ITEM 1. - BUSINESS
OVERVIEW
We are a leading entertainment and communications business, being a “quad-play” provider of broadband internet, television, mobile telephony and fixed line telephony services that offer a variety of entertainment and communications services to residential and commercial customers throughout the U.K. We are one of the U.K.'s largest providers of residential broadband internet, pay television and fixed line telephony services by number of customers. We believe our advanced, deep fiber access network enables us to offer faster and higher quality broadband services than our digital subscriber line, or DSL, competitors. As a result, we provide our customers with a leading next generation broadband service and one of the most advanced TV on-demand services available in the U.K. market. As of December 31, 2012, we provided services to 4.9 million residential cable customers on our network. We are also one of the U.K.'s largest mobile virtual network operators by number of customers, providing mobile telephony service to 1.7 million contract mobile customers and 1.3 million prepay mobile customers over third party networks. In addition, we provide a complete portfolio of voice, data and internet solutions to businesses, public sector organizations and service providers in the U.K. through Virgin Media Business.
Our reporting segments are based on our method of internal reporting and the information used by our chief executive officer, who is our chief operating decision maker, or CODM, to evaluate segment performance and make capital allocation decisions. We have two reporting segments, Consumer and Business, as described below:
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Consumer (83.7% of our 2012 revenue): Our Consumer segment includes the distribution of television programming over our cable network and the provision of broadband and fixed line telephone services to residential consumers, both on and off our cable network. Our Consumer segment also includes our mobile telephony and mobile broadband operations, provided over third party mobile networks.
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Business (16.3% of our 2012 revenue): Our Business segment includes the voice and data telecommunication and internet solutions services we provide through our cable network and third party networks to businesses, public sector organizations and service providers.
For financial and other information on our segments, refer to note 15 to the consolidated financial statements of Virgin Media Inc. included in Item 8 of this annual report on Form 10-K.
RECENT DEVELOPMENTS
Merger agreement with Liberty Global, Inc.
On February 5, 2013, we entered in to a Merger Agreement with Liberty Global, Inc., or Liberty Global, and certain of its direct or indirect wholly-owned subsidiaries, or the Merger Subsidiaries. Under the terms of the Merger Agreement, we have agreed, through a series of intermediate steps and transactions, to be acquired by Liberty Global and merge into one of the Merger Subsidiaries. If consummated, the merger will result in both Liberty Global and Virgin Media becoming directly owned by a new U.K. public limited company, or the Ultimate Parent, listed on NASDAQ, the common stock of which will in turn be held by Liberty Global and Virgin Media Shareholders. We will continue to operate under the Virgin Media brand in the U.K..
Under the Merger Agreement, we have agreed to use our reasonable best efforts to carry on our business consistent with past practice and preserve intact our business organization and commercial goodwill from the date of the Merger Agreement until either the merger is consummated or the Merger Agreement is terminated. In addition, during this period we have undertaken covenants that place certain restrictions on us, and our subsidiaries', ability to, among other things, dispose of material properties or assets, make unbudgeted capital expenditures, acquire substantial assets, make substantial investments, increase the salary of certain of our employees or directors, pay certain bonuses or incentive compensation, grant new equity or non-equity based compensation awards, hire new employees, redeem common stock or other equity interests, declare or pay dividends or make other distributions in respect of our capital
stock, other than a quarterly dividend of up to $0.04 per share, incur or otherwise become liable for material indebtedness, enter into certain transactions with related parties or enter into new material contracts, in each case, other than in the ordinary course of business, pursuant to certain exceptions and baskets set forth in the Merger Agreement or unless Liberty Global consents in writing to the taking of any such action. If we fail to comply with these restrictions in all material respects, unless waived by Liberty Global, the Merger Agreement could be terminated or the merger not consummated.
The consummation of the merger is subject to regulatory approval, the affirmative approval of our shareholders and those of Liberty Global, and other customary closing conditions. In addition, the Merger Agreement will terminate if, prior to the consummation of the merger, we enter into an acquisition agreement with respect to a superior proposal and pay an applicable termination fee of up to $470 million, or if the merger is not consummated on or prior to October 5, 2013, which is the eight month anniversary of the date of signature of the Merger Agreement, or January 5, 2014 if extended for certain reasons to the eleven month anniversary. The Merger Agreement also includes certain other events of termination and certain other termination fee and expense provisions.
At the effective time of the Merger, pursuant to the Merger Agreement, each share of our common stock issued and outstanding immediately prior to the effective time (excluding shares held by ourselves or our subsidiaries in treasury and dissenting shares in accordance with Delaware law) will be converted into the right to receive (i) 0.2582 Series A shares of the Ultimate Parent, (ii) 0.1928 Series C shares of the Ultimate Parent and (iii) $17.50 per share in cash. Based on our fully-diluted shares outstanding of 335 million as of December 31, 2012, we expect that our shareholders will own approximately 36% of the shares outstanding of the Ultimate Parent and have approximately 26% of the voting rights.
The aggregate cash portion of the merger consideration is expected to be $6.1 billion, $2.7 billion of which Liberty Global will finance from its own cash reserves and $3.4 billion of which Liberty Global will raise as bank debt and in the capital markets, which, if the merger is consummated, will, together with debt raised to replace certain of our existing facilities, be assumed by us and result in an increase to our overall level of debt.
Financing implications of the Merger on our existing debt
Consummation of the merger would represent a change of control event under the terms of the relevant indentures of all of the senior secured notes and senior notes issued by our wholly owned subsidiaries Virgin Media Secured Finance PLC, or VMSF, and Virgin Media Finance PLC, or VMF, and obligate us to offer the noteholders the right to put their notes back to us at 101% of the principal amount plus accrued interest. At the request of Liberty Global in order to facilitate the financing by Liberty Global of the merger, on February 6, 2013, VMSF and VMF commenced consent solicitations in respect of some of these notes for the noteholders to preemptively waive this obligation and to seek consents to effect certain other proposed amendments in relation to the Transactions.
We have not solicited consents in relation to our 5.25% Senior Notes due 2022, our 4.875% Senior Notes due 2022 and our 5.125% Senior Notes due 2022 and will be required to repurchase these Notes within 30 days of the consummation of the Merger.
Upon consummation of the merger our convertible notes will have the right to convert and receive the same consideration that is received in the merger as the holders of Common Stock. The convertible holders will also be offered the right to put their notes to the company at 100% of the principal amount plus accrued interest.
KEY DEVELOPMENTS IN 2012
Superfast Broadband
We expect the growth in the market for faster broadband services to continue, with customers demanding more content at a higher quality, spending longer online and connecting multiple devices concurrently within the household. In January 2012, we announced an 18-month program to double the broadband speeds of over four million customers, with approximately 76% of our Network having been upgraded at December 31, 2012.
In August 2012 the U.K. Office of Communications, or Ofcom, re-confirmed that we have the fastest average broadband download speeds widely available to customers in the U.K.
At December 31, 2012 we had 2.2 million customers, or 51% of our broadband base, taking superfast broadband, which we define as a broadband download speed of 30Mbit/s or higher.
TiVo Television Service
Our TiVo service was launched in December 2010 with mass distribution commencing in mid-2011. This “next generation” entertainment set-top box is available in both 1 TB and 500 GB sizes and brings together television, VOD and web video services through a single set-top box and features unique content discovery and personalization tools. In April 2012, we introduced "Collections", our new packages, which include the TiVo digital video recorder, or TiVo, High Definition, or HD, TV and superfast broadband as standard for new customers.
The continued appeal of our TiVo service has driven strong customer growth during 2012. We had 1.3 million TiVo subscribers at December 31, 2012, or 35% of our television customer base. During 2012 we have enhanced our TiVo television service with the introduction of Virgin TV Anywhere, TiVo to TiVo streaming and the relaunch of our on-demand pay-per-view service as Virgin Movies.
Financing & Long Term Debt
During 2012, we have used our strong cash position to access advantageous markets and refinance our debt, reducing interest expense and extending debt maturities. Since announcing our first phase capital optimization program on July 27, 2010, we have refinanced a total of £2.2 billion of debt. The principal transactions during 2012 were:
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On March 13, 2012, we issued U.S. dollar denominated 5.25% senior notes due February 15, 2022 with a principal value of $500 million, the net proceeds of which together with cash on our balance sheet were used on March 28, 2012 to redeem $500 million of the principal amount of our $1,350 million 9.50% senior notes due 2016. We recognized a loss on extinguishment of debt of £58.6 million as a result of this redemption.
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On October 30, 2012, we issued $900 million aggregate principal amount of 4.875% senior notes and £400 million aggregate principal amount of 5.125% senior notes due October 30, 2022 at par, the net proceeds of which were used to redeem our remaining $850 million and €180 million 9.50% senior notes due 2016, and $92.9 million of the principal amount of our $600 million 8.375% senior notes due 2019 and £96.5 million of the principal amount of our £350 million 8.875% senior notes due 2019. We recognized a loss on extinguishment of debt of £129.2 million as a result of these redemptions.
On December 14, 2012 we also announced our intention to use up to £200 million for further transactions related to our debt and convertible debt, which may be effected through open market, privately negotiated, and/or derivative transactions until the end of 2014.
For more information about our senior notes, senior secured notes and the senior credit facility, see Item 7 of this annual report on Form 10-K, “Management's Discussion and Analysis of Results of Operations and Financial Condition - Liquidity and Capital Resources - Long Term Debt.”
Capital Return Programs
Since we began our capital return program in July 2010, we have repurchased 73 million shares of common stock for £1,127 million, which is approximately 22% of our share count at July 2010. We purchased 52.5 million shares during the first and second phases of our program in 2011 and 2010 at an average purchase price of $24.35. The second phase of our program announced on July 27, 2011 continued during 2012 with the purchase and cancellation of a further 20.5 million shares during the year at an average purchase price of $25.39. With the near completion of our second phase program, we announced on December 14, 2012, a third phase to our share buyback program of at least £1,122.5 million to be completed before the end of 2014, which includes £122.5 million remaining under our second phase program. This £1,122.5 million represents approximately 19% of our market capitalization at December 14, 2012.
Under the terms of the merger agreement we signed with Liberty Global on February 5, 2013, we have suspended our capital returns program pending consummation of the merger. Should the merger not be consummated we intend to resume our capital returns program.
For more information on our capital return programs, see Item 7 of this Form 10-K, “Management's Discussion and Analysis of Results of Operations and Financial Condition - Liquidity and Capital Resources - Capital Return Programs.”
OUR BUSINESS
OUR NETWORK
We deliver voice, video and high-speed data services over our access network. The deep fiber design of our access network enables us to transmit data by means of fiber optic cable from equipment in technical properties known as “headends” and “hubsites” to widely deployed distribution cabinets. The connection into each home from the fiber access network comprises two components combined into a single drop cable (twisted copper and coaxial cable). For video and internet access services, we use the high capacity, two-way, coaxial cable which has considerable spectrum and associated bandwidth capabilities. This enables us to support a full portfolio of linear and on-demand TV services as well as high-speed broadband services. In support of moving our Entertainment experience to an application that can be deployed on customers connected devices, we have upgraded our technology platforms to support delivery of select Video content to our Entertainment User Interface on tablets, smart phones and PCs. Using data over cable services interface specification 3.0, or DOCSIS 3.0, we currently offer download speeds of up to 100 Mbit/s. Trials of 300 Mbit/s and 1.5 Gbit/s downstream speeds have also been conducted. For fixed line voice services, we use a twisted copper-pair. Our relatively short twisted copper pairs (typically less than 500 meters in length) are also capable of supporting the latest Very High Speed Digital Subscriber Line 2, or VDSL2, broadband technologies. As a result of the extensive use of fiber in our access networks, we are also able to provide high-speed data network services to business customers delivering nationwide connectivity.
We believe that our deep fiber access provides us with several competitive advantages in the areas served by our network. For instance, our cable network allows us to concurrently deliver downstream broadband services, together with real-time television and video-on-demand, or VOD, content at higher speeds and with less data loss than comparable services of other providers. Our competitors are reliant on the access infrastructure of BT Group plc, or BT, which typically relies on copper-pair technology from the local exchange to the customer's home. BT is upgrading its infrastructure to provide data services capable of higher speeds, using fiber-to-the-cabinet, or FTTC, technology, but service providers using BT's existing network are, and may remain, subject to capacity limits which can affect data download speeds. Our cable network also offers benefits over the infrastructure of satellite service providers, which are unable to offer a full array of interactive services in the absence of a fixed line telephone connection, using third party access infrastructure. By contrast, our cable infrastructure allows us to provide “triple-play” bundled services of broadband internet, television and fixed line telephony services without relying on a third-party service provider or network. In addition, our capacity is dimensioned to support peak consumer demand. In serving the business market, many aspects of the network can be leveraged at very low incremental cost given that business demand peaks at a time when consumer demand is low, and peaks at lower levels than any consumer demand. As such, we have an advantage over competitors who serve either Consumer or Business segments but not both.
We also believe that our deep fiber access network has enabled us to take a leading position in the roll-out of next generation broadband access technologies in the U.K. In 2009, we completed significant upgrades to our network, including the network-wide roll-out of the latest DOCSIS 3.0 cable modem termination system, or CMTS, technology which significantly increased upstream and downstream transmission speeds across our network. Throughout 2011, we continued to invest in the growth of our DOCSIS 3.0 and broadband related network platforms, as well as adding capacity for high definition, or HD, broadcast and VOD services. In 2012, we extended our network to provide triple play cable capability to approximately 35,000 additional homes. In 2011 we continued to invest in upgrading our hybrid fiber coaxial, or HFC, access network from analogue to digital using the latest technology and deep fiber architectures. This largely completed the upgrade from analogue to digital across our entire HFC access network footprint. As of December 31, 2012, approximately 98% of the homes served by our cable network could receive all our broadband, digital television and fixed line telephony services.
We also employ a variety of alternative methods to connect to our national telecommunications network over the “last mile” to the premises of customers located beyond the reach of our cable network, including by using circuits and digital subscriber line, or DSL, connections on the local networks of other service providers.
Our mobile communication services are provided over cellular networks owned by third parties. Our main mobile network provider is EE. We also use networks owned by other providers to provide some ancillary services. EE currently operates 2G, 2.5G, 3G, 3.5G and 4G networks in the U.K.
OUR CONSUMER SEGMENT
Products and Services
Cable Products and Services
We offer our customers a choice of several packages and tariffs within each of our cable product categories. Our bundled packaging and pricing are designed to encourage our customers to purchase multiple services across our product portfolio by offering incentives to customers who subscribe to two or more of our products. The types and number of services that each customer uses, and the prices we charge for these services, drive our revenue. For example, broadband internet is more profitable than our television services and, on average our “triple-play” customers are more profitable than “double-play” or “single-play” customers. As of December 31, 2012, 85% of our cable customers received multiple services from us and 65% were “triple-play” customers, receiving broadband internet, television and fixed line telephone services from us.
Our cable broadband internet, television and fixed line telephone services are distributed via our wholly owned, local access cable network which covers parts of many major metropolitan areas in England, Wales, Scotland and Northern Ireland.
Broadband Internet
We deliver high-speed broadband internet services to customers on our cable network. As of December 31, 2012, we provided cable broadband services to over 4.3 million subscribers. We are one of the leading providers of high-speed broadband in the UK, having introduced both 50 Mbit/s and DOCSIS 3.0 rollouts in 2009 and launched 100 Mbit/s in December 2010 and completed its rollout across the network by end of March 2012. In December 2012, the average speed received by customers on all tiers was above 90% of the advertised, or headline, speed, and we are continuing the upgrade program to increase upload speeds to a minimum of 10% of download speeds.
In January 2012, we announced a program to double the speed of our broadband, involving a significant investment in network capacity and in the rollout of DOCSIS 3.0 wireless gateways. All our customers who were on 10 Mbit/s, 20 Mbit/s, 30 Mbit/s and 50 Mbit/s have seen, or will see, their headline speeds at least doubled under this program. In January 2012, we also commenced a marketing campaign starring Usain Bolt to communicate this news to our customers.
We currently have three tiers of high-speed cable broadband services available to new subscribers. We offer download speeds of 100 Mbit/s to more than 1 million homes, and more broadly offer download speeds of up to 30 Mbit/s and up to 60 Mbit/s. Our customers also benefit from unlimited downloads (subject to our fair usage and traffic management policies), advanced security software, including anti-virus and anti-spyware protection, and online data backup for no additional charge.
Television
We offer a wide range of television services to customers on our cable network. As of December 31, 2012, we provided cable television services to approximately 3.8 million residential subscribers.
Our digital television, or DTV, service includes access to over 185 linear television channels, advanced interactive features, and a range of premium subscription-based and pay-per-view services.
We offer a free-to-view digital television service, or Free TV, to certain customers on our cable platform. Our Free TV service provides access to approximately over 55 linear TV channels such as Dave, E4, Yesterday, and Five USA as well as radio services.
Our cable network enables us to deliver a broad range of digital interactive services, including games, news, entertainment and information services, from an on-screen menu. In addition to our linear television services, which allow our customers to view television programming at a scheduled time, our DTV and Free TV customers also have access to certain of these digital interactive services, including one of the most comprehensive video on-demand, or VOD, services in the U.K. See “Virgin TV On Demand,” below.
We also offer interactive “red button” applications from the British Broadcasting Corporation, or BBC, and other commercial broadcasters. “Red button” functionality in the U.K. permits television viewers to press a red button on their remote control handset to receive additional interactive services, including multiple broadcasts. For example, in an Olympics broadcast, a customer can press the red button and choose which sport they wish to watch. The BBC reinvented their "red button" service in December 2012; "Connected Red Button" was first launched in 1.2 million TiVo
homes as part of the innovation partnership we share with the BBC in which we aim to create a next-generation TV experience.
In November 2012, we launched Virgin TV Anywhere, an innovative internet streaming TV service that allows our TV customers to stream up to 45 live TV channels, including Sky Sports, and watch more than 4,000 hours of TV On-Demand through their web browser, anywhere with a broadband connection. Customers are able to also discover new shows with recommendations and ratings. As an exclusive to our TiVo customers, those with iPad, iPhone or iPod Touch devices can watch up to 25 live TV channels, manage their TiVo box and discover new shows with these devices. And when in the home, these devices can act as a remote control for their TiVo boxes. Virgin TV Anywhere is available at no extra cost to our TiVo customers.
TiVo and Digital Video Recorders
We offer two of the most advanced digital video recorders, or DVRs, in the U.K. Set-top boxes equipped with DVRs digitally record television programming to a hard disk in real-time, which allows customers to play-back, pause, fast-forward or rewind the program at any point during or for a period after the broadcast.
The Virgin Media TiVo service was launched in December 2010 with mass distribution commencing in mid-2011. This “next generation” entertainment set-top box is available in both 1 TB and 500 GB sizes, with the 1TB version recording up to 500 hours of television, and brings together television, VOD and web video services through a single set-top box and features unique content discovery and personalization tools. The TiVo box is HD-enabled and has three tuners, allowing viewers to record three programs while watching a fourth they previously recorded. The TiVo service, combined with the existing VOD service, makes available television shows, movies and music videos in addition to supporting web video services such as the BBC iPlayer and YouTube. Virgin Media TV powered by TiVo service continues to be enhanced and rolled out to customers. As of December 31, 2012 we had approximately 1.3 million TiVo customers.
Under a strategic partnership agreement entered in to in 2009, TiVo is the exclusive provider of user interface software for our next generation set-top boxes which provide converged television and broadband internet capabilities, and we are the exclusive distributor of TiVo services and technology in the U.K.
The previous Virgin Media DVR called the “V+ set-top box”, was available to our DTV customer base and is gradually being phased out in favor of TiVo boxes. The V+ set-top box has 160GB of hard disk storage space (up to 80 hours of broadcast television), is HD-enabled and has three tuners, allowing viewers to record two programs while watching a third. Our V+ set top box customers with a HD-compatible television can also access our HD on-demand content. As of December 31, 2012, we had approximately 1.2 million V+ set-top box customers.
Virgin TV On Demand
Our VOD service, Virgin TV On Demand, provides our customers with instant access to a wide selection of premium movies, television programs, music videos and other on-demand content including live pay-per-view, or PPV, events. Content is available in broadcast SD, HD and in 3D. Our HD content is available to all of our TV customers (excluding analogue TV customers) who have a HD box, in line with their subscription at no additional charge. Viewers can watch programs instantly, without the need for buffering, and can freeze-frame, fast-forward and rewind the content at will. This gives our customers increased control over the content and timing of their television viewing. Additionally, our cable network enables us to provide VOD content to our customers with no concurrent degradation of their broadband speed. We believe the range of content offered by our VOD service is a key driver in discouraging customer churn.
The primary categories of content available within Virgin TV On Demand are television programming, movies (on a PPV and premium subscription basis) and music videos. A selection of content, including our 'catch-up' television service, is available free of charge to all of our TV customers. The BBC iPlayer is the largest service we offer, enabling viewers to view more than 700 hours of BBC programs. Virgin TV's Catch Up On Demand service also includes content from 4OD, Demand Five and ITV Player.
Subscription Video On Demand
We also offer our television customers basic subscription VOD, or SVOD, with a selection of content that increases in volume in line with the customer's DTV subscription tier.
In October 2011, Sky Anytime (now Sky On Demand) was added to the service, allowing customers to access approximately 1,000 hours of television content from across Sky's range of basic channels, and around 500 movie titles being made available as a bonus to Sky Movies subscribers. This movie on-demand service joined the existing premium subscription based movie-on-demand service 'PictureBox'. Other content providers include WarnerTV, BBC Worldwide, Sony, Viacom, NBCU and AETN. Tailored advertising is also inserted across many providers within the basic TV SVOD and free catch-up services.
The VOD package also includes a music video service featuring over 5,000 tracks, which is available to subscribers to our top tier television package at no extra cost, or to lower tier customers on a pay per transaction basis.
The movie on-demand service has both premium SVOD and Transactional VOD, or TVOD, components.
Virgin Movies
Our pay-per-transaction movie service, FilmFlex, was rebranded as Virgin Movies in September 2012, with Virgin Media taking more active control of the scheduling and marketing of the transactional VOD service. It continues to offer a further 500 titles from all the major studios, the majority of which are available for rent on the same day as their DVD release. All of our DTV customers have access to pay-per-transaction movies, which, after purchase, may be viewed multiple times within a 48-hour window. In 2012 'Download to Rent' functionality was added to the online version of Virgin Movies, allowing customers to rent titles and watch them when offline. This, like the rest of Virgin Movies' online service, is available to non-Virgin Media subscribers.
Fixed Line Telephony
We provide local, national and international telephony services to our residential customers on our cable network. We offer a basic line rental service to our cable customers for a fixed monthly fee. In addition to basic line rental, we also offer tiered bundles of call tariffs, features and services, including calling plans that enable customers to make unlimited national landline calls and calls to mobile telephones either during specified periods or at anytime, for an incremental fixed monthly fee. Our customers can also make calls to Virgin mobiles free of charge and may also subscribe to additional services such as call waiting, call blocking, call forwarding, three-way calling, advanced voicemail and caller line identification services for an additional fee. We also intend to launch a mobile handset application that will allow customers to call landlines and mobile phones using wifi networks. As of December 31, 2012, we provided cable telephony services to approximately 4.2 million residential subscribers.
Mobile Products and Services
In 2012, we continued to focus on increasing our proportion of higher value contract customers, improving access to content via our mobile platform, expanding our range of higher value mobile handsets and cross-selling into homes already connected to our cable network. We continued to promote the use of our mobile platform to view internet and television content by introducing features such as easier access to social networking applications via the mobile handset.
As a mobile virtual network operator, or MVNO, we provide mobile telephony services to our customers over cellular networks owned by third parties. Our customer base comprises both contract customers, who subscribe to our services for periods ranging from a minimum of 30 days up to 24 months, and pre-pay customers, who top up their accounts prior to using the services and have no minimum contracted term. As of December 31, 2012, we had approximately 3.0 million mobile telephony customers, of which approximately 1.7 million were contract customers.
We offer a broad range of mobile communications products and services, including mobile voice services and data services, such as SMS, picture messaging, games, news and music services. We also offer a broad range of handsets, including Blackberry and Android based smartphones, and mobile broadband services which complement our fixed broadband offering. Our services are delivered over 2G, 2.5G, 3G and 3.5G platforms provided by our network partner, EE.
Non-cable Products and Services
We also provide broadband and telephony services to residential customers outside of our cable network, or non-cable customers, over third-party telecommunications networks. Our non-cable broadband internet services are provided via BT's local access network and unbundled BT exchanges from Cable & Wireless plc, or C&W. We offer various price and feature packages, including broadband service provided over asymmetric digital subscriber line, or ADSL, technology. As of December 31, 2012, we had 192,800 non-cable broadband subscribers. We also provide fixed line telephony service to non-cable customers via BT's local access network. As of December 31, 2012, we provided non-cable fixed line telephone service to 130,500 subscribers.
Marketing, Sales and Customer Service
Our consumer marketing strategy focuses primarily on bundled offerings of digital products and services across our “quad-play” portfolio to existing and prospective customers. We are focusing on those customers and prospective customers who reside in premises at which our cable services are already available, most of whom are not yet mobile telephone customers. Our bundling strategy provides our customers with discounts and additional value added services when they buy our services. We also provide the convenience of a single bill for “triple-play” (TV, broadband and fixed line telephony) packages and additional value to these customers when they take our mobile services. We believe that customers who subscribe to multiple services from us are less likely to churn. We also actively pursue opportunities to cross-sell complementary services across our product range and up-sell higher value services to our existing customers.
We offer our consumer products and services through a broad range of retail channels, including via inbound and outbound telesales, customer care centers and online. We also engage in direct face-to-face marketing initiatives through a dedicated national sales force of approximately 350 representatives, as well as comprehensive national and regional mass media advertising initiatives. We now have a significant national retail store base with approximately 79 retail stores and over 65 kiosk type retail outlets which offer a complete range of our consumer products and services. Our stores not only provide sales services but also showcase our products, allowing demonstrations and customer interaction, and help resolve customer queries.
We offer our prepay mobile telephony products through over 4,000 third party sales outlets in the U.K., including over 1,000 specialist outlets of our distribution partners, such as Carphone Warehouse and Phones 4U. In addition, we offer SIM-only products and mobile airtime vouchers through independent retailers across the U.K.
We believe that effective customer service contributes to customer satisfaction, which in turn results in reduced churn and acquisition of new customers. As of December 31, 2012, we employed approximately 2,200 staff in our cable and non-cable call centers, which includes the in-sourcing of one of our U.K. call centers in April 2012 that resulted in an additional 700 staff, and approximately 500 staff for our mobile telephony call centers, in the U.K. We also use outsourced call centers in the U.K., the Philippines, India and South Africa.
Consumer Segment Competition
We face intense competition from a variety of entertainment and communications service providers, which offer comparable broadband internet, television, fixed line telephony and mobile telephony services. In addition, technological advances and product innovations have increased, and are likely to continue to increase the number of alternatives available to our customers from other providers and intensify the competitive environment. See “Risk Factors-We operate in highly competitive markets.”
We believe that we have a competitive advantage in the U.K. residential market due to the superior technical capabilities of our cable network over the network of BT which many of our competitors rely on to provide their services.
We also face intense competition in the mobile telephony market, which is primarily driven by increased pricing pressure from both established and new service providers, evolving customer needs and technological developments.
We offer most of our products on a stand alone basis or as part of bundled packages designed to encourage customers to subscribe to multiple services. We offer broadband internet, fixed line telephony and mobile telephony and data services throughout the U.K., and currently offer television services exclusively in areas served by our cable network. Our primary competitors are BT, British Sky Broadcasting Group plc, or BSkyB, TalkTalk Telecom Group plc, or TalkTalk, Vodafone, EE and O2.
Broadband Internet
We have a number of significant competitors in the market for broadband internet services.
BT provides broadband internet access services over its own DSL network both as a retail brand and as a wholesale service. BT is currently rolling out fiber-based broadband, with coverage having reached around 13 million homes by the end of 2012. During 2012, BT announced that it was bringing forward its fiber roll out to enable it to provide services to around two-thirds of U.K. homes by Spring 2012, more than 18 months ahead of their original schedule and within the guided spend of £2.5bn. BT is rolling out fiber primarily using Fiber-To-The-Cabinet, or FTTC, technology. From June 2013 BT Openreach will launch its Fiber-to-the-Premises, or FTTP, On-Demand product, allowing operators to offer FTTP with speeds of up to 330Mb in areas already enabled to FTTC.
Companies such as BSkyB, TalkTalk, EE and O2 are deploying their own network access equipment in BT exchanges via a process known as local loop unbundling, or LLU. This allows an ISP to reduce the recurring operating costs charged by BT by reducing the proportion of traffic that must travel directly over BT's network. LLU deployment requires
a substantial capital investment to implement and requires a large customer base to deliver a return on investment. Competitors may use new alternative access technology such as fiber-to-the-cabinet, which provides subscribers with significantly faster download speeds when compared to traditional asymmetric digital subscriber line, or ADSL2+, connections.
In addition to the increasing competition and pricing pressure in the broadband market arising from LLU we may be subject to increased competition in the provision of broadband services from mobile broadband and technological developments (such as long-term evolution, or LTE, and 3G mobile technology) and other wireless technologies, such as wireless fidelity, or Wi-Fi, and Worldwide Interoperability for Microwave Access, or Wi-Max. In addition, BT has recently announced its intention to expand and accelerate fiber to the home deployments which will allow its retail arm, and its wholesale customers, to offer higher speed broadband services.
Cable Television
Our digital television services compete primarily with those of BSkyB, which is the only pay satellite television platform in the U.K. and has a high market share of the U.K. pay television market. BSkyB owns the U.K. rights to both standard definition, or SD, HD and 3D, as the case may be, versions of various sports and movie programming content, which it has used to create some of the most popular premium pay television channels in the U.K. BSkyB is both our principal competitor in the pay television market and an important supplier of basic and premium television content to us.
Content owners, online aggregators and television channel owners are increasingly using broadband as a new digital distribution channel direct to consumers. A new free-to-air internet-connected TV service to U.K. homes has been launched by YouView, a joint venture which includes Arqiva, BBC, BT, Channel 4, Channel 5, ITV and TalkTalk. The full consumer launch of YouView occurred in the third quarter of 2012 with consumers able to purchase a box from retailers or get a free subsidized box as part of a bundled package (TV, Broadband and Calls) with providers BT and TalkTalk.
Residential customers may also receive digital terrestrial television, or DTT, which is delivered to customer homes through a conventional television aerial and a separately purchased set-top box or an integrated digital television set. The free-to-air DTT service in the U.K. is branded Freeview. This service is provided by a consortium of operators, including the BBC.
BBC and ITV also offer a free-to-air digital satellite alternative to the Freeview DTT service, known as Freesat. Freesat offers approximately 120 subscription-free TV channels, including selected HD channels such as BBC 1 HD, BBC HD, ITV HD and Channel 4 HD. Freesat also offers a range of DVRs under the brand “Freesat+”. A new range of Internet connected DVRs under the brand "Freetime" offering access to popular catch-up TV services were launched in September 2012.
Residential customers may also access digital television content by means of internet protocol television, or IPTV. BT Vision, a combined DTT and VOD service offered by BT over a DSL broadband connection, is available throughout the U.K. BSkyB also offers live streamed TV and VOD services over a broadband connection, through its Sky Anytime+ and Sky Go services. In addition, Netflix, Lovefilm, Google, Apple and others have launched IPTV products.
The U.K. government terminated ATV transmission on October 24, 2012. As a result, the DTT signal and network has been strengthened enabling DTT to be made available to customers that cannot currently receive a signal. In the future this may also provide additional capacity to allow the Freeview channel line-up to be expanded to include new channels. Consumers wishing to receive television services now have to convert to DTV.
The communications industry is constantly evolving and there are a number of new and emerging technologies which can be used to provide video services that are likely to compete with our DTV and VOD services. These include the DSL services mentioned above and next generation LTE services. We expect continued advances in communications technology and in content, such as 3D TV.
Fixed Line Telephony
We compete primarily with BT in providing telephony services to residential customers in the U.K. BT occupies an established market position as the former state provider. We also compete with other telecommunications companies that provide telephony services directly, through LLU, or indirectly. These include TalkTalk and BSkyB, and mobile telephone operators such as O2, EE, Vodafone and 3 UK.
We compete with mobile telephone networks that offer consumers an alternative to fixed line telephone services. Mobile telephone services also contribute to the competitive price pressure on fixed line telephone services. See also “Risk Factors-Risks Relating to our Business and Industry-Our fixed line telephony business is in decline and not likely to improve”.
In addition, we face competition from companies offering Voice over Internet Protocol, or VoIP, services using the customer's existing broadband, 3G and Wi-Fi connections. These services are offered by independent providers, such as Vonage, magicJack, WhatsApp and Skype, as well as those affiliated with established competitors such as BT and EE. These services generally offer free calls between users of the same service, but charge for calls made to fixed line or mobile numbers either on a flat monthly rate for unlimited calls (typically restricted to geographic areas) or based on usage. We also face competition from the growth in online communication through social networking sites such as Facebook and Twitter which has contributed to declining use of telephony services.
Mobile Services
In the mobile telephony market, we face direct competition from mobile network operators, or MNOs, such as O2, EE, Vodafone and 3 UK, and other Mobile Virtual Network Operators, or MVNOs, such as Tesco Mobile, Lebara, TalkTalk and ASDA. We also compete with fixed line telephone operators, with companies offering VOIP services, and from the growth in online communication, as described in “Fixed Line Telephony” above.
EE became the first U.K. mobile network operator to launch 4G in October 2012, following approval from Ofcom to use its existing 1800MHz spectrum. The auction of the 2.6GHz and 800MHz spectrum by Ofcom started at the end of 2012, with 4G services expected to go live in mid-2013. The launch of 4G services may introduce new competitors into the market or strengthen the position of existing competitors.
OUR BUSINESS SEGMENT
Our Business segment, managed through Virgin Media Business, or VMB, offers a broad portfolio of voice, data and internet solutions to commercial and public sector organizations in the U.K., ranging from analog telephony to managed data networks and applications. Our Business segment peak usage occurs at different times of the day from our Consumer segment peak usage, which allows better use of our network. Through Virgin Media Business, we provide services to approximately 50,000 U.K. businesses and almost 250 public sector organizations. We also supply communications services to around three quarters of the U.K.'s health and emergency services providers and nearly one half of U.K. police forces.
Products and Services
We offer contractual service levels to all customers and these are supported by U.K. based regional teams. In addition to our standard service levels, a tiered service level is available to tailor service requirements based on size of organization, sector and criticality. These tiered service levels include priority response, named dedicated staff and field based teams managing service levels face to face based on customer premises.
Data and Internet Services
Converged Solutions
Converged solutions use a single network to transport voice, data and video, allowing our customers to benefit from cost synergies. Additionally, we offer services such as IP virtual private networks, which enable our customers to prioritize bandwidth for different types of traffic so that more time sensitive data or critical application data is transported with priority, providing increased flexibility and control over data management. Our extensive network reach also enables us to offer large or dispersed organizations the ability to effectively link sites across the U.K. using a wide range of access technologies, supporting services such as voice and video conferencing, instant messaging and file transfers.
Ethernet
The Virgin Media Business Ethernet network has approximately 300 Ethernet nodes and is capable of carrying a variety of services and high bandwidth applications simultaneously. We have been delivering Ethernet services for over 10 years and have achieved both Metro Ethernet Forum, or MEF 9 and MEF 14 accreditation (becoming the first service provider in the world to renew this accreditation), ensuring our Ethernet product portfolio can support stringent real-time communications applications, including voice over IP, or VOIP, and HD-quality videoconferencing. We offer a range of products from local area network extensions to managed wide area Ethernet networks, providing our customers with high bandwidth and flexible solutions, including market-leading point to multi-point services.
Applications and Services
As an overlay to network products, we also offer applications, such as video-conferencing, and managed services, such as information security services, designed to increase flexibility and reduce costs to our customers.
Voice
We offer a comprehensive range of voice products, from analog and digital services to converged internet protocol, or IP, telephony solutions. Our business voice solutions include basic features, such as call divert and voicemail, as well as products such as Centrex, which provides switchboard-like capability that is managed from our telephone exchange, offering our customers a cost-effective, scalable alternative to a premises-based system. These mature services continue to be offered in parallel with a next generation of converged services, allowing customers to migrate to new technologies gradually.
Marketing, Sales and Customer Service
Our marketing, sales and customer service initiatives are structured around the differentiated needs of our retail and wholesale customers. Our retail customer base comprises private and public sector organizations, while our wholesale customers include primarily mobile and fixed-line service providers, systems integrators, or SIs, and internet service providers, or ISPs.
Retail Customers
Private Sector
Our private sector retail services focus on a range of the telecommunications needs from small businesses to large, national corporations. Centralized telephone account managers serve small organizations (with 50 to 99 employees), while regionally-located account, service and project management teams, supported by pre-sales technical consultants, provide service to medium and large U.K. businesses (with over 100 employees). We believe that our local presence and the resulting level of service we provide is a key differentiator in this mid-market segment, and that the benefits of this strategy are reflected in the long term relationships held with many of our private sector customers.
Public Sector
Our public sector retail services are structured around industry-specific segments, such as local government, education, health and emergency services. This enables us to provide sector-specific expertise where an understanding of the drivers and procurement processes of publicly funded organizations are necessary for efficient deployment of communications solutions. We believe that the inclusion of VMB as an approved supplier under various government framework agreements acts as both an enabler of growth of our market share in this sector and an endorsement of our track record, commitment and capability to offer value to publicly funded organizations.
Wholesale Customers
Our wholesale services are structured around the network requirements of the different types of service providers. Specialized account and service management teams support carriers, mobile operators, SIs and ISPs. We provide predominantly data connectivity services, both in terms of local access and core networks, including high bandwidth connections between a site and the core network.
Business Segment Competition
The U.K. business telecommunications market is characterized by strong competition and ongoing consolidation. Competition in the U.K. business telecommunications market continues to be value driven, with the key components being quality, reliability and price.
VMB competes primarily with traditional network operators such as BT and C&W. BT represents the main competitive threat nationally due to its network reach and product portfolio. We also compete with regional providers, such as COLT Telecom Group plc, which have a strong network presence within limited geographic areas. Recently, we have faced increasing competition from services provided by MNOs which target small business customers.
In the retail market our traditional competitors are becoming increasingly focused on particular segments of the market. For example, C&W targets larger national and multi-national corporations. We continue to focus on small, medium and large nationally oriented businesses and public sector organizations. System integrators, such as Kcom (formerly known as Kingston Communications (Hull) plc), are also becoming an increasing competitive threat as large organizations continue to focus on IT integration, management and outsourcing.
REGULATORY MATTERS
OVERVIEW
Legislative Framework
Our business activities are subject to the laws and regulations of the European Union, or EU, and the U.K. At an EU level we are regulated by the “European Framework” which applies to all communication networks and services for electronic communications including telecommunications (fixed and mobile), e-mail, access to the internet and content related broadcasting. The purpose of the European Framework is to ensure more effective competition leading to better rights and options for consumers. The European Framework comprises:
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Directive 2002/21 on a common regulatory framework for electronic communications networks and services;
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Directive 2002/20 on the authorization of electronic communications networks and services;
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Directive 2002/19 on access to, and interconnection of, electronic communications networks and associated facilities; and
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Directive 2002/22 on universal service and users rights relating to electronic communications networks and services.
These directives are supplemented by EU Directive 2002/58, concerning the processing of personal data and the protection of privacy in the electronic communications sector.
In the U.K. the European Framework is implemented through the Communications Act 2003, or the Communications Act, which regulates all forms of communications technology, whether used for telecommunications or broadcasting. The Privacy and Electronic Communications Regulations 2003 implemented EU Directive 2002/58.
The European Framework was amended by Directives 2009/140/EC and 2009/136/EC, and changes have been made to the Communications Act 2003 and the Wireless Telegraphy Act 2006 to implement these amendments in the United Kingdom. The Privacy and Electronic Communications Regulations 2003 have also been amended by the Privacy and Electronic Communications (Amendment) Regulations 2011.
We are also subject to regulation under the U.K. Broadcasting Acts 1990 and 1996 and other U.K. statutes and subordinate legislation, including the Competition Act 1998 and the Enterprise Act 2002. On-demand programming is regulated by the Authority for Television On-Demand, or ATVOD, under a co-regulatory regime with the U.K. Office of Communications, or Ofcom. The regulatory regime for on-demand programming is derived from the Audiovisual Media Services Directive.
U.K. Regulatory Authorities
Ofcom is the key regulatory authority for the communications sector in which we operate. It is responsible for furthering the interests of consumers by promoting competition. In particular, Ofcom is responsible for regulating the behavior of providers of electronic communications networks or services that have significant market power, or SMP, in identified markets which may have a harmful influence on competition and consumers. A provider is deemed to have SMP if it has a position of economic strength affording it the power to act independently of competitors and customers within a given market. Currently, the U.K. Office of Fair Trading also has jurisdiction with respect to competition matters, but there is reform anticipated in this area.
BROADBAND EXPANSION
The U.K. Government has decided not to implement the broadband tax proposed by the previous government. It proposes instead to drive the deployment of superfast broadband and the provision of basic broadband to 90% of the U.K. using money from the publicly funded BBC License Fee, under-spend from the Digital TV Switch Off Project and private investment. Two key projects have been announced: the Broadband Delivery Program, which is focused on delivering broadband to areas that the market will not serve of its own accord (mainly rural areas); and the Urban Broadband Fund, which is aimed at establishing 'super connected' cities with fixed broadband capabilities of between 80-100Mbs and comprehensive mobile broadband coverage. We are playing an active role in helping Government and industry understand how best this money might be spent to maximize the long term value of public investment in broadband networks, and to ensure the money is allocated in a way that does not undermine private investments or otherwise distort the market. This includes ensuring that State aid rules are strictly adhered to.
To that end, we have recently lodged a formal challenge against the European Commission's decision to approve a project involving the deployment of a State subsidised broadband network in the city of Birmingham. This project may otherwise have resulted in the over-build of parts of our and other operators' infrastructure. BT has lodged a similar challenge. We continue to work with the U.K. Government to find constructive ways to progress Birmingham and other cities' digital objectives.
REGULATION OF TELEVISION AND VIDEO ON-DEMAND SERVICES
We are required to hold individual licenses under the Broadcasting Acts 1990 and 1996 for any television channels (including barker channels) which we own or operate and for the provision of certain other services on our cable TV platform, such as electronic program guides. These television licensable content service, or TLCS, licenses are granted and administered by Ofcom. Under these licenses, each covered service must comply with a number of Ofcom codes, including the Broadcasting Code, and with all directions issued by Ofcom. Breach of any of the terms of a TLCS license may result in the imposition of fines on the license holder and, ultimately, to the license being revoked.
ATVOD is the independent co-regulator for the editorial content of U.K. video on-demand services that fall within the statutory definition under the Communications Act of an “On-Demand Programme Service”, or ODPS.
As a provider of an ODPS, we must comply with a number of statutory obligations in relation to 'editorial content' and notify ATVOD of our intention to provide an ODPS. Failure to notify ATVOD or comply with the relevant statutory obligations may result in the imposition of fines or, ultimately, the prohibition on providing an ODPS.
In March 2007, following receipt of a request from us, in conjunction with other affected operators, Ofcom initiated an investigation into the U.K. pay television, or pay-TV, market. Our joint submission outlined certain features of the U.K. pay-TV market which, we believe, distort effective competition within this market and, in particular, favor BSkyB. In its final statement on the pay-TV market, issued in March 2010, Ofcom found that BSkyB has market power in the wholesale supply of certain premium sports and premium movie channels and acts on that market power to restrict supply and prevent fair and effective competition.
To remedy the concerns around premium sports channels, Ofcom imposed a wholesale must offer, or WMO, regime for regulating the terms of supply of Sky Sports 1 and 2 SD and HD. This decision was appealed by a number of parties (including ourselves).
These appeals were heard by the Competition Appeal Tribunal between May 9, 2011 and July 15, 2011. On August 8, 2012, the Competition Appeal Tribunal issued its judgment, overturning Ofcom's decision. The Competition Appeal Tribunal found that, whilst Ofcom had the powers to take action, the core competition concerns on which Ofcom based its decision were unfounded. BT has asked for permission to appeal this judgment and at the time of writing, BT's application is still being considered.
In relation to movies, Ofcom decided in August 2010 to refer the linear and VOD movie markets to the U.K. Competition Commission for a 2-year market investigation. In August 2012, the Competition Commission concluded that Sky Movies, which currently offers the first availability on a PPV basis to the U.K. market of movies from all the big Hollywood studios, is not a sufficient driver of subscribers' choice of pay-TV provider to give Sky such an advantage over its rivals when competing for pay-TV subscribers as to harm competition. No remedies have therefore been adopted. Despite this, the Competition Commission found that competition in the pay-TV retail market overall remains ineffective.
In 2006 Ofcom also initiated a review of the terms under which operators of DTV platforms in the U.K., such as us, allow access to their platforms for third-party television channels and content providers. However, this review has not progressed beyond its initial stages. We are therefore unable to assess the likely outcome of this review and resulting impact on our activities in this sector at this time.
REGULATION OF TELECOMMUNICATIONS SERVICES
In order to operate in the telecommunications sector, a provider must comply with general conditions imposed by Ofcom. These general conditions cover a broad range of issues including interconnection standards, number portability, deployment of telephone numbers, access to emergency services and sales and marketing standards. Any breach of these general conditions could lead to the imposition of fines by Ofcom and, ultimately, to the suspension or revocation of a company's right to provide electronic communications networks and services. Ofcom also undertakes triennial reviews of the various economic markets within the telecommunications sector to establish whether any provider has SMP warranting the imposition of remedies. The U.K. Government is currently undertaking a review of certain aspects of the Communications Act. However, it is unclear at this stage what changes will be made or the timing of any changes.
Fixed Line Telephony Services
As a fixed network operator we, like all other fixed network operators, are deemed to have SMP in wholesale call termination on our own network, and are therefore subject to SMP conditions in this market. However, these conditions do not have a significant impact on our ability to compete in the wholesale market, and although Ofcom is currently reviewing this market, it is not anticipated that this will result in any significant regulatory changes.
Ofcom is in the process of undertaking a fundamental review of the regulatory regime applying to non-geographic calling services. This is likely to result in a significant change to the retail and wholesale charging arrangements to which such calls are subject. We are working closely with Ofcom in its consideration and development of these reforms in order to mitigate risks and maximize opportunities.
Broadband Services
Ofcom is in the very first stages of its triennial review of the Wholesale Local Access, or WLA, market (physical or passive network access via methods such as LLU and duct access) and Wholesale Broadband Access, or WBA, market (virtual or active network access via methods such as provision of wholesale managed service products). The outcome of those reviews could have consequences for both Virgin Media's cable and non-cable operations.
We anticipate that BT will again be found to have SMP in the WLA market and certain sub-national areas of the WBA market and will be required to provide certain products and services on regulated terms, (which may continue to include providing access to its ducts and poles).
Mobile Telephony Services
As a MVNO, we are subject to EU regulations relating to retail prices for roaming services. The Roaming Regulation (European Commission Regulation 531/2012) sets limits on certain wholesale and retails tariffs for international mobile voice roaming, SMS tariffs and data roaming within the EU, provides for greater levels of transparency of retail pricing information and sets maximum roaming rates within the EU. The new regulation adopted in June 2012 includes provisions aimed at preventing consumer bill shock relating to data roaming charges both within and outside of the EU.
Mobile termination charges applied by MNOs are regulated by Ofcom under SMP conditions, one of which requires MNOs to reduce their mobile termination charges over time. Under our MVNO agreement with EE these changes in mobile termination charges are passed on to Virgin Mobile U.K. and we have experienced a reduction in revenue from such charges.
NON-INDUSTRY SPECIFIC REGULATION
Our business activities are subject to certain environmental and health and safety laws and regulations. Failure to comply with these laws and regulations may result in us incurring fines or other penalties and we may incur expenditure to account for these fines or penalties, maintain compliance and/or undertake any necessary remediation. In addition, any breach of the aforementioned laws and/or regulations by our affiliates, vendors and contractors could result in liability for us.
The proposed merger between Liberty Global and us remains subject to approval by the relevant competition authorities. For more information on the Merger Agreement see the Recent Developments section of Item 1 of this Form 10-K.
OTHER MATTERS
INFORMATION TECHNOLOGY
The operation, development and support of our information technology systems are performed by a mix of outsourced and internally managed services. These systems include billing, customer management, enterprise resource planning, business intelligence, corporate network, payroll, data center and desktop infrastructure. We are continuing to decommission or consolidate a number of diverse software applications and hardware platforms in order to reduce our dependency on high cost external support and management services and improve the stability of these systems. In 2011 we announced the outsourcing of our mobile application development and applications support function as well as development testing functions to a key strategic partner to improve service levels and lower the total cost of these services.
SEASONALITY
Some revenue streams are subject to seasonal factors. For example, fixed line telephone usage revenue by customers and businesses tends to be slightly lower during summer holiday months, and mobile average revenue per unit, or ARPU, generally decreases in the first quarter of each year due to the fewer number of days in February and customers changing their spending patterns following the Christmas period. Our consumer cable churn rates include persons who disconnect their service because of moves, resulting in a seasonal increase in our churn rates during the summer months when higher levels of U.K. house moves have traditionally occurred and when students leave their accommodation between academic years.
CORPORATE RESPONSIBILITY AND SUSTAINABILITY
We have a long-term commitment to growing a responsible and sustainable business. Accountability for delivering our sustainability strategy sits with our Corporate Responsibility, or CR, Committee. Chaired by our Chief Executive Officer, it is comprised of members of our senior management, who represent our core business functions. Supported by our dedicated Sustainability team, the CR Committee meets quarterly to review our progress.
Following a formal stakeholder engagement program that included key opinion leaders, staff and customers, in 2012 we increased our strategic focus on the positive impact of digital technology on everyday life and in communities and society at large. Alongside our longstanding program, Virgin Media Pioneers, which uses digital technology to support the next generation of entrepreneurs, we launched a new program called 'Our digital future'. Taking a broad and open view from a wide spectrum of audiences, 'Our digital future' will help us understand the wants and concerns of every internet user in the U.K. and support us in developing the services of the future that ensure everyone benefits from what digital technology has to offer.
In 2012, we prioritized three areas of focus to improve sustainability across the Virgin Media business: our products, our operations and our people. Targets for improved performance were set across each of these areas, in addition to our long-term target of reducing our 2007 carbon footprint by 15% by 2015.
We will continue to share updates on our performance and key highlights on our progress through our award winning sustainability website: http://www.virginmedia.com/sustainability.
RESEARCH AND DEVELOPMENT
Our research and development activities involve the analysis of technological developments affecting our cable television, telephone (including mobile) and telecommunications businesses, the evaluation of existing services and sales and marketing techniques and the development of new services and techniques.
PATENTS, TRADEMARKS, COPYRIGHTS AND LICENSES
We do not have any material patents or copyrights nor do we believe that patents play a material role in our business. We own or have the right to use registered trademarks, which in some cases are, and in others may be, of material importance to our business. This includes the exclusive right to use the “Virgin” name and logo under licenses from Virgin Enterprises Limited in connection with our corporate activities and the activities of our consumer and business operations. These licenses, which expire in April 2036, are exclusive to us within the U.K. and Ireland, and are subject to renewal on terms to be agreed. They entitle us to use the “Virgin” name for the television, broadband internet, fixed line telephony and mobile phone services we provide to our consumer and business customers, and in connection with the sale of certain communications equipment, such as set-top boxes and cable modems.
Our license agreements provide for an annual royalty of 0.25% of certain consumer, business and content revenues, subject to a minimum annual royalty, subject to inflationary adjustments, of £8.5 million in relation to our consumer operations, and £1.5 million in relation to our business operations.
Under the agreements we have worldwide exclusivity over the name “Virgin Media” and “Virgin Media Inc.” For our Business division, we are licensed to use the name “Virgin Media Business” for the provision of business communications services.
These agreements are unchanged by the proposed merger with Liberty Global and we will continue to operate under the Virgin Media and Virgin Media Business brands.
EMPLOYEES
At December 31, 2012, we had 14,004 employees, of whom 12,742 were full-time and 1,262 were part-time. We also had 844 temporary employees. We have now terminated the voluntary collective bargaining agreements we had previously with the Communication Workers Union (CWU) and the Broadcasting, Entertainment, Cinematograph and Theatre Union (BECTU). These agreements covered our field service technicians and field engineers and from December 1, 2012, we no longer recognize either trade union for collective bargaining purposes for these employees. As these were the only agreements in existence at Virgin Media this means that there are no employees at Virgin Media covered by collective bargaining or recognition agreements. For employee consultation purposes, we work with and recognize our National and Divisional Employee Voice Forums. We believe we have good relationships with our employees.
AVAILABLE INFORMATION AND WEBSITE
Our principal executive offices are located at 65 Bleecker Street, 6th Floor, New York, NY 10012, United States, and our telephone number is (212) 906-8440. Our U.K. headquarters are located in Hook, Hampshire, England. The public may read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at (800) SEC-0330. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to such reports filed with or furnished to the SEC under Section 13(a) or 15(d) of the U.S. Securities Exchange Act of 1934, as amended, or the Exchange Act, are available free of charge on the SEC's website at www.sec.gov and on our website at www.virginmedia.com, as soon as reasonably practicable after they are filed with, or furnished to, the SEC. The investor relations section of our website can be accessed by going to www.virginmedia.com/investors. Our press releases, which provide notice of upcoming presentations including the relevant dial-in-details, where applicable, are also provided on our website. The information on our website is not incorporated into our SEC filings.
ITEM 1A.
ITEM 1A. - RISK FACTORS
OVERVIEW
In addition to the information contained in this annual report on Form 10-K, you should consider the following risk factors in evaluating our results of operations, financial condition, business and operations or an investment in our stock.
The risk factors described in this section have been separated into three groups:
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risks relating to our business and industry;
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risks relating to our financial indebtedness and structure; and
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risks relating to our common stock.
In addition to the information presented in this annual report, there may be other unknown or unpredictable economic, business, competitive, regulatory or other factors that could have material adverse effects on our results of operations, financial condition, business or operations in the future. In addition, past financial performance may not be a reliable indicator of future performance and historical trends should not be used to anticipate results or trends in future periods.
If any of the events described below were to occur, our businesses, prospects, financial condition, results of operations and/or cash flows could be materially adversely affected.
RISKS RELATING TO OUR BUSINESS AND INDUSTRY
We have entered in to a Merger Agreement with Liberty Global, Inc., which is subject to certain conditions, and as a result the merger may not be consummated; our operations both before and after consummation of the merger will be impacted.
On February 5, 2013, we entered into a Merger Agreement with Liberty Global, Inc., or Liberty Global, pursuant to which we agreed to be acquired by Liberty Global subject to the terms and conditions in the Merger Agreement. The consummation of the Merger pursuant to the Merger Agreement is subject to regulatory approval, the affirmative approval of our shareholders and those of Liberty Global and other customary conditions. In addition, the Merger Agreement may be terminated under certain conditions by Liberty Global or us. As a result the merger may not be consummated.
Whether or not the merger is consummated, the announcement and pendency of the transaction could cause disruptions to our business, which could have an adverse effect on our business and financial condition and results of operations.
Under the Merger Agreement, we have agreed to certain covenants that place restrictions on our ability to, among other things, dispose of properties or assets, make unbudgeted capital expenditures, acquire substantial assets, make substantial investments, increase the salary of certain of our employees or directors, pay certain bonuses or incentive compensation, grant new equity or non-equity based compensation awards, hire new employees, redeem equity interests, declare or pay dividends or make other distributions in respect of our capital stock, other than a quarterly dividend of up to $0.04 per share, incur indebtedness, enter into certain transactions with related parties or enter into new material contracts outside the ordinary course of business, in each case, until the earlier of the termination of the Merger Agreement and the effective time of the Merger.
Once consummated, the combined company may be unable to successfully integrate operations and realize the full anticipated synergies of the Merger, which may have an adverse impact on our financial condition and results of operations.
We operate in highly competitive markets which may lead to a decrease in our revenue, increased costs, increased customer churn or a reduction in the rate of customer acquisition.
The markets for broadband internet, television, telephony and business services in which we operate are highly competitive and, in certain markets, we compete with established companies that hold positions of market power in these and/or closely related markets. We face competition from these companies, other established companies and potential new entrants. Technological advances may increase competition or alter the competitive dynamics of markets in which we operate. For example, the distribution of entertainment and other information over the internet, as well as the distribution of entertainment through mobile phones and other devices that continue to increase in popularity
and could increase the number of media choices available to subscribers. In addition, continued consolidation within the media industry may permit more competitors to offer “triple-play” bundles of digital television, fixed line telephony and broadband services, or “quad-play” bundles including mobile telephone services. Consolidation by competitors can create economies of scale that we cannot replicate, for example in the mobile sector. Many of our competitors are part of multinational groups, and some may have substantially greater financial resources and benefit from greater economies of scale than we do.
In order to compete effectively, we may be required to reduce the prices we charge for our services or increase the value of our services without being able to recoup associated costs. We may also need to pursue legal and regulatory actions. In addition, some of our competitors offer services that we are unable to offer. Any increase in competitive pressures in our markets may lead to a decrease in our revenue, increased costs, increased customer churn or a reduction in the rate of customer acquisition, which could have an adverse effect on our business, financial condition, results of operations and cash flows. See also Item 1 of this Form 10-K, “Business-Competition”.
The sectors in which we compete are subject to rapid and significant changes in technology, and the effect of technological changes on our businesses cannot be predicted.
The broadband internet, television, telephony and business services sectors are characterized by rapid and significant changes in technology. Advances in current technologies, such as VoIP (over fixed and mobile technologies), 3D TV, mobile instant messaging, wireless fidelity, or Wi-Fi, the extension of local Wi-Fi networks across greater distances, or WiMax, LTE, internet protocol television, or the emergence of new technologies, such as white space technologies (which use portions of the old analog TV spectrum), or the availability to our competitors of 4G spectrum and technology, may result in our core offerings becoming less competitive or render our existing products and services obsolete. We may not be able to develop new products and services, or keep up with trends in the technology market, at the same rate as our competitors (or at all). The pace of change may be such that we fail to seize opportunities to become market disrupters or to adequately respond to market disrupters. Any of these could lead to a decrease in our revenue, increased costs, increased customer churn or a reduction in the rate of customer acquisition. This could have an adverse effect on our business, financial condition, results of operations and cash flows. See also Item 1 of this Form 10-K, “Business-Competition”.
The cost of implementing emerging and new technologies could be significant, and our ability to fund that implementation may depend on our ability to obtain additional financing. Similarly, the deployment of new technologies in the spectrum frequencies in which we operate could have a material adverse effect on the existing services offered by us, with a consequential material adverse effect on our businesses either through greater competition or through interference with our customer premises equipment, or CPE.
Adverse economic developments could reduce customer spending for our TV, broadband, and telephony services and increase churn, either of which could therefore have a material adverse effect on our revenue.
Most of our revenue is derived from residential subscribers who could be impacted by adverse economic developments in the U.K. Accordingly unfavorable economic developments, such as recessions or inflationary pressures, could negatively affect the affordability of and demand for many of our products and services. Customers could elect to use fewer higher margin products and services or could turn to lower cost products and services offered by other companies. For example, there may be increased reliance on VoIP or other internet-based telephony solutions in lieu of our fixed and mobile telephony services, and there may be an increased reliance on video streaming over the internet such as through Netflix, LOVEFILM, BBC iPlayer and ITV Player instead of relying on our TV products and services. Such a consumer shift could in turn adversely impact our ability to increase, or in certain cases, maintain our revenue levels.
Our fixed line telephony revenue is declining and unlikely to improve.
Fixed line telephony usage is in decline across the industry, with the rate of decline in lines used by businesses being nearly twice as high as that in the residential fixed telephony market. There is a risk that business and residential customers will migrate from using fixed line telephony to using other forms of telephony such as VoIP, or mobile telephony. There is no assurance that our fixed line customers will migrate to our mobile phones and they may eventually shift to other providers of mobile telephony services. Such a migration could have a material effect on our results of operations, revenue and financial condition.
A failure in our network and information systems, whether caused by a natural failure or a security breach, could significantly disturb our operations, which could have a material adverse effect on those operations, our business, our results of operations and financial condition.
Certain network and information systems are critical to our business activities. Network and information systems may be affected by cyber security incidents that can result from deliberate attacks or system failures. These may include, but are not limited to computer hackings, computer viruses, worms or other destructive or disruptive software, or other malicious activities. Our network and information systems may also be the subject of power outages, fire, natural disasters, terrorist attacks, war or other similar events. Theft of metals is particularly acute in the U.K. due to high prices for scrap metal, and our network is not immune to such thefts. Such events could result in a degradation of, or disruption to, our cable and non-cable services, and could prevent us from billing and collecting revenue due to us or could damage our equipment and data or could result in damage to our reputation. Disruption to services could result in excessive call volumes to call centers that may not be able to cope with such volume, which could in turn have an adverse effect on our reputation and brand. Our plans for recovery from, and resilience to, such challenges may not be sufficient. The amount and scope of insurance we maintain against losses resulting from these events may not be sufficient to cover our losses or otherwise adequately compensate us for any disruptions to our business that may result.
Sustained or repeated failures of our own or third-party systems that interrupt our ability to provide services to our customers, prevent us from billing and collecting revenue, or that otherwise prevent us from meeting our obligations in a timely manner, would adversely affect our reputation and result in a loss of customers and revenue. These network and information systems-related events could also require significant expenditures to repair or replace damaged networks or information systems or to protect them from similar events in the future. Further, any security breaches, such as misappropriation, misuse, penetration by viruses, worms or other destructive or disruptive software, leakage, falsification or accidental release or loss of information maintained in our information technology systems and networks or those of our business partners (including customer, personnel and vendor data) could damage our reputation, result in legal and/or regulatory action against us, and require us to expend significant capital and other resources to remedy any such security breach. As a result of the increasing awareness concerning the importance of safeguarding personal information, the potential misuse of such information and legislation that has been adopted or is being considered regarding the protection, privacy and security of personal information, the liability associated with information-related risks is increasing, particularly for businesses like ours that handle a large amount of personal customer data. The occurrence of any such network or information system-related events or security breaches could have a material adverse effect on our business and results of operations.
Unauthorized access to our network resulting in piracy could result in a loss of revenue.
We rely on the integrity of our technology to ensure that our services are provided only to identifiable paying customers. Increasingly sophisticated means of illicit piracy of television, broadband and telephony services are continually being developed in response to evolving technologies. Furthermore, billing and revenue generation for our pay television services rely on the proper functioning of our encryption systems. While we continue to invest in measures to manage unauthorized access to our networks, any such unauthorized access to our cable television service could result in a loss of revenue, and any failure to respond to security breaches could raise concerns under our agreements with content providers, all of which could have a material adverse effect on our business and results of operations.
We rely on third-party suppliers and contractors to provide necessary hardware, software or operational support and are reliant on them in a way that could economically disadvantage us.
We rely on third-party vendors to supply us with a significant amount of customer equipment, hardware, software and operational support necessary to operate our network and systems and provide our services. In many cases, we have made substantial investments in the equipment or software of a particular supplier, making it difficult for us in the short term to change supply and maintenance relationships in the event that our initial supplier is unwilling or unable to offer us competitive prices or to provide the equipment, software or support that we require. In addition, certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act may soon require us to report on “conflict materials” used in our products and the due diligence plan we put in place to track whether such minerals originate from the Democratic Republic of Congo and adjoining countries. The implementation of these requirements could affect the sourcing and availability of minerals used in certain of our products.
We also rely upon a number of third-party contractors to construct and maintain our network and to install our equipment in customers' homes. Quality issues or installation or service delays relating to these contractors could result in liability, reputational harm or contribute to customer dissatisfaction, which could result in additional churn or discourage potential new customers.
We are furthermore exposed to risks associated with the potential financial instability of our suppliers, some of whom may have been adversely affected by the global economic downturn. If our suppliers were to discontinue certain products, were unable to provide equipment to meet our specifications or interrupt the provision of equipment or services to us, whether as a result of bankruptcy or otherwise, our business and profitability could be materially adversely affected.
The “Virgin” brand is not under our control and the activities of the Virgin Group and other licensees could have a material adverse effect on the goodwill of customers towards us as a licensee.
The “Virgin” brand is integral to our corporate identity. We are reliant on the general goodwill of consumers towards the Virgin brand. Consequently, adverse publicity in relation to the Virgin Group or its principals, particularly Sir Richard Branson who is closely associated with the brand, or in relation to another licensee of the “Virgin” name and logo (particularly in the U.K. where we do business) could have a material adverse effect on our reputation, business and results of operations.
Our inability to obtain popular programming or to obtain it at a reasonable cost could potentially have a material adverse effect on the number of customers or reduce margins.
We enter into agreements for the provision of television programs and channels distributed via our entertainment service with program providers, such as public and commercial broadcasters, or providers of pay or on-demand television. We have historically obtained a significant amount of our premium programming and some of our basic programming and pay per view sporting events from BSkyB. BSkyB is also one of our main competitors in the television services business. BSkyB is a leading supplier of programming to pay television platforms in the U.K. and is the exclusive supplier of some programming, including its Sky Sports channels and Sky Movies channels, which are the most popular premium subscription sports and film channels available in the U.K.
In 2010, Ofcom imposed new license conditions on BSkyB that provide for a WMO obligation on Sky that regulate (or set a fair, reasonable and non-discriminatory requirement for) the price and terms of supply of certain of BSkyB's Sports Channels. While BSkyB and others appealed the imposition of these license conditions and sought to overturn it, we and others appealed that the intervention did not go far enough. See Item 1 of this Form 10-K, "Business-Regulatory Matters-Regulation of Television Services”. In August 2012, the Competition Appeal Tribunal issued its judgment, overturning Ofcom's decision. BT has asked for permission to appeal the Competition Appeal Tribunal's judgment and at the time of writing, BT's application is still being considered.
We currently purchase BSkyB wholesale premium content on the basis of carriage agreements entered into on June 4, 2010, which provide for the wholesale distribution of BSkyB's basic channels and its premium sports and movies channels on our cable TV service. However, for SD we are still exposed to BSkyB changing the ratecard terms of supply on 60 days' notice and we are also exposed to BSkyB offering HD versions of its channels exclusively to its digital satellite customers and not to us. Some of these agreements expire on June 30, 2013, after which we will have to negotiate new arrangements for the supply of BSkyB premium sports and movie channels. In relation to basics, the launch of Sky Atlantic exclusively to its own retail customers on the satellite platform is an example of the ongoing risk of BSkyB offering new channels that it is not contractually obliged to supply to us.
Other significant programming suppliers include the BBC, ITV, Channel 4, UKTV, Five, Viacom Inc., ESPN, Discovery Communications Inc. and Turner, a division of Time Warner Inc. Our dependence on these suppliers for television programming could have a material adverse effect on our ability to provide attractive programming at a reasonable cost. Any loss of programs could negatively affect the quality and variety of the programming delivered to our customers. In addition, there is the risk that suppliers will become exclusive providers to other platforms, including BSkyB, which reduces our ability to offer the same or similar content to our customers. All of these factors could have a material adverse effect on our business and increase customer churn.
Our consumer mobile service relies on EE's network to carry its communications traffic.
Our services to mobile customers rely on our agreement with EE for voice, non-voice and other telecommunications services and for ancillary services such as pre-pay account management. If the agreement with EE is terminated, or if EE fails to provide the services required under the agreement, or if EE fails to deploy and maintain its network, and we are unable to find a replacement network operator on a timely and commercial basis (if at all), we could be prevented from continuing our mobile business. If we find a replacement network operator, we may only be able to carry on our mobile business on less favorable terms. Additionally, migration of all or some of our customer base to any such replacement network operator would be dependent in part on EE and could entail potential technical or commercial risk.
EE is also a customer of Virgin Media Business. Any disagreements between EE and our mobile operations or between EE and Virgin Media Business could have a material adverse effect on the relationship of the other Virgin Media businesses and EE.
We do not insure the underground portion of our cable network and various pavement-based electronics associated with our cable network.
Our cable network is one of our key assets. However, we do not insure the underground portion of our cable network or various pavement-based electronics associated with our cable network. Almost all our cable network is constructed underground. As a result, any catastrophe that affects our underground cable network or our pavement-based electronics could prevent us from providing services to our customers and result in substantial uninsured losses that would have a material adverse effect on our business and results of operations.
We are subject to currency and interest rate risks.
We are subject to currency exchange rate risks because substantially all of our revenues and operating expenses are paid in pounds sterling, but we pay interest and principal obligations with respect to a portion of our indebtedness in U.S. dollars and euros. To the extent that the pound sterling declines in value against the U.S. dollar and the euro, the effective cost of servicing our U.S. dollar and euro-denominated debt will be higher. Changes in the exchange rate result in foreign currency gains or losses.
We are also subject to interest rate risks as we have interest determined on a variable basis, either through unhedged variable rate debt or derivative hedging contracts. We also incur costs in U.S. dollars, euros and South African rand, in the ordinary course of our business, including for customer premises equipment and network maintenance services. Any deterioration in the value of the pound relative to the U.S. dollar, euro or the rand could cause an increase in the effective cost of purchases made in these currencies as only part of these exposures are hedged.
See Item 7A of this Form 10-K, "Quantitative and Qualitative Disclosures About Market Risk".
We are subject to tax in more than one tax jurisdiction and our structure poses various tax risks.
We are subject to taxation in multiple jurisdictions, in particular the U.S. and the U.K. Our effective tax rate and tax liability will be affected by a number of factors in addition to our operating results, including the amount of taxable income in particular jurisdictions, the tax rates in those jurisdictions, tax treaties between jurisdictions, the manner in which and extent to which we transfer funds to and repatriate funds from our subsidiaries, accounting standards and changes in accounting standards, and future changes in the law. We may incur losses in one jurisdiction that cannot be offset against income earned in a different jurisdiction and so we may pay income taxes in one jurisdiction for a particular period even though on an overall basis we incur a net loss for that period.
Substantially all of our operations are conducted through U.K. subsidiaries that are owned by one or more members of a U.S. holding company group. We do not expect to have current U.K. tax liabilities on our operating earnings for at least the medium term. However, our operations may give rise to U.S. tax on “Subpart F” income generated by our U.K. subsidiaries, or on repatriations of cash from our U.K. operating subsidiaries to the U.S. holding company group. We believe that our U.K. subsidiaries have a substantial U.S. tax basis that may be available to avoid or reduce U.S. tax on repatriation of cash from our U.K. subsidiaries. However, there is a risk that the Internal Revenue Service, or IRS, may seek to challenge the amount of that tax basis or that we will not be able to utilize such basis under applicable tax law. As a result, although in accordance with applicable law we will seek to minimize our U.S. tax liability as well as our overall worldwide tax liability, we may incur U.S. tax liabilities with respect to repatriation of cash from our U.K. subsidiaries to the U.S.. The amount of the tax liability, if any, would depend upon a multitude of factors, including the amount of cash actually repatriated.
We also pay Value Added Tax, or VAT, on our revenue generating activities in the U.K. From time to time, the U.K. tax authorities review the basis upon which our VAT liability is assessed. We are currently engaged in a dispute with the tax authorities over one of these reviews. See item 7 of this Form 10-K, “Management's Discussion and Analysis of Financial Condition and Results of Operations-Consolidated Results of Operations-Taxation-Contingencies".
Acquisitions and other strategic transactions present many risks, and we may not realize the financial and strategic goals that were contemplated at the time of any transaction.
From time to time we have made acquisitions, dispositions and have entered into other strategic transactions. In connection with such transactions, we may incur unanticipated expenses, fail to realize anticipated benefits, have difficulty integrating the acquired businesses, disrupt relationships with current and new employees, customers and suppliers, incur significant indebtedness, or experience delays or fail to proceed with announced transactions. These factors could have a material adverse effect on our business and/or our reputation.
Adverse changes in our financial outlook may result in negative or unexpected tax consequences which could adversely affect our net income
During 2012, we recognized a gain on reversing a significant portion of the valuation allowance on our deferred tax assets. Future adverse changes in the underlying profitability and financial outlook of our operations could cause us to change our judgment and establish an additional valuation allowance on our deferred tax assets, which could materially and adversely affect our consolidated balance sheets and statements of comprehensive income. A change in this valuation allowance will not result in any change to the amount of cash payments we make to the tax authorities.
We are subject to significant regulation, and changes in U.K. and EU laws, regulations or governmental policy affecting the conduct of our business may have a material adverse effect on our ability to set prices, enter new markets or control our costs.
Our principal business activities are regulated and supervised by Ofcom and the U.K. Office of Fair Trading, among other regulators. Regulatory change is an ongoing process in the communications sector at both U.K. and EU level. Changes in laws, regulations or governmental policy affecting our activities and those of our competitors could significantly influence how we operate our business and introduce new products and services. For example, regulatory changes relating to our activities and those of our competitors, such as changes relating to third party access to infrastructure, the costs of interconnection with other networks or the prices of competing products and services, or any change in policy allowing more favorable conditions for other operators, could adversely affect our ability to set prices, enter new markets or control our costs. In particular, following the transposition of recent amendments to European directives into U.K. law, Ofcom may attempt to use the non-significant market power, or non-SMP, access provisions to require us to make available access to our ducts. In addition, Ofcom may look to impose regulation on the cable network, which is currently unregulated. Such regulation would allow customers to switch with ease to another provider without informing us. Our ability to introduce new products and services may also be affected if we cannot predict how existing or future laws, regulations or policies would apply to such products or services. In addition, our business and the industry in which we operate are subject to investigation by regulators, which could lead to enforcement actions, fines and penalties or the assertion of private litigation claims and damages. Any such action could harm our reputation and result in increased costs to the business.
RISKS RELATING TO OUR FINANCIAL INDEBTEDNESS AND STRUCTURE
Under the terms of the Merger Agreement, our financial indebtedness will be materially changed and our overall level of indebtedness increased. The risks below, together with other risks, may be relevant to the new debt structure as well as our existing debt structure. For more information on the proposed merger see the Recent Developments section of Item 1 of this Form 10-K.
We have substantial indebtedness that may have a material adverse effect on our available cash flow, our ability to obtain additional financing if necessary in the future, our flexibility in reacting to competitive and technological changes and our operations.
We have a substantial amount of indebtedness. Our consolidated total long term debt, net of £77.1 million current portion, was £5,852.0 million as of December 31, 2012.
Our ability to pay principal and interest on or to refinance the outstanding indebtedness depends upon our operating performance, which will be affected by, among other things, general economic, financial, competitive, regulatory and other factors, some of which are beyond our control. Moreover, we may not be able to refinance or redeem such debt on commercially reasonable terms, on terms acceptable to us, or at all.
The level of our indebtedness could have important consequences, including the following:
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a substantial portion of our cash flow from operations will have to be dedicated to the payment of interest and principal on existing indebtedness, thereby reducing the funds available for other purposes;
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our ability to obtain additional financing in the future for working capital, capital expenditures, product development, acquisitions or general corporate purposes may be impaired;
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our flexibility in planning for, or reacting to, changes in our business, the competitive environment and the industry in which we operate, and to technological and other changes may be limited;
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we may be placed at a competitive disadvantage as compared to our competitors that are not as highly leveraged;
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our substantial degree of leverage could make us more vulnerable in the event of a downturn in general economic conditions or adverse developments in our business; and
•
we are exposed to risks inherent in interest rate and foreign exchange rate fluctuations.
Any of these or other consequences or events could have a material adverse effect on our ability to satisfy our debt obligations, which could adversely affect our business and operations.
We may not be able to fund our debt service obligations in the future.
We have significant principal payments due from 2015 onwards that could require a partial or comprehensive refinancing of our senior credit facility and other debt instruments. Our ability to implement such a refinancing successfully would be significantly dependent on stable debt capital markets. In addition, we may not achieve or sustain sufficient cash flow in the future for the payment of principal or interest on our indebtedness when due. Consequently, we may be forced to raise cash or reduce expenses by doing one or more of the following:
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raising additional debt;
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restructuring or refinancing our indebtedness prior to maturity, and/or on unfavorable terms;
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selling or disposing of some of our assets, possibly on unfavorable terms;
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issuing equity or equity-related instruments that will dilute the equity ownership interest of existing stockholders; or
•
foregoing business opportunities, including the introduction of new products and services, acquisitions and joint ventures.
We cannot be sure that any of, or a combination of, the above actions would be sufficient to fund our debt service obligations, particularly in times of turbulent capital markets.
The covenants under our debt agreements place certain limitations on our ability to finance future operations and how we manage our business.
The agreements that govern our indebtedness contain financial maintenance tests and restrictive covenants that restrict our ability to incur additional debt and limit the discretion of our management over various business matters. For example, the financial maintenance tests include leverage and interest coverage ratios, and the restrictive covenants impact our ability to:
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pay dividends or make other distributions, or redeem or repurchase equity interests or subordinated obligations;
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make investments;
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sell assets, including the capital stock of subsidiaries;
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enter into sale and leaseback transactions and certain vendor financing arrangements;
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create liens;
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enter into agreements that restrict some of our subsidiaries' ability to pay dividends, transfer assets or make intercompany loans;
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merge or consolidate or transfer all or substantially all of our assets; and
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enter into transactions with affiliates.
Although these limitations are subject to significant exceptions and qualifications, if we breach any of these covenants, or are unable to comply with the required financial ratios, we may be in default under our debt instruments. A significant portion of our indebtedness may then become immediately due and payable, and we may not have sufficient assets to repay amounts due thereunder.
These restrictions could also materially adversely affect our ability to finance future operations or capital needs or to engage in other business activities that may be in our best interests. We may also incur other indebtedness in the future that may contain financial or other covenants more restrictive than those applicable under our current indebtedness.
We are a holding company dependent upon cash flow from subsidiaries to meet our obligations.
Virgin Media Inc. and a number of its subsidiaries are holding companies with no independent operations or significant assets other than investments in their subsidiaries. Each of these holding companies depends upon the receipt of sufficient funds from its subsidiaries to meet its obligations.
The terms of our senior credit facility and other indebtedness limit the payment of dividends, loan repayments and other distributions to or from these companies under certain circumstances. Various agreements governing our debt may restrict and, in some cases, may also prohibit the ability of these subsidiaries to move cash within their restricted group. Applicable tax laws may also subject such payments to further taxation.
Applicable law may also limit the amounts that some of our subsidiaries will be permitted to pay as dividends or distributions on their equity interests or as loans, or even prevent such payments.
RISKS RELATING TO OUR COMMON STOCK
Under the terms of the Merger Agreement, our common stock will be partially exchanged, in defined proportions, for two classes of stock of a new ultimate parent. The risks below, together with other risks, may be relevant to the new stock issued as well as our existing common stock. For more information on the proposed merger see the Recent Developments section of Item 1 of this Form 10-K.
Conversion of our convertible senior notes will dilute the ownership interest of existing stockholders.
Any issuance by us of our common stock upon conversion of our convertible senior notes will dilute the equity ownership interest of existing stockholders, including holders who have received shares of our common stock upon prior conversion of our convertible senior notes. Additionally, our convertible senior notes include anti-dilution and “make-whole” premium provisions that, if triggered, would result in an increase in the number of shares of our common stock issuable upon conversion of the convertible senior notes. Conversion of the convertible senior notes in circumstances where these provisions have operated could have a significantly greater dilutive effect.
Sales in the public market of the common stock issued upon conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the convertible senior notes may encourage short selling by market participants, which could cause the value of our common stock to decrease.
We may in the future seek to raise funds through equity offerings, which could have a dilutive effect on our common stock.
In the future, we may determine to raise capital through offerings of our common stock, securities convertible into our common stock, or rights to acquire these securities or our common stock. In any case, the result would ultimately be dilutive to our common stock by increasing the number of shares outstanding. We cannot predict the effect this dilution may have on the price of our common stock.
We may not continue to pay dividends, and the failure to do so could adversely affect our stock price.
The decision to pay a dividend and the amount of any dividend is solely at the discretion of the Board. Our Board may decide not to continue to pay dividends on our common stock at the same level as in recent years, or at all. Any failure to pay a dividend could adversely affect our stock price.
The trading volatility and price of our common stock may be affected by many factors, some of which are beyond our control.
The market price of our common stock has been, and may continue to be, adversely affected by conditions in the global financial markets, and stock prices of highly leveraged companies, in particular, have been highly volatile. The market price of our common stock could also be subject to wide fluctuations in response to additional factors, many of which are beyond our control. These factors include general economic and market conditions, actual or anticipated variations in our operational results and cash flow, our competitors' earnings releases, announcements of technological innovations, changes in financial estimates by securities analysts, trading volume, currency and exchange rate fluctuations, market conditions in the industry and the general state of the securities markets and the market for telecommunications stocks, governmental legislation or regulation.
Sales of stock by stockholders in the Company may decrease the price of the common stock.
A number of our stockholders have large holdings of our stock. Sales by any stockholders of a substantial amount of the company's common stock may significantly reduce the market price of the common stock of the company. Moreover, a perception that these stockholders might sell significant amounts of such common stock could depress the trading price of the company's common stock for a considerable period. Sales of the company's common stock, and the possibility of these sales, could make it more difficult for the company to sell equity, or equity related securities, in the future at a time, and price, that it considers appropriate.
Provisions of our debt agreements, our stockholder rights plan, our certificate of incorporation, Delaware law and our contracts could prevent or delay a change of control of us.
We may, under some circumstances involving a change of control, be obligated to repurchase substantially all of our outstanding senior notes, senior secured notes and convertible senior notes, and repay our outstanding indebtedness under our senior credit facility and other indebtedness. We or any possible acquirer may not have available financial resources necessary to repurchase those notes or repay that indebtedness in those circumstances.
If we or any possible acquirer cannot repurchase those notes or repay our indebtedness under our senior credit facility and other indebtedness in the event of a change of control of us, the failure to do so would constitute an event of default under the agreements under which that indebtedness was incurred and could result in a cross-default under other indebtedness that does not have similar provisions. The threat of this could have the effect of delaying or preventing transactions involving a change of control of us, including transactions in which our stockholders would receive a substantial premium for their shares over then current market prices, or otherwise that they may deem to be in their best interests.
Our stockholder rights plan, some provisions of our certificate of incorporation and our ability to issue additional shares of common stock or preferred stock to third parties without stockholder approval may have the effect, alone or in combination with each other, of preventing or making more difficult transactions involving a change of control of us. We are subject to the Delaware business combinations law that, subject to limited exceptions, prohibits some Delaware corporations from engaging in some business combinations or other transactions with any stockholder who owns 15% or more of the corporation's outstanding voting stock, for three years following the date that the stockholder acquired that interest. The terms of certain of our existing agreements relating to changes of control may also have the effect of delaying or preventing transactions involving a change of control of us.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
We own and lease administrative facilities, operational network facilities, and retail facilities throughout the U.K. We lease our U.K. headquarters in Hook, Hampshire and our principal executive offices in New York City. The administrative and operational network facilities are utilized by our Consumer and Business segments. The retail facilities are utilized by our Consumer segment.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are involved in lawsuits, claims, investigations and proceedings, including those relating to intellectual property, commercial, employee and employee benefits, which arise in the ordinary course of our business. For instance, the U.K. tax authorities have challenged our VAT treatment of certain activities and have assessed us accordingly. VAT has been paid to Her Majesty's Revenue and Customs, or HMRC, in order to appeal that assessment. This may become subject to court proceedings.
Mr. William R. Huff, one of our directors, has advised us that W.R. Huff Asset Management Co., LLC, or Huff Asset Management, which is controlled by Mr. Huff, may submit one or more claims for indemnification to the Company in the aggregate amount of approximately $7.4 million. These claims purportedly arise as a result of settlement payments made and attorneys' fees and other expenses incurred by Huff Asset Management in connection with third-party litigation and regulatory proceedings involving Huff Asset Management and relating to fees received by Huff Asset Management in 2004 for advisory services furnished to NTL Incorporated, or NTL, and Telewest Communications PLC, or Telewest. The businesses of NTL and Telewest merged in 2006 to form the Company. Neither the Company nor any of its predecessors was or is currently a party to these litigation or regulatory proceedings. There can be no assurance that the amount or nature of any claim brought against the Company by Huff Asset Management will be limited to indemnification or the amounts of claims specified above. The Company will vigorously defend any such claims made by Huff Asset Management. We are disclosing the potential claims in light of Mr. Huff's position as a director. We have determined that neither an accrual nor disclosure is required in the financial statements included in this report.
While we do not believe any of the litigation matters alone or in the aggregate will have a material adverse effect on our financial position or results of operation, any adverse outcome in one or more of these matters could be material to our consolidated financial statements for any one period.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
MARKET INFORMATION
The principal market for trading in shares of our common stock is the NASDAQ Global Select Market in the United States. Our common stock is also listed in the U.K. on the London Stock Exchange. As of February 4, 2013, there were 110 record holders of our common stock. The following table sets forth the reported high and low price per share of our common stock on the NASDAQ Global Select Market for the periods indicated:
DIVIDENDS
During the years ended December 31, 2011 and 2012, we paid the following dividends:
On February 5, 2013 our board approved the payment of a $0.04 dividend for the fourth quarter ended December 31, 2012.
Future payments of regular quarterly dividends by us are at the discretion of the Board of Directors and will be subject to our future needs and uses of cash, which could include investments in operations, the repayment of debt, and stock repurchase programs. In addition, the terms of our and our subsidiaries’ existing and future indebtedness and the laws of jurisdictions under which those subsidiaries are organized limit the payment of dividends, loan repayments and other distributions to us under many circumstances.
SHARE REPURCHASES
The table below summarizes our repurchases under our Board-authorized capital structure optimization programs during 2012.
Amounts repurchased under accelerated stock repurchase, or ASR, arrangements are presented in the month in which the ASR is authorized, which may differ to the month during which shares are received, as explained in the footnotes.
____________________________
(1)
In July, 2011, we announced a second phase capital restructure optimization program expected to include the application of, in aggregate, up to £850 million, in part towards repurchases of up to £625 million of our common stock until December 31, 2012 and in part towards transactions relating to our debt, including related derivative transactions. In addition, on October 27, 2011, we announced our intention to expend up to a further £250 million on share repurchases from the proceeds from the sale of our UKTV joint venture companies. On December 14, 2012, we announced a further capital restructure optimization program to include the application of up to £1,122 million towards repurchases of our common stock until December 31, 2014, which includes the £122.5 million remaining under our second phase program.
(2)
In February 2012, we entered into an ASR program in the amount of $250 million as a part of our second phase capital structure optimization program. We received 7,488,393 shares on February 13, 2012, 1,441,313 shares on February 24, 2012 and 1,241,384 on March 26, 2012, totaling 10,171,090 shares under this ASR. This ASR terminated on March 26, 2012. The average price paid per share under this ASR was $24.58.
(3)
In May and June 2012, we repurchased 4,212,700 through open market repurchases as part of our second phase capital structure optimization program. The average price paid per share via these open market repurchases was $22.54.
(4)
In July 2012, we entered into an ASR program in the amount of $175 million as part of our second phase capital structure optimization program. We received 5,038,509 shares on July 27, 2012, 836,199 shares on August 8, 2012 and 219,789 on October 26, 2012, totaling 6,094,497 shares under this ASR. This ASR terminated on October 26, 2012. The average price paid per share under this ASR was $28.71.
STOCK PERFORMANCE
The following graph compares the cumulative total return to stockholders of a $100 investment in our common stock for the five-year period from January 1, 2008 through December 31, 2012, with a similar investment in the Standard & Poor’s 500 Stock Index and a Peer Group Index and assumes the reinvestment of dividends. As no published index of comparable companies currently reports values on a dividends reinvested basis, we have created a Peer Group Index for purposes of this graph in accordance with the requirements of the SEC. The Peer Group Index is made up of companies that are engaged in the telecommunications business, although not all of the companies included in the Peer Group Index participate in all of the lines of business in which we are engaged and some of the companies included in the Peer Group Index also engage in lines of business in which we do not participate. In addition, the market capitalizations of many of the companies included in the Peer Group Index are different from ours. The common stocks of the following companies have been included in the Peer Group Index: AT&T Inc., British Sky Broadcasting Group plc, BT Group plc, Cablevision Systems Corporation, Carphone Warehouse Group plc, Comcast Corporation, DISH Network Corporation, France Telecom SA, Liberty Global, Inc., Rogers Communication Inc., Talk Talk Telephone Group and Verizon Communications Inc.
Comparison of Cumulative Total Return
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial information presented below should be read in conjunction with the consolidated financial statements and notes thereto and the information contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTRODUCTION
Management's Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, is provided to assist readers in understanding our recent developments, results of operations, financial condition and cash flows. Our MD&A should be read in conjunction with the description of our business provided in Item 1, the risk factors affecting us set out in Item 1A, and our financial statements and related notes within Item 8 of this Form 10-K.
Throughout our MD&A, references to 2012, 2011, and 2010 are to the financial years ending December 31, 2012, 2011 and 2010 respectively. We also refer to the year ended December 31, 2012 as the year or the current year.
Our MD&A is organized as follows:
•
Overview: Analysis of recent developments in our business together with a summary of overall performance, provided up-front to give context to the remainder of our MD&A.
•
Critical accounting estimates: A summary of the critical accounting estimates and subjective interpretations of accounting principles which impact our reported results of operations and financial condition.
•
Consolidated results of operations: Discussion and analysis of our results of operations, comparing 2012, 2011 and 2010. We present factors impacting our Consumer and Business segments, our Network costs, and other significant components of our results of operations.
•
Liquidity and capital resources: Discussion and analysis of our financial condition, cash flows and liquidity, comparing 2012, 2011, and 2010. This section includes discussion of the fair values of our financial instruments, contractual obligations, and off-balance sheet arrangements.
OVERVIEW
RESULTS FROM OPERATIONS
We report our results from operations (in millions) for our two segments, Consumer and Business:
We expect to incur additional costs under the terms of the Merger Agreement signed with Liberty Global on February 5, 2013. In particular we expect to incur costs associated with changing our debt and equity structure, which will result in, among other charges, additional administrative expenses, losses on extinguishment of debt, gains and losses on derivative instruments, interest expense and stock based compensation expense. For more information on the proposed merger see the Recent Developments section of Item 1 of this Form 10-K.
Consumer Segment
Our strategy of revenue growth through customer additions, product cross sell, tier mix and selective price increases led to Consumer segment revenues increasing by 2.3% during 2012 to £3,430.2 million compared to £3,354.4 million in 2011.
Demand for superfast broadband and TiVo led to lower churn and a strong increase in new subscribers, with cable customer net additions being 88,700 in 2012 compared to 5,500 in 2011, and 76,600 in 2010. Within our residential cable customer base, net triple play customer additions in 2012 were 112,720, compared to 37,400 in 2011 and 138,051 in 2010, taking our triple play penetration to 64.9% of our residential cable customer base at December 31, 2012.
Average monthly cable customer churn for the quarter ended December 31, 2012 fell to 1.1% compared with 1.3% in the quarter ended December 31, 2011.
Increased subscription to TiVo and strong demand for higher broadband speeds improved the product mix which, together with a price rise in April 2012, increased monthly average revenue per user for our cable customers, or cable ARPU. Average monthly cable ARPU for quarter ended December 31, 2012 was £48.87 compared with £47.85 and £47.51 for the quarters ended December 31, 2011 and 2010 respectively.
Total mobile customer numbers remained flat at 3,037,500 at December 31, 2012 compared to 3,037,300 at December 31, 2011, which decreased from 3,068,900 at December 31, 2010. The movement in both years is consistent with our strategy to improve our mobile customer mix with, during 2012, an increase in customers taking a mobile phone on a contract being offset by a broadly comparable decrease in prepaid customer numbers. At December 31, 2012 contract customers represented 56.3% of our mobile based compared with 50.2% and 39.5% at December 31, 2011 and 2010 respectively.
The step down in regulated mobile termination rates reduced inbound mobile revenue by approximately £24 million during 2012. The impact of this reduction to revenues was offset by the positive impact of an improving customer mix leading to monthly average revenue per user for our mobile customers, or mobile ARPU, decreasing to £15.13 during the quarter to December 31, 2012 compared to £15.46 and £15.16 for the quarters to December 31, 2011 and 2010 respectively.
Quad-play penetration, where a household takes all three of our cable products and at least one mobile phone service from us, increased to approximately 15.8% of our residential cable customer base at December 31, 2012, compared to approximately 14.5% and 12.2% at December 31, 2011 and 2010 respectively.
Consumer segment contribution increased to £2,053.2 million for the year compared to £1,991.5 million and £1,982.4 million for 2011 and 2010 respectively. The increase in 2012 arose principally from the higher revenues discussed above, partially offset by an increase in consumer segment marketing costs in the first half of 2012.
Business Segment
Demand for data across both retail and wholesale markets continues to drive the increase in revenues from our Business segment, although this increase is partially offset by the continued decline in voice revenues in both markets. As a result, total revenues from our business segment increased by 5.2% during 2012 to £670.3 million compared to £637.4 million in 2011 and £596.8 million in 2010.
Increased revenue has been the principal driver of the increase in Business segment contribution to £380.8 million in 2012 compared to £377.4 million and £342.8 million in 2011 and 2010 respectively, although this has been offset by higher acquisition and delivery costs during the early life of certain significant contracts.
Our Network
We continue to invest in our network infrastructure to support our Consumer and Business products, such as the rollout of our TiVo service and our broadband speed upgrade, with purchases of fixed assets during 2012 increasing to £783.2 million, of which £101.5 million related to expenditure on our broadband speed upgrade. Fixed assets acquired under capital leases totaled £88.9 million during 2012, compared to £91.2 million in 2011.
Depreciation of fixed assets increased to £951.7 million in 2012 compared to £923.2 million in 2011, reflecting the increased fixed asset purchases discussed above.
Network and other operating costs remained flat at 9.5% of total revenues during 2012 and 2011, compared with 10.1% of total revenues in 2010.
Income Tax Credit
Over the last two decades we have invested over £13 billion building our cable network and have incurred losses in operating that infrastructure. Under UK tax law certain of these investment costs and operating losses are offset against future operating profits, giving rise to deferred tax assets. We have historically recorded a full valuation allowance to reduce the value of these assets to zero.
Under US GAAP accounting principles, we are required to continually evaluate the need for a valuation allowance and have determined it is more likely than not that in future we will generate sufficient pre-tax income to utilize substantially all of our UK deferred tax assets related to unclaimed capital allowances and net operating losses. An important factor in our assessment was the fact that during 2012, we moved into a three year cumulative pre-tax profit position in the
UK for the first time. Therefore, as required by the applicable accounting rules, we have reduced the valuation allowance, which has resulted in a non-cash income tax benefit of £2,592.3 million.
LIQUIDITY AND CAPITAL RESOURCES
Cashflow
Receipts from customers in our Consumer segment together with receipts from our Business customers continue to be our principal source of cash, and we expect this to continue. Net cash from operating activities decreased by 9.5% in 2012 to £1,039.7 million, compared to £1,149.1 million and £1,037.6 million in 2011 and 2010 respectively.
During the year we invested an additional £101.5 million of cash in upgrading our customer's broadband speeds, which contributed to our total purchase of fixed assets increasing to £783.2 million for the year, compared to £656.7 million in 2011, and £628.4 million in 2010.
During 2012, we paid cash interest of £406.9 million on our borrowings, which was 6.5% lower than the £435.2 million interest paid in 2011, and 7.3% lower than the £438.8 million interest paid in 2010, with both decreases being principally due to lower interest rates on lower levels of debt following the refinancings discussed below.
Cash remaining from our operating and investing activities has been used, as described below, to improve the maturity and interest profile of our long term debt, and to continue our capital return programs.
Long Term Debt
During 2012, we have used our strong cash position to access advantageous markets and refinance our debt, reducing interest expense and extending debt maturities. Since announcing our first phase capital optimization program on July 27, 2010, we have refinanced a total of £2.2 billion of debt, as illustrated by the chart below which shows the carrying value and principal interest rate of our long term debt instruments (in millions, by date of maturity).
Capital returns
We remain committed to a long term program of returning cash to shareholders. Since we began our capital return program in July 2010, we have repurchased 73 million shares of common stock for £1,127 million, which is approximately 22% of our share count at July 2010. We purchased 52.5 million shares during the first and second phases of our program in 2011 and 2010 at an average purchase price of $24.35. The second phase of our program announced on July 27, 2011 continued during 2012 with the purchase and cancellation of a further 20.5 million shares during the year at an average purchase price of $25.39. With the near completion of our second phase program, we announced on December 14, 2012, a third phase to our share buyback program of at least £1,122.5 million to be completed before the end of 2014, which includes £122.5 million remaining under our second phase program. This £1,122.5 million represents approximately 19% of our market capitalization at December 14, 2012. Under the terms of the Merger Agreement we signed with Liberty Global on February 5, 2013, we have suspended our capital returns program pending consummation of the merger. If the merger is not consummated we intend to resume our capital returns program.
We have maintained our quarterly dividend at $0.04 per share for the first three quarters of 2012, and on February 5, 2013 our board approved the payment of a $0.04 dividend for the three months ended December 31, 2012. Under the terms of the Merger Agreement we signed with Liberty Global on February 5, 2013, we are permitted to continue to pay a dividend of up to $0.04 per quarter.
CRITICAL ACCOUNTING ESTIMATES
We apply U.S. GAAP in preparing our consolidated financial statements and related financial information, which requires the use of estimates, assumptions, judgments and subjective interpretations of accounting principles that have an impact on the assets, liabilities, revenue and expense amounts reported, as well as disclosures about contingencies, risk and financial condition. An impact could occur because of the individual significance of the item being estimated, or because of the inherent uncertainty in measuring, at a specific point in time, transactions that are continuous in nature.
Actual results may differ from these estimates under different assumptions and conditions, so we have set out below the critical accounting estimates which have the potential to have a significant impact on our financial statements. If our business changes in the future, then accounting estimates not disclosed below may also become critical.
Our main revenue generating transactions contain relatively few estimates, with revenues being principally driven by cash received from our Consumer and Business customers, and operating costs being principally non-capitalizable expenditure on our Network together with expenses incurred in serving our customers.
There are areas of our business, such as the amount of uncollectible accounts receivable, amounts accrued for vacated properties, the amount to be paid for other liabilities, including contingent liabilities, our pension expense and pension funding requirements, amounts to be paid under our employee incentive plans, costs for interconnection, goodwill and indefinite life assets, and long-lived assets where significant or complex estimates are made, however we do not believe these judgments have a material impact on our financial statements. Actual results could differ from those estimates.
FIXED ASSETS
Our industry is capital intensive, and a significant portion of our resources are spent on extending and upgrading our network. As of December 31, 2012 and 2011, the net book value of our fixed assets was approximately £4.5 billion and £4.6 billion, respectively.
We record fixed assets at cost and depreciate them on a straight line basis. Estimating the useful lives of these assets involves significant judgment. In making these judgments, our management uses its experience and expectations of the utility of the specific asset being evaluated. We also compare the useful lives assigned to fixed assets by other companies that operate similar businesses. Changes in technology or changes in the intended use of these assets may cause the estimated useful life to change, resulting in changes to our depreciation expense. Any revisions to estimated useful lives are reflected prospectively beginning in the period in which the change in estimate is made. We estimate that a one year increase in the useful lives of only those fixed assets that we purchased in 2012 would result in a decrease in our 2012 depreciation expense of £25 million and that a one year decrease would result in an increase of approximately £42 million in our 2012 depreciation expense.
Costs associated with network construction, initial customer installations, initial installations of new services in customer premises, and the addition of network equipment to provide new or enhanced services are capitalized. Costs capitalized as part of initial customer installations include materials and direct labor.
Capitalizable labor costs incurred in connection with customer installations relate to activities such as:
•Dispatching personnel and equipment to the customer's premises;
•Verification that the customer's premises is able to receive our services;
•Physically connecting the customer's premises to our network;
•Set-up of equipment within the customer's premises and connection of that equipment to our network; and
•Programming the equipment so that it is able to function as intended.
We also capitalize certain indirect costs required in order to connect the customer to our network. These indirect costs relate to the compensation and overhead costs of employees who assist in connecting and activating the customer.
Costs incurred to connect a service to a premises that has previously received the same service are expensed as incurred, and costs incurred to connect a new service to a premises that has previously received other services are capitalized. For example, if a premises that has received our telephony service ceases receiving our telephony service, costs incurred to connect telephony services at that premises at any point in the future would be expensed. Additionally, if a premises that has received telephony services ceases receiving our services and a new customer occupies that
premises and subscribes to both our broadband and telephony services, the costs incurred to connect broadband services would be capitalized and the costs to connect telephony services would be expensed. We assess a new service as a product that provides fundamentally new or enhanced functionality to our customers and which delivers incremental revenues.
We are required to make judgments regarding the amount of construction and installation costs that are capitalized. Our capitalization rates for labor costs are based on studies of actual costs as well as operational data demonstrating the amount of actual time that is spent on specific activities. Our capitalization rates for overhead costs are based on studies of activities that are incurred in support of capitalizable activities as well as an analysis of the proportion of those costs that are directly attributable to capitalizable activities. We continuously monitor the appropriateness of our capitalization policy and update the studies used on a regular basis. We update our policy when necessary to respond to changes in facts and circumstances, such as the development of new products and services. Changes resulting from modification to our capitalization have not historically had a material impact on our results.
VALUATION ALLOWANCE ON DEFERRED TAX ASSETS
As at December 31, 2012 we had gross deferred tax assets of £5,682.5 million, of which £5,359.2 million related to the U.K. and which principally comprised capital allowances, net operating losses, or NOLs, and capital losses. We accumulated these assets over the last two decades as we made significant investments in building our network infrastructure and incurred significant losses as we operated that network. These assets represent amounts we, in common with other companies in the U.K., are able to use to reduce our future taxable profits in the U.K. We have historically maintained a full valuation allowance on both our U.K. and U.S. deferred tax assets, reducing the value of these assets on our balance sheet to zero.
The assessment of the amount of value assigned to our deferred tax assets under the applicable accounting rules is highly judgmental. We are required to consider all available positive and negative evidence in evaluating the likelihood that we will be able to realize the benefit of our deferred tax assets in the future. Such evidence includes scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and the results of recent operations. Since this evaluation requires consideration of events that may occur some years into the future, there is significant judgment involved, and our conclusion could be materially different should certain of our expectations not transpire.
When assessing all available evidence, we consider an important piece of objective evidence is the extent to which we have made pre-tax income or losses over the most recent three year period. Historically, we have maintained a full valuation allowance on our net deferred tax assets principally because we have been in a cumulative pre-tax loss position over the most recent three year period. While there has been a trend of positive evidence that has been strengthening in recent years, it was not sufficiently persuasive to outweigh the negative evidence provided by our cumulative pre-tax loss position. During the year ended December 31, 2012, we emerged from a cumulative pre-tax loss position in the U.K. for the first time, which removed this important piece of negative evidence from our evaluation.
Our assessment for the year ended December 31, 2012 considered the following positive and negative evidence. Based on this evidence, we concluded that it was more likely than not that in future periods we will generate sufficient pre-tax income to utilize substantially all of our U.K. deferred tax assets relating to capital allowances and NOLs:
Positive evidence:
•
We have now generated pre-tax income in the U.K. of more than £150 million for two consecutive years and have utilized some of our available tax assets to reduce the tax liabilities that would have otherwise arisen in those periods.
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Our U.K. capital allowances and NOLs do not have an expiration date.
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Our financial performance has continued to improve despite challenging macroeconomic conditions. Steady growth in revenue and operating income has been maintained for three years, and we believe that financial performance will continue to improve even if the current economic conditions persist.
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Our forecasts of future taxable income indicate that our pre-tax income and taxable income will increase in the future.
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We have re-financed a significant portion of our high-coupon debt into lower-coupon, longer duration debt in recent years.
Negative evidence:
In the absence of a cumulative loss in the last three years, the remaining negative evidence consists solely of our long history of significant pre-tax losses prior to 2011, dating back many years prior to the merger with Telewest in 2006. In total, our U.K. group companies have approximately £386.1 million of deferred tax assets on £1,678.7 million of NOLs which accumulated over many years. We believe that the combined impact of a number of company specific and industry specific developments over recent years makes it unlikely that those historic losses will be repeated in the future. These include:
Company specific factors:
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The significant investment associated with building our unique cable network does not need to be replicated. Instead, we are able to spend relatively more modest sums to gradually upgrade and improve that network.
•
We have established ourselves as one of the major telecommunication service providers in the U.K., offering leading next generation broadband and television services, which has enabled us to steadily and economically grow revenues.
•
Significant restructuring and rationalization activities subsequent to the Telewest merger have reduced our cost base and focussed the business on its core activities. This allowed us to leverage our network into financial returns and generate consistently improving operating margins.
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There has been a material improvement in our credit standing in recent years, including certain of our debt being rated investment grade, which has allowed us to reduce and lock-in lower interest rates.
Industry specific factors:
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The cable and telecommunications markets have matured since the late 1990s and early 2000s.
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There is only one competitor in the U.K. with a substantial fiber network.
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Pricing in the U.K. telecommunications market in recent years is considerably more rational than in the early to mid portion of the previous decade. We expect that trend to continue given a) the increase in demand for data traffic that requires a high speed delivery mechanism like our fiber network and b) the structure of the U.K. market.
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Consolidation in the industry has reduced the number of competitors since the years in which we incurred significant losses.
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The industry is capital intensive and barriers to entry are high; therefore, we do not envision uneconomic competition from new entrants.
After consideration of these factors, we determined that it was unlikely that the losses incurred prior to the year ended December 31, 2011 would be repeated and as a result, we did not place significant weight on the negative evidence provided by our long history of losses.
We believe that our positive evidence is strong. The improving financial performance in recent years is an objectively verifiable piece of positive evidence and is the result of a number of factors which have been present to a greater or lesser extent in prior years but have only recently gathered sufficient weight to deliver objectively verifiable, consistent taxable profits.
A key consideration in our analysis was that the unlimited carryforward periods of our U.K. tax assets make the realization of those assets less sensitive to variations in our projections of future taxable income than would otherwise be the case if the carryforward periods were time limited. In performing our analysis, we used the most updated plans and estimates that we currently use to manage the underlying business and calculated the utilisation of our deferred tax assets under a number of scenarios. We do not require material increases in the current levels of cash flows, book income, or taxable income to recover the value of our deferred tax assets other than capital losses.
The emergence from a cumulative loss position in the U.K. during 2012 was an important consideration in our assessment and changed the balance of the remaining available evidence. While strong positive evidence was present during 2011 and in earlier quarters of 2012, we concluded that the significance of the cumulative loss could not be overcome prior to December 31, 2012. In the absence of the negative evidence provided by cumulative losses over
the most recent three year period, we believe that the available positive evidence outweighs the remaining negative evidence. Therefore, we determined that it was appropriate to reverse substantially all of the valuation allowance on our U.K. deferred tax assets other than capital losses. The reversal of the valuation allowance on our U.K. deferred tax assets resulted an income tax benefit of £2,488.9 million, or £9.07 per basic share and £7.52 per diluted share during the year ended December 31, 2012, and an increase in current and non-current deferred tax assets on the consolidated balance sheet for the year ended December 31, 2012. Beginning in the first quarter of 2013, we expect our net income and earnings per share to be impacted to a greater degree by income tax expense, which may fluctuate from period to period. However, this reversal will not result in any change to the amount of cash payments to the U.K. tax authorities for income taxes.
Realization of our deferred tax assets is dependent on generating sufficient taxable income in future periods. Although we believe it is more likely than not that future taxable income will be sufficient to allow us to recover substantially all of the full value of our U.K. deferred tax assets other than capital losses, realization is not assured and future events could cause us to change our judgment. If future events cause us to conclude that it is not more likely than not that we will be able to recover all of the value of our deferred tax assets we would be required to establish a valuation allowance on our deferred tax assets at that time, which would result in a charge to income tax expense and a material decrease in net income in the period in which we change our judgment. Refer to Item 1A of this Form 10-K, Risk Factors, for further discussion of certain events that could have a material impact on our future profitability and taxable income.
During 2012, we also reversed a valuation allowance of £103.4 million on the U.S. deferred tax assets related to certain of our subsidiaries that are considered dual resident in the U.K. and U.S. for tax purposes. The assets in these companies are principally comprised of NOLs. The companies have emerged from a cumulative loss position and after consideration of all available positive and negative evidence we believe it is more likely than not that the deferred tax assets will be utilized. Because those companies have emerged from a cumulative loss position, significant negative evidence no longer exists. Positive evidence exists in the form of recent profitability, forecasts for continued profitability, and long expiration periods for the NOLs. We do not require significant improvements in the level of profitability to utilize the deferred tax assets prior to their expiration.
We continue to maintain a full valuation allowance on our U.S. deferred tax assets related to companies included in our U.S. consolidated federal income tax return, because we do not believe it is more likely than not that we will be able to realize the value of these assets. We are in a cumulative loss position over the most recent three year period in the U.S., and we expect that position to continue into the future, principally because all of our revenue is generated in the U.K. We also continue to maintain a full valuation allowance on our deferred tax assets relating to capital losses, which totaled approximately £2,786.1 million as of December 31, 2012. We do not expect to realize any significant benefit from these capital losses because they can only be used to the extent we generate future U.K. taxable capital gains from assets held by subsidiaries owned prior to 2006.
We have considered the implications of the proposed merger with Liberty Global, as discussed in the Recent Developments section of Item 1 of this Form 10-K, on our accounting for our deferred tax assets. We note that a change in judgment that results in subsequent recognition, derecognition, or change in measurement of a tax position taken in a prior annual period shall be recognized as a discrete item in the period in which the change occurs. We are therefore not permitted to consider the impact of the proposed business combination until 2013 and the partial reversal of the allowance discussed above therefore remains appropriate.
Changes in tax laws and rates will also affect our deferred tax assets in the future. The U.K. government has announced a reduction in the rate of corporation tax from 23% to 21%. These reductions have not been enacted, but we will recognize a reduction in the value of our deferred tax assets and liabilities and a charge to income tax expense in the period of enactment.
NEW ACCOUNTING PRONOUNCEMENTS
New rules for accounting for revenue and lease transactions remain under development by the FASB, which, if and when enacted, may have a material impact on our financial statements, however no formally adopted standards have yet been issued.
Further details of new accounting pronouncements, expected date of adoption, and the likely impact on our financial statements, if any, are provided in note 2, Significant Accounting Policies, in Item 8 of this Form 10-K.
CONSOLIDATED RESULTS OF OPERATIONS
SEGMENTAL RESULTS OF OPERATIONS
We earn revenues and incur costs in our two segments, Consumer and Business. Our segments are based on our management organizational structure at December 31, 2012 and are fully described in note 15, Industry Segments, in item 8 of this Form 10-K.
Segment contribution is our measure of segment profitability and is operating income excluding certain costs. Our primary asset is our cable network which is shared by our Consumer and Business Segments. Assets are reviewed on a consolidated basis and are not allocated to segments for management reporting. Segment contribution therefore excludes the cost of operating our network, depreciation, amortization, and goodwill and intangible asset impairments. Corporate costs are not directly attributable to either segment and are also excluded from segment contribution. Restructuring and other charges are excluded from segment contribution as we believe they are not characteristic of our underlying business operations.
Consumer Segment
Demand for our superfast broadband and TiVo product has led to lower churn and a strong increase in new subscribers during 2012.
Increases in both customer numbers and ARPU during 2012 resulted in our Consumer revenues rising by 2.3% to £3,430.2 million from £3,354.4 million in 2011. Consumer segment contribution increased by 3.1% to £2,053.2 million principally as a result of increased revenues, partially offset by increased marketing costs. In 2011 Consumer segment revenues rose by 2.3% to £3,354.4 million and were the principal driver of Consumer segment contribution increasing by 0.5% to £1,991.5 million.
Consumer Segment Revenue
Consumer segment revenue is earned through recurring fees and usage charges for our fixed line and mobile telephone, broadband and television products. We also earn revenues from connecting customers to our network, and supplying them with mobile handsets and other equipment. Revenue by customer type for the years ended December 31, 2012, 2011 and 2010 was as follows:
(1)
Includes equipment revenue stated net of discounts earned through service usage.
Our consumer segment revenues continue to be driven by our cable product offerings with strong demand for superfast broadband and our TiVo service being partially offset by the downward trend in fixed line telephony usage. In 2012, cable revenues accounted for 81.7% of our total Consumer segment revenues, compared to 81.1% and 80.6% in 2011 and 2010 respectively.
Revenues from our mobile customers contributed 16.2% of our total Consumer segment revenues in 2012 compared to 16.5% and 17.1% in 2011 and 2010 respectively, with the decrease being driven principally by the step down in mobile termination rates, offset by the positive impact of an improving customer mix.
Detailed Consumer segment statistics by customer type are set out at the end of this section.
Cable
Our 'Collections' bundles introduced in April 2012 offer consumers differentiated products which are attractively positioned versus our competitors, and are enabling us to capitalize on the increasing demand for superfast broadband and, through our TiVo service, pay-TV growth.
During 2012 we have seen an increase of 88,700 cable customers compared to an increase of 5,500 during 2011, taking our total cable customers at December 31, 2012 to 4,894,000. Over this same period our total cable products have increased by 248,100, compared to an increase of 47,100 in 2011. This growth is principally from new customers, with the average number of cable products per customer remaining constant at 2.50 in 2012 and 2011. In 2011 cable products per customer grew modestly to 2.50 from 2.49 in 2010.
Existing customers migrating from standard digital television to a TiVo service, or upgrading to superfast broadband, together with selective price rises have been a key driver of increased revenues during 2012.
At December 31, 2012, 1,332,000 customers, or 35.1% of our TV customer base, were subscribing to our TiVo service, compared to 435,100, or 11.6%, at December 31, 2011 following our launch of TiVo in December 2010. We launched our Virgin TV Anywhere service in November 2012 which allows our TV customers to stream up to 45 live channels to tablet computers and smartphones and access further content online, including thousands of hours of on-demand programming. It also allows Virgin Media TiVo customers to connect to their TiVo boxes to manage their recordings remotely.
Our superfast broadband customers, which we define as those subscribing to speeds of 30Mbit/s or above, increased by 1.5 million during 2012, with the result that at December 31, 2012, 51% of our broadband customer base, or 2,175,800 customers, were receiving superfast broadband. Our program to double the broadband speeds of over 4 million customers announced in January 2012 is on track with 76% of our network having been upgraded by December 31, 2012. We expect the trend in customer demand for faster broadband speeds to continue, for example, 41% of new broadband subscribers in the quarter ended December 31, 2012 took broadband speeds of 60Mbit/s or higher.
The success of our 'Collections' packages has also increased the number of customers taking a fixed line telephone from us by 46,400 during 2012 to 4,179,100, compared to 4,132,700 and 4,161,700 at December 31, 2011 and 2010 respectively. As a result, triple-play penetration, which we define as those customers taking all three of our fixed line telephone, broadband, and television products, increased to 64.9% at December 31, 2012, compared to 63.7% and 63.0% at December 31, 2011 and 2010 respectively.
We believe our product differentiation and attractive pricing has also driven the reduction in quarterly average monthly churn, which for the quarter to December 31, 2012 fell to 1.1% compared to 1.3% in both of the quarters ended December 31, 2011 and 2010.
The combination of increased customer numbers and improved product mix from new and existing customers discussed above, together with a price rise implemented in April 2012, and partially offset by the continued decline in fixed line telephony usage, has resulted in cable ARPU increasing by 2.1% to £48.87 in the quarter to December 31, 2012, compared to £47.85 in the quarter to December 31, 2011. The increase in cable ARPU during 2011 to £47.85 for the quarter to December 31, 2011 from £47.51 for the quarter to December 31, 2010 was due in part to selective price increases and successful up-selling and cross selling to existing customers, partially offset by declining telephony usage and price discounting.
Mobile
We have continued in 2012 with our strategy of using our own sales channels to improve mobile customer mix and leveraging our cable customer base to cross sell mobile telephony services to existing cable customers. Quad-play penetration, where a customer takes all three cable services and a mobile telephone service, increased to approximately 15.8% of our residential customer base at December 31, 2012 compared to approximately 14.5% at December 31, 2011, and 12.2% at December 31, 2010.
Total mobile customer numbers were flat at 3,037,500 at December 31, 2012 compared to 3,037,300 at December 31, 2011, reflecting the net effect of an improvement in our mobile customer mix during 2012 with 185,000 more customers taking a mobile phone on a contract and a 184,800 fewer active prepay customers. During October 2012 we launched new all inclusive tariffs under our "Unlimitacular" advertising campaign which together with focusing handset investment towards customer retention has driven the increase in contract customer numbers. The decrease in prepay customers reflects the level of competition in the prepay market and our strategy of migrating prepay customers to contracts due to lower churn and higher overall lifetime value of contract customers.
An increase in the proportion of contract customers generally results in our mobile customer base becoming more profitable, although the step down in regulated mobile termination rates reduced inbound mobile revenue by approximately £24 million during 2012 compared to 2011, resulting in mobile ARPU decreasing to £15.13 during the quarter ended December 31, 2012 compared to £15.46 for the quarter to December 31, 2011. Overall, the impact of the factors discussed above was to modestly increase total mobile revenues in 2012 to £554.8 million from £552.9 million in 2011.
During 2011 the number of mobile customers decreased by a net 31,600 customers with contract customer net gains of 313,100 being offset by a net loss of 344,700 prepay customers. The growth in contract customers during 2011 reflected our strategy of using our own sales channels and cross-selling mobile contracts to our cable customers. The decline in prepay customers reflects increased competition in the prepay market and our strategy of migrating prepay customers to contracts due to the lower churn, higher ARPU and higher overall lifetime value of contract customers.
Mobile ARPU increased to £15.46 for the quarter to December 31, 2011 from £15.16 for the quarter to December 31, 2010, primarily due to an increased proportion of higher value contract customers relative to the total number of mobile customers, which rose to 50.2% at December 31, 2011 from 39.5% at December 31, 2010, partially offset by a fall in revenue due to the regulated change in mobile termination rates.
Total mobile revenues in 2011 decreased to £552.9 million from £560.0 million in 2010, principally as a result of the regulated change in mobile termination rates, which reduced inbound revenue, and a decline in the number of prepay customers, partially offset by an increase in service revenues, mainly driven by increased contract revenue.
Non-cable
Total non-cable customers decreased by 55,400 during 2012 due to competition in the market which continues to increase as our competitors upgrade their networks to provide fiber based services in areas which are outside of our cable network. The decline of 28,500 non-cable products during 2011 was also due to increased competition in the market.
As a result of this drop in customer numbers, although partially offset by prices rises, non-cable revenues have decreased by 10.4% in 2012 to £71.4 million compared to 2011.
Non-cable revenue for the year ended December 31, 2011 increased to £79.7 million from £77.2 million for the year ended December 31, 2010. The increased non-cable revenue was predominantly driven by an increase in the percentage of customers taking both phone and broadband in the year ended December 31, 2011, as compared to the prior year, partially offset by a decline in the number of customers.
Consumer Segment Contribution
During 2012, Consumer segment contribution increased to £2,053.2 million from £1,991.5 million in 2011, being a 3.1% increase, continuing the trend seen in 2011 when segment contribution increased modestly from £1,982.4 in 2010. In both cases the increased consumer revenues described above have been the principal driver of increased segment contribution, although offset in 2012 by our step-change increase in marketing expenses.
The principal components of operating costs and selling, general, and administrative expenses within our consumer segment include:
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television programming services and programming costs;
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payroll and other employee related costs, including outsourcing;
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marketing and selling costs;
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interconnect costs paid to carriers relating to call termination services; and
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purchase costs of mobile handsets and other equipment.
Further discussion of the movement in these costs is provided in the operating expenses section of this MD&A.
Summary Cable Statistics
We have summarized below selected statistics for our cable customers which we believe are important in understanding trends in our cable operations. The two tables below provide these for the three months ended December 31, 2012 and 2011 respectively, and their related four prior quarters.
(1)
Cable churn is the proportion of customers who stop subscribing to all of our services and is calculated on a quarterly basis by dividing the total number of customer disconnections in the quarter by the average number of customers divided by three. The average number of customers is calculated by adding the number of customers at the start of the quarter and at the end of each month of the quarter and dividing by four.
(2)
Cable ARPU is calculated on a quarterly basis by dividing total revenue generated from the provision of telephone, television and internet services to customers who are directly connected to our network in that period together with revenue generated from our customers using our virginmedia.com website, exclusive of VAT, by the average number of customers directly connected to our network in that period divided by three. The average number of customers is calculated by adding the number of customers at the start of the quarter and at the end of each month of the quarter and dividing by four.
Summary Mobile Statistics
We have summarized below selected statistics for our mobile customers which we believe are important in understanding trends in our mobile operations. The two tables below provide these for the three months ended December 31, 2012 and 2011 respectively, and their related four prior quarters.
(1)
Mobile customer information is for active customers. Prepay customers are defined as active customers if they have made an outbound call or text in the preceding 30 days. Contract customers are defined as active customers if they have entered into a contract with Virgin Mobile for a minimum 30-day period and have not been disconnected. Contract mobile customers include customers who have taken either a mobile service or a mobile broadband contract.
(2)
Mobile ARPU is calculated on a quarterly basis by dividing mobile service revenue (contract and prepay) for the period by the average number of active customers (contract and prepay) for the period, divided by three. The average number of customers is calculated by adding the number of customers at the start of the quarter and at the end of each month of the quarter and dividing by four.
Summary Non-cable Statistics
We have summarized below selected statistics for our residential consumer customers that are not connected directly through our cable network, or non-cable customers, which we believe are important in understanding trends in our non-cable operations. The two tables below provide these for the three months ended December 31, 2012 and 2011 respectively, and their related four prior quarters.
Business Segment
Our Business segment continues to be a key driver of overall revenue growth. Demand for data across both retail and wholesale markets continues to drive the increase in Business segment revenues, although this increase is partially offset by the continued decline in voice revenues in both markets. As a result, total revenues from our business segment increased by 5.2% during 2012 to £670.3 million compared to £637.4 million in 2011 and £596.8 million in 2010.
The Business segment results for 2012, 2011 and 2010 were as follows (in millions):
Business Segment Revenue
Business segment revenue is earned through recurring fees and usage charges from retail and wholesale customers, which comprises revenue from, data and internet services, transmission, inbound and outbound voice, and rental of fibers. We also earn revenues from installing equipment and connecting customers to our network.
Business segment revenue is inherently subject to quarter-on-quarter and year-on-year fluctuations due to the uneven way we earn revenue from significant contracts.
Our strategy to grow business data revenues has continued through 2012 with revenue from business customers increasing by 5.2% to £670.3 million from £637.4 million for 2011, driven primarily by an increase in retail and wholesale data revenues, partially offset by a decrease in LAN solutions and retail voice revenues. Data revenue growth was driven by strong revenues from supplying mobile backhaul solutions and major public sector contracts, supported by an increase in retail volumes across key IPVPN and Ethernet products.
During 2011, a 6.8% increase over revenues of £596.8 million for 2010 was primarily attributable to growth in retail and wholesale data and LAN solutions revenues, partially offset by a fall in retail and wholesale voice revenues.
In 2012 total data revenues accounted for 70.8% of total business revenues, compared to 67.5% and 63.5% in 2011 and 2010 respectively.
The Business segment revenue results for 2012, 2011 and 2010 were as follows (in millions):
Retail revenues
During 2012 we have continued our strategy of focusing on higher margin data revenue and increasing demand for our data products within a growing data market. The retail business within our Business segment provides a portfolio of solutions to large, medium and small enterprises and the public sector, seeing particular success during 2012 with new revenues from a major public sector contract won in 2011 together with an increase in retail volumes across key IPVPN and Ethernet products.
As a result retail data revenues rose by 10.9% to £307.2 million in 2012 from £277.0 million in 2011. In 2011 data revenues increased by 14.7% from £241.5 million in 2010. Retail data revenue represented 64.0% of the retail business revenue for 2012, compared with 59.4% for 2011, and 55.3% for 2010.
Retail voice revenues continued to decline during 2012, consistent with the trend across the industry, and our consumer segment, as customers migrated from using fixed line telephony to other forms such as mobile telephony and internet based solutions, including video calling. The decline in retail voice revenues in 2012 of 9.5% to £139.1m was principally as a result of this trend. Retail voice revenue decreased by 5.9% in 2011 compared to 2010, mainly as a result of declining telephony usage and, to a lesser extent, a decline in rental and install revenues.
Our LAN Solutions business saw a decrease in revenue to £33.9 million in 2012 due to a varying level of activity within these infrastructure projects which are by nature non-recurring. In 2011 revenue was £35.4 million compared to £31.7 million for 2010, with growth being primarily from equipment and LAN project revenues.
Wholesale revenues
During 2012, we continued to work with our partner markets to provide core networks and vital access services, securing an increase in mobile backhaul revenues and increased demand for our key data products.
Reflecting the trend of increased data demand, our wholesale data revenues for 2012 of £167.6 million increased by 9.5% compared to £153.1 million in 2011. As noted above, the nature of our relationships with business customers is that significant contracts, where we may earn revenues unevenly, can impact the year-on-year movement as we continue our long term growth trend. The 11.2% increase observed during 2011 from 2010 revenues of £137.7 million was primarily as a a result of increased usage of our network by wholesale data customers.
Wholesale voice revenues increased by 23.6% to £22.5 million in 2012 from £18.2 million in 2011 as we secured traffic from operators that had been migrated to other providers in the second half of 2011.
Business Segment Contribution
During 2012, Business segment contribution increased by 0.9% to £380.8 million from £377.4 million in 2011. In 2011 Business segment contribution increased by 10.1% from £342.8 million for 2010.
The principal components of operating costs and selling, general, and administrative expenses within our Business segment include:
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interconnect and circuit costs paid to other telecommunication carriers;
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payroll and other employee related costs;
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marketing and selling costs.
Further discussion of the annual movement in these costs is provided in the operating expenses section of this MD&A.
Whilst increased revenues have been the principal driver of the increase in Business segment contribution during 2012, these have been offset by higher acquisition and delivery costs during the early life of certain significant contracts. The increase in 2011 Business segment contribution was primarily due to higher revenue.
OPERATING EXPENSES
Operating Costs
Operating costs for 2012, 2011 and 2010 were as follows (in millions):
During 2012, operating costs increased by 1.5% to £1,629.2 million from £1,605.6 million in 2011, being a increase in Business Segment cost of sales and Network and operating costs, partially offset by a decrease in consumer cost of sales.
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Consumer segment cost of sales decreased by £17.8 million, or 1.7%, principally as a result of the continued decline in fixed line and mobile telephony interconnect costs arising from lower usage and the step-down in mobile termination rates, offset by an increase in cable television costs, driven primarily by the increase in cable television customers.
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Business segment cost of sales increased by £28.4 million, or 14.6%, as a result of higher acquisition and delivery costs during the early life of certain significant contracts.
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Network and operating costs increased by £13.0 million, or 3.4%, principally as a result of 2011 facilities costs having benefited from a reduction in rent and related costs due to accrual adjustments in connection with a review of our property portfolio.
As a result of these changes, along with a 2.7% increase in revenue, total operating costs as a percentage of revenue decreased to 39.7% for 2012 from 40.2% in 2011.
During 2011, operating costs, including network expenses, increased by 1.9% to £1,605.6 million from £1,575.0 million in 2010. This increase was primarily attributable to increases in Consumer cost of sales due to increased revenues, and within the Business segment due to increased install activity and higher retail and wholesale data revenues, partially offset in both segments by lower telephony costs as a result of lower usage. The increase in segment cost of sales in 2011 was offset by a decrease in Network and other operating costs primarily as a result of lower facilities costs on our network properties due to accrual adjustments in connection with a review of our property portfolio. As a result of these changes, along with a 3.0% increase in revenue, total operating costs as a percentage of revenue decreased to 40.2% for 2011 from 40.6% in 2010.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for 2012, 2011 and 2010 were as follows (in millions):
During 2012 we significantly increased our level of marketing expenditure. The additional expenditure includes a series of high profile marketing campaigns such as those starring Sir Richard Branson with Usain Bolt, Stephen Fry, and David Tennant. These have been the principal driver of marketing costs increasing by 22.5% compared to 2011.
Disciplined cost control has led to employee and outsourcing costs falling by 3.6%, and a 2.1% decrease in other costs. Facilities costs were relatively unchanged, with the reported 9.8% increase arising from the lower reported facilities costs in 2011 as described below.
In 2011, selling, general and administrative expenses increased by 0.7% to £796.0 million from £790.6 million in 2010. This increase was primarily attributable to higher marketing and other costs, partially offset by lower employee and outsourcing costs and facilities costs. Higher marketing costs were primarily as a result of increased marketing activity. Other costs increased primarily as a result of a higher bad debt expense. Employee and outsourcing costs reduced compared to the prior year primarily as a result of reduced costs in relation to employee incentive programs. Facilities costs were relatively unchanged, however 2011 benefited from of a reduction in rent and related property costs resulting from accrual adjustments in connection with a review of our property portfolio.
Restructuring and Other Charges
Our restructuring plan announced during the fourth quarter of 2008 continued during 2012, incurring expenses of £2.7 million associated with this plan.
Restructuring and other charges of £8.4 million in 2011 and £53.0 million in 2010 related primarily to lease exit costs and involuntary employee termination costs, in both cases also in connection with the restructuring program initiated in 2008.
Depreciation Expense
Depreciation in 2012 of £951.7 million was 3.1% higher than 2011 principally as a result of depreciation on new additions exceeding the reduction in depreciation from assets becoming written down during the year, a trend consistent with the increase in fixed asset purchases during the year.
In 2011 depreciation expense decreased to £923.2 million from £987.7 million in 2010 primarily as a result of fixed assets becoming fully depreciated, partially offset by depreciation in respect of new fixed assets.
Amortization Expense
We have no amortization expense during 2012 since our intangible assets became fully amortized in 2011, which was the principal driver of our amortization expense in 2011 reducing to £118.4 million from £147.6 million in 2010.
OTHER INCOME AND EXPENSES (EXCLUDING OPERATIONS DISCOUNTINUED IN PRIOR YEARS)
Interest Expense
In 2012 interest expense decreased to £398.5 million from £440.8 million in 2011, which was a decrease from £477.8 million in 2010. The reduction in both years arose from a reduction in the level of debt and lower borrowing costs on our debt, along with the effect of interest and cross currency interest rate swaps designated as accounting hedges.
We paid cash interest of £406.9 million for 2012 compared to £435.2 million and £438.8 million for 2011 and 2010 respectively, with the reduction in both years being primarily due to lower levels of debt at lower average interest rates, along with differences in the timing of interest payments on our senior notes, and in 2011 our senior credit facility, due to refinancing activity undertaken during both these years.
Loss on Extinguishment of Debt
In 2012, loss on extinguishment of debt was £187.8 million, which related to the redemption premia paid and the write-off of the associated deferred finance costs in respect of the redemption of our senior notes in the second and fourth quarters as discussed in the Liquidity and Capital Resources section of this MD&A.
In 2011, loss on extinguishment of debt was £47.2 million, which related to the write off of deferred financing costs as a result of the repayments of our senior credit facility from the net proceeds of the senior secured notes issued on March 3, 2011, the refinancing of our senior credit facility on May 20, 2011 and the redemption of our senior notes on July 26, 2011.
In 2010, loss on extinguishment of debt was £70.0 million, which related to the write off of deferred financing costs as a result of the partial repayments of our senior credit facility in 2010 and the call premium totaling £5.5 million on the repayment of a portion of the senior notes due 2014.
Gain (Loss) on Derivative Instruments
The gain on derivative instruments of £148.1 million in 2012 primarily arose from a gain of £173.3 million on the conversion hedges we hold in respect of our convertible debt, which was driven by an increase in the price of our common stock from $21.38 as of December 31, 2011 to $36.75 as of December 31, 2012. This gain is partially offset by a loss of £11.4 million on the cross currency interest rate swap we hold in respect of our convertible senior notes that are not designated as hedges for accounting purposes, and an £10.4 million loss on the interest rate hedge held in respect of our senior credit facility.
The loss on derivative instruments of £50.7 million in 2011 was primarily driven by the loss on the conversion hedges as a result of a decrease in the price of our common stock and an increase in the amount of the counterparty credit risk adjustment used in the calculation of the fair values of the conversion hedges, and losses on derivative instruments resulting from a fall in interest rates, partially offset by the reclassification of gains of £31.1 million on derivative instruments previously designated as accounting hedges from accumulated other comprehensive income to earnings in conjunction with the discontinuance of hedge accounting on these instruments.
The losses on derivative instruments of £65.6 million in 2010 were mainly driven by the termination of swaps relating to the previous senior credit facility refinanced in March 2010, and also include a loss of £13.5 million related to our conversion hedges, which represents the difference between the cash we paid and the fair value, as of December 31, 2010, and a loss of £5.1 million related to cross-currency interest swaps on our U.S. dollar convertible senior notes that are not designated as hedges for accounting purposes.
Foreign Currency Losses
Foreign currency losses of £6.3 million in 2012 were primarily due to foreign exchange movements between the issuance of our $500 million U.S. dollar denominated senior notes due 2022 on March 13, 2012, and the redemption of $500 million of our 9.50% U.S. dollar denominated senior notes due 2016 on March 28, 2012. Although this generated an accounting loss, any economic exposure during this period was fully mitigated by our holding a matching asset and liability position.
Foreign currency losses of £2.4 million in 2011 were primarily due to remeasurement gains on our convertible senior notes and U.S. dollar denominated senior notes due 2019, offset by the weakening of the pound sterling relative to the U.S. dollar.
Foreign currency losses of £34.1 million in 2010 were primarily due to the weakening of the pound sterling relative to the U.S. dollar and related foreign exchange gains on the principal portion of our U.S. dollar convertible senior notes.
Interest Income and Other, Net
Interest income and other of £6.8 million in 2012 reflects amounts earned on cash balances together with the reversal of a contingent liability for which the related exposure expired during the second quarter of 2012. In 2011 interest income and other increased to £82.6 million from £8.3 million in 2010 due to the £77.6 million recognized following the agreement with the U.K. tax authorities regarding the Value Added Tax, or VAT, treatment of certain of our revenue generating activities and a related refund.
Share of Income from Equity Investments
In 2011 our share of income from equity investments was £18.6 million as compared with income of £24.0 million for the same period in 2010. Both periods include our proportionate share of the income earned by UKTV prior to the sale of our interest on September 30, 2011. As a result of this sale we had no income from equity investments during 2012.
UKTV received financing through loans from Virgin Media, which effectively acted as a revolving facility for UKTV. We received cash payments from UKTV in the form of loan capital repayments of £108.2 million for the year ended December 31, 2011. We received dividends, interest payments and payments for consortium tax relief from UKTV totaling £28.1 million during 2011.
Loss on Disposal of Equity Investments
In 2011 the loss on disposal of equity investments was £7.2 million relating to the disposal of our share in the UKTV companies. We had no such disposals during 2012.
TAXATION
Income Tax Benefit (Expense)
The 2012 income tax benefit was £2,591.2 million compared to an expense of £16.0 million for the same period in 2011, and a benefit of £124.1 million in 2010. The 2012, 2011 and 2010 tax benefit (expense) was comprised of (in millions):
The foreign deferred income tax benefit for the year ended December 31, 2012 related to the reversal of the valuation allowance on certain of our U.K. deferred tax assets. The federal income tax benefit for the year ended December 31, 2012 related to the reversal of the valuation allowance on the U.S. deferred tax assets in our dual resident companies. The basis for these reversals is explained in the critical accounting estimates section of this MD&A and in Note 11 of the notes to the consolidated financial statements contained in Item 15 of this Form 10-K.
The income tax expense in 2011 related primarily to our discontinuance of hedge accounting for the swaps associated with the $550 million 9.125% senior notes that were prepaid during the year, which resulted in a reclassification of tax effects associated with gains on those swaps from accumulated other comprehensive income. This expense was partially offset by consortium tax relief receivable from our joint venture operations, which were sold during 2011.
The foreign current tax benefit and the foreign deferred tax benefit in 2010 were primarily driven by the application of the intraperiod allocation rules of the Income Taxes Topic of the FASB ASC. The foreign current tax benefit attributable to continuing operations includes £18.3 million related to the gain on discontinued operations and is offset by tax expense of £18.3 million that is included within discontinued operations. The £23.9 million foreign deferred tax benefit attributable to continuing operations is offset by tax expense of £23.9 million that is included within other comprehensive income as a result of gains in other comprehensive income during 2010.
Additionally, during 2010 we concluded that it was more likely than not that we would be able to utilize certain net operating loss carryforwards prior to their expiration, which will occur between 2020 and 2032, to reduce future U.S. federal income tax liabilities. Accordingly, we reduced the previously established valuation allowance on these net operating loss carryforwards to nil and recorded a federal deferred tax benefit of £79.8 million. This change was due to a re-assessment of our intentions regarding certain assets during the carryforward period and our judgment that it is more likely than not that these NOLs will be utilized prior to expiry.
Contingencies
Our VAT treatment of certain other revenue generating activities remains subject to challenge by the U.K. tax authorities. As a result, we have estimated contingent losses totaling £31.9 million as of December 31, 2012 that are not accrued for, as we deem them to be reasonably possible, but not probable, of resulting in a liability. We currently expect an initial hearing on these matters to take place in 2013.
OTHER INCOME AND EXPENSES (EFFECT OF OPERATIONS DISCONTINUED IN PRIOR YEARS)
Gain on Disposal
In 2010 we reported a gain on disposal of £19.2 million, net of tax of £15 million, relating the sale of our Virgin Media TV business. We had no such disposals during either 2011 or 2012.
(Loss) Income on Discontinued Operations
We had no discontinued operations during 2012.
In 2011 the loss on discontinued operations was £1.2 million compared with an income of £27.8 million for 2010 and represents the results of our former Virgin Media TV business sold in 2010, including the gain on disposal. Further details are provided in our 2011 Annual Report on Form 10-K filed with the SEC.
EARNINGS PER SHARE AND DIVIDENDS
Earnings per share
Income (Loss) from Continuing Operations
During 2012, net income from continuing operations was £2,852.6 million, compared with net income from continuing operations of £77.1 million for 2011 due to the factors discussed above.
In 2011, the net income from continuing operations was £77.1 million, compared with a loss of £169.2 million from continuing operations for 2010 due to the factors discussed above.
Basic Income (Loss) from Continuing Operations Per Share
Basic income from continuing operations per common share for 2012 was £10.40 compared to a basic loss per share of £0.25 for 2011. Basic income (loss) per share is computed using a weighted average of 274.3 million shares issued and outstanding in the year ended December 31, 2012 and a weighted average of 310.1 million shares issued and outstanding for the same period in 2011.
Basic income from continuing operations per common share for 2011 was £0.25 compared to a basic loss per share of £0.52 for 2010. Basic income (loss) per share is computed using a weighted average of 310.1 million shares issued and outstanding in the year ended December 31, 2011 and a weighted average of 327.1 million shares issued and outstanding for the same period in 2010.
Dividends
Details of dividend payments are provided in Item 5 of this Form 10-K, Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
LIQUIDITY AND CAPITAL RESOURCES
SOURCES AND USES OF CASH
Overview
Our business is capital intensive and we are highly leveraged. We have significant cash requirements for operating costs, capital expenditures and interest expense. The level of our capital expenditures and operating expenditures are affected by the significant amounts of capital required to connect customers to our network, expand and upgrade our network and offer new services. We believe that we will be able to meet our current and medium-term liquidity and capital requirements, including fixed charges, through cash on hand, cash from operations, available borrowings under our revolving credit facility, and our ability to obtain future external financing.
Monthly receipts from customers in our Consumer segment together with receipts from our Business customers continue to be our principal source of cash, and we expect this to continue. Net cash from operating activities decreased by 9.5% in 2012 to £1,039.7 million, compared to £1,149.1 million and £1,037.6 million in 2011 and 2010 respectively.
During the year we have invested an additional £101.5 million of cash in upgrading our customer's broadband speeds, which contributed to our total purchase of fixed assets of £783.2 million for the year, compared to £656.7 million in 2011, and £628.4 million in 2010.
During 2012 we paid cash interest of £406.9 million on our borrowings, which was 6.5% lower than the £435.2 million interest paid in 2011, and 7.3% lower than the £438.8 million interest paid in 2010, with both decreases being principally due to lower interest rates following the refinancings discussed below.
Cash remaining from our operating and investing activities has been used to improve the maturity and interest profile of our long term debt, and to continue with our capital return programs.
In 2011 and 2010 we benefited from cash receipts from the disposal of our UKTV and Virgin Media TV businesses respectively.
Operating Activities
During 2012 net cash provided by operating activities decreased by £109.4 million to £1,039.7 million compared to £1,149.1 million in 2011. This decrease arises principally from:
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cash payments associated with the early redemption of senior notes;
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and, the beneficial impact in 2011 of receiving a £77.6 million refund from HMRC for VAT which was not repeated in 2012,
partially offset by:
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improved operating results increasing operating income;
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and, a decrease in cash interest payments as a result of a lower level of debt at lower average interest rates.
In 2011 net cash provided by operating activities increased to £1,149.1 million from £1,037.6 million in 2010, primarily due to the improvements in operating results, offset by changes in operating assets and liabilities.
Cash paid for interest in 2012, exclusive of amounts capitalized, decreased to £406.9 million from £435.2 million during 2011. This decrease was primarily as a result of a lower level of debt at lower average interest rates during the year ended December 31, 2012, along with differences in the timing of the interest payments on our senior credit facility and senior notes. The change in the timing of the interest payments on our senior notes is as a result of the refinancing activity undertaken during both 2012 and 2011.
Investing Activities
During 2012, cash used in investing activities of £783.7 million principally comprised purchases of fixed assets totaling £783.2 million, which has increased from £656.7 million in 2011 primarily as a result of our broadband speed upgrade program. In 2012 we have not benefited from cash inflows from disposals as experienced in 2011 and 2010.
In 2011 cash used in investing activities of £314.7 million principally comprised purchases of fixed assets of totaling £656.7 million, partially offset by the net proceeds received from the sale of our equity accounted investment in the UKTV companies and the related principal repayment on loans to equity investments.
In 2010 cash used in investing activities of £411.4 million was principally comprised of purchases of fixed assets totaling £628.4 million, partially offset by the proceeds from the sale of Virgin Media Television and disposal of 42 properties.
Financing Activities
During 2012 cash used in financing activities totaled £348.5 million compared to £1,001.1 million in 2011.
Cash provided by financing activities in 2012 of £1,441.7 million arose principally from the issuance of our $500 million 5.25% U.S. dollar senior notes due 2022, our $900 million 4.875% U.S. dollar senior notes due 2022, and our £400 million 5.125% sterling senior notes due 2022, together with two drawings of our RCF of £100.0 million and £75.0 million, both of which were repaid during the year.
Principal payments on long-term debt of £1,317.2 million during 2012 has been principally used to fully redeem our $1,350 million U.S. dollar denominated and €180 million euro denominated 9.5% unsecured senior notes due 2016, to repay in full both the £100 million and £75 million draw downs of the RCF, and to partially repay our $600 million 8.375% U.S. dollar denominated and £350.0 million 8.875% sterling denominated senior notes due 2019. We also used £28.3 million to settle cross currency interest rate swaps as part of these redemptions. As more fully described in the following Capital Returns section, we also used £330.2 million of cash to repurchase our common stock during 2012.
Capital lease payments during 2012 increased to £97.7 million compared to £79.2 million in 2011, principally as a result of increased leasing activity related to customer premises equipment to support our TiVo rollout.
In 2011 cash used in financing activities was £1,001.1 million compared with £551.8 million in 2010, with the increase being principally the partial repayments of our previous senior credit facility and repayment of our 9.125% U.S. dollar senior notes due 2016 totaling £1,315.8 million, capital lease payments totaling £79.2 million and purchases of our own shares totaling £635.0 million. The principal components of cash provided by financing activities were new borrowings from the issuance of our senior notes due 2021, net of financing fees, of £977.0 million, and the proceeds from the settlement of cross currency interest rate swaps of £65.5 million.
In 2010 the principal uses of cash in financing activities were the partial repayments under our previous senior credit facility and repayment of our senior notes due 2014 totaling £3,186.6 million, capital lease payments totaling £53.2 million, purchases of our own shares totaling £161.5 million and the purchase of conversion hedges relating to the shares issuable under our convertible senior notes totaling £205.4 million. The principal components of cash provided by financing activities in 2010 were new borrowings from the issuance of our senior notes due 2016 and our senior notes due 2019, net of financing fees, of £3,072.0 million.
During 2012 we paid four quarterly dividends of $0.04 per share of common stock, resulting in a total cash outflow of £27.3 million. The dividend per share of common stock is equivalent to that paid during 2011 and 2010, with the lower total cash payment arising from having fewer shares of common stock in issue. Further details of dividend payments are provided in Item 5 of this Form 10-K.
Cash flows from discontinued operations for the years ended December 31, 2011 and 2010 are attributable to Virgin Media TV.
CAPITAL OPTIMIZATION PROGRAMS
Our capital strategy throughout 2012 continued to be to refinance debt to reduce interest expense and extend debt maturities, and to return capital to our shareholders.
Since announcing our first phase capital optimization program on July 27, 2010, we have refinanced a total of £2.2 billion of debt, and in doing so we recognize a loss on extinguishment of debt of £187.8 million in 2012 compared to £47.2 million and £70.0 million in 2011 and 2010 respectively.
Since beginning our capital return program in July 2010, we have spent £1,127.0 million on repurchasing 73 million shares of common stock, representing around 22% of our share count at July 2010. The second phase of our program was announced on July 27, 2011 and continued during 2012 with the receipt and cancellation of 20.5 million shares of common stock during the year at an average purchase price of $25.39 per share.
During the last three years we have announced three phases to our capital optimization program:
•
Phase 1 announced on July 28, 2010 included the application of, in aggregate, up to £700.0 million to repurchase our common stock, and for transactions relating to our debt and convertible debt , including related derivative transactions, until August 2011. This program allowed for the application of up to £375.0 million in repurchases of our common stock. We completed the transactions authorized under this program during 2011.
•
Phase 2 announced on July 27, 2011 included the application of, in aggregate, up to £850 million to repurchase our common stock and for transactions relating to our debt and for effecting associated derivative transactions until December 31, 2012. Our second phase capital structure optimization program allows for the application of up to £625 million in repurchases of our common stock and up to £225 million for transactions relating to our debt and convertible debt, including related derivative transactions. At December 31, 2012 we had £122.5 million remaining under this program.
•
Phase 2 was extended on October 27, 2011, with the announcement of our intention to spend up to a further £250 million on share repurchases from the proceeds from the sale of our UKTV joint venture companies. These repurchases were completed during 2012 as part of the second phase program.
•
Phase 3 announced on December 14, 2012 will comprise a planned share buyback of at least £1,122.5 million to be completed before the end of 2014, which includes £122.5 million remaining under our second phase program. This £1,122.5 million represents approximately 19% of our market capitalization at December 14, 2012. Under the terms of the Merger Agreement we signed with Liberty Global on February 5, 2013, we have suspended our capital returns program pending consummation of the merger. If the merger is not consummated we intend to resume our capital returns program. For more information on the proposed merger see the Recent Developments section of Item 1 of this Form 10-K.
Our capital structure optimization programs may be effected through open market, privately negotiated, and/or derivative transactions, and may be implemented through arrangements with one or more brokers. Any shares of common stock acquired in connection with these programs will be held in treasury or cancelled.
LONG TERM DEBT
An analysis of our long term debt facilities, including the impact of hedging activity and our capital optimization programs is provided below. Further details of long term debt instruments are provided in note 5, Long Term Debt, in Item 8 of this Form 10-K, with full details being contained in the current report on Form 8-K as filed with the SEC on or around the date of issuance or amendment of the relevant instrument.
Under the terms of the Merger Agreement we signed with Liberty Global on February 5, 2013, our financial indebtedness will be materially changed and the level of debt increased. The instruments described below will be subject to change on consummation of the merger. For more information on the proposed merger see the Recent Developments section of Item 1 of this Form 10-K.
Senior Unsecured Notes
Our wholly owned subsidiary Virgin Media Finance PLC, or VMF, has issued senior unsecured notes in a mix of principally U.S. dollar and Sterling denominated instruments:
(1) Principal amount outstanding at December 31, 2012 was $507.1 million following partial redemption of $92.9 million on October 30, 2012
(2) Principal amount outstanding at December 31, 2012 was £253.5 million following partial redemption of £96.5 million on October 30, 2012
We have entered in to cross currency interest rate swaps to mitigate the interest and foreign exchange risks associated with our U.S. dollar, and historically euro, denominated debt, which for the U.S. dollar senior unsecured notes due 2019 and 2022 increases the weighted average interest rate to 9.02% and 5.35% respectively.
The principal value of our senior unsecured notes outstanding has increased to £1,824.4 million at December 31, 2012 from £1,720.3 million at December 31, 2011, with the weighted average interest rate including the effect of cross-currency interest rate swaps reducing from 9.58% to 6.4%.
In 2011 total senior unsecured notes reduced to £1,720.3 million compared to £2,067.9 million at December 31, 2010, with the weighted average interest rate including cross currency interest rate swaps increasing from 9.43% in 2010 to 9.58% in 2011.
The movements in weighted average interest rates in both 2012 and 2011 are as a result of our program to refinance higher coupon debt, the principal transactions being:
•
On July 26, 2011 we fully redeemed the 9.125% senior notes due 2016 by paying $575.1 million, or £355.8 million of cash.
•
On March 13, 2012, we issued U.S. dollar denominated 5.25% senior notes due February 15, 2022 with a principal value of $500 million, the net proceeds of which together with cash on our balance sheet were used on March 28, 2012 to redeem $500 million of the principal amount of our $1,350 million 9.50% senior notes due 2016. We recognized a loss on extinguishment of debt of £58.6 million as a result of this redemption.
•
On October 30, 2012, we issued $900 million aggregate principal amount of 4.875% senior notes and £400 million aggregate principal amount of 5.125% senior notes due October 30, 2022 at par, the net proceeds of which were used to redeem our remaining $850 million and €180 million 9.50% senior notes due 2016, and $92.9 million of the principal amount of our $600 million 8.375% senior notes due 2019 and £96.5 million of the principal amount of our £350 million 8.875% senior notes due 2019. We recognized a loss on extinguishment of debt of £129.2 million as a result of these redemptions.
Our senior unsecured notes are issued by VMF and are guaranteed on a senior basis by Virgin Media Inc., Virgin Media Group LLC, Virgin Media Holdings Inc., Virgin Media (UK) Group, Inc. and Virgin Media Communications Limited and on a senior subordinated basis by VMIH and VMIL. Interest accrues from date of issuance.
Senior Secured Notes
Our wholly owned subsidiary Virgin Media Secured Finance PLC, or VMSF, has issued senior secured notes in a mix of U.S. dollar and Sterling denominated instruments:
(1) On August 5, 2010, we completed an offer to exchange any and all of the then outstanding senior secured notes due 2018, which we originally issued in a U.S. private placement, for an equivalent amount of new senior secured notes due 2021 which have been registered under the U.S. Securities Act of 1933, as amended.
(2) On September 8, 2011, we completed an offer to exchange any and all of the then outstanding senior secured notes due 2018, which we originally issued in a U.S. private placement, for an equivalent amount of new senior secured notes due 2021 which have been registered under the U.S. Securities Act of 1933, as amended.
We have entered in to cross currency interest rate swaps to mitigate the interest and foreign exchange risks associated with our U.S. dollar denominated debt, which for these senior secured notes due 2018 and 2021 changes the weighted average interest rate to 7.02% and 6 month LIBOR +1.94% respectively.
No senior secured notes have been issued or amended during 2012 with the reduction in the weighted average interest rate from 5.46% to 5.43% being due to reductions in LIBOR.
In 2011 the weighted average interest rate on our senior secured notes fell from 7.01% in 2010 to 5.46% in 2011, principally as a result of issuing the senior secured notes due 2021 with a lower coupon than the senior notes due 2018. During March 2011, the net proceeds from issuing the senior secured notes due 2021 were partly applied against amounts outstanding under our senior credit facility at that date.
Our senior secured notes are issued by VMSF and are guaranteed on a senior basis by Virgin Media Inc., Virgin Media Group LLC, Virgin Media Holdings Inc., Virgin Media (UK) Group, Inc. and Virgin Media Communications Limited and on a senior subordinated basis by VMIH and VMIL. They also rank pari passu with and, subject to certain exceptions, share in the same guarantees and security which has been granted in favor of our senior credit facility.
Senior Credit Facilities
Our senior credit facilities comprise a term loan, which can be used for general corporate purposes, and a revolving credit facility, or RCF, for the financing of our ongoing working capital requirements and general corporate purposes.
Since May 20, 2011, £750 million has been available under the term loan facility, which was fully drawn at December 31, 2012, and £450 million is available under the RCF. At December 31, 2012 £6.4 million of the RCF had been utilized for bank guarantees & letters of credit provided in the usual course of business. On June 28, 2012, we borrowed £100.0 million under the RCF, which was repaid in full on September 28, 2012. On November 30, 2012 we borrowed £75.0 million under the RCF, which was repaid in full on December 31, 2012. As at December 31, 2012, £443.6 million was available to be drawn under the RCF.
Interest on our senior credit facility is payable at least semi-annually based on LIBOR plus an applicable interest margin depending on the total net leverage ratio of the bank group. The interest margin is between 1.625% and 2.125% for the term loan, and between 1.325% and 2.125% for the RCF. We have entered in to interest rate swap agreements to manage our exposure to variability in LIBOR, which from July 2012 to December 2015 have swapped interest receipts based on six month LIBOR for interest payments at fixed rates of between 2.79% and 2.91%.
Prior to May 20, 2011, our Senior Facilities Agreement, or SFA, comprised an original term loan in two Tranches, A and B, and a revolving credit facility, as set out in our Form 10-K for the year ended December 31, 2011.
The other principal terms of our senior credit facilities are set out below, although as a summary this does not purport to be complete and is qualified in its entirety by reference to the full text of the SFA which is filed as Exhibit 10.1 in Virgin Media Inc.’s current report on Form 8-K, as filed with the SEC on May 23, 2011, and is incorporated herein by reference.
Bank group: comprises VMIH and certain of its subsidiaries, and certain other operating companies which are subsidiaries of Virgin Media Inc. but not of VMIH.
Guarantees: Members of the bank group generating not less than 80% of consolidated operating cash flow (a non-GAAP measure defined in the SFA) guarantee all sums payable under the Senior Credit Facility, and have granted first ranking security over all or substantially all of their assets to provide such a guarantee.
Financial Maintenance Covenants: are measured quarterly based on operating cashflows which is a non-GAAP measure defined in the SFA. As of December 31, 2012, we were in compliance with these covenants:
•
Leverage ratio: consolidated net debt to consolidated operating cashflows to be a maximum of 3.75.
•
Interest cover: consolidated operating cashflow to consolidated total net cash interest to be a minimum of 3.10 at Dec 31, 2012 increasing in quarterly steps to a minimum of 4.00 at June 30, 2015.
Maturity: Both facilities are repayable in full at maturity on June 30, 2015 and have no scheduled amortization.
Change in control: A change in control will trigger the repayment of our senior credit facility and cancellation of all commitments.
Restrictions: The SFA restricts the ability of members of the bank group to, among other things, make changes to assets, incur or guarantee further liabilities, or make distributions from within that group.
Events of default: The Senior Credit Facility is immediately repayable on occurrence of events of default specified in the SFA which include, among other things, failure to make payments when due, breaches of terms of the SFA, illegality, or the occurrence of events which materially affect the ability of the obligors (taken together) to comply with the SFA.
Convertible Senior Notes
Our $1 billion of convertible senior notes due 2016 bear interest at an annual rate payable semi-annually on May 15 and November 15 of each year, are unsecured senior obligations of Virgin Media Inc, and may not be redeemed by us prior to maturity on November 15, 2016.
Holders of convertible senior notes may tender their notes for conversion any time on or after August 15, 2016 through to the second scheduled trading date preceding maturity date. Prior to August 15, 2016, notes may be tendered by the holder if:
(i) in any quarter, if the closing sale price of Virgin Media Inc.’s common stock during at least 20 of the last 30 trading days of the prior quarter was more than 120% of the applicable conversion price per share of common stock on the last day of such prior quarter;
(ii) if, for five consecutive trading days, the trading price per $1,000 principal amount of notes was less than 98% of the product of the closing price of our common stock and the then applicable conversion rate;
(iii) if a specified corporate event occurs, such as a merger, recapitalization, reclassification, binding share exchange or conveyance of all, or substantially all, of Virgin Media Inc.’s assets;
(iv) the declaration by Virgin Media Inc. of the distribution of certain rights, warrants, assets or debt securities to all, or substantially all, holders of Virgin Media Inc.’s common stock; or
(v) if Virgin Media Inc. undergoes a fundamental change (as defined in the indenture governing the convertible senior notes), such as a change in control, merger, consolidation, dissolution or delisting.
Upon conversion, we may elect to settle in cash, shares of common stock or a combination of cash and shares of our common stock, except in the case of (v) above where holders may require us to settle in cash. The initial conversion rate represents an initial conversion price of approximately $19.22 per share, which may be adjusted if this price exceeds market values.
We have entered into conversion hedges which are intended to offset a portion of the dilutive effects that could potentially be associated with conversion of the convertible senior notes at maturity and provide us with the option to receive the number of shares of our common stock (or in certain circumstances cash) with a value equal to the excess of (a) the value owed by us (up to the cap price of $35.00 per share) to convertible senior note investors pursuant to the terms of the notes on conversion of up to 90% of the notes over (b) the aggregate face amount of such converted notes upon maturity of the convertible senior notes.
CAPITAL RETURN PROGRAMS
As part of our first phase capital optimization program we were permitted to repurchase £375 million of our common stock, which we did during 2011. Our second phase, and extended second phase, capital optimization programs together permit the repurchase of £875 million of our common stock, of which £122.5 million was remaining authorized and available at December 31, 2012. On December 14, 2012, we announced a third phase to our share buyback program of a further £1 billion of common stock to be repurchased before the end of 2014.
Since commencing our share repurchase program in July 2010 we have repurchased 73 million shares, or approximately 22% of our share count at July 2010. A total of 20.5 million shares have been repurchased during 2012, 40.9 million shares during 2011, and 11.6 million shares during 2010, as described below:
Further details of stock repurchased under our capital returns programs are provided in Item 5 of this Form 10-K.
Accelerated Stock Repurchases, or ASRs
During 2012, we entered into a capped ASR on February 8, 2012 to purchase $250 million (£157.3 million) of our common stock, which delivered 10.2 million shares during 2012 at an average purchase price per share of $24.58. A further capped ASR commenced on July 24, 2012 to purchase $175 million (£112.7 million) of our common stock, which delivered 6.1 million shares during 2012 at an average purchase price per share of $28.71. Both ASRs undertaken during 2012 were under the authority of the 2011 capital optimization program.
During 2011 we entered in to a capped ASR on September 8, 2011 to purchase $250 million (£156.6 million) of our common stock, which delivered 10.1 million shares during 2011 at an average purchase price per share of $24.71. A further capped ASR commenced on November 10, 2011 to purchase $300 million (£188.0 million) of our common stock, which delivered 13.6 million shares during 2011 at an average purchase price per share of $21.99. Both ASRs undertaken during 2011 were under the authority of the 2010 capital optimization program.
Stock acquired under all ASR programs has been cancelled. Further details of our ASR programs are provided on the Form 8-K's we filed with the SEC on commencing each program.
Open Market Repurchases, or OMRs
During 2012, we made open market repurchases of a further 4.2 million shares of common stock in connection with the second phase capital structure optimization program, at an average purchase price per share of $22.54 ($94.9 million, or £60.3 million, in aggregate).
During 2011 we repurchased approximately 17.1 million shares through open market repurchases at an average purchase price per share of $27.64 ($472.5 million in aggregate). Of this total, 12.0 million share were repurchased under the first capital optimization program at an average purchase price per share of $28.83 ($345.5 million in aggregate), with the remaining 5.1 million shares being repurchased under the second capital optimization program at an average purchase price per share of $24.86 ($127.0 million in aggregate).
In 2010, we repurchased 2.3 million shares of common stock under the first capital optimization program at an average purchase price per share of $26.82 ($61.7m in aggregate).
Stock acquired under all OMR programs has been cancelled.
OFF BALANCE SHEET ARRANGEMENTS
As part of our ongoing business we have not participated in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities frequently referred to as special purpose entities, or SPEs, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2012 we were not involved with any material unconsolidated SPEs.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Our contractual obligations and commitments arise from both our operations and our financing arrangements as described earlier in this MD&A. The following table includes aggregate information about the contractual obligations recorded in our consolidated financial statements as of December 31, 2012 , and the periods in which payments are due (in £ millions).
Purchase obligations in the table above represent amounts payable under fixed or minimum guaranteed commitments, and therefore do not represent the total fees that are expected to be paid under certain programming contracts where amounts payable are generally based on the number of customers receiving the programming.
Early termination charges are amounts that would be payable in the above periods in the event of early termination during that period of certain of the contracts underlying the purchase obligations listed above. These amounts are not required to be recorded in our consolidated financial statements.
The following table includes information about our commercial commitments as of December 31, 2012, which are items we could be obligated to pay in the future (in £ millions). These amounts are not required to be recorded in our consolidated financial statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk Overview
We are exposed to various market risks, including changes in foreign currency exchange rates and interest rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. As some of our indebtedness accrues interest at variable rates, we have exposure to volatility in future cash flows and earnings associated with variable interest rate payments.
Substantially all of our revenues, operating costs and selling, general and administrative expenses are earned and paid in pounds sterling but we pay interest and principal obligations on some of our indebtedness in U.S. dollars and euros. As of December 31, 2012, £2,722.3 million, or 46.3%, of our indebtedness based upon contractual obligations, was denominated in U.S. dollars. As a result, we have exposure to volatility in future cash flows and earnings associated with changes in foreign exchange rates on payments of principal and interest on a portion of our indebtedness. We have also committed and forecasted purchases of goods and services in U.S. dollars, euros and South African rand.
The fair market value of long term fixed interest rate debt and the amount of future interest payments on variable interest rate debt are subject to interest rate risk.
To mitigate the risk from these exposures, we have implemented a cash flow hedging program. The objective of this program is to reduce but not eliminate the volatility of our cash flows and earnings caused by changes in underlying rates. To achieve this objective we have entered into a number of derivative instruments. The derivative instruments utilized comprise interest rate swaps, cross-currency interest rate swaps and foreign currency forward contracts. We do not enter into derivative instruments for trading or speculative purposes.
For further details of the accounting for derivative instruments see note 8 to the consolidated financial statements in Item 8
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements, the notes thereto and the report of the independent registered public accounting firm begin on page of this document and are incorporated in this document by reference.
The following is a summary of the unaudited selected quarterly results of operations for the years ended December 31, 2012 and 2011 (in millions, except per share data):
During the three months ended December 31. 2012 we reduced a portion of the valuation allowance on certain of our deferred tax assets as required by the applicable accounting rules which resulted in an income tax benefit of £2,591.2 million for this period. Further details of this allowance reduction are provided in the Critical Accounting Estimates section of Management's Discussion and Analysis of Financial Results of Operations contained in Item 7 of this Form 10-K. The reduction of this allowance will not result in any change to the amount of cash payments we make to the tax authorities.
During the three months ended June 30, 2011 we reached an agreement with the U.K. tax authorities regarding our VAT treatment of certain of our revenue generating activities. The U.K. tax authorities provided us with a refund of £81.5 million, which was collected during the three months ended June 30, 2011, £77.6 million of which was included in the consolidated statement of comprehensive income for the quarter.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a)
Disclosure Controls and Procedures
Our management, with the participation of our chief executive officer and chief financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our chief executive officer and chief financial officer have concluded that, as of the end of such period, these controls and procedures are effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. These disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the report that we file or submit is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
(b)
Management’s Annual Report on Internal Control Over Financial Reporting for Virgin Media Inc.
Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of Virgin Media Inc.’s consolidated financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2012 based on the framework described in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation under the COSO framework, our management has concluded, and hereby reports, that our internal control over financial reporting was effective as of December 31, 2012. This annual report includes an attestation report of Ernst & Young LLP, our independent registered public accounting firm, regarding internal control over financial reporting of Virgin Media Inc.
(c)
Management’s Annual Report on Internal Control Over Financial Reporting for Virgin Media Investment Holdings Limited
Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of VMIH’s consolidated financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2012 based on the framework described in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on our evaluation under the COSO framework, our management has concluded, and hereby reports, that VMIH’s internal control over financial reporting was effective as of December 31, 2012.
This annual report does not include an attestation report of Ernst & Young LLP, our independent registered public accounting firm, regarding internal control over financial reporting of VMIH. VMIH’s internal control over financial reporting was not subject to attestation by Ernst & Young LLP, our independent registered public accounting firm, pursuant to rules of the Securities and Exchange Commission that permit VMIH to provide only management’s report in this annual report.
(d)
Management’s Annual Report on Internal Control Over Financial Reporting for Virgin Media Investments Limited
Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of VMIL’s consolidated financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2012 based on the framework described in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation under the COSO framework, our management has concluded, and hereby reports, that VMIL’s internal control over financial reporting was effective as of December 31, 2012.
This annual report does not include an attestation report of Ernst & Young LLP, our independent registered public accounting firm, regarding internal control over financial reporting of VMIL. VMIL’s internal control over financial reporting was not subject to attestation by Ernst & Young LLP, our independent registered public accounting firm, pursuant to rules of the Securities and Exchange Commission that permit VMIL to provide only management’s report in this annual report.
(e)
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
(f)
Attestation Report of Independent Registered Public Accounting Firm
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Virgin Media Inc. and subsidiaries
We have audited Virgin Media Inc. and subsidiaries' internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Virgin Media Inc. and subsidiaries' management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying “Management's Annual Report on Internal Control Over Financial Reporting for Virgin Media Inc.” . Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed 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 its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Virgin Media Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Virgin Media Inc. and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2012 Virgin Media Inc. and subsidiaries, and our report dated February 7, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
London, England
February 7, 2013
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this Item is incorporated by reference to our Proxy Statement for the 2013 Annual Meeting of Stockholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to our Proxy Statement for the 2013 Annual Meeting of Stockholders.
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 our Proxy Statement for the 2013 Annual Meeting of Stockholders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this Item is incorporated by reference to our Proxy Statement for the 2013 Annual Meeting of Stockholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item is incorporated by reference to our Proxy Statement for the 2013 Annual Meeting of Stockholders.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
(1)
Financial Statements-See list of Financial Statements on page.
(2)
Financial Statement Schedules-See list of Financial Statement Schedules on page.
(3)
Exhibits-See Exhibit Index.
FORM 10K-Item 15(a)(1) and (2)
VIRGIN MEDIA INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULES
The following consolidated financial statements of Virgin Media Inc. and Subsidiaries are included in Item 8:
All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are not applicable and, therefore, have been omitted.
The following consolidated financial statements of Virgin Media Investment Holdings Limited, Virgin Media Investments Limited and Subsidiaries are included in Item 8:
All schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are not applicable and, therefore, have been omitted.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Virgin Media Inc. and subsidiaries
We have audited the accompanying consolidated balance sheets of Virgin Media Inc. and subsidiaries (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedules listed in the index at Item 15 (a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Virgin Media Inc. and subsidiaries at December 31, 2012 and 2011, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Virgin Media Inc.'s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 7, 2013 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
London, England
February 7, 2013
VIRGIN MEDIA INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in millions, except par value)
See accompanying notes.
VIRGIN MEDIA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions, except per share data)
See accompanying notes.
VIRGIN MEDIA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
See accompanying notes.
VIRGIN MEDIA INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in millions)
See accompanying notes.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Note 1-Organization and Business
Virgin Media Inc. is a Delaware corporation and is publicly-traded on the NASDAQ Global Select Market in the United States and the London Stock Exchange in the United Kingdom. We conduct our operations primarily through direct and indirect wholly owned subsidiaries.
We are a leading entertainment and communications business, being a “quad-play” provider of broadband internet, television, mobile telephony and fixed line telephony services that offer a variety of entertainment and communications services to residential and commercial customers throughout the U.K. We are one of the U.K.’s largest providers of residential broadband internet, pay television and fixed line telephony services by number of customers. We believe our advanced, deep fiber access network enables us to offer faster and higher quality broadband services than our digital subscriber line, or DSL, competitors. As a result, we provide our customers with a leading next generation broadband service and one of the most advanced TV on-demand services available in the U.K. market. As of December 31, 2012, we provided services to 4.9 million residential cable customers on our network. We are also one of the U.K.’s largest mobile virtual network operators by number of customers, providing mobile telephony service to 1.7 million contract mobile customers and 1.3 million prepay mobile customers over third party networks.
In addition, we provide a complete portfolio of voice, data and internet solutions to businesses, public sector organizations and service providers in the U.K. through Virgin Media Business.
Our reporting segments are based on our method of internal reporting and the information used by our chief executive officer, who is our chief operating decision maker, or CODM, to evaluate segment performance and make capital allocation decisions. We have two reporting segments, Consumer and Business, as described below:
•
Consumer (83.7% of our 2012 revenue): Our Consumer segment includes the distribution of television programming over our cable network and the provision of broadband and fixed line telephone services to residential consumers, both on and off our cable network. Our Consumer segment also includes our mobile telephony and mobile broadband operations, provided over third party mobile networks
•
Business (16.3% of our 2012 revenue): Our Business segment includes the voice and data telecommunication and internet solutions services we provide through our cable network and third party networks to businesses, public sector organizations and service providers.
On February 5, 2013, we entered in to a Merger Agreement with Liberty Global, Inc., or Liberty Global, and certain of its direct or indirect wholly owned subsidiaries, or the Merger Subsidiaries, pursuant to which we agreed, through a series of intermediate steps and transactions, to be acquired by Liberty Global and merge into one of the Merger Subsidiaries. If consummated, the merger will result in both Liberty Global and Virgin Media becoming directly owned by a new U.K. public limited company, or the Ultimate Parent, listed on NASDAQ, the common stock of which will in turn be held by Liberty Global and Virgin Media Shareholders. We will continue to operate under the Virgin Media brand in the U.K.. Further details of the proposed merger are set out in Note 18 - Subsequent Events.
Note 2-Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP.
On September 30, 2011, we completed the sale to Scripps Network Interactive, Inc. (“Scripps”), of our 50% equity investment in the UKTV joint venture with BBC Worldwide Limited. After the inclusion of associated fees, this transaction resulted in a loss on disposal of £7.2 million.
On July 12, 2010, we completed the sale of our television channel business known as Virgin Media TV to BSkyB. Virgin Media TV’s operations comprised our former Content segment. These consolidated financial statements reflect Virgin Media TV as discontinued operations.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Principles of Consolidation
The consolidated financial statements include the financial statements for us and our wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated on consolidation. The operating results of acquired companies are included in our consolidated statements of comprehensive income from the date of acquisition.
For investments in which we own 20% to 50% of the voting shares and have significant influence over the operating and financial policies, the equity method of accounting is used. Accordingly, our share of the earnings and losses of these companies are included in the share of income (losses) in equity investments in the accompanying consolidated statements of comprehensive income.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such estimates and assumptions impact, among others, the following: the amount of uncollectible accounts receivable, amounts accrued for vacated properties, the amount to be paid for other liabilities, including contingent liabilities, our pension expense and pension funding requirements, amounts to be paid under our employee incentive plans, costs for interconnection, the amount of costs to be capitalized in connection with the construction and installation of our network and facilities, goodwill and indefinite life assets, long-lived assets, certain other intangible assets and the computation of our valuation allowance on deferred tax assets. Actual results could differ from those estimates.
Fair Values
We have determined the estimated fair value amounts presented in these consolidated financial statements using available market information and appropriate methodologies including, where appropriate, the recording of adjustments to fair values to reflect non-performance risk. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. We have based these fair value estimates on information available to us as of December 31, 2012, 2011, and 2010.
Foreign Currency Translation
Our reporting currency is the pound sterling because substantially all of our revenues, operating costs and selling, general and administrative expenses are denominated in pounds sterling. Exchange gains and losses on translation of our net equity investments in subsidiaries having functional currencies other than the pound sterling are reported as a separate component of accumulated other comprehensive income in shareholders’ equity. Foreign currency transactions involving amounts denominated in currencies other than a subsidiary’s functional currency are recorded at the exchange rate ruling at the date of the transaction and are remeasured each period with gains and losses recorded in the consolidated statement of comprehensive income.
Cash and Cash Equivalents and Restricted Cash
Cash equivalents are short term highly liquid investments purchased with an original maturity of three months or less and are recorded at amortized cost, which approximates fair value. We had cash and cash equivalents totaling £206.3 million and £300.4 million as at December 31, 2012 and 2011, respectively.
Restricted cash balances of £1.9 million as at December 31, 2012 and £1.9 million as at December 31, 2011 represent cash balances collateralized against performance bonds given on our behalf.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Trade Receivables
Our trade receivables are stated at outstanding principal balance, net of allowance for doubtful accounts. Allowances for doubtful accounts are estimated based on the current aging of trade receivables, prior collection experience and future expectations of conditions that might impact recoverability. Amounts charged to expense are included in selling, general and administrative expenses in the consolidated statement of comprehensive income. The movements in our allowance for doubtful accounts for the years ended December 31, 2012, 2011 and 2010 are as follows (in millions):
Inventory
Inventory consists of consumer goods for re-sale. Consumer goods for re-sale are valued at the lower of cost or market value using the first-in, first-out, or FIFO, method. Cost represents the invoiced purchase cost of inventory. This valuation requires us to make judgments, based on currently available information, about obsolete, slow-moving, or defective inventory. Based upon these judgments and estimates, which are applied consistently from period to period, we adjust the carrying amount of our inventory for re-sale to the lower of cost or market value. Included within prepaid expenses and other current assets is inventory of £17.5 million and £13.1 million as at December 31, 2012 and 2011, respectively.
Fixed Assets
Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Land is not depreciated. Estimated useful lives are as follows:
Costs associated with network construction, initial customer installations, initial installations of new services in customer premises, and the addition of network equipment to provide new or enhanced services are capitalized. Costs capitalized as part of initial customer installations include materials and direct labor.
Capitalizable labor costs incurred in connection with customer installations relate to activities such as:
•
Dispatching personnel and equipment to the customer's premises;
•
Verification that the customer's premises are able to properly receive our services;
•
Physically connecting the customer's premises to our network;
•
Set-up of equipment within the customer's premises and connection of that equipment to our network; and
•
Programming the equipment so that it is able to function as intended.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
We also capitalize certain indirect costs required in order to connect the customer to our network. These indirect costs relate to the compensation and overhead costs of employees who assist in connecting and activating the customer.
Costs incurred to connect a service to premises that have previously received the same service are expensed as incurred, and costs incurred to connect a new service to premises that have previously received the same service are capitalized. For example, if premises that have received our telephony service ceases receiving our telephony service, costs incurred to connect telephony services at that premises at any point in the future would be expensed. Additionally, if premises that have received telephony services ceases receiving our services and a new customer occupies that premises and subscribes to both our broadband and telephony services, the costs incurred to connect broadband services would be capitalized and the costs to connect telephony services would be expensed. We assess a new service as a product that provides fundamentally new or enhanced functionality to our customers and which delivers incremental revenues.
We are required to make judgments regarding the amount of construction and installation costs that are capitalized. Our capitalization rates for labor costs are based on studies of actual costs as well as operational data demonstrating the amount of actual time that is spent on specific activities. Our capitalization rates for overhead costs are based on studies of activities that are incurred in support of capitalizable activities as well as an analysis of the proportion of those costs that are directly attributable to capitalizable activities. We continuously monitor the appropriateness of our capitalization policy and update the studies used on a regular basis. We update our policy when necessary to respond to changes in facts and circumstances, such as the development of new products and services. Changes resulting from modification to our capitalization have not historically had a material impact on our results.
Software Development Costs
We capitalize costs related to computer software developed or obtained for internal use in accordance with the Intangibles-Goodwill and Other Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). Software obtained for internal use has generally been enterprise-level business and finance software that we customize to meet our specific operational needs. Costs incurred in the application development phase are capitalized and amortized over their useful lives, which are generally three to five years. We have not sold, leased or licensed software developed for internal use to our customers and we have no intention of doing so in the future. Amounts attributable to software development costs are included in fixed assets and depreciation expense in the consolidated balance sheets and consolidated statements of comprehensive income, respectively.
Goodwill and Intangible Assets
Goodwill and other intangible assets with indefinite lives, such as reorganization value in excess of amounts allocatable to identifiable assets, are not amortized and are tested for impairment annually or more frequently if circumstances indicate a possible impairment exists in accordance with the Intangibles-Goodwill and Other Topic of the FASB ASC.
Asset Retirement Obligations
We account for our obligations under the Waste Electrical and Electronic Equipment Directive adopted by the European Union in accordance with the Asset Retirement and Environmental Obligations Topic of the FASB ASC whereby we accrue the cost to collect and dispose of certain of our customer premises equipment at the time of acquisition. We also record asset retirement obligations for the estimated cost of removing leasehold improvements and equipment that have been installed on leased network sites and administrative buildings.
Impairment of Long-Lived Assets
In accordance with the Property, Plant, and Equipment Topic of the FASB ASC, long-lived assets, including fixed assets and amortizable definite lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. We assess the recoverability of the carrying value of long-lived assets, by first grouping our long-lived assets with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities (the asset group) and, secondly, estimating the undiscounted future cash flows that are directly associated with and expected to arise from the use of and eventual disposition of such asset group. We estimate the undiscounted cash flows over the remaining useful life of the primary asset within the asset group. If the carrying value of the asset group exceeds the
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
estimated undiscounted cash flows, we record an impairment charge to the extent the carrying value of the long-lived asset exceeds its fair value. We determine fair value through quoted market prices in active markets or, if quoted market prices are unavailable, through the performance of internal analysis of discounted cash flows or external appraisals. The undiscounted and discounted cash flow analyses are based on a number of estimates and assumptions, including the expected period over which the asset will be utilized, projected future operating results of the asset group, discount rate and long term growth rate.
As of December 31, 2012 there were no indicators of impairment that suggest the carrying amounts of our long-lived assets are not recoverable.
Deferred Financing Costs
Deferred financing costs are incurred in connection with the issuance of debt and are amortized over the term of the related debt using the effective interest method. Deferred financing costs of £61.5 million and £75.7 million as of December 31, 2012 and 2011, respectively, are included on the consolidated balance sheets. Deferred financing costs associated with our convertible senior notes are amortized to the expected due date of the notes which is currently November 2016. Should the holders of the convertible senior notes have the ability to, and elect to, convert their notes prior to November 2016, we will expense the deferred financing costs associated with the converted notes in the period of conversion.
Restructuring Costs
We account for our restructuring costs, which comprise lease and contract exit costs as well as employee termination costs, in accordance with the Exit or Disposal Cost Obligations Topic of the FASB ASC and recognize a liability for costs associated with restructuring activities when the liability is incurred.
Revenue Recognition
Revenue is stated net of value added tax, or VAT, collected from customers on behalf of tax authorities.
Consumer
Fixed line telephone, cable television and internet revenues are recognized as the services are provided to customers. At the end of each period, adjustments are recorded to defer revenue relating to services billed in advance and to accrue for earned but unbilled services.
Installation revenue for our Consumer segment is recognized in accordance with the provisions of the Entertainment-Cable Television Topic of the FASB ASC in relation to installation fees for cable television, fixed line telephone, and broadband internet services. Installation revenues are recognized at the time the installation is completed to the extent those fees are less than direct selling costs, which is generally the case.
Mobile handset and other equipment revenues are recognized when the goods have been delivered and title has passed. Equipment revenue is stated net of discounts earned through service usage.
Mobile service revenues include airtime, data, roaming and long-distance revenues and are invoiced and recorded as part of a periodic billing cycle. Service revenues are recognized as the services are provided. At the end of each period, adjustments are recorded to defer revenue relating to services billed in advance and to accrue for earned but unbilled services. Revenue from non-contract pre-pay customers is recorded as deferred revenue prior to commencement of services and is recognized as the services are rendered or usage rights expire.
Business
Rental revenues in respect of connectivity services provided to customers are recognized on a straight-line basis over the term of the rental agreement.
Installation revenues are recognized when the contracted installation service has been delivered, which is generally when a customer is connected to our network and has acknowledged acceptance.
Bundled revenue arrangements generally have two units of accounting: an up-front installation element and an ongoing service provision element.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Revenue is allocated to each unit of accounting based on a selling price hierarchy. The selling price for a deliverable is based on its vendor-specific objective evidence (VSOE) if available, third party evidence (TPE) if VSOE is not available, or estimated selling price (ESP) if neither VSOE nor TPE is available. Currently, we do not sell installation services or ongoing rental separately on a regular basis and therefore we do not have the evidence to support VSOE for these deliverables. We use evidence of the amounts that third parties charge for similar or identical services, when available, to establish selling price. In some cases, when we are unable to establish VSOE or TPE, we use our best estimate of selling price. Our objective in determining the best estimate of selling price is to establish the price at which we would transact a sale if the deliverable were sold regularly on a stand-alone basis. We consider all reasonably available information including both market data and conditions, as well as entity specific factors. In addition, we consider all factors contemplated in negotiating the arrangement with the customer and our own normal pricing practices. These considerations include competitor pricing, customization of the product, profit objectives and cost structures. Once we have established the selling price of each deliverable, we allocate total arrangement consideration based on the relative stand alone selling price of each deliverable. We recognize revenue on each deliverable in accordance with our policies for product and service revenue recognition, as previously discussed.
In all bundled revenue arrangements, the amount of revenue recognized for any up-front elements, including installation services, is limited to the amount of cash collected.
Subscriber Acquisition Costs
Costs incurred in respect of the acquisition of our customers, including commissions and the cost of mobile handsets, are expensed as incurred.
Advertising and Marketing Expense
We expense the cost of advertising and marketing as incurred. Advertising and marketing costs were £192.4 million, £157.1 million and £147.7 million in 2012, 2011 and 2010 respectively.
Stock-Based Compensation
We have a number of stock-based employee compensation plans, as described more fully in note 9. We account for these compensation plans in accordance with the Compensation-Stock Compensation Topic of the FASB ASC. We measure stock-based compensation expense at fair value and record that expense based on our estimate of the number of instruments for which the requisite service period is expected to be rendered. Awards with graded vesting terms are recognized over the requisite service period for each separately vesting portion of the award. Where applicable, modifications to the terms or conditions of an award are measured by comparing the fair value of the modified award with the fair value of the award immediately before the modification.
Pensions
We account for our defined benefit pension arrangements in accordance with the Compensation-Retirement Benefits Topic of the FASB ASC which requires that pension expense is recognized on an accrual basis over employees’ approximate service periods. Pension expense is generally independent of funding decisions or requirements.
We recognize the funded status of our defined benefit post-retirement plans on our balance sheet and changes in the funded status are reflected in comprehensive income.
Derivative Financial Instruments
We are exposed to various market risks, including changes in foreign currency exchange rates and interest rates. As certain portions of our indebtedness accrue interest at variable rates, we are exposed to volatility in future cash flows and earnings associated with variable interest rate payments. Also, substantially all of our revenue and operating costs are earned and paid in pounds sterling and, to a lesser extent, U.S. dollars and euros, but we pay interest and principal obligations on some of our indebtedness in U.S. dollars and euros. As a result, we have exposure to volatility in future cash flows and earnings associated with changes in foreign currency exchange rates on payments of principal and interest on a portion of our indebtedness. We are also exposed to volatility in future cash flows and earnings associated
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
with foreign currency payments in relation to operating costs and purchases of fixed assets incurred in the normal course of business.
Our objective in managing exposure to fluctuations in interest rates and foreign currency exchange rates is to decrease the volatility of our earnings and cash flows caused by changes in underlying rates. To achieve this objective, we have entered into derivative financial instruments. We have established policies and procedures to govern the management of these exposures through a variety of derivative financial instruments, including interest rate swaps, cross-currency interest rate swaps and foreign currency forward rate contracts. By policy, we do not enter into derivative financial instruments with a level of complexity or with a risk that is greater than the exposure to be managed.
In order to qualify for hedge accounting in accordance with the Derivatives and Hedging Topic of the FASB ASC we are required to document in advance the relationship between the item being hedged and the hedging instrument. We are also required to demonstrate that the hedge will be highly effective on an ongoing basis. This effectiveness testing is performed and documented at each period end to ensure that the hedge remains highly effective.
We recognize all derivative financial instruments as either assets or liabilities measured at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting. To the extent that the derivative instrument is designated and considered to be effective as a cash flow hedge of an exposure to future changes in interest rates or foreign currency exchange rates, the change in fair value of the instrument is deferred in accumulated other comprehensive income or loss. Amounts recorded in accumulated other comprehensive income or loss are reclassified to net income in the statement of comprehensive income in the same period as the corresponding impact on earnings from the underlying hedged transaction. Changes in the fair value of any instrument not designated as an accounting hedge or considered to be ineffective as an accounting hedge are reported in earnings immediately.
Where an accounting hedge no longer meets the effectiveness criteria, any gains or losses deferred in equity are only transferred to net income in the statement of comprehensive income when the committed or forecasted transaction is recognized in the statement of comprehensive income. However, where we have applied cash flow hedge accounting for a forecasted or committed transaction that is no longer expected to occur, then the cumulative gain or loss that has been recorded in equity is recognized immediately as a gain or loss on derivative instruments in the statement of comprehensive income.
Equity-linked Instruments
We determine the accounting treatment of equity-linked instruments according to the Distinguishing Liabilities from Equity and Derivatives and Hedging Topics of the FASB ASC. This involves assessing whether the instrument falls within the scope of the first topic and should be classified as an asset, liability or as equity. If the guidance in the first topic is not applicable, we evaluate the instrument according to the second topic to determine whether it is indexed to our stock and if necessary, whether it would be classified in equity.
Operating Leases
Our leasing activities are principally related to administrative facilities, network related facilities, retail facilities and operating equipment. These leases generally provide us with renewal options. Certain leases contain fluctuating or escalating payments and rent holiday periods. The related rent expense is recorded on a straight line basis over the lease term.
Contingent rent is not a material component of our total rent expense.
Income Taxes
We provide for income taxes in accordance with the Income Taxes Topic of the FASB ASC. Judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and the extent to which valuation allowances are necessary to reduce our deferred tax assets. We recognize valuation allowances if it is not more likely than not that sufficient taxable income will be available in the future against which the temporary differences and unused tax losses can be utilized. We have considered future taxable income and tax planning strategies in assessing whether deferred tax assets should be recognized.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Recent Accounting Pronouncements
On January 1, 2012 we adopted the FASB's new guidance for presentation of net income and other comprehensive income. Adopting these presentational rules has no impact on our reported results, and no material impact on our consolidated financial statements.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 3-Earnings Per Share
Basic net income (loss) per common share and basic income (loss) from continuing operations per share is computed by dividing the net income (loss) and income (loss) from continuing operations, respectively, by the weighted average number of shares outstanding during the respective periods. Diluted net income (loss) per common share and diluted income (loss) from continuing operations per common share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method for stock options, sharesave options, shares of restricted stock held in escrow, restricted stock units and warrants, and the if-converted method for shares potentially issuable under our convertible senior notes.
Basic and diluted income (loss) from discontinued operations per share for the years ended December 31, 2012, 2011 and 2010 was £0.00, £0.00 and £0.08 respectively.
The weighted average number of shares outstanding for the years ended December 31, 2012, 2011 and 2010 is computed as follows (in millions):
The following table sets forth the components of basic and diluted income (loss) per common share (in millions):
The following table sets forth the number of potential common shares excluded from the calculation of the denominator for diluted income (loss) per common shares (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 3-Earnings Per Share (continued)
Each of these instruments are excluded from the calculation of diluted net income per common share in periods in which there is a loss, because the inclusion of potential common shares would have an anti-dilutive effect.
In the year ended December 31, 2012, certain share based awards to employees have been excluded from the calculation of the diluted weighted average number of shares because their exercise prices exceeded our average share price during the calculation period.
In the year ended December 31, 2012, certain restricted stock held in escrow and certain restricted stock units have been excluded from the calculation of the diluted weighted average number of shares because these shares are contingently issuable based on the achievement of performance and/or market conditions that have not been achieved as of December 31, 2012.
Stock Option Grants
All options outstanding under our stock incentive plans have a ten year term and become fully exercisable within five years of continued employment. We generally issue new shares upon exercise of the options and expect to continue to do so. For performance-based option grants, the performance objectives are based upon both quantitative and qualitative objectives, including earnings and stock price performance, amongst others. These objectives may be absolute or relative to prior performance or to the performance of other entities, indices or benchmarks and may be expressed in terms of progression within a specific range.
Sharesave Option Grants
All options granted under the Virgin Media Inc. Sharesave Plan enable eligible employees to purchase shares of our common stock at a discount. Employees are invited to take out savings contracts that last for three years. At the end of the contract, employees use the proceeds of these savings to exercise the options granted under the plan. We intend to issue new shares upon exercise of the options.
Restricted Stock Grants
The shares of restricted stock granted under our stock incentive plans have a restrictions for up to ten years and vest based on time or performance, subject to continued employment. For performance-based restricted stock grants, the performance objectives are based upon quantitative and qualitative objectives, including earnings, operational performance and achievement of strategic goals, amongst others, and vest after a one to three year period. These objectives may be absolute or relative to prior performance or to the performance of other entities, indices or benchmarks and may be expressed in terms of progression within a specific range.
Restricted Stock Unit and Performance Share Grants
The restricted stock units and performance shares granted under our stock incentive plans have a term of up to ten years and vest based on performance, subject to continued employment. The performance targets include stock price performance, earnings and cash flows and may be absolute or relative to prior performance or to the performance of other entities, indices or benchmarks and may be expressed in terms of progression within a specific range.
Convertible Notes
Holders of our U.S. dollar denominated 6.50% convertible senior notes due 2016 may tender their notes for conversion at any time on or after August 15, 2016 through to the second scheduled trading date preceding the maturity date. Prior to August 15, 2016, holders may convert their notes, at their option, only under the following circumstances: (i) in any quarter, if the closing sale price of Virgin Media Inc.'s common stock during at least 20 of the last 30 trading days of the prior quarter was more than 120% of the applicable conversion price per share of common stock on the last day of such prior quarter; (ii) if, for five consecutive trading days, the trading price per $1,000 principal amount of notes was less than 98% of the product of the closing price of our common stock and the then applicable conversion rate; (iii) if a specified corporate event occurs, such as a merger, recapitalization, reclassification, binding share exchange or conveyance of all, or substantially all, of Virgin Media Inc.'s assets; (iv) the declaration by Virgin Media Inc. of the distribution of certain rights, warrants, assets or debt securities to all, or substantially all, holders of Virgin Media Inc.'s
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 3-Earnings Per Share (continued)
common stock; or (v) if Virgin Media Inc. undergoes a fundamental change (as defined in the indenture governing the convertible senior notes), such as a change in control, merger, consolidation, dissolution or delisting.
The initial conversion rate is equal to 52.0291 shares of Virgin Media Inc.'s common stock per $1,000 of convertible notes, which represents an initial conversion price of approximately $19.22 per share of common stock. The conversion rate is subject to adjustment for stock splits, stock dividends or distributions, stock repurchases where the price exceeds market values, the issuance of certain rights or warrants or certain cash dividends or distributions.
Note 4-Fixed Assets (Including Leases)
Certain prior year amounts in the table above have been reclassified to conform to current year presentation.
During the years ended December 31, 2012, 2011 and 2010, the assets acquired under capital leases totaled £88.9 million, £91.2 million and £132.2 million, respectively. Amortization expense on capital leases is included as a component of depreciation expense in the consolidated statements of comprehensive income.
Future minimum annual payments under capital and operating leases at December 31, 2012 are as follows (in millions). The table reflects our contractual obligations.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 4-Fixed Assets (Including Leases)
Total rental expense for the years ended December 31, 2012, 2011 and 2010 under operating leases was £49.8 million, £47.1 million and £52.7 million, respectively.
The weighted average interest rate for capital lease obligations as of December 31, 2012 and 2011 was 5.8% and 6.8%, respectively.
During 2012 and 2011, the changes in the asset retirement obligations were as follows (in millions):
Note 5 - Goodwill and Intangible Assets
Goodwill and intangible assets consist of (in millions):
As at December 31, 2012, the gross carrying amount of goodwill was £2,235.6 million and accumulated impairment charges were £362.2 million.
As at December 31, 2012, goodwill and intangible assets not subject to amortization totaling £1,811.6 million and £205.9 million are allocated to our Consumer and Business reporting units, respectively. We performed our annual impairment reviews of our Consumer and Business reporting units as at October 1, 2012 and 2011. As a result of these reviews we concluded that no impairment charge was required at either date. Based on the results of the review as at October 1, 2012, neither our Business or Consumer reporting units were at risk of failing Step 1 of the goodwill impairment test, under FASB ASC, which requires comparison of the carrying values and fair values of reporting units.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 6-Long Term Debt
Long term debt consists of (in millions):
The carrying values of the $500 million 5.25% and £650 million 5.50% senior secured notes due 2021 include increases of £42.9 million and £109.1 million, respectively, at December 31, 2012 and increases of £45.7 million and £77.9 million, respectively, at December 31, 2011, as a result of our application of fair value hedge accounting to these instruments.
The effective interest rate on the senior credit facility was 2.4% and 3.3% as at December 31, 2012 and 2011 respectively.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 6-Long Term Debt (continued)
The terms of the senior notes, senior credit facility and revolving credit facility as at December 31, 2012 are summarized below.
Senior Notes
At December 31, 2012, we had the following senior notes outstanding:
•
6.50% Senior Secured Notes due January 15, 2018 - The principal amount at maturity is $1,000 million. Interest is payable semi-annually on June 15 and December 15 commencing June 15, 2010.
•
7.00% Senior Secured Notes due January 15, 2018 - The principal amount at maturity is £875 million. Interest is payable semi-annually on June 15 and December 15 commencing June 15, 2010.
•
8.375% Senior Notes due October 15, 2019 - The principal amount at maturity is $507.1 million. Interest is payable semi-annually on April 15 and October 15 commencing April 15, 2010.
•
8.875% Senior Notes due October 15, 2019 - The principal amount at maturity is £253.5 million. Interest is payable semi-annually on April 15 and October 15 commencing April 15, 2010.
•
5.25% Senior Secured Notes due January 15, 2021 - The principal amount at maturity is $500 million. Interest is payable semi-annually on January 15 and July 15 commencing July 15, 2011.
•
5.50% Senior Secured Notes due January 15, 2021 - The principal amount at maturity is £650 million. Interest is payable semi-annually on January 15 and July 15 commencing July 15, 2011.
•
5.25% Senior Notes due February 15, 2022 - The principal amount at maturity is $500 million. Interest is payable semi annually on February 15 and August 15 commencing August 15 2012.
•
4.875% Senior Notes due February 15, 2022 - The principal amount at maturity is $900 million. Interest is payable semi-annually on February 15 and August 15 commencing February 15, 2013.
•
5.125% Senior Notes due February 15, 2022 - The principal amount at maturity is £400 million. Interest is payable semi-annually on February 15 and August 15 commencing February 15, 2013.
On March 13, 2012, our wholly owned subsidiary, Virgin Media Finance PLC, issued $500 million aggregate principal amount of 5.25% senior notes due 2022 at par. The proceeds of $495.5 million, net of fees, were received on March 13, 2012. Interest is payable on February 15 and August 15 each year, beginning on August 15, 2012. The senior notes due 2022 rank pari passu with Virgin Media Finance PLC's outstanding senior notes due 2019 and 2022. On March 28, 2012, we used the net proceeds from these new senior notes, and cash on our balance sheet, to redeem $500 million of the principal amount of the $1,350 million 9.50% senior notes due 2016. We recognized a loss on extinguishment of debt of £58.6 million as a result of this redemption, which represented the difference between the consideration paid to redeem $500 million of the 9.50% senior notes due 2016 and the carrying value of those notes, and the write-off of associated deferred finance costs.
On October 30, 2012, Virgin Media Finance PLC, issued $900 million aggregate principal amount of 4.875% senior notes due 2022 at par and £400 million aggregate principal amount of 5.125% senior notes due 2022, at par. The proceeds of $893.0 million and £396.9 million, net of fees, were received on October 30, 2012. Interest is payable on February 15 and August 15 each year, beginning on February 15, 2013. The senior notes due 2022 rank pari passu with Virgin Media Finance PLC's outstanding senior notes due 2019 and 2022.
We used the net proceeds from the senior notes due 2022, issued in October 2012, to redeem in full the outstanding $850 million and €180 million 9.50% senior notes due 2016 and to redeem $92.9 million of the principal amount of the $600 million 8.375% senior notes due 2019 and £96.5 million of the principal amount of the £350 million 8.875% senior notes due 2019. We recognized a loss on extinguishment of debt of £129.2 million as a result of these redemptions, which represented the difference between the consideration paid to redeem the respective notes and the carrying value of those notes, and the write-off of associated deferred finance costs.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 6-Long Term Debt (continued)
Convertible Senior Notes
On April 16, 2008, Virgin Media Inc. issued U.S. dollar denominated 6.50% convertible senior notes due 2016 with a principal amount outstanding of $1,000 million. The convertible senior notes bear interest at an annual rate of 6.50% payable semi-annually on May 15 and November 15 of each year, beginning November 15, 2008. The convertible senior notes mature on November 15, 2016 and may not be redeemed by us prior to their maturity date. Upon conversion, we may elect to settle in cash, shares of common stock or a combination of cash and shares of our common stock. Based on the December 31, 2012 closing price of our common stock, the 'if converted value' of the convertible senior notes exceeds the outstanding principal amount by approximately £563.4 million.
If the trading price of our common stock exceeds 120% of the conversion price of the convertible notes for 20 out of the last 30 trading days of a calendar quarter, holders of the convertible notes may elect to convert their convertible notes during the following quarter. This condition was met in the three months ended December, 31 2012.
We have classified this debt as long term debt in the consolidated balance sheet as of December 31, 2012 because we determined, in accordance with the Derivatives and Hedging Topic of the FASB ASC, that we have the ability to settle the obligations in equity in all circumstances, except in the case of a fundamental change (as defined in the indenture governing the convertible notes).
The liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) are required to be separately accounted for in a manner that reflects an issuer's nonconvertible debt borrowing rate. As a result, the liability component is recorded at a discount reflecting its below market coupon interest rate, and is subsequently accreted to its par value over its expected life, with the rate of interest that reflects the market rate at issuance being reflected in the results of operations.
We have applied a non-convertible borrowing rate of 10.35% which resulted in the recognition of a discount on the convertible senior notes totaling £108.2 million, with the offsetting amount recognized as a component of additional paid-in capital. In addition, a cumulative translation adjustment of £36.1 million was recognized in relation to prior periods due to the decrease in the foreign currency denominated debt balance subject to translation during 2008.
The equity component of the convertible senior notes was £108.2 million as of December 31, 2012 and 2011. The following table presents the principal amount of the liability component, the unamortized discount, and the net carrying amount of our convertible debt instruments as of December 31, 2012 and 2011 (in millions):
As of December 31, 2012, the remaining discount will be amortized over a period of approximately 4 years. The amount of interest cost recognized for the contractual interest coupon during the years ended December 31, 2012 and 2011 was approximately £41.0 million and £40.5 million, respectively. The amount of interest cost recognized for the amortization of the discount on the liability component of the senior convertible notes for the years ended December 31, 2012 and 2011 was £15.1 million and £13.5 million, respectively.
During 2010, we entered into capped call option transactions, or conversion hedges, with certain counterparties relating to our convertible senior notes. The conversion hedges are intended to offset a portion of the dilutive effects that could potentially be associated with conversion of the convertible senior notes at maturity. These conversion hedges have an initial strike price of $19.22 per share of our stock, which is the conversion price provided under the terms of our convertible senior notes, and a cap price of $35.00 per share of our stock. We paid £205.4 million for the conversion hedges during the fourth quarter of 2010. The cost of these transactions was not deductible for U.S. federal income tax purposes, and the proceeds, if any, received upon exercise of the options will not be taxable for U.S. federal income tax purposes.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 6-Long Term Debt (continued)
The conversion hedges do not qualify for equity classification under the authoritative guidance as there are potential circumstances in which cash settlement may be required at the discretion of the counterparties. As such, the fair value of the conversion hedges, which was approximately £302.4 million and £138.2 million as of December 31, 2012 and 2011, respectively, have been included as a non-current derivative financial asset in the consolidated balance sheets. The conversion hedges will be recorded at fair value at each reporting period with changes in fair values reported as a gain (loss) on derivative instruments in net income in the consolidated statement of comprehensive income. Refer to note 7 for additional discussion of the fair value measurement of the conversion hedges.
Senior Credit Facility
The principal amount outstanding under our senior credit facility at December 31, 2012 was £750.0 million. Our senior credit facility comprises a term facility denominated in pounds sterling of £750.0 million and a revolving facility of £450.0 million. At December 31, 2012, £750.0 million of the term facility had been drawn and £6.4 million of the revolving credit facility had been utilized for bank guarantees and standby letters of credit.
The term credit facility bears interest at LIBOR, plus a margin currently ranging from 1.625% to 2.125% based on leverage ratios. The margins on the revolving credit facility range from 1.325% to 2.125% based on leverage ratios. Interest is payable at least semi-annually. The term credit facility and the revolving credit facility are repayable in full on their maturity dates, which are June 30, 2015.
The facility is secured through a guarantee from Virgin Media Finance PLC. In addition, the bulk of the facility is secured through guarantees and first priority pledges of the shares and assets of substantially all of the operating subsidiaries of Virgin Media Investment Holdings Limited, and of receivables arising under any intercompany loans to those subsidiaries. We are subject to financial maintenance tests under the facility, including a test of liquidity, coverage and leverage ratios applied to us and certain of our subsidiaries. As of December 31, 2012, we were in compliance with these covenants.
The agreements governing the senior secured notes and the senior credit facility significantly restrict the ability of our subsidiaries to transfer funds to us in the form of cash dividends, loans or advances. In addition, the agreements significantly, and, in some cases absolutely, restrict our ability and the ability of most of our subsidiaries to:
•incur or guarantee additional indebtedness;
•
pay dividends at certain levels of leverage, or make other distributions, or redeem or repurchase equity interests or subordinated obligations;
•make investments;
•sell assets, including the capital stock of subsidiaries;
•create liens;
•
enter into agreements that restrict the restricted subsidiaries' ability to pay dividends, transfer assets or make intercompany loans;
•merge or consolidate or transfer all or substantially all of our assets; and
•enter into transactions with affiliates.
Long term debt repayments, excluding capital leases, as of December 31, 2012, are due as follows (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 7-Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The types of inputs used to measure fair value are classified into the following hierarchy:
Level 1
Unadjusted quoted prices in active markets for identical assets or liabilities
Level 2
Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability
Level 3
Unobservable inputs for the asset or liability
We endeavor to utilize the best available information in measuring fair value. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
The tables below present our assets and liabilities measured at fair value as of December 31, 2012 and 2011, aggregated by the level in the fair value hierarchy into which those measurements fall (in millions):
In estimating the fair value of our financial assets and liabilities, we used the following methods and assumptions:
Derivative financial instruments:
As a result of our financing activities, we are exposed to market risks from changes in interest and foreign currency exchange rates, which may adversely affect our operating results and financial position. When deemed appropriate, we minimize our risks from interest and foreign currency exchange rate fluctuations through the use of derivative financial instruments such as foreign currency forward rate contracts, interest rate swaps and cross-currency interest rate swaps. These contracts are valued using internal models based on observable inputs, counterparty valuations, or market transactions in either the listed or over-the-counter markets, adjusted for non-performance risk. As such, these derivative instruments are classified within level 2 in the fair value hierarchy.
The fair values of our derivative financial instruments are disclosed in note 8.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 7-Fair Value Measurements (continued)
Valuation of conversion hedges:
Because the conversion hedges do not qualify for equity classification, the fair values have been included as a non-current derivative financial asset in the consolidated balance sheets. The conversion hedges may only be exercised by us upon maturity of the convertible notes. As of December 31, 2012, the fair value of these instruments was estimated to be £302.4 million, using the Black-Scholes Merton valuation technique. The fair values of the conversion hedges are primarily impacted by the price of our stock on the measurement date, but are also impacted by the remaining duration of the options, the strike price ($19.22 per share) of the instrument, the expected volatility of our stock, the cap price ($35.00 per share) of the instrument, the dividend yield on our stock, exchange rates, and counterparty non-performance risk. The table below presents the estimated impact on the December 31, 2012 fair value of a hypothetical 20% increase and decrease in our stock price, holding all other inputs constant (in millions):
We have determined that the overall valuation of the conversion hedges falls within level 3 of the fair value hierarchy as the assumption for the expected volatility of our stock price over the term of the options is based on an unobservable input and is deemed to be significant to the determination of fair value. Other impacts are not significant or are observable. We utilized expected volatility assumptions of 24% and 32% in the valuation of each component of the conversion hedges as of December 31, 2012. An increase in this input in isolation would generally result in a lower value of the conversion hedges whilst a decrease in this input would result in a higher value of the conversion hedges. Non-performance risk is based on quoted credit default swaps for each of the four counterparties to the contracts. The inclusion of counterparty non-performance risk resulted in a decrease to the fair values of the conversion hedges of £13.7 million and £25.0 million as of December 31, 2012 and December 31, 2011, respectively.
The following table presents a reconciliation of the beginning and ending balances of the conversion hedges (in millions):
Future changes in fair values of the conversion hedges will be reported as gains (losses) on derivative instruments in the consolidated statements of comprehensive income.
Long term debt:
The carrying value of our senior credit facility approximates its fair value and is excluded from the table below. The fair values of our senior notes, convertible notes and senior secured notes in the table below are based on the market prices in active markets which incorporate non-performance risk. As such, these measurements are classified within level 1 in the fair value hierarchy.
The carrying values of the $500 million 5.25% and £650 million 5.50% senior secured notes due 2021 include increases of £42.9 million and £109.1 million, respectively, at December 31, 2012, and increases of £45.7 million and £77.9 million, respectively, at December 31, 2011, as a result of our application of fair value hedge accounting to these instruments.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 7-Fair Value Measurements (continued)
The carrying amounts and fair values of our long term debt, excluding capital leases, were as follows (in millions):
Concentrations of Credit Risk
Our financial instruments that are exposed to concentrations of credit risk consist primarily of cash, trade receivables and derivative contracts.
At December 31, 2012 and 2011, we had £206.3 million and £300.4 million, respectively, in cash and cash equivalents. These cash and cash equivalents are on deposit with major financial institutions and, as part of our cash management process, we perform regular evaluations of the credit standing of these institutions using a range of metrics. We have not experienced any losses in cash balances and do not believe we are exposed to any significant credit risk on our cash balances.
Concentrations of credit risk with respect to trade receivables are limited because of the large number of customers. We perform periodic credit evaluations of our Business segment customers' financial condition and generally do not require collateral. No single group or customer represents greater than 10% of total accounts receivable.
Concentrations of credit risk with respect to derivative contracts are focused within a limited number of international financial institutions with which we operate and relate only to derivatives with gross recorded asset balances at December 31, 2012. We perform regular reviews of the financial institutions with which we operate as to their credit worthiness and financial condition. We have not experienced non-performance by any of our derivative counterparties nor do we expect there to be non-performance risks associated with our counterparties. At December 31, 2012, based on market values, we had 81.9% of our derivative contracts with four financial institutions, each with more than 10% of our total exposure. At December 31, 2011, based on market values, we had 84.1% of our derivative contracts with six financial institutions, each with more than 10% of our total exposure.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 8-Derivative Financial Instruments and Hedging Activities
Strategies and Objectives for Holding Derivative Instruments
Our operations are materially impacted by changes in interest rates and foreign currency exchange rates. In an effort to manage these risks, we periodically enter into various derivative instruments including interest rate swaps, cross-currency interest rate swaps and foreign exchange forward rate contracts. We recognize all derivative instruments as either assets or liabilities at fair value on our consolidated balance sheets.
We have entered into cross-currency interest rate swaps and foreign currency forward rate contracts to manage interest rate and foreign exchange rate currency exposures with respect to our U.S. dollar and euro denominated debt obligations. We have entered into interest rate swaps to manage interest rate exposures resulting from variable rates of interest we pay on our U.K. pound sterling denominated debt obligations, and we have entered into interest rate swaps and cross-currency interest rate swaps to hedge the fair values of certain of our U.S. dollar and U.K. pounds sterling debt obligations. We have also entered into U.S. dollar forward rate contracts to manage our foreign exchange rate currency exposures related to certain committed and forecasted purchases.
Whenever it is practical to do so, we designate a derivative contract as either a cash flow or fair value hedge for accounting purposes. These relationships are referred to as “Accounting Hedges” below. When a derivative contract is not designated as an Accounting Hedge, it is treated as an economic hedge with mark-to-market movements and realized gains or losses recognized through gains (losses) on derivative instruments in net income in the consolidated statements of comprehensive income. These derivatives are referred to as “Economic Hedges” below. We do not enter into derivatives for speculative or trading purposes.
During the years ended December 31, 2012 and 2011, we recognized gains of £152.3 million and losses of £54.5 million, respectively, on derivative instruments relating to derivative instruments that were not designated or qualifying as a hedging instrument.
We believe that those relationships designated as Accounting Hedges will be highly effective throughout their term in offsetting changes in cash flow or fair value attributable to the hedged risk. If we determine it is probable that forecasted transactions to which a hedge contract relates will not occur, we discontinue hedge accounting prospectively and immediately reclassify any amounts accumulated in other comprehensive income to net income. We perform, at least quarterly, both a prospective and retrospective assessment of the effectiveness of our hedge contracts, including assessing the possibility of counterparty default. If we determine that a hedging relationship is no longer expected to be highly effective, we discontinue hedge accounting prospectively and recognize subsequent changes in the fair value of the derivative in gains (losses) on derivative instruments in net income in the consolidated statements of comprehensive income. As a result of our effectiveness assessment at December 31, 2012, we believe our derivative contracts that are designated and qualify for hedge accounting will continue to be highly effective in offsetting changes in cash flow or fair value attributable to the hedged risk.
Our derivative contracts are valued using internal models based on observable inputs, counterparty valuations, or market transactions in either the listed or over-the-counter markets, adjusted for non-performance risk. Non-performance is based on quoted credit default swaps for counterparties to the contracts and swaps. These derivative instruments are classified within level 2 in the fair value hierarchy, because we consider all of the significant inputs are observable. Derivative instruments which are subject to master netting arrangements are not offset and we have not provided, nor do we require, cash collateral with any counterparty.
The conversion hedges are intended to offset a portion of the dilutive effects of conversion of the convertible notes at maturity and provide us with the option to receive the number of shares of our common stock (or in certain circumstances cash) with a value equal to the excess of (a) the value owed by us (up to the cap price of $35.00 per share) to convertible senior note investors pursuant to the terms of the notes on conversion of up to 90% of the notes over (b) the aggregate face amount of such converted notes upon maturity of the convertible senior notes.
Refer to note 7 for a discussion of the conversion hedges.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 8-Derivative Financial Instruments and Hedging Activities (continued)
The fair values of our derivative instruments recorded on our consolidated balance sheets were as follows (in millions):
Cross-Currency Interest Rate Swaps-Hedging the Interest Payments of Senior Notes and Senior Secured Notes
During the three months ended March 31, 2012, we terminated the cross-currency interest rate swaps on the $500 million 9.50% senior notes due 2016 that were redeemed in the quarter. We also entered into new cross-currency interest rate swaps to mitigate the foreign exchange rate risk associated with the $500 million 5.25% senior notes due 2022.
During the three months ended December 31, 2012, we terminated the cross-currency interest rate swaps on the $850 million 9.50% senior notes due 2016, the €180 million 9.5% senior notes due 2016, and $100 million of the $600 million principal 8.375% senior notes due 2019 that were redeemed in the quarter. We also entered into new cross-currency interest rate swaps to mitigate the foreign exchange rate risk associated with the $900 million 4.875% senior notes due 2022.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 8-Derivative Financial Instruments and Hedging Activities (continued)
As of December 31, 2012, we had outstanding cross-currency interest rate swaps to mitigate the interest and foreign exchange rate risks relating to the pounds sterling value of interest and principal payments on the U.S. dollar denominated senior notes and senior secured notes.
The terms of our outstanding cross-currency interest rate swaps at December 31, 2012, were as follows:
All of our cross-currency interest rate swaps include exchanges of the notional amounts at the end of the contract except for the contract maturing in November 2016 hedging the $1,000 million convertible senior notes due 2016.
Interest Rate Swaps-Hedging of Interest Rate Sensitive Obligations
As of December 31, 2012, we had outstanding interest rate swap agreements to manage the exposure to variability in future cash flows on the interest payments associated with our senior credit facility which accrues at variable rates based on LIBOR. We have also entered into interest rate swap agreements to manage our exposure to changes in the fair value of certain debt obligations due to interest rate fluctuations. The interest rate swaps allow us to receive or pay interest based on three or six month LIBOR in exchange for payments or receipts of interest at fixed rates.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 8-Derivative Financial Instruments and Hedging Activities (continued)
The terms of our outstanding interest rate swap contracts at December 31, 2012 were as follows:
Foreign Currency Forward Rate Contracts-Hedging Committed and Forecasted Transactions
As of December 31, 2012, we had outstanding foreign currency forward rate contracts to purchase U.S. dollars to hedge committed and forecasted purchases. The terms of our outstanding foreign currency forward rate contracts at December 31, 2012 were as follows:
Cash Flow Hedging
For derivative instruments that are designated and qualify as cash flow Accounting Hedges, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into net income in the statement of comprehensive income in the same period or periods during which the hedged transactions affect earnings. In our consolidated statement of cash flows, we recognize the cash flows resulting from derivative contracts that are treated as Accounting Hedges in the same line item that the cash flows from the underlying exposure are recognized. Cash flows from derivative contracts that are not designated as Accounting Hedges are recognized as cash flows from operating activities in the consolidated statements of cash flows. If we discontinue hedge accounting for an instrument, subsequent cash flows are classified based on the nature of the instrument.
Gains or losses representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized as gains or losses on derivative instruments in net income in the consolidated statements of comprehensive income in the period in which they occur. During the years ended December 31, 2012 and 2011 we recognized no gain or loss relating to ineffectiveness on our cash flow hedges and £0.5 million in the year ended December 31, 2010.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 8-Derivative Financial Instruments and Hedging Activities (continued)
The following table presents the effective amount of gain or (loss) recognized in other comprehensive income (loss) and amounts reclassified to earnings during the years ended December 31, 2012, 2011 and 2010 (in millions):
Assuming no change in interest rates or foreign exchange rates for the next twelve months, the amount of pre-tax income or losses that would be reclassified from other comprehensive income (loss) to net income would be losses of £3.2 million relating to interest rate swaps, losses of £5.8 million relating to cross-currency interest rate swaps, and income of £0.0 million relating to forward foreign exchange contracts.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 8-Derivative Financial Instruments and Hedging Activities (continued)
Fair Value Hedging
For derivative instruments that are designated in qualifying fair value Accounting Hedge relationships, changes in the fair value of the derivatives, inclusive of counterparty risk, are included in gains (losses) on derivatives in net income in other comprehensive income along with changes in the fair value of the hedged debt obligations due to changes in the hedged risk. The difference between this gain or loss and changes in the fair value of the hedged debt obligations due to changes in the hedged risk is referred to as hedge ineffectiveness. In our consolidated balance sheets, changes in the value of the hedged debt obligations due to changes in the hedged risk are included as adjustments to the carrying value of the debt.
In our consolidated statement of cash flows, we recognize the cash flows resulting from derivative contracts that are treated as Accounting Hedges in the same category where the cash flows from the underlying exposure are recognized. Cash flows from derivative contracts, that are not treated as Accounting Hedges, are recognized as operating activities in the consolidated statement of cash flows.
Gains or losses representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized as gains or losses on derivative instruments in net income in the consolidated statements of comprehensive income in the period in which they occur. During the years ended December 31, 2012, 2011 and 2010, we recognized hedge ineffectiveness (losses) gains of £(4.2) million, £3.7 million and £0.0 million, respectively.
Note 9-Stock-Based Compensation Plans
At December 31, 2012, we had a number of stock-based compensation plans, which are described below. In the years ended December 31, 2012, 2011 and 2010, the compensation cost that has been charged against income for these plans was £20.9 million, £22.5 million and £29.4 million, respectively. All our stock-based awards granted under our long term incentive plans or individual employment agreements are issued under our Stock Incentive Plans or our Sharesave Plan which have been approved by our stockholders.
Virgin Media Stock Incentive Plans
The Virgin Media Inc. stock incentive plans are intended to encourage Virgin Media stock ownership by employees and directors so that they may acquire or increase their proprietary interest in our company, to encourage such employees and directors to remain in our employ or service and to put forth maximum efforts for the success of the business. To accomplish these purposes, the plans provide that we may grant incentive stock options, nonqualified stock options, restricted stock, restricted stock units, performance share awards and stock awards.
Under the Virgin Media Inc. 2010 Stock Incentive Plan, under which subsequent options have been issued, options to purchase up to 29.0 million shares of our common stock may be granted from time to time to certain of our employees. Accordingly, we have reserved 29.0 million shares of common stock for issuance under the Virgin Media Inc. 2010 Stock Incentive Plan.
Virgin Media Sharesave Plan
The Virgin Media Sharesave Plan is a broad based stock option arrangement which enables eligible employees to receive options to purchase shares of our common stock at a discount. Employees are invited to take out savings contracts that last for three, five, or seven years. At the end of the contract, employees use the proceeds of these savings to exercise options granted under the plan. Under the Virgin Media Sharesave Plan, options to purchase up to 10.0 million shares of our common stock may be granted to certain of our employees. Accordingly, we have 10.0 million shares of common stock reserved for issuance under the Virgin Media Sharesave Plan.
Valuation Basis
The following bases were applied in setting the assumptions used to measure the fair value of our stock based compensation plans.
Risk-free interest rates. This is the range of domestic risk free rates representing the principle markets in which our stock and the stocks of the comparator group organizations trade. For option grants this is the U.S. Treasury Strip rate
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 9-Stock-Based Compensation Plans (continued)
posted at the date of grant having a term equal to the expected life of the option. An increase in the risk-free rates will increase compensation cost.
Expected dividend yield. This is the annual rate of dividends per share over the exercise price of the option. An increase in the dividend yield will increase compensation cost.
Expected volatility. Actual historical changes in the market value of our stock are used to calculate the volatility assumption. We calculate daily market value changes over the most recent historical period as of the date of grant equal to the expected life of the option. An increase in the expected volatility will increase compensation cost.
Expected lives. This is the period of time over which the granted options are expected to remain outstanding, and the period over which restricted stock units and performance shares will vest. For stock option grants, this assumption is based on actual stock option exercises. For restricted stock units and performance share grants, this assumption is based on the stated performance period. An increase in the expected lives will increase compensation cost.
Expected volatility of selected comparator group shares. Actual historical changes in the market values of the selected comparator group stocks are used to calculate the volatility assumption. We calculate daily market value changes over the most recent historical period as of the date of grant equal to the expected term of the award. An increase in the expected volatility will decrease compensation cost.
Stock Option Grants
All options have a 10 year term and vest and become fully exercisable within 5 years of continued employment. We generally issue new shares upon exercise of the options. The fair value of these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions for the years ended December 31, 2012, 2011 and 2010:
A summary of the status of our stock option grants outstanding as of December 31, 2012 pursuant to the stock incentive plans and the Virgin Media Sharesave Plan and of the changes during the year ended December 31, 2012, is provided below:
The weighted-average grant-date fair value of options granted during the years ended December 31, 2012, 2011 and 2010, was $9.95, $10.44 and $8.81, respectively. The total intrinsic value of options exercised during the years ended December 31, 2012, 2011 and 2010, was £27.2 million, £31.1 million and £20.6 million, respectively.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 9-Stock-Based Compensation Plans (continued)
For performance based option grants, the performance objectives are set by the Compensation Committee of the Board of Directors based upon quantitative and qualitative objectives, including earnings and stock price performance, amongst others. These objectives may be absolute or relative to prior performance or to the performance of other entities, indices or benchmarks and may be expressed in terms of progression within a specific range.
The aggregate intrinsic value of options outstanding as at December 31, 2012 was £131.7 million with a weighted average remaining contractual term of 6.8 years. The aggregate intrinsic value of options exercisable as at December 31, 2012 was £56.1 million with a weighted average remaining contractual term of 5.4 years. The aggregate intrinsic value of options expected to vest as at December 31, 2012 was £62.4 million with a weighted average remaining contractual term of 7.7 years.
Restricted Stock Unit and Performance Share Grants
Participants in the our long term incentive plans are awarded restricted stock units or performance shares which vest after a three year period dependent on the achievement of certain long term performance targets and continued employment. The final number of awards vesting will be settled, at the Compensation Committee’s discretion, in either common stock or an amount of cash equivalent to the fair market value at the date of vesting.
In 2010, the Compensation Committee introduced a relative stock performance measure to our stock incentive plan. The vesting of a proportion of restricted stock units under the 2010-2012, 2011-2013 and 2012-2014 long term incentive plans are subject to a relative Total Shareholder Value (“TSV”) performance measure. The measure is based on a comparison of our stock price growth with that of a comparator group of organizations selected by the Compensation Committee. The fair value of our restricted stock units containing a market condition, granted under our 2010-2012, 2011-2013 and 2012-2014 long term incentive plans was estimated at the date of grant using the Monte Carlo simulation model.
The following assumptions were used to measure the fair value of the proportion of restricted stock units subject to the TSV performance measure as of the grant date.
A summary of the status of our non-vested restricted stock units as of December 31, 2012, and of the changes during the year ended December 31, 2012, is provided below:
The restricted stock units that vested during the years ended December 31, 2012, 2011 and 2010 had total values on date of vesting of £16.1 million, £16.3 million and £1.8 million, respectively.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 9-Stock-Based Compensation Plans (continued)
Restricted Stock Grants
A summary of the status of our non-vested shares of restricted stock as of December 31, 2012, and of changes during the year ended December 31, 2012, is provided below:
As of December 31, 2012, there was no unrecognized compensation cost related to non-vested shares of restricted stock granted for which a measurement date has been established.
The total fair value of shares of restricted stock vested during the years ended December 31, 2012, 2011 and 2010, was £5.2 million, £5.1 million and £7.0 million, respectively.
Note 10-Employee Benefit Plans
Defined Benefit Plans
Certain of our subsidiaries operate two defined benefit pension plans in the U.K. The assets of the plans are held separately from those of ourselves and are invested in portfolios under the management of investment groups. The pension cost is calculated using the projected unit method. Our defined benefit pension plans use a measurement date of December 31. Our funding requirements are reviewed and generally revised based on a valuation that is performed every three years. The current triennial funding valuation is being performed as of December 31, 2011 and we expect our funding requirements arising from this valuation to be determined prior to March 31, 2013. Our policy is to fund amounts to the defined benefit plans necessary to comply with the funding requirements as prescribed by the laws and regulations in the U.K.
Employer Contributions
For the year ended December 31, 2012, we contributed £17.7 million to our pension plans. We presently anticipate contributing a total of £17.0 million to fund our pension plans in 2013, but this is subject to the outcome of the on-going triennial valuation.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 10-Employee Benefit Plans (continued)
Obligations and Funded Status
The change in projected benefit obligation was as follows (in millions):
The change in plan assets was as follows (in millions):
The funded status as of December 31, 2012 and 2011 was as follows (in millions):
As of December 31, 2012 and 2011, all of the pension plans had projected benefit obligations in excess of plan assets. The following table presents information for pension plans with an accumulated benefit obligation in excess of plan assets (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 10-Employee Benefit Plans (continued)
Amount Included in Other Comprehensive Income
The amount included in other comprehensive income for the years ended December 31, 2012 and 2011 consisted of (in millions):
The following table presents the amounts recognized in accumulated other comprehensive income as of December 31, 2012 and 2011 that have not yet been recognized as components of net periodic benefit cost (in millions):
Net Periodic Benefit Costs
The components of net periodic benefit costs were as follows (in millions):
The expected return on plan assets for the year ended December 31, 2013 is £21.7 million. We expect to recognize £2.0 million of actuarial losses in the net periodic benefit cost for the year ended December 31, 2013.
As a result of the sale of various business operations in prior periods, we have retained the earned pension and other post-retirement benefits liabilities related to certain employees of those operations. Accordingly, the information disclosed in the tables above includes amounts relating to liabilities of these employees.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 10-Employee Benefit Plans (continued)
Assumptions
The weighted-average assumptions used to determine benefit obligations were as follows:
The weighted-average assumptions used to determine net periodic benefit costs were as follows:
The expected rate of return on plan assets is the expected future long term rate of earnings on plan assets and is based on expected returns on specific asset classes. These estimates are based on a combination of factors including current market rates, valuation levels, historical returns and premia for certain asset classes to determine the aggregate return for the plan assets. The projected return is then weighted according to the asset allocation of the overall plan assets.
Plan Assets
Our pension plan weighted-average asset allocations by asset category and by fair value hierarchy level at December 31, 2012 and 2011 were as follows (in millions):
During the fourth quarter of 2012, the trustees of one of our defined benefit plans purchased an insurance contract that will pay an income stream to the plan which is expected to match all future cash outflows in respect of certain liabilities. The fair value of this insurance contract is presented as an asset of the plan and is measured based on the future cash flows to be received under the contract discounted using the same discount rate used to measure the associated liabilities.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 10-Employee Benefit Plans (continued)
The substantial majority of plan assets are valued using quoted prices for the holding.
The trustees of the main defined benefit pension plan, which makes up approximately 75% of the assets of our two defined benefit pension plans, have in place an asset allocation of 20% equities, 20% diversified growth funds, 40% insurance contracts and 20% bonds, at December 31, 2012. The assets are managed by a number of fund managers, which means as markets move relative to each other the assets move away from the target investment strategy. Rebalancing of the assets will be carried out from time to time. As the main defined benefit pension scheme is now closed to new entrants, the trustees are considering moving towards a higher proportion of matching assets over time to reflect the steadily maturing profile of the liabilities and the improvement in the funding position.
There were no directly owned shares of our common stock included in the equity securities at December 31, 2012 or 2011.
Estimated Future Benefit Payments
The benefits expected to be paid out of the pension plans in total are set out below for each of the next five years and the following five years in aggregate. The benefits expected to be paid are based on the same assumptions used to measure our benefit obligation at December 31, 2012 and include estimated future employee services (in millions):
Defined Contribution Pension Plans
Our subsidiaries operate defined contribution pension plans in the U.K. The total expense in relation to these plans was £13.7 million, £13.6 million and £14.0 million for the years ended December 31, 2012, 2011 and 2010, respectively.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 11-Income Taxes
Overview
For the year ended December 31, 2012 we recognized an income tax benefit of £2,591.2 million compared to an expense of £16.0 million and a benefit of £124.1 million in the years ended December 31, 2011 and 2010 respectively. The significant benefit recognized during 2012 related to the reversal of the valuation allowance on certain of our deferred tax assets.
Deferred tax valuation allowance
As of December 31, 2012 we had gross deferred tax assets of £5,682.5 million of which £5,359.2 million related to the U.K. and which principally comprised capital allowances, net operating losses, or NOLs, and capital losses. We accumulated these assets over the last two decades as we made significant investments in building our network infrastructure and incurred significant losses as we operated that network. These assets represent amounts we, in common with other companies in the U.K., are able to use to reduce our future taxable profits in the U.K. We have historically maintained a full valuation allowance on both our U.K. and U.S. deferred tax assets, reducing the value of these assets on our balance sheet to zero.
The assessment of the amount of value assigned to our deferred tax assets under the applicable accounting rules is highly judgmental. We are required to consider all available positive and negative evidence in evaluating the likelihood that we will be able to realize the benefit of our deferred tax assets in the future. Such evidence includes scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and the results of recent operations. Since this evaluation requires consideration of events that may occur some years into the future, there is significant judgment involved, and our conclusion could be materially different should certain of our expectations not transpire.
When assessing all available evidence, we consider an important piece of objective evidence is the extent to which we have made pre-tax income or losses over the most recent three year period. Historically, we have maintained a full valuation allowance on our net deferred tax assets principally because we have been in a cumulative pre-tax loss position over the most recent three year period. While there has been a trend of positive evidence that has been strengthening in recent years, it was not sufficiently persuasive to outweigh the negative evidence provided by our cumulative pre-tax loss position. During the year ended December 31, 2012, we emerged from a cumulative pre-tax loss position in the U.K. for the first time, which removed this important piece of negative evidence from our evaluation.
Our assessment for the year ended December 31, 2012 considered the following positive and negative evidence. Based on this evidence, we concluded that it was more likely than not that in future periods we will generate sufficient pre-tax income to utilize substantially all of our U.K. deferred tax assets relating to capital allowances and NOLs:
Positive evidence:
•
We have now generated pre-tax income in the U.K. of more than £150 million for two consecutive years and have utilized some of our available tax assets to reduce the tax liabilities that would have otherwise arisen in those periods.
•
Our U.K. capital allowances and NOLs do not have an expiration date.
•
Our financial performance has continued to improve despite challenging macroeconomic conditions. Steady growth in revenue and operating income has been maintained for three years, and we believe that financial performance will continue to improve even if the current economic conditions persist.
•
Our forecasts of future taxable income indicate that our pre-tax income and taxable income will increase in the future.
•
We have re-financed a significant portion of our high-coupon debt into lower-coupon, longer duration debt in recent years.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 11-Income Taxes (continued)
Negative evidence:
In the absence of a cumulative loss in the last three years, the remaining negative evidence consists solely of our long history of significant pre-tax losses prior to 2011, dating back many years prior to the merger with Telewest in 2006. In total, our U.K. group companies have approximately £386.1 million of deferred tax assets on £1,678.7 million of NOLs which accumulated over many years. We believe that the combined impact of a number of company specific and industry specific developments over recent years makes it unlikely that those historic losses will be repeated in the future. These include:
Company specific factors:
•
The significant investment associated with building our unique cable network does not need to be replicated. Instead, we are able to spend relatively more modest sums to gradually upgrade and improve that network.
•
We have established ourselves as one of the major telecommunication service providers in the U.K., offering leading next generation broadband and television services, which has enabled us to steadily and economically grow revenues.
•
Significant restructuring and rationalization activities subsequent to the Telewest merger have reduced our cost base and focused the business on its core activities. This allowed us to leverage our network into financial returns and generate consistently improving operating margins.
•
There has been a material improvement in our credit standing in recent years, including certain of our debt being rated investment grade, which has allowed us to reduce and lock-in lower interest rates.
Industry specific factors:
•
The cable and telecommunications markets have matured since the late 1990s and early 2000s.
•
There is only one competitor in the U.K. with a substantial fiber network.
•
Pricing in the U.K. telecommunications market in recent years is considerably more rational than in the early to mid portion of the previous decade. We expect that trend to continue given a) the increase in demand for data traffic that requires a high speed delivery mechanism like our fiber network and b) the structure of the U.K. market.
•
Consolidation in the industry has reduced the number of competitors since the years in which we incurred significant losses.
•
The industry is capital intensive and barriers to entry are high; therefore, we do not envision uneconomic competition from new entrants.
After consideration of these factors, we determined that it was unlikely that the losses incurred prior to the year ended December 31, 2011 would be repeated and as a result, we did not place significant weight on the negative evidence provided by our long history of losses.
We believe that our positive evidence is strong. The improving financial performance in recent years is an objectively verifiable piece of positive evidence and is the result of a number of factors which have been present to a greater or lesser extent in prior years but have only recently gathered sufficient weight to deliver objectively verifiable, consistent taxable profits.
A key consideration in our analysis was that the unlimited carryforward periods of our U.K. tax assets make the realization of those assets less sensitive to variations in our projections of future taxable income than would otherwise be the case if the carryforward periods were time limited. In performing our analysis, we used the most updated plans and estimates that we currently use to manage the underlying business and calculated the utilization of our deferred tax assets under a number of scenarios. We do not require material increases in the current levels of cash flows, book income, or taxable income to recover the value of our deferred tax assets other than capital losses.
The emergence from a cumulative loss position in the U.K. during 2012 was an important consideration in our assessment and changed the balance of the remaining available evidence. While strong positive evidence was present during 2011 and in earlier quarters of 2012, we concluded that the significance of the cumulative loss could not be overcome prior to December 31, 2012. In the absence of the negative evidence provided by cumulative losses over
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 11-Income Taxes (continued)
the most recent three year period, we believe that the available positive evidence outweighs the remaining negative evidence. Therefore, we determined that it was appropriate to reverse substantially all of the valuation allowance on our U.K. deferred tax assets other than capital losses. The reversal of the valuation allowance on our U.K. deferred tax assets resulted in an income tax benefit of £2,488.9 million, or £9.07 per basic share and £7.52 per diluted share during the year ended December 31, 2012, and an increase in current and non-current deferred tax assets on the consolidated balance sheet for the year ended December 31, 2012. Beginning in the first quarter of 2013, we expect our net income and earnings per share to be impacted to a greater degree by income tax expense, which may fluctuate from period to period. However, this reversal will not result in any change to the amount of cash payments to the U.K. tax authorities for income taxes.
Realization of our deferred tax assets is dependent on generating sufficient taxable income in future periods. Although we believe it is more likely than not that future taxable income will be sufficient to allow us to recover substantially all of the value of our U.K. deferred tax assets other than capital losses, realization is not assured and future events could cause us to change our judgment. If future events cause us to conclude that it is not more likely than not that we will be able to recover all of the value of our deferred tax assets we would be required to establish a valuation allowance on our deferred tax assets at that time, which would result in a charge to income tax expense and a material decrease in net income in the period in which we change our judgment.
During 2012, we also reversed a valuation allowance on the U.S. deferred tax assets related to certain of our subsidiaries that are considered dual resident in the U.K. and U.S. for tax purposes, and recognized a benefit of £103.4 million. The assets in these companies are principally comprised of NOLs. The companies have emerged from a cumulative loss position and after consideration of all available positive and negative evidence we believe it is more likely than not that the deferred tax assets will be utilized. Because those companies have emerged from a cumulative loss position, significant negative evidence no longer exists. Positive evidence exists in the form of recent profitability, forecasts for continued profitability, and long expiration periods for the NOLs. We do not require significant improvements in the level of profitability to utilize the deferred tax assets prior to their expiration.
We continue to maintain a full valuation allowance on our U.S. deferred tax assets related to companies included in our U.S. consolidated federal income tax return, because we do not believe it is more likely than not that we will be able to realize the value of these assets. We are in a cumulative loss position over the most recent three year period in the U.S., and we expect that position to continue into the future, principally because all of our revenue is generated in the U.K. We also continue to maintain a full valuation allowance on our deferred tax assets relating to capital losses, which totaled approximately £2,786.1 million as of December 31, 2012. We do not expect to realize any significant benefit from these capital losses because they can only be used to the extent we generate future U.K. taxable capital gains from assets held by subsidiaries owned prior to 2006.
We have considered the implications of the proposed merger with Liberty Global, as discussed in Subsequent Events in Note 18, on our accounting for our deferred tax assets. We note that a change in judgment that results in subsequent recognition, derecognition, or change in measurement of a tax position taken in a prior annual period shall be recognized as a discrete item in the period in which the change occurs. We are therefore not permitted to consider the impact of the proposed business combination until 2013 and the partial reversal of the allowance discussed above therefore remains appropriate.
Changes in tax laws and rates will also affect our deferred tax assets in the future. The U.K. government has announced a reduction in the rate of corporation tax from 23% to 21%. These reductions have not been enacted, but we will recognize a reduction in the value of our deferred tax assets and liabilities and a charge to income tax expense in the period of enactment which is expected to be during 2013.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 11-Income Taxes (continued)
Income tax benefit (expense)
The benefit (expense) for income taxes consists of the following (in millions):
The foreign deferred income tax benefit for the year ended December 31, 2012 related to the reversal of the valuation allowance on certain of our U.K. deferred tax assets. The federal income tax benefit for the year ended December 31, 2012 related to the reversal of the valuation allowance on the U.S. deferred tax assets in our dual resident companies.
Based on the location of the entity to which earnings are attributable, consolidated income from continuing operations before income taxes for U.S. based operations was £45.4 million in 2012, losses of £122.4 million in 2011 and losses of £61.3 million in 2010 and the corresponding amounts for non-U.S. based operations were income of £216.0 million and £215.5 million in 2012 and 2011 respectively, and losses of £240.0 million in 2010 . However taxation of an entity's earnings may not correlate solely to where an entity is located and because of this the distribution of income tax benefit (expense) presented above between U.S. and non-U.S. may not correspond to the distribution of earnings presented above.
The reconciliation of income taxes computed at U.S. federal statutory rates to income tax benefit (expense) attributable to continuing operations is as follows (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 11-Income Taxes (continued)
Deferred taxes
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets are reduced by a valuation allowance if, based upon the weight of available evidence, it is not more likely than not that we will realize some portion or all of the deferred tax assets. Significant components of deferred tax liabilities and assets are as follows (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 11-Income Taxes (continued)
Certain of our subsidiaries are dual resident for tax purposes as they are subject to taxation in both the U.S. and the U.K. The U.K. deferred tax assets of these subsidiaries are included in the U.K. column of the table above. The U.S. deferred tax assets and liabilities of these subsidiaries are included in the dual resident column of the table above. The U.S. deferred tax assets of the companies included in our U.S. parent company's consolidated federal income tax return are included in the U.S. column of the table above.
The following table summarizes the movements in our deferred tax valuation allowance during the years ended December 31, 2012, 2011 and 2010 (in millions):
The change in tax rates relates to a reduction in the U.K. corporate income tax rate from 28% to 27% in 2010, to 25% in 2011, and to 23% in 2012. The deferred tax assets and liabilities presented for 2012 reflect the 23% rate. The U.K. government has announced a reduction in this rate to 21% from 1 April 2014, which when enacted during 2013 will result in a reduction in the value of our deferred tax assets.
At December 31, 2012, we had net operating loss carryforwards for U.S. federal income tax purposes of £376.3 million that expire between 2020 and 2032. We have U.K. net operating loss carryforwards of £1.7 billion that have no expiration date. Pursuant to U.K. law, these losses are only available to offset income of the legal entity that generated the loss. A portion of the U.K. net operating loss carryforwards relates to dual resident companies, of which the U.S. net operating loss carryforward amount is £527.5 million and expires between 2012 and 2028. We also have U.K. capital loss carryforwards of £12.1 billion that have no expiration date. However, we do not expect to realize any significant benefit from these capital losses, which can only be used to the extent we generate future U.K. taxable capital gain income from assets held by subsidiaries owned by the group prior to the merger with Telewest in 2006.
At December 31, 2012, we had fixed assets on which future U.K. tax deductions can be claimed of £13.2 billion. The maximum amount that can be claimed in any one year is 18% of the remaining balance, after additions, disposals and prior claims.
We recognize interest and penalties related to unrecognized tax benefits in income tax expense. The statute of limitations is open for the years 2009 to 2012 in the U.S. and 2011 to 2012 in the U.K., our major tax jurisdictions.
In the normal course of business, our tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest assessments by these taxing authorities for uncertain tax positions taken in respect to matters such as business acquisitions and disposals and certain financing transactions including intercompany transactions, amongst others. We accrue a liability when we believe an assessment may be probable and the amount is estimable. In accordance with generally accepted accounting principles, the impact of revisions to these estimates is recorded as income tax expense or benefit in the period in which they become known. Accordingly, the estimates used to compute the provision for income taxes may change as new events occur, as more experience is acquired, as additional information is obtained and as our tax environment changes.
We have accumulated undistributed earnings in one of our foreign subsidiaries that exceeds our tax basis in that subsidiary by approximately £950 million. We have not recognized a deferred tax liability in respect of U.S. taxes for this excess because a substantial majority of the earnings have been permanently invested in our U.K. operations. If we were able to repatriate these earnings, we believe there would be various methods available to us, each with
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 11-Income Taxes (continued)
different U.S. tax consequences. It is impractical to estimate the amount of U.S. tax that would be recognized upon the reversal of this basis difference because of the uncertainty regarding the manner in which such a transaction and potential remittance might take place, the availability and complexity of calculating foreign tax credits that may be available, and the implications of indirect taxes.
Note 12-Related Party Transactions
Virgin Enterprises Limited
We have identified Virgin Enterprises Limited as a related party to us. Virgin Entertainment Investment Holdings Limited became a holder of our common stock as a result of our acquisition of Virgin Mobile on July 4, 2006. As of December 31, 2012, Virgin Entertainment Investment Holdings Limited beneficially owned 2.5% of our common stock (based on SEC filings). Virgin Enterprises Limited is a wholly owned subsidiary of Virgin Entertainment Investment Holdings Limited. In addition, Gordon McCallum is a member of our Board of Directors and is a Director of Virgin Enterprises Limited.
We own and have the right to use registered trademarks, including the exclusive right to use the “Virgin” name and logo in connection with our corporate activities and in connection with the activities of our consumer business under license from Virgin Enterprises Limited. This license with Virgin Enterprises Limited is for a 30-year term and exclusive to us within the U.K. and Ireland. The license entitles us to use the “Virgin” name for the TV, broadband internet, telephone and mobile phone services we provide to our residential customers, as well as the acquisition and branding of sports, movies and other premium television content and the sale of certain communications equipment, such as set top boxes and cable modems. Our license agreement provides for an annual royalty of 0.25% of certain consumer revenues, subject to a minimum annual royalty of £8.5 million. As part of the agreement, we have the right to adopt, and have adopted, a company name for our parent, Virgin Media Inc., over which together with the name “Virgin Media”, we retain worldwide exclusivity. Under a related agreement, Virgin Enterprises Limited has the right to propose a candidate to fill a seat on our Board of Directors. Pursuant to this right, Virgin Enterprises Limited proposed Gordon McCallum who was appointed to our Board of Directors.
During the first quarter of 2010, ntl:Telewest Business announced that it would rebrand using the Virgin trade marks to “Virgin Media Business”. Virgin Media has entered into a trade mark license with Virgin Enterprises Limited under which an annual royalty is payable of 0.25% of revenues from our business segment, subject to a minimum payment of £1.5 million.
During the years ended December 31, 2012, 2011 and 2010, respectively, we incurred expenses of £10.2 million, £10.1 million, and £10.1 million for charges in respect of brand licensing and promotion of which £5.1 million, £5.0 million and £4.7 million was payable at December 31, 2012, 2011 and 2010, respectively.
Other Virgin Companies
As a licensee of the “Virgin” brand name, we participate in mutually beneficial activities with other Virgin companies. These arrangements are in the ordinary course of business and believed to be on arm’s length terms.
UKTV Joint Ventures
Through our wholly owned subsidiary, Flextech Broadband Limited, we owned a 50% equity investment in the UKTV joint venture companies until September 30, 2011, when the sale of UKTV was completed. We have therefore identified the UKTV joint venture companies as related parties to us for the period to September 30, 2011. We also carry the UKTV channels in our pay television packages available to our customers.
We pay UKTV for purchases of television programming rights. During the years ended December 31, 2011 and 2010, the net expense recognized in respect to these transactions through the consolidated statement of comprehensive income totaled £24.4 million and £24.8 million, respectively.
During the years ended December 31, 2011 and 2010, we received cash payments from UKTV for loan principal payments, interest, dividends and consortium tax relief totaling £34.0 million and £34.4 million, respectively.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 13-Shareholders' Equity
Authorized Share Capital
Our authorized share capital for issuance consists of one billion shares of common stock, 300 million shares of Class B redeemable common stock and five million shares of preferred stock with a par value of $0.01 each. As at December 31, 2012 there were 269.3 million shares of common stock outstanding, and no Class B redeemable common stock or preferred stock outstanding. The common stock is voting with rights to dividends as declared by the Board of Directors.
The following table summarizes the movement in the number of shares of common stock outstanding during the years ended December 31, 2012, 2011 and 2010 (in millions):
During the years ended December 31, 2012, 2011 and 2010, we paid the following dividends:
Future payments of regular quarterly dividends by us are at the discretion of our Board of Directors and will be subject to our future needs and uses of cash, which could include investments in operations, the repayment of debt, and share repurchase programs. In addition, the terms of our and our subsidiaries’ existing and future indebtedness and the laws of jurisdictions under which those subsidiaries are organized limit the payment of dividends, loan repayments and other distributions to us under many circumstances.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 13-Shareholders' Equity (continued)
Capital Structure Optimization
On July 27, 2011, we announced Phase 2 of our structure optimization program which included the application of up to £625 million for purposes of repurchasing our common stock. Phase 2 was extended on October 27, 2011, with the announcement of our intention to expend up to a further £250 million on share repurchases from the proceeds from the sale of our UKTV joint venture companies. These repurchases were completed during 2012 as part of the second phase program. At December 31, 2012 we had £122.5 million remaining under this program.
On February 8, 2012, we entered into a capped Accelerated Stock Repurchase (ASR) to purchase $250 million (£157.3 million) of our common stock. We received 10.2 million shares of common stock in connection with this ASR at an average purchase price per share of $24.58. The ASR was terminated on March 26, 2012 and the shares of common stock so acquired were cancelled. A further capped ASR commenced on July 24, 2012 to purchase $175 million (£112.7 million) of our common stock. We received 6.1 million shares of common stock in connection with this ASR at an average purchase price per share of $28.71. The ASR was terminated on October 26, 2012 and the shares of common stock so acquired were cancelled. Both ASRs undertaken during 2012 were under the authority of the 2011 capital optimization program.
During 2012 we made open market repurchases of 4.2 million shares of common stock in connection with the second phase capital structure optimization program, at an average purchase price per share of $22.54 ($94.9 million, £60.3 million, in aggregate). The shares of the common stock so acquired were cancelled.
During the year ended December 31, 2011, we repurchased approximately 40.9 million shares of common stock at an average purchase price per share of $25.03 ($1,022.5 million in aggregate), of which approximately 17.1 million shares were repurchased through open market repurchases at an average purchase price per share of $27.64 ($472.5 million in aggregate) and approximately 23.8 million shares were repurchased through capped accelerated stock repurchase programs at an average purchase price per share of $23.15 ($550 million in aggregate). These shares of common stock so acquired were cancelled.
On December 14, 2012, we announced Phase 3 of our capital structure optimization program, which comprises a planned share buyback of at least £1,122.5 million (including £122.5 million remaining under Phase 2 of the program) to be completed before the end of 2014. Under the terms of the Merger Agreement we signed with Liberty Global on February 5, 2013, we have suspended our capital returns program pending consummation of the merger. If the merger is not consummated we intend to resume our capital returns program. For more information on the proposed merger see note 18.
Note 14-Commitments and Contingent Liabilities
At December 31, 2012, we were committed to pay £1,369.4 million for equipment and services, exclusive of capital and operating leases. This amount includes £514.4 million for operations and maintenance contracts and other commitments from January 1, 2014 to 2019.
The aggregate amount of the fixed and determinable portions of these obligations for the succeeding five fiscal years and thereafter is as follows (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 14-Commitments and Contingent Liabilities (continued)
Purchase obligations in the table above represent amounts payable under fixed or minimum guaranteed commitments, and therefore do not represent the total fees that are expected to be paid under certain programming contracts where amounts payable are generally based on the number of customers receiving the programming.
This table excludes £668.9 million of accounts payable and accrued liabilities as at December 31, 2012 which will be paid in 2013.
We are involved in lawsuits, claims, investigations and proceedings, consisting of intellectual property, commercial, employee and employee benefits which arise in the ordinary course of our business. In accordance with the Contingencies Topic of the FASB ASC, we recognize a provision for a liability when management believes that it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. We believe we have adequate provisions for any such matters. We review these provisions at least quarterly and adjust these provisions to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Additionally, when we believe it is at least reasonably possible that a liability has been incurred in excess of any recorded liabilities we provide an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made. While litigation is inherently unpredictable, we believe that we have valid defenses with respect to legal matters pending against us.
Our revenue generating activities are subject to VAT. During the second quarter of 2011, we reached an agreement with the U.K. tax authorities regarding our VAT treatment of certain of these activities. The U.K. tax authorities provided us with a refund of £81.5 million, which was collected during the second quarter of 2011, and £77.6 million of which is included in interest income and other, net in the consolidated statement of comprehensive income for the year ended December 31, 2011.
Our VAT treatment of certain other revenue generating activities remains subject to challenge by the U.K. tax authorities. As a result, we have estimated contingent losses totaling £31.9 million as of December 31, 2012 that are not accrued for, as we deem them to be reasonably possible, but not probable, of resulting in a liability. We currently expect an initial hearing on these matters to take place in 2013.
Our banks have provided guarantees in the form of stand by letters of credit on our behalf as part of our contractual obligations. The amount of commitment expires over the following periods (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 15-Industry Segments
Our reporting segments are based on our method of internal reporting and the information used by our chief executive officer, who is our chief operating decision maker, or CODM, to evaluate segment performance and make capital allocation decisions. We have two reporting segments, Consumer and Business, as described below.
Our Consumer segment is our largest segment, consisting of the distribution of television programming, broadband and fixed line telephone services to residential customers on our cable network, the provision of broadband and fixed line telephony services to residential customers outside of our cable network, and the provision of mobile telephony and mobile broadband to residential customers.
Our Business segment comprises our operations carried out through Virgin Media Business which provides voice, data and internet solutions to businesses, public sector organizations and service providers in the U.K.
Segment contribution, which is operating income before network operating costs, corporate costs, depreciation, amortization, goodwill and intangible asset impairments and restructuring and other charges, is management’s measure of segment profit. Segment contribution excludes the impact of certain costs and expenses that are not directly attributable to the reporting segments, such as the costs of operating the network, corporate costs and depreciation and amortization. Restructuring and other charges, and goodwill and intangible asset impairments are excluded from segment contribution as management believes they are not characteristic of our underlying business operations. Assets are reviewed on a consolidated basis and cannot be allocated to segments for management reporting since the primary asset of the business is the cable network infrastructure, which is shared by our Consumer and Business segments.
Segment information for the years ended December 31, 2012, 2011 and 2010 was as follows (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 15-Industry Segments (continued)
The reconciliation of total segment contribution to our consolidated operating income and net income (loss) is as follows (in millions):
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes
We present the following condensed consolidating financial information as of December 31, 2012 and December 31, 2011 and for the years ended December 31, 2012, 2011 and 2010 as required by Rule 3-10(d) of Regulation S-X.
Virgin Media Finance PLC is the issuer of the following senior notes:
•
$507.1 million aggregate principal amount of 8.375% senior notes due 2019
•
£253.5 million aggregate principal amount of 8.875% senior notes due 2019
•
$500 million aggregate principal amount of 5.25% senior notes due 2022
•
$900 million aggregate principal amount of 4.875% senior notes due 2022
•
£400 million aggregate principal amount of 5.125% senior notes due 2022
Virgin Media Inc. and certain of its subsidiaries, namely Virgin Media Group LLC, Virgin Media Holdings Inc., Virgin Media (UK) Group, Inc. and Virgin Media Communications Limited, have guaranteed the senior notes on a senior basis. Each of Virgin Media Investment Holdings Limited, or VMIH, and Virgin Media Investments Limited, or VMIL, are conditional guarantors and have guaranteed the senior notes on a senior subordinated basis.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 16-Condensed Consolidating Financial Information-Senior Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information-Senior Secured Notes
We present the following condensed consolidating financial information as of December 31, 2012 and December 31, 2011 and for the years ended December 31, 2012, 2011 and 2010 as required by Rule 3-10(d) of Regulation S-X.
Virgin Media Secured Finance PLC is the issuer of the following senior secured notes:
•
£875 million aggregate principal amount of 7.00% senior notes due 2018
•
$1,000 million aggregate principal amount of 6.50% senior notes due 2018
•
£650 million aggregate principal amount of 5.50% senior notes due 2021
•
$500 million aggregate principal amount of 5.25% senior notes due 2021
Our senior secured notes are issued by Virgin Media Secured Finance PLC and are guaranteed on a senior basis by Virgin Media Inc., Virgin Media Group LLC, Virgin Media Holdings Inc., Virgin Media (UK) Group, Inc. and Virgin Media Communications Limited and on a senior subordinated basis by VMIH and VMIL. They also rank pari passu with and, subject to certain exceptions, share in the same guarantees and security which has been granted in favor of our senior credit facility.
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information - Senior Secured Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information - Senior Secured Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information - Senior Secured Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information - Senior Secured Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information - Senior Secured Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information - Senior Secured Notes (continued)
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 17-Condensed Consolidating Financial Information - Senior Secured Notes (continued)
Note 18 - Subsequent Events
Merger agreement with Liberty Global, Inc.
On February 5, 2013, we entered in to a Merger Agreement with Liberty Global, Inc., or Liberty Global, and certain of its direct or indirect wholly-owned subsidiaries, or the Merger Subsidiaries. Under the terms of the Merger Agreement, we have agreed, through a series of intermediate steps and transactions, to be acquired by Liberty Global and merge into one of the Merger Subsidiaries. If consummated, the merger will result in both Liberty Global and Virgin Media becoming directly owned by a new U.K. public limited company, or the Ultimate Parent, listed on NASDAQ, the common stock of which will in turn be held by Liberty Global and Virgin Media Shareholders. We will continue to operate under the Virgin Media brand in the U.K..
Under the Merger Agreement, we have agreed to use our reasonable best efforts to carry on our business consistent with past practice and preserve intact our business organization and commercial goodwill from the date of the Merger Agreement until either the merger is consummated or the Merger Agreement is terminated. In addition, during this
VIRGIN MEDIA INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Note 18-Subsequent Events
period we have undertaken covenants that place certain restrictions on us, and our subsidiaries', ability to, among other things, dispose of material properties or assets, make unbudgeted capital expenditures, acquire substantial assets, make substantial investments, increase the salary of certain of our employees or directors, pay certain bonuses or incentive compensation, grant new equity or non-equity based compensation awards, hire new employees, redeem common stock or other equity interests, declare or pay dividends or make other distributions in respect of our capital stock, other than a quarterly dividend of up to $0.04 per share, incur or otherwise become liable for material indebtedness, enter into certain transactions with related parties or enter into new material contracts, in each case, other than in the ordinary course of business, pursuant to certain exceptions and baskets set forth in the Merger Agreement or unless Liberty Global consents in writing to the taking of any such action. If we fail to comply with these restrictions in all material respects, unless waived by Liberty Global, the Merger Agreement could be terminated or the merger not consummated.
The consummation of the merger is subject to regulatory approval, the affirmative approval of our shareholders and those of Liberty Global, and other customary closing conditions. In addition, the Merger Agreement will terminate if, prior to the consummation of the merger, we enter into an acquisition agreement with respect to a superior proposal and pay an applicable termination fee of up to $470 million, or if the merger is not consummated on or prior to October 5, 2013, which is the eight month anniversary of the date of signature of the Merger Agreement, or January 5, 2014 if extended for certain reasons to the eleven month anniversary. The Merger Agreement also includes certain other events of termination and certain other termination fee and expense provisions.
At the effective time of the Merger, pursuant to the Merger Agreement, each share of our common stock issued and outstanding immediately prior to the effective time (excluding shares held by ourselves or our subsidiaries in treasury and dissenting shares in accordance with Delaware law) will be converted into the right to receive (i) 0.2582 Series A shares of the Ultimate Parent, (ii) 0.1928 Series C shares of the Ultimate Parent and (iii) $17.50 per share in cash. Based on our fully-diluted shares outstanding of 335 million as of December 31, 2012, we expect that our shareholders will own approximately 36% of the shares outstanding of the Ultimate Parent and have approximately 26% of the voting rights.
The aggregate cash portion of the merger consideration is expected to be $6.1 billion, $2.7 billion of which Liberty Global will finance from its own cash reserves and $3.4 billion of which Liberty Global will raise as bank debt and in the capital markets, which, if the merger is consummated, will, together with debt raised to replace certain of our existing facilities, be assumed by us and result in an increase to our overall level of debt.
Financing implications of the Merger on our existing debt
Consummation of the merger would represent a change of control event under the terms of the relevant indentures of all of the senior secured notes and senior notes issued by our wholly owned subsidiaries Virgin Media Secured Finance PLC, or VMSF, and Virgin Media Finance PLC, or VMF, and obligate us to offer the noteholders the right to put their notes back to us at 101% of the principal amount plus accrued interest. At the request of Liberty Global in order to facilitate the financing by Liberty Global of the merger, on February 6, 2013, VMSF and VMF commenced consent solicitations in respect of some of these notes for the noteholders to preemptively waive this obligation and to seek consents to effect certain other proposed amendments in relation to the Transactions.
We have not solicited consents in relation to our 5.25% Senior Notes due 2022, our 4.875% Senior Notes due 2022 and our 5.125% Senior Notes due 2022 and will be required to repurchase these Notes within 30 days of the consummation of the Merger.
Upon consummation of the merger our convertible notes will have the right to convert and receive the same consideration that is received in the merger as the holders of Common Stock. The convertible holders will also be offered the right to put their notes to the company at 100% of the principal amount plus accrued interest.
VIRGIN MEDIA INC.
SCHEDULE I-FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEET
(in millions, except par value)
See accompanying notes.
VIRGIN MEDIA INC.
FINANCIAL INFORMATION OF REGISTRANT
STATEMENT OF COMPREHENSIVE INCOME
(in millions)
See accompanying notes.
VIRGIN MEDIA INC.
FINANCIAL INFORMATION OF REGISTRANT
STATEMENT OF CASH FLOWS
(in millions)
See accompanying notes.
VIRGIN MEDIA INC.
NOTES TO FINANCIAL INFORMATION OF REGISTRANT
Note 1-Basis of Presentation
In our financial statements, our investment in subsidiaries is stated at cost plus equity in the undistributed earnings of the subsidiaries. Our share of net income (loss) of our subsidiaries is included in net income (loss) using the equity method of accounting. The financial statements should be read in conjunction with our consolidated financial statements.
On February 5, 2013, we entered in to a Merger Agreement with Liberty Global, Inc., or Liberty Global, and certain of its direct or indirect wholly owned subsidiaries, or the Merger Subsidiaries, pursuant to which we agreed, through a series of intermediate steps and transactions, to be acquired by Liberty Global and merge into one of the Merger Subsidiaries. If consummated, the merger will result in both Liberty Global and Virgin Media becoming directly owned by a new U.K. public limited company, or the Ultimate Parent, listed on NASDAQ, the common stock of which will in turn be held by Liberty Global and Virgin Media Shareholders. We will continue to operate under the Virgin Media brand in the U.K..
Note 2-Other
No cash dividend was paid to the registrant by subsidiaries for the years ended December 31, 2012, December 31, 2011 and December 31, 2010.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholder of Virgin Media Investment Holdings Limited and subsidiaries
We have audited the accompanying consolidated balance sheets of Virgin Media Investment Holdings Limited and subsidiaries (the “Company”) an indirect wholly owned subsidiary of Virgin Media Inc. (the “Parent”) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, shareholder's equity, and cash flows for each of the three years in the period ended December 31, 2012. 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. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Virgin Media Investment Holdings Limited and subsidiaries at December 31, 2012 and 2011, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with U.S. generally accepted accounting principles.
/s/ Ernst & Young LLP
London, England
February 7, 2013
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholder of Virgin Media Investments Limited and subsidiaries
We have audited the accompanying consolidated balance sheets of Virgin Media Investments Limited and subsidiaries (the “Company”) an indirect wholly owned subsidiary of Virgin Media Inc. (the “Parent”) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, shareholder's equity, and cash flows for each of the three years in the period ended December 31, 2012. 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. We were not engaged to perform an audit of the Company's internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Virgin Media Investments Limited and subsidiaries at December 31, 2012 and 2011, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with U.S. generally accepted accounting principles.
/s/ Ernst & Young LLP
London, England
February 7, 2013
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in millions, except share data)
See accompanying notes.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions)
See accompanying notes.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
See accompanying notes.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDER’S EQUITY
(in millions, except share data)
See accompanying notes.
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in millions, except par value)
See accompanying notes.
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions)
See accompanying notes.
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(in millions)
See accompanying notes.
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDER’S EQUITY
(in millions, except share data)
See accompanying notes.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Note 1-Organization and Business
Virgin Media Investment Holdings Limited and its subsidiaries, or VMIH, and Virgin Media Investments Limited and its subsidiaries, or VMIL, are indirect, wholly owned subsidiaries of Virgin Media Inc. incorporated in the United Kingdom. VMIL is a direct, wholly owned subsidiary of VMIH.
On January 1, 2010, VMIL acquired VMIH’s shareholdings in its wholly owned subsidiaries other than Virgin Media Secured Finance PLC, which remains a subsidiary of VMIH. VMIL issued an initial 1,000,141 shares to VMIH on January 1, 2010 and an additional 1,489,994 shares on December 13, 2010 following the filing of the 2009 audited financial statements of VMIH with the appropriate authorities in England and Wales as part of this internal reorganization. As a result of the reorganization, it was determined that a change in reporting entity had occurred for VMIL and accordingly the comparative separate financial statements for VMIL have been adjusted to consist of the combined historical balance sheet, results of operations, and cash flows of the wholly owned subsidiaries of VMIH that were contributed to VMIL as part of the group reorganization. These comparative financial statements have been prepared in accordance with the guidance permissible for reorganizations between wholly owned subsidiaries such that the historic values of all assets and liabilities acquired in the reorganization have been carried over with no new purchase accounting considered. The effect of the issuances of common stock to VMIH has been retrospectively applied to the shareholder’s equity amounts in the consolidated balance sheet as at December 31, 2009 to reflect these amounts as if the transaction had occurred at the beginning of the periods presented. The retrospective application had no material effect on other amounts. Intercompany accounts and transactions have been eliminated on consolidation.
Under the terms of the indentures governing the senior notes issued by Virgin Media Finance PLC and the indentures governing the senior secured notes issued by Virgin Media Secured Finance PLC, VMIL was required to grant guarantees that are identical to the guarantees granted by VMIH under the same indentures. Under the terms of the intercreditor deed governing the senior credit facility, VMIL was required to grant a guarantee identical to the guarantee granted by VMIH under the same deed. VMIH is fully dependent on the cash flows of the operating subsidiaries of VMIL to service these debt obligations. As a result, debt obligations, cash required to service debt obligations, derivative financial instruments, and any effects on the consolidated results of operations and cash flows related to the senior notes, senior secured notes and senior credit facility have been reflected in the separate consolidated financial statements of VMIL. As such, the amounts included in the financial statements of VMIL do not necessarily represent items to which VMIL has legal title.
As used in these notes, the terms “we”, “our”, or “companies” refer to VMIH and VMIL and, except as otherwise noted, the information in these combined notes relates to both of the companies.
We are a leading entertainment and communications business, being a “quad-play” provider of broadband internet, television, mobile telephony and fixed line telephony services that offer a variety of entertainment and communications services to residential and commercial customers throughout the U.K. We are one of the U.K.’s largest providers of residential broadband internet, pay television and fixed line telephony services by number of customers. We believe our advanced, deep fiber access network enables us to offer faster and higher quality broadband services than our digital subscriber line, or DSL, competitors. As a result, we provide our customers with a leading next generation broadband service and one of the most advanced TV on-demand services available in the U.K. market. As of December 31, 2012, we provided services to 4.9 million residential cable customers on our network. We are also one of the U.K.’s largest mobile virtual network operators by number of customers, providing mobile telephony service to 1.7 million contract mobile customers and 1.3 million prepay mobile customers over third party networks.
On February 5, 2013, Virgin Media Inc entered in to a Merger Agreement with Liberty Global, Inc., or Liberty Global, and certain of its direct or indirect wholly owned subsidiaries, or the Merger Subsidiaries, pursuant to which they agreed, through a series of intermediate steps and transactions, to be acquired by Liberty Global and merge into one of the Merger Subsidiaries. If consummated, the merger will result in both Liberty Global and Virgin Media becoming directly owned by a new U.K. public limited company, or the Ultimate Parent, listed on Nasdaq, the common stock of which will in turn be held by Liberty Global and Virgin Media Shareholders. We will continue to operate under the Virgin Media brand in the U.K.. Further details of the proposed merger are set out in Note 13 - Subsequent Events.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP.
On September 30, 2011, we completed the sale to Scripps Network Interactive, Inc. (“Scripps”), of our 50% equity investment in the UKTV joint venture with BBC Worldwide Limited. After the inclusion of associated fees, this transaction resulted in a loss on disposal of £7.2 million.
On July 12, 2010, we completed the sale of our television channel business known as Virgin Media TV to BSkyB. Virgin Media TV’s operations comprised our former Content segment. These consolidated financial statements reflect Virgin Media TV as discontinued operations.
Principles of Consolidation
The consolidated financial statements include the financial statements for us and our wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated on consolidation. The operating results of acquired companies are included in our consolidated statements of comprehensive income from the date of acquisition.
For investments in which we own 20% to 50% of the voting shares and have significant influence over the operating and financial policies, the equity method of accounting is used. Accordingly, our share of the earnings and losses of these companies are included in the share of income (losses) in equity investments in the accompanying consolidated statements of comprehensive income.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such estimates and assumptions impact, among others, the following: the amount of uncollectible accounts receivable, amounts accrued for vacated properties, the amount to be paid for other liabilities, including contingent liabilities, our pension expense and pension funding requirements, amounts to be paid under our employee incentive plans, costs for interconnection, the amount of costs to be capitalized in connection with the construction and installation of our network and facilities, goodwill and indefinite life assets, long-lived assets, certain other intangible assets and the computation of our valuation allowance on deferred tax assets. Actual results could differ from those estimates.
Fair Values
We have determined the estimated fair value amounts presented in these consolidated financial statements using available market information and appropriate methodologies including, where appropriate, the recording of adjustments to fair values to reflect non-performance risk. However, considerable judgment is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. We have based these fair value estimates on information available to us as of December 31, 2012, 2011 and 2010.
Foreign Currency Translation
Our reporting currency is the pound sterling because substantially all of our revenues, operating costs and selling, general and administrative expenses are denominated in pounds sterling. Exchange gains and losses on translation of our net equity investments in subsidiaries having functional currencies other than the pound sterling are reported as a separate component of accumulated other comprehensive income in shareholder’s equity. Foreign currency transactions involving amounts denominated in currencies other than a subsidiary’s functional currency are recorded at the exchange rate ruling at the date of the transaction and are remeasured each period with gains and losses recorded in the consolidated statement of comprehensive income.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Cash and Cash Equivalents and Restricted Cash
Cash equivalents are short term highly liquid investments purchased with an original maturity of three months or less and are recorded at amortized cost, which approximates fair value. We had cash and cash equivalents totaling £194.9 million and £282.0 million as at December 31, 2012 and 2011, respectively.
Restricted cash balances of £1.9 million as at December 31, 2012 and £1.9 million as at December 31, 2011 represent cash balances collateralized against performance bonds given on our behalf.
Trade Receivables
Our trade receivables are stated at outstanding principal balance, net of allowance for doubtful accounts. Allowances for doubtful accounts are estimated based on the current aging of trade receivables, prior collection experience and future expectations of conditions that might impact recoverability. Amounts charged to expense are included in selling, general and administrative expenses in the consolidated statements of comprehensive income. The movements in our allowance for doubtful accounts for the years ended December 31, 2012, 2011 and 2010 are as follows (in millions):
Inventory
Inventory consists of consumer goods for re-sale. Consumer goods for re-sale are valued at the lower of cost or market value using the first-in, first-out, or FIFO, method. Cost represents the invoiced purchase cost of inventory. This valuation requires us to make judgments, based on currently available information, about obsolete, slow-moving, or defective inventory. Based upon these judgments and estimates, which are applied consistently from period to period, we adjust the carrying amount of our inventory for re-sale to the lower of cost or market value. Included within prepaid expenses and other current assets is inventory of £17.5 million and £13.1 million as at December 31, 2012 and 2011, respectively.
Fixed Assets
Depreciation is computed by the straight-line method over the estimated useful lives of the assets. Land is not depreciated. Estimated useful lives are as follows:
Costs associated with network construction, initial customer installations, initial installations of new services in customer premises, and the addition of network equipment to provide new or enhanced services are capitalized. Costs capitalized as part of initial customer installations include materials and direct labor.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Capitalizable labor costs incurred in connection with customer installations relate to activities such as:
•
Dispatching personnel and equipment to the customer's premises;
•
Verification that the customer's premises is able to properly receive our services;
•
Physically connecting the customer's premises to our network;
•
Set-up of equipment within the customer's premises and connection of that equipment to our network; and
•
Programming the equipment so that it is able to function as intended.
We also capitalize certain indirect costs required in order to connect the customer to our network. These indirect costs relate to the compensation and overhead costs of employees who assist in connecting and activating the customer.
Costs incurred to connect a service to a premises that has previously received the same service are expensed as incurred, and costs incurred to connect a new service to a premises that has previously received the same service are capitalized. For example, if a premises that has received our telephony service ceases receiving our telephony service, costs incurred to connect telephony services at that premises at any point in the future would be expensed. Additionally, if a premises that has received telephony services ceases receiving our services and a new customer occupies that premises and subscribes to both our broadband and telephony services, the costs incurred to connect broadband services would be capitalized and the costs to connect telephony services would be expensed. We assess a new service as a product that provides fundamentally new or enhanced functionality to our customers and which delivers incremental revenues.
We are required to make judgments regarding the amount of construction and installation costs that are capitalized. Our capitalization rates for labor costs are based on studies of actual costs as well as operational data demonstrating the amount of actual time that is spent on specific activities. Our capitalization rates for overhead costs are based on studies of activities that are incurred in support of capitalizable activities as well as an analysis of the proportion of those costs that are directly attributable to capitalizable activities. We continuously monitor the appropriateness of our capitalization policy and update the studies used on a regular basis. We update our policy when necessary to respond to changes in facts and circumstances, such as the development of new products and services. Changes resulting from modification to our capitalization have not historically had a material impact on our results.
Software Development Costs
We capitalize costs related to computer software developed or obtained for internal use in accordance with the Intangibles-Goodwill and Other Topic of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). Software obtained for internal use has generally been enterprise-level business and finance software that we customize to meet our specific operational needs. Costs incurred in the application development phase are capitalized and amortized over their useful lives, which are generally three to five years. We have not sold, leased or licensed software developed for internal use to our customers and we have no intention of doing so in the future. Amounts attributable to software development costs are included in fixed assets and depreciation expense in the consolidated balance sheets and consolidated statements of comprehensive income respectively.
Goodwill and Intangible Assets
Goodwill and other intangible assets with indefinite lives, such as reorganization value in excess of amount allocable to identifiable assets, are not amortized and are tested for impairment annually or more frequently if circumstances indicate a possible impairment exists in accordance with the Intangibles-Goodwill and Other Topic of the FASB ASC.
Asset Retirement Obligations
We account for our obligations under the Waste Electrical and Electronic Equipment Directive adopted by the European Union in accordance with the Asset Retirement and Environmental Obligations Topic of the FASB ASC whereby we accrue the cost to collect and dispose of certain of our customer premises equipment at the time of acquisition. We also record asset retirement obligations for the estimated cost of removing leasehold improvements and equipment that have been installed on leased network sites and administrative buildings.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Impairment of Long-Lived Assets
In accordance with the Property, Plant, and Equipment Topic of the FASB ASC, long-lived assets, including fixed assets and amortizable definite lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. We assess the recoverability of the carrying value of long-lived assets, by first grouping our long-lived assets with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities (the asset group) and, secondly, estimating the undiscounted future cash flows that are directly associated with and expected to arise from the use of and eventual disposition of such asset group. We estimate the undiscounted cash flows over the remaining useful life of the primary asset within the asset group. If the carrying value of the asset group exceeds the estimated undiscounted cash flows, we record an impairment charge to the extent the carrying value of the long-lived asset exceeds its fair value. We determine fair value through quoted market prices in active markets or, if quoted market prices are unavailable, through the performance of internal analysis of discounted cash flows or external appraisals. The undiscounted and discounted cash flow analyses are based on a number of estimates and assumptions, including the expected period over which the asset will be utilized, projected future operating results of the asset group, discount rate and long term growth rate.
As of December 31, 2012 there were no indicators of impairment that suggest the carrying amounts of our long-lived assets are not recoverable.
Deferred Financing Costs
Deferred financing costs are incurred in connection with the issuance of debt and are amortized over the term of the related debt using the effective interest method. Deferred financing costs of £35.9 million and £44.5 million as of December 31, 2012 and 2011, respectively, are included on the consolidated balance sheets.
Restructuring Costs
We account for our restructuring costs, which comprise lease and contract exit costs as well as employee termination costs, in accordance with the Exit or Disposal Cost Obligations Topic of the FASB ASC and recognize a liability for costs associated with restructuring activities when the liability is incurred.
Revenue Recognition
Revenue is stated net of value added tax, or VAT, collected from customers on behalf of tax authorities.
Consumer
Fixed line telephone, cable television and internet revenues are recognized as the services are provided to customers. At the end of each period, adjustments are recorded to defer revenue relating to services billed in advance and to accrue for earned but unbilled services.
Installation revenue for our Consumer segment is recognized in accordance with the provisions of the Entertainment-Cable Television Topic of the FASB ASC in relation to installation fees for cable television, fixed line telephone, and broadband internet services. Installation revenues are recognized at the time the installation is completed to the extent those fees are less than direct selling costs, which is generally the case.
Mobile handset and other equipment revenues are recognized when the goods have been delivered and title has passed. Equipment revenue is stated net of discounts earned through service usage.
Mobile service revenues include airtime, data, roaming and long-distance revenues and are invoiced and recorded as part of a periodic billing cycle. Service revenues are recognized as the services are provided. At the end of each period, adjustments are recorded to defer revenue relating to services billed in advance and to accrue for earned but unbilled services. Revenue from non-contract pre-pay customers is recorded as deferred revenue prior to commencement of services and is recognized as the services are rendered or usage rights expire.
Business
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
Rental revenues in respect of connectivity services provided to customers are recognized on a straight-line basis over the term of the rental agreement.
Installation revenues are recognized when the contracted installation service has been delivered, which is generally when a customer is connected to our network and has acknowledged acceptance.
Bundled revenue arrangements generally have two units of accounting: an up-front installation element and an ongoing service provision element.
Revenue is allocated to each unit of accounting based on a selling price hierarchy. The selling price for a deliverable is based on its vendor-specific objective evidence (VSOE) if available, third party evidence (TPE) if VSOE is not available, or estimated selling price (ESP) if neither VSOE nor TPE is available. Currently, we do not sell installation services or ongoing rental separately on a regular basis and therefore we do not have the evidence to support VSOE for these deliverables. We use evidence of the amounts that third parties charge for similar or identical services, when available, to establish selling price. In some cases, when we are unable to establish VSOE or TPE, we use our best estimate of selling price. Our objective in determining the best estimate of selling price is to establish the price at which we would transact a sale if the deliverable were sold regularly on a stand-alone basis. We consider all reasonably available information including both market data and conditions, as well as entity specific factors. In addition, we consider all factors contemplated in negotiating the arrangement with the customer and our own normal pricing practices. These considerations include competitor pricing, customization of the product, profit objectives and cost structures. Once we have established the selling price of each deliverable, we allocate total arrangement consideration based on the relative stand alone selling price of each deliverable. We recognize revenue on each deliverable in accordance with our policies for product and service revenue recognition, as previously discussed.
In all bundled revenue arrangements, the amount of revenue recognized for any up-front elements, including installation services, is limited to the amount of cash collected.
Subscriber Acquisition Costs
Costs incurred in respect of the acquisition of our customers, including commissions and the cost of mobile handsets, are expensed as incurred.
Advertising and Marketing Expense
We expense the cost of advertising and marketing as incurred. Advertising and marketing costs were £186.4 million, £152.8 million and £143.0 million in 2012, 2011 and 2010 respectively.
Stock-Based Compensation
We are indirect, wholly owned subsidiaries of Virgin Media. Accordingly, we have no stock-based compensation plans. Certain of our employees participate in the stock-based compensation plans of Virgin Media, which are described in Virgin Media’s consolidated financial statements.
Pensions
We account for our defined benefit pension arrangements in accordance with the Compensation-Retirement Benefits Topic of the FASB ASC which requires that pension expense is recognized on an accrual basis over employees’ approximate service periods. Pension expense is generally independent of funding decisions or requirements.
We recognize the funded status of our defined benefit post-retirement plans on our balance sheet and changes in the funded status are reflected in comprehensive income.
Derivative Financial Instruments
We are exposed to various market risks, including changes in foreign currency exchange rates and interest rates. As certain portions of our indebtedness accrue interest at variable rates, we are exposed to volatility in future cash flows and earnings associated with variable interest rate payments. Also, substantially all of our revenue and operating costs are earned and paid in pounds sterling and, to a lesser extent, U.S. dollars and euros, but we pay interest and principal obligations on some of our indebtedness in U.S. dollars and euros. As a result, we have exposure to volatility in future
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 2-Significant Accounting Policies (continued)
cash flows and earnings associated with changes in foreign currency exchange rates on payments of principal and interest on a portion of our indebtedness. We are also exposed to volatility in future cash flows and earnings associated with foreign currency payments in relation to operating costs and purchases of fixed assets incurred in the normal course of business.
Our objective in managing exposure to fluctuations in interest rates and foreign currency exchange rates is to decrease the volatility of our earnings and cash flows caused by changes in underlying rates. To achieve this objective, we have entered into derivative financial instruments. We have established policies and procedures to govern the management of these exposures through a variety of derivative financial instruments, including interest rate swaps, cross-currency interest rate swaps and foreign currency forward rate contracts. By policy, we do not enter into derivative financial instruments with a level of complexity or with a risk that is greater than the exposure to be managed.
In order to qualify for hedge accounting in accordance with the Derivatives and Hedging Topic of the FASB ASC we are required to document in advance the relationship between the item being hedged and the hedging instrument. We are also required to demonstrate that the hedge will be highly effective on an ongoing basis. This effectiveness testing is performed and documented at each period end to ensure that the hedge remains highly effective.
We recognize all derivative financial instruments as either assets or liabilities measured at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting. To the extent that the derivative instrument is designated and considered to be effective as a cash flow hedge of an exposure to future changes in interest rates or foreign currency exchange rates, the change in fair value of the instrument is deferred in accumulated other comprehensive income or loss. Amounts recorded in accumulated other comprehensive income or loss are reclassified to net income in the statement of comprehensive income in the same period as the corresponding impact on earnings from the underlying hedged transaction. Changes in the fair value of any instrument not designated as an accounting hedge or considered to be ineffective as an accounting hedge are reported in earnings immediately.
Where an accounting hedge no longer meets the effectiveness criteria, any gains or losses deferred in equity are only transferred to net income in the statement of comprehensive income when the committed or forecasted transaction is recognized in the statement of comprehensive income. However, where we have applied cash flow hedge accounting for a forecasted or committed transaction that is no longer expected to occur, then the cumulative gain or loss that has been recorded in equity is recognized immediately as a gain or loss on derivative instruments in the statement of comprehensive income.
Operating Leases
Our leasing activities are principally related to administrative facilities, network related facilities, retail facilities and operating equipment. These leases generally provide us with renewal options. Certain leases contain fluctuating or escalating payments and rent holiday periods. The related rent expense is recorded on a straight line basis over the lease term.
Contingent rent is not a material component of our total rent expense.
Income Taxes
We provide for income taxes in accordance with the Income Taxes Topic of the FASB ASC. Judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and the extent to which valuation allowances are necessary to reduce our deferred tax assets. We recognize valuation allowances if it is not more likely than not that sufficient taxable income will be available in the future against which the temporary differences and unused tax losses can be utilized. We have considered future taxable income and tax planning strategies in assessing whether deferred tax assets should be recognized.
Recent Accounting Pronouncements
On January 1, 2012 we adopted the FASB's new guidance for presentation of net income and other comprehensive income. Adopting these presentational rules has no impact on our reported results, and no material impact on our consolidated financial statements.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 3-Fixed Assets (Including Leases)
Fixed assets consist of (in millions):
Certain prior year amounts in the table above have been reclassified to conform to current year presentation.
During the years ended December 31, 2012, 2011 and 2010, the assets acquired under capital leases totaled £88.9 million, £91.2 million and £132.2 million, respectively. Amortization expense on capital leases is included as a component of depreciation expense in the consolidated statements of comprehensive income.
Future minimum annual payments under capital and operating leases at December 31, 2012 are as follows (in millions). The table reflects our contractual obligations.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 3-Fixed Assets (Including Leases) (continued)
Total rental expense for the years ended December 31, 2012, 2011 and 2010 under operating leases was £49.7 million, £47.0 million and £52.6 million, respectively.
The weighted average interest rate for capital lease obligations as of December 31, 2012 and 2011 was 5.8% and 6.8%, respectively.
During 2012 and 2011, the changes in the asset retirement obligations were as follows (in millions):
Note 4-Goodwill and Intangible Assets
Goodwill and intangible assets consist of (in millions):
As at December 31, 2012, the gross carrying amount of goodwill was £2,235.6 million and accumulated impairment charges were £362.2 million.
As at December 31, 2012, goodwill and intangible assets not subject to amortization totaling £1,819.8 million and £206.8 million are allocated to our Consumer and Business reporting units, respectively. We performed our annual impairment reviews of our Consumer and Business reporting units as at October 1, 2012 and 2011. As a result of this review we concluded that no impairment charge was required at either date. Based on the results of the review as at October 1, 2012, neither our Business or Consumer reporting units were at risk of failing Step 1 of the goodwill impairment test, under FASB ASC, which requires comparison of the carrying values and fair values of reporting units.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 5-Long Term Debt
Long term debt reflects our obligations under the terms of the indentures governing the senior notes and senior secured notes as well as the intercreditor deed governing the senior credit facility. As such, these amounts include debt owed directly to third parties by affiliated entities not consolidated by us which have been classified as amounts due to group companies.
Long term debt consists of (in millions):
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 5-Long Term Debt (continued)
The carrying values of the $500 million 5.25% and £650 million 5.50% senior secured notes due 2021 include increases of £42.9 million and £109.1 million, respectively, at December 31, 2012 and increases of £45.7 million and £77.9 million, respectively, at December 31, 2011, as a result of our application of fair value hedge accounting to these instruments.
The effective interest rate on the senior credit facility was 2.4% and 3.3% as at December 31, 2012 and 2011 respectively.
The terms of the senior notes and senior credit facility as at December 31, 2012 are summarized below.
Senior Notes
All senior notes have been guaranteed by us pursuant to a senior subordinated guarantee. The terms of our senior notes and loan notes due to Virgin Media Finance PLC as at December 31, 2012, are summarized below.
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6.50% Senior Secured Notes due January 15, 2018 - The principal amount at maturity is $1,000 million. Interest is payable semi-annually on June 15 and December 15 commencing June 15, 2010
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7.00% Senior Secured Notes due January 15, 2018 - The principal amount at maturity is £875 million. Interest is payable semi-annually on June 15 and December 15 commencing June 15, 2010
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8.375% Senior Notes due October 15, 2019 - The principal amount at maturity is $507.1 million. Interest is payable semi-annually on April 15 and October 15 commencing April 15, 2010.
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8.875% Senior Notes due October 15, 2019 - The principal amount at maturity is £253.5 million. Interest is payable semi-annually on April 15 and October 15 commencing April 15, 2010.
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5.25% Senior Secured Notes due January 15, 2021 - The principal amount at maturity is $500 million. Interest is payable semi-annually on January 15 and July 15 commencing July 15, 2011.
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5.50% Senior Secured Notes due January 15, 2021 - The principal amount at maturity is £650 million. Interest is payable semi-annually on January 15 and July 15 commencing July 15, 2011.
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5.25% Senior Notes due February 15, 2022 - The principal amount at maturity is $500 million. Interest is payable semi-annually on February 15 and August 15 commencing August 15, 2012.
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4.875% Senior Notes due February 15, 2022 - The principal amount at maturity is $900 million. Interest is payable semi-annually on February 15 and August 15 commencing February 15, 2013.
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5.125% Senior Notes due February 15, 2022 - The principal amount at maturity is £400 million. Interest is payable semi-annually on February 15 and August 15 commencing February 15, 2013.
On March 13, 2012, Virgin Media Finance PLC, the parent company of VMIH, issued $500 million aggregate principal amount of 5.25% senior notes due 2022 at par. The proceeds of $495.5 million, net of fees, were received on March 13, 2012. Interest is payable on February 15 and August 15 each year, beginning on August 15, 2012. The senior notes due 2022 rank pari passu with Virgin Media Finance PLC's outstanding senior notes due 2019 and 2022. On March 28, 2012, we used the net proceeds from these new senior notes, and cash on our balance sheet, to redeem $500 million of the principal amount of the $1,350 million 9.50% senior notes due 2016. Virgin Media Finance PLC recognized a loss on extinguishment of debt of £58.6 million as a result of this redemption, which represented the difference between the consideration paid to redeem $500 million of the 9.50% senior notes due 2016 and the carrying value of those notes, and the write-off of associated deferred finance costs. Each of VMIH and VMIL are conditional guarantors and have guaranteed these senior notes on a senior subordinated basis.
On October 30, 2012, Virgin Media Finance PLC, issued $900 million aggregate principal amount of 4.875% senior notes due 2022 at par and £400 million aggregate principal amount of 5.125% senior notes due 2022, at par. The proceeds of $893.0 million and £396.9 million, net of fees, were received on October 30, 2012. Interest is payable on February 15 and August 15 each year, beginning on February 15, 2013. The senior notes due 2022 rank pari passu with Virgin Media Finance PLC's outstanding senior notes due 2019 and 2022. Each of VMIH and VMIL are conditional guarantors and have guaranteed these senior notes on a senior subordinated basis.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 5-Long Term Debt (continued)
We used the net proceeds from the senior notes due 2022, issued in October 2012, to redeem in full the outstanding balance of $850 million and €180 million 9.5% senior notes due 2016 and to redeem $92.9 million of the principal amount of $600 million 8.375% senior notes due 2019 and £96.5 million of the principal amount of £350 million 8.875% senior notes due 2019. Virgin Media Finance PLC recognized a loss on extinguishment of debt of £129.2 million as a result of these redemptions, which represented the difference between the consideration paid to redeem the respective notes and the carrying value of those notes, and the write-off of associated deferred finance costs.
Senior Credit Facility
The principal amount outstanding under our senior credit facility at December 31, 2012 was £750.0 million. Our senior credit facility comprises a term facility denominated in pounds sterling of £750.0 million and a revolving facility of £450.0 million. At December 31, 2012, £750.0 million of the term facility had been drawn and £6.4 million of the revolving credit facility had been utilized for bank guarantees and standby letters of credit.
The term credit facility bears interest at LIBOR, plus a margin currently ranging from 1.625% to 2.125% based on leverage ratios. The margins on the revolving credit facility range from 1.325% to 2.125% based on leverage ratios. Interest is payable at least semi-annually. The term credit facility and the revolving credit facility are repayable in full on their maturity dates, which are June 30, 2015.
The facility is secured through a guarantee from Virgin Media Finance PLC. In addition, the bulk of the facility is secured through guarantees and first priority pledges of the shares and assets of substantially all of the operating subsidiaries of VMIH, and of receivables arising under any intercompany loans to those subsidiaries. We are subject to financial maintenance tests under the facility, including a test of liquidity, coverage and leverage ratios applied to us and certain of our subsidiaries. As of December 31, 2012, we were in compliance with these covenants.
The agreements governing the senior secured notes and the senior credit facility significantly, and, in some cases, absolutely restrict our ability and the ability of most of our subsidiaries to:
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incur or guarantee additional indebtedness;
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pay dividends at certain levels of leverage, or make other distributions, or redeem or repurchase equity interests or subordinated obligations;
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make investments;
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sell assets, including the capital stock of subsidiaries;
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create liens;
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enter into agreements that restrict the restricted subsidiaries’ ability to pay dividends, transfer assets or make intercompany loans;
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merge or consolidate or transfer all or substantially all of our assets; and
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enter into transactions with affiliates.
Long term debt repayments, excluding capital leases as of December 31, 2012, are due as follows (in millions):
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 6-Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The types of inputs used to measure fair value are classified into the following hierarchy:
Level 1
Unadjusted quoted prices in active markets for identical assets or liabilities
Level 2
Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability
Level 3
Unobservable inputs for the asset or liability
We endeavor to utilize the best available information in measuring fair value. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
In estimating the fair value of our financial assets and liabilities, we used the following methods and assumptions:
Derivative financial instruments:
As a result of our financing activities, we are exposed to market risks from changes in interest and foreign currency exchange rates, which may adversely affect our operating results and financial position. When deemed appropriate, we minimize our risks from interest and foreign currency exchange rate fluctuations through the use of derivative financial instruments such as foreign currency forward rate contracts, interest rate swaps and cross-currency interest rate swaps. These contracts are valued using internal models based on observable inputs, counterparty valuations, or market transactions in either the listed or over-the-counter markets, adjusted for non-performance risk. As such, these derivative instruments are classified within level 2 in the fair value hierarchy.
The fair values of our derivative financial instruments are disclosed in note 7.
Long term debt:
The carrying value of our senior credit facility approximates its fair value and is excluded from the table on the following page. The fair values of the senior notes and senior secured notes in the following table are based on the market prices in active markets which incorporate non-performance risk. As such, these measurements are classified within level 1 in the fair value hierarchy.
The carrying values of the $500 million 5.25% and £650 million 5.50% senior secured notes due 2021 include increases of £42.9 million and £109.1 million, respectively, at December 31, 2012, and increases of £45.7 million and £77.9 million, respectively, at December 31, 2011, as a result of our application of fair value hedge accounting to these instruments.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIAIRES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 6-Fair Value Measurements (continued)
The carrying amounts and fair values of our long term debt, excluding capital leases, were as follows (in millions):
Concentrations of Credit Risk
Our financial instruments that are exposed to concentrations of credit risk consist primarily of cash, trade receivables and derivative contracts.
At December 31, 2012 and 2011, we had £194.9 million and £282.0 million, respectively, in cash and cash equivalents. These cash and cash equivalents are on deposit with major financial institutions and, as part of our cash management process, we perform regular evaluations of the credit standing of these institutions using a range of metrics. We have not experienced any losses in cash balances and do not believe we are exposed to any significant credit risk on our cash balances.
Concentrations of credit risk with respect to trade receivables are limited because of the large number of customers. We perform periodic credit evaluations of our Business segment customers’ financial condition and generally do not require collateral. No single group or customer represents greater than 10% of total accounts receivable.
Concentrations of credit risk with respect to derivative contracts are focused within a limited number of international financial institutions with which we operate and relate only to derivatives with recorded asset balances at December 31, 2012. We perform regular reviews of the financial institutions with which we operate as to their credit worthiness and financial condition. We have not experienced non-performance by any of our derivative counterparties nor do we expect there to be non-performance risks associated with our counterparties. At December 31, 2012, based on market values, we had 76.6% of our derivative contracts with four financial institutions, each with more than 10% of our total exposure. At December 31, 2011, based on market values, we had 82.0% of our derivative contracts with five financial institutions, each with more than 10% of our total exposure.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 7-Derivative Financial Instruments and Hedging Activities
Strategies and Objectives for Holding Derivative Instruments
Our operations are materially impacted by changes in interest rates and foreign currency exchange rates. In an effort to manage these risks, we periodically enter into various derivative instruments including interest rate swaps, cross-currency interest rate swaps and foreign exchange forward rate contracts. We recognize all derivative instruments as either assets or liabilities at fair value on our consolidated balance sheets.
We have entered into cross-currency interest rate swaps and foreign currency forward rate contracts to manage interest rate and foreign exchange rate currency exposures with respect to our U.S. dollar and euro denominated debt obligations. We have entered into interest rate swaps to manage interest rate exposures resulting from variable rates of interest we pay on our pounds sterling denominated debt obligations, and we have entered into interest rate swaps and cross-currency interest rate swaps to hedge the fair values of certain of our U.S. dollar and U.K. pounds sterling debt obligations. We have also entered into U.S. dollar forward rate contracts to manage our foreign exchange rate currency exposures related to certain committed and forecasted purchases.
Whenever it is practical to do so, we designate a derivative contract as either a cash flow or fair value hedge for accounting purposes. These relationships are referred to as “Accounting Hedges” below. When a derivative contract is not designated as an Accounting Hedge, the derivative is treated as an economic hedge with mark-to-market movements and realized gains or losses recognized through gains (losses) on derivative instruments in net income in the consolidated statements of comprehensive income. These derivatives are referred to as “Economic Hedges” below. We do not enter into derivatives for speculative or trading purposes.
During the years ended December 31, 2012 and 2011, we recognized losses of £21.9 million and £11.1 million on derivative instruments, respectively, relating to derivative instruments that were not designated or qualifying as a hedging instrument.
We believe that those relationships designated as Accounting Hedges will be highly effective throughout their term in offsetting changes in cash flow or fair value attributable to the hedged risk. If we determine it is probable that forecasted transactions to which a hedge contract relates will not occur, we discontinue hedge accounting prospectively and immediately reclassify any amounts accumulated in other comprehensive income to net income. We perform, at least quarterly, both a prospective and retrospective assessment of the effectiveness of our hedge contracts, including assessing the possibility of counterparty default. If we determine that a hedging relationship is no longer expected to be highly effective, we discontinue hedge accounting prospectively and recognize subsequent changes in the fair value of the derivative in gains (losses) on derivative instruments in net income in the consolidated statements of comprehensive income. As a result of our effectiveness assessment at December 31, 2012, we believe our derivative contracts that are designated and qualify for hedge accounting will continue to be highly effective in offsetting changes in cash flow or fair value attributable to the hedged risk.
Our derivative contracts are valued using internal models based on observable inputs, counterparty valuations, or market transactions in either the listed or over-the-counter markets, adjusted for non-performance risk. Non-performance is based on quoted credit default swaps for counterparties to the contracts and swaps. These derivative instruments are classified within level 2 in the fair value hierarchy, because we consider all of the significant inputs are observable. Derivative instruments which are subject to master netting arrangements are not offset and we have not provided, nor do we require, cash collateral with any counterparty.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 7-Derivative Financial Instruments and Hedging Activities (continued)
The fair values of our derivative instruments recorded on our consolidated balance sheets were as follows (in millions):
Cross-Currency Interest Rate Swaps-Hedging the Interest Payments of Senior Notes and Senior Secured Notes
During the three months ended March 31, 2012, we terminated the cross-currency interest rate swaps on the $500 million 9.50% senior notes due 2016 that were redeemed in the quarter. We also entered into new cross-currency interest rate swaps to mitigate the foreign exchange rate risk associated with the $500 million 5.25% senior notes due 2022.
During the three months ended December 31, 2012, we terminated the cross-currency interest rate swaps on the $850 million 9.50% senior notes due 2016, the €180 million 9.5% senior notes due 2016, and $100 million of the $600 million principal 8.375% senior notes due 2019 that were redeemed in the quarter. We also entered into new cross-currency interest rate swaps to mitigate the foreign exchange rate risk associated with the $900 million 4.875% senior notes due 2022.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 7-Derivative Financial Instruments and Hedging Activities (continued)
As of December 31, 2012, we had outstanding cross-currency interest rate swaps to mitigate the interest and foreign exchange rate risks relating to the pounds sterling value of interest and principal payments on the U.S. dollar denominated senior notes and senior secured notes.
The terms of our outstanding cross-currency interest rate swaps at December 31, 2012, were as follows:
All of our cross-currency interest rate swaps include exchanges of the notional amounts at the end of the contract except for the contract maturing in November 2016 hedging the $1,000 million senior notes due 2016.
Interest Rate Swaps-Hedging of Interest Rate Sensitive Obligations
As of December 31, 2012, we had outstanding interest rate swap agreements to manage the exposure to variability in future cash flows on the interest payments associated with our senior credit facility which accrues at variable rates based on LIBOR. We have also entered into interest rate swap agreements to manage our exposure to changes in the fair value of certain debt obligations due to interest rate fluctuations. The interest rate swaps allow us to receive or pay interest based on three or six month LIBOR in exchange for payments or receipts of interest at fixed rates.
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Note 7-Derivative Financial Instruments and Hedging Activities (continued)
The terms of our outstanding interest rate swap contracts at December 31, 2012 were as follows:
Foreign Currency Forward Rate Contracts-Hedging Committed and Forecasted Transactions
As of December 31, 2012, we had outstanding foreign currency forward rate contracts to purchase U.S. dollars to hedge committed and forecasted purchases. The terms of our outstanding foreign currency forward rate contracts at December 31, 2012 were as follows:
Cash Flow Hedging
For derivative instruments that are designated and qualify as cash flow Accounting Hedges, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into net income in the statement of comprehensive income in the same period or periods during which the hedged transactions affect earnings. In our consolidated statement of cash flows, we recognize the cash flows resulting from derivative contracts that are treated as Accounting Hedges in the same category where the cash flows from the underlying exposure are recognized. Cash flows from derivative contracts that are not designated as Accounting Hedges are recognized as operating activities in the consolidated statements of cash flows. If we discontinue hedge accounting for an instrument, subsequent cash flows are classified based on the nature of the instrument.
Gains or losses representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized as gains or losses on derivative instruments in net income in the consolidated statements of comprehensive income in the period in which they occur. During the years ended December 31, 2012 and 2011 we recognized no gain or loss relating to ineffectiveness on our cash flow hedges and a gain of £0.5 million in the year ended December 31, 2010.
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Note 7-Derivative Financial Instruments and Hedging Activities (continued)
The following table presents the effective amount of gain(loss) recognized in other comprehensive income (loss) and amounts reclassified to earnings during the years ended December 31, 2012, 2011 and 2010 (in millions):
Assuming no change in interest rates or foreign exchange rates for the next twelve months, the amount of pre-tax income or losses that would be reclassified from other comprehensive income (loss) to earnings would be losses of £3.2 million relating to interest rate swaps, losses of £5.8 million relating to cross-currency interest rate swaps, and income of £0.0 million relating to forward foreign exchange contracts.
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Note 7-Derivative Financial Instruments and Hedging Activities (continued)
Fair Value Hedging
For derivative instruments that are designated in qualifying fair value Accounting Hedge relationships, changes in the fair value of the derivatives, inclusive of counterparty risk, are included in gain (loss) on derivatives in net income in the statement of changes in equity along with changes in the fair value of the hedged debt obligations due to changes in the hedged risk. The difference between this gain or loss and changes in the fair value of the hedged debt obligations due to changes in the hedged risk is referred to as hedge ineffectiveness. In our consolidated balance sheets, changes in the value of the hedged debt obligations due to changes in the hedged risk are included as adjustments to the carrying value of the debt.
In our consolidated statement of cash flows, we recognize the cash flows resulting from derivative contracts that are treated as Accounting Hedges in the same category where the cash flows from the underlying exposure are recognized. Cash flows from derivative contracts, that are not treated as Accounting Hedges, are recognized as operating activities in the consolidated statement of cash flows.
Gains or losses representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized as gains or losses on derivative instruments in net income in the consolidated statements of comprehensive income in the period in which they occur. During the years ended December 31, 2012, 2011 and 2010 we recognized hedge ineffectiveness (losses) gains of £(4.2) million, £3.7 million and £0.0 million, respectively.
Note 8-Employee Benefit Plans
Defined Benefit Plans
Certain of our subsidiaries operate two defined benefit pension plans in the U.K. The assets of the plans are held separately from those of ourselves and are invested in portfolios under the management of investment groups. The pension cost is calculated using the projected unit method. Our defined benefit pension plans use a measurement date of December 31. Our funding requirements are reviewed and generally revised based on a valuation that is performed every three years. The current triennial funding valuation is being performed as of December 31, 2011 and we expect our funding requirements arising from this valuation to be determined prior to March 31, 2013. Our policy is to fund amounts to the defined benefit plans necessary to comply with the funding requirements as prescribed by the laws and regulations in the U.K.
Employer Contributions
For the year ended December 31, 2012, we contributed £17.7 million to our pension plans. We presently anticipate contributing a total of £17.0 million to fund our pension plans in 2013, but this is subject to the outcome of the on-going triennial valuation.
Obligations and Funded Status
The change in projected benefit obligation was as follows (in millions):
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Note 9-Employee Benefit Plans
The change in plan assets was as follows (in millions):
The funded status as of December 31, 2012 and 2011 was as follows (in millions):
As of December 31, 2012 and 2011, one of the pension plans had projected benefit obligations in excess of plan assets. The following table presents information for pension plans with an accumulated benefit obligation in excess of plan assets (in millions):
Amount Included in Other Comprehensive Income
The amount included in other comprehensive income for the years ended December 31, 2012 and 2011 consisted of (in millions):
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Note 8-Employee Benefit Plans (continued)
The following table presents the amounts recognized in accumulated other comprehensive income as of December 31, 2012 and 2011 that have not yet been recognized as components of net periodic benefit cost (in millions):
Net Periodic Benefit Costs
The components of net periodic benefit costs were as follows (in millions):
The expected return on plan assets for the year ended December 31, 2013 is £21.7 million. We expect to recognize £2.0 million of actuarial losses in the net periodic benefit cost for the year ended December 31, 2013.
As a result of the sale of various business operations in prior periods, we have retained the earned pension and other post-retirement benefits liabilities related to certain employees of those operations. Accordingly, the information disclosed in the tables above includes amounts relating to liabilities of these employees.
Assumptions
The weighted-average assumptions used to determine benefit obligations were as follows:
The weighted-average assumptions used to determine net periodic benefit costs were as follows:
The expected rate of return on plan assets is the expected future long term rate of earnings on plan assets and is based on expected returns on specific asset classes. These estimates are based on a combination of factors including current market rates, valuation levels, historical returns and premia for certain asset classes to determine the aggregate
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Note 8-Employee Benefit Plans (continued)
return for the plan assets. The projected return is then weighted according to the asset allocation of the overall plan assets.
Plan Assets
Our pension plan weighted-average asset allocations by asset category and by fair value hierarchy level at December 31, 2012 and 2011 were as follows (in millions):
During the fourth quarter of 2012, the trustees of one of our defined benefit plans purchased an insurance contract that will pay an income stream to the plan which is expected to match all future cash outflows in respect of certain liabilities. The fair value of this insurance contract is presented as an asset of the plan and is measured based on the future cash flows to be received under the contract discounted using the same discount rate used to measure the associated liabilities.
The substantial majority of plan assets are valued using quoted prices for the holding.
The trustees of the main defined benefit pension plan, which makes up approximately 75% of the assets of our two defined benefit pension plans, have in place an asset allocation of 20% equities, 20% diversified growth funds, 40% insurance contracts and 20% bonds and cash, at December 31, 2012. The assets are managed by a number of fund managers, which means as markets move relative to each other the assets move away from the target investment strategy. Rebalancing of the assets will be carried out from time to time. As the main defined benefit pension scheme is now closed to new entrants, the trustees are considering moving towards a higher proportion of matching assets over time to reflect the steadily maturing profile of the liabilities and the improvement in the funding position.
There were no directly owned shares of our common stock included in the equity securities at December 31, 2012 or 2011.
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Note 8-Employee Benefit Plans (continued)
Estimated Future Benefit Payments
The benefits expected to be paid out of the pension plans in total are set out below for each of the next five years and the following five years in aggregate. The benefits expected to be paid are based on the same assumptions used to measure our benefit obligation at December 31, 2012 and include estimated future employee services (in millions):
Defined Contribution Pension Plans
Our subsidiaries operate defined contribution pension plans in the U.K. The total expense in relation to these plans was £13.7 million, £13.6 million and £14.0 million for the years ended December 31, 2012, 2011 and 2010, respectively.
Note 9-Income Taxes
Overview
For the year ended December 31, 2012 we recognized an income tax benefit of £2,531.1 million compared to an expense of £15.6 million and a benefit of £127.9 million in the years ended December 31, 2011 and 2010 respectively. The significant benefit recognized during 2012 related to the reversal of the valuation allowance on certain of our deferred tax assets.
Deferred tax valuation allowance
As at December 31, 2012 we had gross deferred tax assets of £5,418.7 million, of which £5,232.1 million related to the U.K. and which principally comprised capital allowances, net operating losses, or NOLs, and capital losses. We accumulated these assets over the last two decades as we made significant investments in building our network infrastructure and incurred significant losses as we operated that network. These assets represent amounts we, in common with other companies in the U.K., are able to use to reduce our future taxable profits in the U.K. We have historically maintained a full valuation allowance on both our U.K. and U.S. deferred tax assets, reducing the value of these assets on our balance sheet to zero.
The assessment of the amount of value assigned to our deferred tax assets under the applicable accounting rules is highly judgmental. We are required to consider all available positive and negative evidence in evaluating the likelihood that we will be able to realize the benefit of our deferred tax assets in the future. Such evidence includes scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and the results of recent operations. Since this evaluation requires consideration of events that may occur some years into the future, there is significant judgment involved, and our conclusion could be materially different should certain of our expectations not transpire.
When assessing all available evidence, we consider that an important piece of objective evidence is the extent to which we have made pre-tax income or losses over the most recent three year period. Historically, we have maintained a full valuation allowance on our net deferred tax assets principally because we have been in a cumulative pre-tax
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Note 9 - Income Taxes (continued)
loss position over the most recent three year period. While there has been a trend of positive evidence that has been strengthening in recent years, it was not sufficiently persuasive to outweigh the negative evidence provided by our cumulative pre-tax loss position. During the year ended December 31, 2012, we emerged from a cumulative pre-tax loss position in the U.K. for the first time, which removed this important piece of negative evidence from our evaluation.
Our assessment for the year ended December 31, 2012 considered the following positive and negative evidence. Based on this evidence, we concluded that it was more likely than not that in future periods we will generate sufficient pre-tax income to utilize substantially all of our U.K. deferred tax assets relating to capital allowances and NOLs:
Positive evidence:
•
We have now generated pre-tax income in the U.K. of more than £150 million for two consecutive years and have utilized some of our available tax assets to reduce the tax liabilities that would have otherwise arisen in those periods.
•
Our U.K. capital allowances and NOLs do not have an expiration date.
•
Our financial performance has continued to improve despite challenging macroeconomic conditions. Steady growth in revenue and operating income has been maintained for three years, and we believe that financial performance will continue to improve even if the current economic conditions persist.
•
Our forecasts of future taxable income indicate that our pre-tax income and taxable income will increase in the future.
•
We have re-financed a significant portion of our high-coupon debt into lower-coupon, longer duration debt in recent years.
Negative evidence:
In the absence of a cumulative loss in the last three years, the remaining negative evidence consists solely of our long history of significant pre-tax losses prior to 2011, dating back many years prior to the merger with Telewest in 2006. In total, our U.K. group companies have approximately £377.2 million of deferred tax assets on £1,639.9 million of NOLs which accumulated over many years. We believe that the combined impact of a number of company specific and industry specific developments over recent years makes it unlikely that those historic losses will be repeated in the future. These include:
Company specific factors:
•
The significant investment associated with building our unique cable network does not need to be replicated. Instead, we are able to spend relatively more modest sums to gradually upgrade and improve that network.
•
We have established ourselves as one of the major telecommunication service providers in the U.K., offering leading next generation broadband and television services which has enabled us to steadily and economically grow revenues.
•
Significant restructuring and rationalization activities subsequent to the Telewest merger have reduced our cost base and focused the business on its core activities. This allowed us to leverage our network into financial returns and generate consistently improving operating margins.
•
There has been a material improvement in our credit standing in recent years, including certain of our debt being rated investment grade, which has allowed us to reduce and lock-in lower interest rates.
Industry specific factors:
•
The cable and telecommunications markets have matured since the late 1990s and early 2000s.
•
There is only one competitor in the U.K. with a substantial fiber network.
•
Pricing in the U.K. telecommunications market in recent years is considerably more rational than in the early to mid portion of the previous decade. We expect that trend to continue given a) the increase in
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Note 9 - Income Taxes (continued)
demand for data traffic that requires a high speed delivery mechanism like our fiber network and b) the structure of the U.K. market.
•
Consolidation in the industry has reduced the number of competitors since the years in which we incurred significant losses.
•
The industry is capital intensive and barriers to entry are high; therefore, we do not envision uneconomic competition from new entrants.
After consideration of these factors, we determined that it was unlikely that the losses incurred prior to the year ended December 31, 2011 would be repeated and as a result, we did not place significant weight on the negative evidence provided by our long history of losses.
We believe that our positive evidence is strong. The improving financial performance in recent years is an objectively verifiable piece of positive evidence and is the result of a number of factors which have been present to a greater or lesser extent in prior years but have only recently gathered sufficient weight to deliver objectively verifiable, consistent taxable profits.
A key consideration in our analysis was that the unlimited carryforward periods of our U.K. tax assets make the realization of those assets less sensitive to variations in our projections of future taxable income than would otherwise be the case if the carryforward periods were time limited. In performing our analysis, we used the most updated plans and estimates that we currently use to manage the underlying business and calculated the utilization of our deferred tax assets under a number of scenarios. We do not require material increases in the current levels of cash flows, book income, or taxable income to recover the value of our deferred tax assets other than capital losses.
The emergence from a cumulative loss position in the U.K. during 2012 was an important consideration in our assessment and changed the balance of the remaining available evidence. While strong positive evidence was present during 2011 and in earlier quarters of 2012, we concluded that the significance of the cumulative loss could not be overcome prior to December 31, 2012. In the absence of the negative evidence provided by cumulative losses over the most recent three year period, we believe that the available positive evidence outweighs the remaining negative evidence. Therefore, we determined that it was appropriate to reverse substantially all of the valuation allowance on our U.K. deferred tax assets other than capital losses. The reversal of the valuation allowance resulted an income tax benefit of £2,428.4 million, during the year ended December 31, 2012, and an increase in current and non-current deferred tax assets on the consolidated balance sheet for the year ended December 31, 2012. Beginning in the first quarter of 2013, we expect our net income and earnings per share to be impacted to a greater degree by income tax expense, which may fluctuate from period to period. However, this reversal will not result in any change to the amount of cash payments to the U.K. tax authorities for income taxes.
Realization of our deferred tax assets is dependent on generating sufficient taxable income in future periods. Although we believe it is more likely than not that future taxable income will be sufficient to allow us to recover substantially all of the value of our U.K. deferred tax assets other than capital losses, realization is not assured and future events could cause us to change our judgment. If future events cause us to conclude that it is not more likely than not that we will be able to recover of the value of our deferred tax assets we would be required to establish a valuation allowance on our deferred tax assets at that time, which would result in a charge to income tax expense and a material decrease in net income in the period in which we change our judgment.
During 2012, we also reversed a valuation allowance on the U.S. deferred tax assets related to certain of our subsidiaries that are considered dual resident in the U.K. and U.S. for tax purposes and recognized a benefit of £103.4 million. The assets in these companies are principally comprised of NOLs. The companies have emerged from a cumulative loss position and after consideration of all available positive and negative evidence we believe it is more likely than not that the deferred tax assets will be utilized. Because those companies have emerged from a cumulative loss position, significant negative evidence no longer exists. Positive evidence exists in the form of recent profitability, forecasts for continued profitability, and long expiration periods for the NOLs. We do not require significant improvements in the level of profitability to utilize the deferred tax assets prior to their expiration.
We have considered the implications of the proposed merger with Liberty Global, as discussed Note 13 - Subsequent Events, on our accounting for our deferred tax assets. We note that a change in judgment that results in subsequent recognition, derecognition, or change in measurement of a tax position taken in a prior annual period shall be recognized
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Note 9 - Income Taxes (continued)
as a discrete item in the period in which the change occurs. We are therefore not permitted to consider the impact of the proposed business combination until 2013 and the partial reversal of the allowance discussed above therefore remains appropriate.
Changes in tax laws and rates will also affect our deferred tax assets in the future. The U.K. government has announced a reduction in the rate of corporation tax from 23% to 21%. These reductions have not been enacted, but we will recognize a reduction in the value of our deferred tax assets and liabilities and a charge to income tax expense in the period of enactment which is expected to be during 2013.
Income tax benefit (expense)
The benefit (expense) for income taxes consists of the following (in millions):
The reconciliation of income taxes computed at U.S. federal statutory rates to income tax benefit (expense) attributable to continuing operations is as follows (in millions):
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Note 9 - Income Taxes (continued)
Deferred taxes
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred tax assets are reduced by a valuation allowance if, based upon the weight of available evidence, it is more likely than not that we will not realize some portion or all of the deferred tax assets. Significant components of deferred tax liabilities and assets are as follows (in millions):
The following table summarizes the movements in our deferred tax valuation allowance during the years ended December 31, 2012, 2011 and 2010 (in millions):
The change in tax rates relates to a reduction in the U.K. corporate income tax rate from 28% to 27% in 2010, to 25% in 2011, and to 23% in 2012. The deferred tax assets and liabilities presented for 2012 reflect the 23% rate. Further rate changes have been announced that are expected to reduce the U.K. corporate income tax rate in equal annual decrements of one percentage point to 21%, but these changes have not yet been enacted.
At December 31, 2012, we had deferred tax assets of £372.9 million on U.K. net operating loss carryforwards that have no expiration date. Pursuant to U.K. law, these losses are only available to offset income of the legal entity that generated the loss. A portion of the U.K. net operating loss carryforwards relates to dual resident companies, of which the U.S. net operating loss carryforward amount is £528 million and expires between 2012 and 2028. We also have U.K. capital loss carryforwards of £11.8 billion that have no expiration date. However, we do not expect to realize any significant benefit from these capital losses, which can only be used to the extent we generate future U.K. taxable capital gain income from assets held by subsidiaries owned by the group prior to the merger with Telewest in 2006.
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Note 9 - Income Taxes (continued)
At December 31, 2012, we had fixed assets on which future U.K. tax deductions can be claimed of £12.7 billion. The maximum amount that can be claimed in any one year is 18% of the remaining balance, after additions, disposals and prior claims.
At each period end, it is necessary for us to make certain estimates and assumptions to compute the provision for income taxes including, but not limited to the expected operating income (or loss) for the year, projections of the proportion of income (or loss) earned and taxed in the U.K. and the extent to which this income (or loss) may also be taxed in the United States, permanent and temporary differences, the likelihood of deferred tax assets being recovered and the outcome of contingent tax risks. In the normal course of business, our tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest assessments by these taxing authorities for uncertain tax positions taken in respect to matters such as business acquisitions and disposals and certain financing transactions including intercompany transactions, amongst others. We accrue a liability when we believe an assessment may be probable and the amount is estimable. In accordance with generally accepted accounting principles, the impact of revisions to these estimates is recorded as income tax expense or benefit in the period in which they become known. Accordingly, the estimates used to compute the provision for income taxes may change as new events occur, as more experience is acquired, as additional information is obtained and as our tax environment changes.
Note 10-Related Party Transactions
Virgin Media Inc. and its consolidated subsidiaries
We are wholly owned subsidiaries of Virgin Media Inc. We charge Virgin Media Inc. and certain of its group companies for operating costs and selling, general and administrative expenses incurred by us on their behalf. The following information summarizes our significant related party transactions with Virgin Media Inc. and its group companies (in millions):
The above recharges are recorded in operating costs and selling, general and administrative expenses and offset the respective costs incurred.
Virgin Enterprises Limited
We have identified Virgin Enterprises Limited as a related party to us. Virgin Entertainment Investment Holdings Limited became a holder of the common stock of Virgin Media Inc. as a result of its acquisition of Virgin Mobile on July 4, 2006. As of December 31, 2012, Virgin Entertainment Investment Holdings Limited beneficially owned 2.5% of the common stock of Virgin Media Inc. (based on SEC filings). Virgin Enterprises Limited is a wholly owned subsidiary of Virgin Entertainment Investment Holdings Limited. In addition, Gordon McCallum is a member of the Board of Directors of Virgin Media Inc. and is a Director of Virgin Enterprises Limited.
We own and have the right to use registered trademarks, including the exclusive right to use the “Virgin” name and logo in connection with our corporate activities and in connection with the activities of our consumer business under license from Virgin Enterprises Limited. This license with Virgin Enterprises Limited is for a 30-year term and exclusive to us within the U.K. and Ireland. The license entitles us to use the “Virgin” name for the TV, broadband internet, telephone and mobile phone services we provide to our residential customers, as well as the acquisition and branding of sports, movies and other premium television content and the sale of certain communications equipment, such as set top boxes and cable modems. Our license agreement provides for an annual royalty of 0.25% of certain consumer revenues, subject to a minimum annual royalty of £8.5 million. As part of the agreement, we have the right to adopt,
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Note 10-Related Party Transactions (continued)
and have adopted, a company name for our parent, Virgin Media Inc., over which together with the name “Virgin Media”, we retain worldwide exclusivity. Under a related agreement, Virgin Enterprises Limited has the right to propose a candidate to fill a seat on Virgin Media Inc.’s Board of Directors. Pursuant to this right, Virgin Enterprises Limited proposed Gordon McCallum who was appointed to Virgin Media Inc.’s Board of Directors.
During the first quarter of 2010, ntl:Telewest Business announced that it would rebrand using the Virgin trade marks to “Virgin Media Business”. Virgin Media has entered into a trade mark license with Virgin Enterprises Ltd under which an annual royalty is payable of 0.25% of revenues from our business segment, subject to a minimum payment of £1.5 million.
During the years ended December 31, 2012, 2011 and 2010, respectively, we incurred expenses of £10.2 million, £10.1 million, and £10.1 million for charges in respect of brand licensing and promotion of which £5.1 million and £5.0 million was payable at December 31, 2012 and 2011, respectively.
Other Virgin Companies
As a licensee of the “Virgin” brand name, we participate in mutually beneficial activities with other Virgin companies. These arrangements are in the ordinary course of business and believed to be on arm’s length terms.
UKTV Joint Ventures
Through our wholly owned subsidiary, Flextech Broadband Limited, we owned a 50% equity investment in the UKTV joint venture companies until September 30, 2011, when the sale of UKTV was completed. We have therefore identified the UKTV joint venture companies as related parties to us for the period to September 30, 2011. We also carry the UKTV channels in our pay television packages available to our customers.
We pay UKTV for purchases of television programming rights. During the years ended December 31, 2011 and 2010, the net expense recognized in respect to these transactions through the consolidated statement of comprehensive income totaled £24.4 million and £24.8 million, respectively.
During the years ended December 31, 2011 and 2010, we received cash payments from UKTV for loan principal payments, interest, dividends and consortium tax relief totaling £34.0 million and £34.4 million, respectively.
Note 11-Commitments and Contingent Liabilities
At December 31, 2012, we were committed to pay £1,369.4 million for equipment and services, exclusive of capital and operating leases. This amount includes £514.4 million for operations and maintenance contracts and other commitments from January 1, 2014 to 2019. The aggregate amount of the fixed and determinable portions of these obligations for the succeeding five fiscal years and thereafter is as follows (in millions):
Purchase obligations in the table above represent amounts payable under fixed or minimum guaranteed commitments, and therefore do not represent the total fees that are expected to be paid under certain programming contracts where amounts payable are generally based on the number of customers receiving the programming
This table excludes £667.7 million of accounts payable and accrued liabilities as at December 31, 2012 which will be paid in 2013.
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Note 11-Commitments and Contingent Liabilities (continued)
We are involved in lawsuits, claims, investigations and proceedings, consisting of intellectual property, commercial, employee and employee benefits which arise in the ordinary course of our business. In accordance with the Contingencies Topic of the FASB ASC, we recognize a provision for a liability when management believes that it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. We believe we have adequate provisions for any such matters. We review these provisions at least quarterly and adjust these provisions to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Additionally, when we believe it is at least reasonably possible that a liability has been incurred in excess of any recorded liabilities we provide an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made. While litigation is inherently unpredictable, we believe that we have valid defenses with respect to legal matters pending against us.
Our revenue generating activities are subject to VAT. During the second quarter of 2011, we reached an agreement with the U.K. tax authorities regarding our VAT treatment of certain of these activities. The U.K. tax authorities provided us with a refund of £81.5 million, which was collected during the second quarter of 2011, and £77.6 million of which is included in interest income and other, net in the consolidated statement of comprehensive income for the year ended December 31, 2011.
Our VAT treatment of certain other revenue generating activities remains subject to challenge by the U.K. tax authorities. As a result, we have estimated contingent losses totaling £31.9 million as of December 31, 2012 that are not accrued for, as we deem them to be reasonably possible, but not probable, of resulting in a liability. We currently expect an initial hearing on these matters to take place in 2013.
Our banks have provided guarantees in the form of stand by letters of credit on our behalf as part of our contractual obligations. The amount of commitment expires over the following periods (in millions):
Note 12-Industry Segments
VMIH and VMIL are not managed separately from Virgin Media and financial information is only prepared and reviewed by the chief operating decision maker, or CODM, of Virgin Media, who is also the CODM of VMIH and VMIL, at the consolidated Virgin Media level. Virgin Media’s segments are based on its method of internal reporting along with criteria used by its chief executive officer, who is its CODM, to evaluate segment performance and make capital allocation decisions. Virgin Media has two reporting segments, Consumer and Business, as described below:
Virgin Media’s Consumer segment is its largest segment, consisting of the distribution of television programming, broadband and fixed line telephony services to residential customers on its cable network, the provision of broadband and fixed line telephone services to residential customers outside of its cable network, and the provision of mobile telephony and broadband to residential customers.
Virgin Media’s Business segment comprises its operations carried out through Virgin Media Business, which provides a complete portfolio of voice, data and internet solutions to leading businesses, public sector organizations and service providers in the U.K.
Segment contribution, which is operating income before network operating costs, corporate costs, depreciation, amortization, goodwill and intangible asset impairments and restructuring and other charges, is management’s measure of segment profit. Segment contribution excludes the impact of certain costs and expenses that are not directly
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
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COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 12-Industry Segments
attributable to the reporting segments, such as the costs of operating the network, corporate costs and depreciation and amortization. Restructuring and other charges, and goodwill and intangible asset impairments are excluded from segment contribution as management believes they are not characteristic of our underlying business operations. Assets are reviewed on a consolidated basis and are not allocated to segments for management reporting since the primary asset of the business is the cable network infrastructure, which is shared by Virgin Media’s Consumer and Business segments.
Segment information for the years ended December 31, 2012, 2011 and 2010 was as follows (in millions):
The reconciliation of total segment contribution to our consolidated operating income and net income (loss) is as follows (in millions):
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
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COMBINED NOTED TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 12-Industry Segments (continued)
1) Interest expense represents the total of interest expense and interest expense to group companies.
2) Interest income and other, net represents the total of interest income and other, net and interest income from group companies
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
VIRGIN MEDIA INVESTMENTS LIMITED AND SUBSIDIARIES
COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 13-Subsequent Events
Merger agreement with Liberty Global, Inc.
On February 5, 2013, Virgin Media Inc, or VMI, entered in to a Merger Agreement with Liberty Global, Inc., or Liberty Global, and certain of its direct or indirect wholly-owned subsidiaries, or the Merger Subsidiaries. Under the terms of the Merger Agreement, VMI have agreed, through a series of intermediate steps and transactions, to be acquired by Liberty Global and merge into one of the Merger Subsidiaries. If consummated, the merger will result in both Liberty Global and VMI becoming directly owned by a new U.K. public limited company, or the Ultimate Parent, listed on Nasdaq, the common stock of which will in turn be held by Liberty Global and Virgin Media Shareholders. We will continue to operate under the Virgin Media brand in the U.K..
Under the Merger Agreement, we have agreed to use our reasonable best efforts to carry on our business consistent with past practice and preserve intact our business organization and commercial goodwill from the date of the Merger Agreement until either the merger is consummated or the Merger Agreement is terminated. In addition, during this period we have undertaken covenants that place certain restrictions on us, and our subsidiaries', ability to, among other things, dispose of material properties or assets, make unbudgeted capital expenditures, acquire substantial assets, make substantial investments, increase the salary of certain of our employees or directors, pay certain bonuses or incentive compensation, grant new equity or non-equity based compensation awards, hire new employees, redeem common stock or other equity interests, declare or pay dividends or make other distributions in respect of our capital stock, other than a quarterly dividend of up to $0.04 per share, incur or otherwise become liable for material indebtedness, enter into certain transactions with related parties or enter into new material contracts, in each case, other than in the ordinary course of business, pursuant to certain exceptions and baskets set forth in the Merger Agreement or unless Liberty Global consents in writing to the taking of any such action. If we fail to comply with these restrictions in all material respects, unless waived by Liberty Global, the Merger Agreement could be terminated or the merger not consummated.
The consummation of the merger is subject to regulatory approval, the affirmative approval of our shareholders and those of Liberty Global, and other customary closing conditions. In addition, the Merger Agreement will terminate if, prior to the consummation of the merger, we enter into an acquisition agreement with respect to a superior proposal and pay an applicable termination fee of up to $470 million, or if the merger is not consummated on or prior to October 5, 2013, which is the eight month anniversary of the date of signature of the Merger Agreement, or January 5, 2014 if extended for certain reasons to the eleven month anniversary. The Merger Agreement also includes certain other events of termination and certain other termination fee and expense provisions.
At the effective time of the Merger, pursuant to the Merger Agreement, each share of our common stock issued and outstanding immediately prior to the effective time (excluding shares held by ourselves or our subsidiaries in treasury and dissenting shares in accordance with Delaware law) will be converted into the right to receive (i) 0.2582 Series A shares of the Ultimate Parent, (ii) 0.1928 Series C shares of the Ultimate Parent and (iii) $17.50 per share in cash. Based on our fully-diluted shares outstanding of 335 million as of December 31, 2012, we expect that our shareholders will own approximately 36% of the shares outstanding of the Ultimate Parent and have approximately 26% of the voting rights.
The aggregate cash portion of the merger consideration is expected to be $6.1 billion, $2.7 billion of which Liberty Global will finance from its own cash reserves and $3.4 billion of which Liberty Global will raise as bank debt and in the capital markets, which, if the merger is consummated, will, together with debt raised to replace certain of our existing facilities, be assumed by us and result in an increase to our overall level of debt.
VIRGIN MEDIA INVESTMENT HOLDINGS LIMITED AND SUBSIDIARIES
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COMBINED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)
Note 13-Subsequent Events (continued)
Financing implications of the Merger on our existing debt
Consummation of the merger would represent a change of control event under the terms of the relevant indentures of all of the senior secured notes and senior notes issued by Virgin Media Secured Finance PLC, or VMSF, and Virgin Media Finance PLC, or VMF, and obligate us to offer the noteholders the right to put their notes back to us at 101% of the principal amount plus accrued interest. At the request of Liberty Global in order to facilitate the financing by Liberty Global of the merger, on February 6, 2013, VMSF and VMF commenced consent solicitations in respect of some of these notes for the noteholders to preemptively waive this obligation and to seek consents to effect certain other proposed amendments in relation to the Transactions.
We have not solicited consents in relation to our 5.25% Senior Notes due 2022, our 4.875% Senior Notes due 2022 and our 5.125% Senior Notes due 2022 and will be required to repurchase these Notes within 30 days of the consummation of the Merger.
Upon consummation of the merger our convertible notes will have the right to convert and receive the same consideration that is received in the merger as the holders of Common Stock. The convertible holders will also be offered the right to put their notes to the company at 100% of the principal amount plus accrued interest.
SIGNATURES
Pursuant to the requirements of Section13 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.
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.
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