-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, A/41uSekYjabAf/1TzQBhdii5KevPRr61fXx32wwUIYmIBC8hT/bIkIb0znxlZ1l 9hljb5NrDSj7haI1zZUxEw== 0000020520-03-000017.txt : 20030812 0000020520-03-000017.hdr.sgml : 20030812 20030812161531 ACCESSION NUMBER: 0000020520-03-000017 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20030630 FILED AS OF DATE: 20030812 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CITIZENS COMMUNICATIONS CO CENTRAL INDEX KEY: 0000020520 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 060619596 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-11001 FILM NUMBER: 03837775 BUSINESS ADDRESS: STREET 1: HIGH RIDGE PK BLDG 3 CITY: STAMFORD STATE: CT ZIP: 06905 BUSINESS PHONE: 2036145600 MAIL ADDRESS: STREET 1: HIGH RIDGE PARK BLDG NO 3 CITY: STAMFORD STATE: CT ZIP: 06905 FORMER COMPANY: FORMER CONFORMED NAME: CITIZENS UTILITIES CO DATE OF NAME CHANGE: 19920703 10-Q 1 form10q2ndqtr2003.txt 2ND QTR FORM 10-Q 2003 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, 2003 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, 2003 ------------- 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 --------- CITIZENS COMMUNICATIONS COMPANY ---------------------------------------------------- (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 - --------------------------------------- ----------- (Address of principal executive offices) (Zip Code) (203) 614-5600 -------------------------------------------------- (Registrant's telephone number, including area code) N/A - ------------------------------------------------------------------------------- (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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes X No --- --- The number of shares outstanding of the registrant's Common Stock as of July 31, 2003 was 284,318,606.
CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES Index Page No. -------- Part I. Financial Information (Unaudited) Financial Statements Consolidated Balance Sheets at June 30, 2003 and December 31, 2002 2 Consolidated Statements of Operations for the three months ended June 30, 2003 and 2002 3 Consolidated Statements of Operations for the six months ended June 30, 2003 and 2002 4 Consolidated Statements of Shareholders' Equity for the year ended December 31, 2002 and the six months ended June 30, 2003 5 Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2003 and 2002 5 Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2002 6 Notes to Consolidated Financial Statements 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 21 Quantitative and Qualitative Disclosures About Market Risk 32 Controls and Procedures 34 Part II. Other Information Legal Proceedings 35 Submission of Matters to a Vote of Security Holders 36 Other Information 36 Exhibits and Reports on Form 8-K 36 Signature 38
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PART I. FINANCIAL INFORMATION Item 1.Financial Statements -------------------- CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ($ in thousands) (Unaudited) June 30, 2003 December 31, 2002 ------------------- ------------------ ASSETS - ------ Current assets: Cash and cash equivalents $ 385,038 $ 393,177 Accounts receivable, less allowances of $40,052 and $38,946, respectively 279,472 310,929 Other current assets 38,390 49,114 Assets held for sale 471,331 447,764 ------------------- ------------------ Total current assets 1,174,231 1,200,984 Property, plant and equipment, net 3,620,734 3,690,056 Goodwill, net 1,858,558 1,869,348 Other intangibles, net 875,904 942,970 Investments 37,619 29,846 Other assets 395,226 413,538 ------------------- ------------------ Total assets $ 7,962,272 $ 8,146,742 =================== ================== LIABILITIES AND EQUITY - ---------------------- Current liabilities: Long-term debt due within one year $ 105,776 $ 58,911 Accounts payable and other current liabilities 503,489 565,986 Liabilities related to assets held for sale 113,186 145,969 ------------------- ------------------ Total current liabilities 722,451 770,866 Deferred income taxes 244,682 137,116 Customer advances for construction and contributions in aid of construction 133,811 146,661 Other liabilities 287,735 301,349 Equity units 460,000 460,000 Long-term debt 4,556,392 4,957,361 Company Obligated Manditorily Redeemable Convertible Preferred Securities* 201,250 201,250 Shareholders' equity: Common stock, $0.25 par value (600,000,000 authorized shares; 284,273,000 and 282,482,000 outstanding and 295,312,000 and 294,080,000 issued at June 30, 2003 and December 31, 2002, respectively) 73,828 73,520 Additional paid-in capital 1,951,460 1,943,406 Accumulated deficit (391,545) (553,033) Accumulated other comprehensive loss (97,371) (102,169) Treasury stock (180,421) (189,585) ------------------- ------------------ Total shareholders' equity 1,355,951 1,172,139 ------------------- ------------------ Total liabilities and equity $ 7,962,272 $ 8,146,742 =================== ==================
* Represents securities of a subsidiary trust, the sole assets of which are securities of a subsidiary partnership, substantially all the assets of which are convertible debentures of the Company. 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, 2003 AND 2002 ($ in thousands, except per-share amounts) (Unaudited) 2003 2002 -------------- -------------- Revenue $ 643,954 $ 662,439 Operating expenses: Cost of services 113,537 113,786 Other operating expenses 232,493 251,426 Depreciation and amortization 150,359 186,378 Reserve for telecommunications bankruptcies 2,260 10,001 Restructuring and other expenses 10,113 18,280 -------------- -------------- Total operating expenses 508,762 579,871 -------------- -------------- Operating income 135,192 82,568 Investment and other income (loss), net 24,566 (29,188) Gain on sales of assets 6,671 - Interest expense 106,436 119,947 -------------- -------------- Income (loss) before income taxes 59,993 (66,567) Income tax expense (benefit) 24,384 (26,560) -------------- -------------- Income (loss) before dividends on convertible preferred securities 35,609 (40,007) Dividends on convertible preferred securities, net of income tax benefit of $(963) 1,552 1,552 -------------- -------------- Net income (loss) attributable to common shareholders $ 34,057 $ (41,559) ============== ============== Basic and diluted income (loss) per common share $ 0.12 $ (0.15)
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, 2003 AND 2002 ($ in thousands, except per-share amounts) (Unaudited) 2003 2002 -------------- -------------- Revenue $ 1,295,816 $ 1,341,773 Operating expenses: Cost of services 226,756 242,024 Other operating expenses 468,314 512,280 Depreciation and amortization 288,907 364,552 Reserve for telecommunications bankruptcies 2,260 17,805 Restructuring and other expenses 10,092 22,185 -------------- -------------- Total operating expenses 996,329 1,158,846 -------------- -------------- Operating income 299,487 182,927 Investment and other income (loss), net 74,388 (78,139) Gain on sales of assets, net 5,021 - Interest expense 215,712 241,554 -------------- -------------- Income (loss) from continuing operations before income taxes, dividends on convertible preferred securities and cumulative effect of change in accounting principle 163,184 (136,766) Income tax expense (benefit) 64,360 (53,502) -------------- -------------- Income (loss) from continuing operations before dividends on convertible preferred securities and cumulative effect of change in accounting principle 98,824 (83,264) Dividends on convertible preferred securities, net of income tax benefit of $(1,926) 3,105 3,105 -------------- -------------- Income from continuing operations before cumulative effect of change in accounting principle 95,719 (86,369) Loss from discontinued operations, net of income tax benefit of $(920) - (1,478) Gain on disposal of water segment, net of tax of $139,874 - 169,326 -------------- -------------- Total income from discontinued operations, net of tax of $138,954 - 167,848 Income before cumulative effect of change in accounting principle 95,719 81,479 Cumulative effect of change in accounting principle, net of tax of $41,591 and $0, respectively 65,769 (39,812) -------------- -------------- Net income attributable to common shareholders $ 161,488 $ 41,667 ============== ============== Basic income (loss) per common share: Income (loss) from continuing operations before cumulative effect of change in accounting principle $ 0.34 $ (0.31) Income from discontinued operations $ - $ 0.60 Income before cumulative effect of change in accounting principle $ 0.34 $ 0.29 Cumulative effect of change in accounting principle $ 0.23 $ (0.14) Net income attributable to common shareholders $ 0.57 $ 0.15 Diluted income (loss) per common share: Income (loss) from continuing operations before cumulative effect of change in accounting principle $ 0.33 $ (0.31) Income from discontinued operations $ - $ 0.59 Income before cumulative effect of change in accounting principle $ 0.33 $ 0.28 Cumulative effect of change in accounting principle $ 0.22 $ (0.13) Net income attributable to common shareholders $ 0.55 $ 0.15
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, 2002 AND THE SIX MONTHS ENDED JUNE 30, 2003 ($ in thousands) (Unaudited) Retained Accumulated Common Stock Additional Earnings Other Treasury Stock Total ------------------- Paid-In (Accumulated Comprehensive ---------------------- Shareholders' Shares Amount Capital Deficit) Income (Loss) Shares Amount Equity --------- --------- ----------- ------------ -------------- --------- ----------- ------------ Balances January 1, 2002 292,840 $73,210 $ 1,927,518 $ 129,864 $ 4,907 (11,551) $ (189,357) $1,946,142 Stock plans 1,240 310 15,888 - - (47) (228) 15,970 Net loss - - - (682,897) - - - (682,897) Other comprehensive income, net of tax and reclassifications adjustments - - - - (107,076) - - (107,076) --------- --------- ----------- ------------ ------------ --------- ------------ ----------- Balances December 31, 2002 294,080 73,520 1,943,406 (553,033) (102,169) (11,598) (189,585) 1,172,139 Stock plans 1,232 308 8,054 - - 559 9,164 17,526 Net income - - - 161,488 - - - 161,488 Other comprehensive income, net of tax and reclassifications adjustments - - - - 4,798 - - 4,798 --------- --------- ----------- ------------ ------------ -------- ------------ ----------- Balances June 30, 2003 295,312 $73,828 $ 1,951,460 $ (391,545) $ (97,371) (11,039) $ (180,421) $1,355,951 ========= ========= =========== ============ ============ ======== ============ =========== The accompanying Notes are an integral part of these Consolidated Financial Statements. CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2003 AND 2002 ($ in thousands) (Unaudited) For the three months ended June 30, For the six months ended June 30, -------------------------------------- -------------------------------------- 2003 2002 2003 2002 ------------------ ------------------ ------------------ ------------------ Net income (loss) $ 34,057 $ (41,559) $ 161,488 $ 41,667 Other comprehensive income (loss), net of tax and reclassifications adjustments* 908 (5,189) 4,798 (5,482) ------------------ ------------------ ------------------ ------------------ Total comprehensive income (loss) $ 34,965 $ (46,748) $ 166,286 $ 36,185 ================== ================== ================== ==================
* Consists of unrealized gains/(losses) of marketable securities. 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, 2003 AND 2002 ($ in thousands) 2003 2002 --------------- --------------- Income (loss) from continuing operations before cumulative effect of change in accounting principle $ 95,719 $ (86,369) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization expense 288,907 364,552 Investment write-downs - 100,377 Gain on extinguishment of debt (71,889) (10,033) Investment (gains)/losses - (3,363) Gain on sales of assets, net (5,021) - Allowance for equity funds used during construction (96) (895) Deferred and accrued income taxes 104,591 (148,964) Change in accounts receivable 39,407 9,049 Change in accounts payable, accrued expenses and other liabilities (118,337) (145,085) Change in other current assets 10,479 110,014 --------------- --------------- Net cash provided by continuing operating activities 343,760 189,283 Cash flows from investing activities: Proceeds from sales of assets, net of selling expenses 54,900 - Capital expenditures (115,602) (162,558) Securities purchased (605) (450) Securities sold - 8,387 Securities matured - 2,014 Other - 498 --------------- --------------- Net cash used by investing activities (61,307) (152,109) Cash flows from financing activities: Long-term debt principal payments (301,583) (664,632) Issuance of common stock 15,706 8,079 Customer advances for construction and contributions in aid of construction (4,715) (1,597) --------------- --------------- Net cash used by financing activities (290,592) (658,150) Cash provided by (used by) discontinued operations Proceeds from sale of discontinued operations - 859,065 Net cash used by discontinued operations - (32,889) Increase (decrease) in cash and cash equivalents (8,139) 205,200 Cash and cash equivalents at January 1, 393,177 215,869 --------------- --------------- Cash and cash equivalents at June 30, $ 385,038 $ 421,069 =============== =============== Cash paid during the period for: Interest $ 212,634 $ 247,139 Income taxes $ 1,236 $ 10,895 Non-cash investing and financing activities: Change in fair value of interest rate swaps $ 864 $ 5,758
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 2002 Annual Report on Form 10-K. These unaudited consolidated financial statements include all adjustments, which consist of normal recurring accruals 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 amounts of assets, liabilities, revenue and expenses we have reported and our disclosure of contingent assets and liabilities at the date of the financial statements. Actual results may differ from those estimates. We believe that our critical estimates are depreciation rates, pension assumptions, calculations of impairment amounts, intangible assets, income taxes and contingencies, and allowance for doubtful accounts, including reserves established for telecommunication bankruptcies. 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. Certain reclassifications of balances previously reported have been made to conform to current presentation. (b) Cash Equivalents: We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. (c) 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 acquired and allocate purchase prices to property, plant and equipment, goodwill and other identifiable intangibles. On January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," which applies to all goodwill and other intangible assets recognized in the statement of financial position at that date, regardless of when the assets were initially recognized. This statement requires that goodwill and other intangibles with indefinite useful lives no longer be amortized to earnings, but instead be reviewed for impairment, at least annually. The amortization of goodwill and other intangibles with indefinite useful lives ceased upon adoption of the statement on January 1, 2002. We annually (during the fourth quarter) examine the carrying value of our goodwill and other intangibles with indefinite useful lives to determine whether there are any impairment losses. (d) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed of: We adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" as of January 1, 2002. In accordance with SFAS No. 144, 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. (e) Derivative Instruments and Hedging Activities: On the date the derivative contract is entered into, we designate the derivative as either a fair value or cash flow hedge. A hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment is a fair value hedge. A hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability is a cash flow hedge. We formally document all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking the hedge transaction. This process includes linking all derivatives that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. 7 We also formally assess, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. If it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, we would discontinue hedge accounting prospectively. All derivatives are recognized on the balance sheet at their fair value. Changes in the fair value of derivative financial instruments are either recognized in income or shareholders equity (as a component of other comprehensive income), depending on whether the derivative is being used to hedge changes in fair value or cash flows. We entered into interest rate swap arrangements during 2002 and in May 2003 related to a portion of our fixed rate debt. These hedge strategies satisfy the fair value hedging requirements of SFAS No. 133. As a result, the fair value of the hedges is carried on the balance sheet in other current assets and the related underlying liabilities are also adjusted to fair value by the same amount. (f) Employee Stock Plans: We have various employee stock-based compensation plans. Awards under these plans are granted to eligible employees. 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. As permitted by current accounting rules, we recognize compensation expense in the financial statements only if the market price of the underlying stock exceeds the exercise price on the date of grant. At June 30, 2003, we have four stock based compensation plans: the Management Equity Incentive Plan (MEIP), the Equity Incentive Plan (EIP), the Employee Stock Purchase Plan (ESPP) and our Directors' Deferred Fee Equity Plan. We apply Accounting Principles Board Opinions (APB) No. 25 and related interpretations in accounting for the employee stock plans resulting in the use of the intrinsic value to value the stock option. In addition, we grant restricted stock awards to key employees in the form of our Common Stock. Compensation expense is recognized as a component of operating expense for our Directors' Deferred Fee Equity Plan and restricted stock grants. Compensation cost is not generally recognized in the financial statements for options issued pursuant to the MEIP or EIP, as the exercise price for such options was equal to the market price of the stock at the time of grant. Compensation cost is also not recognized in the financial statements related to the ESPP because the purchase price is 85% of the fair value. For purposes of presenting pro forma information the fair value of options granted is computed using the Black Scholes option-pricing model. 8
Had we determined compensation cost based on the fair value at the grant date for the MEIP, EIP and ESPP, our pro forma net income and net income per common share would have been as follows: Three Months Ended June 30, Six Months Ended June 30, ----------------------------- ------------------------- 2003 2002 2003 2002 ------------- ----------- ------------ --------- ($ in thousands) Net income (loss) As reported $ 34,057 $ (41,559) $161,488 $41,667 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 2,721 314 3,565 1,604 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (5,035) (3,901) (8,140) (7,989) --------- --------- -------- ------- Pro forma $ 31,743 $ (45,146) $156,913 $35,282 ========= ========= ======== ======== Net income (loss) per common share As reported: Basic $ 0.12 $ (0.15) $ 0.57 $ 0.15 Diluted $ 0.12 $ (0.15) $ 0.55 $ 0.15 Pro forma: Basic $ 0.11 $ (0.16) $ 0.56 $ 0.13 Diluted $ 0.11 $ (0.16) $ 0.53 $ 0.13
(g) Revenue Recognition: Incumbent Local Exchange Carrier (ILEC) - 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 current liabilities on our 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. Electric Lightwave, Inc. (ELI) - Revenue is recognized when the services are provided. Revenue from long-term prepaid network services agreements including Indefeasible Rights to Use (IRU), are deferred and recognized on a straight-line basis over the terms of the related agreements. 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. 9 Public Utilities Services - Revenue is recognized when services are provided for public utilities services. Certain revenue is based upon consumption while other revenue is based upon a flat fee. Earned but unbilled public services revenue is accrued and included in accounts receivable and revenue. (h) Net Income Per Common Share: Basic net income per common share is computed using the weighted average number of common shares outstanding during the period being reported on. Diluted net income per common share reflects the potential dilution that could occur if securities or other contracts to issue common stock that are in the money were exercised or converted into common stock at the beginning of the period being reported on. (2) Property, Plant and Equipment, Net: ---------------------------------- Property, plant and equipment at June 30, 2003 and December 31, 2002 is as follows:
($ in thousands) June 30, 2003 December 31, 2002 ---------------------- --------------------- Property, plant and equipment $ 6,167,963 $ 6,139,772 Less accumulated depreciation (2,547,229) (2,449,716) ---------------------- --------------------- Property, plant and equipment, net $ 3,620,734 $ 3,690,056 ====================== =====================
Depreciation expense, calculated using the straight-line method, is based upon the estimated service lives of various classifications of property, plant and equipment. Depreciation expense was $118,729,000 and $156,050,000 for the three months ended June 30, 2003 and 2002, respectively and $225,565,000 and $303,870,000 for the six months ended June 30, 2003 and 2002, respectively. Effective January 1, 2003, as a result of the adoption of SFAS No. 143, "Accounting for Asset Retirement Obligations", we ceased recognition of the cost of removal provision in depreciation expense and eliminated the cumulative cost of removal included in accumulated depreciation. In addition, we increased the average depreciable lives for certain of our equipment. This change in estimate reduced depreciation expense by $10,141,000 and $20,098,000, or $0.02 and $0.04 per share for the three and six months ended June 30, 2003, respectively. For the three and six months ended June 30, 2002, we recognized accelerated depreciation of $900,000 and $12,800,000, respectively, related to the closing of our Plano, Texas facility. (3) Dispositions: ------------ On April 1, 2003, we completed the sale of approximately 11,000 telephone access lines in North Dakota for approximately $25,700,000 in cash. The pre-tax gain on the sale recognized in the second quarter of 2003 was $2,274,000. On April 4, 2003, we completed the sale of our wireless partnership interest in Wisconsin for approximately $7,500,000 in cash. The pre-tax gain on the sale recognized in the second quarter of 2003 was $4,397,000. (4) Discontinued Operations and Net Assets Held for Sale: ---------------------------------------------------- On August 24, 1999, our Board of Directors approved a plan of divestiture for our public utilities services businesses, which included gas, electric and water and wastewater businesses. Water and Wastewater -------------------- On January 15, 2002, we completed the sale of our water and wastewater operations to American Water Works, Inc. for $859,100,000 in cash and $122,500,000 of assumed debt and other liabilities. The pre-tax gain on the sale recognized in the first quarter of 2002 was $309,200,000, subsequently adjusted to $316,672,000 in the fourth quarter of 2002. Electric and Gas ---------------- On October 29, 2002, we entered into definitive agreements to sell our Arizona gas and electric divisions to UniSource Energy Corporation for $230,000,000 in cash ($220,000,000 if we close the sale by August 11, 2003), subject to adjustments specified in the agreements. The transaction is subject to customary approvals and is expected to close in the third quarter of 2003 (see Note 17 to Consolidated Financial Statements). 10 On November 1, 2002, we completed the sale of our Kauai Electric division to Kauai Island Utility Cooperative (KIUC) for $215,000,000 in cash. The pre-tax gain on the sale recognized in the fourth quarter of 2002 was $8,273,000. On December 19, 2002, we entered into a definitive agreement to sell The Gas Company in Hawaii to K-1 USA Ventures, Inc. for $115,000,000 in cash and assumed liabilities, subject to adjustments under the terms of the agreement. The transaction is subject to customary approvals and is expected to close in the third quarter of 2003 (see Note 17 to Consolidated Financial Statements). We have entered into definitive agreements to sell the assets of our Vermont electric division to Vermont Electric Power Company, Inc. and Vermont Electric Cooperative, Inc. for an aggregate of approximately $25,000,000 in cash, subject to adjustments under the terms of the agreements. The transactions, which are subject to regulatory and other customary approvals, are expected to close by mid-2004. All our gas and electric assets (comprised of Arizona gas and electric, Hawaii gas and Vermont electric) and their related liabilities are classified as "assets held for sale" and "liabilities related to assets held for sale," respectively. These assets have been written down to our best estimate of the net realizable value upon sale. Discontinued operations in the consolidated statements of operations reflect the results of operations of the water/wastewater properties sold in January 2002 including allocated interest expense for the periods presented. Interest expense was allocated to the discontinued operations based on the outstanding debt specifically identified with these businesses. Summarized financial information for the water/wastewater operations (discontinued operations) is set forth below:
($ in thousands) For the six months ended June 30, ------------------------------------------- 2003 2002 ------------------- -------------------- Revenue $ - $ 4,650 Operating loss $ - $ (419) Income tax benefit $ - $ (920) Loss from discontinued operations, net of tax $ - $ (1,478) Gain on disposal of water segment, net of tax $ - $ 169,326
Summarized financial information for the gas and electric operations (assets held for sale) is set forth below:
($ in thousands) June 30, 2003 December 31, 2002 -------------------- ------------------- Current assets $ 44,856 $ 49,549 Net property, plant and equipment 376,484 358,135 Other assets 49,991 40,080 -------------------- ------------------- Total assets held for sale $ 471,331 $ 447,764 ==================== =================== Current liabilities $ 54,402 $ 79,194 Other liabilities 58,784 66,775 -------------------- ------------------- Total liabilities related to assets held for sale $ 113,186 $ 145,969 ==================== ===================
11 (5) Goodwill: -------- Goodwill at June 30, 2003 and December 31, 2002 is as follows: ($ in thousands) June 30, 2003 December 31, 2002 ------------------------ --------------------- Goodwill, net $ 1,858,558 $ 1,869,348 ======================== ===================== On January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," which applies to all goodwill and other intangible assets recognized in the statement of financial position at that date, regardless of when the assets were initially recognized. This statement requires that goodwill and other intangibles with indefinite useful lives no longer be amortized to earnings, but instead be reviewed for impairment, at least annually. The amortization of goodwill and other intangibles with indefinite useful lives ceased upon adoption of the statement on January 1, 2002. The decline in goodwill at June 30, 2003 is due to the April 1, 2003 sale of access lines in North Dakota. (6) Other Intangibles: ----------------- Other intangibles at June 30, 2003 and December 31, 2002 are as follows:
($ in thousands) June 30, 2003 December 31, 2002 ------------------------ --------------------- Customer base - amortizable over 96 months $ 995,853 $ 1,000,816 Trade name - non-amortizable 122,058 122,058 ------------------------ --------------------- Other intangibles 1,117,911 1,122,874 Accumulated amortization (242,007) (179,904) ------------------------ --------------------- Total other intangibles, net $ 875,904 $ 942,970 ======================== =====================
We have reflected assets acquired at fair market values at the time of acquisition in accordance with purchase accounting standards. Our allocations are based upon an independent appraisal of the respective properties acquired. Amortization expense was $31,630,000 and $30,328,000 for the three months ended June 30, 2003 and 2002, respectively and $63,342,000 and $60,682,000 for the six months ended June 30, 2003 and 2002, respectively. The decline in customer base at June 30, 2003 is due to the April 1, 2003 sale of access lines in North Dakota. (7) Restructuring Charges and Other Expenses: ---------------------------------------- 2003 ---- Restructuring and other expenses primarily consist of expenses related to reductions in personnel at our telecommunications operations and the write off of software no longer useful. We continue to review our operations, personnel and facilities to achieve greater efficiency. 2002 ---- Restructuring and other expenses primarily consist of expenses related to our various restructurings, including reductions in personnel at our telecommunications operations, costs that were spent at our Plano, Texas facility and at other locations as a result of transitioning functions and jobs, and $6,800,000 of costs and expenses related to our tender offer in June 2002 for all publicly held ELI common shares that we did not own. 2001 ---- During 2001, we examined all aspects of our business operations and our facilities to take advantage of operational and functional synergies among all our telecommunications operations. 12 Plano Restructuring Pursuant to a plan adopted in the third quarter of 2001, we closed our operations support center in Plano, Texas in August 2002. In connection with this plan, we recorded a pre-tax charge of $839,000 for the three months ended March 31, 2002 and we adjusted our accrual down by $92,000 for the three months ended June 30, 2002. The restructuring expenses primarily consist of severance benefits, retention earned through March 31, 2002 and other planning and communication costs. We sold our Plano office building in March 2003. Sacramento Call Center Restructuring In April 2002, we closed our Sacramento Customer Care Center pursuant to a plan adopted in the fourth quarter of 2001. In connection with this closing, we recorded a pre-tax charge of $62,000 for the three months ended March 31, 2002 and $9,000 for the three months ended June 30, 2002. ELI Restructuring In the first half of 2002, ELI redeployed the internet routers, frame relay switches and ATM switches from the Atlanta, Cleveland, Denver, Philadelphia and New York markets to other locations in ELI's network pursuant to a plan adopted in the fourth quarter of 2001. ELI ceased leasing the collocation facilities and off-net circuits for the backbone and local loops supporting the service delivery in these markets. It was anticipated that this would lead to $4,179,000 of termination fees, which were accrued for but not paid at December 31, 2001. In the first and second quarters of 2002, ELI adjusted its original accrual down by $2,100,000 and $100,000, respectively, due to the favorable settlement of termination charges for an off-net circuit agreement. As of December 31, 2002, this accrual was adjusted down by $725,000, $1,354,000 was paid and no accrual remained. Tender Offer During May 2002, we announced a tender offer for all of the shares of ELI that we did not already own for a price of $0.70 per share. We completed the tender offer in June 2002, resulting in ELI becoming a wholly-owned subsidiary, for total costs and expenses of approximately $6,800,000. We accounted for this transaction as a purchase and allocated the entire amount to goodwill. We evaluated the recoverability of this goodwill in accordance with SFAS No. 142 and determined that a write-down was necessary based on fair market value as determined by discounted cash flows. This charge is included in restructuring and other expenses.
($ in thousands) 2001 Severance Benefits Retention Other Total ----------------- -------------- -------------- ------------- ---------- 2001 Plano Restructuring Original accrued amount $ 9,353 $ 1,535 $ 1,178 $ 936 $ 13,002 Amount paid (8,985) (1,390) (3,832) (523) (14,730) Additional accrual 616 - 2,943 27 3,586 Adjustments (984) (132) (289) (440) (1,845) ----------------- -------------- -------------- ------------- ---------- Accrued @ 12/31/2002 - 13 - - 13 ----------------- -------------- -------------- ------------- ---------- Amount paid - (13) - - (13) Additional accrual - - - - - Adjustments - - - - - ----------------- -------------- -------------- ------------- ---------- Accrued @ 6/30/2003 $ - $ - $ - $ - $ - ================= ============== ============== ============= ==========
13
(8) Long-Term Debt: -------------- The activity in our long-term debt from December 31, 2002 to June 30, 2003 is as follows: Six Months Ended June 30, 2003 --------------------------------------- Interest Rate* at December 31, Interest June 30, June 30, ($ in thousands) 2002 Payments** Rate Swap Other 2003 2003 ------------ ---------- --------- ----- -------- -------------- FIXED RATE Rural Utilities Service Loan Contracts $ 30,874 $ (433) $ - $ $ 30,441 6.210% Senior Unsecured Debt 4,508,880 (99,640) 864 - 4,410,104 8.095% Equity Units 460,000 - - - 460,000 7.480% ELI Notes 5,975 - - - 5,975 6.232% ELI Capital Leases 135,200 (7,906) - (53,385) 73,909 10.267% Industrial Development Revenue Bonds 186,390 (74,655) - - 111,735 5.874% Other 40 (9) - - 31 12.986% ----------- --------- --------- ---------- ----------- TOTAL FIXED RATE 5,327,359 (182,643) 864 (53,385) 5,092,195 ----------- ---------- --------- ---------- ----------- VARIABLE RATE Industrial Development Revenue Bonds 148,913 (118,940) - - 29,973 1.609% ----------- ---------- --------- ---------- ----------- TOTAL VARIABLE RATE 148,913 (118,940) - - 29,973 ----------- ---------- --------- ---------- ----------- TOTAL $ 5,476,272 $(301,583) $ 864 $ (53,385) $ 5,122,168 ----------- ========== ========= =========== ----------- Less: Current Portion (58,911) (105,776) Less: Equity Units (460,000) (460,000) ----------- ----------- TOTAL LONG TERM DEBT $ 4,957,361 $ 4,556,392 =========== ===========
* Interest rate includes amortization of debt issuance expenses, debt premiums or discounts. The interest rate for Rural Utilities Service Loan Contracts, Senior Unsecured Debt, and Industrial Development Revenue Bonds represent a weighted average of multiple issuances. ** Includes purchases on the open market. During June 2003, we redeemed five separate issues of the Company's Industrial Development Revenue Bonds aggregating $75,500,000, and seven issues of the Company's Special Purpose Revenue Bonds aggregating $88,800,000. All of these redemptions were funded with cash. In addition, we called for redemption two additional Industrial Development Revenue Bond series aggregating $13,500,000, $12,400,000 of which was redeemed with cash on July 2, 2003, with the remaining $1,100,000 issue to be redeemed with cash on August 1, 2003. During the first six months of 2003, we executed a series of purchases in the open market of our outstanding debt securities. The aggregate principal amount of debt securities purchased was $93,900,000 at a premium of approximately $3,100,000. In March 2003, we terminated a capital lease obligation at ELI, which resulted in a non-cash pre-tax gain of $40,703,000 included in investment and other income (loss), net. In addition, in June 2003, ELI reduced the number of optical fibers leased under another capital lease, which resulted in a non-cash pre-tax gain of approximately $25,021,000 included in investment and other income (loss), net. Total future minimum cash payment commitments over the next 24 years under ELI's long-term capital leases amounted to $156,886,000 as of June 30, 2003. On February 1, 2003, we repaid at maturity $35,000,000 of Frontier Communications of Minnesota 7.61% Senior Notes. 14 (9) Income (Loss) Per Common Share: ------------------------------ The reconciliation of the income (loss) per common share calculation for the three and six months ended June 30, 2003 and 2002, respectively, is as follows:
($ in thousands, except per-share amounts) For the three months ended June 30, For the six months ended June 30, ------------------------------------ ------------------------------------ 2003 2002 2003 2002 ---------------- ------------------ ---------------- ------------------ Net income (loss) used for basic and diluted- earnings per common share Income (loss) from continuing operations before cumulative effect of change in accounting principle $ 34,057 $ (41,559) $ 95,719 $ (86,369) Income from discontinued operations - - - 167,848 ---------------- ---------------- ---------------- ---------------- Income (loss) before cumulative effect of change in accounting principle 34,057 (41,559) 95,719 81,479 Cumulative effect of change in accounting principle - - 65,769 (39,812) ---------------- ---------------- ---------------- ---------------- Total basic net income (loss) $ 34,057 $ (41,559) $ 161,488 $ 41,667 ================ ================ ================ ================ Effect of conversion of preferred securities 1,552 1,552 3,105 3,105 ---------------- ---------------- ---------------- ---------------- Total diluted net income (loss) $ 35,609 $ (40,007) $164,593 $ 44,772 ================ ================ ================ ================ Basic earnings (loss) per common share Weighted-average shares outstanding - basic 282,180 280,610 281,934 280,432 ---------------- ---------------- ---------------- ---------------- Income (loss) from continuing operations before cumulative effect of change in accounting principle $ 0.12 $ (0.15) $ 0.34 $ (0.31) Income from discontinued operations - - - 0.60 ---------------- ---------------- ---------------- ---------------- Income (loss) before cumulative effect of change in accounting principle 0.12 (0.15) 0.34 0.29 Cumulative effect of change in accounting principle - - 0.23 (0.14) ---------------- ---------------- ---------------- ---------------- Net income (loss) attributable to common shareholders $ 0.12 $ (0.15) $ 0.57 $ 0.15 ================ ================ ================ ================ Diluted earnings (loss) per common share Weighted-average shares outstanding 282,180 280,610 281,934 280,432 Effect of dilutive shares 5,389 4,644 4,763 4,418 Effect of conversion of preferred securities 15,134 15,134 15,134 15,134 ---------------- ---------------- ---------------- ---------------- Weighted-average shares outstanding - diluted 302,703 300,388 301,831 299,984 ================ ================ ================ ================ Income (loss) from continuing operations before cumulative effect of change in accounting principle $ 0.12 $ (0.15) $ 0.33 $ (0.31) Income from discontinued operations - - - 0.59 ---------------- ---------------- ---------------- ---------------- Income (loss) before cumulative effect of change in accounting principle 0.12 (0.15) 0.33 0.28 Cumulative effect of change in accounting principle - - 0.22 (0.13) ---------------- ---------------- ---------------- ---------------- Net income (loss) attributable to common shareholders $ 0.12 $ (0.15) $ 0.55 $ 0.15 ================ ================ ================ ================
All share amounts represent weighted average shares outstanding for each respective period. The diluted income (loss) per common share calculation excludes the effect of potentially dilutive shares when their exercise price exceeds the average market price over the period. At June 30, 2003, 4,025,000 shares of Mandatorily Redeemable Convertible Preferred Securities which are convertible into common stock at a 3.76 to 1 ratio at an exercise price of $13.30 per share have been included in the diluted income (loss) per common share calculation. We also have 11,284,000 potentially dilutive stock options exercisable at prices ranging from $11.09 to $21.47 per share and 18,400,000 potentially dilutive equity units. Each equity unit initially consists of a 6.75% senior note due 2006 and a purchase contract (warrant) for our common stock. These items were not included in the diluted income (loss) per common share calculation for any of the above periods as their effect was antidilutive. Restricted stock awards of 1,553,000 shares and 1,477,000 shares at June 30, 2003 and 2002 respectively, are excluded from our basic weighted average shares outstanding and included in our dilutive shares until the shares are no longer contingent upon the satisfaction of all specified conditions. 15 (10) Segment Information: ------------------- We operate in four segments, ILEC, ELI (a competitive local exchange carrier (CLEC)), gas and electric. The ILEC segment provides both regulated and unregulated communications services to residential, business and wholesale customers and is typically the incumbent provider in its service areas. Our gas and electric segments are intended to be sold and are classified as "assets held for sale" and "liabilities related to assets held for sale." As an ILEC, we compete with CLECs that may operate in our markets. As a CLEC, we provide telecommunications services, principally to businesses, in competition with the incumbent ILEC. As a CLEC, we frequently obtain the "last mile" access to customers through arrangements with the applicable ILEC. ILECs and CLECs are subject to different regulatory frameworks of the Federal Communications Commission (FCC). Our ILEC operations and ELI do not compete with each other. 16
($ in thousands) For the three months ended June 30, 2003 --------------------------------------------------------------------------- Total ILEC ELI Gas Electric Segments -------------- -------------- --------------- ------------- -------------- Revenue $ 510,153 $ 43,719 $ 56,150 $ 33,932 $ 643,954 Depreciation and amortization 144,374 5,985 - - 150,359 Reserve for telecommunications bankruptcies 1,113 1,147 - - 2,260 Restructuring and other expenses 9,482 631 - - 10,113 Operating income 121,814 2,350 6,159 4,869 135,192 Capital expenditures, net 56,415 2,254 4,296 4,827 67,792 ($ in thousands) For the three months ended June 30, 2002 --------------------------------------------------------------------------- Total ILEC ELI Gas Electric Segments -------------- -------------- --------------- ------------- -------------- Revenue $ 514,686 $ 45,287 $ 47,856 $ 54,610 $ 662,439 Depreciation and amortization 154,741 31,591 46 - 186,378 Reserve for telecommunications bankruptcies 9,567 434 - - 10,001 Restructuring and other expenses 9,207 9,073 - - 18,280 Operating income (loss) 100,607 (38,976) 8,416 12,521 82,568 Capital expenditures, net 81,364 3,067 4,940 4,500 93,871 ($ in thousands) For the six months ended June 30, 2003 --------------------------------------------------------------------------- Total ILEC ELI Gas Electric Segments -------------- -------------- --------------- ------------- -------------- Revenue $ 1,023,762 $ 84,812 $ 119,681 $ 67,561 $ 1,295,816 Depreciation and amortization 276,729 12,178 - - 288,907 Reserve for telecommunications bankruptcies 1,113 1,147 - - 2,260 Restructuring and other expenses 9,482 610 - - 10,092 Operating income 268,729 2,885 18,010 9,863 299,487 Capital expenditures, net 94,292 3,401 7,465 9,972 115,130 ($ in thousands) For the six months ended June 30, 2002 --------------------------------------------------------------------------- Total ILEC ELI Gas Electric Segments -------------- -------------- --------------- ------------- -------------- Revenue $ 1,022,717 $ 92,534 $ 119,221 $107,301 $ 1,341,773 Depreciation and amortization 313,031 51,391 130 - 364,552 Reserve for telecommunications bankruptcies 17,371 434 - - 17,805 Restructuring and other expenses 15,212 6,973 - - 22,185 Operating income (loss) 192,828 (55,996) 20,304 25,791 182,927 Capital expenditures, net 137,404 5,656 9,319 9,704 162,083 The following table reconciles sector capital expenditures to total consolidated capital expenditures. ($ in thousands) For the three months ended For the six months ended June 30, June 30, ------------------------------ ----------------------------- 2003 2002 2003 2002 -------------- -------------- --------------- ------------- Total segment capital expenditures $ 67,792 $ 93,871 $ 115,130 $ 162,083 General capital expenditures 58 248 472 475 -------------- -------------- --------------- ------------- Consolidated reported capital expenditures $ 67,850 $ 94,119 $ 115,602 $ 162,558 ============== ============== =============== =============
17 (11) Adelphia Investment: ------------------- We recognized losses of $45,600,000 and $49,700,000 on our Adelphia Communications Corp. (Adelphia) investment for the three months ended June 30, 2002 and March 31, 2002, respectively. This non-cash charge reflected an other than temporary decline in Adelphia's stock price. As of June 30, 2002, we had written this investment down to zero. (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 sheet 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 fixed-rate indebtedness hedged as of June 30, 2003 and December 31, 2002 was $350,000,000 and $250,000,000, respectively. Such contracts require us to pay variable rates of interest (average pay rate of approximately 4.67% as of June 30, 2003) and receive fixed rates of interest (average receive rate of 7.89% as of June 30, 2003). The fair value of these derivatives is reflected in other assets as of June 30, 2003, in the amount of $17,523,000 and the related underlying debt has been increased by a like amount. The amounts received during the three and six months ended June 30, 2003 as a result of these contracts amounted to $2,813,000 and $4,117,000 and are included as a reduction of interest expense. We do not anticipate any nonperformance by counterparties to its derivative contracts as all counterparties have investment grade credit ratings. (13) Shareholder Rights Plan: ----------------------- On March 6, 2002, our Board of Directors adopted a Shareholder Rights Plan. The purpose of the Shareholder Rights Plan is to deter coercive takeover tactics and to encourage third parties interested in acquiring us to negotiate with our Board of Directors. It is intended to strengthen the ability of our Board of Directors to fulfill its fiduciary duties to take actions which are in the best interest of our shareholders. The rights were distributed to shareholders as a dividend at the rate of one right for each share of our common stock held by shareholders of record as of the close of business on March 26, 2002. The rights generally are exercisable only if a person or group acquired beneficial ownership of 20 percent or more of our common stock (an "Acquiror") without the consent of our independent directors. Each right not owned by an Acquiror becomes the right to purchase our common stock at a 50 percent discount. (14) Settlement of Retained Liabilities: ---------------------------------- We were actively pursuing the settlement of certain retained liabilities at less than face value, which are associated with customer advances for construction from our disposed water properties. For the six months ended June 30, 2003 and 2002, we recognized income of $6,165,000 and $10,000,000, respectively, which is reflected in investment and other income (loss), net, as a result of these settlements. (15) Change in Accounting Principle and New Accounting Pronouncements: ---------------------------------------------------------------- In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations." We adopted SFAS No. 143 effective January 1, 2003. As a result of our adoption of SFAS No. 143, we recognized an after tax non-cash gain of approximately $65,769,000. This gain resulted from the elimination of the cumulative cost of removal included in accumulated depreciation as a cumulative effect of a change in accounting principle in our statement of operations in the first quarter of 2003 as the Company has no legal obligation to remove certain of its long-lived assets. The following table presents reconciliation between reported net income and adjusted net income. Adjusted net income excludes depreciation expense recognized in prior periods related to the cost of removal provision as required by SFAS No. 143. 18
For the three months ended June 30, For the six months ended June 30, ---------------------------------- ---------------------------------- (In thousands, except per-share amounts) 2003 2002 2003 2002 ---------------- ---------------- ---------------- ---------------- Reported attributable to common shareholders $ 34,057 $ (41,559) $ 161,488 $ 41,667 Add back: Cost of removal in depreciation expense, net of tax - 3,589 - 7,302 ---------------- ---------------- ---------------- ---------------- Adjusted attributable to common shareholders $ 34,057 $ (37,970) $ 161,488 $ 48,969 ================ ================ ================ ================ Basic earnings per share: Reported attributable to common shareholders $ 0.12 $ (0.15) $ 0.57 $ 0.15 Cost of removal in depreciation expense - 0.01 - 0.03 ---------------- ---------------- ---------------- ---------------- Adjusted attributable to common shareholders $ 0.12 $ (0.14) $ 0.57 $ 0.18 ================ ================ ================ ================ Diluted earnings per share: Reported attributable to common shareholders $ 0.12 $ (0.15) $ 0.55 $ 0.15 Cost of removal in depreciation expense - 0.01 - 0.02 ---------------- ---------------- ---------------- ---------------- Adjusted attributable to common shareholders $ 0.12 $ (0.14) $ 0.55 $ 0.17 ================ ================ ================ ================
In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets." As a result of our adoption of SFAS No. 142, we recognized a transitional impairment loss of $39,800,000 for goodwill related to ELI as a cumulative effect of a change in accounting principle in our statement of operations in the first quarter of 2002. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which nullified Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity." SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, rather than on the date of commitment to an exit plan. This Statement is effective for exit or disposal activities that are initiated after December 31, 2002. We adopted SFAS No. 146 on January 1, 2003. The adoption of SFAS No. 146 did not have any material impact on our financial position or results of operations. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging," which clarifies financial accounting and reporting for derivative instruments including derivative instruments embedded in other contracts. This Statement is effective for contracts entered into or modified after June 30, 2003. We are currently evaluating the impact of the adoption of SFAS No. 149. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." The Statement requires issuers to classify as liabilities (or assets in some circumstances) certain financial instruments that embody obligations of the issuer. Generally, the Statement is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. We adopted the provisions of the Statement on July 1, 2003. The adoption of SFAS No. 150 did not have any material impact on our financial position or results of operations. The FASB also recently indicated that it will require stock-based employee compensation to be recorded as a charge to earnings beginning in 2004. We will continue to monitor the progress on the issuance of this standard. (16) Commitments and Contingencies: ----------------------------- We expect capital expenditures in 2003 to be approximately $270,000,000 for ILEC and ELI and $45,200,000 (assuming we own all our utility businesses for the entire year) for gas and electric. However, if we close on our pending sales on the currently expected dates we will spend approximately $25,000,000 for gas and electric. Our public utility properties are currently carried at amounts that do not exceed their net realizable values upon sale. Under the terms of the definitive agreements relating to the sale of these properties, there will be no adjustment to the sales prices for most of the capital expenditures we will make for these properties prior to their sale. To the extent that the carrying amounts of these properties increase above their realizable values upon sale as a result of capital expenditures or for any other reason, we would record an impairment charge for such excess. We currently estimate we will make $6,100,000 of capital expenditures for these properties from July 1, 2003 through their expected dates of sale. We did not expense any of our $17,437,000 of capital additions related to these properties during the first half of 2003. If the sale of our Arizona utility businesses to UniSource is completed, the sale agreement requires us to promptly redeem $31,240,000 principal amount of industrial development revenue bonds. 19 If the sale of our Hawaii gas operations to K-1 USA Ventures is completed, the buyer has agreed to assume $17,593,000 of our special purpose development bonds. In March 1999, ELI entered into a 20-year fiber agreement. Under the agreement, we were to pay the other carrier approximately $96,900,000 over the next 20 years. ELI terminated the capital lease obligation in March 2003, which resulted in a non-cash pre-tax gain of $40,703,000. In addition, in June 2003, ELI reduced the number of optical fibers leased under another capital lease, which resulted in a non-cash pre-tax gain of approximately $25,021,000. These gains were reported for the three months ended March 31, 2003 and June 30, 2003 in investment and other income (loss), net. (17) Subsequent Events: ----------------- On August 8, 2003, we completed the sale of our Gas Company in Hawaii to K-1 USA Ventures, Inc. for approximately $115,000,000 in cash and assumed liabilities. On August 11, 2003, we completed the sale of our Arizona gas and electric divisions to UniSource Energy Corporation for approximately $220,000,000 in cash and issued call notices on $31,240,000 in industrial development revenue bonds to be repaid in the fourth quarter of 2003. 20 PART I. FINANCIAL INFORMATION (Continued) CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results ----------------------------------------------------------------------- of Operations ------------- This quarterly report on Form 10-Q contains forward-looking statements that are subject to risks and uncertainties which could cause actual results to differ materially from those expressed or implied in the 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, any of the following possibilities: * Changes in the number of our access lines; * The effects of competition from wireless, other wireline carriers (through Unbundled Network Elements (UNE), Unbundled Network Elements Platform (UNEP) or otherwise), high speed cable modems and cable telephony; * The effects of general and local economic conditions on our revenues; * Our ability to effectively manage and otherwise monitor our operations, costs, regulatory compliance and service quality; * Our ability to successfully introduce new product offerings including our ability to offer bundled service packages on terms attractive to our customers, and our ability to sell enhanced and data services; * Our ability to manage our operating expenses, capital expenditures and reduce our debt; * 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 bankruptcies in the telecommunications industry which could result in higher network access costs and potential bad debts; * The effects of technological changes, 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 pension and retiree medical expenses and related funding requirements; * The effects of changes in regulation in the telecommunications industry as a result of the Telecommunications Act of 1996 and other federal and state legislation and regulation, including changes in access charges and subsidy payments; * The effect of changes in the telecommunications market, including the likelihood of significantly increased price and service competition; * The effects of possible 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, including the contract covering the 668 Communications Workers of America members in Rochester that is scheduled to expire in January 2004; and * The effects of more general factors, including changes in economic conditions; changes in the capital markets; changes in industry conditions; changes in our credit ratings; and changes in accounting policies or practices adopted voluntarily or as required by generally accepted accounting principles or regulators. 21 Competition in the telecommunications industry is increasing. Although we have not faced as much competition as larger, more urban telecommunications companies, we do experience competition from other wireline local carriers through Unbundled Network Elements (UNE) and potentially in the future through Unbundled Network Elements Platform (UNEP), from other long distance carriers (including Regional Bell Operating Companies), from cable companies and internet service providers with respect to internet access and potentially in the future cable telephony, and from wireless carriers. Most of the wireline competition we face is in our Rochester, New York market, with limited competition in a few other areas. Competition from cable companies with respect to high-speed Internet access is intense in Rochester and a few of our other markets such as Elk Grove, California (which is near Sacramento). Competition from wireless companies, other long distance companies and internet service providers is present in varying degrees in all of our markets. One of the ways we are responding to actual and potential competition is by bundling services and products and offering them for a single price. In addition, revenues from data products and services such as DSL continue to increase as a percentage of our total revenues. These factors may cause our margins to decrease. The telecommunications industry in general, and the CLEC sector in particular, are undergoing significant changes and difficulties. Demand and pricing for CLEC services have decreased substantially, particularly for long haul services, and economic and competitive pressures are likely to cause these trends to continue. These factors result in a challenging environment with respect to revenues for our CLEC business and to a lesser extent our ILEC business. These factors could also result in more bankruptcies in the sector and therefore affect our ability to collect money owed to us by bankrupt carriers. The market for internet access, long-haul and related services in the United States is extremely competitive, with substantial overcapacity in the market. In addition, new and enhanced internet services are constantly under development in the market and we expect additional innovation in this market by a range of competitors. Several Interexchange Carriers (IXC's) have filed for bankruptcy protection, which will allow them to substantially reduce their cost structure and debt. This could enable such companies to further reduce prices and increase competition. You should consider these important factors in evaluating any statement in this 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 and as presented in our 2002 Annual Report on Form 10-K. We have no obligation to update or revise these forward-looking statements. (a) Liquidity and Capital Resources ------------------------------- For the six months ended June 30, 2003, we used cash flow from continuing operations and cash and investment balances to fund capital expenditures, interest payments and debt repayments. As of June 30, 2003, we maintained cash and short-term investment balances aggregating $385.0 million. We expect to spend on 2003 capital projects approximately $258.0 million for the ILEC segment, $12.0 million for the ELI segment and $45.2 million (assuming we own all of our remaining utility businesses for the entire year) for the public utilities segment. However, if we close on our pending sales on the currently expected dates we will spend approximately $25.0 million for gas and electric. In the ordinary course of business, capital expenditures for the public utilities segment would increase the amount of assets that would be reflected on the balance sheet. However, we may expense certain of our capital expenditures with respect to our public utilities segment during 2003 if book values exceed our estimate of expected net realizable sales prices (see Note 16 to Consolidated Financial Statements). For the six months ended June 30, 2003, our actual capital expenditures were $94.3 million for the ILEC segment, $3.4 million for the ELI segment, $17.4 million for the public utilities segments and $0.5 million for general capital expenditures. Funds necessary for our 2003 capital expenditures were, and are expected to continue to be, provided from our operations and our existing cash and investment balances. We have an available shelf registration for $825.6 million and we have available lines of credit with financial institutions in the aggregate amount of $805 million. Associated facility fees vary depending on our credit ratings and are 0.25% per annum as of June 30, 2003. The expiration date for these facilities is October 24, 2006. During the term of the facilities we may borrow, repay and reborrow funds. As of June 30, 2003, there were no outstanding borrowings under these facilities. 22 If the sale of our Arizona utility businesses to UniSource is completed, the sale agreement requires us to promptly redeem $31.2 million of the Company's Arizona industrial development revenue bonds. We intend to fund these redemptions using cash flows from continuing operations, the proceeds from the sale of utility properties, and/or cash and cash equivalents and investment balances. Debt Reduction - -------------- On February 1, 2003, we repaid at maturity $35.0 million of Frontier Communications of Minnesota 7.61% Senior Notes. In March 2003, we terminated a capital lease obligation at ELI, which resulted in a non-cash pre-tax gain of $40.7 million included in investment and other income (loss), net. In addition, in June 2003, ELI reduced the number of optical fibers leased under another capital lease, which resulted in a non-cash pre-tax gain of $25.0 million included in investment and other income (loss), net. During June 2003, we redeemed five separate issues of the Company's Industrial Development Revenue Bonds aggregating $75.5 million, and seven issues of the Company's Special Purpose Revenue Bonds aggregating $88.8 million. All of these redemptions were funded with cash. In addition, we called for redemption two additional Industrial Development Revenue Bond series aggregating $13.5 million, $12.4 million of which was redeemed with cash on July 2, 2003, and the remaining $1.1 million issue was redeemed with cash on August 1, 2003. During the first six months of 2003, we executed a series of purchases in the open market of our outstanding debt securities. The aggregate principal amount of debt securities purchased was $93.9 million at a premium of approximately $3.1 million. During the period between June 15, 2003 and July 15, 2003, holders of the Company's outstanding $15.1 million principal amount of 6.80% Debentures due August 15, 2026 had the option to put the Debentures to the Company for mandatory redemption at par on August 15, 2003. As a result, the entire outstanding principal amount of these debentures has been classified as debt due within one year on the Company's balance sheet since the third quarter of 2002. By July 15, 2003 holders of $2.5 million of the debentures had exercised their right to put the debentures to us on August 15, 2003. Accordingly, the $12.6 of debentures that were not put to us for redemption has been reclassified as long-term debt on the balance sheet, with a final maturity of August 15, 2026. Interest Rate Management - ------------------------ In order to manage our interest expense, we entered into five interest swap agreements in 2002 and 2001 with investment grade financial institutions. During the second quarter of 2003, we entered into two additional interest rate swaps. Each agreement covers a notional amount of $50.0 million. Under the terms of the agreements, we make semi-annual, floating rate interest payments based on six month LIBOR and receive a fixed rate on the notional amount. There are two interest rate swap agreements that were executed in 2001 that receive a 6.375% fixed rate until the swaps' termination date of August 15, 2004, and there are now five swaps that were executed in 2002 and 2003 that receive an 8.500% fixed rate until their termination date of May 15, 2006. The underlying variable rate on these swaps is set either in advance, in arrears or, as in the case of one agreement, based on each period's daily average six-month LIBOR. In connection with these swaps, we have entered into agreements which set the average effective rate on $200 million of swaps at 5.166% for the six month period ending November 15, 2003, as well as setting the effective rate on $200 million of swaps at an average rate of 6.218% for the six month period beginning November 15, 2003, all compared to the unhedged rate of 8.50%. All swaps and associated supplemental rate agreements are accounted for under SFAS No. 133 as fair value hedges. Covenants - --------- The terms and conditions contained in our indentures and credit facility agreements are of a general nature, and do not currently impose significant financial performance criteria on us. These general covenants include the timely and punctual 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 by us either by contract, rule or regulation. 23 Our $805.0 million credit facilities and our $200.0 million term loan facility with the Rural Telephone Finance Cooperative (RTFC) 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 million to (ii) consolidated adjusted EBITDA (as defined in the agreements) over the last four quarters no greater than 4.50 to 1 through December 30, 2003, 4.25 to 1 from then until December 30, 2004, and 4.00 to 1 thereafter. We are in compliance with all of our debt covenants. Divestitures - ------------ On August 24, 1999, our Board of Directors approved a plan of divestiture for our public utilities services businesses, which included gas, electric and water and wastewater businesses. During 2001, we sold two of our natural gas operations and in 2002 we sold all of our water and wastewater treatment operations and one electric business. On January 15, 2002, we sold our water and wastewater services operations for $859.1 million in cash and $122.5 million in assumed debt and other liabilities. On October 29, 2002, we entered into definitive agreements to sell our Arizona gas and electric divisions to UniSource Energy Corporation for $230.0 million in cash ($220.0 million if we close the sale by August 11, 2003) subject to adjustments specified in the agreements. The transaction is subject to customary approvals and is expected to close in the third quarter of 2003 (see Note 17 to Consolidated Financial Statements). On October 31, 2002, we completed the sale of approximately 4,000 telephone access lines in North Dakota for approximately $9.7 million in cash. On November 1, 2002, we completed the sale of our Kauai Electric division for $215.0 million in cash. On December 19, 2002, we entered into a definitive agreement to sell The Gas Company in Hawaii to K-1 USA Ventures, Inc. for $115.0 million in cash and assumed liabilities, subject to adjustments under the terms of the agreement. The transaction is subject to customary approvals and is expected to close in the third quarter of 2003 (see Note 17 to Consolidated Financial Statements). We have entered into definitive agreements to sell the assets of our Vermont electric division to Vermont Electric Power Company, Inc. and Vermont Electric Cooperative, Inc. for an aggregate of approximately $25.0 million in cash subject to adjustments under the terms of the agreements. The transactions, which are subject to regulatory and other customary approvals, are expected to close during the first half of 2004. On April 1, 2003, we completed the sale of approximately 11,000 telephone access lines in North Dakota for approximately $25.7 million in cash. On April 4, 2003, we completed the sale of our wireless partnership interest in Wisconsin for approximately $7.5 million in cash. All of our gas and electric assets and their related liabilities are classified as "assets held for sale" and "liabilities related to assets held for sale," respectively. These assets have been written down to our best estimate of the net realizable value upon sale. As discussed in Note 16 to Consolidated Financial Statements we may record additional impairment losses during 2003. Discontinued operations in the consolidated statements of operations reflect the results of operations and the gain on sale of the water/wastewater properties sold in January 2002 including allocated interest expense for the periods presented. Interest expense was allocated to the discontinued operations based on the outstanding debt specifically identified with this business. 24 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 and contingencies, among others. Our estimate of anticipated losses related to telecommunications bankruptcies is a "critical accounting estimate." We have significant on-going normal course business relationships with many telecom providers, some of which have filed for bankruptcy. We generally reserve approximately 95% of the net outstanding pre-bankruptcy balances owed to us and believe that our estimate of the net realizable value of the amounts owed to us by bankrupt entities is appropriate. We believe that the accounting estimate related to asset impairment is a "critical accounting estimate." With respect to ELI, the estimate is highly susceptible to change from period to period because it requires management to make significant judgments and assumptions about future revenue, operating costs and capital expenditures over the life of the property, plant and equipment (generally 5 to 15 years) as well as the probability of occurrence of the various scenarios and appropriate discount rates. Management's assumptions about ELI's future revenue, operating costs and capital expenditures as well as the probability of occurrence of these various scenarios require significant judgment because the CLEC industry is changing and because actual revenue, operating costs and capital expenditures have fluctuated dramatically in the past and may continue to do so in the future. The calculation of depreciation and amortization expense is based on the estimated economic useful lives of the underlying property, plant and equipment and identifiable intangible assets. Rapid changes in technology or changes in market conditions could result in revisions to such estimates that could affect the carrying value of these assets and our future consolidated operating results. Our depreciation expense has decreased substantially from prior periods as a result of the impairment write down we recorded during 2002, the adoption of SFAS No. 143 and the increase in the average depreciable lives for certain of our equipment. With respect to our remaining gas and electric properties, our estimate of net realizable value is based upon expected future sales prices of these properties. Our indefinite lived intangibles consist of goodwill and trade name, which resulted from the purchase of ILEC properties. We test for impairment of these assets annually, or more frequently, as circumstances warrant. All of our ILEC properties share similar economic characteristics and as a result, our reporting unit is the ILEC segment. In determining fair value during 2002 we utilized two tests. One test utilized recent trading prices for completed ILEC acquisitions of similarly situated properties. A second test utilized current trading values for the Company's publicly traded common stock. We reviewed the results of both tests for consistency to insure that our conclusions were appropriate. Additionally, we utilized a range of prices to gauge sensitivity. Our tests determined that fair values exceeded book value. Our estimates of pension expense, other post retirement benefits including retiree medical benefits and related liabilities are "critical accounting estimates." Our pension and other post retirement benefits expenses are based upon a set of assumptions that include projections of future interest rates and asset returns. Actual results may vary from these estimates. We are assuming a long-term rate of return on plan assets of 8.25% and a discount rate of 6.75% for 2003. Actual returns have been negative in recent years. If future market conditions cause either a decline in interest rates used to value our pension plan liabilities or reductions to the value of our pension plan assets we potentially could incur additional charges to our shareholder's equity. Based upon market conditions existing at the end of June 2003, should market conditions remain unchanged, an additional charge to equity of approximately $15 - - $20 million would be required at the end of 2003. Our income tax expense is computed utilizing an estimated annual effective income tax rate in accordance with Accounting Principles Board Opinions (APB) No. 28, "Interim Financial Reporting." The tax rate is computed using estimates as to the Company's net income before income taxes for the entire year and the impact of estimated permanent book-tax differences relative to that forecast. 25 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. New Accounting Pronouncements - ----------------------------- In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 applies to fiscal years beginning after June 15, 2002, and addresses financial accounting and reporting obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. We adopted SFAS No. 143 effective January 1, 2003. The standard applies to legal obligations associated with the retirement of long-lived assets that result from acquisition, construction, development or normal use of the assets and requires that a legal liability for an asset retirement obligation be recognized when incurred, recorded at fair value and classified as a liability in the balance sheet. When the liability is initially recorded, the entity will capitalize the cost and increase the carrying value of the related long-lived asset. The liability is then accreted to its present value each period and the capitalized cost is depreciated over the estimated useful life of the related asset. At the settlement date, the entity will settle the obligation for its recorded amount or recognize a gain or loss upon settlement. Depreciation expense for the Company's wireline operations has historically included an additional provision for cost of removal. Effective with the adoption of SFAS No. 143, on January 1, 2003, the Company ceased recognition of the cost of removal provision in depreciation expense and eliminated the cumulative cost of removal included in accumulated depreciation as the Company has no legal obligation to remove certain long-lived assets. The cumulative effect of retroactively applying these changes to periods prior to January 1, 2003, resulted in an after tax non-cash gain of approximately $65.8 million recognized in the first quarter of 2003. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which nullified Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity." SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, rather than on the date of commitment to an exit plan. This Statement is effective for exit or disposal activities that are initiated after December 31, 2002. We adopted SFAS No. 146 on January 1, 2003. The adoption of SFAS No. 146 did not have any material impact on our financial position or results of operations. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging," which clarifies financial accounting and reporting for derivative instruments including derivative instruments embedded in other contracts. This Statement is effective for contracts entered into or modified after June 30, 2003. We are currently evaluating the impact of the adoption of SFAS No. 149. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." The Statement requires issuers to classify as liabilities (or assets in some circumstances) certain financial instruments that embody obligations of the issuer. Generally, the Statement is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. We adopted the provisions of the Statement on July 1, 2003. The adoption of SFAS No. 150 did not have any material impact on our financial position or results of operations. The FASB also recently indicated that it will require stock-based employee compensation to be recorded as a charge to earnings beginning in 2004. We will continue to monitor the progress on the issuance of this standard. 26 (b) Results of Operations --------------------- REVENUE Consolidated revenue for the three and six months ended June 30, 2003 decreased $18.5 million and $46.0 million, respectively, or 3% as compared with the prior year periods. The decrease in the second quarter is due to a $12.4 million net decrease in gas and electric revenue, a $4.5 million decrease in ILEC revenue, and a decrease in ELI revenue of $1.6 million. The year-to-date decrease is due to a $39.3 million net decrease in gas and electric revenue, a $7.7 million decrease in ELI revenue partially offset by an increase in ILEC revenue of $1.0 million. On April 1, 2003, we completed the sale of approximately 11,000 telephone access lines in North Dakota. The North Dakota revenues totaled $1.9 million and $5.6 million for the six months ended June 30, 2003 and 2002, respectively.
TELECOMMUNICATIONS REVENUE ($ in thousands) For the three months ended June 30, For the six months ended June 30, -------------------------------------------- ----------------------------------------------- 2003 2002 $ Change % Change 2003 2002 $ Change % Change ---------- ------------ ----------- -------- ------------ ----------- ------------ --------- Access services $ 160,142 $ 171,163 $ (11,021) -6% $ 325,139 $ 336,996 $ (11,857) -4% Local services 220,710 217,638 3,072 1% 441,805 434,438 7,367 2% Long distance and data services 76,487 71,029 5,458 8% 151,265 141,315 9,950 7% Directory services 26,736 25,810 926 4% 53,779 52,054 1,725 3% Other 26,078 29,046 (2,968) -10% 51,774 57,914 (6,140) -11% ---------- ------------ ----------- ----------- ----------- ------------ ILEC revenue 510,153 514,686 (4,533) -1% 1,023,762 1,022,717 1,045 0% ELI 43,719 45,287 (1,568) -3% 84,812 92,534 (7,722) -8% ---------- ------------ ----------- ----------- ----------- ------------ $ 553,872 $ 559,973 $ (6,101) -1% $1,108,574 $1,115,251 $ (6,677) -1% ========== ============ =========== =========== =========== ============
Changes in the number of our access lines is the most fundamental driver of changes in our telecommunications revenue. Historically, rural local telephone companies experienced steady growth in access lines because of positive demographic trends, steady rural local economies and little competition. In recent quarters many rural local telephone companies (including ours) have experienced a loss of access lines because of difficult economic conditions, increased competition and disconnecting second lines by some customers when they add DSL or other high-speed internet service. Excluding the North Dakota sale, we lost approximately 14,600 access lines during the six months ended June 30, 2003 but added more than 21,000 DSL subscribers during this period. Residential lines lost represented 81 percent of the total loss, excluding the North Dakota sale. The non-residential line losses were principally in Rochester, New York while the residential losses were throughout our markets other than Arizona and California. We expect to continue to lose access lines during the remainder of 2003. A continued decrease in access lines, combined with continuing difficult economic conditions, lower access rates and increased competition, may cause our revenues to decrease further during the remainder of 2003. Beginning in the first quarter 2003, the presentation of revenue categories includes certain reclassifications to ensure consistency among reporting properties. All prior periods have been conformed to this presentation. Access services revenue for the three months ended June 30, 2003 decreased $11.0 million or 6% as compared with the prior year period. Switched access revenue decreased $5.2 million primarily due to the effect of access rate reductions effective July 1, 2002. Subsidies revenue decreased $3.8 million due to lower Universal Service Fund (USF) support. Access services revenue for the six months ended June 30, 2003 decreased $11.9 million or 4% as compared with the prior year period primarily due to a decrease of $10.4 million in switched access revenue due to the effect of access rate reductions effective July 1, 2002. Our overall subsidy revenues in 2003 are expected to be slightly lower than 2002. Local services revenue for the three months ended June 30, 2003 increased $3.1 million or 1% as compared with the prior year period. Local revenue increased $0.4 million primarily due to $3.4 million in higher subscriber line charges (SLC) effective July 2002, partially offset by the $1.5 million impact of the sale of our North Dakota exchanges in 2003, and a $1.6 million decrease from continued losses of access lines. Enhanced services revenue increased $2.7 million primarily due to the sale of additional feature packages. 27 Local services revenue for the six months ended June 30, 2003 increased $7.4 million or 2% as compared with the prior year period. Local revenue increased $2.0 million primarily due to $7.1 million in higher SLC effective July 2002, partially offset by the $1.5 million impact of the sale of our North Dakota exchanges in 2003, and a $5.5 million decrease from continued losses of access lines. Enhanced services revenue increased $5.4 million primarily due to the sale of additional feature packages. Long distance and data services revenue for the three months ended June 30, 2003 increased $5.5 million or 8% as compared with the prior period primarily due to growth of $7.8 million related to data partially offset by a decrease of $2.3 million in long distance revenue due to declining minutes of use. Long distance and data services revenue for the six months ended June 30, 2003 increased $10.0 million or 7% as compared with the prior period primarily due to growth of $11.2 million related to data partially offset by a decrease of $1.3 million in long distance revenue due to declining minutes of use. Our long distance revenues decreased during the second quarter of 2003 because of competition from wireless providers and declining minutes of use. We expect these factors will continue to affect our long distance revenues during 2003. Directory revenue for the three months ended June 30, 2003 increased $0.9 million or 4% as compared with the prior period primarily due to growth in yellow pages advertising. Directory revenue for the six months ended June 30, 2003 increased $1.7 million or 3% as compared with the prior period primarily due to growth in yellow pages advertising. Other revenue for the three months ended June 30, 2003 decreased $3.0 million or 10% compared with the prior period primarily due to higher uncollectible revenue of $1.1 million and the termination at December 31, 2002 of $1.1 million (for the three months) in contract services provided to Global Crossing Ltd. (Global). Other revenue for the six months ended June 30, 2003 decreased $6.1 million or 11% compared with the prior period primarily due to the termination at December 31, 2002 of $2.5 million (for the six months) in contract services provided to Global Crossing. ELI revenue for the three and six months ended June 30, 2003 decreased $1.6 million, or 3%, and $7.7 million, or 8%, respectively, as compared to the prior year period primarily due to a decline in Integrated Service Digital Network (ISDN) services due to less demand from Internet service providers and lower demand for long haul services. ELI's revenue rose from $41.1 million for the three months ended March 31, 2003 to $43.7 million for the three months ended June 30, 2003, reversing a nine consecutive quarter trend of declining revenues.
GAS AND ELECTRIC REVENUE ($ in thousands) For the three months ended June 30, For the six months ended June 30, -------------------------------------------- ----------------------------------------------- 2003 2002 $ Change % Change 2003 2002 $ Change % Change ---------- ----------- ----------- --------- ------------ ----------- ------------ --------- Gas revenue $ 56,150 $ 47,856 $ 8,294 17% $ 119,681 $ 119,221 $ 460 0% Electric revenue $ 33,932 $ 54,610 $ (20,678) -38% $ 67,561 $ 107,301 $ (39,740) -37%
Gas revenue for the three months ended June 30, 2003 increased $8.3 million, or 17%, as compared with the prior year period primarily due to higher purchased gas costs passed on to consumers in 2003. Under tariff provisions, the costs of our gas purchases are primarily passed on to customers. Gas revenue for the six months ended June 30, 2003 increased $0.5 million as compared with the prior year period primarily due to higher purchased gas costs passed on to consumers in Hawaii offset by an Arizona commission ruling precluding higher purchased gas costs to be passed on to consumers during the first three months of 2003. Electric revenue for the three and six months ended June 30, 2003 decreased $20.7 million, or 38%, and $39.7 million, or 37%, respectively, as compared with the prior year periods primarily due to the sale of Kauai Electric on November 1, 2002 partially offset by the effect of a rate increase in Vermont on July 15, 2002 and a slight increase in unit sales. 28
COST OF SERVICES ($ in thousands) For the three months ended June 30, For the six months ended June 30, ------------------------------------------ ----------------------------------------------- 2003 2002 $ Change % Change 2003 2002 $ Change % Change --------- ----------- ----------- -------- ------------ ---------- ------------ --------- Network access $ 58,168 $ 58,598 $ (430) -1% $ 114,683 $ 116,556 $ (1,873) -2% Gas purchased 34,041 26,201 7,840 30% 69,987 69,801 186 0% Electric energy and fuel oil purchased 21,328 28,987 (7,659) -26% 42,086 55,667 (13,581) -24% --------- ----------- ----------- ----------- ---------- ------------ $113,537 $ 113,786 $ (249) 0% $ 226,756 $ 242,024 $ (15,268) -6% ========= =========== =========== =========== ========== ============
Network access expenses for the three and six months ended June 30, 2003 decreased $0.4 million, or 1%, and $1.9 million, or 2%, respectively as compared with the prior year periods. ELI costs have declined slightly due to a drop in demand while ILEC sector costs have risen slightly due to increased circuit expense associated with additional data product introductions and increased long distance access expense. Gas purchased for the three months ended June 30, 2003 increased $7.8 million, or 30%, as compared with the prior year period primarily due to higher purchased propane fuel expense due to an overall increase in petroleum prices. Gas purchased for the six months ended June 30, 2003 increased $0.2 million as compared with the prior year period primarily due to higher purchased propane fuel expense offset by lower commodity pricing and the effect of an Arizona commission ruling precluding higher purchased gas costs from being passed on to consumers, thus deferring recoverability to a future period. Electric energy and fuel oil purchased for the three and six months ended June 30, 2003 decreased $7.7 million, or 26%, and $13.6 million, or 24%, respectively, as compared with the prior year periods primarily due to the sale of Kauai Electric on November 1, 2002 partially offset by increased purchased power costs.
OTHER OPERATING EXPENSES ($ in thousands) For the three months ended June 30, For the six months ended June 30, ------------------------------------------- ----------------------------------------------- 2003 2002 $ Change % Change 2003 2002 $ Change % Change ----------- ----------- ----------- ------- ------------- ----------- ------------ -------- Operating expenses $ 178,038 $ 191,019 $ (12,981) -7% $ 355,618 $ 390,272 $ (34,654) -9% Taxes other than income taxes 28,566 31,384 (2,818) -9% 58,887 64,748 (5,861) -9% Sales and marketing 25,889 29,023 (3,134) -11% 53,809 57,260 (3,451) -6% ----------- ----------- ----------- ----------- ----------- ------------ $ 232,493 $ 251,426 $ (18,933) -8% $ 468,314 $ 512,280 $ (43,966) -9% =========== =========== =========== =========== =========== ============
Operating expenses for the three months ended June 30, 2003 decreased $13.0 million, or 7%, as compared with the prior year period primarily due to increased operating efficiencies and a reduction of personnel in the ILEC and ELI sectors and decreased operating expenses in the electric sector due to the sale of Kauai Electric. Expenses were negatively impacted by increased compensation expense of $4.3 million primarily because of variable stock plans (under variable stock plans, the amount of compensation expense changes as our stock price changes) and increased pension expenses as discussed below. Operating expenses for the six months ended June 30, 2003 decreased $34.7 million, or 9%, as compared with the prior year period primarily due to increased operating efficiencies and a reduction of personnel in the ILEC and ELI sectors and decreased operating expenses in the electric sector due to the sale of Kauai Electric. Expenses were negatively impacted by increased compensation expense of $3.5 million related to variable stock plans and increased pension expenses as discussed below. We routinely review our operations, personnel and facilities to achieve greater efficiencies. These reviews may result in reductions in personnel and an increase in severance costs. We incurred $2.7 million of severance costs in our telecommunications operations during the three months ended June 30, 2003. 29 Included in operating expenses is pension expense. In future periods, if the value of our pension assets decline and/or projected benefit costs increase, we may have increased pension expenses. Based on current assumptions and plan asset values, we estimate that our pension expense will increase from $4.3 million in 2002 to approximately $13.0 - $15.0 million in 2003 but that no contribution to our pension plans will be required in 2003. In addition, as medical costs increase the costs of our retiree medical obligations also increase. Our retiree medical costs for 2002 were $15.1 million and our current estimate for 2003 is $15.0 - $16.0 million. In future periods, compensation expense related to variable stock plans may be materially affected by our stock price. A $1.00 change in our stock price impacts compensation expense by approximately $1.0 million. Taxes other than income taxes for the three and six months ended June 30, 2003 decreased $2.8 million and $5.9 million, or 9%, respectively, as compared with the prior year periods primarily due to decreased property taxes at ELI due to lower asset values. Sales and marketing expenses for the three and six months ended June 30, 2003 decreased $3.1 million, or 11%, and $3.5 million, or 6%, respectively, as compared to the prior year period due to a reduction of personnel and related costs in the ILEC sector.
DEPRECIATION AND AMORTIZATION EXPENSE ($ in thousands) For the three months ended June 30, For the six months ended June 30, ------------------------------------------- ---------------------------------------------- 2003 2002 $ Change % Change 2003 2002 $ Change % Change ---------- ----------- ----------- -------- ---------- ----------- ------------ ---------- Depreciation expense $ 118,729 $ 156,050 $ (37,321) -24% $ 225,565 $ 303,870 $ (78,305) -26% Amortization expense 31,630 30,328 1,302 4% 63,342 60,682 2,660 4% ---------- ----------- ----------- ----------- ----------- ------------ $ 150,359 $ 186,378 $ (36,019) -19% $ 288,907 $ 364,552 $ (75,645) -21% ========== =========== =========== =========== =========== ============
Depreciation expense for the three months ended June 30, 2003 decreased $37.3 million, or 24%, as compared with the prior year period primarily due to the ELI impairment charge recognized during the third quarter of 2002, which reduced ELI's asset base, the adoption of SFAS No. 143 and the increase in the average depreciable lives for certain of our equipment. Depreciation expense for the six months ended June 30, 2003 decreased $78.3 million, or 26%, as compared with the prior year period primarily due to the ELI impairment charge recognized during the third quarter of 2002, which reduced ELI's asset base, the adoption of SFAS No. 143 and the increase in the average depreciable lives for certain of our equipment. Accelerated depreciation in 2002 of $12.8 million relating to the closing of our Plano, Texas facility also contributed to the decrease. Amortization expense for the three and six months ended June 30, 2003 increased $1.3 million and $2.7 million, or 4%, respectively, as compared with the prior year periods primarily due to increased amortization of customer base, due to a final purchase price allocation, resulting from the receipt of the final valuation report of our Frontier acquisition during the second quarter of 2002.
RESERVE FOR TELECOMMUNICATIONS BANKRUPTCIES / RESTRUCTURING AND OTHER EXPENSES ($ in thousands) For the three months ended June 30, For the six months ended June 30, ------------------------------------------- ----------------------------------------------- 2003 2002 $ Change % Change 2003 2002 $ Change % Change ---------- ----------- ----------- -------- ------------ ----------- ------------ --------- Reserve for telecommunications bankruptcies $ 2,260 $ 10,001 $ (7,741) -77% $ 2,260 $ 17,805 $ (15,545) -87% Restructuring and other expenses $ 10,113 $ 18,280 $ (8,167) -45% $ 10,092 $ 22,185 $ (12,093) -55%
During the second quarter 2003, we reserved approximately $2.3 million of trade receivables with Touch America as a result of Touch America's filing for bankruptcy. These receivables were generated as a result of providing ordinary course telecommunication services. If other telecommunications companies file for bankruptcy we may have additional significant reserves in future periods. During the second quarter 2002, we reserved approximately $21.6 million of trade receivables with WorldCom, as a result of WorldCom's filing for bankruptcy. These receivables were generated as a result of providing ordinary course telecommunications services. This charge was partially offset by an $11.6 million settlement with Global as discussed below. 30 Concurrent with the acquisition of Frontier, we entered into several operating agreements with Global. We have ongoing commercial relationships with Global affiliates. We reserved a total of $29.0 million of Global receivables during 2001 and 2002 as a result of Global's filing for bankruptcy to reflect our best estimate of the net realizable value of receivables incurred from these commercial relationships. We recorded a write-down of such receivables in the amount of $7.8 million in the first quarter 2002 and $21.2 million in the fourth quarter of 2001. In the second quarter 2002, as the result of a settlement agreement with Global, we reversed $11.6 million of our previous write-down of the net realizable value of these receivables. Restructuring and other expenses for 2003 primarily consist of expenses related to reductions in personnel at our telecommunications operations and the write off of software no longer useful. During 2002, restructuring and other expenses primarily consist of expenses related to our various restructurings, including reductions in personnel at our telecommunications operations, and costs that were spent at our Plano, Texas facility and at other locations as a result of transitioning functions and jobs.
INVESTMENT AND OTHER INCOME (LOSS), NET / GAIN (LOSS) ON SALE OF ASSETS / INTEREST EXPENSE / INCOME TAX EXPENSE (BENEFIT) ($ in thousands) For the three months ended June 30, For the six months ended June 30, ------------------------------------------- ---------------------------------------------- 2003 2002 $ Change % Change 2003 2002 $ Change % Change ----------- ---------- ----------- -------- ---------- ----------- ------------ ---------- Investment and other income (loss), net $ 24,566 $ (29,188) $ 53,754 184% $ 74,388 $ (78,139) $ 152,527 195% Gain (loss) on sale of assets $ 6,671 $ - $ 6,671 100% $ 5,021 $ - $ 5,021 100% Interest expense $106,436 $ 119,947 $(13,511) -11% $215,712 $ 241,554 $ (25,842) -11% Income tax expense (benefit) $ 24,384 $ (26,560) $ 50,944 192% $ 64,360 $ (53,502) $ 117,862 220%
Investment and other income (loss), net for the three months ended June 30, 2003 increased $53.8 million as compared with the prior year period primarily due a $25.0 million non-cash pre-tax gain in 2003 related to a capital lease restructuring at ELI. The 2002 activity included $10.0 million of income from the settlement of certain retained liabilities at less than face value which were associated with customer advances for construction from our disposed water properties, and the recognition in 2002 of a $45.6 million non-cash pre-tax loss resulting from an other than temporary decline in the value of our investment in Adelphia (see Note 11 to Consolidated Financial Statements). The increase was partially offset by lower income from money market balances and short-term investments. Investment and other income (loss), net for the six months ended June 30, 2003 increased $152.5 million as compared with the prior year period primarily due to $65.7 million in non-cash pre-tax gains in 2003 related to capital lease restructurings at ELI, $6.2 million of income in 2003 associated with the retained liabilities settlements and the recognition in 2002 of a $95.3 million non-cash pre-tax loss resulting from an other than temporary decline in the value of our investment in Adelphia (see Note 11 to Consolidated Financial Statements). The increase was partially offset by lower income from money market balances and short-term investments. Gain on sale of assets represents the gain on the sale of access lines in North Dakota and the sale of our wireless partnership interest in Wisconsin, partially offset by a loss recognized on the sale of our Plano office building in March 2003. Interest expense for the three months ended June 30, 2003 decreased $13.5 million, or 11%, as compared with the prior year period primarily due to the retirement of debt partially offset by higher average interest rates. During the three months ended June 30, 2003, we had average long-term debt (excluding equity units and convertible preferred stock) outstanding of $4.7 billion compared to $5.4 billion during the three months ended June 30, 2002. Our weighted average borrowing rate for the three months ended June 30, 2003 as compared with the prior year period was 27 basis points higher, increasing from 7.76% to 8.03%, due to the repayment of debt with interest rates below our average rate. 31 Interest expense for the six months ended June 30, 2003 decreased $25.8 million, or 11%, as compared with the prior year period primarily due to the retirement of debt partially offset by higher average interest rates. During the six months ended June 30, 2003, we had average long-term debt (excluding equity units and convertible preferred stock) outstanding of $4.8 billion compared to $5.4 billion during the six months ended June 30, 2002. Our weighted average borrowing rate for the six months ended June 30, 2003 as compared with the prior year period was 25 basis points higher, increasing from 7.79% to 8.04%, due to the repayment of debt with interest rates below our average rate. Income taxes for the three and six months ended June 30, 2003 increased $50.9 million and $117.9 million, respectively, as compared with the prior year periods primarily due to changes in taxable income. The effective tax rate for the first six months of 2003 was 39.4% as compared with 39.1% for the first six months of 2002. Assuming the Company's operating structure remains the same, we estimate that our effective tax rate will increase to approximately 44% to 46% for fiscal 2004. DISCONTINUED OPERATIONS ($ in thousands) For the six months ended June 30, 2003 2002 ---------- ------------ Revenue $ - $ 4,650 Operating income (loss) $ - $ (419) Income (loss) from discontinued operations, net of tax $ - $ (1,478) Gain on disposal of water segment, net of tax $ - $169,326 On January 15, 2002, we completed the sale of our water and wastewater operations to American Water Works, Inc. for $859.1 million in cash and $122.5 million of assumed debt and other liabilities. The pre-tax gain on the sale recognized in the first quarter of 2002 was $309.2 million, subsequently adjusted to $316.7 million in the fourth quarter of 2002. The gain on the disposal of the water segment, net of tax was $169.3 million. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE During the first quarter of 2003, as a result of our adoption of SFAS No. 143, "Accounting for Asset Retirement Obligations", we recognized an after tax non-cash gain of approximately $65.8 million. During the first quarter of 2002, as a result of our adoption of SFAS No. 142, "Goodwill and Other Intangible Assets", we recognized a transitional impairment loss of $39.8 million for goodwill related to ELI (see Note 15 to Consolidated Financial Statements). Item 3. Quantitative and Qualitative Disclosures about Market Risk ---------------------------------------------------------- Disclosure of primary market risks and how they are managed 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 and commodity 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 and commodity 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 and capital lease obligations. The long term debt and capital lease obligations include various instruments with various maturities and interest rates. 32 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 and capital lease obligations. A hypothetical 10% 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, 2003, 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 entered into five interest swap agreements in 2002 and 2001 with investment grade financial institutions. During the second quarter of 2003, we entered into two additional interest rate swaps. Each agreement covered a notional amount of $50.0 million. 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. There are two interest rate swap agreements that were executed in 2001 that receive a 6.375% fixed rate until the swaps' termination date of August 15, 2004, and there are five swaps executed in 2002 and 2003 that receive an 8.500% fixed rate until their termination date of May 15, 2006. The underlying variable rate on the swaps is set either in advance, in arrears or, as in the case of one agreement, based on each period's daily average six-month LIBOR. In connection with these swaps, the Company entered into a series of supplemental rate agreements which had the effect of setting the floating rate portion of the swaps in advance of the contractually agreed upon rate determination date. Sensitivity analysis of interest rate exposure At June 30, 2003, the fair value of our long-term debt and capital lease obligations was estimated to be approximately $5.4 billion, based on our overall weighted average rate of 8.0% and our overall weighted maturity of 12 years. There has been no material change in the weighted average maturity applicable to our obligations since December 31, 2002. The overall weighted average interest rate declined approximately 3 basis points during 2003. A hypothetical increase of 80 basis points (10% of our overall weighted average borrowing rate) would result in an approximate $242.7 million decrease in the fair value of our fixed rate obligations. Equity Price Exposure Our exposure to market risk for changes in equity prices relate primarily to the equity portion of our investment portfolio. The equity portion of our investment portfolio includes marketable equity securities of media and telecommunications companies. As of June 30, 2003, we owned 3,059,000 shares of Adelphia common stock. As of June 30, 2002, we had written this investment down to zero, and therefore we have no additional exposure related to the market value of Adelphia stock. As of June 30, 2003, we owned 2,305,908 common shares which represent an ownership of 19% of the equity in Hungarian Telephone and Cable Corp., a company of which our Chairman and Chief Executive Officer is a member of the Board of Directors. In addition, we hold 30,000 shares of non-voting convertible preferred stock, each share having a liquidation value of $70 per share and is convertible at our option into 10 shares of common stock. As of June 30, 2003, we owned 1,333,500 shares of D & E Communications (D & E) common stock. As the result of an other than temporary decline in the stock price of D & E, we recognized a non-cash pre-tax loss of $16.4 million on our investment during the fourth quarter 2002. Sensitivity analysis of equity price exposure At June 30, 2003, the fair value of the equity portion of our investment portfolio was estimated to be $37.6 million. A hypothetical 10% decrease in quoted market prices would result in an approximate $3.8 million decrease in the fair value of the equity portion of our investment portfolio. 33 Commodity Price Exposure We purchase monthly gas future contracts, from time to time, to manage commodity price fluctuations, caused by weather and other unpredictable factors, associated with our commitments to deliver natural gas to customers at fixed prices. Customers pay for gas service based upon prices that are defined by a tariff. A tariff is an agreement between the public utility commission and us, which determines the price that will be charged to the customer. Fluctuations in gas prices are routinely handled through a pricing mechanism called the purchase gas adjustor (PGA). The PGA allows for a process whereby any price change from the agreed upon tariff will be settled as a pass through to the customer. As a result, if gas prices increase, the PGA will increase and pass more costs on to the customer. If gas prices decrease, the PGA will decrease and refunds will be provided to the customer. This commodity activity relates to our gas businesses and is not material to our consolidated financial position or results of operations. In all instances we take physical delivery of the gas supply purchased or contracted for by us. These gas future contracts and gas supply contracts are considered derivative instruments as defined by SFAS 133. However, such contracts are excluded from the provisions of SFAS 133 since they are purchases made in the normal course of business and not for speculative purposes. Based upon our overall commodity price exposure at June 30, 2003, a material near-term change in the quoted market price of gas would not materially affect our consolidated financial position or results of operations. Disclosure of limitations of sensitivity analysis Certain shortcomings are inherent in the method of analysis presented in the computation of fair value of financial instruments. Actual values may differ from those presented should market conditions vary from assumptions used in the calculation of the fair value. This analysis incorporates only those exposures that exist as of June 30, 2003. It does not consider those exposures or positions, which could arise after that date. As a result, our ultimate exposure with respect to our market risks will depend on the exposures that arise during the period and the fluctuation of interest rates and quoted market prices. 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, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective. It should be noted that the design of any system of controls is based in part upon certain assumptions, and there can be no assurance that any design will succeed in achieving its stated goals. (b) Changes in internal controls over financial reporting. There was no change in our internal control over financial reporting that occurred during the fiscal quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting. 34 PART II. OTHER INFORMATION CITIZENS COMMUNICATIONS COMPANY AND SUBSIDIARIES Item 1. Legal Proceedings ----------------- On July 20, 2001, we notified Qwest Corporation (Qwest) that we were terminating eight acquisition agreements. On July 23, 2001, Qwest filed a notice of claim for arbitration with respect to the terminated acquisition agreements. Qwest asserted that we wrongfully terminated these agreements and sought approximately $64.0 million in damages, which is the aggregate of liquidated damages under letters of credit established in the terminated acquisition agreements. On September 7, 2001, we filed a response and counterclaims in the same arbitration proceedings, contesting Qwest's asserted claims and asserting substantial claims against Qwest for material breaches of representations, warranties, and covenants in the terminated acquisition agreements and in the acquisition agreement relating to North Dakota assets that we purchased from Qwest. The parties have entered into a settlement agreement, which became effective on June 19, 2003, resolving all claims that were the subjects of the arbitration. There was no impact on our financial position or results of operations. 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 has 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 by Bangor Gas Company, which we owned from 1948-1963. The City alleged the existence of extensive contamination of the Penobscot River and nearby land areas and has 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 have filed an answer denying liability to the City, and have asserted a number of counter claims against the City. We intend to defend ourselves vigorously against the City's lawsuit. In addition, we have identified a number of other potentially responsible parties that may be responsible for the damages alleged by the City and joined them as parties to the lawsuit. These additional parties include Honeywell Corporation, the Army Corps of Engineers, Guilford Transportation (formerly Maine Central Railroad), UGI Utilities, Inc., and Centerpoint Energy Resources Corporation. We also have demanded that various of our insurance carriers defend and indemnify us with respect to the City's lawsuit. On or about 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 insurance coverage for the City's lawsuit. On February 7, 2003, we received a letter from counsel representing Enron North America Corporation (formerly known as Enron Gas Marketing, Inc.) demanding payment of an "early termination liability" of approximately $12.5 million that Enron claims it is owed under a gas supply agreement that we lawfully terminated in November 2001. The demand was made in connection with Enron's ongoing bankruptcy proceeding in the United States Bankruptcy Court for the Southern District of New York. We believe Enron's claim lacks any merit and have so advised that company's counsel. Enron has threatened to initiate an adversary proceeding in the bankruptcy court to recover the amount of its demand plus applicable interest and attorney's fees. If that occurs, we will vigorously defend against any such action. We are currently engaged in discussions with Enron in an effort to resolve these claims without litigation. In connection with an inquiry that we believe has arisen as a result of allegations made to federal authorities during their investigation of an embezzlement by two of our former officers, our employees and we are cooperating fully with the Office of the U.S. Attorney for the Southern District of New York and with the New York office of the Securities and Exchange Commission. We have provided requested documents to the SEC and we have agreed to comply with an SEC request that, in connection with the informal inquiry that it has initiated, we preserve financial, audit, and accounting records. Since the filing of our Form 10-K on March 24, 2003, there have been no material developments concerning this matter. We are party to 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. 35 Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- (a) The registrant held its 2003 Annual Meeting of the Stockholders on May 13, 2003. (b) Proxies for the Annual Meeting were solicited pursuant to Regulation 14A; there was no solicitation in opposition to management's nominees for directors as listed in the Proxy Statement. All such nominees were elected pursuant to the following votes: Number of Votes --------------- DIRECTORS FOR WITHHELD --------- --- -------- Aaron I. Fleischman 232,329,933 23,394,579 Rudy J. Graf 235,188,578 20,535,934 Stanley Harfenist 235,410,901 20,313,611 Andrew N. Heine 234,921,536 20,802,976 William M. Kraus 234,636,182 21,088,330 Scott N. Schneider 235,397,940 20,326,572 John L. Schroeder 234,937,237 20,787,275 Robert A. Stanger 235,031,327 20,693,185 Edwin Tornberg 235,362,909 20,361,603 Claire L. Tow 231,061,748 24,662,764 Leonard Tow 232,112,565 23,611,947 David H. Ward 235,373,974 20,350,538 (c) Ratification of appointment of KPMG LLP as the Company's independent public accountants for 2003. Number of vote FOR 250,568,674 Number of votes AGAINST/WITHHELD 2,751,007 Number of votes ABSTAINING 2,404,831 Number of BROKER NON-VOTES 0 Item 5. Other Information ----------------- As disclosed in our proxy statement for the 2003 Annual Meeting under our bylaws, if any stockholder intends to propose any matter at the 2004 annual meeting, the proponent must give written notice to us not earlier than January 14, 2004 nor later than February 13, 2004. Furthermore, in accordance with the proxy rules and regulations of the Securities and Exchange Commission, if a stockholder does not notify us by February 13, 2004 of a proposal, then our proxies would be able to use their discretionary voting authority if a stockholder's proposal is raised at the meeting. Item 6. Exhibits and Reports on Form 8-K -------------------------------- 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. 36 b) Reports on Form 8-K: We furnished on Form 8-K on May 6, 2003 under Item 9 "Regulation FD Disclosure", a press release announcing our earnings for the quarter ended March 31, 2003. 37 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 12, 2003 38 EX-31.1 3 exhibit31-1.txt TOW CERTIFICATION Exhibit 31.1 CERTIFICATIONS I, Leonard Tow, certify that: 1. I have reviewed this quarterly report of Citizens Communications Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 12, 2003 By: /s/ Leonard Tow ---------------------------------- Leonard Tow Chief Executive Officer and Chairman of the Board of Directors (principal executive officer) EX-31.2 4 exhibit31-2.txt ELLIOTT CERTIFICATION Exhibit 31.2 CERTIFICATIONS I, Jerry Elliott, certify that: 1. I have reviewed this quarterly report of Citizens Communications Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 12, 2003 By: /s/ Jerry Elliott ----------------------------- Jerry Elliott Chief Financial Officer (principal financial officer) EX-32.1 5 exhibit32-1.txt TOW 906 CERTIFICATION Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350. AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Citizens Communications Company (the "Company") on Form 10-Q for the quarter ended June 30, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Leonard Tow, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Leonard Tow - ----------------------- Leonard Tow Chief Executive Officer August 12, 2003 This certification is made solely for purpose of 18 U.S.C. Section 1350, subject to the knowledge standard contained therein, and not for any other purpose. A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Citizens Communications Company and will be retained by Citizens Communications Company and furnished to the Securities and Exchange Commission or its staff upon request. EX-32.2 6 exhibit32-2.txt ELLIOTT 906 CERTIFICATION Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350. AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Citizens Communications Company (the "Company") on Form 10-Q for the quarter ended June 30, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Jerry Elliott, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Jerry Elliott - ----------------------- Jerry Elliott Chief Financial Officer August 12, 2003 This certification is made solely for purpose of 18 U.S.C. Section 1350, subject to the knowledge standard contained therein, and not for any other purpose. A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to Citizens Communications Company and will be retained by Citizens Communications Company and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----