access to our network and resale of our services purchased at wholesale rates, file tariffs for access charges, maintain certain types of accounts, and file certain types of reports. Similarly, Iowa law imposes, among other things, accounting and reporting requirements and service obligations on us that do not exist for our competitors. In addition, in Iowa we operate under a statutory price regulation plan that, with regard to our single line flat-rated retail local exchange services, imposes obligations and restrictions on us that are not generally imposed on our competitors. As our business becomes increasingly competitive, these regulatory disparities could impede our incumbent local exchange carrier business’s ability to compete in the marketplace, which, in turn, could have a material adverse effect on our business.
Changes to existing regulations may reduce the revenue we receive from network access charges.
Access charges, which are intended to compensate us for providing other carriers with originating, terminating or transport services for their calls on our local network, accounted for approximately 41% of our revenues in 2006. Access charges are collected as fees charged to providers of long distance services, fees charged to business and residential customers, and fees charged to wireless providers and other local exchange carriers for originating and terminating their interexchange calls.
Large long distance providers have advocated in the past, and continue to advocate, that access charges they are required to pay should be reduced and the revenues replaced, perhaps only in part, by raising the fees charged
to business and residential customers or by receipts from a universal service fund. Large long-haul network providers have also argued and continue to argue that access charges do not apply to specific types of traffic. The combined or individual results of these long distance carrier efforts could reduce the amount of access charge revenue we receive. Access charge reform is a key element of the universal service and intercarrier compensation issues under review by state and federal regulators and legislators. We cannot predict whether or when action may be taken on any of these issues, or what effect any action may have on revenues and costs of our incumbent local exchange carrier and competitive local exchange carrier operations.
To the extent that services that compete with ours are subject to different regulatory regimes, our revenues, particularly from network access charges, may be reduced.
The emerging technology known as voice over Internet protocol can be used to carry user-to-user voice communications over dial-up or broadband service. The FCC has determined that a particular type of entirely Internet-based voice over Internet protocol service also is an information service and exempt from such regulatory obligations, but that another, more widely-used, version of voice over Internet protocol service is an interstate service and therefore outside the jurisdiction of state telecommunications regulations. Certain aspects of the FCC’s determination have been challenged in judicial proceedings. The FCC is currently considering the regulatory status of a variety of voice over Internet protocol service configurations in the context of a comprehensive proceeding launched in February 2004 as well as several more application and issue-specific proceedings. These proceedings concern, among other things, what, if any, intercarrier compensation must be paid by providers of such service and what, if any, universal service contributions such providers must make. Expanded use of voice over Internet protocol technology could reduce the access revenues received by local exchange carriers like us. We cannot predict the outcome of these proceedings or the effect of FCC or judicial decisions on any of our ISP, incumbent local exchange carrier or competitive local exchange carrier businesses.
Because we are subject to extensive laws and regulations relating to the protection of the environment, natural resources and worker health and safety, we may face significant liabilities or compliance costs in the future.
Our operations and properties are subject to federal, state and local laws and regulations relating to protection of the environment, natural resources and worker health and safety, including laws and regulations governing and creating liability relating to, the management, storage and disposal of hazardous materials, asbestos, petroleum products and other regulated materials. As a result, we face several risks, including the following:
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Under certain environmental laws, we could be held liable, jointly and severally and without regard to fault, for the costs of investigating and remediating any actual or threatened environmental contamination at currently and formerly owned or operated properties, and those of our predecessors, and for contamination associated with disposal by us or our predecessors of hazardous materials at third party disposal sites. Hazardous materials may have been released at certain current or formerly owned properties as a result of historic operations.
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The presence of contamination can adversely affect the value of our properties and our ability to sell any such affected property or to use it as collateral.
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We could be held responsible for third party property damage claims, personal injury claims or natural resource damage claims relating to any such contamination.
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The cost of complying with existing environmental requirements could be significant.
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Adoption of new environmental laws or regulations or changes in existing laws or regulations or their interpretations could result in significant compliance costs or as yet identified environmental liabilities.
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Future acquisitions of businesses or properties subject to environmental requirements or affected by environmental contamination could require us to incur substantial costs relating to such matters.
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In addition, environmental laws regulating wetlands, endangered species and other land use and natural resource issues may increase costs associated with future business or expansion opportunities, delay, alter or interfere with such plans, or otherwise adversely affect such plans.
As a result of the above, we may face significant liabilities and compliance costs in the future.
ITEM 1B.
ITEM 1B. Unresolved Staff Comments
None.
ITEM 2.
ITEM 2. Properties
We own most of our administrative and maintenance facilities, central offices and remote switching platforms, and transport and distribution network facilities. Our corporate headquarters is located in Newton, Iowa in a 41,600 square foot facility that we own. We also own a 63,100-square foot building in Grinnell, Iowa, of which approximately 50% is used for our operations and approximately 50% is leased to a third party, and a 35,900-square foot warehouse and distribution center in Grinnell, Iowa. In addition we lease office space from several parties.
On February 13, 2007 we purchased the former Maytag Corporation headquarters complex in downtown Newton, Iowa. The complex consists of 8 buildings with approximately 500,000 square feet of office space. We plan to use approximately half of the space for our corporate headquarters, including our customer contact centers, and intend to lease the remainder to third parties.
Our transport and distribution network facilities include a fiber optic and copper wire backbone, and a distribution network that connects customers both to remote switch locations or the central office in their exchange and to network points of presence or interconnections with interexchange carriers. These facilities are located on land either owned by us or used by us pursuant to permits, rights of way, easements or other authorizations.
ITEM 3.
ITEM 3. Legal Proceedings
We currently, and from time to time, are involved in litigation and regulatory proceedings incidental to the conduct of our business. We are not a party to any lawsuit or proceeding that, in the opinion of our management, is likely to have a material adverse effect on us.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
PART II.
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for Common Stock
Our Common Stock is listed on the New York Stock Exchange and is traded under the symbol “IWA.” As of February 22, 2007, we had approximately 100 shareholders of record. Because many of our shares are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. The high and low reported sales prices per share of our common stock are set forth in the following table for the periods indicated.
Dividend Policy and Restrictions
Our board of directors has adopted a dividend policy which reflects an intention to distribute, as regular quarterly dividends to our shareholders, a substantial portion of the cash generated by our business in excess of operating needs, interest and principal payments on our indebtedness and capital expenditures rather than retaining all of such cash for other purposes.
We believe that our dividend policy will limit, but not preclude, our ability to pursue growth. If we continue paying dividends at the level currently anticipated under our dividend policy, we expect that we would need additional financing to fund significant acquisitions or to pursue growth opportunities requiring capital expenditures significantly beyond our current expectations. However, we intend to retain sufficient cash after the distribution of dividends to permit the pursuit of growth opportunities that do not require material capital investment.
The Board of Directors declared the following dividend distributions under our dividend policy:
Prior to announcing these dividends, we had no history of paying dividends. Dividends on our common stock are not cumulative.
Despite our dividend policy, our shareholders may not receive dividends in the future for reasons that may include any of the following factors:
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we may not have enough cash to pay dividends due to changes in our operating earnings, working capital requirements and anticipated cash needs;
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while the dividend policy adopted by our board of directors contemplates the distribution of a substantial portion of our cash available to pay dividends, our board could modify or revoke this policy at any time;
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even if our dividend policy is not modified or revoked, the actual amount of dividends distributed under the policy and the decision to make any distribution will remain at all times entirely at the discretion of our board of directors;
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the amount of dividends that we may distribute is limited by restricted payment and leverage covenants in our credit facilities and, potentially, the terms of any future indebtedness that we may incur;
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the amount of dividends that we may distribute is subject to restrictions under Iowa law; and
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our shareholders have no contractual or other legal right to dividends.
Equity Compensation Plan Information
The following table sets forth information, as of December 31, 2006, concerning compensation plans previously approved by security holders and not previously approved by security holders.
(1) Excludes 339,300 shares of common stock that have been issued as restricted stock, subject to certain vesting requirements.
2006 Performance Graph
Recent Sales of Unregistered Securities
None.
Repurchase of Equity Securities by the Issuer and Affiliated Purchasers
None.
ITEM 6.
ITEM 6. Selected Financial Data
The following selected financial data for the years ended December 31, 2002 through 2006 has been derived from our consolidated financial statements. The following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Item 7
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in combination with the selected financial data and the consolidated financial statements and notes thereto included in Items 6 and 8 herein.
Overview
General
We are the largest provider of wireline local exchange telecommunications services to residential and business customers in rural Iowa, serving over 440 communities across the state. We are the second-largest local exchange carrier in Iowa. Iowa Telecom currently operates 288 telephone exchanges as the incumbent or “historical” local exchange carrier and is the sole telecommunications company providing wireline services in approximately 85% of those exchanges. Together with our competitive local exchange carrier subsidiaries, we provide services to approximately 252,000 access lines in Iowa.
Our core businesses are the provision of local telephone service and network access to other telecommunications carriers for calls originated or terminated on our network. In addition to these core activities, which generated 74% of our total revenues in 2006, we provide long distance service, dial-up and DSL Internet access and other communications services. As part of our strategy of pursuing growth beyond our current service area, we compete for customers in adjacent markets in Iowa through our competitive local exchange carrier subsidiaries, Iowa Telecom Communications, Inc. (“ITC”) and IT Communications, LLC (“IT Communications”). Together, ITC and IT Communications are referred to as the “CLEC” or our “CLEC Operations”.
Factors Affecting Our Operating Performance
We believe that a number of industry and Company-specific factors have affected and will continue to affect our results of operations. These factors include the following:
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the effect on our revenues of declining numbers of access lines resulting from competition and other factors and our strategic response to this trend, which includes efforts to introduce enhanced local services and additional services like dial-up and DSL Internet access and long distance service and to cross-sell these services to our subscriber base;
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the effect on our revenues of our rate and pricing structure, including recent and potential future changes in rate regulation at the state and federal levels;
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the continuing effects of the implementation of 2004 and 2005 Iowa Utilities Board orders deregulating retail local service rates in 28 exchanges and the statewide election we made effective July 1, 2005;
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our ability to control our variable operating expenses, such as sales and marketing expense; and
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the development of our competitive local exchange carrier strategy.
Access Line Trends
The number of access lines served is a factor that can affect a telecommunications provider’s revenues. Consistent with a general trend in the rural local exchange carrier industry in the past few years, the number of access lines we serve as an incumbent local exchange carrier has been gradually decreasing. We expect that this trend will continue. Because substantially all of our revenues result from our relationships with customers who utilize our access lines and the level of activity recorded on those lines, the access line trend has an adverse impact on our revenues. Our response to this trend will have an important impact on our future revenues. Our primary strategy to respond to this trend is to leverage our strong incumbent market position to increase our revenue per access line by selling additional services to our customer base and to promote our DSL Internet access service offering, which is often used in lieu of additional access lines devoted to Internet usage. In
addition, we expect to add new access lines as we pursue expansion of our service area through our competitive local exchange carrier subsidiaries and, potentially, through selected acquisitions of other telecommunications companies or lines from other telecommunications companies. However, we believe that the number of access lines served is not the sole meaningful indicator of our operating prospects and that, given our relatively stable subscriber base and ability to offer additional services, average revenue per access line is also a meaningful indicator for us.
The table below indicates the total number of access lines we serve and the number of customers subscribing to the indicated types of service as of the dates and for the periods shown:
(1) Includes lines subscribed by our incumbent local exchange carrier retail customers and lines subscribed by our “wholesale” customers who are competing local exchange carriers. Wholesale access lines include: lines subscribed by our local exchange carrier competitors pursuant to interconnection agreements on an unbundled network element basis, for which the competitive local exchange carrier pays us a monthly fee; lines that we provide to competitive local exchange carriers for resale to their subscribers, for which the competitive local exchange carrier pays us a monthly fee equal to what we would charge our customers for local service less an agreed discount; and shared lines, for which a competitive local exchange carrier pays us a monthly fee to provide DSL service to its customers. We had 3,100 wholesale lines subscribed at December 31, 2006; 3,200 at December 31, 2005; and 4,600 at December 31, 2004.
(2) Access lines subscribed by retail customers of our competitive local exchange carrier subsidiaries.
We intend to continue our strategy of increasing revenues by cross-selling services to our existing customer base, in the form of both bundled service packages and individual additional services. Between December 31, 2004 and December 31, 2006, total long distance service subscribers increased by 10,800, total DSL Internet access service subscribers increased by 34,400, and total dial-up Internet access service subscribers decreased by 20,000, with much of the decrease in total dial-up subscribers being a reflection of customer migration from dial-up to DSL service.
The following is a discussion of the major factors affecting our access line counts:
Competition. Competitive local exchange carriers are offering service in approximately 44 of the 418 incumbent local exchange communities that we serve.
In addition, we have experienced and expect to continue experiencing some line losses due to competition from wireless providers, but cannot precisely quantify the effect of this competition on us. We are responding proactively to wireless competition by offering bundled service packages that include blocks of long distance minutes. These packages are designed to meet the demand of our customers who wish to purchase both local and long distance services in a package, as is typically offered by wireless providers.
Our rates for many of our retail local exchange services have been deregulated on both an exchange-by-exchange and a service-by-service basis. The Iowa Utilities Board has determined that all of the retail local exchange services we provide in 28 exchanges are subject to effective competition and has deregulated our rates in those exchanges.
Retail local exchange service deregulation became effective on July 1, 2005, pursuant to our election to deregulate our rates for all of our retail local exchange services except for single line flat-rated business and residential service and extended area service (“EAS”) in accordance with legislation enacted by the Iowa General Assembly in March 2005. In addition, single line flat-rated business and residential service and EAS will also be deregulated as of July 1, 2008 unless the Iowa Utilities Board determines that the public interest requires it to extend its jurisdiction over such services to July 1, 2010. This legislation also provides us the opportunity to increase rates for services that remain price regulated, as discussed in more detail below. We believe that the gradual deregulation of our business, on an exchange-by-exchange, and a service-by-service basis, will enable us to better respond to competitive offerings by other providers.
Mediacom’s telephony affiliate, MCC Telephony of Iowa, Inc. (“MCC”) has stated that it intends to offer voice services in certain of the communities where we operate as the incumbent local exchange carrier through a business arrangement with Sprint Communications L. P. (“Sprint”) pursuant to an interconnection agreement approved by the Iowa Utilities Board on April 24, 2006. On June 23, 2006, we filed a complaint against the Iowa Utilities Board and Sprint in the U. S. District Court for the Southern District of Iowa asking the court to rule that the Iowa Utilities Board acted unlawfully when it required us to enter into the agreement with Sprint and asking the court to invalidate the agreement. Notwithstanding the filing of our federal complaint, we have negotiated, mediated and litigated with Sprint and, at times, with MCC, to resolve issues relating to interpretation and implementation of the interconnection agreement. On January 22, 2007, we filed a second complaint against the Iowa Utilities Board and Sprint in U.S. District Court asking the court to rule that the Iowa Utilities Board acted unlawfully when it interpreted the interconnection agreement to require Iowa Telecom to provide certain services to Sprint, particularly in the manner requested by Sprint. In addition to the disputes pending in federal district court and before the Iowa Utilities Board, we are also defending a complaint filed by MCC on July 31, 2006, in the Iowa District Court for Polk County alleging that our refusal to accede to Sprint’s negotiation demands improperly interfered with MCC’s contracts and prospective customer relationships. The state court complaint seeks unspecified damages and costs and additional relief as warranted. This state court proceeding is currently stayed pending resolution of the federal complaints. How and when the disputes regarding interpretation and implementation of the interconnection agreement are ultimately resolved is uncertain, as is the ultimate outcome the federal and state litigation.
Exchange Sales. On July 1, 2006, we closed a transaction for the sale of four exchanges, representing approximately 2,000 access lines. On April 28, 2006 we closed a transaction for the sales of three exchanges, representing approximately 600 access lines.
Exchange Purchase. During July 2006, we completed the purchase of the Montezuma Mutual Telephone Company (“Montezuma Telephone”). Montezuma Telephone provides telecommunications services to 2,100 access lines, cable television service to approximately 1,350 subscribers and Internet access service to more than 950 subscribers, most of which are located in Montezuma, Iowa.
Ancillary Effects of our Data Businesses. Part of our decreasing line count has been an ancillary effect of our strategic focus on growing our dial-up and DSL Internet access service business. As our Internet service provider business expanded, some competitors have cancelled their connections to our network. These connections had historically been counted as access lines. Moreover, as we increase DSL Internet access service penetration, customer demand for second lines for dial-up Internet access service decreases accordingly because DSL Internet access service often replaces a second line dedicated to Internet usage. We believe that the revenue generated by our dial-up and DSL Internet access services outweighs the effect of these types of access line losses.
Our Retail Local Rate and Pricing Structure
As described under “Overview - Competition” above, effective July 1, 2005, the rates for all of our retail local exchange service except for single line flat-rated business and residential service and EAS were deregulated. Beginning July 1, 2005, monthly rates for single line services remaining under price regulation may
be adjusted annually by one dollar for residential lines and two dollars for business lines, plus an inflation increment, up to a monthly rate cap of $19.00 for residential lines and $38.00 for business lines. Pursuant to a January 25, 2007 interpretation by the Iowa Utilities Board, the $19.00 and $38.00 limits are inclusive of any incremental inflationary adjustments and, therefore, once met, do not permit further inflationary adjustments. These rates do not, however, include charges or Extended Area Services, which, to the extent that it is offered in conjunction with single line flat-rate service, remains regulated by the Iowa Utilities Board. Single line flat-rated business and residential service and EAS will also be deregulated as of July 1, 2008 unless the Iowa Utilities Board determines that the public interest requires it to extend its jurisdiction over such services to July 1, 2010. If the Iowa Utilities Board decides to continue price regulation to 2010, both residential and business monthly rates may be increased up to two dollars during each twelve-month period of the extension and the overall rate caps of $19.00 and $38.00 will be eliminated.
Effective January 1, 2007, our regulated monthly single line flat-rated business rate became $37.96. Effective February 1, 2007, our regulated monthly single line flat-rated residential rate became $18.99. Both rates are exclusive of EAS, taxes, fees and regulatory surcharges.
Deregulation of Retail Local Service Rates
We offer a variety of bundled packages on a deregulated basis, particularly in our competitive markets. In addition, we have also exercised our ability to modify prices on single line flat-rated residential and business services in the exchanges in which such offerings are deregulated. The ability to offer these services on a deregulated basis provides us with the flexibility to more quickly respond to new competition and enhances our ability to regain market share in previously competitive exchanges. In addition, it allows us flexibility to create bundled packages that can more effectively compete against wireless and other competitors.
Our Ability to Control Operating Expenses
We strive to control expenses in order to maintain our operating margins. We anticipate that operating expenses generally will remain stable in line with revenue growth. Because some of our operating expenses, such as those relating to sales and marketing, are variable, we believe we can calibrate expenses to growth in the business to a significant degree.
Development of our Competitive Local Exchange Carrier Strategy
Part of our business strategy is to use our competitive local exchange carrier subsidiaries, ITC and IT Communications, to pursue customers in markets in close proximity to our rural local exchange carrier markets. We plan to continue this strategy by seeking growth opportunities on a low-cost, selective basis.
As of December 31, 2006, our CLEC Operations served 23,800 access lines. Our CLEC Operations accounted for 9.4% of Iowa Telecom’s total access lines as of December 31, 2006. Throughout 2007, we plan to maintain a limited investment approach as we continue to grow our competitive local exchange carrier business.
Revenues
We derive our revenues from four sources:
Local Services. We receive revenues from providing local exchange telephone services. These revenues include monthly subscription charges for basic service, as well as charges for extended area service (mandatory expanded calling service to selected nearby communities at a flat monthly rate), local private line services and enhanced calling features, such as voice mail, caller ID and 3-way calling.
Network Access Services. We receive revenues from charges established to compensate us for the origination, transport and termination of calls generated by the customers of long distance carriers and for calls
transported and terminated for the customers of wireless carriers. These include subscriber line charges imposed on end users, and switched and special access charges paid by carriers and others. We receive federally administered universal service support, representing approximately 1% of our total revenue in 2006, as a result of the interstate switched access support provisions of the FCC’s CALLS Order to which the Company became subject in 2000. In addition, Montezuma Telephone received high cost loop universal service support amounting to less than 1% of our revenue. Switched access charges for services within Iowa are based on rates approved by the Iowa Utilities Board. Switched and special access charges for interstate and international services are based on rates approved by the FCC. The transport and termination charges paid by wireless carriers are specified in interconnection agreements negotiated with each individual wireless carrier.
Toll Services. We receive revenues for providing toll, or long distance, services to our customers. This revenue category also includes fees relating to our provision of directory assistance, operator assistance and long distance private lines.
Other Services and Sales. We receive revenues from monthly recurring charges for dial-up and DSL Internet access services. Other services and sales also include revenues from directory publishing, inside line care and the sale, installation and maintenance of customer premise voice and data equipment, or CPE.
The following table summarizes our revenues and sales from these sources:
(1) Local services revenue for 2004 includes the recognition, as a result of our rate settlement with the Iowa Utilities Board in April 2004, of $7.1 million of revenue collected in prior periods subject to refund. Excluding the prior period revenue, the percentages of total revenues and sales, for 2004 attributable to local services, network access services, toll services and other services and sales were 34%, 43%, 11%, and 12%, respectively.
Operating Expenses
Our operating expenses are categorized as cost of services and sales; selling, general and administrative expense; and depreciation and amortization.
Cost of services and sales. This includes expense for salaries and wages relating to plant operations and maintenance; other plant operations, maintenance and administrative costs; network access costs; bad debt expense; operating tax expense and cost of sales for our dial-up and DSL Internet access services and customer premise equipment products and services.
Selling, general and administrative expense. This includes expense for salaries, wages and benefits and contract service payments (e.g., legal fees) relating to customer and corporate operations; recruiting costs; expenses for travel, lodging and meals; internal communications costs; insurance premiums; and supplies and postage.
Depreciation and amortization. This includes depreciation of our telecommunications network and equipment, and amortization of intangible assets.
Results of Operations
The following table sets forth certain items reflected in our consolidated statements of income for the periods indicated, expressed as a percentage of total revenues and sales:
(1) As a result of our initial public offering in November 2004 and the concurrent refinancing of our debt, we paid, in the fourth quarter of 2004, $18.6 million for prepayment fees on the retired debt and $3.8 million of selling shareholder equity issuance costs. Therefore, other expense, net, which includes these additional transactions costs, increased to 32% in 2004. If we had excluded the one-time costs due to our initial public offering, other expense, net would have been 23% of total revenues.
Year ended December 31, 2006 compared to year ended December 31, 2005
Revenues and Sales
The table below sets forth the components of our revenues and sales for 2006 as compared to 2005:
Local Services. Local services revenues increased $847,000, or 1.1%, for 2006 as compared to 2005. The increase is primarily attributable to higher revenue from enhanced local services, which increased by $900,000 due to growth of our bundled product offerings. Local rate increases also helped to offset the impact of access line erosion. From December 31, 2005 to December 31, 2006, total access lines decreased by 6,700, including the loss of 9,700 incumbent local exchange carrier lines offset by an increase in lines served by our competitive local exchange carriers of 3,000.
Network Access Services. Our network access services revenues decreased $5.0 million, or 4.9%, for 2006 as compared to 2005. Revenues from switched access services decreased approximately $6.6 million due to decreases in access lines, access minutes per line and in the average revenue per minute of use due to a larger
shift to cellular usage. We are compensated at a slightly lower rate per minute for terminating cellular traffic. These reductions were partially offset by a $2.3 million increase in revenue from special access services.
Toll Services. Our toll services revenues decreased by $2.0 million, or 8.4%, for 2006 as compared to 2005. The number of long distance customers increased by approximately 3,800, or 2.7%. However, this increase was offset by a decrease in average minutes of use per customer and average revenue per minute.
Other Services and Sales. Other services and sales revenues increased by $8.6 million, or 27.8%, for 2006 as compared to 2005. The revenue increase was in part due to growth of our CPE and data business, primarily as a result of our acquisition of Baker Communications in August 2006. Additionally, DSL Internet access service revenues increased $5.8 million, or 51.6%, due primarily to customer growth. This increase was partially offset by decreases in dial-up Internet revenue of $2.0 million. We believe the decline in dial-up Internet access service customers is generally the result of customer migration to broadband products such as our DSL service.
Operating Costs and Expenses
The table below sets forth the components of our operating costs and expenses for 2006 as compared to 2005.
Cost of Services and Sales. Cost of services and sales increased $2.4 million, or 3.8%, for 2006 as compared to 2005. The increase was principally due to growth of our CPE and data business, primarily as a result of our acquisition of Baker Communications in August 2006.
Selling, General and Administrative Costs. Selling, general and administrative costs increased $4.6 million, or 11.1%, for 2006 as compared to 2005. The 2006 period included a pension settlement charge of approximately $3.0 million as compared to pension settlement charges of $1.5 million during 2005. During the second quarter of 2005, we amended our defined benefit pension plan. As a result of the amendment, the benefits to be paid to salaried participants at their normal retirement age of 65 are fixed. The accrued benefits for certain hourly employees subject to a mandatory benefit freeze and for those who elected to discontinue further benefit accruals were transferred to a separate plan (the “Spin-Off Plan”), which was terminated during the fourth quarter of 2006. Non-cash equity-based compensation expense for 2006 was $526,000 higher than the prior year. The 2005 period included a $2.0 million benefit resulting from past access disputes with other carriers.
Gain on sale of Properties. The 2006 period included a $4.2 million gain on the sale of exchanges.
Depreciation and Amortization. Depreciation and amortization decreased $864,000, or 1.8%, for 2006 as compared to 2005. The decrease was due to the elimination of depreciation expense on certain five-year assets in the latter part of 2005 and a reduction in our composite average depreciation rate as a result of a depreciation study that was completed during the first quarter of 2006. The lower composite average depreciation rate reduced expense during 2006 by approximately $500,000.
Other Income (Expense)
The table below sets forth other income (expense) for the year ended December 31, 2006 as compared to the same period for 2005.
Interest and Dividend Income. Interest and dividend income decreased $125,000, or 11.6%, primarily due to higher dividend income from the RTFC during 2005.
Interest Expense. Interest expense increased $619,000, or 2.0%, for 2006 as compared to 2005 principally as a result of higher interest rates on our variable rate debt and the increase in the rate on our interest rate swap agreement, resulting from the extension of the term in August 2005.
Other, Net. Other, net was a net expense of $572,000 for 2006, compared to $813,000 in 2005. The expense for 2005 included $579,000 of costs related to an amendment to our credit agreement.
Income Tax Expense
A valuation allowance had been recorded at December 31, 2005 for our deferred tax assets that expire over time to the extent that they exceeded the net deferred tax assets and liabilities resulting from reversing temporary differences. We determined that, based upon the evidence available as of December 31, 2006, that the combination of the continued generation of taxable income and the taxable income generated from reversing temporary differences will be, more likely than not, sufficient to utilize the entire deferred tax asset. As such, we have determined that no valuation allowance was required for our deferred tax assets, and we reversed the remaining valuation allowance during the period.
Income tax expense for 2006, before adjustments to the deferred tax valuation allowance, was $19.5 million. As a result of reversing the remaining valuation allowance during 2006, income tax expense was reduced by $7.2 million, resulting in net expense for the period of $12.3 million.
Our initial public offering resulted in an ownership change for purposes of Section 382 of the Internal Revenue Code, and consequently our ability to utilize our net operating losses will be subject to limitation each year. We currently anticipate that, as a result of such ownership change, we will generally be limited by Section 382 to utilizing approximately $19 million of our pre-transaction net operating losses annually. However, Internal Revenue Code Section 338 allows for an increase in this allowance by an additional $762,000, $37.4 million, $26.3 million, $18.7 million and $17.2 million, for tax periods ending in 2005 through 2009, respectively. After 2009, the IRC Section 382 limitation will apply. At December 31, 2006, the company had unused tax net operating loss carryforwards of approximately $185 million which expire in 2020 to 2024. Furthermore, we expect that we will continue to be able to take deductions related to the amortization of intangibles in excess of the amount recorded for book purposes in the amount of approximately $40 million annually through 2014.
Year ended December 31, 2005 compared to year ended December 31, 2004
Revenues and Sales
The table below sets forth the components of our revenues and sales for 2005 as compared to 2004:
Local Services. Local services revenues decreased $7.2 million, or 8.7%, for 2005, as compared to 2004, primarily due to $7.1 million of revenue collected subject to refund in prior periods and recognized during 2004. Our new rates established under the settlement agreement with the Iowa Utilities Board became effective on April 23, 2004. Also contributing to the decrease was the loss of $3.6 million in revenues resulting from the discontinuance of the expanded local area calling plans during the third quarter of 2004, as more fully described below, and the decrease in total access lines. These reductions were partially offset by the benefit of the April 23, 2004 rate increase for the entire period of 2005, which resulted in additional revenue of $2.3 million. In addition, we experienced an increase in revenue from enhanced local services of $1.1 million for 2005 as compared to 2004, due to the growth of bundled product offerings. From December 31, 2004 to December 31, 2005, total access lines decreased by 8,300 including the loss of 13,900 incumbent local exchange carrier lines and an increase in lines served by our competitive local exchange carriers of 5,600.
Our historical ability to provide expanded local calling plans at favorable margins depended on the existence of an agreement for mutual exchange of traffic with another telecommunications provider. That agreement terminated on July 31, 2004. As a result, we discontinued the expanded local calling plans and encouraged customers who subscribed to our expanded local calling plans to replace those plans with substitute services. The termination of the agreement for mutual exchange of traffic and discontinuance of our expanded local calling plans have affected several of our revenue streams and our costs of services and sales. Local services revenue for 2004 included $3.6 million from the expanded local calling plans that have been discontinued. While that revenue stream has ended, we have increased our long distance and access revenues as subscribers migrate from our expanded local calling plans to toll plans.
Network Access Services. Our network access services revenues increased $6.3 million, or 6.6%, for 2005 as compared to 2004. Revenues from switched access services increased approximately $6.2 million, due primarily to an increase in access minutes per line which is due in part to the elimination of the expanded local calling plans.
Toll Services. Our toll services revenues increased by $646,000, or 2.8%, for 2005 as compared to 2004. This revenue growth was attributable to an increase in the number of long distance customers of approximately 7,000, or 5.2%, partially offset by a decrease in average minutes of use per customer and average revenue per minute.
Other Services and Sales. Other services and sales revenues increased by $3.8 million, or 14.0%, for 2005 as compared to 2004. The revenue increase was primarily due to growth in the number of DSL Internet customers. DSL Internet access service revenues increased $5.5 million, or 97.5%, due primarily to customer growth. This increase was partially offset by a decrease in dial-up Internet-revenues of $1.1 million and a decline
in revenue from customer premise equipment sales of $483,000. We believe the decline in dial-up Internet access service customers is generally the result of customer migration to broadband products such as our DSL service.
Operating Costs and Expenses
The table below sets forth the components of our operating costs and expenses for 2005 as compared to 2004.
Cost of Services and Sales. Cost of services and sales increased $8.4 million, or 15.0%, for 2005 as compared to 2004. The increase in long distance customers, coupled with the termination of the historical agreement for the exchange of traffic related to our discontinued local calling plans, resulted in approximately $4.4 million of additional cost to deliver long distance traffic. As a result of customer growth, we experienced an increase in competitive local exchange carrier access lines which, in turn, raised costs for providing this service by $3.3 million for 2005 as compared to 2004.
Selling, General and Administrative Costs. Selling, general and administrative costs increased $4.3 million, or 11.5%, for 2005 as compared to 2004. The 2005 period includes a $2 million favorable impact resulting from past access disputes with other carriers. Offsetting this favorable impact was a $4.8 million increase in salary, wages and benefits, $1.4 million of external costs related to Sarbanes Oxley compliance and other costs related to being a publicly traded company. Salary, wages and benefits for 2005 includes a pension settlement charge of approximately $1.5 million for distributions related to amendments to the pension plan during the second quarter of 2005. The amendments to the plan will reduce our future pension obligations. Also contributing to the increase in salaries, wages and benefits was additional non-cash equity-based compensation expense of $1.7 million related to exercise price reductions on vested outstanding stock options under the 2002 Stock Incentive Plan to reflect the dividends on our common stock and expense for the unvested shares issued under the 2005 Stock Incentive Plan.
Depreciation and Amortization. Depreciation and amortization increased $659,000, or 1.4%, for 2005 as compared to 2004. This was primarily due to higher average property, plant and equipment balances relating mainly to additions to our network facilities.
Other Income (Expense)
The table below sets forth other income (expense) for the year ended December 31, 2005 as compared to the same period for 2004.
Interest and Dividend Income. Interest and dividend income decreased $3.0 million, or 73.4%, primarily due to the reduction in patronage dividend income from the Rural Telephone Finance Cooperative Subordinated Capital Certificates, which were partially redeemed in connection with the initial public offering and debt refinancing in November 2004.
Interest Expense. Interest expense decreased $24.6 million, or 44.1%, for 2005 as compared to 2004, principally as a result of the reductions in the amount of debt outstanding, and in the average interest rate on our new debt issued in connection with our debt refinancing in November 2004.
Other, Net. Other, net was a net expense of $813,000 for 2005 compared to $21.2 million in 2004. The expense for 2005 includes $579,000 of costs related to an amendment to our credit agreement, which resulted in a reduction in the interest rate on the Term B loans, and our interest rate swap agreement as described in “- Long-Term Debt and Credit Facilities.” The costs in 2004 relate primarily to our initial public offering, which resulted in one-time expenses of $22.4 million in the fourth quarter of 2004. The transaction-related expenses included prepayment fees on the retired debt of $18.6 million and $3.8 million of selling shareholder equity issuance costs.
Income Tax Expense: A valuation allowance had been provided at December 31, 2005 for our deferred tax assets that expire over time to the extent that they exceed the net deferred tax assets and liabilities resulting from reversing temporary differences. Prior to fiscal 2005, we had not paid income taxes. During fiscal 2005, we paid $140,000 of alternative minimum tax.
As of December 31, 2005, the balance of the valuation allowance was approximately $6 million. Our unused tax net operating loss carryforward was approximately $211 million, and will expire between 2020 and 2024. As of December 31, 2005 we have a $140,000 Alternative Minimum Tax (“AMT”) credit carryforward. No valuation allowance has been provided for the AMT credit carryforward due to its indefinite life.
Redemption of Preferred Stock: On March 26, 2004, we repurchased our Series A mandatorily redeemable convertible preferred stock and related accrued dividends for an aggregate purchase price of $100 million. The recorded amounts of the preferred stock and the related accrued preferred stock dividend were $125 million and $32.7 million, respectively, as of the redemption date of March 26, 2004.
Liquidity and Capital Resources
Our short-term and long-term liquidity requirements arise primarily from: (i) interest payments related to our credit facilities; (ii) capital expenditures; (iii) working capital requirements; (iv) dividend payments on our common stock; (v) potential acquisitions and (vi) our pension obligation as described below.
The table below reflects the dividends declared or paid by the Company during 2006:
Our intention is to distribute a substantial portion of the cash generated by our business to our shareholders in regular quarterly dividends to the extent we generate cash in excess of operating needs, interest and principal payments on our indebtedness, and capital expenditures.
We intend to fund our operations, interest expense, capital expenditures, working capital requirements and dividend payments on our common stock with cash from operations. For 2006 and 2005, cash provided by operating activities was $89.5 million and $97.3 million, respectively.
During the second quarter of 2005, we amended our defined benefit pension plan to freeze the accrued benefit for all salaried participants and for certain hourly participants and to permit certain other hourly participants to elect to discontinue further benefit accruals. As a result of the amendment, the benefits to be paid to salaried participants at their normal retirement age of 65 are fixed. The accrued benefits for hourly employees subject to the mandatory benefit freeze and for those who elect to discontinue further benefit accruals were transferred to a separate plan (the “Spin-Off Plan”). The Spin-Off Plan was terminated during the third quarter, with almost all benefits distributed in the fourth quarter. As a result of the amendment and Spin-Off Plan termination, the number of employees accruing further benefits under the defined benefit pension plan has been reduced to approximately 40 from 175.
The total pension expense for the Spin-Off Plan in 2006 was approximately $3.5 million. We recognized $510,000 of SFAS 87 periodic pension costs and a $3.0 million settlement loss for the Spin-Off during 2006. Cash funding upon the termination of the Spin-Off Plan was approximately $5.9 million. The total pension expense for the continuing pension plan in 2006, excluding costs related to the Spin-Off Plan, was $766,000.
To fund any significant future acquisitions, we intend to use borrowings under our revolving credit facility or, subject to the restrictions in our credit facilities, to arrange additional funding through the sale of public or private debt and/or equity securities, including common stock, or to obtain additional senior bank debt.
Our ability to service our indebtedness will depend on our ability to generate cash in the future. We are not required to make any scheduled principal payments under our credit facilities, which will mature in 2011. However, we may be required to make annual mandatory prepayments under our new credit facilities with a portion of our available cash. We will need to refinance all or a portion of our indebtedness on or before maturity in 2011.
The dividend policy adopted by our board of directors calls for us to distribute a substantial portion of our cash flow to our shareholders. As a result, we may not have significant cash available to meet any large unanticipated liquidity requirements, other than through available borrowings, if any, under our revolving credit facility. Therefore, we may not have a sufficient amount of cash to finance growth opportunities, including acquisitions, to fund unanticipated capital expenditures or to fund our operations. If we do not have sufficient cash for these purposes, our financial condition and our business could suffer. However, our board of directors may, in its discretion, amend or repeal this dividend policy to decrease the level of dividends provided for under the policy, or discontinue entirely the payment of dividends.
We have historically funded our operations and capital expenditure requirements primarily with cash from operations and our revolving line of credit. The following table summarizes our short-term liquidity and Adjusted Total Debt and Adjusted EBITDA, as defined in our credit agreement, as of December 31, 2005 and 2006:
The decrease in net working capital from December 31, 2005 to December 31, 2006 is primarily due to the lower cash balance.
The following table summarizes our sources and uses of cash for the years ended December 31, 2004, 2005 and 2006.
Cash Provided by Operating Activities
For the years ended December 31, 2004, 2005, and 2006, cash provided by operating activities was $76.6 million, $97.3 million, and $89.5 million, respectively. The increase of $20.7 million for 2005 as compared to 2004 was primarily attributable to the increase in net income for the period. The decrease of $7.8 million for 2006 as compared to 2005 was primarily attributable to the additional funding for the pension Spin-Off Plan of approximately $5.9 million.
Cash (Provided by) Used in Investing Activities
The table below sets forth the components of cash (provided by) used in investing activities for the years ended December 31, 2004, 2005, and 2006:
In April 2004, our incumbent local exchange carrier reached a settlement agreement with the Iowa Utilities Board and other parties. Pursuant to the settlement agreement, we are obligated to invest substantially all additional revenues generated by the allowed increase in our rates, except for revenues resulting from inflation adjustments, on capital improvements identified in our network improvement plan. This investment is in addition to our baseline level of network capital expenditures, which was assumed to be $16 million per year during the initial period of the plan. The initial period continued until we had spent $38.9 million of cumulative capital expenditures in excess of our assumed baseline investment level. This requirement was satisfied in 2006. Beginning in 2007, both the baseline and the incremental investment levels will increase or decrease consistent with access line changes and further deregulation. We expect that a minimum annual capital investment of approximately $18 million will satisfy the ongoing commitments.
We expect that total capital expenditures, including those pursuant to the settlement agreement and the approximate $2 million incremental expenditures required for the acquisition and upgrade of our new headquarters facility, will be between approximately $25 million and $27 million in fiscal 2007. We expect to fund all of these capital expenditures through cash generated by our operations. Our capital expenditures can fluctuate from quarter to quarter, and are impacted to some extent by factors beyond our control, such as customer demand, the level of construction activity in our region, and weather.
During the first quarter of 2006, we received the required regulatory approval for the sale of three exchanges representing approximately 600 access lines. We closed the transaction on April 28, 2006 and received net proceeds of approximately $4.8 million. During April 2006 we received the final regulatory approval for the sale of four additional exchanges representing approximately 2,000 access lines. We closed the transaction on July 1, 2006 and received net proceeds of approximately $8.4 million.
On July 1, 2006, we completed the purchase of the Montezuma Mutual Telephone Company (“Montezuma Telephone”) for a total purchase price of $11.9 million, inclusive of $1.2 million in cash and working capital and
$222,000 of direct transaction costs. Montezuma Telephone provides telecommunications services to 2,100 access lines, cable television service to approximately 1,350 subscribers and Internet access service to more than 950 subscribers, most of which are located in Montezuma, Iowa.
On August 1, 2006, we completed the purchase of Baker Communications, Inc. for a total purchase price of $8.8 million, inclusive of $359,000 in cash and working capital, which are subject to certain future adjustments, and $148,000 of direct transaction costs. Baker Communications designs, develops, and provides ongoing support of technology solutions for clients. Areas of specialization include enterprise voice solutions, IP communications and data networking. Baker Communications is headquartered in Des Moines, Iowa, with additional offices in Cedar Rapids, Iowa and Omaha, Nebraska.
During the third quarter of 2006, we participated in the FCC’s auction of Advanced Wireless Services licenses in the 1710-1755 MHz and 2110-2155 MHz bands (AWS-1) (Auction No. 66). Prior to the commencement of the auction, we deposited $3.1 million to establish bidding credits. In September 2006, we were the successful bidder for 15 licenses in Iowa covering a population area of approximately 1.9 million and the majority of our local exchange serving area for a total amount of approximately $11.5 million. On October 19, 2006, we paid the balance due of approximately $8.4 million. In order to renew such licenses after their initial 15-year term, certain build out requirements must be met, the precise amount of which has not been determined.
On August 4, 2004, the FCC adopted rules requiring certain telecommunications carriers to begin reporting additional information to the FCC in the event of selected service outages and related events affecting some fiber rings. On December 20, 2004, the FCC stayed the rules’ effectiveness pending agency reconsideration of their merits, in part due to concerns about the substantial expenditures required of telecommunications carriers in order to comply with the new reporting obligations. At this time, we cannot predict the consequences of the FCC’s reconsideration or the financial or operational impacts any final rules may have on us.
On September 23, 2005, the FCC released an order determining that facilities-based broadband providers and providers of interconnected voice over Internet Protocol (“VoIP”) services must be prepared to accommodate law enforcement wiretaps pursuant to the Communications Assistance with Law Enforcement Act (“CALEA”) by May 14, 2007. On May 12, 2006, the FCC released a follow-up order further detailing compliance obligations, although uncertainty remains regarding technical aspects of such compliance. We cannot predict whether and when the FCC might modify such regulations or any other rules, or what compliance with new rules might cost.
Cash Used in Financing Activities
For the year ended December 31, 2006, net cash used in financing was $58.2 million, consisting primarily of dividends on common stock of $51.0 million and a reduction in the balance outstanding on the revolving credit facility of $9.0 million. For the year ended December 31, 2005, net cash used in financing activities was $43.2 million, consisting primarily of dividends on common stock. For the year ended December 31, 2004, net cash used in financing activities was $116.3 million due primarily to the use of $36 million of cash on hand to redeem the Redeemable Convertible Preferred Stock and the net impact of our initial public offering and the related refinancing.
Long-Term Debt and Revolving Credit Facilities
Credit Facilities
As a part of our initial public offering and the related debt refinancing in 2004, we entered into an Amended and Restated Credit Agreement with the Rural Telephone Finance Cooperative, as administrative agent, and a group of lenders, including the Rural Telephone Finance Cooperative, providing for a total of up to $577.8 million in term and revolving credit facilities, and simultaneously retired the previously outstanding senior credit
facility with the Rural Telephone Finance Cooperative. In August 2005, we entered into amendments to the credit agreement that reduced the applicable interest rates and clarified certain definitions. As of December 31, 2006, we had outstanding $477.8 million of senior debt under the term facilities, and had $31.0 million drawn under the $100 million revolving credit facility. The details of the credit facilities are as follows:
The revolving credit facility will expire in 2011 and permits borrowings up to the aggregate principal amount of $100 million (less amounts reserved for letters of credit up to a maximum amount of $25 million). As of December 31, 2006, $31.0 million was outstanding on the revolving credit facility, $50,000 under letters of credit and $69.0 million was available. Borrowings under the revolving credit facility bear interest per annum at either (a) the London inter-bank offered rate, or LIBOR, plus 2.0% or (b) a base rate plus 1.0%. As of December 31, 2006, we had $31 million outstanding under LIBOR elections at an average all-in rate of 7.36%.
Term Loan B is a $400.0 million senior secured term facility maturing in 2011, bearing interest per annum at either (a) a LIBOR rate plus an applicable rate adder or (b) a base rate election plus an applicable rate adder. On August 26, 2005, the Company entered into Amendment No. 1 to the credit facilities. Amendment No. 1 reduced the applicable rate adder for Term Loan B (i) from 1.00% to 0.75% per annum for the base rate, and (ii) from 2.00% to 1.75% per annum for the LIBOR rate. As of December 31, 2006, $350 million was based upon a LIBOR election effective through March 29, 2007, at an all-in rate of 7.12%. We have entered into interest rate swap agreements to fix the rate on $350 million of Term Loan B as more fully described below. As of December 31, 2006, the interest rate on the remaining $50 million was based upon a LIBOR election effective through June 12, 2007 at an all-in rate of 7.08%.
Term Loan C is a $70.0 million senior secured term facility maturing in 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. Upon the expiration of the 6.65% fixed interest rate on Term Loan C in November 2007, the interest rate on such term loan will convert to the Rural Telephone Finance Cooperative base variable rate plus 0.85%.
Term Loan D is a $7.8 million senior secured term facility maturing in 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. Upon the expiration of the 6.65% fixed interest rate on Term Loan D in November 2007, interest on such term loan will convert to the Rural Telephone Finance Cooperative base variable rate plus 0.85%.
As a condition of borrowing under Term Loans C and D, we are required to invest $7.8 million, representing 10% of the total amounts of Term Loans C and D, in Subordinated Capital Certificates (“SCCs”) of the Rural Telephone Finance Cooperative. SCCs are non-interest bearing but, as a member of the Rural Telephone Finance Cooperative, we share proportionately in the institution’s net earnings. The Rural Telephone Finance Cooperative will redeem the SCCs in proportion to our principal repayments on Term Loans C and D.
The credit facilities are secured by substantially all of our tangible and intangible assets, properties and revenues as well as those of all of our subsidiaries. The credit facilities are guaranteed by all of our subsidiaries.
The credit facilities permit us to pay dividends to holders of our common stock; however, they contain significant restrictions on our ability to do so. The credit facilities contain certain negative covenants that, among other things, limit or restrict our ability (as well as those of our subsidiaries) to: create liens and encumbrances; incur debt, issue preferred stock, or enter into leases and guarantees; enter into loans, investments and acquisitions; make asset sales, transfers or dispositions; change lines of business; enter into hedging agreements; pay dividends, redeem stock, or make certain restricted payments; amend material debt agreements or other material contracts; engage in certain transactions with affiliates; enter into sale/leaseback or synthetic lease transactions; grant negative pledges or agree to such other restrictions relating to subsidiary dividends and distributions; make changes to our fiscal year; and engage in mergers and consolidations.
The credit facilities require us, subject to certain exceptions, to prepay outstanding loans under the credit facilities to the extent of net cash proceeds received from the following: issuance of certain indebtedness;
proceeds of certain asset sales; and casualty insurance proceeds. The credit facilities further require us, subject to certain exceptions, to make prepayments under the credit facilities equal to 50% of any net increase in the following: distributable cash during a dividend suspension period, as defined; and cumulative distributable cash, as defined, during the fiscal year less the cumulative reductions of revolving loans through such period, with reductions to the percentage to be determined based on improvements in certain credit ratios. As of December 31, 2006, no prepayment amounts were due under these provisions.
The credit facilities generally permit voluntary prepayments of the term loans and reductions of commitments without penalty or premium, other than standard breakage costs.
In addition, the financial covenants under the credit facilities specify, among other things, certain fixed charge coverage ratios and a maximum total leverage ratio, as defined, all of which we were in compliance with as of December 31, 2006.
Interest Rate Swaps
On August 26, 2005, we amended the swap arrangements that were originally entered into on November 4, 2004. The amended swap arrangements effectively fixed the interest rate we will pay on $350 million of our indebtedness under Term Loan B. The purpose of the swap agreements was to adjust the interest rate profile of our debt obligations and to achieve a targeted mix of floating and fixed rate debt. As a result of these arrangements, the effective all-in interest rate on $350.0 million of indebtedness under Term Loan B for the period beginning August 31, 2005 and ending November 23, 2011 will be 5.865%.
Obligations and Commitments
Our ongoing capital commitments include capital expenditures and debt service requirements. For 2006 our capital expenditures were $28.1 million; see “-Liquidity and Capital Resources-Cash (Provided by) Used in Investing Activities.”
The following table sets forth our contractual obligations as of December 31, 2006, together with cash payments due in each period indicated.
(1) Excludes interest payments on variable rate long-term debt that has not been fixed through hedging arrangements. Amounts include the impact of hedging arrangements.
(2) Excludes the working capital payment for the purchase of Baker Communications, Inc. of approximately $359,000, which was paid on February 6, 2007.
As of December 31, 2006, we had one outstanding letter of credit in the amount of $50,000.
We currently project that cash provided by operations will be adequate to meet our foreseeable operational liquidity needs for the next 12 months. However, our actual cash needs and the availability of required funding may differ from our expectations and estimates, and those differences could be material. Our future capital
requirements will depend on many factors, including, among others, the demand for our services in our existing markets and regulatory, technological and competitive developments.
Critical Accounting Policies
The process of preparing financial statements requires the use of estimates on the part of management. The estimates used by management are based on our historical experiences combined with management’s understanding of current facts and circumstances. Certain of our accounting policies are considered critical, as they are both important to the portrayal of our financial statements and require significant or complex judgments on the part of management. The following is a summary of certain policies considered critical by management:
Impairment of Long-Lived Assets (Including Property, Plant and Equipment), Goodwill and Identifiable Intangible Assets. We reduce the carrying amounts of long-lived assets, goodwill and identifiable intangible assets to their fair values when the fair value of such assets is determined to be less than their carrying amounts. Fair value is typically estimated using a discounted cash flow analysis, which requires us to estimate the future cash flows anticipated to be generated by the particular asset being tested for impairment, and to select a discount rate to measure the present value of the anticipated cash flows. When determining future cash flow estimates, we consider historical operating results, as adjusted to reflect current and anticipated operating conditions. Estimating future cash flows requires significant judgment by us in such areas as future economic conditions, industry specific conditions and necessary capital expenditures. The use of different assumptions or estimates for future cash flows could produce different impairment amounts (or none at all) for long-lived assets, goodwill and identifiable intangible assets.
We are required to perform an annual impairment review of goodwill as required by SFAS No. 142. No impairment of goodwill or other long-lived assets resulted from the annual valuation of goodwill we conducted in August 2006.
Revenue Recognition. Revenues are recorded based upon services provided to customers. We record unbilled revenue representing the estimated amounts customers will be billed for services rendered since the last billing date through the end of a particular month. The unbilled revenue estimate is reversed in the following month when actual billings are made.
Allowance for Doubtful Accounts. Our allowance for doubtful accounts reflects reserves for customer receivables to reduce receivables to amounts expected to be collected. In estimating uncollectible amounts, management considers factors such as current overall economic conditions, industry-specific economic conditions, historical customer payment trends and anticipated customer payment trends. While we believe our process effectively addresses our exposure for doubtful accounts, changes in economic, industry or specific customer conditions may require adjustment to the allowance for doubtful accounts recorded by us.
Income Taxes. Management calculates the income tax provision, current and deferred income taxes, along with the valuation allowance based upon various complex estimates and interpretations of income tax laws and regulations. Deferred tax assets are reduced by a valuation allowance to the extent that it is more likely than not they will not be realized.
A valuation allowance had been provided at December 31, 2005 for our deferred tax assets that expire over time to the extent that they exceeded the net deferred tax assets and liabilities resulting from reversing temporary differences. We determined that, based upon the evidence available as of December 31, 2006, that the combination of the continued generation of taxable income and the taxable income generated from reversing temporary differences will be, more likely than not, sufficient to utilize the entire deferred tax asset. As such, we have determined that no valuation allowance was required for our deferred tax assets, and we reversed the remaining valuation allowance during the period.
Income tax expense for the twelve months ended December 31, 2006, before adjustments to the deferred tax valuation allowance was $19.5 million. As a result of reversing the remaining valuation allowance during the
twelve months ended December 31, 2006, income tax expense was reduced by $7.2 million resulting in net expense for the period of $12.3 million. During fiscal 2006, we paid $964,000 of alternative minimum tax.
At December 31, 2006, our unused tax net operating loss carryforward was $185 million, and will expire between 2020 and 2024. The amount of net operating loss allowable to offset income after a change in ownership is limited under Internal Revenue Code (“IRC”) Section 382. However, IRC Section 338 may allow for an increase in this allowance for the periods ending in 2006 through 2009. IRC Section 382 will continue to apply after 2009. Furthermore, we expect that we will continue to be able to take deductions related to the amortization of intangibles in excess of the amount recorded for book purposes in the amount of approximately $40 million annually through 2014.
Employee-Related Benefits. We incur certain employee-related benefits associated with pensions and other postretirement health care benefits (“OPEB”). We use third party specialists to assist management in appropriately measuring the expenses associated with these employee-related benefits. In order to measure the expense associated with these employee-related benefits, management must make a variety of estimates, including discount rates used to measure the present value of certain liabilities, assumed rates of return on assets set aside to fund these expenses, compensation increases, employee turnover rates, anticipated mortality rates and anticipated healthcare costs. The estimates used by management are based on our historical experience, as well as current facts and circumstances. Different estimates could result in our recognizing different amounts of expense over different time periods. We evaluate our critical assumptions at least annually, and selected assumptions are based on the following factors:
•
The discount rate is based on a hypothetical portfolio of high quality bonds with cash flows matching our expected benefit payments;
•
The expected return on plan assets is based on our asset allocation mix and our historical return, taking into consideration current and expected market conditions; and
•
The healthcare costs trend rate is based on our historical rates of inflation and expected market conditions.
The following table presents the key assumptions used to measure pension and OPEB expense for 2006 and the estimated impact on the continuing pension plan and OPEB expense relative to a change in those assumptions:
Off-Balance Sheet Risk and Concentration of Credit Risk
The Company has no known off-balance sheet exposure or risk.
Certain financial instruments potentially subject us to concentrations of credit risk. These financial instruments consist primarily of trade receivables, interest rate swap agreements, cash, and cash equivalents.
We place our cash and temporary cash investments with high credit quality financial institutions. We also periodically evaluate the credit worthiness of the institutions with which we invest.
We have entered into interest rate swap agreements to adjust the interest rate profile of our debt obligations and to achieve a targeted mix of floating and fixed rate debt. The floating rate payers under the interest rate swap agreements are nationally recognized counterparties. While we may be exposed to losses due to non-performance of the counterparties or the calculation agents, we consider the risk remote and do not expect the settlement of these transactions to have a material adverse effect on our financial condition or results of operations.
New Accounting Pronouncements
In September 2006, the FASB released Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”). SFAS 158 requires that we recognize the over-funded or under-funded status of our defined benefit and retiree medical plans as an asset or liability in our 2006 year-end balance sheet, with changes in the funded status recognized through comprehensive income in the year in which they occur. The Company was required to adopt the recognition and disclosure provisions of SFAS 158 as of December 31, 2006.
The following table illustrates the incremental effect of applying SFAS Statement No 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” on individual line items in the Balance Sheet as of December 31, 2006.
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes” (“SFAS 109”). Guidance is provided on derecognition, classification, interest and penalties accounting in interim periods, disclosure and transition. FIN 48 requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Adoption of FIN 48 on January 1, 2007, is not expected to have a material effect on our financial position, results of operations or cash flows.
In December 2004, the FASB issued SFAS No. 123 (Revised), “Share-Based Payment” (“SFAS 123(R)”). This statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires companies to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees and to record compensation cost for all stock awards granted after the required effective date and to awards modified,
repurchased, or cancelled after that date. Previously, we had accounted for stock-based compensation under the fair value recognition provisions of SFAS 123. Adoption of SFAS 123(R) on January 1, 2006 did not have a material effect on our financial position, results of operations or cash flows because all of our outstanding stock options were fully vested at the date of issuance of SFAS 123(R). Additional grants of stock-based awards under the 2005 Incentive Plan or modifications to outstanding stock options after the effective date of the standard and may result in additional compensation expense pursuant to the provisions of SFAS 123(R).
Inflation
We do not believe that inflation has a significant effect on the financial results of our operations.
ITEM 7A.
ITEM 7A. Quantitative And Qualitative Disclosures About Market Risk
Our short-term excess cash balance, if any, is typically invested in short-term commercial paper. We do not invest in any derivative or commodity type instruments. Accordingly, we are subject to minimal market risk on our investments.
Under the terms of our credit facilities as amended, our long-term secured debt facilities will mature November 2011. Our $400.0 million of indebtedness under Term Loan B, maturing in 2011, bears interest per year at either (a) LIBOR plus 1.75% or (b) a base rate plus 0.75%. On August 26, 2005, we entered into an interest rate swap agreement with nationally recognized counterparties for the purpose of fixing the interest on a portion of these borrowings. Pursuant to the swap agreement, we will pay a fixed rate of interest on Term Loan B on a notional $350.0 million from August 31, 2005 through November 23, 2011.
We pay interest at a fixed rate on all borrowings under Term Loans C and D through November 2007. Thereafter, we expect our interest rates under Term Loans C and D to convert to the Rural Telephone Finance Cooperative variable rate then in effect, as provided in the credit facilities.
We are exposed to interest rate risk, resulting primarily from fluctuations in LIBOR, with respect to: $50.0 million of borrowings under Term Loan B through November 2011. Similarly, changes in LIBOR will be the primary source of interest rate risk we face with respect to the $31.0 million of borrowings drawn under the revolving credit facility at December 31, 2006. With respect to our $77.8 million of borrowings under Terms Loan C and D, we are exposed to interest rate risk, resulting primarily from fluctuations in the Rural Telephone Finance Cooperative’s variable rate, from November 2007 through maturity in November 2011. A one percent change in the underlying interest rates for the variable rate debt that was outstanding on December 31, 2006 would have an impact of approximately $810,000 per year on our interest expense while our fixed rates and swaps are in place.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Iowa Telecommunications Services, Inc. and subsidiaries
Newton, Iowa
We have audited the accompanying consolidated balance sheets of Iowa Telecommunications Services, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2006, and the related consolidated statements of income, of stockholders’ equity and comprehensive income and of cash flows for each of the three years in the period ended December 31, 2006. 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Iowa Telecommunications Services, Inc. and subsidiaries as of December 31, 2005 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, as of December 31, 2006.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 5, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ Deloitte & Touche LLP
Des Moines, Iowa
March 5, 2007
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2005 AND 2006
(Dollars in Thousands Except Per Share Amounts)
See notes to consolidated financial statements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
(Dollars in Thousands, Except Per Share Amounts)
See notes to consolidated financial statements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
(Dollars in Thousands Except Per Share Amounts)
See notes to consolidated financial statements
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
(Dollars in Thousands)
SUPPLEMENTAL NONCASH INVESTING AND FINANCING ACTIVITIES:
During the years ended December 31, 2004, 2005 and 2006, the Company recorded undeclared and unpaid preferred stock dividends of $2,056, $0 and $0, respectively.
Dividends on common stock of $5,401 were declared on December 17, 2004 and paid on January 17, 2005. Dividends on common stock of $12,680 were declared on December 16, 2005 for shareholders of record as of December 30, 2005 and paid on January 17, 2006. Dividends on common stock of $12,846 were declared on December 15, 2006 for shareholders of record as of December 29, 2006 and paid on January 16, 2007.
See notes to consolidated financial statements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
1. ORGANIZATION
Business Description-Iowa Telecommunications Services, Inc. and subsidiaries (“Iowa Telecom” or the “Company”) is the second largest incumbent local exchange carrier (ILEC) in the State of Iowa and is estimated to be one of the top 20 largest ILECs in the United States, with an integrated telecommunications network serving approximately 288 local exchanges with approximately 252,000 total access lines. Iowa Telecom provides local, long distance and Internet access and communications equipment primarily to rural residential and business customers, and provides access services to interexchange carriers (IXCs) and other communications companies. The Company primarily operates on a regulatory basis under intrastate price cap regulation in the State of Iowa and under various FCC regulations for its interstate services. The Company manages its business as one operating segment.
Basis of Consolidation-The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Iowa Telecommunications Services, Inc., the parent company, is an operating company. For 2006, the parent company represents approximately 93% of total revenues, approximately 96% of net income and over 97% of total assets of the consolidated company. The subsidiaries, individually and in the aggregate, are not material as they represent less than 10% of consolidated revenue, earnings and total assets.
Revenue Recognition-Revenue is recognized when evidence of an arrangement exists, the earning process is complete and collectibility is reasonably assured. The prices for regulated services are filed in tariffs with the appropriate regulatory bodies that exercise jurisdiction over the various services.
Local Services-Monthly recurring local line charges are billed to end users in advance. Revenue is recognized during the period these services are rendered. Billed but unearned revenue is deferred and recorded as a current liability included in advance billings and customer deposits.
Network Access Services-Network access revenue primarily consists of switched access revenue billed to other carriers. Switched access revenue is billed in arrears based on originating and terminating minutes of use. Earned but unbilled switched access revenue is included in receivables. Network access revenue also contains special access revenue. Special access revenue is billed in advance based on recurring fees and recognized in revenue during the period services are provided. Network access revenue and special access revenue is recognized in the month services are provided.
Toll Services-Toll services are typically billed to end users in arrears based on actual usage. Earned but unbilled toll services are included in receivables. Toll service revenue is recognized in the month services are provided.
Other Services and Sales-Other services and sales consist primarily of dial-up and DSL Internet access services. Other services and sales also include revenues from directory publishing, inside line care and the sale, installation and maintenance of customer premise voice and data equipment, or CPE. The monthly recurring charges for dial-up and DSL Internet access services and inside line care are billed to end users in advance. Revenue is recognized during the period these services are provided. Billed but unearned revenue is included in advance billings and customer deposits. The Company recognizes directory services revenue on a straight-line basis over the twelve month period in which the corresponding directory is distributed. The Company recognizes the revenue from the sale and maintenance of CPE in the period the sale or service is rendered.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
Cash and Cash Equivalents-Cash and cash equivalents include cash and temporary investments with maturities at acquisition of three months or less.
Estimating Valuation Allowances-The Company must make estimates of the uncollectability of its accounts receivables. The Company specifically analyzes accounts receivables and historic bad debts, customer concentrations, customer creditworthiness, current economic trends and changes in its customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.
Inventories-Inventories, which consists mainly of cable, supplies and replacement parts, are stated at the lower of cost, determined principally by the average cost method, or net realizable value.
Property and Depreciation-Property, plant and equipment are carried at cost. Depreciation has been calculated using the composite remaining life methodology and straight-line depreciation rates. This method depreciates the remaining net investment in telephone plant, less anticipated net salvage value, over remaining economic asset lives by asset category. This method requires the periodic review and revision of depreciation rates. The economic asset lives used are as follows: buildings - 20 years; cable and wire - 7-20 years; switching and circuit equipment - 10 years; and other property - 5-10 years. When depreciable telephone plant is retired in the normal course of business, the amount of such plant is deducted from the respective plant and accumulated depreciation accounts with no gain or loss recognized.
The Company completed a review of the depreciation rates during the first quarter of 2006. The revised depreciation rates were made effective January 1, 2006 and decreased the composite depreciation rates from 9.8% to 9.6%. The effect of this change in accounting estimate is expected to be a reduction to depreciation expense of approximately $500,000 on an annualized basis, based on the levels of property, plant, and equipment as of December 31, 2005.
Goodwill and Other Intangible Assets-Goodwill and indefinite-lived intangible assets are not amortized but are reviewed annually (or more frequently under various conditions) for impairment in accordance with Statement of Financial Accounting Standard (SFAS) No. 142, “Goodwill and Other Intangible Assets”. Impairment occurs when the fair value of the asset is less than its carrying value. The Company performs its annual goodwill impairment test during the third quarter, primarily using discounted cash flow and market value of equity and debt methodologies. Intangible assets with definite lives include the value assigned to customer base and easements at the date of acquisition, which are being amortized using a straight-line method over 6 to 20 years.
While our wireless licenses are issued for only a fixed time, such licenses are subject to renewal by the FCC. Renewals of licenses occur routinely and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful life of our wireless licenses. As a result, we treat the wireless licenses as an indefinite-lived intangible asset under the provisions of SFAS No. 142.
Impairment of Long-Lived Assets-The Company assesses the recoverability of long-lived assets, including property, plant and equipment and definite-lived intangible assets, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In such cases, if the sum of the expected cash flows (undiscounted and without interest) resulting from the use of the asset are less than the carrying amount, an impairment loss is recognized based on the difference between the carrying amount and the fair value of the assets. No impairment loss has been recognized to date.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
Debt Issuance-Deferred financing costs are amortized over the term of the related debt issuance.
Income Taxes-Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities at each balance sheet date using enacted tax rates expected to be in effect in the year the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance to the extent that it is unlikely they will be realized. See note 10, Income Taxes, for further discussion.
Stock-Based Compensation-The Company adopted SFAS No. 123 (Revised), “Share-Based Payment” (“SFAS 123(R)”) effective January 1, 2006. This statement replaced SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires companies to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees and to record compensation cost for all stock awards granted after the required effective date and for awards modified, repurchased, or cancelled after that date. Adoption of SFAS 123 (R) standard on January 1, 2006 did not have a material effect on the Company’s financial position, results of operations or cash flows because all of the Company’s outstanding stock options were fully vested at the date of issuance of SFAS 123(R). The Company had adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), during 2004 using the retroactive restatement method described in SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”, effective January 1, 2004. Under the fair value recognition provisions of SFAS No. 123, stock-based compensation cost is recognized as expense over the vesting period. In connection with the use of the retroactive restatement method, the Company calculated the fair value of outstanding awards using the minimum value method as if the fair value method of SFAS No. 123 had been applied from its original effective date.
The Company recognizes compensation cost related to awards of restricted stock on a straight-line basis over the requisite service period for the entire award.
Fair Value of Financial Instruments-The estimated fair value of accounts receivable, accounts payable, and short-term and long-term notes payable approximate the carrying values unless otherwise indicated. The carrying value of receivables and accounts payable approximate fair value based on their short-term nature.
Use of Estimates-The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Recently Issued Accounting Pronouncements-In September 2006, the FASB released Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements 87, 88, 106, and 132” (“SFAS 158”). SFAS 158 requires that the Company recognize the over-funded or under-funded status of its defined benefit and retiree medical plans as an asset or liability in its 2006 year-end balance sheet, with changes in the funded status recognized through comprehensive income in the year in which they occur. The Company has adopted the recognition and disclosure provisions of SFAS 158 as of December 31, 2006. See note 13, Employee Benefit Plans, for further discussion.
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”).
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes” (“SFAS 109”). Guidance is provided on derecognition, classification, interest and penalties accounting in interim periods, disclosure and transition. FIN 48 requires that the Company recognize in its financial statements, the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of the Company’s 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Management has not yet completed its assessment of the adoption of FIN 48, however it is currently not expected to have a material effect on the Company’s financial position, results of operations or cash flows. This is subject to revision as management completes its analysis.
2. EARNINGS PER SHARE
Basic earnings per share is computed based on the weighted average number of common shares outstanding. Diluted earnings per share is computed based on the weighted average outstanding common shares plus equivalent shares assuming exercise of stock options, vesting of unvested compensatory shares and conversion of outstanding convertible securities, where dilutive. The following is a reconciliation between basic and diluted weighted average shares outstanding:
As of December 31, 2004, 2005 and 2006, total options outstanding were 1,195,919, 995,507 and 682,579 respectively.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
3. ACCOUNTS RECEIVABLE
Accounts receivable consist of the following at December 31:
The following is a summary of activity for the allowance of doubtful accounts during each of the three years ended December 31, 2006:
The Company grants credit to its customers in the normal course of business and at December 31, 2005 and 2006 had outstanding trade receivables from telecommunications companies which totaled $6.6 million and $7.1 million, respectively. During 2004, the Company had no customers that represented more than 10% of revenue and sales. During 2005 and 2006, the Company had one customer that represented approximately 12% and approximately 11% of total revenue and sales respectively.
4. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following at December 31:
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
5. GOODWILL, INTANGIBLE ASSETS AND OTHER
The Company performed its annual impairment test, primarily using discounted cash flow and market value of equity and debt methodologies, as of August 31, 2004, 2005 and 2006. This test indicated no impairment of goodwill existed.
Total goodwill at December 31, 2005 was $460.1 million. During 2006, the purchase of Montezuma Mutual Telephone Company (“Montezuma Telephone”), and Baker Communications, Inc. (“Baker Communications”) increased goodwill by $6.6 million and $5.4 million respectively. The sale of exchanges reduced goodwill by $5.5 million, which resulted in a goodwill balance of $466.6 million at December 31, 2006.
Intangible assets and other consists of the following at December 31:
Amortization expense for definite-lived intangible assets was $2.4 million, $2.4 million and $2.1 million for the years ended December 31, 2004, 2005 and 2006, respectively. Estimated annual amortization expense for definite lived intangible assets for each of the next five years and cumulative thereafter is as follows (in thousands):
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
6. ACCRUED AND OTHER CURRENT LIABILITIES
Accrued and other current liabilities consist of the following at December 31:
7. LONG-TERM DEBT
Long-term debt obligations consist of the following at December 31:
The aggregate maturities of long-term obligations for each of the next five years and thereafter subsequent to December 31, 2006 are as follows:
Long-Term Debt and Revolving Credit Facilities.
Credit Facilities
As a part of the Company’s initial public offering and the related debt refinancing in 2004, we entered into the Amended and Restated Credit Agreement with the Rural Telephone Finance Cooperative, as administrative agent, and a group of lenders, including the Rural Telephone Finance Cooperative, providing for a total of up to $577.8 million in term and revolving credit facilities, and simultaneously retired the previously outstanding senior credit facility with the Rural Telephone Finance Cooperative. In August 2005, the Company entered into amendments to the credit agreement that reduced the applicable interest rates and clarified certain definitions. As of December 31,
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
2006, the Company had outstanding $477.8 million of senior debt under the term facilities, and had $31.0 million drawn under the $100 million revolving credit facility. The details of the credit facilities are as follows:
The revolving credit facility will expire in 2011 and permits borrowings up to the aggregate principal amount of $100 million (less amounts reserved for letters of credit up to a maximum amount of $25 million). As of December 31, 2006, $31.0 million was outstanding on the revolving credit facility, $50,000 under letters of credit and $69.9 million was available. Borrowings under the revolving credit facility bear interest per annum at either (a) the London inter-bank offered rate, or LIBOR, plus 2.0% or (b) a base rate plus 1.0%. As of December 31, 2006, the Company had $31.0 million outstanding under LIBOR elections at an average all-in rate of 7.36%. As of December 31, 2005, the Company had $40.0 million outstanding under LIBOR elections at an average all-in rate of 6.3%.
Term Loan B is a $400.0 million senior secured term facility maturing in 2011, bearing interest per annum at either (a) a LIBOR rate plus an applicable rate adder or (b) a base rate election plus an applicable rate adder. On August 26, 2005, the Company entered into Amendment No. 1 to the credit facilities. Amendment No. 1 reduced the applicable rate adder for Term Loan B (i), from 1.00% to 0.75% per annum for the base rate, and (ii), from 2.00% to 1.75% per annum for the LIBOR rate. As of December 31, 2006, $350 million was based upon a LIBOR election effective through March 29, 2007, at an all-in rate of 7.12%. As of December 31, 2005, $350 million was based upon a LIBOR election effective through March 30, 2006, at an all-in rate of 6.28%. The Company entered into interest rate swap agreements to fix the rate on $350 million of Term Loan B as more fully described below. As of December 31, 2006, the interest rate on the remaining $50 million was based upon a LIBOR election effective through June 12, 2007 at an all-in rate of 7.08%. As of December 31, 2005, the interest rate on the remaining $50 million was based upon a LIBOR election effective through June 12, 2006 at an all-in rate of 6.4%
Term Loan C is a $70.0 million senior secured term facility maturing in 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. Upon the expiration of the 6.65% fixed interest rate on Term Loan C in November 2007, the interest rate on such term loan will convert to the Rural Telephone Finance Cooperative base variable rate plus 0.85%.
Term Loan D is a $7.8 million senior secured term facility maturing in 2011, bearing interest per annum at either (a) a fixed rate or (b) a Rural Telephone Finance Cooperative variable rate plus 0.85%. Upon the expiration of the 6.65% fixed interest rate on Term Loan D in November 2007, interest on such term loan will convert to the Rural Telephone Finance Cooperative variable rate plus 0.85%.
As a condition of borrowing under Term Loans C and D, the Company is required to invest $7.8 million, representing 10% of the total amounts of Term Loans C and D, in Subordinated Capital Certificates (“SCCs”) of the Rural Telephone Finance Cooperative. SCCs are non-interest bearing but, as a member of the Rural Telephone Finance Cooperative, the Company shares proportionately in the institution’s net earnings. The Rural Telephone Finance Cooperative will redeem the SCCs in proportion to the Company’s principal repayments on Term Loans C and D.
The Company’s share of Rural Telephone Finance Cooperative net earnings, included in interest and dividend income, was, $3.8 million, $924,000, and $740,000 for the years ended December 31, 2004, 2005, and 2006, respectively.
The credit facilities are secured by substantially all of the Company’s tangible and intangible assets, properties and revenues as well as those of all of its subsidiaries. The credit facilities are guaranteed by all of the Company’s subsidiaries.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The credit facilities permit the Company to pay dividends to holders of its common stock; however, they contain significant restrictions on the ability to do so. The credit facilities contain certain negative covenants that, among other things, limit or restrict the Company’s ability (as well as those of its subsidiaries) to: create liens and encumbrances; incur debt, issue preferred stock, or enter into leases and guarantees; enter into loans, investments and acquisitions; make asset sales, transfers or dispositions; change lines of business; enter into hedging agreements; pay dividends, redeem stock, or make certain restricted payments; amend material debt agreements or other material contracts; engage in certain transactions with affiliates; enter into sale/leaseback or synthetic lease transactions; grant negative pledges or agree to such other restrictions relating to subsidiary dividends and distributions; make changes to its fiscal year; and engage in mergers and consolidations.
The credit facilities require the Company, subject to certain exceptions, to prepay outstanding loans under the credit facilities to the extent of net cash proceeds received from the following: issuance of certain indebtedness; proceeds of certain asset sales; and casualty insurance proceeds. The credit facilities further require the Company, subject to certain exceptions, to make prepayments under the credit facilities for 50% of any net increase in the following: distributable cash during a dividend suspension period, as defined; and cumulative distributable cash, as defined, during the fiscal year less the cumulative reductions of revolving loans through such period, with reductions to the percentage to be determined based on improvements in certain credit ratios. As of December 31, 2006, no prepayment amounts were due under these provisions.
The credit facilities generally permit voluntary prepayments of the term loans and reductions of commitments without penalty or premium, other than standard breakage costs.
In addition, the financial covenants under the credit facilities specify, among other things, certain fixed charge coverage ratios and a maximum total leverage ratio, as defined, all of which we were in compliance with as of December 31, 2006.
Interest Rate Swap
On August 26, 2005, the Company amended the swap arrangements that were originally entered into on November 4, 2004. The amended swap arrangements effectively fixed the interest rate the Company will pay on $350 million of its indebtedness under its Term Loan B. The purpose of the swap agreements is to adjust the interest rate profile of the Company’s debt obligations and to achieve a targeted mix of floating and fixed rate debt. As a result of these arrangements, the effective all-in interest rate on $350.0 million of indebtedness under the Company’s Term Loan B for the period beginning August 31, 2005 and ending November 23, 2011 will be 5.865%.
The swap arrangements that the Company entered into on November 4, 2004, effectively fixed the interest rate that would have been paid on specified portions of its indebtedness under Term Loan B. Pursuant to this swap: from November 5, 2004 through December 30, 2007 the interest on $350 million of indebtedness under Term Loan B was to be fixed at a weighted average rate of 5.69%; from December 31, 2007 through December 30, 2008 the interest rate on $285.3 million of such indebtedness was to be fixed at a weighted average rate of 5.76%; and from December 31, 2008 through November 4, 2009 the interest rate on $142.7 million of such indebtedness was to be fixed at 5.87%.
Retired Senior Credit Facility Term Loan with Rural Telephone Finance Cooperative:
The Tranche A term loan of $220 million was repayable in quarterly installments of 2.5% of outstanding principal commencing on June 30, 2001 escalating to 5.625% on June 30, 2006, with the balance due on
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
March 31, 2007. The loan bore interest at LIBOR plus 3% (4.19% to 4.25% at December 31, 2003). The loan was extinguished in connection with the Company’s initial public offering and related debt restructuring in 2004.
The Tranche B term loan of $500 million was repayable in quarterly installments of 2.5% of outstanding principal commencing on June 30, 2007 escalating to 3.5% on June 30, 2013, with the balance due on March 31, 2015. The loan bore interest at a fixed rate of 8.85% through August 2005, subsequently, the interest rate reverted to the RTFC variable rate plus 1.10%. The remaining $25 million bore interest at the RTFC variable rate plus 1.10%. The loan was extinguished in connection with the Company’s initial public offering and related debt refinancing in 2004.
The Company had a long-term revolving credit facility through the Rural Telephone Finance Cooperative in the amount of $30 million expiring in June 2005. The credit facility bore interest at the Rural Telephone Finance Cooperative revolving rate plus 1.25%. The facility was extinguished in connection with the Company’s initial public offering and related debt refinancing in 2004.
As a condition of being granted the original Rural Telephone Finance Cooperative loan, the Company was required to invest $50 million in Subordinated Capital Certificates (“SCC’s”) with the Rural Telephone Finance Cooperative. SCC’s are non-interest bearing, but as a member of the Rural Telephone Finance Cooperative, the Company shares proportionately in the net earnings of the Rural Telephone Finance Cooperative. Rural Telephone Finance Cooperative distributions of net earnings are made through cash distributions and issuances of patronage capital certificates (included in investment in and receivables from Rural Telephone Finance Cooperative), which are redeemed at the option of the Rural Telephone Finance Cooperative.
Retired Senior Subordinated Notes:
In connection with the repurchase of the redeemable convertible preferred stock, on March 26, 2004 the Company issued $66 million of senior subordinated notes due March 26, 2007. Interest on the notes was payable quarterly beginning in June 2004. The notes bore interest at a floating rate per annum, reset quarterly, equal to LIBOR plus 925 basis points, with LIBOR never being less than 1.5%. The senior subordinated notes were redeemed in connection with the Company’s initial public offering and related debt refinancing in 2004.
8. REDEEMABLE CONVERTIBLE PREFERRED STOCK
On July 1, 2000, the Company issued 125,000 shares of Series A mandatorily redeemable convertible preferred stock in connection with the GTE acquisition. The Company could pay, at any time, all or a portion of accumulated dividends. On March 5, 2004, the Company agreed to repurchase its Series A mandatorily redeemable convertible preferred stock and related accrued preferred stock dividends for an aggregate purchase price of $100 million. The recorded amounts of preferred stock and related accrued preferred stock dividend were $125 million and $32.7 million, respectively, as of closing of the repurchase on March 26, 2004. The repurchase was financed through a combination of funds received from the issuance of $66 million of senior subordinated notes and cash on hand.
9. COMMON AND PREFERRED STOCK
Common Stock-The Company is authorized to issue 100,000,000 shares of common stock, $0.01 par value. Holders of common stock have one vote per share. As of December 31, 2006, the Company has 31,379,670 shares of common stock issued and outstanding.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
Preferred Stock-The Company’s Board of Directors is authorized to issue up to 50,000,000 shares of preferred stock, $0.01 par value, in one or more series, from time to time, with such designations, preferences and relative, participating, optional or other special rights and qualifications, limitations or restrictions thereof as may be provided in a resolution or resolutions adopted by the Board of Directors. The authority of the Board of Directors includes, but is not limited to, the determination of the following with respect to any such series: (i) the number of shares; (ii) the dividend rate and time of payment, if any, whether such dividends are cumulative, and if so, from which date; (iii) whether shares are to be redeemable and, if so, the terms and amount of any sinking fund providing for the purchase or redemption of such shares; (iv) whether shares shall be convertible and, if so, the terms and provisions thereof; (v) the rights of the shares in the event of voluntary or involuntary liquidation, dissolution or winding up affairs of the Company; (vi) whether the shares will have priority over or be on a parity with or be junior to any other class or series in any respect; and (vii) whether the shares will have voting rights.
10. INCOME TAXES
The Company’s provision for income taxes for the years ended December 31, 2004, 2005 and 2006 differs from the amounts determined by applying the statutory federal income tax rate of approximately 35% to income before taxes for the following reasons:
Income tax (benefit) expense consists of the following for the years ended December 31:
Current income tax expense for 2005 and 2006 is due pursuant the alternative minimum tax requirements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The Company’s deferred income tax asset/(liability) consists of the following temporary differences at December 31:
At December 31, 2006, the Company had unused tax net operating loss carryforwards of approximately $185 million which expire in 2021 to 2024. For income tax purposes, the amount of net operating loss available to offset income after a change in ownership is limited under IRC Section 382. Additionally, IRC Section 338 allows for an increase in this allowance by an additional $762,000, $37.4 million, $26.3 million, $18.7 million, and $17.2 million, for tax periods ending in 2005 through 2009, respectively. The IRC Section 382 limitation of approximately $19 million will continue to apply to any remaining unreleased net operating losses after 2009.
A valuation allowance had been provided at December 31, 2005 for the deferred tax assets that expire over time to the extent that they exceeded the net deferred tax assets and liabilities resulting from reversing temporary differences. The Company has determined that, based upon the evidence available during 2006, the combination of the continued generation of taxable income and the taxable income generated from reversing temporary differences will be, more likely than not, sufficient to utilize the entire deferred tax asset. As such, the Company determined that no valuation allowance is required for its deferred tax assets, and has reversed the remaining valuation allowance during 2006.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
11. OTHER COMPREHENSIVE INCOME
Accumulated other comprehensive income (loss) is comprised of the following components as of December 31:
Components of other comprehensive income for the twelve months ended December 31 were:
12. LEASES
The Company leases property in various locations throughout its service area.
Future minimum rental payments required under operating leases that have initial or remaining lease terms in excess of one year are as follows as of December 31, 2006:
Rental expense for the years ended December 31, 2004, 2005 and 2006 was $571,000, $332,000 and $403,000, respectively.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
13. EMPLOYEE BENEFIT PLANS
SFAS 158
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158). The Company adopted SFAS 158 prospectively on December 31, 2006. SFAS 158 requires that the Company recognize all obligations related to defined benefit pensions and other postretirement benefits. This statement requires that the Company quantify the plans’ funding status as an asset or a liability on its consolidated balance sheet.
SFAS 158 requires that the Company measure the plans’ assets and obligations that determine its funded status as of the end of the fiscal year. The Company was also required to recognize as a component of other comprehensive income the changes in funded status that occurred during the year that was not recognized as part of net periodic benefit cost as explained in SFAS No. 87, “Employers’ Accounting for Pensions,” or SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.”
Retirement Pension Plan
The Company sponsors the Iowa Telecom Pension Plan (the “Plan”), a defined benefit pension plan, that covers many former GTE employees and most union employees. The provisions of the Plan were assumed by the Company in connection with the GTE Acquisition. The Plan generally provides for employee retirement at age 65 with benefits based upon length of service and compensation. The Plan provides for early retirement, lump sum benefits, and various annuity options.
During the second quarter of 2005, the Company amended its defined benefit pension plan to freeze the accrued benefit for all salaried participants and for certain hourly participants, and permit certain other hourly participants to elect to discontinue further benefit accruals. As a result of the amendment, the benefits to be paid to salaried participants at their normal retirement age of 65 in the form of a life annuity are fixed. The accrued benefits for hourly employees subject to the mandatory benefit freeze and for those who elected to discontinue further benefit accruals were transferred to a separate plan (the “Spin-Off Plan”). The Spin-Off-Plan was terminated during the third quarter, with almost all benefits distributed in the fourth quarter. As a result of the amendment and Spin-Off Plan termination, the number of employees accruing further benefits under the defined benefit pension plan has been reduced to approximately 40 from 175.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
Components of pension benefit costs and weighted average actuarial assumptions at December 31, were:
Due to the Plan amendment during 2005, the pension costs estimate for the period beginning June 1, 2005 through December 31, 2005 was determined using a discount rate of 5.25%. The pension costs estimate beginning January 1, 2005 through May 31, 2005 was determined using a discount rate of 5.75%. During 2006, the pension costs estimate was determined using a discount rate of 5.50%.
During 2005 and 2006, the lump-sum distributions from the Plan exceeded the settlement threshold equal to the sum of the service cost and interest cost components of net periodic pension cost resulting in an additional charge to income of $1.5 million and $3.0 million, respectively.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The change in projected benefit obligation, change in plan assets, and funded status of the plan at December 31, were:
The estimated net loss and prior service cost that will be amortized from accumulated other comprehensive income into the net periodic benefit cost over the next fiscal year are $151,000 and $0 respectively.
The discount rate the Company used is based on the yield of a portfolio of high quality, fixed income debt instruments matched against the timing and amounts of projected future benefits. The expected return on plan assets is based on the Company asset allocation mix and the Company historical return, taking into account current and expected market conditions. The actual return on pension plan assets, net of trust paid expenses, was approximately 8.80% in 2006, compared to 3.00% in 2005. During 2005, the Company’s expected return on plan assets was 7.00%. The expected return on plan assets decreased for 2006 to 6.26% and included a 5.70% expected return on plan assets for the Spin-Off Plan and a 7.00% expected return on plan assets for the continuing plan.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets at December 31, were:
Cash Contributions
The following table details the Company cash contributions for the years ended December 31, 2005 and 2006, and the expected contributions for 2007 (in thousands):
The Company contributed $5.9 million due to the termination of the Spin-Off Plan. The Company’s policy with respect to funding the qualified plans is to fund at least the minimum required by the Employee Retirement Income Security Act of 1974, as amended, and not more than the maximum amount deductible for tax purposes.
Benefit Payments
The following table details expected benefit payments for the years 2007 through 2016 (in thousands):
Asset Allocation Strategy
The Company pension plan asset allocation at December 31, 2005 and 2006 and target allocation for 2007 were as follows:
The investment strategy for pension plan assets is to maintain a broadly diversified portfolio designed to achieve the Company’s target of an average long-term rate of return of 7.0% to 8.0%. While the Company believes achievement of a long-term average rate of return of 7.0% to 8.0% is possible, the Company cannot be
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
certain that the portfolio will perform to these expectations. Assets are strategically allocated between equity and debt securities in order to achieve a diversification level that mitigates wide swings in investment returns. The majority of the plan’s assets are invested in debt securities because debt portfolios have historically provided less volatility than equity portfolios. Correspondingly, debt portfolios also entail lower returns than equity portfolios based on historical information. The risk of loss in the plan’s portfolio is mitigated by investment in a broad range of corporate bonds and equity types.
The investment of pension plan assets in securities of the Company is specifically prohibited for both the equity and debt portfolios other than through index fund holdings.
Defined Contribution Plan
The Company participates in two 401(k) employee savings plans, which allow for voluntary contributions into designated investment funds by eligible employees. The Iowa Telecom Savings Plan covers full-time salaried employees, with the Company matching employees’ contributions at the rate of 75% on the first 6% of contributions. The Iowa Telecom Hourly Savings Plan covers members of the Communication Workers of America (CWA) and International Brotherhood of Electrical Workers (IBEW), with the Company matching employees’ contributions at the rate of 66% on the first 6% of contributions. The Company may make additional contributions on behalf of both 401(k) employee savings plans’ participants who are not participants in the Iowa Telecom Pension Plan. For fiscal 2004, 2005 and 2006, the Company made additional contributions of either 3% or 4% of eligible compensation. Company contributions for both plans were $1.3 million, $1.6 million and $1.5 million for the years ended December 31, 2004, 2005 and 2006, respectively.
Post Retirement Benefits
The Company assumed a postretirement benefit obligation plan for employees who were qualifying for benefits at the date of the GTE Acquisition. This plan provides for certain medical and life insurance benefits to select employees who satisfy the requirements for an early or normal pension under the defined benefit pension plan. Components of postretirement benefit costs and weighted average actuarial assumptions at December 31, were:
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The change in accumulated benefit obligation, change in plan assets, and funded status of the plans at December 31, were:
The estimated net loss and prior service cost that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are $72,000 and ($155,000) respectively.
The health care cost trend rate used in determining the accumulated postretirement benefit obligation at December 31, 2005 and 2006 was assumed to be 9.5%, decreasing incrementally until reaching an ultimate rate of 5.0% in 2015 and 2016, respectively.
Assumed health care cost trend rates may have a significant effect on the amount reported for health care plans. A one percentage point change in the assumed health care cost trend rates would have the following effects as of and for the year ended December 31, 2006:
Cash Contributions and Benefit Payments
The Company’s postretirement benefits are unfunded, and therefore cash contributions for postretirement benefits are equal to the benefit payments.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The following table details the cash contributions and benefit payments for the years ended December 31, 2004, 2005 and 2006, and the expected cash contributions and benefit payments for 2007 through 2016 (in thousands):
All benefit payments for other postretirement benefits are voluntary, as the postretirement plans are not funded, and are not subject to any minimum regulatory funding requirements. Benefit payments for each year represent claims paid for medical and life insurance, and the Company anticipates the 2007 postretirement benefit payments will be made from cash generated from operations.
Changes In Medicare
The effects, if any, of the Medicare Prescription Drug Improvement and Modernization Act of 2003 on the plan were not reflected in the above measures of the benefit obligation or benefit cost. Recent regulations provide guidance on whether plans may qualify for the federal subsidy provided to employers who provide prescription drug benefits that are at least actuarial equivalent to those provided under the Act. The Company did not apply for the subsidy for 2006 and has not determined whether it qualifies for the subsidy for subsequent years. If the Company qualifies for the subsidy, it could require the Company to change previously reported information to reflect lower expected company-paid benefits.
14. STOCK INCENTIVE PLANS
2002 Stock Incentive Plan
The Iowa Telecommunications, Inc. 2002 Stock Incentive Plan (the “2002 Incentive Plan”) allows for the issuance of incentive stock options or nonqualified stock options. Under the 2002 Incentive Plan, options have been granted for the purchase of 2,227,714 shares of which 1,031,795 were redeemed for cash in 2004 in conjunction with the Company’s IPO, 513,340 have been exercised and 682,579 remain outstanding as of December 31, 2006. No new options will be granted under the 2002 Incentive Plan. The term of each option did not exceed 10 years from the date of grant. Options granted to employees vested over 3 to 5 years from the date of the grant. All unvested options outstanding at the time of the closing of the initial public offering vested pursuant to the terms of the 2002 Incentive Plan. The exercise price for unexercised options is automatically decreased by the amount of dividends that would have been paid on the shares issuable upon exercise.
The Company recorded $123,000, $1.4 million, and $1.1 million of stock-based compensation expense during 2004, 2005, and 2006, respectively, to reflect the change in the fair value of the options upon the reduction of the exercise price resulting from the declaration of cash dividends. During 2004, the Company also recorded $18,000 of stock-based compensation expense related to options granted representing 27,028 shares of common stock with a weighted-average grant date fair value of $0.67 per share. The following weighted-average assumptions were used in determining the options fair value: dividend yield of 0%, average risk-free interest rate of approximately 5%, expected lives of 10 years from the grant date, and volatility rate of 0%. There were no options granted in 2006 or 2005.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The fair value of each option grant and subsequent modification is estimated using the Black-Scholes option-pricing model. The table below depicts the weighted-average assumptions used in determining the options’ fair value at the time of the exercise price reductions.
(1) Because the Company’s stock had not been publicly traded long enough to establish a reliable historical volatility rate, the average historical volatility rate for a pool of similar entities was used.
A summary of the status of options granted under the 2002 Incentive Plan as of December 31, 2005 and 2006, and the changes during the years then ended, is presented below:
The following table summarizes information about stock options outstanding at December 31, 2006:
The weighted average exercise price of options exercisable at December 31, 2006 reflects the reductions required by the plan, as a result of the declaration of cash dividends. Pursuant to the 2002 Incentive Plan, all options became fully vested on November 23, 2004 as a result of the change in share ownership resulting from the Company’s initial public offering of common stock.
The total intrinsic value of options exercised during 2004, 2005, and 2006 was $0, $2.3 million and $4.0 million respectively. The Company received total cash proceeds of $0, $1.4 million and $1.7 million during 2004, 2005, and 2006, respectively, related to the exercise of options. The income tax benefit realized as a result of options exercised was $0, $61,000 and $49,000 during 2004, 2005, and 2006, respectively.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
2005 Stock Incentive Plan
The Iowa Telecommunications Services, Inc. 2005 Stock Incentive Plan (the “2005 Incentive Plan”) allows for the issuance of up to an aggregate of 500,000 shares of restricted or unrestricted stock, of which 339,300 shares of restricted stock have been awarded to various officers and employees of the Company and 2,135 shares of unrestricted stock have been issued to members of the Company’s Board of Directors.
During 2006, the Company awarded 84,800 shares of Restricted Stock and 12,000 shares of Performance Stock to various officers and employees of the Company. The restricted shares had a weighted average grant date fair value of $17.93 per share, total grant date fair values of $1.5 million, and vest over four years. The Performance shares had a weighted average grant date fair value of $19.32 per share, aggregate grant date fair values of $230,000, and will vest, subject to participants meeting specified performance targets, over 41 months. During 2005, 242,500 shares of restricted stock, with weighted average grant date fair values of $18.66 per share, were awarded under the 2005 Stock Incentive Plan. These awards have a weighted average vesting period of 58 months and total grant date fair values of $4.5 million.
As of December 31, 2005 and 2006, all restricted and performance shares awarded were expected to vest.
The Company recognizes compensation cost related to awards of restricted and performance stock on a straight-line basis over the requisite service period for the entire award. The total grant date fair market value of all outstanding restricted and performance stock awards to officers and employees was $6.3 million. During 2006, the Company recorded $1.2 million of stock-based compensation expense related to the restricted and performance stock. The Company recorded approximately $388,000 of stock-based compensation expense related to the 2005 Incentive Plan during 2005. The remaining amount to be charged to expense over the remaining service periods is $4.7 million. The Company also recorded $25,000 and $13,000 of expense during 2005 and 2006, respectively, related to the unrestricted shares issued to members of its Board of Directors.
A summary of the status of the restricted and performance shares awarded pursuant to the 2005 Incentive Plan as of December 31, 2005 and 2006, and the changes during the years then ended is presented below:
During 2004 and 2005, a valuation allowance had been provided for our deferred tax assets that expire over time to the extent they exceeded the net deferred tax assets and liabilities resulting from reversing temporary differences. Accordingly, no income tax benefit was recognized related to stock-based compensation arrangements. During 2006, the Company recognized $831,000 of income tax benefit related to all stock-based compensation arrangements, excluding the effects related to the reversal of our income tax valuation allowance.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
15. RELATED PARTY TRANSACTIONS
During 2004, 2005 and 2006 the Company sold network and special access services to a significant stockholder. The Company also purchased certain services including switch monitoring and telecommunication circuits from the related party and resold certain products obtained from the related party. During 2006, the significant stockholder reduced its holdings of the Company’s common stock, and therefore, as of December 31, 2006, is no longer considered a related party. The following table summarizes the amounts included in the accompanying financial statements related to these services:
16. COMMITMENTS AND CONTINGENCIES
The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s financial position, results of operations or cash flows.
17. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and Cash Equivalents-The carrying amount approximates fair value because of the short maturity of these instruments.
Long-Term Investments-Long-term investments consist primarily of Rural Telephone Finance Cooperative (“RTFC”) Subordinated Capital Certificates. It is not practicable to estimate the fair value of the RTFC Subordinated Capital Certificates because there is no quoted market price for these instruments. Ownership of RTFC Subordinated Capital Certificates is a requirement of the Company’s debt agreement with the RTFC.
Debt-The fair value of bank debt was estimated using discounted cash flow calculations and current market interest rates. The fair value of floating rate debt is considered to be equal to the carrying value because the interest rates are reset at market rates at least every twelve months and the Company does not believe its credit risk has changed materially from the date of the most recent rate reset.
Interest Rate Swaps-See note 18 for information regarding the fair value of the Company’s interest rate swap agreements.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The estimated fair value of the Company’s financial instruments is as follows:
Certain financial instruments potentially subject the Company to concentrations of credit risk. These financial instruments consist primarily of trade receivables and cash and temporary cash investments.
The Company places its cash and cash equivalents with high credit quality financial institutions. The Company also periodically evaluates the credit worthiness of the institutions with which it invests.
The Company has entered into an interest rate swap agreements to adjust the interest rate profile of its debt obligations and to achieve a targeted mix of floating and fixed rate debt. The floating rate payers under the interest rate swap agreements are nationally recognized counterparties. They have been accorded ratings similar to other large commercial banks and the Company periodically monitor these credit ratings. While the Company may be exposed to losses due to non-performance of the bank (the calculation agent), it considers the risk remote and does not expect the settlement of this transaction to have a material effect on its financial condition or results of operations.
18. DISCLOSURES ABOUT FAIR VALUE OF INTEREST RATE SWAPS
Effective August 31, 2005, the Company amended the terms of its interest rate swap agreement which the Company designated as a hedge against the variability in future interest payments due on $350 million of Term Loan B. The amended terms of the interest rate swap agreement effectively convert the variable rate interest payments due on $350 million of Term Loan B to a fixed rate of 5.865% through maturity on November 23, 2011. The purpose of the swap agreement is to adjust the interest rate profile of the Company’s debt obligations and to achieve a targeted mix of floating and fixed rate debt.
During 2006, the fair market value of the swap instrument increased by $1.4 million. The portion of the change in fair value attributable to hedge ineffectiveness, which for 2006 was a loss of $368,000, is recorded in the Other Income section of the Company’s Consolidated Statement of Income. The portion of the change in fair value attributable to hedge effectiveness is recorded, net of income tax effects, in the Accumulated Other Comprehensive Income section of the Company’s Consolidated Statement of Stockholders’ Equity. In assessing hedge effectiveness, no portion of the gain or loss from the swap is excluded.
During 2005, the Company recognized a gain of $10.8 million, resulting from changes in the fair market value of the swap instrument. The portion of the change in fair value attributable to hedge ineffectiveness, which
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
for 2005 was $1,000, was recorded in the Other Income section of the Company’s Consolidated Statement of Income. The portion of the change in fair value attributable to hedge effectiveness was recorded in the Accumulated Other Comprehensive Income section of the Company’s Consolidated Statement of Stockholders’ Equity. In assessing hedge effectiveness, no portion of the gain or loss from the swap was excluded.
The fair value of the Company’s interest rate swap has been calculated by discounting the future cash flows of both the fixed rate and variable rate interest payments. The discount rate was derived from a yield curve created by a nationally recognized financial institution. The fair value of the interest rate swap was $13.6 million as of December 31, 2006 and $12.1 million as of December 31, 2005. The swap is recorded in the Intangible and Other Assets section of the Company’s Consolidated Balance Sheets.
19. SALE OF EXCHANGES
The Company closed on the sale of three exchanges representing approximately 600 access lines on April 28, 2006, and received proceeds of approximately $4.8 million. As part of the transaction, the Company retired net plant of $1.5 million and goodwill and other intangible assets of $2.0 million and recorded a gain of approximately $1.3 million, which is included in gain on sale of properties in the Consolidated Statements of Income.
On July 1, 2006, the Company completed the sale of four of its incumbent local exchanges representing approximately 2,000 access lines and received net proceeds of approximately $8.4 million. As part of the transaction, the Company retired net plant of $1.8 million and goodwill and other intangible assets of $3.7 million and recorded a gain of approximately $2.9 million, which is included in gain on sale of properties in the Consolidated Statements of Income.
20. BUSINESS ACQUISITIONS
Montezuma Telephone. On July 1, 2006, the Company acquired Montezuma Mutual Telephone Company, a provider of telecommunications, cable television, and Internet services to customers in rural Iowa. The acquisition of Montezuma Telephone expanded the Company’s local exchange service area. The purchase price was $11.9 million and consisted of $11.7 million in cash consideration and $222,000 of direct transaction costs.
The allocation of the purchase price of Montezuma Mutual Telephone Company is as follows:
Baker Communications. On August 1, 2006, the Company acquired Baker Communications, Inc. Baker Communications designs, develops, and provides ongoing support of technology solutions for clients. The acquisition of Baker Communications provides growth beyond our local exchange service area. The purchase price was $8.8 million and consisted of $8.6 million in cash consideration and $148,000 of direct transaction costs.
IOWA TELECOMMUNICATIONS SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
FOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006
The allocation of the purchase price of Baker Communications is as follows:
21. CONSOLIDATED QUARTERLY OPERATING INFORMATION (UNAUDITED)
(1) Operating income and net income for the second quarter of 2006 include a $1.3 million gain on the sale of exchanges. Net income for the second quarter of 2006 included a charge of $2.8 million in income tax expense.
(2) Operating income and net income for the third quarter of 2006 included a $2.9 million gain on the sale of exchanges. Net income for the third quarter of 2006 included a charge of $5.6 million in income tax expense.
(3) Operating income and net income for the fourth quarter of 2006 include a pension settlement charge of approximately $2.7 million for distributions related to the retirement pension plan. Net income for the fourth quarter of 2006 included a charge of $3.9 million in income tax expense.
(4) Net income for the second quarter of 2005 include a $2.0 million favorable impact resulting from the settlement of past access disputes with other carriers.
(5)
Operating income and net income for the third quarter of 2005 include a pension settlement charge of approximately $1.0 million for distributions related to amendments to the pension plan during the second quarter of 2005. Net income for the 3 rd quarter of 2005 include expense of $0.6 million related to an amendment to the Company’s credit agreement.
(6) Operating income, and net income for the fourth quarter of 2005 include a pension settlement charge of approximately $0.4 million for distributions related to amendments to the pension plan during the second quarter of 2005.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A. Controls And Procedures
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of December 31, 2006 (the “Evaluation Date”). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective to provide reasonable assurance to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized, and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Changes in internal controls
There was no significant change in the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting.
Internal Control over Financial Reporting.
(a) Management’s Report on Internal Control Over Financial Reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting is a process designed by, or under the supervision of, our chief executive and chief financial officers and effected by our board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorizations of our management and directors; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.
Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, management used the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report that follows.
(b) Attestation Report of the Independent Registered Public Accounting Firm.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Iowa Telecommunications Services, Inc. and subsidiaries
Newton, Iowa
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Iowa Telecommunications Services, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. 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 an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered 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 by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2006 of the Company and our report dated March 5, 2007 expressed an unqualified opinion on those financial statements and included an explanatory paragraph relating to the Company’s adoption of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, as of December 31, 2006.
/s/ Deloitte & Touche LLP
Des Moines, Iowa
March 5, 2007
******
ITEM 9B.
ITEM 9B. Other Information
None.
PART III.
ITEM 10.
ITEM 10. Directors, Executive Officers of the Registrant and Corporate Governance
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 11.
ITEM 11. Executive Compensation
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions and Director Independence
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 14.
ITEM 14. Principal Accountant Fees and Services
The information required by this item is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
PART IV.
ITEM 15.
ITEM 15. Exhibits and Financial Statement Schedules
(a) Index to Financial Statements
1. Financial Statements: The consolidated financial statements and supplementary data are set forth under Item 8 of this Form 10-K.
2. Financial Statement Schedules: All schedules are inapplicable or the required information is included elsewhere herein.
(b) Exhibits
Reference is made to the Index to Exhibits, immediately preceding the exhibits to this Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 5, 2007.
IOWA TELECOMMUNICATIONS SERVICES, INC.
/s/ ALAN L. WELLS
Alan L. Wells
President, Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
* Previously filed as exhibits to Iowa Telecom’s Registration Statement on Form S-1 (File No. 333-114349) and incorporated herein by reference thereto.
# Management agreement or compensatory plan or arrangement.