CITIZENS COMMUNICATIONS COMPANY
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2007
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2007
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or
--
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from _________to__________
Commission file number: 001-11001
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CITIZENS COMMUNICATIONS COMPANY
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(Exact name of registrant as specified in its charter)
Delaware 06-0619596
------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
3 High Ridge Park
Stamford, Connecticut 06905
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(Address of principal executive offices) (Zip Code)
(203) 614-5600
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(Registrant's telephone number, including area code)
N/A
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ----
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer [X] Accelerated filer [] Non-accelerated filer []
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes No X
--- -----
The number of shares outstanding of the registrant's Common Stock as of July 27,
2007 was 338,434,462.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Index
Page No.
--------
Part I. Financial Information (Unaudited)
Financial Statements
Consolidated Balance Sheets at June 30, 2007 and December 31, 2006 2
Consolidated Statements of Operations for the three months ended June 30, 2007 and 2006 3
Consolidated Statements of Operations for the six months ended June 30, 2007
and 2006 4
Consolidated Statements of Shareholders' Equity for the year ended
December 31, 2006 and the six months ended June 30, 2007 5
Consolidated Statements of Comprehensive Income for the three and
six months ended June 30, 2007 and 2006 5
Consolidated Statements of Cash Flows for the six months ended June 30, 2007 and 2006 6
Notes to Consolidated Financial Statements 7
Management's Discussion and Analysis of Financial Condition and Results of Operations 25
Quantitative and Qualitative Disclosures about Market Risk 39
Controls and Procedures 39
Part II. Other Information
Legal Proceedings 40
Risk Factors 41
Unregistered Sales of Equity Securities and Use of Proceeds 41
Submission of Matters to a Vote of Security Holders 42
Other Information 42
Exhibits 43
Signature 44
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
--------------------
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
($ in thousands)
(Unaudited)
June 30, 2007 December 31, 2006
------------------------- ------------------------
ASSETS
------
Current assets:
Cash and cash equivalents $ 418,100 $ 1,041,106
Accounts receivable, less allowances of $24,195 and $108,537, respectively 224,308 187,737
Other current assets 53,067 44,150
------------------------ -------------------------
Total current assets 695,475 1,272,993
Property, plant and equipment, net 3,300,549 2,983,504
Goodwill, net 2,486,642 1,917,751
Other intangibles, net 849,645 432,353
Investments 21,207 16,474
Other assets 174,230 168,130
------------------------- -------------------------
Total assets $ 7,527,748 $ 6,791,205
========================= =========================
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Current liabilities:
Long-term debt due within one year $ 32,774 $ 39,271
Accounts payable and other current liabilities 404,599 386,372
------------------------- -------------------------
Total current liabilities 437,373 425,643
Deferred income taxes 759,538 514,130
Other liabilities 402,485 332,645
Long-term debt 4,698,583 4,460,755
Shareholders' equity:
Common stock, $0.25 par value (600,000,000 authorized shares; 340,250,000
and 322,265,000 outstanding, respectively, 349,456,000 issued at
June 30, 2007 and 343,956,000 issued at December 31, 2006) 87,364 85,989
Additional paid-in capital 1,287,312 1,207,399
Retained earnings 72,090 134,705
Accumulated other comprehensive loss, net of tax (78,755) (81,899)
Treasury stock (138,242) (288,162)
------------------------- -------------------------
Total shareholders' equity 1,229,769 1,058,032
------------------------- -------------------------
Total liabilities and shareholders' equity $ 7,527,748 $ 6,791,205
========================= =========================
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
2
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED JUNE 30, 2007 AND 2006
($ in thousands, except for per-share amounts)
(Unaudited)
2007 2006
-------------------- -------------------
Revenue $ 578,826 $ 506,912
Operating expenses:
Network access expenses 51,878 38,402
Other operating expenses 215,188 179,500
Depreciation and amortization 140,462 119,552
-------------------- -------------------
Total operating expenses 407,528 337,454
-------------------- -------------------
Operating income 171,298 169,458
Investment and other income (loss), net (6,517) 65,363
Interest expense 98,649 85,341
-------------------- -------------------
Income from continuing operations before income taxes 66,132 149,480
Income tax expense 25,573 54,734
-------------------- -------------------
Income from continuing operations 40,559 94,746
Discontinued operations (see Note 6):
Income from discontinued operations - 11,482
Income tax expense - 4,526
-------------------- -------------------
Income from discontinued operations - 6,956
-------------------- -------------------
Net income available for common shareholders $ 40,559 $ 101,702
==================== ===================
Basic income per common share:
Income from continuing operations $ 0.12 $ 0.30
Income from discontinued operations - 0.02
-------------------- -------------------
Net income per common share $ 0.12 $ 0.32
==================== ===================
Diluted income per common share:
Income from continuing operations $ 0.12 $ 0.29
Income from discontinued operations - 0.02
-------------------- -------------------
Net income per common share $ 0.12 $ 0.31
==================== ===================
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
3
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE SIX MONTHS ENDED JUNE 30, 2007 AND 2006
($ in thousands, except for per-share amounts)
(Unaudited)
2007 2006
-------------------- -------------------
Revenue $ 1,134,973 $ 1,013,773
Operating expenses:
Network access expenses 102,671 78,620
Other operating expenses 405,059 366,801
Depreciation and amortization 262,643 241,556
-------------------- -------------------
Total operating expenses 770,373 686,977
-------------------- -------------------
Operating income 364,600 326,796
Investment and other income (loss), net 3,500 64,012
Interest expense 192,613 170,734
-------------------- -------------------
Income from continuing operations before income taxes 175,487 220,074
Income tax expense 67,261 81,341
-------------------- -------------------
Income from continuing operations 108,226 138,733
Discontinued operations (see Note 6):
Income from discontinued operations - 21,940
Income tax expense - 8,488
-------------------- -------------------
Income from discontinued operations - 13,452
-------------------- -------------------
Net income available for common shareholders $ 108,226 $ 152,185
==================== ===================
Basic income per common share:
Income from continuing operations $ 0.33 $ 0.43
Income from discontinued operations - 0.04
-------------------- -------------------
Net income per common share $ 0.33 $ 0.47
==================== ===================
Diluted income per common share:
Income from continuing operations $ 0.32 $ 0.43
Income from discontinued operations - 0.04
-------------------- -------------------
Net income per common share $ 0.32 $ 0.47
==================== ===================
The accompanying Notes are an integral part of these
Consolidated Financial Statements.
4
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEAR ENDED DECEMBER 31, 2006 AND THE SIX MONTHS ENDED JUNE 30, 2007
($ in thousands)
(Unaudited)
Accumulated
Common Stock Additional Other Treasury Stock Total
------------------- Paid-In Retained Comprehensive ------------------- Shareholders'
Shares Amount Capital Earnings Loss Shares Amount Equity
--------- --------- ------------- ---------- ------------- -------- ---------- -----------
Balance January 1, 2006 343,956 $85,989 $ 1,374,610 $ (85,344) $(123,242) (15,788) $ (210,204) $1,041,809
Cumulative effect adjustment - - - 36,392 - - - 36,392
Stock plans - - (1,875) - - 2,908 38,793 36,918
Conversion of EPPICS - - (2,563) - - 1,389 18,488 15,925
Dividends on common stock of
$1.00 per share - - (162,773) (160,898) - - - (323,671)
Shares repurchased - - - - - (10,200) (135,239) (135,239)
Net income - - - 344,555 - - - 344,555
Pension liability adjustment, after
adoption of SFAS No. 158, net of
taxes - - - - (83,634) - - (83,634)
Other comprehensive income, net of
tax and reclassifications
adjustments - - - - 124,977 - - 124,977
--------- --------- ------------- ---------- ------------ ---------- ------------ -----------
Balance December 31, 2006 343,956 85,989 1,207,399 134,705 (81,899) (21,691) (288,162) 1,058,032
Stock plans - - 546 - - 1,691 14,066 14,612
Acquisition of Commonwealth 5,500 1,375 77,945 - - 12,632 167,995 247,315
Conversion of EPPICS - - (535) - - 286 3,814 3,279
Conversion of Commonwealth Notes - - 1,957 - - 2,509 34,775 36,732
Dividends on common stock of
$0.50 per share - - - (170,841) - - - (170,841)
Shares repurchased - - - - - (4,633) (70,730) (70,730)
Net income - - - 108,226 - - - 108,226
Other comprehensive income, net of
tax and reclassifications
adjustments - - - - 3,144 - - 3,144
--------- --------- ------------- ---------- ------------ ---------- ------------ -----------
Balance June 30, 2007 349,456 $87,364 $ 1,287,312 $ 72,090 $ (78,755) (9,206) $ (138,242) $1,229,769
========= ========= ============= ========== ============ ========== ============ ===========
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2007 AND 2006
($ in thousands)
(Unaudited)
For the three months ended June 30, For the six months ended June 30,
------------------------------------------- --------------------------------------
2007 2006 2007 2006
--------------------- ------------------- ----------------- ------------------
Net income $ 40,559 $ 101,702 $ 108,226 $ 152,185
Other comprehensive income(loss), net
of tax and reclassifications adjustments 3,164 2 3,144 10
--------------------- ------------------- ----------------- ------------------
Total comprehensive income $ 43,723 $ 101,704 $ 111,370 $ 152,195
===================== =================== ================= ==================
The accompanying Notes are an integral part of these Consolidated
Financial Statements.
5
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2007 AND 2006
($ in thousands)
(Unaudited)
2007 2006
--------------------- --------------------
Cash flows provided by (used in) operating activities:
Net income $ 108,226 $ 152,185
Deduct: Income from discontinued operations, net of tax - (13,452)
Adjustments to reconcile income to net cash provided by
operating activities:
Depreciation and amortization expense 262,643 241,556
Stock based compensation expense 5,445 5,335
Investment gain - (61,428)
Other non-cash adjustments 4,760 5,065
Deferred income taxes 28,576 78,153
Change in accounts receivable 4,232 7,844
Change in accounts payable and other liabilities (71,248) (37,763)
Change in other current assets 6,736 2,974
--------------------- --------------------
Net cash provided by continuing operating activities 349,370 380,469
Cash flows from investing activities:
Capital expenditures (111,769) (98,284)
Cash paid for Commonwealth (net of cash acquired) (657,610) -
Other assets (purchased) distributions received, net 3,851 62,244
--------------------- --------------------
Net cash used by investing activities (765,528) (36,040)
Cash flows from financing activities:
Receipt (payment) of customer advances for
construction and contributions in aid of construction, net (506) 17
Long-term debt borrowings 950,000 -
Long-term debt payments (914,516) (198,126)
Financing costs paid (11,727) -
Issuance of common stock 11,472 12,756
Common stock repurchased (70,730) (135,239)
Dividends paid (170,841) (162,773)
--------------------- --------------------
Net cash used by financing activities (206,848) (483,365)
Cash flows of discontinued operations:
Operating cash flows - 16,880
Investing cash flows - (5,545)
Financing cash flows - -
--------------------- --------------------
- 11,335
Decrease in cash and cash equivalents (623,006) (127,601)
Cash and cash equivalents at January 1, 1,041,106 268,917
--------------------- --------------------
Cash and cash equivalents at June 30, $ 418,100 $ 141,316
===================== ====================
Cash paid during the period for:
Interest $ 176,558 $ 169,841
Income taxes $ 47,426 $ 2,871
Non-cash investing and financing activities:
Change in fair value of interest rate swaps $ (3,628) $ (15,100)
Conversion of EPPICS $ 3,279 $ 14,249
Conversion of Commonwealth Notes $ 36,732 $ -
Debt-for-debt exchange, net $ - $ (70)
Shares issued for Commonwealth acquisition $ 247,315 $ -
The accompanying Notes are an integral part of these Consolidated
Financial Statements.
6
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Summary of Significant Accounting Policies:
-------------------------------------------
(a) Basis of Presentation and Use of Estimates:
-------------------------------------------
Citizens Communications Company and its subsidiaries are referred to
as "we," "us," "our," or the "Company" in this report. Our unaudited
consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of
America (GAAP) and should be read in conjunction with the consolidated
financial statements and notes included in our Annual Report on Form
10-K for the year ended December 31, 2006. Certain reclassifications
of balances previously reported have been made to conform to the
current presentation. All significant intercompany balances and
transactions have been eliminated in consolidation. These unaudited
consolidated financial statements include all adjustments (consisting
of normal recurring accruals) considered necessary to present fairly
the results for the interim periods shown.
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions which affect the
reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the
reporting period. Actual results may differ from those estimates.
Estimates and judgments are used when accounting for allowance for
doubtful accounts, impairment of long-lived assets, intangible assets,
depreciation and amortization, employee benefit plans, income taxes,
contingencies and pension and postretirement benefits expenses among
others. Certain information and footnote disclosures have been
excluded and/or condensed pursuant to Securities and Exchange
Commission rules and regulations. The results of the interim periods
are not necessarily indicative of the results for the full year.
(b) Cash Equivalents:
-----------------
We consider all highly liquid investments with an original maturity of
three months or less to be cash equivalents.
(c) Revenue Recognition:
--------------------
Revenue is recognized when services are provided or when products are
delivered to customers. Revenue that is billed in advance includes:
monthly recurring network access services, special access services and
monthly recurring local line charges. The unearned portion of this
revenue is initially deferred as a component of other liabilities on
our consolidated balance sheet and recognized in revenue over the
period that the services are provided. Revenue that is billed in
arrears includes: non-recurring network access services, switched
access services, non-recurring local services and long-distance
services. The earned but unbilled portion of this revenue is
recognized in revenue in our statement of operations and accrued in
accounts receivable in the period that the services are provided.
Excise taxes are recognized as a liability when billed. Installation
fees and their related direct and incremental costs are initially
deferred and recognized as revenue and expense over the average term
of a customer relationship. We recognize as current period expense the
portion of installation costs that exceeds installation fee revenue.
The Company collects various taxes from its customers and subsequently
remits such funds to governmental authorities. Substantially all of
these taxes are recorded through the consolidated balance sheet and
presented on a net basis in our consolidated statements of operations.
We also collect Universal Service Fund ("USF") surcharges from
customers (primarily federal USF) which have been recorded on a gross
basis in our consolidated statements of operations and have been
included in revenues and other operating expenses at $9.9 million and
$11.1 million for the three months ended June 30, 2007 and 2006,
respectively, and at $17.2 million and $21.3 million for the six
months ended June 30, 2007 and 2006, respectively.
(d) Property, Plant and Equipment:
------------------------------
Property, plant and equipment are stated at original cost or fair
market value for our acquired properties, including capitalized
interest. Maintenance and repairs are charged to operating expenses as
incurred. The gross book value of routine property, plant and
equipment retired is charged against accumulated depreciation.
7
PART I. FINANCIAL INFORMATION (Continued)
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
(e) Goodwill and Other Intangibles:
-------------------------------
Intangibles represent the excess of purchase price over the fair value
of identifiable tangible assets acquired. We undertake studies to
determine the fair values of assets and liabilities acquired and
allocate purchase prices to assets and liabilities, including
property, plant and equipment, goodwill and other identifiable
intangibles. We annually (during the fourth quarter) examine the
carrying value of our goodwill and trade name to determine whether
there are any impairment losses.
Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill
and Other Intangible Assets," requires that intangible assets with
estimated useful lives be amortized over those lives and be reviewed
for impairment in accordance with SFAS No. 144, "Accounting for
Impairment or Disposal of Long-Lived Assets," to determine whether any
changes to these lives are required. We periodically reassess the
useful life of our intangible assets to determine whether any changes
to those lives are required.
(f) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed
----------------------------------------------------------------------
of:
---
We review long-lived assets to be held and used and long-lived assets
to be disposed of, including intangible assets with estimated useful
lives, for impairment whenever events or changes in circumstances
indicate that the carrying amount of such assets may not be
recoverable. Recoverability of assets to be held and used is measured
by comparing the carrying amount of the asset to the future
undiscounted net cash flows expected to be generated by the asset.
Recoverability of assets held for sale is measured by comparing the
carrying amount of the assets to their estimated fair market value. If
any assets are considered to be impaired, the impairment is measured
by the amount by which the carrying amount of the assets exceeds the
estimated fair value.
(g) Derivative Instruments and Hedging Activities:
----------------------------------------------
We account for derivative instruments and hedging activities in
accordance with SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," as amended. SFAS No. 133, as amended,
requires that all derivative instruments, such as interest rate swaps,
be recognized in the financial statements and measured at fair value
regardless of the purpose or intent of holding them.
We have interest rate swap arrangements related to a portion of our
fixed rate debt. These hedge strategies satisfy the fair value hedging
requirements of SFAS No. 133, as amended. As a result, the fair value
of the swaps is carried on the consolidated balance sheets in other
liabilities and the related hedged liabilities are also adjusted to
fair value by the same amount.
(h) Stock Plans:
------------
We have various employee stock-based compensation plans. Awards under
these plans are granted to eligible officers, management employees,
non-management employees and non-employee directors. Awards may be
made in the form of incentive stock options, non-qualified stock
options, stock appreciation rights, restricted stock or other
stock-based awards. We have no awards with market or performance
conditions. Our general policy is to issue shares upon the grant of
restricted shares and exercise of options from treasury.
On January 1, 2006, we adopted the provisions of SFAS No. 123 (revised
2004), "Share-Based Payment" (SFAS No. 123R) and elected to use the
modified prospective transition method. The modified prospective
transition method requires that compensation cost be recognized in the
financial statements for all awards granted after the date of adoption
as well as for existing awards for which the requisite service had not
been rendered as of the date of adoption. Estimated compensation cost
for awards that are outstanding at the effective date will be
recognized over the remaining service period using the compensation
cost calculated for pro forma disclosure purposes. Prior periods have
not been restated.
On November 10, 2005, the Financial Accounting Standards Board (FASB)
issued FASB Staff Position SFAS No. 123R-3, "Transition Election
Related to Accounting for Tax Effects of Share-Based Payment Awards."
We elected to adopt the alternative transition method provided for
calculating the tax effects of share-based compensation pursuant to
8
SFAS No. 123R. The alternative transition method includes a simplified
method to establish the beginning balance of the additional paid-in
capital pool (APIC pool) related to the tax effects of employee
share-based compensation, which is available to absorb tax
deficiencies recognized subsequent to the adoption of SFAS No. 123R.
In accordance with the adoption of SFAS No. 123R, we recorded
stock-based compensation expense for the cost of stock options,
restricted shares and stock units issued under our stock plans
(together, Stock-Based Awards). Stock-based compensation expense was
$2.0 million and $2.7 million for the three months ended June 30, 2007
and 2006, respectively, and $5.4 million and $5.3 million for the six
months ended June 30, 2007 and 2006, respectively.
The compensation cost recognized is based on awards ultimately
expected to vest. SFAS No. 123R requires forfeitures to be estimated
and revised, if necessary, in subsequent periods if actual forfeitures
differ from those estimates.
Prior to the adoption of SFAS No. 123R, we applied Accounting
Principles Board Opinion (APB) No. 25 and related interpretations to
account for our stock plans resulting in the use of the
intrinsic-value based method to value the stock. Under APB No. 25, we
were not required to recognize compensation expense for the cost of
stock options issued under our stock plans.
(i) Net Income Per Common Share Available for Common Shareholders:
--------------------------------------------------------------
Basic net income per common share is computed using the weighted
average number of common shares outstanding during the period being
reported on. Except when the effect would be antidilutive, diluted net
income per common share reflects the dilutive effect of the assumed
exercise of stock options using the treasury stock method at the
beginning of the period being reported on as well as common shares
that would result from the conversion of convertible preferred stock
(EPPICS) and convertible notes. In addition, the related interest on
debt (net of tax) is added back to income since it would not be paid
if the debt was converted to common stock.
(2) Recent Accounting Literature and Changes in Accounting Principles:
------------------------------------------------------------------
Accounting for Uncertainty in Income Taxes
------------------------------------------
In July 2006, the FASB issued FASB Interpretation No. (FIN) 48, "Accounting
for Uncertainty in Income Taxes." Among other things, FIN No. 48 requires
applying a "more likely than not" threshold to the recognition and
derecognition of uncertain tax positions either taken or expected to be
taken in the Company's income tax returns. We adopted the provisions of FIN
No. 48 in the first quarter of 2007. The total amount of our FIN No. 48 tax
liability for tax positions that may not be sustained under a "more likely
than not" threshold is reflected on the Company's balance sheet as of the
date of adoption at $44.7 million and amounts to $47.5 million as of June
30, 2007. This amount includes an accrual for interest in the amount of
$5.2 million as of June 30, 2007. These balances include amounts of $9.0
million and $1.4 million for total FIN No. 48 tax liabilities and accrued
interest, respectively, pursuant to the Company's acquisition of
Commonwealth Telephone Enterprises, Inc., completed in March 2007. The
amount of our total FIN No. 48 tax liabilities reflected above that would
positively impact the calculation of our effective income tax rate, if our
tax positions are sustained, is $23.7 million as of June 30, 2007.
The Company's policy regarding the classification of interest and penalties
is to include these amounts as a component of income tax expense. This
treatment of interest and penalties is consistent with prior periods. We
have recognized in our year to date statement of operations additional
interest in the amount of $0.5 million. We do not expect that our balances
with respect to our uncertain tax positions will significantly increase or
decrease within the next 12 months. We are subject to income tax
examinations generally for the years 2003 forward for both our federal and
state filing jurisdictions.
How Taxes Collected from Customers and Remitted to Governmental Authorities
---------------------------------------------------------------------------
Should be Presented in the Income Statement
-------------------------------------------
In June 2006, the FASB issued EITF Issue No. 06-3, "How Taxes Collected
from Customers and Remitted to Governmental Authorities Should be Presented
in the Income Statement," which requires disclosure of the accounting
policy for any tax assessed by a governmental authority that is directly
imposed on a revenue-producing transaction, that is Gross versus Net
presentation. EITF No. 06-3 is effective for periods beginning after
December 15, 2006. We adopted the disclosure requirements of EITF No. 06-3
commencing January 1, 2007.
9
Accounting for Purchases of Life Insurance
------------------------------------------
In September 2006, the FASB reached consensus on the guidance provided by
EITF No. 06-5, "Accounting for Purchases of Life Insurance-Determining the
Amount That Could Be Realized in Accordance with FASB Technical Bulletin
No. 85-4, Accounting for Purchases of Life Insurance." EITF No. 06-5 states
that a policyholder should consider any additional amounts included in the
contractual terms of the insurance policy other than the cash surrender
value in determining the amount that could be realized under the insurance
contract. EITF No. 06-5 also states that a policyholder should determine
the amount that could be realized under the life insurance contract
assuming the surrender of an individual-life by individual-life policy (or
certificate by certificate in a group policy). EITF No. 06-5 is effective
for fiscal years beginning after December 15, 2006. The adoption of the
accounting requirements of EITF No. 06-5 in the first quarter of 2007 had
no impact on our financial position, results of operation or cash flows.
Accounting for Endorsement Split-Dollar Life Insurance Arrangements
-------------------------------------------------------------------
In September 2006, the FASB reached consensus on the guidance provided by
EITF No. 06-4, "Accounting for Deferred Compensation and Postretirement
Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements."
The guidance is applicable to endorsement split-dollar life insurance
arrangements, whereby the employer owns and controls the insurance policy,
that are associated with a postretirement benefit. EITF No. 06-4 requires
that for a split-dollar life insurance arrangement within the scope of the
issue, an employer should recognize a liability for future benefits in
accordance with SFAS No. 106 (if, in substance, a postretirement benefit
plan exists) or Accounting Principles Board Opinion No. 12 (if the
arrangement is, in substance, an individual deferred compensation contract)
based on the substantive agreement with the employee. EITF No. 06-4 is
effective for fiscal years beginning after December 15, 2007. The Company
is currently evaluating the impact the adoption of the standard will have
on the Company's results of operations or financial condition.
Fair Value Measurements
-----------------------
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements,"
which defines fair value, establishes a framework for measuring fair value,
and expands disclosures about fair value measurements. The provisions of
SFAS No. 157 are effective as of the beginning of our 2008 fiscal year. The
Company is currently evaluating the impact that the adoption of the
standard will have on the Company's results of operations or financial
condition.
Fair Value Option for Financial Assets and Financial Liabilities
----------------------------------------------------------------
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities Including an amendment of FASB
Statement No. 115," which permits entities to choose to measure many
financial instruments and certain other items at fair value. The provisions
of SFAS No. 159 are effective as of the beginning of our 2008 fiscal year.
The Company is currently evaluating the impact that the adoption of the
standard will have on the Company's results of operations or financial
condition.
Accounting for Collateral Assignment Split-Dollar Life Insurance
----------------------------------------------------------------
Arrangements
------------
In March 2007, the FASB ratified the consensus reached by the EITF on Issue
No. 06-10, "Accounting for Collateral Assignment Split-Dollar Life
Insurance Arrangements." EITF No. 06-10 provides guidance on an employers'
recognition of a liability and related compensation costs for collateral
assignment split-dollar life insurance arrangements that provide a benefit
to an employee that extends into postretirement periods and the asset in
collateral assignment split-dollar life insurance arrangements. The
effective date of EITF No. 06-10 is for fiscal years beginning after
December 15, 2007. The Company is currently evaluating the impact that the
adoption of the standard will have on the Company's results of operations
or financial condition.
(3) Acquisition of Commonwealth Telephone:
--------------------------------------
On March 8, 2007, we acquired Commonwealth Telephone Enterprises, Inc.
("Commonwealth" or "CTE") in a cash-and-stock taxable transaction, for a
total consideration of approximately $1.1 billion. We paid $798.0 million
in cash ($657.6 million net, after cash acquired), issued common stock with
a value of $247.3 million and had $10.5 million of accrued closing costs at
June 30, 2007.
10
In connection with the acquisition of Commonwealth, we assumed $35.0
million of debt under a revolving credit facility and $191.8 million face
amount of Commonwealth convertible notes (fair value of $209.6 million).
During March 2007, we paid down the $35.0 million credit facility. We have
retired all but $8.5 million of the $191.8 million face amount of
Commonwealth convertible notes as of June 30, 2007. The notes were retired
by the payment of $165.4 million in cash and the issuance of our common
stock valued at $36.7 million. The premium paid of $18.9 million was
recorded as $17.8 million to goodwill and $1.1 million to expense.
We have accounted for the acquisition of Commonwealth as a purchase under
U.S. generally accepted accounting principles. Under the purchase method of
accounting, the assets and liabilities of Commonwealth are recorded as of
the acquisition date, at their respective fair values, and consolidated
with those of Citizens. The reported consolidated financial condition of
Citizens as of June 30, 2007 reflects a preliminary estimated allocation of
these fair values.
The following schedule provides a summary of the purchase price paid by
Citizens in the acquisition of Commonwealth as of June 30, 2007 ($ in
thousands):
Cash paid $ 798,015
Value of Citizens common stock issued 247,315
Accrued closing costs 10,540
-----------------
Total Purchase Price $ 1,055,870
=================
The allocation of the purchase price to assets and liabilities is
preliminary. The estimated purchase price has been allocated to the net
tangible and intangible assets and liabilities acquired as follows ($ in
thousands):
Allocation of estimated purchase price:
Current assets (1) $ 190,361
Property, plant and equipment 387,720
Goodwill 568,891
Other intangibles - customer list 500,000
Other assets 11,234
Current portion of debt (35,000)
Accounts payable and other current liabilities (77,224)
Deferred income taxes (247,208)
Convertible Notes (209,553)
Other liabilities (33,351)
---------------
Total Purchase Price $ 1,055,870
===============
(1) Includes $140.5 million of acquired cash.
The final allocation of the purchase price will be based on the fair values
of the assets acquired and liabilities assumed as determined by third-party
valuation. The actual allocation may differ significantly from the
preliminary allocation.
The following unaudited pro forma financial information presents the
combined results of operations of Citizens and Commonwealth as if the
acquisition had occurred at the beginning of each period presented. The
historical results of the Company include the results of Commonwealth from
the date of acquisition on March 8, 2007. The pro forma information is not
necessarily indicative of what the financial position or results of
operations actually would have been had the acquisition been completed at
the date indicated. In addition, the unaudited pro forma financial
information does not purport to project the future financial position or
operating results of Citizens after completion of the acquisition.
11
For the six months ended
June 30,
------------------------------------------ For the three months ended
2007 2006 June 30, 2006
-------------------- -------------------- --------------------------------
($ in thousands, except per share amounts)
----------------------------------------
Revenue $ 1,197,237 $ 1,177,430 $ 588,378
Operating income $ 376,130 $ 357,481 $ 185,122
Income from continuing operations $ 116,223 $ 157,337 $ 112,022
Income from discontinued operations $ - $ 13,452 $ 6,956
Net income available for common shareholders $ 116,223 $ 170,789 $ 118,978
Basic income per common share:
Income from continuing operations $ 0.35 $ 0.46 $ 0.33
Income from discontinued operations - 0.04 0.02
-------------------- -------------------- ------------------------
Net income per common share $ 0.35 $ 0.50 $ 0.35
==================== ==================== ========================
Diluted income per common share:
Income from continuing operations $ 0.35 $ 0.45 $ 0.33
Income from discontinued operations - 0.04 0.02
-------------------- -------------------- ------------------------
Net income per common share $ 0.35 $ 0.49 $ 0.35
==================== ==================== ========================
(4) Accounts Receivable:
--------------------
The components of accounts receivable, net at June 30, 2007 and December
31, 2006 are as follows:
($ in thousands) June 30, 2007 December 31, 2006
-------------- ---------------------------- ---------------------------
End user $ 223,953 $ 273,828
Other 24,550 22,446
Less: Allowance for doubtful accounts (24,195) (108,537)
---------------------------- ---------------------------
Accounts receivable, net $ 224,308 $ 187,737
============================ ===========================
The Company maintains an allowance for estimated bad debts based on its
estimate of collectibility of its accounts receivable. Bad debt expense,
which is recorded as a reduction of revenue, was $6.7 million and $2.8
million for the three months ended June 30, 2007 and 2006, respectively,
and $11.6 million and $7.2 million for the six months ended June 30, 2007
and 2006, respectively.
Our allowance for doubtful accounts (and "end user" receivables) declined
from December 31, 2006, primarily as a result of the resolution of a
carrier dispute. On March 12, 2007, we entered into a settlement agreement
with a carrier pursuant to which we were paid $37.5 million, resulting in a
favorable impact on our revenue in the first quarter of 2007 and for the
six months ended June 30, 2007 of $38.7 million.
(5) Property, Plant and Equipment, Net:
-----------------------------------
Property, plant and equipment at June 30, 2007 and December 31, 2006 are as
follows:
($ in thousands) June 30, 2007 December 31, 2006
-------------- ---------------------------- ----------------------------
Property, plant and equipment $ 7,153,975 $ 6,685,466
Less: accumulated depreciation (3,853,426) (3,701,962)
---------------------------- ----------------------------
Property, plant and equipment, net $ 3,300,549 $ 2,983,504
============================ ============================
12
Depreciation expense is principally based on the composite group method.
Depreciation expense was $93.4 million and $88.0 million for the three
months ended June 30, 2007 and 2006, respectively, and $180.0 million and
$178.4 million for the six months ended June 30, 2007 and 2006,
respectively.
(6) Discontinued Operations:
------------------------
On July 31, 2006, we sold our CLEC business, Electric Lightwave, LLC (ELI),
for $255.3 million in cash plus the assumption of approximately $4.0
million in capital lease obligations. We recognized a pre-tax gain on the
sale of ELI of approximately $116.7 million. Our after-tax gain on the sale
was $71.6 million. Our cash liability for taxes as a result of the sale is
expected to be approximately $5.0 million due to the utilization of
existing tax net operating losses on both the federal and state level.
In accordance with SFAS No. 144, any component of our business that we
dispose of, or classify as held for sale, that has operations and cash
flows clearly distinguishable from continuing operations for financial
reporting purposes, and that will be eliminated from the ongoing
operations, should be classified as discontinued operations. Accordingly,
we have classified the results of operations of ELI as discontinued
operations in our consolidated statement of operations.
Summarized financial information for ELI is set forth below:
For the three months For the six months
($ in thousands) ended June 30, 2006 ended June 30, 2006
-------------- ----------------------- -----------------------
Revenue $ 43,584 $ 86,078
Operating income $ 11,482 $ 21,940
Income taxes $ 4,526 $ 8,488
Net income $ 6,956 $ 13,452
(7) Other Intangibles:
------------------
Other intangibles at June 30, 2007 and December 31, 2006 are as follows:
($ in thousands) June 30, 2007 December 31, 2006
-------------- ---------------------- -------------------
Customer base - amortizable over 96 months $ 1,494,605 $ 994,605
Trade name - non-amortizable 122,058 122,058
---------------------- -------------------
Other intangibles 1,616,663 1,116,663
Less: Accumulated amortization (767,018) (684,310)
---------------------- -------------------
Total other intangibles, net $ 849,645 $ 432,353
====================== ===================
Amortization expense was $47.2 million and $31.6 million for the three
months ended June 30, 2007 and 2006, respectively, and $82.7 million and
$63.2 million for the six months ended June 30, 2007 and 2006,
respectively. Amortization expense for the three and six months ended June
30, 2007 is comprised of $31.6 million and $63.2 million, respectively, for
our "base Citizens business" and $15.6 million and $19.5 million,
respectively, for the customer base acquired in the Commonwealth
acquisition. On a preliminary basis, $500.0 million has been allocated to
the customer base acquired in the Commonwealth acquisition, with
amortization to be based on an eight-year life ($62.5 million annually).
13
(8) Long-Term Debt:
---------------
The activity in our long-term debt from December 31, 2006 to June 30, 2007
is as follows:
Six months ended June 30, 2007
------------------------------------------------------------
Assumed Interest
From Rate* at
December 31, New Commonwealth Interest Reclassification/ June 30, June 30,
($ in thousands) 2006 Payments Borrowings Acquisition Rate Swap Other 2007 2007
---------------- ----- -------- ---------- ----------- --------- ----- ----- ----
FIXED RATE
Rural Utilities Service
Loan Contracts $ 21,886 $ (3,877) $ - $ - $ - $ - $ 18,009 5.99%
Senior Unsecured Debt 4,435,018 (896,399) 950,000 226,779 (3,628) (17,833) 4,693,937 8.06%
EPPICS 17,860 - - - - (3,279) 14,581 5.00%
Industrial Development 58,140 (14,240) - - - - 43,900 5.66%
Revenue Bonds ----------- --------- --------- ---------- -------- --------- -----------
TOTAL LONG-TERM DEBT $ 4,532,904 $(914,516) $ 950,000 $ 226,779 $ (3,628) $ (21,112) $ 4,770,427 8.02%
----------- ========= ========= ========== ======== ========= -----------
Less: Debt Discount (32,878) (39,070)
Less: Current Portion (39,271) (32,774)
----------- -----------
$ 4,460,755 $ 4,698,583
=========== ===========
* Interest rate includes amortization of debt issuance costs, debt premiums or
discounts. The interest rates for Rural Utilities Service Loan Contracts, Senior
Unsecured Debt, and Industrial Development Revenue Bonds represent a weighted
average of multiple issuances.
For the six months ended June 30, 2007, we retired an aggregate principal
amount of $935.6 million of debt, including $3.3 million of 5% Company
Obligated Mandatorily Redeemable Convertible Preferred Securities due 2036
(EPPICS) and $17.8 million of 3.25% Commonwealth convertible notes that
were converted into our common stock. As further described below, we
temporarily borrowed and repaid $200.0 million during the month of March
2007, utilized to temporarily fund our acquisition of Commonwealth.
Although this borrowing does not appear in our December 31, 2006 or June
30, 2007 balance sheet, the borrowing and repayment are shown gross in the
above table.
During the first quarter of 2006, we entered into two debt-for-debt
exchanges of our debt securities. As a result, $47.5 million of our 7.625%
notes due 2008 were exchanged for approximately $47.4 million of our 9.00%
notes due 2031. The 9.00% notes are callable on the same general terms and
conditions as the 7.625% notes that were exchanged. No cash was exchanged
in these transactions. However, a non-cash pre-tax loss of approximately
$2.4 million was recognized in accordance with EITF No. 96-19, "Debtor's
Accounting for a Modification or Exchange of Debt Instruments," which is
included in investment and other income (loss), net for the six months
ended June 30, 2006.
In connection with the acquisition of Commonwealth, we assumed $35.0
million of debt under a revolving credit facility and approximately $191.8
million face amount of Commonwealth convertible notes (fair value of
approximately $209.6 million). During March 2007 we paid down the $35.0
million credit facility, and through June 30, 2007 we have retired
approximately $183.3 million face amount (for which we paid $165.4 million
in cash and $36.7 million in common stock) of the convertible notes
(premium paid of $18.9 million was recorded as $17.8 million to goodwill
and $1.1 million to expense), resulting in a remaining outstanding balance
of $8.5 million as of June 30, 2007.
On March 23, 2007, we issued in a private placement an aggregate $300.0
million principal amount of 6.625% Senior Notes due 2015 and $450.0 million
principal amount of 7.125% Senior Notes due 2019. Proceeds from the sale
were used to pay down $200.0 million principal amount of indebtedness
borrowed on March 8, 2007 under a bridge loan facility. The bridge loan was
established to help fund our acquisition of Commonwealth, and with the pay
down the facility was terminated.
14
During the first quarter of 2007, we incurred and expensed approximately
$4.0 million of fees associated with the bridge loan facility. We also
filed with the SEC a registration statement for an exchange offer on the
$750.0 million in total of private placement notes described above, in
addition to the $400.0 million principal amount of 7.875% Senior Notes
issued in a private placement on December 22, 2006, for registered notes.
The exchange offer was completed in the second quarter of 2007. On April
26, 2007, we redeemed $495.2 million principal amount of our 7.625% Senior
Notes due 2008 at a price of 103.041% plus accrued and unpaid interest. The
debt retirement generated a pre-tax loss on the early extinguishment of
debt at a premium of approximately $16.3 million in the second quarter of
2007 and is included in investment and other income (loss), net. As a
result of this debt redemption, we also terminated three interest rate swap
agreements hedging an aggregate $150.0 million of indebtedness. Payments on
the swap terminations of approximately $1.0 million were made in the second
quarter of 2007.
As of June 30, 2007, EPPICS representing a total principal amount of $197.2
million have been converted into 15,912,949 shares of our common stock.
Approximately $4.1 million of EPPICS, which are convertible into 355,493
shares of our common stock, were outstanding at June 30, 2007. Our
long-term debt footnote indicates $14.6 million of EPPICS outstanding at
June 30, 2007, of which $10.5 million is debt of related parties for which
the company has an offsetting receivable.
A summary of the activity for our industrial development revenue bonds is
as follows ($ in millions):
Principal amount outstanding at December 31, 2006 $ 58.1
Retirements during the first six months of 2007 (14.2)
--------
Principal amount outstanding at June 30, 2007 43.9
Expected retirements on August 1, 2007 (30.4)
--------
Remaining principal with a maturity at May 1, 2030 $ 13.5
========
As of June 30, 2007, we had available lines of credit with financial
institutions in the aggregate amount of $250.0 million and there were no
outstanding standby letters of credit issued under the facility. Associated
facility fees vary, depending on our debt leverage ratio, and were 0.20%
per annum as of June 30, 2007. The expiration date for this new $250.0
million five year revolving credit agreement is May 18, 2012. During the
term of the credit facility we may borrow, repay and reborrow funds. The
credit facility is available for general corporate purposes but may not be
used to fund dividend payments.
We are in compliance with all of our debt and credit facility covenants.
15
(9) Net Income Per Common Share:
----------------------------
The reconciliation of the net income per common share calculation for the
three and six months ended June 30, 2007 and 2006, respectively, is as
follows:
($ in thousands, except per-share amounts) For the three months ended June 30, For the six months ended June 30,
---------------------------------------- ------------------------------------ ----------------------------------
2007 2006 2007 2006
---------------- ----------------- ---------------- ----------------
Net income used for basic and diluted earnings
----------------------------------------------
per common share:
-----------------
Income from continuing operations $ 40,559 $ 94,746 $ 108,226 $ 138,733
Income from discontinued operations - 6,956 - 13,452
---------------- ----------------- ---------------- ----------------
Total basic net income available for common
shareholders $ 40,559 $ 101,702 $ 108,226 $ 152,185
================ ================= ================ ================
Effect of conversion of preferred securities -
EPPICS 32 79 89 261
---------------- ----------------- ---------------- ----------------
Total diluted net income available for common
shareholders $ 40,591 $ 101,781 $ 108,315 $ 152,446
================ ================= ================ ================
Basic earnings per common share:
--------------------------------
Weighted-average shares outstanding - basic 340,469 322,337 332,331 324,501
---------------- ----------------- ---------------- ----------------
Income from continuing operations $ 0.12 $ 0.30 $ 0.33 $ 0.43
Income from discontinued operations - 0.02 - 0.04
---------------- ----------------- ---------------- ----------------
Net income per share available for common
shareholders $ 0.12 $ 0.32 $ 0.33 $ 0.47
================ ================= ================ ================
Diluted earnings per common share:
----------------------------------
Weighted-average shares outstanding 340,469 322,337 332,331 324,501
Effect of dilutive shares 760 698 953 992
Effect of conversion of preferred securities -
EPPICS 359 847 441 1,191
---------------- ----------------- ---------------- ----------------
Weighted-average shares outstanding - diluted 341,588 323,882 333,725 326,684
================ ================= ================ ================
Income from continuing operations $ 0.12 $ 0.29 $ 0.32 $ 0.43
Income from discontinued operations - 0.02 - 0.04
---------------- ----------------- ---------------- ----------------
Net income per share available for common
sharesholders $ 0.12 $ 0.31 $ 0.32 $ 0.47
================ ================= ================ ================
Stock Options
-------------
For the three and six months ended June 30, 2007, options to purchase
1,221,150 shares (at exercise prices ranging from $15.94 to $18.46)
issuable under employee compensation plans were excluded from the
computation of diluted EPS for those periods because the exercise prices
were greater than the average market price of common shares and, therefore,
the effect would be antidilutive. In calculating diluted EPS we apply the
treasury stock method and include future unearned compensation as part of
the assumed proceeds.
For the three and six months ended June 30, 2006, options to purchase
1,960,000 shares at exercise prices ranging from $13.03 and $18.46 issuable
under employee compensation plans were excluded from the computation of
diluted EPS for those periods because the exercise prices were greater than
the average market price of our common stock and, therefore, the effect
would be antidilutive.
In addition, for the three and six months ended June 30, 2007 and 2006,
restricted stock awards of 1,389,000 and 1,212,000 shares, respectively,
are excluded from our basic weighted average shares outstanding and
included in our dilutive shares until the shares are no longer contingent
upon the satisfaction of all specified conditions.
EPPICS
------
As a result of our July 2004 dividend announcement with respect to our
common stock, our EPPICS began to convert into shares of our common stock.
As of June 30, 2007, approximately 98% of the EPPICS outstanding, or about
$197.2 million aggregate principal amount of EPPICS, have converted into
15,912,949 shares of our common stock, including shares issued from
treasury.
16
At June 30, 2007, we had 81,507 shares of potentially dilutive EPPICS,
which were convertible into our common stock at a 4.3615 to 1 ratio at an
exercise price of $11.46 per share. If all remaining EPPICS are converted,
we would issue approximately 355,493 shares of our common stock. These
securities have been included in the diluted income per common share
calculation for the period ended June 30, 2007.
At June 30, 2006, we had 180,594 shares of potentially dilutive EPPICS,
which were convertible into our common stock at a 4.3615 to 1 ratio at an
exercise price of $11.46 per share. If all remaining EPPICS had been
converted we would have issued approximately 787,661 shares of our common
stock. These securities have been included in the diluted income per common
share calculation for the period ended June 30, 2006.
Stock Units
-----------
At June 30, 2007 and 2006, we had 191,450 and 282,000 stock units,
respectively, issued under our Non-Employee Directors' Deferred Fee Equity
Plan (Deferred Fee Plan), Non-Employee Directors' Equity Incentive Plan
(Directors' Equity Plan) and Non-Employee Directors' Retirement Plan. These
securities have not been included in the diluted income per share of common
stock calculation because their inclusion would have had an antidilutive
effect.
Share Repurchase Programs
-------------------------
In February 2007, our Board of Directors authorized us to repurchase up to
$250.0 million of our common stock in public or private transactions over
the following twelve-month period. This share repurchase program commenced
on March 19, 2007. As of June 30, 2007, we had repurchased approximately
4,633,000 shares of our common stock at an aggregate cost of approximately
$70.7 million.
(10) Stock Plans:
------------
At June 30, 2007, we had five stock-based compensation plans pursuant to
which grants are outstanding, which are described below. Prior to the
adoption of SFAS No. 123R, we applied APB No. 25 and related
interpretations to account for our stock plans resulting in the use of the
intrinsic value to value the stock and determine compensation expense.
Under APB No. 25, we were not required to recognize compensation expense
for the cost of stock options. In accordance with the adoption of SFAS No.
123R, we recorded stock-based compensation expense for the cost of stock
options, restricted shares and stock units issued pursuant to the
Management Equity Incentive Plan (MEIP), the 1996 Equity Incentive Plan
(1996 EIP), the Amended and Restated 2000 Equity Incentive Plan (2000 EIP),
the Deferred Fee Plan and the Directors' Equity Plan. Our general policy is
to issue shares upon the grant of restricted shares and exercise of options
from treasury. At June 30, 2007, there were 16,058,182 shares authorized
for grant under these plans and 5,225,199 shares available for grant. No
further awards may be granted under the MEIP, the 1996 EIP or the Deferred
Fee Plan.
Management Equity Incentive Plan
--------------------------------
Prior to its expiration on June 21, 2000, awards of our common stock could
have been granted under the MEIP to eligible officers, management employees
and non-management employees in the form of incentive stock options,
non-qualified stock options, stock appreciation rights (SARs), restricted
stock or other stock-based awards.
Since the expiration of the MEIP, no awards have been or may be granted
under the MEIP. The exercise price of stock options issued was equal to or
greater than the fair market value of the underlying common stock on the
date of grant. Stock options were not ordinarily exercisable on the date of
grant but vest over a period of time (generally 4 years). Under the terms
of the MEIP, subsequent stock dividends and stock splits have the effect of
increasing the option shares outstanding, which correspondingly decreases
the average exercise price of outstanding options.
1996 and 2000 Equity Incentive Plans
------------------------------------
Since the expiration date of the 1996 EIP on May 22, 2006, no awards have
been or may be granted under the 1996 EIP. Under the 2000 EIP, awards of
our common stock may be granted to eligible officers, management employees
and non-management employees in the form of incentive stock options,
non-qualified stock options, SARs, restricted stock or other stock-based
awards. As discussed under the Non-Employee Directors' Compensation Plans
below, prior to May 25, 2006 non-employee directors received an award of
stock options under the 2000 EIP upon commencement of service.
At June 30, 2007, there were 13,517,421 shares authorized for grant under
the 2000 EIP and 2,820,503 shares available for grant, as adjusted to
reflect stock dividends. No awards will be granted more than 10 years after
the effective date (May 18, 2000) of the 2000 EIP.
17
The exercise price of stock options and SARs under the 2000 and 1996 EIP
generally shall be equal to or greater than the fair market value of the
underlying common stock on the date of grant. Stock options are not
ordinarily exercisable on the date of grant but vest over a period of time
(generally 4 years). Under the terms of the EIPs, subsequent stock
dividends and stock splits have the effect of increasing the option shares
outstanding, which correspondingly decrease the average exercise price of
outstanding options.
The following summary presents information regarding outstanding stock
options as of June 30, 2007 and changes during the six months then ended
with regard to options under the MEIP and the EIPs:
Aggregate
Weighted Weighted Intrinsic
Shares Average Average Value at
Subject to Option Price Remaining June 30,
Option Per Share Life in Years 2007
------------------------------------------------ -------------------- ------------------- -------------------- --------------
Balance at January 1, 2007 5,242,000 $12.41
Options granted - -
Options exercised (1,018,000) $10.32 $ 4,872,000
Options canceled, forfeited or lapsed (17,000) $11.53
------------------------------------------------ --------------------
Balance at June 30, 2007 4,207,000 $12.92 3.88 $12,629,000
================================================ ====================
Exercisable at June 30, 2007 4,184,000 $12.92 3.85 $12,576,000
================================================ ====================
There were no options granted during the first six months of 2007. Cash
received upon the exercise of options during the first six months of 2007
totaled $11.5 million. Total remaining unrecognized compensation cost
associated with unvested stock options at June 30, 2007 was $0.1 million
and the weighted average period over which this cost is expected to be
recognized is approximately one year.
The total intrinsic value of stock options exercised during the first six
months of 2006 was $4.3 million. The total intrinsic value of stock options
outstanding and exercisable at June 30, 2006 was $14.3 million and $13.2
million, respectively. Options granted during the first six months of 2006
totaled 13,000. The weighted average grant-date fair value of options
granted during the six months ended June 30, 2006 was $3.08. Cash received
upon the exercise of options during the first six months of 2006 totaled
$12.8 million.
For purposes of determining compensation expense, the fair value of each
option grant is estimated on the date of grant using the Black-Scholes
option-pricing model which requires the use of various assumptions
including expected life of the option, expected dividend rate, expected
volatility, and risk-free interest rate. The expected life (estimated
period of time outstanding) of stock options granted was estimated using
the historical exercise behavior of employees. The risk free interest rate
is based on the U.S. Treasury yield curve in effect at the time of the
grant. Expected volatility is based on historical volatility for a period
equal to the stock option's expected life, calculated on a monthly basis.
The following table presents the weighted average assumptions used for
grants in fiscal 2006:
2006
--------------------------- -------------------
Dividend yield 7.55%
Expected volatility 44%
Risk-free interest rate 4.89%
Expected life 5 years
--------------------------- -------------------
18
The following summary presents information regarding unvested restricted
stock as of June 30, 2007 and changes during the six months then ended with
regard to restricted stock under the MEIP and the EIPs:
Weighted Aggregate
Average Fair Value at
Number of Grant Date June 30,
Shares Fair Value 2007
--------------------------------------- ------------------ ----------------- -----------------------
Balance at January 1, 2007 1,174,000 $12.89
Restricted stock granted 696,000 $15.08 $10,638,000
Restricted stock vested (468,000) $12.76 $ 7,151,000
Restricted stock forfeited (13,000) $14.23 $ 197,000
--------------------------------------- ------------------
Balance at June 30, 2007 1,389,000 $14.02 $21,211,000
======================================= ==================
For purposes of determining compensation expense, the fair value of each
restricted stock grant is estimated based on the average of the high and
low market price of a share of our common stock on the date of grant. Total
remaining unrecognized compensation cost associated with unvested
restricted stock awards at June 30, 2007 was $17.5 million and the weighted
average period over which this cost is expected to be recognized is
approximately three years.
The total fair value of shares granted and vested during the six months
ended June 30, 2006 was approximately $9.5 million and $7.6 million,
respectively. The total fair value of unvested restricted stock at June 30,
2006 was $15.8 million. The weighted average grant-date fair value of
restricted shares granted during the six months ended June 30, 2006 was
$12.86. Shares granted during the first six months of 2006 totaled 730,000.
Non-Employee Directors' Compensation Plans
------------------------------------------
Upon commencement of his or her service on the Board of Directors, each
non-employee director receives a grant of 10,000 stock options. These
options are currently awarded under the Directors' Equity Plan. Prior to
effectiveness of the Directors' Equity Plan on May 25, 2006, these options
were awarded under the 2000 EIP. The exercise price of these options, which
become exercisable six months after the grant date, is the fair market
value (as defined in the relevant plan) of our common stock on the date of
grant. Options granted under the Directors' Equity Plan expire on the
earlier of the tenth anniversary of the grant date or the first anniversary
of termination of service as a director. Options granted under the 2000 EIP
expire on the tenth anniversary of the grant date.
Each non-employee director also receives an annual grant of 3,500 stock
units. These units are currently awarded under the Directors' Equity Plan
and prior to effectiveness of that plan, were awarded under the Deferred
Fee Plan. Since the effectiveness of the Directors' Equity Plan, no further
grants have been made under the Deferred Fee Plan. Prior to April 20, 2004,
each non-employee director received an award of 5,000 stock options. The
exercise price of such options was set at 100% of the fair market value on
the date the options were granted. The options are exercisable six months
after the grant date and remain exercisable for ten years after the grant
date.
In addition, each year, each non-employee director is also entitled to
receive a retainer, meeting fees, and, when applicable, fees for serving as
a committee chair or as Lead Director, which are awarded under the
Directors' Equity Plan. For 2007, each non-employee director had to elect,
by December 31 of the preceding year, to receive $40,000 cash or 5,760
stock units as an annual retainer and to receive meeting fees and Lead
Director and committee chair stipends in the form of cash or stock units.
Directors making a stock unit election must also elect to convert the units
to either common stock (convertible on a one-to-one basis) or cash upon
retirement or death. Prior to June 30, 2003, a director could elect to
receive 20,000 stock options as an annual retainer in lieu of cash or stock
units. The exercise price of the stock options was set at the average of
the high and low market prices of our common stock on the date of grant.
The options were exercisable six months after the date of grant and had a
10-year term.
The number of shares of common stock authorized for issuance under the
Directors' Equity Plan is 2,540,761, which includes 540,761 shares that
were available for grant under the Deferred Fee Plan on the effective date
of the Directors' Equity Plan. In addition, if and to the extent that any
"plan units" outstanding on May 25, 2006 under the Deferred Fee Plan are
forfeited, or if any option granted under the Deferred Fee Plan terminates,
expires, or is cancelled or forfeited, without having been fully exercised,
shares of common stock subject to such "plan units" or options cancelled
shall become available under the Directors' Equity Plan. At June 30, 2007,
there were 2,404,696 shares available for grant. There were 13 directors
participating in the directors' plans during the second quarter of 2007. In
the first six months of 2007, total plan units earned were 81,249. At June
30, 2007, 177,951 options were exercisable at a weighted average exercise
price of $12.61.
19
We account for the Deferred Fee Plan and the Directors' Equity Plan in
accordance with SFAS No. 123R. To the extent directors elect to receive the
distribution of their stock unit accounts in cash, they are considered
liability-based awards. To the extent directors elect to receive the
distribution of their stock unit accounts in common stock, they are
considered equity-based awards. Compensation expense for stock units that
are considered equity-based awards is based on the market value of our
common stock at the date of grant. Compensation expense for stock units
that are considered liability-based awards is based on the market value of
our common stock at the end of each period. For awards granted prior to
1999, a director could elect to be paid in stock options. Generally,
compensation cost was not recorded because the options were granted at the
fair market value of our common stock on the grant date under APB No. 25
and related interpretations.
We had also maintained a Non-Employee Directors' Retirement Plan providing
for the payment of specified sums annually to our non-employee directors,
or their designated beneficiaries, starting at the director's retirement,
death or termination of directorship. In 1999, we terminated this Plan. As
of June 30, 2007, the liability for such payments was reduced to $0, as the
obligation was fully settled during the second quarter of 2007.
(11) Segment Information:
--------------------
As of January 1, 2007, we operate in one reportable segment, Frontier.
Frontier provides both regulated and unregulated communications services to
residential, business and wholesale customers and is typically the
incumbent provider in its service areas.
As permitted by SFAS No. 131, we have utilized the aggregation criteria in
combining our markets because all of our Frontier properties share similar
economic characteristics, in that they provide the same products and
services to similar customers using comparable technologies in all of the
states in which we operate. The regulatory structure is generally similar.
Differences in the regulatory regime of a particular state do not
materially impact the economic characteristics or operating results of a
particular property.
(12) Derivative Instruments and Hedging Activities:
----------------------------------------------
Interest rate swap agreements are used to hedge a portion of our debt that
is subject to fixed interest rates. Under our interest rate swap
agreements, we agree to pay an amount equal to a specified variable rate of
interest times a notional principal amount, and to receive in return an
amount equal to a specified fixed rate of interest times the same notional
principal amount. The notional amounts of the contracts are not exchanged.
No other cash payments are made unless the agreement is terminated prior to
maturity, in which case the amount paid or received in settlement is
established by agreement at the time of termination and represents the
market value, at the then current rate of interest, of the remaining
obligations to exchange payments under the terms of the contracts.
The interest rate swap contracts are reflected at fair value in our
consolidated balance sheets and the related portion of fixed-rate debt
being hedged is reflected at an amount equal to the sum of its book value
and an amount representing the change in fair value of the debt obligations
attributable to the interest rate risk being hedged. Changes in the fair
value of interest rate swap contracts, and the offsetting changes in the
adjusted carrying value of the related portion of the fixed rate debt being
hedged, are recognized in the consolidated statements of operations in
interest expense. The notional amounts of interest rate swap contracts
hedging fixed-rate indebtedness as of June 30, 2007 and December 31, 2006
were $400.0 million and $550.0 million, respectively. Such contracts
require us to pay variable rates of interest (average pay rates of
approximately 9.22% as of June 30, 2007 and approximately 9.02% as of
December 31, 2006) and receive fixed rates of interest (average receive
rates of 8.50% as of June 30, 2007 and 8.26% as of December 31, 2006). The
fair value of these derivatives is reflected in other liabilities as of
June 30, 2007 and December 31, 2006, in the amount of ($13.9 million) and
($10.3 million), respectively. The related underlying debt has been
decreased by a like amount. For the three and six months ended June 30,
2007, the interest expense resulting from these interest rate swaps totaled
approximately $0.8 million and $2.0 million, respectively.
We do not anticipate any non-performance by counter-parties to our
derivative contracts as all counter-parties have investment grade credit
ratings.
20
(13) Investment and Other Income (Loss), Net:
----------------------------------------
The components of investment and other income (loss), net are as follows:
For the three months ended June 30, For the six months ended June 30,
------------------------------------------- ---------------------------------------------
($ in thousands) 2007 2006 2007 2006
-------------- ------------------ ---------------------- --------------------- ---------------------
Interest and dividend income $ 8,444 $ 4,213 $ 22,970 $ 8,019
Bridge loan fee - - (4,026) -
Gain from Rural Telephone Bank
Dissolution - 61,428 - 61,428
Loss on exchange of debt - (41) - (2,433)
Premium on Debt Repurchases (17,092) - (18,217) -
Equity earnings/minority interest
in joint ventures, net 1,575 (794) 578 (1,827)
Other, net 556 557 2,195 (1,175)
------------------ ---------------------- --------------------- ---------------------
Total investment and other
income (loss), net $ (6,517) $ 65,363 $ 3,500 $ 64,012
================== ====================== ===================== =====================
The gain of $61.4 million resulted from the dissolution and liquidation of
the Rural Telephone Bank in April 2006.
(14) Company Obligated Mandatorily Redeemable Convertible Preferred Securities:
--------------------------------------------------------------------------
In 1996, our consolidated wholly owned subsidiary, Citizens Utilities Trust
(the Trust), issued, in an underwritten public offering, 4,025,000 shares
of EPPICS, representing preferred undivided interests in the assets of the
Trust, with a liquidation preference of $50 per security (for a total
liquidation amount of $201.3 million). These securities convert into our
common stock at an adjusted conversion price of $11.46 per share of our
common stock. The conversion price was reduced from $13.30 to $11.46 during
the third quarter of 2004 as a result of the $2.00 per share of common
stock special, non-recurring dividend. The proceeds from the issuance of
the Trust Convertible Preferred Securities and a Company capital
contribution were used to purchase $207.5 million aggregate liquidation
amount of 5% Partnership Convertible Preferred Securities due 2036 from
another wholly owned subsidiary, Citizens Utilities Capital L.P. (the
Partnership). The proceeds from the issuance of the Partnership Convertible
Preferred Securities and a Company capital contribution were used to
purchase from us $211.8 million aggregate principal amount of 5%
Convertible Subordinated Debentures due 2036. The sole assets of the Trust
are the Partnership Convertible Preferred Securities, and our Convertible
Subordinated Debentures are substantially all the assets of the
Partnership. Our obligations under the agreements related to the issuances
of such securities, taken together, constitute a full and unconditional
guarantee by us of the Trust's obligations relating to the Trust
Convertible Preferred Securities and the Partnership's obligations relating
to the Partnership Convertible Preferred Securities.
In accordance with the terms of the issuances, we paid the annual 5%
interest in quarterly installments on the Convertible Subordinated
Debentures in the first and second quarters of 2007 and the four quarters
of 2006. Cash was paid (net of investment returns) to the Partnership in
payment of the interest on the Convertible Subordinated Debentures. The
cash was then distributed by the Partnership to the Trust and then by the
Trust to the holders of the EPPICS.
As of June 30, 2007, EPPICS representing a total principal amount of $197.2
million have been converted into 15,912,949 shares of our common stock. A
total of approximately $4.1 million of EPPICS is outstanding as of June 30,
2007 and if all outstanding EPPICS were converted, 355,493 shares of our
common stock would be issued upon such conversion. Our long-term debt
footnote indicates $14.6 million of EPPICS outstanding at June 30, 2007, of
which $10.5 million is debt of related parties for which the company has an
offsetting receivable.
21
(15) Retirement Plans:
-----------------
The following tables provide the components of net periodic benefit cost:
Pension Benefits
----------------------------------------------------------------------------
For the three months ended For the six months ended
June 30, June 30,
------------------------------------- ------------------------------------
2007 2006 2007 2006
------------------ ----------------- ----------------- -----------------
($ in thousands)
--------------
Components of net periodic benefit cost
---------------------------------------
Service cost $ 2,754 $ 1,759 $ 4,763 $ 3,518
Interest cost on projected benefit obligation 13,115 11,504 25,045 23,008
Expected return on plan assets (17,106) (15,126) (32,781) (30,252)
Amortization of prior service cost and
unrecognized net obligation 81 (61) 53 (122)
Amortization of unrecognized loss 2,906 3,085 5,806 6,170
------------------ ----------------- ----------------- -----------------
Net periodic benefit cost $ 1,750 $ 1,161 $ 2,886 $ 2,322
================== ================= ================= =================
Other Postretirement Benefits
----------------------------------------------------------------------------
For the three months ended For the six months ended
June 30, June 30,
------------------------------------- ------------------------------------
2007 2006 2007 2006
------------------ ----------------- ----------------- -----------------
($ in thousands)
----------------
Components of net periodic benefit cost
---------------------------------------
Service cost $ 175 $ 174 $ 349 $ 348
Interest cost on projected benefit obligation 2,218 2,211 4,426 4,422
Expected return on plan assets (254) (245) (507) (490)
Amortization of prior service cost and
unrecognized net obligation (1,447) (1,026) (2,895) (2,052)
Amortization of unrecognized loss 1,171 1,513 2,361 3,026
------------------ ----------------- ----------------- -----------------
Net periodic benefit cost $ 1,863 $ 2,627 $ 3,734 $ 5,254
================== ================= ================= =================
We expect that our 2007 pension and other postretirement benefit expenses,
including the costs associated with our recently acquired Commonwealth
plans, will be between $13.0 million and $15.0 million, and that no
contribution will be required to be made by us to the pension plans in
2007.
(16) Commitments and Contingencies:
------------------------------
We anticipate capital expenditures of approximately $315.0 million - $325.0
million for 2007. Although we from time to time make short-term purchasing
commitments to vendors with respect to these expenditures, we generally do
not enter into firm, written contracts for such activities.
The City of Bangor, Maine, filed suit against us on November 22, 2002, in
the U.S. District Court for the District of Maine (City of Bangor v.
Citizens Communications Company, Civ. Action No. 02-183-B-S). The City
alleged, among other things, that we are responsible for the costs of
cleaning up environmental contamination alleged to have resulted from the
operation of a manufactured gas plant owned by Bangor Gas Company from
1852-1948 and by us from 1948-1963. In acquiring the operation in 1948, we
acquired the stock of Bangor Gas Company and merged it into us. The City
alleged the existence of extensive contamination of the Penobscot River and
initially asserted that money damages and other relief at issue in the
lawsuit could exceed $50.0 million. The City also requested that punitive
damages be assessed against us. We filed an answer denying liability to the
City, and asserted a number of counterclaims against the City. In addition,
we identified a number of other potentially responsible parties that may be
liable for the damages alleged by the City and joined them as parties to
the lawsuit. These additional parties include UGI Utilities, Inc. and
Centerpoint Energy Resources Corporation. The Court dismissed all but two
of the City's claims, including its claims for joint and several liability
under the Comprehensive Environmental Response, Compensation, and Liability
Act (CERCLA) and the claim against us for punitive damages.
22
On June 27, 2006, the court issued Findings of Fact and Conclusions of Law
in the first phase of the case. The court found contamination in only a
small section of the River and determined that Citizens and the City should
share cleanup costs.
Subsequent to the June 27, 2006 findings, we began settlement discussions
with the City, with participation from the State of Maine. In February
2007, we reached an agreement to settle the matter for a payment by us of
$7.6 million. The payment was made on July 31, 2007 and the settlement is
now final. Under the settlement agreement, we and the City will share in
any recoveries from the various third party defendants. We also executed a
Consent Decree with the City and the State that subsequently was approved
and entered by the Court. On July 31, certain of the third party defendants
filed a notice of appeal concerning entry of the Consent Decree. Even if
such appeal (which we intend to vigorously contest) were successful, it
would not affect the finality of our settlement with the City.
In addition, we have demanded that various of our insurance carriers defend
and indemnify us with respect to the City's lawsuit, and on December 26,
2002, we filed a declaratory judgment action against those insurance
carriers in the Superior Court of Penobscot County, Maine, for the purpose
of establishing their obligations to us with respect to the City's lawsuit.
We intend to vigorously pursue this lawsuit and to obtain from our
insurance carriers indemnification for any amounts paid by us in settlement
of the City's lawsuit as well as to recover the costs of our defense of
that lawsuit. We cannot at this time determine what amount we may recover
from third parties or insurance carriers.
Ronald A. Katz Technology Licensing, LP, filed suit against us for patent
infringement on June 8, 2007 in the U.S. District Court for the District of
Delaware. Katz Technology alleges that by operating automated telephone
systems, including customer service systems, that allow our customers to
utilize telephone calling cards, order internet, DSL, and dial-up services,
and perform a variety of account related tasks such as billing and
payments, we have infringed thirteen of Katz Technology's patents and
continue to infringe three of Katz Technology's patents. Katz Technology
seeks unspecified damages resulting from our alleged infringement, as well
as a permanent injunction enjoining us from continuing the alleged
infringement. Katz Technology subsequently filed a tag-along notice with
the Judicial Panel on Multi-District Litigation, notifying them of this
action and its relatedness to In re Katz Interactive Dial Processing Patent
Litigation (MDL No. 1816), pending in the Central District of California
before Judge R. Gary Klausner. The Judicial Panel on Multi-District
Litigation has transferred the case to the Central District of California.
We intend to vigorously defend against this lawsuit.
On June 24, 2004, one of our subsidiaries, Frontier Subsidiary Telco, Inc.,
received a "Notice of Indemnity Claim" from Citibank, N.A., that is related
to a complaint pending against Citibank and others in the U.S. Bankruptcy
Court for the Southern District of New York as part of the Global Crossing
bankruptcy proceeding. Citibank bases its claim for indemnity on the
provisions of a credit agreement that was entered into in October 2000
between Citibank and our subsidiary. We purchased Frontier Subsidiary
Telco, Inc., in June 2001 as part of our acquisition of the Frontier
telephone companies. The complaint against Citibank, for which it seeks
indemnification, alleges that the seller improperly used a portion of the
proceeds from the Frontier transaction to pay off the Citibank credit
agreement, thereby defrauding certain debt holders of Global Crossing North
America Inc. Although the credit agreement was paid off at the closing of
the Frontier transaction, Citibank claims the indemnification obligation
survives. Damages sought against Citibank and its co-defendants could
exceed $1.0 billion. In August 2004, we notified Citibank by letter that we
believe its claims for indemnification are invalid and are not supported by
applicable law. In 2005, Citibank moved to dismiss the underlying complaint
against it. That motion is currently pending. We have received no further
communications from Citibank since our August 2004 letter.
We are party to other legal proceedings arising in the normal course of our
business. The outcome of individual matters is not predictable. However, we
believe that the ultimate resolution of all such matters, after considering
insurance coverage, will not have a material adverse effect on our
financial position, results of operations, or our cash flows.
23
We sold all of our utility businesses as of April 1, 2004. However, we have
retained a potential payment obligation associated with our previous
electric utility activities in the state of Vermont. The Vermont Joint
Owners (VJO), a consortium of 14 Vermont utilities, including us, entered
into a purchase power agreement with Hydro-Quebec in 1987. The agreement
contains "step-up" provisions that state that if any VJO member defaults on
its purchase obligation under the contract to purchase power from
Hydro-Quebec the other VJO participants will assume responsibility for the
defaulting party's share on a pro-rata basis. Our pro-rata share of the
purchase power obligation is 10%. If any member of the VJO defaults on its
obligations under the Hydro-Quebec agreement, then the remaining members of
the VJO, including us, may be required to pay for a substantially larger
share of the VJO's total power purchase obligation for the remainder of the
agreement (which runs through 2015). Paragraph 13 of FIN No. 45 requires
that we disclose "the maximum potential amount of future payments
(undiscounted) the guarantor could be required to make under the
guarantee." Paragraph 13 also states that we must make such disclosure "...
even if the likelihood of the guarantor's having to make any payments under
the guarantee is remote..." As noted above, our obligation only arises as a
result of default by another VJO member, such as upon bankruptcy.
Therefore, to satisfy the "maximum potential amount" disclosure requirement
we must assume that all members of the VJO simultaneously default, a highly
unlikely scenario given that the two members of the VJO that have the
largest potential payment obligations are publicly traded with credit
ratings equal to or superior to ours, and that all VJO members are
regulated utility providers with regulated cost recovery. Regardless,
despite the remote chance that such an event could occur, or that the State
of Vermont could or would allow such an event, assuming that all the
members of the VJO defaulted on January 1, 2008 and remained in default for
the duration of the contract (another 8 years), we estimate that our
undiscounted purchase obligation for 2008 through 2015 would be
approximately $1.1 billion. In such a scenario the Company would then own
the power and could seek to recover its costs. We would do this by seeking
to recover our costs from the defaulting members and/or reselling the power
to other utility providers or the northeast power grid. There is an active
market for the sale of power. We could potentially lose money if we were
unable to sell the power at cost. We caution that we cannot predict with
any degree of certainty any potential outcome.
(17) Subsequent Events:
------------------
We have entered into an agreement with Country Road Communications LLC
("Country Road") to acquire Global Valley Networks Inc. ("GVN") and GVN
Services ("GVS") through the purchase from Country Road of 100% of the
outstanding common stock of Evans Telephone Holdings, Inc., the parent
company of GVN and GVS. The purchase price is $62.0 million in cash,
subject to adjustment. We intend to finance the acquisition with cash on
hand. The closing is subject to satisfaction of certain usual and customary
conditions, including Hart-Scott-Rodino antitrust clearance and necessary
approvals from the Federal Communications Commission and the California
Public Utilities Commission. The transaction is expected to close within
six to nine months.
24
Item 2. Management's Discussion and Analysis of Financial Condition and Results
-----------------------------------------------------------------------
of Operations
-------------
Forward-Looking Statements
--------------------------
This quarterly report on Form 10-Q contains forward-looking statements that are
subject to risks and uncertainties that could cause actual results to differ
materially from those expressed or implied in the statements. Statements that
are not historical facts are forward-looking statements made pursuant to the
"Safe Harbor" provisions of the Private Securities Litigation Reform Act of
1995. Words such as "believes," "anticipates," "expects" and similar expressions
are intended to identify forward-looking statements. Forward-looking statements
(including oral representations) are only predictions or statements of current
plans, which we review continuously. Forward-looking statements may differ from
actual future results due to, but not limited to, and our future results may be
materially affected by, any of the following possibilities:
* Our ability to successfully integrate Commonwealth's operations and to
realize the synergies from the acquisition;
* Changes in the number of our revenue generating units, which consist
of access lines plus high-speed internet subscribers;
* The effects of competition from wireless, other wireline carriers
(through voice over internet protocol (VOIP) or otherwise), high-speed
cable modems and cable telephony;
* The effects of greater than anticipated competition requiring new
pricing, marketing strategies or new product offerings and the risk
that we will not respond on a timely or profitable basis;
* The effects of general and local economic and employment conditions on
our revenues;
* Our ability to effectively manage service quality;
* Our ability to successfully introduce new product offerings, including
our ability to offer bundled service packages on terms that are both
profitable to us and attractive to our customers;
* Our ability to sell enhanced and data services in order to offset
ongoing declines in revenue from local services, switched access
services and subsidies;
* Changes in accounting policies or practices adopted voluntarily or as
required by generally accepted accounting principles or regulators;
* The effects of ongoing changes in the regulation of the communications
industry as a result of federal and state legislation and regulation,
including potential changes in access charges and subsidy payments,
and regulatory network upgrade and reliability requirements;
* Our ability to comply with federal and state regulation (including
state rate of return limitations on our earnings) and our ability to
successfully renegotiate state regulatory plans as they expire or come
up for renewal from time to time;
* Our ability to effectively manage our operations, operating expenses
and capital expenditures, to pay dividends and to reduce or refinance
our debt;
* Adverse changes in the ratings given to our debt securities by
nationally accredited ratings organizations, which could limit or
restrict the availability and/or increase the cost of financing;
* The effects of bankruptcies in the telecommunications industry, which
could result in potential bad debts;
25
* The effects of technological changes and competition on our capital
expenditures and product and service offerings, including the lack of
assurance that our ongoing network improvements will be sufficient to
meet or exceed the capabilities and quality of competing networks;
* The effects of increased medical, retiree and pension expenses and
related funding requirements;
* Changes in income tax rates, tax laws, regulations or rulings, and/or
federal or state tax assessments;
* The effects of state regulatory cash management policies on our
ability to transfer cash among our subsidiaries and to the parent
company;
* Our ability to successfully renegotiate expiring union contracts;
* Our ability to pay a $1.00 per common share dividend annually may be
affected by our cash flow from operations, amount of capital
expenditures, debt service requirements, cash paid for income taxes
(which will increase in the future) and our liquidity;
* The effects of utilizing our Federal and state net operating loss
carry forwards and AMT tax credit carry forwards which will
significantly increase our cash taxes in 2007 and beyond;
* The effects of any future liabilities or compliance costs in
connection with worker health and safety matters;
* The effects of any unfavorable outcome with respect to any of our
current or future legal, governmental, or regulatory proceedings,
audits or disputes; and
* The effects of more general factors, including changes in economic,
business and industry conditions.
Any of the foregoing events, or other events, could cause financial information
to vary from management's forward-looking statements included in this report.
You should consider these important factors, as well as the risks set forth
under Item 1A. "Risk Factors," in our Annual Report on Form 10-K for the year
ended December 31, 2006, in evaluating any statement in this report on Form 10-Q
or otherwise made by us or on our behalf. The following information is unaudited
and should be read in conjunction with the consolidated financial statements and
related notes included in this report. We have no obligation to update or revise
these forward-looking statements.
Overview
--------
We are a full-service communications provider and one of the largest exchange
telephone carriers in the country. We offer our incumbent local exchange carrier
(ILEC) services under the "Frontier" name. On July 31, 2006, we sold our
competitive local exchange carrier (CLEC), Electric Lightwave, LLC (ELI). We
accounted for ELI as a discontinued operation in our consolidated statements of
operations. On March 8, 2007, we completed the acquisition of Commonwealth
Telephone Enterprises, Inc., which includes a small CLEC component. This
acquisition expands our presence in Pennsylvania and strengthens our position as
a market-leading full-service communications provider to rural markets.
Competition in the telecommunications industry is intense and increasing. We
experience competition from many telecommunications service providers, including
cable operators, wireless carriers, voice over internet protocol (VOIP)
providers, long distance providers, competitive local exchange carriers,
internet providers and other wireline carriers. We believe that competition will
continue to intensify in 2007 across all of our products and in all of our
markets. Our Frontier business experienced erosion in access lines and switched
access minutes in 2006 and the first half of 2007 as a result of competition.
Competition in our markets may result in reduced revenues in 2007.
The communications industry is undergoing significant changes. The market is
extremely competitive, resulting in lower prices. These trends are likely to
continue and result in a challenging revenue environment. These factors could
also result in more bankruptcies in the sector and, therefore, affect our
ability to collect money owed to us by carriers.
26
Revenues from data and internet services such as high-speed internet continue to
increase as a percentage of our total revenues and revenues from services such
as local line and access charges (including federal and state subsidies) are
decreasing as a percentage of our revenues. These factors, along with the
potential for increasing operating costs, could cause our profitability and our
cash generated by operations to decrease.
a) Liquidity and Capital Resources
-------------------------------
Cash Flow from Operating Activities
-----------------------------------
As of June 30, 2007, we had cash and cash equivalents aggregating $418.1
million. Our primary source of funds continues to be cash generated from
operations. For the six months ended June 30, 2007, we used cash flow from
continuing operations and cash and cash equivalents to fund a significant
portion of the acquisition of Commonwealth, capital expenditures, dividends,
interest payments, debt repayments and stock repurchases.
We believe our operating cash flows, existing cash balances, and credit facility
will be adequate to finance our working capital requirements, fund capital
expenditures, make required debt payments through 2008, pay taxes, pay dividends
to our stockholders in accordance with our dividend policy and support our
short-term and long-term operating strategies. We have approximately $31.6
million of debt maturing during the last six months of 2007 and $2.4 million and
$2.5 million of debt maturing in 2008 and 2009, respectively.
A number of factors, including but not limited to, losses of access lines,
increases in competition and lower subsidy and access revenues are expected to
reduce our cash generated by operations and may require us to increase capital
expenditures. Our below investment grade credit ratings may make it more
difficult and expensive to refinance our maturing debt. We have in recent years
paid relatively low amounts of cash taxes. We expect that in 2007 and beyond our
cash taxes will increase substantially as our Federal and state net operating
loss carry forwards and AMT tax credit carry forwards are estimated to be fully
utilized during 2007 and 2008. We paid $47.4 million in cash taxes during the
first six months of 2007 and expect to pay approximately $30.0 million to $35.0
million in the second half of 2007.
Cash Flow from Investing Activities
-----------------------------------
Acquisition
-----------
On March 8, 2007, we acquired Commonwealth in a cash-and-stock taxable
transaction, for a total consideration of approximately $1.1 billion. We paid
$798.0 million in cash ($657.6 million net, after cash acquired), issued common
stock with a value of $247.3 million and had $10.5 million of accrued closing
costs at June 30, 2007.
In connection with the acquisition of Commonwealth, we assumed $35.0 million of
debt under a revolving credit facility and $191.8 million face amount of
Commonwealth convertible notes (fair value of $209.6 million). During March
2007, we paid down the $35.0 million credit facility. We have retired all but
$8.5 million of the $191.8 million face amount of Commonwealth notes as of June
30, 2007. The notes were retired by the payment of $165.4 million in cash and
the issuance of our common stock valued at $36.7 million. The premium paid of
$18.9 million was recorded as $17.8 million to goodwill and $1.1 million to
expense.
Capital Expenditures
--------------------
For the six months ended June 30, 2007, our capital expenditures were $111.8
million. We continue to closely scrutinize all of our capital projects,
emphasize return on investment and focus our capital expenditures on areas and
services that have the greatest opportunities with respect to revenue growth and
cost reduction. We anticipate capital expenditures of approximately $315.0
million - $325.0 million for 2007.
Increasing competition and improving the capabilities or reducing the
maintenance costs of our plant may cause our capital expenditures to increase in
the future. Our capital expenditures planned for new services such as wireless
and VOIP in 2007 are not material. However, based on the success of our planned
roll-out of these products that began in late 2006, our capital expenditures for
these products may increase in the future.
Rural Telephone Bank
--------------------
In August 2005, the Board of Directors of the Rural Telephone Bank (RTB) voted
to dissolve the bank. In November 2005, the liquidation and dissolution of the
RTB was initiated with the signing of the 2006 Agricultural Appropriation bill
by President Bush. We received approximately $64.6 million in cash from the
dissolution of the RTB in April 2006, which resulted in the recognition of a
pre-tax gain of approximately $61.4 million during the second quarter of 2006 as
reflected in investment and other income (loss), net in the consolidated
statements of operations. Our tax net operating losses were used to absorb the
cash liability for taxes.
27
Cash Flow from Financing Activities
-----------------------------------
Debt Reduction and Debt Exchanges
---------------------------------
For the six months ended June 30, 2007, we retired an aggregate principal amount
of $935.6 million of debt, including $3.3 million of 5% Company Obligated
Mandatorily Redeemable Convertible Preferred Securities (EPPICS) and $17.8
million of 3.25% Commonwealth convertible notes that were converted into our
common stock. On April 26, 2007, we redeemed $495.2 million principal amount of
our 7.625% Senior Notes due 2008 at a price of 103.041% plus accrued and unpaid
interest. During the first quarter of 2007, we temporarily borrowed and repaid
$200.0 million utilized to temporarily fund the acquisition, and we paid down
the $35.0 million Commonwealth credit facility. Through June 30, 2007 we have
retired $183.3 million face amount of Commonwealth convertible notes for which
we paid $165.4 million in cash and $36.7 million in common stock (premium paid
of $18.9 million was recorded as $17.8 million to goodwill and $1.1 million to
expense), resulting in a remaining outstanding balance of $8.5 million as of
June 30, 2007. We also paid down $14.2 million of industrial development revenue
bonds and $3.9 million of rural utilities service loan contracts.
We may from time to time repurchase our debt in the open market, through tender
offers, exchanges of debt securities, by exercising rights to call or in
privately negotiated transactions. We may also exchange existing debt for newly
issued debt obligations.
Issuance of Debt Securities
---------------------------
On March 23, 2007, we issued in a private placement an aggregate $300.0 million
principal amount of 6.625% Senior Notes due 2015 and $450.0 million principal
amount of 7.125% Senior Notes due 2019. Proceeds from the sale were used to
refinance $200.0 million principal amount of indebtedness incurred on March 8,
2007 under a bridge loan facility in connection with the acquisition of
Commonwealth. We also filed with the SEC a registration statement for an
exchange offer on the $750.0 million in total of private placement notes
described above, in addition to the $400.0 million principal amount of 7.875%
Senior Notes issued in a private placement on December 22, 2006, for registered
notes. The exchange offer was completed in the second quarter of 2007.
EPPICS
------
In 1996, our consolidated wholly owned subsidiary, Citizens Utilities Trust (the
Trust), issued, in an underwritten public offering, 4,025,000 shares of 5%
Company Obligated Mandatorily Redeemable Convertible Preferred Securities due
2036 (Trust Convertible Preferred Securities or EPPICS), representing preferred
undivided interests in the assets of the Trust, with a liquidation preference of
$50 per security (for a total liquidation amount of $201.3 million). These
securities have an adjusted conversion price of $11.46 per share of our common
stock. The conversion price was reduced from $13.30 to $11.46 during the third
quarter of 2004 as a result of the $2.00 per share of common stock special,
non-recurring dividend. The proceeds from the issuance of the Trust Convertible
Preferred Securities and a Company capital contribution were used to purchase
$207.5 million aggregate liquidation amount of 5% Partnership Convertible
Preferred Securities due 2036 from another wholly owned consolidated subsidiary,
Citizens Utilities Capital L.P. (the Partnership). The proceeds from the
issuance of the Partnership Convertible Preferred Securities and a Company
capital contribution were used to purchase from us $211.8 million aggregate
principal amount of 5% Convertible Subordinated Debentures due 2036. The sole
assets of the Trust are the Partnership Convertible Preferred Securities, and
our Convertible Subordinated Debentures are substantially all the assets of the
Partnership. Our obligations under the agreements related to the issuances of
such securities, taken together, constitute a full and unconditional guarantee
by us of the Trust's obligations relating to the Trust Convertible Preferred
Securities and the Partnership's obligations relating to the Partnership
Convertible Preferred Securities.
In accordance with the terms of the issuances, we paid the annual 5% interest in
quarterly installments on the Convertible Subordinated Debentures in the first
and second quarters of 2007 and the four quarters of 2006. Cash was paid (net of
investment returns) to the Partnership in payment of the interest on the
Convertible Subordinated Debentures. The cash was then distributed by the
Partnership to the Trust and then by the Trust to the holders of the EPPICS.
28
As of June 30, 2007, EPPICS representing a total principal amount of $197.2
million have been converted into 15,912,949 shares of our common stock, and a
total of $4.1 million remains outstanding to third parties. Our long-term debt
footnote indicates $14.6 million of EPPICS outstanding at June 30, 2007, of
which $10.5 million is debt of related parties for which we have an offsetting
receivable.
Interest Rate Management
------------------------
In order to manage our interest expense, we have entered into interest swap
agreements. Under the terms of these agreements, we make semi-annual, floating
rate interest payments based on six month LIBOR and receive a fixed rate on the
notional amount. The underlying variable rate on these swaps is set either in
advance or in arrears.
The notional amounts of fixed-rate indebtedness hedged as of June 30, 2007 and
December 31, 2006 were $400.0 million and $550.0 million, respectively. Such
contracts require us to pay variable rates of interest (estimated average pay
rates of approximately 9.22% as of June 30, 2007 and approximately 9.02% as of
December 31, 2006) and receive fixed rates of interest (average receive rate of
8.50% as of June 30, 2007 and 8.26% as of December 31, 2006). All swaps are
accounted for under SFAS No. 133 (as amended) as fair value hedges. For the
three and six months ended June 30, 2007, the interest expense resulting from
these interest rate swaps totaled approximately $0.8 million and $2.0 million,
respectively.
Credit Facilities
-----------------
As of June 30, 2007, we had available lines of credit with financial
institutions in the aggregate amount of $250.0 million and there were no
outstanding standby letters of credit issued under the facility. Associated
facility fees vary, depending on our debt leverage ratio, and were 0.20% per
annum as of June 30, 2007. The expiration date for this $250.0 million five year
revolving credit agreement is May 18, 2012. During the term of the credit
facility we may borrow, repay and reborrow funds. The credit facility is
available for general corporate purposes but may not be used to fund dividend
payments.
Covenants
---------
The terms and conditions contained in our indentures and credit facilities
agreements include the timely payment of principal and interest when due, the
maintenance of our corporate existence, keeping proper books and records in
accordance with GAAP, restrictions on the allowance of liens on our assets, and
restrictions on asset sales and transfers, mergers and other changes in
corporate control. We currently have no restrictions on the payment of dividends
either by contract, rule or regulation.
Our $200.0 million term loan facility with the Rural Telephone Finance
Cooperative (RTFC) contains a maximum leverage ratio covenant. Under the
leverage ratio covenant, we are required to maintain a ratio of (i) total
indebtedness minus cash and cash equivalents in excess of $50.0 million to (ii)
consolidated adjusted EBITDA (as defined in the agreement) over the last four
quarters no greater than 4.00 to 1.
Our $250.0 million credit facility and our $150.0 million senior unsecured term
loan contain a maximum leverage ratio covenant. Under the leverage ratio
covenant, we are required to maintain a ratio of (i) total indebtedness minus
cash and cash equivalents in excess of $50.0 million to (ii) consolidated
adjusted EBITDA (as defined in the agreements) over the last four quarters no
greater than 4.50 to 1. Although both facilities are unsecured, they will be
equally and ratably secured by certain liens and equally and ratably guaranteed
by certain of our subsidiaries if we issue debt that is secured or guaranteed.
Certain indentures for our senior unsecured debt obligations limit our ability
to create liens or merge or consolidate with other companies and our
subsidiaries' ability to borrow funds, subject to important exceptions and
qualifications.
We are in compliance with all of our debt and credit facility covenants.
Proceeds from the Sale of Equity Securities
-------------------------------------------
We receive proceeds from the issuance of our common stock pursuant to our
stock-based compensation plans. For the six months ended June 30, 2007 and 2006,
we received approximately $11.5 million and $12.8 million, respectively, upon
the exercise of outstanding stock options.
29
Share Repurchase Programs
-------------------------
In February 2007, our Board of Directors authorized us to repurchase up to
$250.0 million of our common stock in public or private transactions over the
following twelve month period. This share repurchase program commenced on March
19, 2007. As of June 30, 2007, we had repurchased approximately 4,633,000 shares
of our common stock at an aggregate cost of approximately $70.7 million.
In February 2006, our Board of Directors authorized us to repurchase up to
$300.0 million of our common stock in public or private transactions over the
following twelve-month period. This share repurchase program commenced on March
6, 2006. As of December 31, 2006, we had repurchased 10,199,900 shares of our
common stock at an aggregate cost of approximately $135.2 million. No more
shares can be repurchased under this authorization.
Dividends
---------
Our ongoing annual dividends of $1.00 per share of common stock under our
current policy utilize a significant portion of our cash generated by operations
and therefore could limit our operating and financial flexibility. While we
believe that the amount of our dividends will allow for adequate amounts of cash
flow for other purposes, any reduction in cash generated by operations and any
increases in capital expenditures, interest expense or cash taxes would reduce
the amount of cash available in excess of dividends.
Off-Balance Sheet Arrangements
------------------------------
We do not maintain any off-balance sheet arrangements, transactions, obligations
or other relationships with unconsolidated entities that would be expected to
have a material current or future effect upon our financial statements.
Critical Accounting Policies and Estimates
------------------------------------------
We review all significant estimates affecting our consolidated financial
statements on a recurring basis and record the effect of any necessary
adjustment prior to their publication. Uncertainties with respect to such
estimates and assumptions are inherent in the preparation of financial
statements; accordingly, it is possible that actual results could differ from
those estimates and changes to estimates could occur in the near term. The
preparation of our financial statements requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of the contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Estimates and judgments are used when accounting for allowance for
doubtful accounts, impairment of long-lived assets, intangible assets,
depreciation and amortization, employee benefit plans, income taxes,
contingencies, and pension and postretirement benefits expenses among others.
Management has discussed the development and selection of these critical
accounting estimates with the Audit Committee of our Board of Directors and our
Audit Committee has reviewed our disclosures relating to them.
There have been no material changes to our critical accounting policies and
estimates from the information provided in "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations" included in our
Annual Report on Form 10-K for the year ended December 31, 2006.
New Accounting Pronouncements
-----------------------------
Accounting for Uncertainty in Income Taxes
------------------------------------------
In July 2006, the FASB issued FASB Interpretation No. (FIN) 48, "Accounting
for Uncertainty in Income Taxes." Among other things, FIN No. 48 requires
applying a "more likely than not" threshold to the recognition and
derecognition of uncertain tax positions either taken or expected to be
taken in the Company's income tax returns. We adopted the provisions of FIN
No. 48 in the first quarter of 2007. The total amount of our FIN No. 48 tax
liability for tax positions that may not be sustained under a "more likely
than not" threshold is reflected on the Company's balance sheet as of the
date of adoption at $44.7 million and amounts to $47.5 million as of June
30, 2007. This amount includes an accrual for interest in the amount of
$5.2 million as of June 30, 2007. These balances include amounts of $9.0
million and $1.4 million for total FIN No. 48 tax liabilities and accrued
interest, respectively, pursuant to the Company's acquisition of
Commonwealth Telephone Enterprises, Inc., completed in March 2007. The
amount of our total FIN No. 48 tax liabilities reflected above that would
positively impact the calculation of our effective income tax rate, if our
tax positions are sustained, is $23.7 million as of June 30, 2007.
30
The Company's policy regarding the classification of interest and penalties
is to include these amounts as a component of income tax expense. This
treatment of interest and penalties is consistent with prior periods. We
have recognized in our year to date statement of operations additional
interest in the amount of $0.5 million. We do not expect that our balances
with respect to our uncertain tax positions will significantly increase or
decrease within the next 12 months. We are subject to income tax
examinations generally for the years 2003 forward for both our federal and
state filing jurisdictions.
How Taxes Collected from Customers and Remitted to Governmental Authorities
---------------------------------------------------------------------------
Should be Presented in the Income Statement
-------------------------------------------
In June 2006, the FASB issued EITF Issue No. 06-3, "How Taxes Collected
from Customers and Remitted to Governmental Authorities Should be Presented
in the Income Statement," which requires disclosure of the accounting
policy for any tax assessed by a governmental authority that is directly
imposed on a revenue-producing transaction, that is Gross versus Net
presentation. EITF No. 06-3 is effective for periods beginning after
December 15, 2006. We adopted the disclosure requirements of EITF No. 06-3
commencing January 1, 2007.
Accounting for Purchases of Life Insurance
------------------------------------------
In September 2006, the FASB reached consensus on the guidance provided by
EITF No. 06-5, "Accounting for Purchases of Life Insurance-Determining the
Amount That Could Be Realized in Accordance with FASB Technical Bulletin
No. 85-4, Accounting for Purchases of Life Insurance." EITF No. 06-5 states
that a policyholder should consider any additional amounts included in the
contractual terms of the insurance policy other than the cash surrender
value in determining the amount that could be realized under the insurance
contract. EITF No. 06-5 also states that a policyholder should determine
the amount that could be realized under the life insurance contract
assuming the surrender of an individual-life by individual-life policy (or
certificate by certificate in a group policy). EITF No. 06-5 is effective
for fiscal years beginning after December 15, 2006. The adoption of the
accounting requirements of EITF No. 06-5 in the first quarter of 2007 had
no material impact on our financial position, results of operation or cash
flows.
Accounting for Endorsement Split-Dollar Life Insurance Arrangements
-------------------------------------------------------------------
In September 2006, the FASB reached consensus on the guidance provided by
EITF No. 06-4, "Accounting for Deferred Compensation and Postretirement
Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements."
The guidance is applicable to endorsement split-dollar life insurance
arrangements, whereby the employer owns and controls the insurance policy,
that are associated with a postretirement benefit. EITF No. 06-4 requires
that for a split-dollar life insurance arrangement within the scope of the
issue, an employer should recognize a liability for future benefits in
accordance with SFAS No. 106 (if, in substance, a postretirement benefit
plan exists) or Accounting Principles Board Opinion No. 12 (if the
arrangement is, in substance, an individual deferred compensation contract)
based on the substantive agreement with the employee. EITF No. 06-4 is
effective for fiscal years beginning after December 15, 2007. The Company
is currently evaluating the impact the adoption of the standard will have
on the Company's results of operations or financial condition.
Fair Value Measurements
-----------------------
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements,"
which defines fair value, establishes a framework for measuring fair value,
and expands disclosures about fair value measurements. The provisions of
SFAS No. 157 are effective as of the beginning of our 2008 fiscal year. The
Company is currently evaluating the impact that the adoption of the
standard will have on the Company's results of operations or financial
condition.
Fair Value Option for Financial Assets and Financial Liabilities
----------------------------------------------------------------
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities Including an amendment of FASB
Statement No. 115," which permits entities to choose to measure many
financial instruments and certain other items at fair value. The provisions
of SFAS No. 159 are effective as of the beginning of our 2008 fiscal year.
The Company is currently evaluating the impact that the adoption of the
standard will have on the Company's results of operations or financial
condition.
31
Accounting for Collateral Assignment Split-Dollar Life Insurance
----------------------------------------------------------------
Arrangements
------------
In March 2007, the FASB ratified the consensus reached by the EITF on Issue
No. 06-10, "Accounting for Collateral Assignment Split-Dollar Life
Insurance Arrangements." EITF No. 06-10 provides guidance on an employers'
recognition of a liability and related compensation costs for collateral
assignment split-dollar life insurance arrangements that provide a benefit
to an employee that extends into postretirement periods and the asset in
collateral assignment split-dollar life insurance arrangements. The
effective date of EITF No. 06-10 is for fiscal years beginning after
December 15, 2007. The Company is currently evaluating the impact that the
adoption of the standard will have on the Company's results of operations
or financial condition.
(b) Results of Operations
---------------------
REVENUE
Revenue is generated primarily through the provision of local, network access,
long distance, and data and internet services. Such services are provided under
either a monthly recurring fee or based on usage at a tariffed rate and revenue
recognition is not dependent upon significant judgments by management, with the
exception of a determination of a provision for uncollectible amounts.
Consolidated revenue for the three months ended June 30, 2007 increased $71.9
million, or 14%, as compared with the prior year period. Consolidated revenue
for the six months ended June 30, 2007 increased $121.2 million, or 12%, as
compared with the prior year period. Excluding the additional revenue due to the
CTE acquisition, revenue increased $17.6 million during the first half of 2007,
or 2%, as compared with the prior year period. During the first quarter of 2007,
we had a significant favorable settlement of a dispute with a carrier that
resulted in a favorable one-time impact to our revenues of $38.7 million.
Excluding the impact of the CTE acquisition and the one-time favorable
settlement, our revenues for the six months ended June 30, 2007 would have been
$992.6 million, a decrease of $21.1 million, or 2%, as compared to the prior
year period.
Change in the number of our access lines is important to our revenue and
profitability. We have lost access lines primarily because of competition,
changing consumer behavior, economic conditions, changing technology and by some
customers disconnecting second lines when they add high-speed internet or cable
modem service. Excluding the impact of the CTE acquisition, we lost
approximately 54,300 access lines during the six months ended June 30, 2007, but
added approximately 32,500 high-speed internet subscribers during this same
period. For the three months ended June 30, 2007, CTE lost approximately 3,100
access lines. The loss of lines during the first six months of 2007 was
primarily among residential customers. The non-residential line losses were
principally in our central region and Rochester, New York, while the residential
losses were throughout our markets. We expect to continue to lose access lines
but to increase high-speed internet subscribers during 2007. A continued loss of
access lines, combined with increased competition and the other factors
discussed herein may cause our revenues, profitability and cash flows to
decrease in the second half of 2007.
Our historical results include the results of operations of Commonwealth from
the date of its acquisition on March 8, 2007. The financial tables below include
a comparative analysis of our results of operations on a historical basis for
the three and six months ended June 30, 2007 and 2006. We have also presented an
analysis of each category for the three and six months ended June 30, 2007 for
the results of Citizens (excluding CTE) and the results of CTE for the last 23
days of March and the three months ended June 30, 2007, as included in the
consolidated results of operations. All variance explanations in the succeeding
paragraphs are based on analysis of the three and six months ended June 30, 2007
financial data for Citizens (excluding CTE) in comparison to the three and six
months ended June 30, 2006, as presented below.
32
TELECOMMUNICATIONS REVENUE
For the three months ended June 30, 2007
---------------------------------------------------- For the three
($ in thousands) As Citizens months ended
-------------- Reported CTE (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- --------------- --------------- -----------
Local services $ 232,622 $ 36,391 $ 196,231 $ 203,254 $ (7,023) -3%
Data and internet services 131,984 10,623 121,361 103,459 17,902 17%
Access services 113,429 22,673 90,756 104,611 (13,855) -13%
Long distance services 47,053 8,031 39,022 38,692 330 1%
Directory services 28,664 275 28,389 28,547 (158) -1%
Other 25,074 4,984 20,090 28,349 (8,259) -29%
-------------- -------------- ------------------- --------------- ---------------
$ 578,826 $ 82,977 $ 495,849 $ 506,912 $ (11,063) -2%
============== ============== =================== =============== ===============
For the six months ended June 30, 2007
------------------------------------------------------- For the six
($ in thousands) As CTE Citizens months ended
-------------- Reported (for 114 days) (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- --------------- --------------- -----------
Local services $ 438,664 $ 45,065 $ 393,599 $ 406,820 $ (13,221) -3%
Data and internet services 248,410 13,179 235,231 203,548 31,683 16%
Access services 252,454 28,368 224,086 215,848 8,238 4%
Long distance services 87,481 10,078 77,403 77,850 (447) -1%
Directory services 57,334 343 56,991 57,344 (353) -1%
Other 50,630 6,610 44,020 52,363 (8,343) -16%
-------------- -------------- ------------------- --------------- ---------------
$ 1,134,973 $ 103,643 $ 1,031,330 $ 1,013,773 $ 17,557 2%
============== ============== =================== =============== ===============
Local Services
Local services revenue for the three months ended June 30, 2007 decreased $7.0
million, or 3%, as compared with the prior year period. The loss of access lines
accounted for $6.5 million of the decline in local revenue.
Local services revenue for the six months ended June 30, 2007 decreased $13.2
million, or 3%, as compared with the prior year period. The loss of access lines
accounted for $12.4 million of the decline in local revenue. Enhanced services
revenue increased $1.3 million, as compared with the prior year period,
primarily due to sale of additional feature packages.
Economic conditions or increasing competition could make it more difficult to
sell our packages and bundles and cause us to lower our prices for those
products and services, which would adversely affect our revenues, profitability
and cash flow.
Data and Internet Services
Data and internet services revenue for the three months ended June 30, 2007
increased $17.9 million, or 17%, as compared with the prior year period
primarily due to growth in data and high-speed internet services. The number of
the Company's high-speed internet subscribers has increased by more than 66,800,
or 19%, since June 30, 2006. Data and Internet services also includes revenue
from data transmission services to other carriers and high-volume commercial
customers with dedicated high-capacity circuits like DS-1's and DS-3's. Revenue
from these dedicated high-capacity circuits increased $6.1 million, or 12%, as
compared with the prior year period, primarily due to growth in those circuits.
Data and internet services revenue for the six months ended June 30, 2007
increased $31.7 million, or 16%, as compared with the prior year period,
primarily due to growth in data and high-speed internet services. Revenue from
the dedicated high-capacity circuits increased $8.2 million, or 8%, as compared
with the prior year period, primarily due to growth in those circuits.
Access Services
Access services revenue for the three months ended June 30, 2007 decreased $13.9
million, or 13%, as compared with the prior year period. Switched access revenue
of $61.8 million decreased $1.0 million, as compared with the prior year period,
primarily due to the impact of a decline in minutes of use related to access
line losses. Access service revenue includes subsidy payments we receive from
federal and state agencies. Subsidy revenue of $29.0 million decreased $12.9
million, primarily due to lower receipts under the Federal High Cost Fund
program resulting from our lower cost structure and an increase in the program's
national average cost per local loop (NACPL), along with reductions in USF
surcharges due to the elimination of high-speed internet units from the USF
calculation. Second quarter 2007 subsidy revenue was negatively impacted by a
$3.3 million local switching support true-up relating to 2005.
33
Access services revenue for the six months ended June 30, 2007 increased $8.2
million, or 4%, as compared with the prior year period. Switched access revenue
of $162.3 million increased $31.6 million, or 24%, as compared with the prior
year period, primarily due to the settlement in the first quarter of a dispute
with a carrier resulting in a favorable impact on our revenue of $38.7 million
(a one-time event), partially offset by the impact of a decline in minutes of
use related to access line losses. Subsidy revenue of $61.8 million decreased
$23.4 million, primarily due to lower receipts under the Federal High Cost Fund
program resulting from our lower cost structure and an increase in the program's
NACPL, along with reductions in USF surcharges due to the elimination of
high-speed internet units from the USF calculation.
Increases in the number of Competitive Eligible Telecommunications Companies
(including wireless companies) receiving federal subsidies, among other factors,
may lead to further increases in the NACPL, thereby resulting in decreases in
our federal subsidy revenue in the future. The FCC and state regulators are
currently considering a number of proposals for changing the manner in which
eligibility for federal subsidies is determined as well as the amounts of such
subsidies. The FCC is also reviewing the mechanism by which subsidies are
funded. Additionally, the FCC has an open proceeding to address reform to access
charges and other intercarrier compensation. We cannot predict when or how these
matters will be decided nor the effect on our subsidy or access revenues. Future
reductions in our subsidy and access revenues are not expected to be accompanied
by proportional decreases in our costs, so any further reductions in those
revenues will directly affect our profitability and cash flows.
Long Distance Services
Long distance services revenue for the three months ended June 30, 2007
increased $0.3 million, or 1%, as compared with the prior year period. Long
distance services revenue for the six months ended June 30, 2007 decreased $0.4
million, or 1%, as compared with the prior year period. We have actively
marketed a package of unlimited long distance minutes with our digital phone
bundled service offerings. The sale of our digital phone product and its
associated unlimited minutes has resulted in an increase in minutes used by our
long distance customers and has had the effect of lowering our overall average
rate per minute billed. Our long distance minutes of use increased by 9% during
the six months ended June 30, 2007 compared to the first half of 2006 and, as
noted below, has increased our cost of services provided. Our long distance
revenues have remained relatively steady, but may decrease in the future due to
lower rates and/or minutes of use. Competing services such as wireless, VOIP,
and cable telephony are resulting in a loss of customers, minutes of use and
further declines in the rates we charge our customers. We expect these factors
to affect our long distance revenues during the remainder of 2007.
Directory Services
Directory services revenue for the three and six months ended June 30, 2007 was
relatively unchanged as compared with the prior year periods with slightly lower
yellow pages advertising, mainly in Rochester, New York.
Other
Other revenue for the three months ended June 30, 2007 decreased $8.3 million,
or 29%, as compared with the prior year period, primarily due to higher bad debt
expenses and the impact of our free video promotions in some of our markets.
Other revenue for the six months ended June 30, 2007 decreased $8.3 million, or
16%, as compared with the prior year period, primarily due to higher bad debt
expenses and the impact of our free video promotions in some of our markets.
34
NETWORK ACCESS EXPENSES
For the three months ended June 30, 2007
---------------------------------------------------- For the three
($ in thousands) As Citizens months ended
-------------- Reported CTE (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- -------------------- ---------------- --------------- -----------
Network access $ 51,878 $ 6,837 $ 45,041 $ 38,402 $ 6,639 17%
For the six months ended June 30, 2007
---------------------------------------------------- For the six
($ in thousands) As CTE Citizens months ended
-------------- Reported (for 114 days) (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- --------------- --------------- -----------
Network access $ 102,671 $ 10,686 $ 91,985 $ 78,620 $ 13,365 17%
Network access expenses for the three months ended June 30, 2007 increased $6.6
million, or 17%, as compared with the prior year period, primarily due to
increasing rates and usage related to our long distance product and our data
backbone. Network access expenses for the six months ended June 30, 2007
increased $13.4 million, or 17%, as compared with the prior year period,
primarily due to increasing rates and usage related to our long distance product
and our data backbone. As we continue to increase our sales of data products
such as high-speed internet and expand the availability of our unlimited long
distance calling plans, our network access expense is likely to continue to
increase. Expenses associated with access lines lost have offset some of the
increase.
OTHER OPERATING EXPENSES
For the three months ended June 30, 2007
---------------------------------------------------- For the three
($ in thousands) As Citizens months ended
-------------- Reported CTE (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- --------------- --------------- ----------
Operating expenses $ 162,246 $ 37,266 $ 124,980 $ 135,827 $ (10,847) -8%
Taxes other than income taxes 22,754 971 21,783 20,934 849 4%
Sales and marketing 30,188 2,797 27,391 22,739 4,652 20%
-------------- -------------- ------------------- --------------- ---------------
$ 215,188 $ 41,034 $ 174,154 $ 179,500 $ (5,346) -3%
============== ============== =================== =============== ===============
For the six months ended June 30, 2007
---------------------------------------------------- For the six
($ in thousands) As CTE Citizens months ended
-------------- Reported (for 114 days) (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- --------------- --------------- ----------
Operating expenses $ 301,971 $ 44,192 $ 257,779 $ 274,073 $ (16,294) -6%
Taxes other than income taxes 48,954 2,260 46,694 46,769 (75) 0%
Sales and marketing 54,134 4,586 49,548 45,959 3,589 8%
-------------- -------------- ------------------- --------------- ---------------
$ 405,059 $ 51,038 $ 354,021 $ 366,801 $ (12,780) -3%
============== ============== =================== =============== ===============
Operating expenses for the three months ended June 30, 2007 decreased $10.8
million, or 8%, as compared with the prior year period, primarily due to a
reduction in employees, improved expense control in benefit costs and the
allocation of common corporate costs over a larger base of operations. Operating
expenses in the second quarter of 2007 included approximately $3.0 million of
incremental expenses related to the CTE integration and severance costs in other
areas of the business. Operating expenses for the six months ended June 30, 2007
decreased $16.3 million, or 6%, as compared with the prior year period,
primarily due to headcount reductions and associated decreases in salaries and
benefits and the allocation of common corporate costs over a larger base of
operations. The USF contribution rate and PUC fees decreased from the prior year
period, resulting in a reduction in costs of $5.7 million.
We routinely review our operations, personnel and facilities to achieve greater
efficiencies. We are in the process of consolidating our call center operations
and pursuing workforce efficiencies in other areas. As we work through the
consolidation, including the opening of a new call center in Deland, FL in
August 2006, and the closing of call centers in 2007, we expect that our
operating expenses will temporarily increase. During the third quarter of 2007,
we expect that over 100 employees will have accepted early retirement incentives
or had their positions eliminated. Some of these positions will be replaced in
other locations. Accordingly, a charge for the severance or early retirement
costs will be recorded in the third quarter of 2007, and such charge may be in
the range of $5.0 million to $10.0 million, based on the acceptances of early
retirement and other employment considerations. As noted elsewhere, the
introduction of new service offerings may also negatively impact our cost
structure.
35
Included in operating expenses is stock compensation expense. Stock compensation
expense was $2.0 million and $2.7 million for the three months ended June 30,
2007 and 2006, respectively, and $5.4 million and $5.3 million for the six
months ended June 30, 2007 and 2006, respectively. In 2006, we began expensing
the cost of the unvested portion of outstanding stock options pursuant to SFAS
No. 123R.
Included in operating expenses is pension and other postretirement benefit
expenses. Based on current assumptions and plan asset values, we estimate that
our 2007 pension and other postretirement benefit expenses, including the costs
associated with our recently acquired Commonwealth plans, will be approximately
$13.0 million to $15.0 million and that no contribution will be required to be
made by us to the pension plans in 2007. In future periods, if the value of our
pension assets decline and/or projected pension and/or postretirement benefit
costs increase, we may have increased pension and/or postretirement expenses.
Taxes other than income taxes for the three and six months ended June 30, 2007
were relatively unchanged as compared with the prior year periods.
Sales and marketing expenses for the three months ended June 30, 2007 increased
$4.7 million, or 20%, as compared with the prior year period. Sales and
marketing expenses for the six months ended June 30, 2007 increased $3.6
million, or 8%, as compared with the prior year period. Sales and marketing
expenses may increase due to higher advertising and marketing in a competitive
environment and the launch of new products.
DEPRECIATION AND AMORTIZATION EXPENSE
For the three months ended June 30, 2007
---------------------------------------------------- For the three
($ in thousands) As Citizens months ended
-------------- Reported CTE (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- --------------- --------------- -----------
Depreciation expense $ 93,286 $ 11,488 $ 81,798 $ 87,957 $ (6,159) -7%
Amortization expense 47,176 15,582 * 31,594 31,595 (1) 0%
-------------- -------------- ------------------- --------------- ---------------
$ 140,462 $ 27,070 $ 113,392 $ 119,552 $ (6,160) -5%
============== ============== =================== =============== ===============
For the six months ended June 30, 2007
---------------------------------------------------- For the six
($ in thousands) As CTE Citizens months ended
-------------- Reported (for 114 days) (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- --------------- --------------- -----------
Depreciation expense $ 179,933 $ 14,448 $ 165,485 $ 178,366 $ (12,881) -7%
Amortization expense 82,710 19,520 * 63,190 63,190 - 0%
-------------- -------------- ------------------- --------------- ---------------
$ 262,643 $ 33,968 $ 228,675 $ 241,556 $ (12,881) -5%
============== ============== =================== =============== ===============
*Represents amortization expense related to the customer base acquired in the
Commonwealth acquisition.
Depreciation expense for the three months ended June 30, 2007 decreased $6.2
million, or 7%, as compared with the prior year period due to a declining net
asset base partially offset by changes in the remaining useful lives of certain
assets.
Depreciation expense for the six months ended June 30, 2007 decreased $12.9
million, or 7%, as compared with the prior year period due to a declining net
asset base partially offset by changes in the remaining useful lives of certain
assets.
36
INVESTMENT AND OTHER INCOME (LOSS), NET / INTEREST EXPENSE / INCOME TAX EXPENSE
For the three months ended June 30, 2007
---------------------------------------------------- For the three
($ in thousands) As Citizens months ended
-------------- Reported CTE (excluding CTE) June 30, 2006 $ Change % Change
-------------- -------------- ------------------- ---------------- --------------- ---------
Investment and
other income (loss), net $ (6,517) $ 3,381 $ (9,898) $ 65,363 $ (75,261) -115%
Interest expense $ 98,649 $ (394) $ 99,043 $ 85,341 $ 13,702 16%
Income tax expense $ 25,573 $ 14,136 $ 11,437 $ 54,734 $ (43,297) -79%
For the six months ended June 30, 2007
------------------------------------------------------ For the six
($ in thousands) As CTE Citizens months ended
-------------- Reported (for 114 days) (excluding CTE) June 30, 2006 $ Change % Change
-------------- --------------- ---------------------- --------------- -------------- ---------
Investment and
other income (loss), net $ 3,500 $ 4,165 $ (665) $ 64,012 $ (64,677) -101%
Interest expense $192,613 $ (169) $192,782 $170,734 $ 22,048 13%
Income tax expense $ 67,261 $ 16,417 $ 50,844 $ 81,341 $ (30,497) -37%
Investment and other income (loss), net for the three months ended June 30, 2007
decreased $75.3 million, or 115%, as compared with the prior year period,
primarily due to the $64.6 million in proceeds received in April 2006 as a
result of the liquidation and dissolution of the RTB, the loss on retirement of
debt in the second quarter of 2007 for $17.1 million, partially offset by an
increase of $4.2 million in income from short-term investments of cash.
Investment and other income (loss), net for the six months ended June 30, 2007
decreased $64.7 million, or 101%, as compared with the prior year period,
primarily due to the $64.6 million in proceeds received in April 2006 as a
result of the liquidation and dissolution of the RTB, the loss on retirement of
debt during the first six months of 2007 for $18.2 million, partially offset by
an increase of $15.0 million in income from short-term investments of cash.
In August 2005, the Board of Directors of the Rural Telephone Bank (RTB) voted
to dissolve the bank. In November 2005, the liquidation and dissolution of the
RTB was initiated with the signing of the 2006 Agricultural Appropriation bill
by President Bush. We received approximately $64.6 million in cash from the
dissolution of the RTB in April 2006, which resulted in the recognition of a
pre-tax gain of approximately $61.4 million during the second quarter of 2006.
Our tax net operating losses were used to absorb the cash liability for taxes.
We borrowed $550.0 million in December 2006 in anticipation of the Commonwealth
acquisition in 2007. Our average cash balance was $729.6 million and $205.1
million for the six months ended June 30, 2007 and 2006, respectively.
Interest expense for the three months ended June 30, 2007 increased $13.7
million, or 16%, as compared with the prior year period, primarily due to a
higher average debt balance resulting from financing the Commonwealth
acquisition. Our average debt outstanding was $5,064.5 million and $4,110.6
million for the three months ended June 30, 2007 and 2006, respectively. Our
composite average borrowing rate (including the effect of our swap agreements)
for the three months ended June 30, 2007 as compared with the prior year period
was 17 basis points lower, decreasing from 8.16% to 7.99%.
Interest expense for the six months ended June 30, 2007 increased $22.0 million,
or 13%, as compared with the prior year period, primarily due to a higher
average debt balance resulting from financing the Commonwealth acquisition. Our
average debt outstanding was $4,887.3 million and $4,152.3 million for the six
months ended June 30, 2007 and 2006, respectively.
Income taxes for the three and six months ended June 30, 2007 decreased $43.3
million, or 79% and $30.5 million, or 37%, respectively, as compared with the
prior year periods, primarily due to changes in taxable income. The effective
tax rate on a fully consolidated basis for the first six months of 2007 was
38.3% as compared with 37.0% for the first six months of 2006. Our cash taxes
paid for the six months ended June 30, 2007 were $47.4 million, an increase of
$44.6 million over the first six months of 2006, as our tax loss carryforwards
become utilized. We expect to pay approximately $30.0 million to $35.0 million
in the second half of 2007.
37
DISCONTINUED OPERATIONS
($ in thousands) For the three months ended June 30,
-------------- ----------------------------------------------------------------------
2007 2006 $ Change % Change
-------------- -------------- ------------------- ---------------
Revenue $ - $ 43,584 $ (43,584) -100%
Operating income $ - $ 11,482 $ (11,482) -100%
Income taxes $ - $ 4,526 $ (4,526) -100%
Net income $ - $ 6,956 $ (6,956) -100%
($ in thousands) For the six months ended June 30,
-------------- ----------------------------------------------------------------------
2007 2006 $ Change % Change
-------------- -------------- ------------------- ---------------
Revenue $ - $ 86,078 $ (86,078) -100%
Operating income $ - $ 21,940 $ (21,940) -100%
Income taxes $ - $ 8,488 $ (8,488) -100%
Net income $ - $ 13,452 $ (13,452) -100%
On July 31, 2006, we sold our CLEC business, Electric Lightwave, LLC (ELI), for
$255.3 million in cash plus the assumption of approximately $4.0 million in
capital lease obligations. We recognized a pre-tax gain on the sale of ELI of
approximately $116.7 million. Our after-tax gain on the sale was $71.6 million.
Our cash liability for taxes as a result of the sale is expected to be
approximately $5.0 million due to the utilization of existing tax net operating
losses on both the federal and state level.
38
Item 3. Quantitative and Qualitative Disclosures about Market Risk
----------------------------------------------------------
We are exposed to market risk in the normal course of our business operations
due to ongoing investing and funding activities. Market risk refers to the
potential change in fair value of a financial instrument as a result of
fluctuations in interest rates and equity prices. We do not hold or issue
derivative instruments, derivative commodity instruments or other financial
instruments for trading purposes. As a result, we do not undertake any specific
actions to cover our exposure to market risks, and we are not party to any
market risk management agreements other than in the normal course of business or
to hedge long-term interest rate risk. Our primary market risk exposures are
interest rate risk and equity price risk as follows:
Interest Rate Exposure
Our exposure to market risk for changes in interest rates relates primarily to
the interest-bearing portion of our investment portfolio and interest on our
long-term debt. The long-term debt include various instruments with various
maturities and weighted average interest rates.
Our objectives in managing our interest rate risk are to limit the impact of
interest rate changes on earnings and cash flows and to lower our overall
borrowing costs. To achieve these objectives, a majority of our borrowings have
fixed interest rates. Consequently, we have limited material future earnings or
cash flow exposures from changes in interest rates on our long-term debt. An
adverse change in interest rates would increase the amount that we pay on our
variable obligations and could result in fluctuations in the fair value of our
fixed rate obligations. Based upon our overall interest rate exposure at June
30, 2007, a near-term change in interest rates would not materially affect our
consolidated financial position, results of operations or cash flows.
In order to manage our interest rate risk exposure, we have entered into
interest rate swap agreements. Under the terms of the agreements, we make
semi-annual, floating interest rate interest payments based on six month LIBOR
and receive a fixed rate on the notional amount.
Sensitivity analysis of interest rate exposure
At June 30, 2007, the fair value of our long-term debt was estimated to be
approximately $4.7 billion, based on our overall weighted average interest rate
of 8.02% and our overall weighted average maturity of approximately 13 years.
There has been no material change in the weighted average maturity applicable to
our obligations since December 31, 2006.
The overall weighted average interest rate decreased approximately 7 basis
points during the second quarter of 2007. A hypothetical increase of 80 basis
points (10% of our overall weighted average borrowing rate) would result in an
approximate $264.4 million decrease in the fair value of our fixed rate
obligations.
Equity Price Exposure
Our exposure to market risks for changes in equity prices as of June 30, 2007 is
limited to our pension assets. We have no other equity investments of any
material amount.
Item 4. Controls and Procedures
-----------------------
(a) Evaluation of disclosure controls and procedures
We carried out an evaluation, under the supervision and with the participation
of our management, including our principal executive officer and principal
financial officer, regarding the effectiveness of the design and operation of
our disclosure controls and procedures. Based upon this evaluation, our
principal executive officer and principal financial officer concluded, as of the
end of the period covered by this report, June 30, 2007, that our disclosure
controls and procedures are effective.
(b) Changes in internal control over financial reporting
As a result of our Commonwealth acquisition we have begun to integrate certain
business processes and systems of the acquired entity. Accordingly, certain
changes have been made and will continue to be made to our internal controls
over financial reporting until such time as this integration is complete. There
have been no other changes in our internal control over financial reporting
identified in an evaluation thereof that occurred during the second fiscal
quarter of 2007 that materially affected or is reasonably likely to materially
affect our internal control over financial reporting.
39
PART II. OTHER INFORMATION
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES
Item 1. Legal Proceedings
-----------------
There have been no material changes to our legal proceedings from the
information provided in Item 3. Legal Proceedings included in our Annual Report
on Form 10-K for the year ended December 31, 2006, except as set forth below:
As reported in our Annual Report on Form 10-K for the year ended December 31,
2006, the City of Bangor, Maine, filed suit against us on November 22, 2002, in
the U.S. District Court for the District of Maine (City of Bangor v. Citizens
Communications Company, Civ. Action No. 02-183-B-S). The City alleged, among
other things, that we are responsible for the costs of cleaning up environmental
contamination alleged to have resulted from the operation of a manufactured gas
plant owned by Bangor Gas Company from 1852-1948 and by us from 1948-1963. In
acquiring the operation in 1948, we acquired the stock of Bangor Gas Company and
merged it into us. The City alleged the existence of extensive contamination of
the Penobscot River and initially asserted that money damages and other relief
at issue in the lawsuit could exceed $50.0 million. The City also requested that
punitive damages be assessed against us. We filed an answer denying liability to
the City, and asserted a number of counterclaims against the City. In addition,
we identified a number of other potentially responsible parties that may be
liable for the damages alleged by the City and joined them as parties to the
lawsuit. These additional parties include UGI Utilities, Inc. and Centerpoint
Energy Resources Corporation. The Court dismissed all but two of the City's
claims, including its claims for joint and several liability under the
Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA)
and the claim against us for punitive damages.
On June 27, 2006, the court issued Findings of Fact and Conclusions of Law in
the first phase of the case. The court found contamination in only a small
section of the River and determined that Citizens and the City should share
cleanup costs.
Subsequent to the June 27, 2006 findings, we began settlement discussions with
the City, with participation from the State of Maine. In February 2007, we
reached an agreement to settle the matter for a payment by us of $7.6 million.
The payment was made on July 31, 2007 and the settlement is now final. Under the
settlement agreement, we and the City will share in any recoveries from the
various third party defendants. We also executed a Consent Decree with the City
and the State that subsequently was approved and entered by the Court. On July
31, certain of the third party defendants filed a notice of appeal concerning
entry of the Consent Decree. Even if such appeal (which we intend to vigorously
contest) were successful, it would not affect the finality of our settlement
with the City.
In addition, we have demanded that various of our insurance carriers defend and
indemnify us with respect to the City's lawsuit, and on December 26, 2002, we
filed a declaratory judgment action against those insurance carriers in the
Superior Court of Penobscot County, Maine, for the purpose of establishing their
obligations to us with respect to the City's lawsuit. We intend to vigorously
pursue this lawsuit and to obtain from our insurance carriers indemnification
for any amounts paid by us in settlement of the City's lawsuit as well as to
recover the costs of our defense of that lawsuit. We cannot at this time
determine what amount we may recover from third parties or insurance carriers.
Ronald A. Katz Technology Licensing LP, filed suit against us for patent
infringement on June 8, 2007 in the U.S. District Court for the District of
Delaware. Katz Technology alleges that, by operating automated telephone
systems, including customer service systems, that allow our customers to utilize
telephone calling cards, order internet, DSL, and dial-up services, and perform
a variety of account related tasks such as billing and payments, we have
infringed thirteen of Katz Technology's patents and continue to infringe three
of Katz Technology's patents. Katz Technology seeks unspecified damages
resulting from our alleged infringement, as well as a permanent injunction
enjoining us from continuing the alleged infringement. Katz Technology
subsequently filed a tag-along notice with the Judicial Panel on Multi-District
Litigation, notifying them of this action and its relatedness to In re Katz
Interactive Dial Processing Patent Litigation (MDL No. 1816), pending in the
Central District of California before Judge R. Gary Klausner. The Judicial Panel
on Multi-District Litigation has transferred the case to the Central District of
California. We intend to vigorously defend against this lawsuit.
40
On June 24, 2004, one of our subsidiaries, Frontier Subsidiary Telco, Inc.,
received a "Notice of Indemnity Claim" from Citibank, N.A., that is related to a
complaint pending against Citibank and others in the U.S. Bankruptcy Court for
the Southern District of New York as part of the Global Crossing bankruptcy
proceeding. Citibank bases its claim for indemnity on the provisions of a credit
agreement that was entered into in October 2000 between Citibank and our
subsidiary. We purchased Frontier Subsidiary Telco, Inc., in June 2001 as part
of our acquisition of the Frontier telephone companies. The complaint against
Citibank, for which it seeks indemnification, alleges that the seller improperly
used a portion of the proceeds from the Frontier transaction to pay off the
Citibank credit agreement, thereby defrauding certain debt holders of Global
Crossing North America Inc. Although the credit agreement was paid off at the
closing of the Frontier transaction, Citibank claims the indemnification
obligation survives. Damages sought against Citibank and its co-defendants could
exceed $1.0 billion. In August 2004, we notified Citibank by letter that we
believe its claims for indemnification are invalid and are not supported by
applicable law. In 2005, Citibank moved to dismiss the underlying complaint
against it. That motion is currently pending. We have received no further
communications from Citibank since our August 2004 letter.
Item 1A. Risk Factors
------------
There have been no material changes to our risk factors from the information
provided in Item 1A. "Risk Factors" included in our Annual Report on Form 10-K
for the year ended December 31, 2006.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
-----------------------------------------------------------
There were no unregistered sales of equity securities during the quarter ended
June 30, 2007.
------------------------------------------------------------------------------------------------------------------------------------
(d) Maximum
Approximate
Dollar Value of
(c) Total Number of Shares that May
(a) Total Shares Purchased as Yet Be Purchased
Number of (b) Average Part of Publicly Under the Plans or
Shares Price Paid Announced Plans or Programs (in
Period Purchased per Share Programs millions)
------------------------------------------------------------------------------------------------------------------------------------
April 1, 2007 to April 30, 2007
Share Repurchase Program (1) 1,155,400 $15.28 1,987,400 $220.3
Employee Transactions (2) 4,225 $15.46 N/A N/A
May 1, 2007 to May 31, 2007
Share Repurchase Program (1) 1,100,000 $15.65 3,078,400 $203.1
Employee Transactions (2) 273 $15.67 N/A N/A
June 1, 2007 to June 30, 2007
Share Repurchase Program (1) 1,554,400 $15.34 4,632,800 $179.3
Employee Transactions (2) - $ - N/A N/A
Totals April 1, 2007 to June 30, 2007
Share Repurchase Program (1) 3,809,800 $15.41 4,632,800 $179.3
Employee Transactions (2) 4,498 $15.47 N/A N/A
(1) In February 2007, our Board of Directors authorized us to repurchase up to
$250.0 million of our common stock, in public or private transactions over
the following twelve-month period. This share repurchase program commenced
on March 19, 2007.
(2) Includes restricted shares withheld (under the terms of grants under
employee stock compensation plans) to offset minimum tax withholding
obligations that occur upon the vesting of restricted shares. The Company's
stock compensation plans provide that the value of shares withheld shall be
the average of the high and low price of the Company's common stock on the
date the relevant transaction occurs.
41
Item 4. Submission of Matters to a Vote of Security Holders
---------------------------------------------------
(a) The registrant held its 2007 Annual Meeting of the Stockholders on May
18, 2007 (the "Meeting").
(b) Election of directors. At the Meeting, all nominees were elected
pursuant to the following votes:
Number of Votes
---------------
DIRECTOR FOR WITHHELD
-------- --- --------
Kathleen Q. Abernathy 292,095,408 14,555,073
Leroy T. Barnes, Jr. 289,333,550 17,316,931
Michael T. Dugan 292,230,330 14,420,151
Jeri B. Finard 290,019,145 16,631,335
Lawton W. Fitt 289,884,698 16,765,783
William M. Kraus 283,385,838 23,264,643
Howard L. Schrott 284,997,277 21,653,204
Larraine D. Segil 284,781,732 21,868,748
Bradley E. Singer 290,654,624 15,995,857
David H. Ward 289,049,068 17,601,413
Myron A. Wick, III 290,183,581 16,466,900
Mary Agnes Wilderotter 289,284,504 17,365,977
(c) Other matters submitted to stockholders at the Meeting:
(1) Adoption of the 2008 Citizens Incentive Plan. The matter passed
with the following vote:
Number of votes FOR 284,889,080
Number of votes AGAINST 16,337,549
Number of votes ABSTAINING 5,423,849
(2) Adoption of the amendment to the Amended and Restated 2000 Equity
Incentive Plan. The matter passed with the following vote:
Number of votes FOR 280,306,779
Number of votes AGAINST 20,063,425
Number of votes ABSTAINING 6,280,276
(3) Ratification of appointment of KPMG LLP as the Company's
independent registered public accounting firm for 2007. The
matter passed with the following vote:
Number of votes FOR 296,763,309
Number of votes AGAINST 7,003,372
Number of votes ABSTAINING 2,883,797
Item 5. Other Information
-----------------
As disclosed in our Proxy Statement for the 2007 Annual Meeting, proposals that
stockholders wish to include in our Proxy Statement and form of proxy for our
2008 annual Stockholders meeting must be received by the Secretary of the
Company no later than December 22, 2007. For a stockholder proposal that is not
intended to be included in our Proxy Statement for our 2008 Annual Meeting, the
proposal must be received by the Secretary of the Company not earlier than
January 18, 2008 nor later than February 19, 2008 in order to be properly
presented at the 2008 annual meeting. Furthermore, in accordance with the proxy
rules and regulations of the Securities and Exchange Commission, if a
stockholder does not notify us of a proposal by February 19, 2008, then our
proxies would be able to use their discretionary voting authority if a
stockholder's proposal is raised at the meeting.
42
Item 6. Exhibits
--------
a) Exhibits:
31.1 Certification of Principal Executive Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934.
31.2 Certification of Principal Financial Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
43
SIGNATURE
---------
Pursuant to the requirements 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.
CITIZENS COMMUNICATIONS COMPANY
-------------------------------
(Registrant)
By: /s/ Robert J. Larson
--------------------------------
Robert J. Larson
Senior Vice President and
Chief Accounting Officer
Date: August 2, 2007
44