-----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, BWpb1+HtqUmDoJ3e75urwlcp5t0KhPMLvl+9cjFs3xuf4CMlj6LAkhDJpj17H+dS 4TIffN4zCuGeN6z7E70TwA== 0000912057-97-009664.txt : 19970327 0000912057-97-009664.hdr.sgml : 19970327 ACCESSION NUMBER: 0000912057-97-009664 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970321 DATE AS OF CHANGE: 19970326 SROS: AMEX FILER: COMPANY DATA: COMPANY CONFORMED NAME: TELEPHONE & DATA SYSTEMS INC CENTRAL INDEX KEY: 0000096966 STANDARD INDUSTRIAL CLASSIFICATION: 4812 IRS NUMBER: 362669023 STATE OF INCORPORATION: IA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: 1934 Act SEC FILE NUMBER: 001-08251 FILM NUMBER: 97560875 BUSINESS ADDRESS: STREET 1: 30 NORTH LASALLE STREET SUITE 400 CITY: CHICAGO STATE: IL ZIP: 60602 BUSINESS PHONE: 6088288324 MAIL ADDRESS: STREET 1: 30 NORTH LASALLE STREE SUITE 400 CITY: CHICAGO STATE: IL ZIP: 60602 FORMER COMPANY: FORMER CONFORMED NAME: TELEPHONE SYSTEMS INC STOCK OPTION PLANS DATE OF NAME CHANGE: 19741118 FORMER COMPANY: FORMER CONFORMED NAME: TELEPHONE SYSTEMS INC DATE OF NAME CHANGE: 19740509 10-K405 1 FORM 10-K405 - - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (MARK ONE) /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 1-8251 - - -------------------------------------------------------------------------------- TELEPHONE AND DATA SYSTEMS, INC. (Exact name of Registrant as specified in its charter) - - -------------------------------------------------------------------------------- IOWA 36-2669023 - - -------------------------------- -------------------------------- (State or other jurisdiction (IRS Employer Identification of incorporation or No.) organization)
30 NORTH LASALLE STREET, CHICAGO, ILLINOIS 60602 (Address of principal executive offices) (Zip code) REGISTRANT'S TELEPHONE NUMBER: (312) 630-1900 Securities registered pursuant to Section 12(b) of the Act: Name of each exchange Title of each class on which registered - - ----------------------------- ----------------------------- Common Shares, $1 par value American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None ------------------- 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.___X___ As of February 28, 1997, the aggregate market values of the registrant's Common Shares, Series A Common Shares and Preferred Shares held by nonaffiliates were approximately $2.2 billion, $15.4 million and $40.8 million, respectively. The closing price of the Common Shares on February 28, 1997, was $40.00, as reported by the American Stock Exchange. Because no market exists for the Series A Common Shares and Preferred Shares, the registrant has assumed for purposes hereof that (i) each Series A Common Share has a market value equal to one Common Share because the Series A Common Shares were initially issued by the registrant in exchange for Common Shares on a one-for-one basis and are convertible on a share-for-share basis into Common Shares, (ii) each nonconvertible Preferred Share has a market value of $100 because each of such shares had a stated value of $100 when issued, and (iii) each convertible Preferred Share has a value of $40.00 times the number of Common Shares into which it was convertible on February 28, 1997. The number of shares outstanding of each of the registrant's classes of common stock, as of February 28, 1997, is 54,145,158 Common Shares, $1 par value, and 6,916,546 Series A Common Shares, $1 par value. DOCUMENTS INCORPORATED BY REFERENCE Those sections or portions of the registrant's 1996 Annual Report to Shareholders, and of the registrant's Notice of Annual Meeting and Proxy Statement for its 1997 Annual Meeting of Shareholders, described in the cross reference sheet and table of contents attached hereto are incorporated by reference into Part II of this report. - - -------------------------------------------------------------------------------- CROSS REFERENCE SHEET AND TABLE OF CONTENTS - - --------------------------------------------------------------------------------
PAGE NUMBER OR REFERENCE(1) --------------- Item 1. Business............................................. 3 Item 2. Properties........................................... 38 Item 3. Legal Proceedings.................................... 38 Item 4. Submission of Matters to a Vote of Security Holders............................................ 38 Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................................ 39 (2) Item 6. Selected Financial Data.............................. 39 (3) Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................ 39 (4) Item 8. Financial Statements and Supplementary Data.......... 39 (5) Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure................ 39 Item 10. Directors and Executive Officers of the Registrant... 40 (6) Item 11. Executive Compensation............................... 40 (7) Item 12. Security Ownership of Certain Beneficial Owners and Management......................................... 40 (8) Item 13. Certain Relationships and Related Transactions....... 40 (9) Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................................ 41
- - --------- (1) Parenthetical references are to information incorporated by reference from the registrant's Exhibit 13, which includes portions of its Annual Report to Shareholders for the year ended December 31, 1996 ("Annual Report"), and from the registrant's Notice of Annual Meeting of Shareholders and Proxy Statement for its 1997 Annual Meeting of Shareholders (the "Proxy Statement"). (2) Annual Report sections entitled "TDS Stock and Dividend Information" and "Market Price per Common Share by Quarter." (3) Annual Report section entitled "Selected Consolidated Financial Data." (4) Annual Report section entitled "Management's Discussion and Analysis of Results of Operations and Financial Condition." (5) Annual Report sections entitled "Consolidated Statements of Income," "Consolidated Statements of Cash Flows," "Consolidated Balance Sheets," "Consolidated Statements of Common Stockholders' Equity," "Notes to Consolidated Financial Statements," "Consolidated Quarterly Income Information (Unaudited)" and "Report of Independent Public Accountants." (6) Proxy Statement sections entitled "Election of Directors" and "Executive Officers." (7) Proxy Statement section entitled "Executive Compensation," except for the information specified in Item 402(a)(8) of Regulation S-K under the Securities Exchange Act of 1934, as amended. (8) Proxy Statement section entitled "Security Ownership of Certain Beneficial Owners and Management." (9) Proxy Statement section entitled "Certain Relationships and Related Transactions." - - -------------------------------------------------------------------------------- - - -------------------------------------------------------------------------------- TELEPHONE AND DATA SYSTEMS, INC. 30 NORTH LASALLE STREET, CHICAGO, ILLINOIS 60602 TELEPHONE (312) 630-1900 [LOGO] - - -------------------------------------------------------------------------------- PART I - - -------------------------------------------------------------------------------- ITEM 1. BUSINESS Telephone and Data Systems, Inc. (the "Company" or "TDS"), is a diversified telecommunications service company with established cellular telephone, local telephone and radio paging operations and developing personal communications services ("PCS") operations. At December 31, 1996, the Company served approximately 2.3 million customer units in 37 states, including 1,073,000 cellular telephones, 484,500 telephone access lines and 777,400 pagers. For the year ended December 31, 1996, cellular operations provided 58% of the Company's consolidated revenues; telephone operations provided 33%; and paging operations provided 9%. The Company's long-term business development strategy is to expand its existing operations through internal growth and acquisitions and to explore and develop other telecommunications businesses that management believes will utilize the Company's expertise in customer-based telecommunications. The Company conducts substantially all of its cellular operations through its 80.6%-owned subsidiary, United States Cellular Corporation [AMEX: USM]. U.S. Cellular provides cellular telephone service to 1,073,000 customers through 131 majority-owned and managed ("consolidated") cellular systems serving approximately 16% of the geography and approximately 8% of the population of the 48 contiguous United States. Since 1985, when the Company began providing cellular service in Knoxville, Tennessee, the Company has expanded its cellular networks and customer service operations to cover 140 managed markets in 27 states as of December 31, 1996. In total, the Company now operates nine market clusters, of which five have a total population of more than two million, and each of which has a total population of more than one million, plus one other unclustered market. Overall, 81% of the Company's 25.1 million population equivalents are in markets which are consolidated, 1% are in managed but not consolidated markets and 18% are in markets in which the Company holds an investment interest. The Company conducts substantially all of its telephone operations through its wholly owned subsidiary, TDS Telecommunications Corporation ("TDS Telecom"). TDS Telecom currently operates 105 telephone companies serving 484,500 access lines in 28 states. TDS Telecom is expanding by offering additional lines of telecommunications products and services to existing customers and through the selective acquisition of local exchange telephone companies serving rural and suburban areas. TDS Telecom has acquired 22 telephone companies and divested one telephone company since the beginning of 1992. These net acquisitions added 90,400 access lines during this five-year period, while internal growth added 90,100 lines. The Company conducts substantially all of its broadband personal communications services operations through its 82.8%-owned subsidiary, Aerial Communications, Inc. [NASDAQ: AERL], formerly American Portable Telecom, Inc. [NASDAQ: APTI]. In March 1995, Aerial was the successful bidder for eight broadband PCS licenses. The six 30 megahertz PCS licenses that are being developed 3 cover the Major Trading Areas of Minneapolis, Tampa-St. Petersburg-Orlando, Houston, Pittsburgh, Kansas City and Columbus, and account for 27.6 million population equivalents. Aerial has sold its licenses covering the Guam and Alaska MTAs. The Company conducts substantially all of its radio paging operations through its 82.3%-owned subsidiary, American Paging, Inc. [AMEX: APP]. American Paging offers radio paging and related services through its subsidiaries. Since the beginning of 1992, the number of pagers in service increased from 236,800 to 777,400 at December 31, 1996, primarily from internal growth. APP provides service in 21 states and the District of Columbia through 51 sales and service offices. American Paging's service areas cover a total population of approximately 76 million. The Company was incorporated in Iowa in 1968. The Company's executive offices are located at 30 North LaSalle Street, Chicago, Illinois 60602. Its telephone number is 312-630-1900. Unless the context indicates otherwise: (i) references to "TDS" or the "Company" refer to Telephone and Data Systems, Inc., and its subsidiaries; (ii) references to "USM" or "U.S. Cellular" refer to United States Cellular Corporation and its subsidiaries; (iii) references to "TDS Telecom" refer to TDS Telecommunications Corporation and its subsidiaries; (iv) references to "AERL" or "Aerial" refer to Aerial Communications, Inc. and its subsidiaries;(v) references to "APP" or "American Paging" refer to American Paging, Inc. and its subsidiaries; (vi) references to "MSA" or to a particular city refer to the Metropolitan Statistical Area, as designated by the U.S. Office of Management and Budget and used by the Federal Communications Commission ("FCC") in designating metropolitan cellular market areas; (vii) references to "RSA" refer to the Rural Service Area, as used by the FCC in designating non-MSA cellular market areas; (viii) references to cellular "markets" or "systems" refer to MSAs, RSAs or both; (ix) references to "MTA" refer to Major Trading Areas, as used by the FCC in designating Personal Communications Services ("PCS") markets; (x) references to "population equivalents" mean the population of a market, based on 1996 Donnelley Marketing Service Estimates, multiplied by the percentage interests that the Company owns or has the right to acquire in an entity licensed, designated to receive a license or expected to receive a construction permit ("licensee") by the FCC to construct or operate a cellular or a PCS system in such market. PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 SAFE HARBOR CAUTIONARY STATEMENT This Annual Report on Form 10-K, including exhibits, contains "forward-looking" statements, as defined in the Private Securities Litigation Reform Act of 1995, that are based on current expectations, estimates and projections. Statements that are not historical facts, including statements about the Company's beliefs and expectations are forward-looking statements. These statements contain potential risks and uncertainties and therefore, actual results may differ materially. TDS undertakes no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Important factors that may affect these projections or expectations include, but are not limited to: changes in the overall economy; changes in competition in markets in which TDS operates; advances in telecommunications technology; changes in the telecommunications regulatory environment; pending and future litigation; availability of future financing; start-up of PCS operations; and unanticipated changes in growth in cellular customers, penetration rates, churn rates and the mix of products and services offered in the Company's markets. Readers should evaluate any statements in light of these important factors. CELLULAR TELEPHONE OPERATIONS The Company's cellular operations are conducted through U.S. Cellular and subsidiaries. U.S. Cellular serves 1,073,000 customers through 131 majority-owned and managed cellular systems at December 31, 1996. Overall, U.S. Cellular owned 25.1 million population equivalents in 204 markets. THE CELLULAR TELEPHONE INDUSTRY Cellular telephone technology provides high-quality, high-capacity communications services to in-vehicle and hand-held portable cellular telephones. Cellular technology is a major improvement over 4 earlier mobile telephone technologies. Cellular telephone systems are designed for maximum mobility of the customer. Access is provided through system interconnections to local, regional, national and world-wide telecommunications networks. Cellular telephone systems also offer a full range of ancillary services such as conference calling, call-waiting, call-forwarding, voice mail, facsimile and data transmission. Cellular telephone systems divide each service area into smaller geographic areas or "cells." Each cell is served by radio transmitters and receivers operating on discrete radio frequencies licensed by the FCC. All of the cells in a system are connected to a computer-controlled Mobile Telephone Switching Office ("MTSO"). The MTSO is connected to the conventional ("landline") telephone network and potentially other MTSOs. Each conversation on a cellular phone involves a transmission over a specific set of radio frequencies from the cellular phone to a transmitter/receiver at a cell site. The transmission is forwarded from the cell site to the MTSO and from there may be forwarded to the landline telephone network to complete the call. As the cellular telephone moves from one cell to another, the MTSO determines radio signal strength and transfers ("hands off") the call from one cell to the next. This hand-off is not noticeable to either party on the phone call. The FCC currently grants only two licenses to provide cellular telephone service in each market. However, competition for customers includes competing communications technologies such as conventional landline and mobile telephone, Specialized Mobile Radio ("SMR") systems and radio paging. PCS has become available in certain areas of the United States, including U.S. Cellular's markets, and U.S. Cellular expects PCS competitors to initiate service in all of its markets in the next one or two years. Additionally, emerging technologies such as Enhanced Specialized Mobile Radio ("ESMR") and mobile satellite communication systems may prove to be competitive with cellular service in the future in some or all U.S. Cellular markets. The services available to cellular customers and the sources of revenue available to cellular system operators are similar to those provided by conventional landline telephone companies. Customers are charged a separate fee for system access, airtime, long-distance calls, and ancillary services. Cellular system operators often provide service to customers of other operators' cellular systems while the customers are temporarily located within the operators' service areas. Customers using service away from their home system are called "roamers." Roaming is available because technical standards require that analog cellular telephones be compatible in all market areas in the United States. The system that provides the service to these roamers will generate usage revenue. Many operators, including U.S. Cellular, charge premium rates for this roaming service. There are a number of recent technical developments in the cellular industry. Currently, while most of the MTSOs process information digitally, most of the radio transmission is done on an analog basis. During 1992, a new transmission technique was approved for implementation by the cellular industry. Time Division Multiple Access ("TDMA") technology was selected as one industry standard by the cellular industry and has been deployed in several markets, including U.S. Cellular's operations in Tulsa, Oklahoma and its Florida/Georgia market cluster. Another digital technology, Code Division Multiple Access ("CDMA"), is expected to be deployed by U.S. Cellular in a commercial trial during 1997. The Company may also deploy some CDMA digital radio channels in other markets on a trial basis in the near future. Digital radio technology offers several advantages including greater privacy, less transmission noise, greater system capacity and potentially lower incremental costs for additional customers. The conversion from analog to digital radio technology has begun on an industry-wide basis; however this process is expected to take a number of years. The cellular telephone industry is characterized by high initial fixed costs. Accordingly, if and when revenues less variable costs exceed fixed costs, incremental revenues should yield an operating profit. The amount of profit, if any, under such circumstances is dependent on, among other things, prices and variable marketing costs which in turn are affected by the amount and extent of competition. Until technological limitations on total capacity are approached, additional cellular system capacity can normally be added in increments that closely match demand and at less than the proportionate cost of the initial capacity. 5 CELLULAR OPERATIONS A significant portion of the aggregate market value of TDS's Common Shares is represented by the market value of TDS's interest in USM. From its inception in 1983 until 1993, U.S. Cellular has principally been in a start-up phase. Until that time, U.S. Cellular's activities had been concentrated significantly on the acquisition of interests in cellular licensees and on the construction and initial operation of cellular systems. The development of a cellular system is capital-intensive and requires substantial investment prior to and subsequent to initial operation. U.S. Cellular experienced operating losses and net losses from its inception until 1993. During the past three years, U.S. Cellular generated operations-driven net income and has significantly increased its operating cash flows during that time. Management anticipates increasing growth in cellular units in service and revenues as U.S. Cellular continues to expand through internal growth. Marketing and system operations expenses associated with this expansion may reduce the rate of growth in operating cash flow and operating income during the period of accelerated growth. In addition, U.S. Cellular anticipates that the seasonality of revenue streams and operating expenses may cause U.S. Cellular's operating income to vary from quarter to quarter. While U.S. Cellular produced operating income and net income during 1994, 1995 and 1996, changes in any of several factors may reduce U.S. Cellular's growth in operating income and net income over the next few years. These factors include: (i) the growth rate in U.S. Cellular's customer base; (ii) the usage and pricing of cellular services; (iii) the churn rate; (iv) the cost of providing cellular services, including the cost of attracting new customers; (v) the introduction of competition from PCS and other emerging technologies; and (vi) continuing technological advances which may provide competitive alternatives to cellular service. U.S. Cellular is building a substantial presence in selected geographic areas throughout the United States where it can efficiently integrate and manage cellular telephone systems. Its cellular interests include regional market clusters in the following areas: Iowa, Wisconsin/Illinois, Missouri, Eastern North Carolina/South Carolina, Virginia, West Virginia/Maryland/Pennsylvania, Oregon/California, Washington/Oregon/Idaho, Indiana/Kentucky/Ohio, Maine/New Hampshire/Vermont, Eastern Tennessee/Western North Carolina, Oklahoma/Missouri/Kansas, Texas/Oklahoma, Florida/Georgia and Southwestern Texas. See "U.S. Cellular's Cellular Interests." U.S. Cellular has acquired its cellular interests through the wireline application process (21%), including settlements and exchanges with other applicants, and through acquisitions (79%), including acquisitions from TDS and third parties. CELLULAR SYSTEMS DEVELOPMENT ACQUISITIONS. During the last five years, U.S. Cellular has expanded its size, particularly in contiguous or adjacent markets, through acquisitions which have been aimed at strengthening U.S. Cellular's position in the cellular industry. This growth has resulted primarily from acquisitions of interests in mid-sized and rural markets and has been based on obtaining interests with rights to manage the underlying market. U.S. Cellular has increased its population equivalents by 31% from approximately 19.1 million at December 31, 1991, to approximately 25.1 million at December 31, 1996. Markets managed by U.S. Cellular have increased from 91 markets at December 31, 1991, to 140 markets at December 31, 1996. As of December 31, 1996, 82% of the Company's population equivalents represented interests in markets U.S. Cellular manages compared to 66% at December 31, 1991. Recently, the pace of acquisitions has slowed as industry-wide consolidation has reduced the number of markets available for acquisition. U.S. Cellular's population equivalents grew at a compound annual rate of over 5% over the last five years due to the increased number of exchange and divestiture transactions in the past few years. U.S. Cellular may continue to make opportunistic acquisitions or exchanges in markets that further strengthen its market clusters and in other attractive markets. U.S. Cellular also seeks to acquire minority interests in markets where it already owns the majority interest. There can be no assurance that U.S. Cellular, or TDS for the benefit of U.S. Cellular, will be able to negotiate additional acquisitions or exchanges on terms acceptable to it or that regulatory approvals, where required, will be received. U.S. Cellular plans to retain minority interests in certain cellular markets which it believes will earn a favorable return on investment. Other minority interests may be exchanged for interests in markets which enhance 6 U.S. Cellular's market clusters or may be sold for cash or other consideration. U.S. Cellular also continues to evaluate the disposition of certain managed interests which are not essential to its corporate development strategy. U.S. Cellular, or TDS for the benefit of U.S. Cellular, has historically negotiated acquisitions of cellular interests from third parties primarily in consideration for U.S. Cellular's or TDS's equity securities. Cellular interests acquired by TDS in these transactions have been assigned to U.S. Cellular. At that time, U.S. Cellular reimbursed TDS for the value of TDS securities issued in such transactions, generally by issuing Common Shares to TDS or by increasing the balance due TDS under U.S. Cellular's Revolving Credit Agreement in amounts equal to the value of TDS securities delivered at the time the acquisitions were completed. The fair market value of the U.S. Cellular securities issued to TDS in connection with these transactions was equal to the fair market value of the TDS securities delivered in the transactions and was determined at the time the transactions were completed. In the past three years, U.S. Cellular has also negotiated substantial divestitures and exchanges of cellular interests with third parties. The consideration received from these divestitures of non-strategic markets has primarily been cash, which has been used to reduce debt or for general corporate purposes. The exchanges have included the divestiture of controlling interests in non-strategic markets in exchange for controlling interests in markets which further enhance U.S. Cellular's clusters. COMPLETED ACQUISITIONS. During 1996, U.S. Cellular, or TDS for the benefit of U.S. Cellular, completed the acquisition of controlling interests in two markets and several additional minority interests representing approximately 400,000 population equivalents for an aggregate consideration of $56.1 million. The consideration consisted of 1.1 million TDS Common Shares, 1,000 U.S. Cellular Common Shares and $13.6 million in cash. U.S. Cellular reimbursed TDS for TDS securities issued in the acquisitions through the issuance to TDS of 1.3 million U.S. Cellular Common Shares. U.S. Cellular also acquired several minority interests representing approximately 600,000 pops from TDS for $102.8 million in cash. COMPLETED DIVESTITURES AND EXCHANGES. During 1996, U.S. Cellular completed the divestiture of controlling interests in eight markets plus one market partition and minority interests in two other markets representing approximately 1.2 million population equivalents for an aggregate consideration of $176.5 million in cash. Also during 1996, U.S. Cellular completed an exchange transaction which resulted in the acquisition of a controlling interest in one market, representing 116,000 population equivalents, and the divestiture of one market representing 97,000 population equivalents. U.S. Cellular also received $11.3 million in cash pursuant to this exchange. PENDING ACQUISITIONS, DIVESTITURES, AND EXCHANGES. At December 31, 1996, U.S. Cellular had entered into an agreement to purchase a controlling interest in one market representing approximately 213,000 population equivalents. U.S. Cellular has also entered into an agreement with TDS to acquire minority interests in two markets from TDS representing 104,000 population equivalents. These pending transactions are expected to be completed during 1997. In February 1997, U.S. Cellular announced that it had entered into an exchange agreement with BellSouth Corporation, pursuant to which U.S. Cellular will receive controlling interests in twelve contiguous markets adjacent to its Iowa and Wisconsin/Illinois clusters. In exchange, U.S. Cellular will trade its controlling interest in ten markets and investment interests in 13 markets and pay cash, the amount of which is dependent upon certain factors. The transaction is subject to various regulatory and other approvals. TDS and U.S. Cellular maintain shelf registration of their respective Common Shares and Preferred Shares under the Securities Act of 1933 for issuance specifically in connection with acquisitions. The Company has had voting control of U.S. Cellular since U.S. Cellular's incorporation. TDS owned an aggregate of 69,396,227 shares of common stock of U.S. Cellular at December 31, 1996, representing over 80% of the combined total of U.S. Cellular's outstanding Common and Series A Common Shares and over 95% of their combined voting power. 7 CELLULAR INTERESTS AND CLUSTERS U.S. Cellular operates clusters of adjacent cellular systems in nearly all of its markets, enabling its customers to benefit from larger service areas than otherwise possible. Where U.S. Cellular offers wide-area coverage, its customers enjoy uninterrupted service within the designated area. Customers may also make outgoing calls and receive incoming calls within this area without special roaming arrangements. In addition to benefits to customers, clustering also has provided to U.S. Cellular certain economies in its capital and operating costs. These economies are made possible through increased sharing of facilities, personnel and other costs and have resulted in a reduction of U.S. Cellular's per customer cost of service. The extent to which U.S. Cellular benefits from these revenue enhancements and economies of operation is dependent on market conditions, population size of each cluster and engineering considerations. U.S. Cellular may continue to make opportunistic acquisitions and exchanges which will complement its established market clusters. From time to time, U.S. Cellular may also consider exchanging or selling its interests in markets which are not essential to its long-term strategies. U.S. Cellular owned interests in cellular telephone systems in 204 markets at December 31, 1996, representing 25.1 million population equivalents. Including the controlling interest to be acquired from a third party and the two minority interests to be acquired from TDS, U.S. Cellular owned or had the right to acquire interests in cellular telephone systems in 207 markets at December 31, 1996, representing 25.4 million population equivalents. The following table summarizes the growth in U.S. Cellular's population equivalents in recent years and the development status of these population equivalents.
DECEMBER 31, ----------------------------------------------------- 1996 1995 1994 1993 1992 --------- --------- --------- --------- --------- (THOUSANDS OF POPULATION EQUIVALENTS)(1) Operational Markets: Majority-Owned and Managed........................................... 20,276 19,958 18,556 18,807 14,749 Minority-Owned and Managed (2)....................................... 401 513 1,206 1,179 2,069 Markets to be Managed, Net of Markets to be Divested (3) To Be Majority-Owned................................................. 213 272 2,212 1,026 1,859 To Be Minority-Owned (2)............................................. -- -- -- 8 5 --------- --------- --------- --------- --------- Total Markets Managed and to be Managed.............................. 20,890 20,743 21,974 21,020 18,682 Minority Interest in Markets Managed by Others......................... 4,501 3,990 3,745 3,547 3,642 --------- --------- --------- --------- --------- Total................................................................ 25,391 24,733 25,719 24,567 22,324 --------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
- - --------- (1) Based on 1996 Donnelley Marketing Services estimates for all years. (2) Includes markets where U.S. Cellular has the right to acquire an interest but does not currently own an interest. (3) Includes markets which are operational but which are currently managed by third parties. The following section details U.S. Cellular's cellular interests, including those it owned or had the right to acquire as of December 31, 1996. The table presented therein lists clusters of markets that U.S. Cellular manages or anticipates managing. U.S. Cellular's market clusters show the areas in which U.S. Cellular is currently focusing its development efforts. These clusters have been devised with a long-term goal of allowing delivery of cellular service to areas of economic interest and along corridors of economic activity. The number of population equivalents represented by U.S. Cellular's cellular interests may have no direct relationship to the number of potential cellular customers or the revenues that may be realized from the operation of the related cellular systems. 8 U.S. CELLULAR'S CELLULAR INTERESTS The table below sets forth certain information with respect to the interests in cellular markets which U.S. Cellular and TDS owned or had the right to acquire pursuant to definitive agreements as of December 31, 1996.
TOTAL CURRENT AND ACQUIRABLE POPULATION CLUSTER/MAJOR SERVICE AREA 1996 POPULATION EQUIVALENTS - - ------------------------------------------------------------------------------------------------ --------------- --------------- MIDWEST REGIONAL MARKET CLUSTER: Iowa.......................................................................................... 2,732,000 2,512,000 Wisconsin/Illinois............................................................................ 2,032,000 1,930,000 Missouri...................................................................................... 686,000 686,000 --------------- --------------- Total Midwest Regional Market Cluster....................................................... 5,450,000 5,128,000 --------------- --------------- MID-ATLANTIC REGIONAL MARKET CLUSTER: Eastern North Carolina/South Carolina......................................................... 2,349,000 2,319,000 Virginia...................................................................................... 949,000 941,000 West Virginia/Maryland/Pennsylvania........................................................... 1,138,000 1,138,000 --------------- --------------- Total Mid-Atlantic Regional Market Cluster.................................................. 4,436,000 4,398,000 --------------- --------------- NORTHWEST REGIONAL MARKET CLUSTER: Oregon/California............................................................................. 1,029,000 957,000 Washington/Oregon/Idaho....................................................................... 1,471,000 1,247,000 --------------- --------------- Total Northwest Regional Market Cluster..................................................... 2,500,000 2,204,000 --------------- --------------- INDIANA/KENTUCKY/OHIO MARKET CLUSTER:........................................................... 2,352,000 1,972,000 --------------- --------------- MAINE/NEW HAMPSHIRE/VERMONT MARKET CLUSTER:..................................................... 1,689,000 1,631,000 --------------- --------------- EASTERN TENNESSEE/WESTERN NORTH CAROLINA MARKET CLUSTER:........................................ 1,769,000 1,458,000 --------------- --------------- TEXAS/OKLAHOMA/MISSOURI/KANSAS REGIONAL MARKET CLUSTER: Oklahoma/Missouri/Kansas...................................................................... 1,412,000 874,000 Texas/Oklahoma................................................................................ 694,000 498,000 --------------- --------------- Total Texas/Oklahoma/Missouri/Kansas Regional Market Cluster:............................... 2,106,000 1,372,000 --------------- --------------- FLORIDA/GEORGIA MARKET CLUSTER.................................................................. 1,520,000 1,373,000 SOUTHWESTERN TEXAS MARKET CLUSTER:.............................................................. 1,224,000 1,213,000 --------------- --------------- Other Operations:............................................................................... 141,000 141,000 --------------- --------------- Total Managed Markets........................................................................... 23,187,000 20,890,000 Markets Managed by Others....................................................................... 4,501,000 --------------- Total Population Equivalents.................................................................... 25,391,000 --------------- ---------------
9 Upon completion of the exchange transaction with BellSouth, U.S. Cellular will acquire and divest interests in certain markets. The effect on population and population equivalents is summarized below.
TOTAL POPULATION EQUIVALENTS TO BE ACQUIRED 1996 POPULATION (DIVESTED) --------------- ---------------- Markets to be acquired from BellSouth......................................................... 4,050,000 3,952,000 Markets to be traded to BellSouth: Markets Managed by U.S. Cellular (1)........................................................ 1,960,000 (1,916,000) Markets Managed by Others (2)............................................................... (1,405,000) ---------------- Total Markets to be traded to BellSouth................................................... (3,321,000) Markets to be Divested (3) Markets Managed by U.S. Cellular............................................................ 236,000 (174,000) Markets Managed by Others................................................................... (110,000) ---------------- Total Markets to be Divested.............................................................. (284,000) ---------------- Net Population Equivalents to be Acquired Related to BellSouth Transaction.............. 347,000 ---------------- ---------------- Summary of U.S. Cellular's Cellular Interests After the Completion of the Transaction with BellSouth: Total Managed Markets....................................................................... 25,041,000 22,752,000 Total Population Equivalents of Markets Managed by Others................................... 2,986,000 ---------------- 25,738,000 ---------------- ----------------
- - --------- (1) Pursuant to the agreement with BellSouth, U.S. Cellular has agreed to transfer to BellSouth a 100% interest in these markets. If U.S. Cellular owns less than 100% of these markets at the time of completion of the transaction, U.S. Cellular will pay cash to BellSouth in lieu of any interests U.S. Cellular does not own at the time. (2) In addition to these interests, U.S. Cellular will deliver to BellSouth interests in two markets which are currently owned by TDS. (3) As a result of the transaction with BellSouth, U.S. Cellular expects to divest its interest in these markets. SYSTEM DESIGN AND CONSTRUCTION. U.S. Cellular designs and constructs its systems in a manner it believes will permit it to provide high-quality service to mobile, transportable and portable cellular telephones, generally based on market and engineering studies which relate to specific markets. Engineering studies are performed by U.S. Cellular personnel or independent engineering firms. U.S. Cellular's switching equipment is digital, which reduces noise and crosstalk and is capable of interconnecting in a manner which reduces costs of operation. While digital microwave interconnections are typically made between the MTSO and cell sites, primarily analog radio transmission is used between cell sites and the cellular telephones themselves. In accordance with its strategy of building and strengthening market clusters, U.S. Cellular has selected high capacity digital cellular switching systems that are capable of serving multiple markets through a single MTSO. U.S. Cellular's cellular systems are designed to facilitate the installation of equipment which will permit microwave interconnection between the MTSO and the cell site. U.S. Cellular has implemented such microwave interconnection in most of the cellular systems it manages. In other systems in which U.S. Cellular owns or has a right to acquire a majority interest and where it is believed to be cost-efficient, such microwave technology will also be implemented. Otherwise, such systems will rely upon landline telephone connections or microwave links owned by others to link cell sites with the MTSO. Although the installation of microwave network interconnection equipment requires a greater initial capital investment, a microwave network enables a system operator to avoid the current and future charges associated with leasing telephone lines from the landline telephone company, while 10 generally improving system reliability. In addition, microwave facilities can be used to connect separate cellular systems to allow shared switching, which reduces the aggregate cost of the equipment necessary to operate both systems. U.S. Cellular has continued to expand its internal network in 1996 to encompass all of its managed markets. This network provides automatic call delivery for U.S. Cellular's customers and handoff between adjacent markets. The network has also been extended through links with certain systems operated by several other carriers, including GTE, US West, Ameritech, BellSouth, Centennial Cellular Corp., Southwestern Bell, AT&T Wireless Communications, Vanguard Cellular Systems and others. Additionally, U.S. Cellular has implemented four Signal Transfer Points which have allowed it to interconnect efficiently with network providers such as Illuminet and the North American Cellular Network. During 1997, U.S. Cellular intends to extend the network for its customers through interconnection with additional system operators for call delivery and hand-off. This expanded network will increase the area in which customers can automatically receive incoming calls, and should also reduce the incidence of "tumbling" electronic serial number fraud due to the pre-call validation feature of networked systems. In addition, the extension of these networks will allow for the termination of wireless-to-wireless traffic without the inherent costs that are otherwise incurred if this traffic is routed through the landline network. U.S. Cellular believes that currently available technologies will allow sufficient capacity on U.S. Cellular's networks to meet anticipated demand over the next few years. COSTS OF SYSTEM CONSTRUCTION AND FINANCING Construction of cellular systems is capital-intensive, requiring substantial investment for land and improvements, buildings, towers, MTSOs, cell site equipment, microwave equipment, engineering and installation. U.S. Cellular, consistent with FCC control requirements, uses primarily its own personnel to engineer and oversee construction of each cellular system it owns and operates. In so doing, U.S. Cellular expects to improve the overall quality of its systems and to reduce the expense and time required to make them operational. The costs (exclusive of license costs) of the systems in which U.S. Cellular owns an interest have historically been financed through capital contributions or intercompany loans from U.S. Cellular to the entities owning the systems, and through certain vendor financing. MARKETING U.S. Cellular's marketing plan is centered around rapid penetration of its market clusters, increasing customer awareness of cellular service and reducing churn through both the building of brand awareness and the implementation of marketing programs. The marketing plan stresses the value of U.S. Cellular's service offerings and incorporates combinations of rate plans and cellular telephone equipment which are designed to meet the needs of a variety of customer segments and their usage patterns. U.S. Cellular's distribution channels include direct sales personnel, agents and retail service centers in the vast majority of its markets. In late 1996, U.S. Cellular implemented its new site on the WorldWideWeb to support its marketing efforts and to be a future distribution channel. These U.S. Cellular-owned and managed locations are designed to market cellular service to the consumer segment in a familiar setting. U.S. Cellular manages each cluster of markets from an administrative office with a local staff, which typically includes sales, customer service, engineering and in some cases installation personnel. Direct sales consultants market cellular service to business customers throughout each cluster. Retail associates work out of the retail locations and market cellular service primarily to the consumer and small business segment. U.S. Cellular maintains an ongoing training program to improve the effectiveness of sales consultants and retail associates by focusing their efforts on obtaining customers and maximizing the sale of high-user packages. These packages provide for customers to obtain a minimum amount of usage at discounted rates per minute, at fixed prices which are charged even if usage falls below a defined monthly minimum amount. U.S. Cellular continues to expand its relationships with agents, dealers and non-U.S. Cellular retailers to obtain customers. Agents and dealers are independent business people who obtain customers for U.S. Cellular on a commission basis. U.S. Cellular's agents are generally in the business of selling 11 cellular telephones, cellular service packages and other related products. U.S. Cellular's dealers include car stereo companies and other companies whose customers are also potential cellular customers. The non-U.S. Cellular retailers include car dealers, major appliance dealers, office supply dealers and mass merchants. U.S. Cellular opened its first retail locations in late 1993, expanding to 220 stand-alone retail stores by the end of 1996. These U.S. Cellular-owned and operated businesses utilize rental facilities in high-traffic areas. U.S. Cellular has implemented a uniform appearance of these stores, with all having similar displays and layouts. The retail centers' hours of business match those of the retail trade in the local marketplace, often staying open on weekends and later in the evening than a typical business supplier. To fully serve customer needs, these stores sell accessories to complement the phones and services U.S. Cellular has traditionally provided. During 1996, U.S. Cellular further expanded its retail presence by opening smaller retail kiosks within larger merchandiser and grocery stores. At December 31, 1996, U.S. Cellular had opened over 150 "stores within a store" in Wal-Mart and Kroger locations. In addition to its own retail centers, U.S. Cellular actively pursues national retail accounts, as agents for U.S. Cellular, which yield new customer additions in multiple markets. Agreements have been entered into with such national distributors as Chrysler Corporation, Ford Motor Company, General Motors, MCI, Radio Shack, Best Buy and Sears, Roebuck & Co. in certain of U.S. Cellular's markets. Upon the sale of a cellular telephone by one of these national distributors, U.S. Cellular receives, often exclusively within the territories served, the resulting cellular customer. U.S. Cellular uses a variety of direct mail, billboard, radio, television and newspaper advertising to stimulate interest by prospective customers in purchasing its cellular service and to establish familiarity with U.S. Cellular's name. Advertising is directed at gaining customers, improving customers' awareness of the United States Cellular brand, increasing existing customers usage and increasing the public awareness and understanding of the cellular services offered by U.S. Cellular. U.S. Cellular attempts to select the advertising and promotion media that are most appealing to the targeted groups of potential customers in each local market. U.S. Cellular utilizes local advertising media and public relations activities and establishes programs to enhance public awareness of U.S. Cellular, such as providing telephones and service for public events and emergency uses. CUSTOMERS AND SYSTEM USAGE Cellular customers come from a wide range of occupations. They typically include a large proportion of individuals who work outside of their offices, such as people in the construction, real estate, wholesale and retail distribution businesses, and professionals. Increasingly, U.S. Cellular is providing cellular service to consumers and to customers who use their cellular telephones for security purposes. Although many of U.S. Cellular's customers still use in-vehicle cellular telephones, most new customers are selecting portable cellular telephones. These units have become more compact and fully featured as well as more attractively priced, and they appeal to newer segments of the customer population. U.S. Cellular's cellular systems are used most extensively during normal business hours between 7:00 am and 6:00 pm. On average, the local retail customers in U.S. Cellular's consolidated systems used their cellular systems approximately 107 minutes per unit each month and generated retail revenue of approximately $43 per month during 1996, compared to 95 minutes and $44 per month in 1995. Revenue generated by roamers, together with local retail, toll and other revenues, brought U.S. Cellular's total average monthly service revenue per customer unit in consolidated markets to $66 during 1996. Average monthly service revenue per customer unit decreased approximately 8% during 1996. This decrease is related to the industry-wide trend of newer customers tending to use fewer minutes during peak business hours, which has reduced the average local retail revenue per minute, and to declining contribution of inbound roaming revenue per customer. U.S. Cellular believes that its customer base is growing faster than that of the cellular industry as a whole, which has a dilutive effect on inbound roaming revenue per customer. U.S. Cellular anticipates that average monthly service revenue per customer unit will continue to decline as its distribution channels provide additional customers who generate lower revenue per local minute of use and as roaming revenues grow more slowly. However, this effect is more than offset by U.S. Cellular's increasing number of customers; therefore, U.S. Cellular expects total revenues to continue to grow for the next several years. 12 In addition to revenue from local retail customers, U.S. Cellular generates revenue from roaming customers and other services. U.S. Cellular's roaming service allows a customer to place or receive a call in a cellular service area away from the customer's home market area. U.S. Cellular has entered into "roaming agreements" with operators of other cellular systems covering virtually all systems in the United States and Canada. These agreements offer customers the opportunity to roam in these systems. These reciprocal agreements automatically pre-register the customers of U.S. Cellular's systems in the other carriers' systems. Also, a customer of a participating system roaming (i.e. traveling) in a U.S. Cellular market where this arrangement is in effect is able to make and receive calls on U.S. Cellular's system. The charge for this service is typically at premium rates and is billed by U.S. Cellular to the customer's home system, which then bills the customer. U.S. Cellular has entered into agreements with other cellular carriers to transfer roaming usage at agreed-upon rates. In some instances, based on competitive factors, U.S. Cellular may charge a lower amount to its customers than the amount actually charged to U.S. Cellular by another cellular carrier for roaming. The following table summarizes certain information about customers and market penetration in U.S. Cellular's managed operations.
YEAR ENDED OR AT DECEMBER 31, -------------------------------------------------------------- 1996 1995 1994 1993 -------------- -------------- -------------- -------------- (DOLLARS IN THOUSANDS) Majority-owned and managed markets: Cellular markets in operation (1).................... 131 137 130 116 Total population of markets in service (000s)........ 21,712 22,309 21,314 19,383 Customer Units: at beginning of period (2)......................... 710,000 421,000 261,000 150,800 additions during period (2)........................ 561,000 426,000 250,000 165,300 disconnects during period (2)...................... 198,000 137,000 90,000 55,100 at end of period (2)............................... 1,073,000 710,000 421,000 261,000 Market penetration at end of period (3).............. 4.94% 3.18% 1.98% 1.35% Consolidated revenues.................................. $ 707,820 $ 492,395 $ 332,404 $ 214,310 Depreciation expense................................... 74,631 57,302 39,520 25,665 Amortization expense................................... 34,208 32,156 25,934 19,362 Operating income (loss)................................ 87,366 42,755 17,385 (8,656) Construction expenditures.............................. 248,123 210,878 167,164 92,915 Identifiable assets.................................... $ 2,116,592 $ 1,890,621 $ 1,584,142 $ 1,275,569 1992 ------------ Majority-owned and managed markets: Cellular markets in operation (1).................... 92 Total population of markets in service (000s)........ 15,014 Customer Units: at beginning of period (2)......................... 97,000 additions during period (2)........................ 88,600 disconnects during period (2)...................... 34,800 at end of period (2)............................... 150,800 Market penetration at end of period (3).............. 1.00% Consolidated revenues.................................. $ 139,929 Depreciation expense................................... 16,606 Amortization expense................................... 13,033 Operating income (loss)................................ (12,705) Construction expenditures.............................. 56,033 Identifiable assets.................................... $ 858,795
- - ------------ (1) Represents the number of markets in which U.S. Cellular owned at least a 50% interest and which it managed, including its reseller operation in 1992. The revenues and expenses of these cellular markets are included in U.S. Cellular's consolidated revenues and expenses. (2) Represents the approximate number of revenue-generating cellular telephones served by the cellular markets referred to in footnote (1). The revenue generated by such cellular telephones is included in consolidated revenues. (3) Computed by dividing the number of customer units at the end of the period by the total population of markets in service as estimated by Donnelley Marketing Service for the respective years. 13 The following table summarizes, by operating cluster, the total population, U.S. Cellular's customer units and penetration for U.S. Cellular's consolidated markets as of December 31, 1996.
OPERATING CLUSTERS POPULATION CUSTOMERS PENETRATION - - ----------------------------------------------------------------- ---------- ---------- ------------ Iowa............................................................. 2,462,000 145,000 5.89% Wisconsin/Illinois............................................... 2,032,000 71,000 3.49 Missouri......................................................... 686,000 32,000 4.66 Eastern North Carolina/South Carolina............................ 2,349,000 98,000 4.17 Virginia......................................................... 949,000 42,000 4.43 West Virginia/Maryland/Pennsylvania.............................. 1,138,000 46,000 4.04 Oregon/California................................................ 1,029,000 47,000 4.57 Washington/Oregon/Idaho.......................................... 1,370,000 74,000 5.40 Indiana/Kentucky/Ohio............................................ 1,801,000 88,000 4.89 Maine/New Hampshire/Vermont...................................... 1,476,000 73,000 4.95 Eastern Tennessee/Western North Carolina......................... 1,429,000 90,000 6.30 Oklahoma/Missouri/Kansas......................................... 1,412,000 93,000 6.59 Texas/Oklahoma................................................... 694,000 32,000 4.61 Florida/Georgia.................................................. 1,520,000 82,000 5.39 Southwestern Texas............................................... 1,224,000 47,000 3.84 Other Operations................................................. 141,000 13,000 9.22 ---------- ---------- --- 21,712,000 1,073,000 4.94% ---------- ---------- --- ---------- ---------- ---
PRODUCTS AND SERVICES CELLULAR TELEPHONES AND INSTALLATION There are a number of different types of cellular telephones, all of which are currently compatible with cellular systems nationwide. U.S. Cellular offers a full range of vehicle-mounted, transportable and hand-held portable cellular telephones. Features offered in some of the cellular telephones include hands-free calling, repeat dialing, horn alert and others. U.S. Cellular negotiates volume discounts from its cellular telephone suppliers. U.S. Cellular discounts cellular telephones to meet competition or to stimulate sales by reducing the cost of becoming a cellular customer. In these instances, where permitted by law, customers are generally required to sign a service contract with U.S. Cellular. U.S. Cellular also cooperates with cellular equipment manufacturers in local advertising and promotion of cellular equipment. U.S. Cellular has established service and/or installation facilities in many of its local markets to ensure quality installation and service of the cellular telephones it sells. These facilities allow U.S. Cellular to improve its service by promptly assisting customers who experience equipment problems. Additionally, U.S. Cellular maintains a repair facility in Tulsa, Oklahoma, which handles more complex service and repair issues. CELLULAR SERVICES U.S. Cellular's customers are able to choose from a variety of packaged pricing plans which are designed to fit different calling patterns. In 1996, the Company developed and introduced its new consumer line of products under the CarryPhone brand. These products include a) Express, a pre-packaged phone plus price plan aimed at the convenience buyer; b) TalkTracker, a cellular phone with usage prepaid; and c) Home and Away, a combination cordless and cellular phone in a single package. U.S. Cellular's customer bills typically show separate charges for custom-calling features, airtime in excess of the packaged amount, and toll calls. Custom-calling features provided by U.S. Cellular include wide-area call delivery, call forwarding, call waiting, three-way calling and no-answer transfer. U.S. Cellular also offers a voice message service in many of its markets. This service, which functions like a sophisticated answering machine, allows customers to receive messages from callers when they are not available to take calls. REGULATION REGULATORY ENVIRONMENT. The operations of U.S. Cellular are subject to FCC and state regulation. The cellular telephone licenses held by U.S. Cellular are granted by the FCC for the use of radio frequencies and are an important component of the overall value of the assets of the Company. The construction, operation and transfer of cellular systems in the United States are regulated to varying 14 degrees by the FCC pursuant to the Communications Act of 1934 (the "Communications Act"). In 1996, Congress enacted the Telecommunications Act of 1996 (the "1996 Act"), which amended the Communications Act. The 1996 Act mandates significant changes in existing telecommunications rules and policies to promote competition, ensure the availability of telecommunications services to all parts of the nation and to streamline regulation of the telecommunications industry to remove regulatory burdens, as competition develops and makes regulation unnecessary. The FCC has promulgated regulations governing construction and operation of cellular systems, licensing (including renewal of licenses) and technical standards for the provision of cellular telephone service under the Communications Act, and is implementing the legislative objectives of the 1996 Act, as discussed below. LICENSING. For cellular telephone licensing purposes, the FCC has divided the United States into separate geographic markets (MSAs and RSAs). In each market, the allocated cellular frequencies are divided into two equal blocks. During the application process, the FCC reserved one block of frequencies for non-wireline applicants and another block for wireline applicants. Subject to FCC approval, a cellular system may be sold to either a wireline or non-wireline entity, but no entity which controls a cellular system may own an interest in another cellular system in the same MSA or RSA. The completion of acquisitions involving the transfer of control of a cellular system requires prior FCC approval. Acquisitions of minority interests generally do not require FCC approval. Whenever FCC approval is required, any interested party may file a petition to dismiss or deny the application for approval of the proposed transfer. The FCC must be notified each time an additional cell is constructed which enlarges the service area of a given market. The FCC's rules also generally require persons or entities holding cellular construction permits or licenses to coordinate their proposed frequency usage with neighboring cellular licensees in order to avoid electrical interference between adjacent systems. The height and power of base stations in the cellular system are regulated by FCC rules, as are the types of signals emitted by these stations. In addition to regulation by the FCC, cellular systems are subject to certain Federal Aviation Administration ("FAA") regulations with respect to the siting and construction of cellular transmitter towers and antennas. Beginning in 1996, the FCC has also imposed a requirement that all licensees register and obtain FCC registration numbers for all of their antenna towers which require prior FAA clearance. U.S. Cellular is currently engaged in this registration process. All new towers must be registered at the time of construction and existing towers are being registered on a staggered state-by-state basis, to be concluded in May 1998. The FCC is currently considering whether to take action to pre-empt moratoria imposed by certain localities on the construction of wireless towers. U.S. Cellular has supported such FCC action. Initial cellular telephone licenses were granted for ten-year periods. The FCC has established standards for conducting comparative renewal proceedings between a cellular licensee seeking renewal of its license and challengers filing competing applications. The FCC has: (i) established criteria for comparing the renewal applicant to challengers, including the standards under which a renewal expectancy will be granted to the applicant seeking license renewal; (ii) established basic qualifications standards for challengers; and (iii) provided procedures for preventing possible abuses in the comparative renewal process. The FCC has concluded that it will award a renewal expectancy if the licensee has (i) provided "substantial" performance, which is defined as "sound, favorable and substantially above a level of mediocre service just minimally justifying renewal," and (ii) complied with FCC rules, policies and the Communications Act. If a renewal expectancy is awarded to an existing licensee, its license is renewed and competing applications are not considered. U.S. Cellular's Tulsa and Knoxville licenses were renewed in 1995, and U.S. Cellular's Des Moines, Iowa; Peoria, Illinois; and Roanoke, Virginia licenses were renewed in 1996. U.S. Cellular's next renewal applications for several markets are due to be filed in 1997. U.S. Cellular conducts and plans to conduct its operations in accordance with all relevant FCC rules and regulations and anticipates being able to qualify for a renewal expectancy in its upcoming renewal filings. Accordingly, U.S. Cellular believes that current regulations will have no significant effect 15 on its operations and financial condition. However, changes in the regulation of cellular operators or their activities and of other mobile service providers could have a material adverse effect on U.S. Cellular's operations. The FCC has also provided that five years after the initial licenses are granted, unserved areas within markets previously granted to licensees may be applied for by both wireline and non-wireline entities and by third parties. Accordingly, many unserved area applications have been filed by U.S. Cellular and others. U.S. Cellular's strategy with respect to system construction in its markets has been and will be to build cells covering areas within such markets that U.S. Cellular considers economically feasible to serve or might conceivably wish to serve and to do so within the five-year period following issuance of the license. In cases where applications for unserved areas are filed which are mutually exclusive and would result in overlapping service areas, the FCC decides between the competing applicants by an auction process. Pursuant to 1993 amendments to the Communications Act, cellular service is classified as a Commercial Mobile Radio Service ("CMRS"), in that it is service offered to the public, for a fee, which is interconnected to the public switched telephone network. The FCC has determined that it will forebear from requiring CMRS carriers to comply with a number of statutory provisions otherwise applicable to common carriers, such as the filing of tariffs. RECENT EVENTS. There are certain regulatory proceedings currently pending before the FCC which are of particular importance to the cellular industry. In one proceeding, the FCC has imposed new "enhanced 911" regulations on cellular carriers. Enhanced 911 capabilities would enable cellular systems to determine the precise location of the person making the emergency call. The new rules will require cellular carriers to work with local public safety officials to process 911 calls, including those made from mobile telephones not registered with the cellular system, and will require cellular systems to improve their ability to locate wireless 911 callers over a five-year period. The FCC has adopted a limited expansion of the obligation of cellular carriers to serve the subscribers of broadband PCS providers, among others, even though the subscribers involved have no pre-existing service relationship with that carrier. Under these new policies, broadband PCS providers may offer their subscribers handsets which are capable of operating over broadband PCS and cellular networks so that when their subscribers are out of range of broadband PCS networks, they will be able to obtain non-automatic access to cellular networks. The FCC expects that implementation of these roaming capabilities will promote competition between broadband PCS and cellular service providers. The FCC has adopted requirements which will make it possible for subscribers to retain, at the same location, their existing telephone numbers when they switch from one service provider to another. This numbering portability will include switching between Local Exchange Carriers ("LECs") and other wireline providers, between wireless service providers and between LEC/wireline and wireless providers. LECs have implementation deadlines by the end of 1998. Broadband PCS, cellular and certain other wireless providers have phased implementation deadlines in 1998 and 1999. In another proceeding, the FCC in 1996 adopted rules regarding the method by which cellular carriers and LECs shall compensate each other for interconnecting cellular and local exchange facilities. The FCC rules provided for symmetrical and reciprocal compensation between LECs and cellular carriers, and also prescribed interim interconnection proxy rates, which are much lower than the rates formerly paid by cellular carriers to LECs. Symmetrical and reciprocal compensation means they must pay each other at the same rate. The U.S. Court of Appeals for the Eighth Circuit has stayed the effect of the rules prescribing interim rates because it has held that the 1996 Act requires that rate issues are to be decided by the states. However, the FCC's rules requiring reciprocal and symmetrical compensation remain in effect. If the U.S. Court of Appeals sustains its earlier ruling, interconnection rate issues will be decided by the states. Whether the issue is decided by the states or the federal government, cellular carriers in the future can be expected to pay lower rates to LECs than they previously paid. This result is expected to be favorable to the wireless industry and somewhat unfavorable to LECs. The FCC is also proceeding to implement the 1996 Act. The 1996 Act provides that implementing its legislative objectives will be the task of the FCC, the state public utilities commissions and a Federal- 16 state Joint Board. Much of this implementation is proceeding in numerous, concurrent proceedings with aggressive deadlines. The Company cannot predict the full extent, nature and interrelationships among state and federal implementation and other responses to the 1996 Act. The primary purpose and effect of the new law is to open all tele-communications markets to competition. The 1996 Act makes most direct or indirect state and local barriers to competition unlawful. It directs the FCC to preempt all inconsistent state and local laws and regulations, after notice and comment proceedings. It also enables electric and other utilities to engage in telecommunications service through qualifying subsidiaries. Only narrow powers over competitive entry are left to state and local authorities. Each state retains the power to impose competitively neutral requirements that are consistent with the 1996 Act's universal service provision and necessary for universal services, public safety and welfare, continued service quality and consumer rights. While a state may not impose requirements that effectively function as barriers to entry, it retains limited authority to regulate certain competitive practices in rural telephone company service areas. The 1996 Act establishes principles and a process for implementing a modified "universal service" policy. This policy seeks nationwide, affordable service and access to advanced telecommunications and information services. It calls for reasonably comparable urban and rural rates and services. The 1996 Act also requires universal service to schools, libraries and rural health facilities at discounted rates. The FCC is now considering how to implement the mandate of the 1996 Act to create a new universal service support mechanism "to ensure that all Americans have access to telecommunications services." The 1996 Act requires all interstate telecommunications providers, including wireless service providers, to "make an equitable and non-discriminatory contribution," to support the cost of providing universal service, unless their contribution would be de minimis. At present, the provision of landline telephone service in high cost areas is subsidized by access charges and other payments by interexchange carriers to LECs. It is expected that the obligation to make some kind of payments to support universal service will be expanded to include other telecommunications service providers, including cellular carriers. It is not known how those payments may be calculated or what revenue base may be used. However, it is also possible that cellular carriers may become eligible to receive universal service support payments in certain circumstances under the new system. The FCC has also allocated a total of 140 megahertz ("MHz") to broadband PCS, 20 MHz to unlicensed operations and 120 MHz to licensed operations, consisting of two 30 MHz blocks in each of the 51 Major Trading Areas ("MTAs") and one 30 MHz block and three 10 MHz blocks in each of 493 Basic Trading Areas ("BTAs"). Cellular operators and those entities under common ownership with them are permitted to participate in the ownership of PCS licenses, except for those PCS licenses reserved for small businesses, and licenses for PCS service areas in which the cellular operator owns a 20% or greater interest in a cellular licensee, the service area of which covers 10% or more of the population of the PCS service area. In the latter case, the cellular license is limited to two 10 MHz PCS channel blocks. The FCC licensed the first two 30 MHz MTA frequency blocks in 1995 and the 30 MHz block which is reserved for small business entities in 1996, and has announced the winning bidders in the D, E and F Block auctions in 1997. TDS's subsidiary, Aerial Communications, Inc. ("Aerial"), was licensed in eight MTAs for 30 MHz blocks but has sold its licenses for the Guam and Alaska MTAs. It is now constructing PCS systems in the other six MTAs. See "Broadband PCS Operations." In compliance with FCC restrictions on common ownership of cellular and broadband PCS interests in overlapping market areas, U.S. Cellular entered into a series of arrangements for the divestiture or restructuring of certain of its cellular interests in market areas where Aerial was awarded broadband PCS licenses. A number of these proposed arrangements required FCC approval of assignment or transfer of control applications before they could be consummated. All of these applications have been approved by the FCC and have been consummated. U.S. Cellular believes that it has taken reasonable steps to comply with the FCC's cross-interest policies. PCS technology is currently under development and is similar in some respects to cellular technology. Where it has become commercially available, this technology is capable of offering increased capacity for wireless two-way and one-way voice, data and multimedia communications 17 services and will result in increased competition with U.S. Cellular's operations. The ability of these future PCS licensees to complement or compete with existing cellular licensees will be affected by future FCC rule-makings. These and other future technological and regulatory developments in the wireless telecommunications industry and the enhancement of current technologies will likely create new products and services that are competitive with the services currently offered by U.S. Cellular. There can be no assurance that U.S. Cellular will not be adversely affected by such technological and regulatory developments. Media reports have suggested that certain radio frequency ("RF") emissions from portable cellular telephones might be linked to cancer. U.S. Cellular has reviewed relevant scientific information and, based on such information, is not aware of any credible evidence linking the usage of portable cellular telephones with cancer. In 1996 the FCC announced rules, now scheduled to go into effect in September 1997, dealing, INTER ALIA, with RF emissions from cellular towers of less than 10 meters in height and cellular telephones. It is anticipated that U.S. Cellular will be able to comply with RF tower emission standards and U.S. Cellular believes that the cellular telephones it currently sells comply with the standards. STATE AND LOCAL REGULATION. U.S. Cellular is also subject to state and local regulation in some instances. In 1981, the FCC preempted the states from exercising jurisdiction in the areas of licensing, technical standards and market structure. In 1993, Congress preempted states from regulating the entry of cellular systems into service and the rates charged by cellular systems to customers. The siting and construction of the cellular facilities, including transmitter towers, antennas and equipment shelters are still subject to state or local zoning and land use regulations. In addition, states may still regulate other terms and conditions of cellular service. The FCC is required to forbear from applying any statutory or regulatory provision that is not necessary to keep telecommunications rates and terms reasonable or to protect consumers. A state may not apply a statutory or regulatory provision that the FCC decides to forbear from applying. In addition, the FCC must review its telecommunications regulations every two years and change any that are no longer necessary. U.S. Cellular and its subsidiaries have been and intend to remain active participants in proceedings before the FCC and, through its membership in state associations of wireless providers, before state regulatory authorities. Proceedings with respect to the foregoing policy issues before the FCC and state regulatory authorities could have a significant impact on the competitive market structure among wireless providers and the relationships between wireless providers and other carriers. U.S. Cellular is unable to predict the scope, pace or financial impact of policy changes which could be adopted in these proceedings. COMPETITION U.S. Cellular's principal competitor for cellular telephone service in each market is the licensee of the second cellular system in that market. Since each competitor operates its cellular system on a 25 MHz frequency block licensed by the FCC using comparable technology and facilities, competition for customers between the two systems in each market is principally on the basis of quality of service, price, size of area covered, services offered and responsiveness of customer service. The competing entities in many of the markets in which U.S. Cellular has an interest have financial resources which are substantially greater than those of U.S. Cellular and its partners in such markets. The FCC's rules require all operational cellular systems to provide, on a nondiscriminatory basis, cellular service to resellers which purchase blocks of mobile telephone numbers from an operational system and then resell them to the public. In addition to competition from the other cellular licensee in each market, there is also competition from, among other technologies, conventional mobile telephone and SMR systems, both of which are able to connect with the landline telephone network. U.S. Cellular believes that conventional mobile telephone systems and conventional SMR systems are competitively disadvantaged because of technological limitations on the capacity of such systems. The FCC has previously given approval, through waivers of its rules, to ESMR, an enhanced SMR system. ESMR systems may have cells and frequency reuse like cellular thereby potentially eliminating any current technological limitation. The first 18 ESMR systems were implemented in 1993 in Los Angeles and are being implemented in many other cities across the United States. ESMR providers have initiated service in several areas where U.S. Cellular operates cellular systems. Although less directly a substitute for cellular service, wireless data services and one-way paging service (and in the future, two-way paging services) may be adequate for those who do not need full two-way voice service. PCS providers have initiated service in several markets across the United States, including markets where U.S. Cellular has operations. PCS providers offer digital, wireless communications services to their customers. Similar technological advances or regulatory changes in the future may make available other alternatives to cellular service, thereby creating additional sources of competition. U.S. Cellular expects PCS operators to continue deployments of PCS across all of the U.S. Cellular markets over the next one or two years. U.S. Cellular anticipates that PCS competitors will build out the larger metropolitan areas before the mid-sized metropolitan and rural areas where U.S. Cellular operates. As a result, the effects of PCS competition may not reach U.S. Cellular's markets as quickly as they may in other cellular operators' markets. Continuing technological advances in the communications field make it difficult to predict the extent of additional future competition for cellular systems. For example, the FCC has allocated radio channels to a mobile satellite system in which transmissions from mobile units to satellites would augment or replace transmissions to cell sites, and several consortia to provide such service have been formed. Such a system is designed primarily to serve the communications needs of remote locations and a mobile satellite system could provide viable competition for land-based cellular systems in such areas. It is also possible that the FCC may in the future assign additional frequencies to cellular telephone service to provide for more than two cellular telephone systems per market. TELEPHONE OPERATIONS The Company's telephone operations are conducted through TDS Telecom and 105 telephone subsidiaries. These telephone companies, ranging in size from less than 500 to more than 40,000 access lines, serve 484,500 access lines in 28 states. TDS Telecom provides modern, high-quality local and long-distance telephone service. Local service is provided by TDS Telecom's operating telephone subsidiaries. Long-distance or toll service is provided through connections with long-distance carriers, primarily AT&T and the Bell Operating Companies ("BOCs"). Future growth in telephone operations is expected to be derived from the acquisition of additional telephone companies, from providing service to new or presently unserved establishments, from business expansion in the areas served by TDS Telecom, from upgrading existing customers to higher grades of service, from increased usage of the network through both local and long-distance calling and from providing additional services made possible by advances in technology. 19 The following table summarizes certain information regarding TDS Telecom's telephone operations.
YEAR ENDED OR AT DECEMBER 31, -------------------------------------------------------------------------- 1996 1995 1994 1993 1992 --------------- --------------- ------------ ------------ ------------ (DOLLARS IN THOUSANDS) Telephone Operations Access lines*..................................... 484,500 425,900 392,500 356,200 321,700 % Residential................................... 79.9 80.6 81.3 82.0 83.1 % Business (nonresidential)..................... 20.1 19.4 18.7 18.0 16.9 Total revenues.................................... $ 402,629 $ 354,841 $ 306,341 $ 268,122 $ 238,095 % Local service................................. 27.4 26.8 26.8 26.9 27.4 % Network access and long-distance.............. 58.5 61.6 60.0 59.3 57.9 Depreciation and amortization expense............. $ 88,967 $ 77,354 $ 68,878 $ 59,562 $ 51,946 Operating income.................................. 103,358 98,240 91,606 79,110 72,217 Construction expenditures......................... 144,440 104,372 115,483 80,818 65,652 Total identifiable assets......................... $ 1,181,084 $ 1,058,241 $ 984,563 $ 829,489 $ 723,855
- - --------- * An "access line" is a single or multi-party circuit between the customer's establishment and the central switching office. TELEPHONE ACQUISITIONS TDS continually reviews attractive opportunities to acquire operating telephone companies. Since January 1, 1992, TDS has acquired 22 telephone companies serving a total of 90,400 access lines for an aggregate consideration totaling $297.1 million. The consideration consisted of $59.5 million in cash and notes, 155,000 Preferred Shares and 5.2 million Common Shares of the Company. TDS also sold one telephone company serving 1,100 access lines in 1995. The Company continually evaluates acquisition opportunities. Telephone holding companies and others actively compete for the acquisition of telephone companies and such acquisitions are subject to the consent or approval of regulatory agencies in most states and, in some cases, to federal waivers that may affect the form of regulation or amount of interstate cost recovery of acquired telephone exchanges. While management believes that it will be successful in making additional acquisitions, there can be no assurance that the Company will be able to negotiate additional acquisitions on terms acceptable to it or that regulatory approvals, where required, will be received. The Company maintains shelf registration of its Common Shares and Preferred Shares under the Securities Act of 1933 for issuance specifically in connection with acquisitions. It is the Company's policy to preserve, insofar as possible, the local management of each telephone company it acquires. The Company provides the telephone subsidiaries with centralized purchasing and general management and other services, at cost plus a reasonable rate of return on invested capital. These services afford the subsidiaries expertise in the following areas: finance, accounting and treasury services; marketing; customer service; traffic; engineering and construction; customer billing; rate administration; credit and collection; and the development of administrative and procedural practices. CONSTRUCTION AND DEVELOPMENT PROGRAM In 1996, and continuing in 1997, TDS Telecom has expanded and upgraded its service providing network in accordance with its first-to-market service provisioning strategy. Utilizing state-of-the-art technologies such as Signaling System 7 ("SS7"), Advance Calling Services ("ACS"), and fiber-fed Digital Serving Areas ("DSA") to condition the network for the Integrated Services Digital Network ("ISDN"), TDS Telecom will bring cutting edge telecommunications services to its predominantly rural markets. TDS Telecom intends to utilize this world-class network as a competitive advantage to protect and grow its customer base in the increasingly competitive telecommunications industry. TDS Telecom made significant progress in 1996 in network modernization through the deployment of 425 miles of fiber optic cable and 207 DSAs. TDS Telecom further embraced its strategic alliance with Lucent Technologies and Siemens Stromberg Carlson by continuing its program of upgrading switching platforms. In 1996, 35 new switching systems, including eight hosts, were installed representing an additional 50,900 lines 20 and making available an additional 50,900 lines of ISDN, SS7 and ACS. TDS Telecom plans to install 530 additional miles of fiber optic cable and 214 additional DSAs in 1997. TDS Telecom's 1997 switching platform upgrade plans include 45 additional switching systems including eight additional hosts representing 43,900 lines, to bring the cumulative total Lucent and Siemens installed lines to 276,000. As a result, TDS Telecom will make available to its customers 45,300 additional lines of ISDN, SS7 and ACS. By the end of 1997, TDS Telecom projects having 289,338 ISDN, 344,686 SS7, and 320,183 ACS cumulative equipped lines representing 57%, 68% and 63%, respectively, of all equipped lines. In 1996, TDS Telecom continued its efforts to reduce costs while improving its customer responsiveness by further deployment of its Transmission Control Protocol/Internet Protocol ("TCP/IP") data network to an additional 55 operating locations. The TCP/IP network is utilized by TDS Telecom's centralized network management center ("NEMAC") to monitor the switching network for errors and provide corrective action even before the customer realizes that a fault has occurred. The TCP/IP data network also provides transport for TDS Telecom's support and service centers, allowing for increased coverage of customer inquiries and their related customer care systems. Rollout of the data network to additional operating locations is planned for 1997. TDS Telecom supplemented its revenue in 1996 with the deployment of additional Internet nodes through its wholly owned Internet subsidiary, TDSNET. TDSNET deployed 61 additional operating nodes in 1996 and expects to deploy at least 30 more nodes in 1997. In 1996, voicemail deployment continued to 16 more serving areas. TDS Telecom will continue to enhance its voice mail revenues in 1997 through the installation of an additional seven systems. TDS Telecom's total 1997 capital budget is $130.0 million compared to actual capital expenditures of $144.4 million in 1996 and $104.4 million in 1995. Financing for the 1997 capital additions will be primarily provided by internally generated funds and supplemented by federal long-term financing. FEDERAL FINANCING TDS Telecom's primary sources of long-term financing for additions to telephone plant and equipment have been the Rural Utilities Service ("RUS"), the Rural Telephone Bank ("RTB") and the Federal Financing Bank ("FFB"), agencies of the United States of America. The RUS has made primarily 35-year loans to telephone companies since 1949, at interest rates of 2% and 5%, for the purpose of improving telephone service in rural areas. Currently, the RUS is authorized to make hardship loans at a 5% interest rate and other loans at an interest rate approximating the government's rate for instruments of comparable maturity. The RTB, established in 1971, makes loans at interest rates based on its average cost of money (6.42% for its fiscal year ended September 30, 1996), and in some cases makes loans concurrently with RUS loans. In addition, the RUS guarantees loans made to telephone companies by the FFB at the federal cost of money (6.72% for a 35-year note at December 31, 1996). Substantially all of TDS Telecom's telephone plant is pledged or is subject to mortgages securing obligations of the operating telephone companies to the RUS, RTB and FFB. The amount of dividends on common stock that may be paid by the operating telephone companies is limited by certain financial requirements set forth in the mortgages. Of the $301.6 million of underlying retained earnings of telephone subsidiaries at December 31, 1996, $212.0 million was available for the payment of dividends on the subsidiaries' common stock. At December 31, 1996, TDS Telecom's operating telephone companies had unadvanced loan commitments under the RUS, RTB and FFB loan programs aggregating approximately $129.8 million, at a weighted average annual interest rate of 6.15%, to finance specific construction activities in 1997 and future years. These loan commitments are generally issued for five-year periods and may be extended under certain circumstances. TDS Telecom's operating telephone companies intend to make further applications for additional loans from the RUS, RTB and FFB as their needs arise. There is no assurance that these applications will be accepted or what the terms or interest rates of any future loan commitments will be. ACCESS REVENUES TDS Telecom's operating telephone subsidiaries receive access revenue from interstate and intrastate long- distance carriers as compensation for originating and terminating their traffic. The interstate 21 and intrastate access rates charged include the cost of providing service plus a fair rate of return. Access revenues account for approximately 55% of the revenue generated by TDS Telecom's local exchange carrier ("LEC") subsidiaries. TDS Telecom will file an interstate access rate tariff for one of its operating subsidiaries in 1997. However TDS Telecom concurs in the National Exchange Carrier Association ("NECA") interstate common line and traffic sensitive tariffs for the remainder of its LEC subsidiaries. These operating companies participate in the access revenue pools administered by NECA, which collect and distribute revenue from interstate access services. The FCC created NECA and it operates subject to FCC rules and oversight. The FCC regulates interstate toll rates and other matters relating to interstate telephone service. On December 23, 1996, the FCC released a notice of proposed rulemaking regarding interstate access revenues. In the notice, the FCC stated its intention to reform the existing interstate access charge rules and policies and sought comment from interested parties. The FCC did not indicate what changes it will propose; however, final rules are expected by May 8, 1997. The outcome of this and other rulemaking proceedings may affect the source and nature of the operating companies' recovery of costs from the interstate jurisdiction. In the past, the FCC has generally adopted transition rules when changing cost recovery mechanisms to prevent abrupt rate and revenue changes. The 1996 Act provides for reciprocal compensation for parties of any interconnection arrangement. The FCC issued a 1996 order governing the compensation arrangements between LECs and wireless providers. LECs must charge wireless carriers cost-based rates and must now pay access charges to wireless carriers that terminate calls from LEC customers. Since this order raises interconnection costs, the operating companies may adjust their charges to recover such increased costs. The FCC has also stated its intention to initiate review of current procedures for separating incumbent LECs' service costs between the state and federal jurisdictions. To the extent that cost allocations have been used in the past to limit the costs a LEC must recover in local or intrastate access rates, the proceeding may seek to shift costs to the states. To the extent that such support is not made up in the new federal and state universal service mechanisms, TDS Telecom may seek rate increases to offset any reductions in interstate revenues. Where applicable and subject to state regulatory approval, TDS Telecom's LEC subsidiaries utilize intrastate access tariffs and participate in intrastate revenue pools. However, many intrastate toll revenue pooling arrangements, a source of substantial revenues to TDS Telecom's LECs, have been replaced with access-charge-based arrangements. In these cases, access charges are typically set to generate revenue flows similar to those realized in the pooling process. The impact of the 1996 Act is likely to accelerate the pace of regulatory re-evaluation at both the state and federal level. To the extent that state- ordered access charge revisions reduce revenues, TDS Telecom may seek adjustments in other rates. Given the many regulatory issues still unresolved, TDS Telecom cannot predict the cumulative nature or extent of impacts from regulatory reform. FEDERAL SUPPORT REVENUES To promote universal service, the FCC developed a number of federal support mechanisms to keep telephone rates affordable for both high-cost, rural areas and low-income customers. Many of TDS Telecom's LEC subsidiaries provide telephone service in rural areas and virtually all of them offer service to low-income customers. To control the cost of universal service, the FCC capped and indexed the universal service fund through 1996. The 1996 Act codified universal service; set forth clear principles for ensuring affordable access to modern telephone service nationwide; established discounts for rural schools, libraries and health care facilities; and established a federal-state joint board to make recommendations to the FCC regarding implementation of the universal service provisions of the 1996 Act. The joint board convened and released its recommendation to the FCC on November 8, 1996. The joint board and FCC are considering controlling and reducing the total amount of universal service support. The joint board has proposed not only using forward-looking proxy costs to measure high cost support, but also using a nationwide 22 average revenues-per-line benchmark that has the potential to underestimate rural LECs' high costs and thus limit their high cost support. The FCC opened a comment cycle on the joint board recommendation and TDS Telecom has filed comments and reply comments. One major principle of the 1996 Act is that support shall be specific, predictable and sufficient. In its comments to the FCC, TDS Telecom stated its position that rural telephone companies, as defined in the 1996 Act, should continue to base their costs on embedded (historical) rather than proxy (forward-looking) costs proposed by the joint board. This would ensure that support is predictable and sufficient. Because the 1996 Act also attempted to eliminate implicit subsidies, TDS Telecom also suggested in its filing with the FCC that the cost to support universal service should be added to the end user bills generated by all telecommunications carriers. Such an explicit surcharge would ensure adequate support and eliminate the need for LECs to pursue local service rate increases for the potential changes. The FCC is expected to issue an Order on universal service by May 8, 1997. The final rules to implement the universal service provisions of the 1996 Act could involve development of new support mechanisms and changes in the eligibility criteria. In addition, some of TDS Telecom's LEC subsidiaries operate in states where support and rate structures are either being re- evaluated or have already been changed. Full recovery of universal service costs in the future through interstate and intrastate mechanisms is uncertain. If interstate or intrastate support decrease,TDS Telecom's LEC subsidiaries may pursue local service rate increases to recover the difference. Telephone company acquisition and investment decisions assume the ability to recover the cost and a reasonable rate of return though local service, access and support revenues. Significant changes in the universal service funding system might affect the Company's acquisition strategy. TDS Telecom is pursuing a strategy of network modernization to maintain a strong competitive position. The speed of such network modernization may depend on favorable support and access policies on the federal and state levels. REGULATION TDS Telecom's LEC subsidiaries are regulated by state regulatory agencies and TDS Telecom seeks to maintain positive relationships with these regulators. Rate setting, including local rates, intrastate toll rates and intrastate access charges, is subject to state commission approval. TDS Telecom will continue to pursue necessary changes in rate structures to ensure affordable rates and reasonable earnings. State regulators can approve service areas, service standards, accounting and related matters. In some states, construction plans, borrowing, depreciation rates, affiliated charge transactions and certain other financial transactions are also subject to regulatory approval. States have traditionally regulated entry into local markets by designating a single carrier to be the universal service provider. However, the 1996 Act has almost completely pre-empted state authority over market entry. Each state retains the power to impose competitively neutral requirements that are consistent with the 1996 Act's universal service provision and necessary for universal services, public safety, and welfare, continued service quality and consumer rights. While a state may not impose requirements that effectively function as barriers to entry, it retains limited authority to regulate certain competitive practices in rural telephone company service areas. The 1996 Act establishes a general duty for all telecommunications carriers, including wireless providers, to interconnect with other carriers. Congress prescribed a more specific list of interconnection requirements for all LECs including resale, number portability, dialing parity, access to rights-of-way and reciprocal compensation. Unless exempted, or granted suspension or modification, incumbent LECs have additional obligations: (a) to negotiate in good faith terms of interconnection; (b) to comply with more detailed interconnection terms, including non-discrimination and unbundling their network and service components so competitors may provide only those elements they choose to provide; (c) to offer their retail services at wholesale rates to facilitate resale by their competitors; and (d) to allow other carriers to place equipment necessary for interconnection or access on their premises. As defined in the 1996 Act, TDS Telecom's LEC subsidiaries qualify as rural telephone companies. Therefore, they enjoy an exemption from the incumbent LEC requirements until they receive a bonafide 23 request for interconnection and the state commission lifts the exemption. The FCC has also adopted extensive rules for state commissions to follow in mediating and arbitrating interconnection negotiations between incumbent LECs and carriers requesting interconnection, services or network elements. The 1996 Act establishes deadlines, standards for state commission approval of interconnection agreements and recourse to the FCC if a state commission fails to act. TDS Telecom seeks to maintain and enhance existing revenue streams despite heightened earnings review activity by state regulators and the advent of local exchange competition sparked by the 1996 Act. TDS Telecom is preparing for competition even though its operating subsidiaries remain governed by state regulators. For example, TDS Telecom is seeking the necessary pricing flexibility to adjust its rate structures to a more competitive model. TDS Telecom is also participating in state regulatory and legislative processes to ensure that any telecommunications reform measures treat rural areas fairly. The ongoing changes in public policy and introduction of competition might affect the earnings of the operating subsidiaries and TDS Telecom is not able to predict the impact. While the majority of TDS Telecom's LEC subsidiaries continue to operate in a rate-of-return environment, a number of state commissions are proactively negotiating alternative regulation plans with LECs. Price regulation, the most common form of alternative regulation, focuses on the price of telecommunication services. TDS Telecom's LEC subsidiaries in both Alabama and Michigan are currently operating in a price-regulated environment, whereby the commissions in those states are no longer reviewing earnings. For several years, the RBOCs and some of the nation's larger LECs have operated under an FCC "price cap" plan, where earnings can only be increased through productivity improvements. The LECs determine the amount of productivity gains above an allowed return and then must share the excess gains with their customers. For 1997, TDS Telecom's telephone subsidiaries have neither elected price caps nor the alternative FCC plan, which was designed for smaller LECs. Instead, the operating subsidiaries will continue to abide by traditional rate-of-return regulation for interstate purposes. Since approximately one-third of TDS Telecom's telephone subsidiaries serve high-cost areas, important averaging mechanisms associated with the NECA pooling process would be lost if TDS Telecom elected either of the alternatives to traditional rate-of-return regulation. However, the FCC is currently considering whether to initiate a proceeding to lower the allowed rate-of-return for rate-of-return LECs. NECA filed a Petition for Rulemaking with the FCC, which proposes rule revisions to allow incentive settlement options within the NECA pools. The FCC has not acted on this petition yet. The settlement options allow LECs to remain in the NECA pools and still enjoy incentives previously available only to non-NECA participants. Management continues to evaluate opportunities under all forms of regulation. Access to affordable long-distance service in rural areas was achieved because the FCC ordered AT&T to provide nationwide average rates. As a result of increasing competition, the FCC lifted all regulations relating to AT&T's interstate services in 1996. However, the 1996 Act preserves interstate toll rate averaging and endorses a nationwide policy that interstate and intrastate long-distance rates should not be higher in rural areas than in urban areas. The statute is intended to ensure affordable long distance services even in TDS Telecom's most remote exchanges. COMPETITION The 1996 Act will help introduce a new wave of competition in the telecommunications industry. The 1996 Act embraced competition in telecommunications as a national policy and also started the process of deregulation. The 1996 Act applies expanded interconnection and other requirements to local exchange telephone companies for the purpose of stimulating competition. The Act establishes a framework for local service competition and it establishes different standards for different types of telecommunications carriers. The Act defines rural telephone companies ("RTC") and provides them with an exemption from certain incumbent LEC obligations. All TDS Telecom LECs meet the RTC definition and fall under the exemption. At a minimum, this likely will delay certain forms of competition occurring in our LECs while additional regulatory issues are resolved. 24 TDS Telecom believes there will eventually be open entry into nearly every aspect of the telephone industry, including local service, interstate and intrastate toll, switched and special access services and customer premises equipment. Accordingly, TDS Telecom expects competition in the telephone business to be dynamic and intense as a result of the entrance of new competitors and the development of new technologies, products and services. To face this increasing competition, TDS Telecom has strategically positioned itself to provide customer intimacy and to provide complete solutions to customers' telecommunication needs. To position TDS Telecom as a customer-intimate organization, TDS Telecom is dedicating resources to establishing a Virtual Business Office ("VBO"). The VBO is an environment that is technically equipped to enable multiple local business offices to perform customer contact functions as if they were a "virtual" office in the eyes of the customer. VBO is TDS Telecom's solution to connect offices together to better use resources and preserve local presence. Through extended availability that coincides with customers' schedules and expectations, VBO will help provide greater market coverage and customer service on the customer's terms. It will also enable the business office teams to deliver high-quality service to the customer through more efficient call answering capabilities, provide continued focused local service to walk-in customers, and leverage voice and customer service application technology. TDS Telecom is providing the operating telephone companies with the most advanced central office switching equipment possible in order to offer customers up-to-date technology such as ISDN, Advanced Calling Services, High-Speed Data access and Internet access. TDS Telecom sees expanded competition as an opportunity to provide a broader range of services to a greater number of potential customers. TDS Telecom plans to provide its customers bundled service offerings and become a "one stop shop" for all its customers telecommunications needs. In 1996,TDS Telecom entered into new competitive markets with products like LAN and data structured wiring (connecting computers in multiple customer locations), and resale of Direct Broadcast Satellite. TDS Telecom also expanded its Internet access service through its subsidiary, TDSNET. TDS Telecom will continue to seek additional attractive opportunities in competitive markets in 1997. BROADBAND PCS OPERATIONS The Company's broadband PCS operations are conducted through Aerial Communications, Inc. and subsidiaries. Aerial is currently developing its PCS licenses covering the MTAs of Minneapolis, Tampa-St. Petersburg-Orlando, Houston, Pittsburgh, Kansas City and Columbus. Aerial has commenced development of a marketing program, intends to launch commercial services in its first market in March 1997, and expects to complete initial construction of its PCS networks within twelve months of launch of commercial service. THE WIRELESS TELECOMMUNICATIONS INDUSTRY PCS is the term used to describe the wireless telecommunications services that will be offered by those companies that acquired or will acquire licenses for radio spectrum (frequency range 1850-1990 MHz) in the FCC auctions and are the newest entrants in the wireless telecommunications market. PCS will initially compete directly with existing cellular telephone, paging and mobile radio services. PCS will also include features which have not traditionally been offered by cellular providers, such as: (i) the provision of all services to one untethered, mobile number; (ii) lower-priced service options; and (iii) in the near future, medium-speed data transmissions to and from portable computers, advanced paging services and facsimile services. Aerial believes that these enhanced features will contribute to the acceleration of growth in the wireless telecommunications market. Aerial believes that PCS providers will be the first wireless direct competitors to cellular providers and the first to offer mass market all-digital mobile networks. In addition, PCS providers may be among the first to be able to offer mass market wireless local loop applications, in competition with switched and direct access local telecommunications services. OPERATION OF WIRELESS NETWORKS. Wireless service areas are divided into smaller geographic areas called "cells," each of which contains an antenna and a base transceiver station ("BTS") consisting of a low-power transmitter, a receiver and signaling equipment. The cells are typically configured on a grid in a honeycomb-like pattern, although terrain factors (including natural and man-made obstructions) and signal coverage patterns may result in irregularly shaped cells and overlaps or gaps in coverage. The 25 BTS in each cell is connected by microwave, fiber optic cable or telephone wires to a switching office ("mobile switching center" or "MSC"). The MSC controls the operation of the wireless telephone network for its entire service area, performing inter-BTS hand-offs, managing call delivery to handsets, allocating calls among the cells within the network and connecting calls to local landline telephone systems or to long-distance telephone carriers. Wireless service providers have interconnection agreements with various local exchange carriers and interexchange carriers, thereby integrating the wireless telephone network with landline telecommunications systems. Because two-way wireless networks are fully interconnected with landline telephone networks and long-distance networks, customers can receive and originate both local and long-distance calls from their wireless telephones. The signal strength of a transmission between a handset and a BTS antenna declines as the handset moves away from the BTS antenna. The MSC and the BTSs monitor the signal strength of calls in process. When the signal strength of a call declines to a predetermined level, the MSC may "hand off" the call to another BTS that can establish a stronger signal with the handset. If a handset leaves the service area of the wireless service provider, the call is disconnected unless an appropriate technical interface is established to hand off the call to an adjacent service provider's system. Operators of wireless networks frequently agree to provide service to customers from other compatible networks who are temporarily located or traveling through the operator's service area. Such customers are called "roamers". Agreements among network operators allocate revenues received from roamers. With automatic roaming, wireless customers are preregistered in certain networks outside their home service area and receive service automatically while they are roaming. Other roaming features permit calls to a customer to follow the customer into different networks, so that the customer will continue to receive calls in a different network just as if the customer were within his or her service area. Global System for Mobile Communications ("GSM"), Aerial's technology choice, is not directly compatible with other PCS or cellular technologies. However, compatibility can be achieved through the use of handsets that support multiple technologies. Aerial expects that compatibility between GSM and the existing analog cellular systems will be achieved with the use of dual-mode handsets. Dual-mode handsets are expected to be available in late 1997. Because analog cellular service is available nationwide, Aerial expects the PCS customers will be able to roam into many service areas by analog cellular providers. To date, in North America, nearly 20 PCS companies have chosen or are expected to choose GSM. With the completion of the U.S. broadband PCS auctions, license areas of GSM committed operators now total more than 260 million population equivalents (representing 98.3% of the U.S. population). Aerial anticipates that its customers will be able to roam throughout the United States and Canada, either on other GSM-based PCS networks or by using dual-mode handsets that also can be used on existing cellular networks. Wireless customers generally are charged separately for monthly access, air time, long-distance calls and custom-calling features (although custom-calling features may be included in monthly access charges in certain pricing plans). Wireless network operators pay fees to local exchange and long-distance telephone companies for access to their networks and toll charges based on standard or negotiated rates. When wireless operators provide service to roamers from other networks, they generally charge roamer air-time usage rates, which usually are higher than standard air-time usage rates for their own customers, and additionally may charge daily access fees. Special, discounted rate roaming arrangements, often between neighboring operators who wish to stimulate usage in their respective territories, provide for reduced roaming fees and no daily access fees. PRODUCTS AND SERVICES Aerial's fundamental customer proposition will be an affordable, reliable, high-quality mobile voice communications service. At the commencement of commercial service, Aerial intends to offer coverage in those areas of the PCS markets where most of the population lives and works. Subsequent construction of its PCS networks will provide coverage which is competitive with that of current cellular operators. Aerial will also provide roaming capabilities, through agreements with other GSM operators and cellular operators. 26 Aerial will provide several distinct services and features, certain of which are currently available only on PCS networks. These include: THE SMART CARD. GSM technology employs a credit-card sized Smart Card which contains a microchip containing detailed information about a customer's service profile. The Smart Card will allow Aerial to initiate services or change a customer's service package from a remote location. The Smart Card also allows customers to roam onto other participating GSM-based networks by using their cards in handsets compatible with the local network. FEATURE-RICH HANDSETS. As part of its basic service package, Aerial will provide easy-to-use, interactive menu-driven phones that will enable customers to utilize the features available in a GSM network. These handsets will primarily use words and easy-to-use menus rather than numeric codes to operate handset functions such as call-forwarding, call-waiting and text-messaging. SHORT TEXT MESSAGING. GSM technology allows for the capability to send and receive short text messages, similar to two-way radio paging services. This service allows Aerial to offer a quicker and less expensive form of wireless communication when a full conversation is not necessary. ENHANCED SECURITY. Aerial's service will provide greater security from eavesdropping and cloning than existing wireless service. Greater conversation security is provided by the encryption code of the digital GSM signal. Greater fraud protection is provided because GSM handsets require the use of a Smart Card with a sophisticated authentication scheme, the replication of which is virtually impossible. As the market for wireless telecommunications services continues to develop, Aerial expects to offer advanced wireless applications such as mobile data services, wireless private branch exchange applications, wireless local loop services and other individually customized wireless products and services. MARKETING AND DISTRIBUTION Aerial's marketing objective is to create demand for its PCS service by clearly differentiating its service offerings. Aerial believes the strength of its marketing efforts will be a key contributor to its success. Aerial has developed overall marketing strategies as well as certain, specific local marketing strategies for each PCS market. Aerial's mass marketing efforts will emphasize the value of Aerial's high-quality, innovative services and will be supported by heavily promoting the Aerial brand name. This will be supported by a substantial advertising program. Aerial plans to offer its services and products through traditional cellular sales channels as well as through new, lower cost channels which increase the quality of the typical sale. Aerial will utilize traditional sales channels which include mass merchandisers and retail outlets, company retail stores, sales agents and a direct sales force. Based in part upon the remote activation feature of the GSM Smart Card, Aerial also intends to develop distribution innovations such as simplified retail sales processes and lower-cost channels which include inbound telesales, affinity marketing programs, neighborhood sales and on-line sales. AERIAL'S PCS MARKETS The PCS markets cover large areas with attractive demographic characteristics including growing populations, high population densities, favorable commuting patterns, high median household incomes and favorable business climates. Aerial believes the geographic diversity of the PCS markets mitigates adverse consequences which may result from an economic slowdown in one particular region. COMPETITION The wireless telecommunications industry is experiencing significant technological change, as evidenced by the increasing pace of digital upgrades to existing analog cellular networks, evolving industry standards, ongoing improvements in the capacity and quality of digital technology, shorter development cycles for new products and enhancements, and changes in end-user requirements and preferences. Accordingly, Aerial expects competition in the wireless telecommunications business to be dynamic and intense as a result of the entrance of new competitors and the development of new technologies, products and services. 27 Aerial anticipates that market prices for two-way wireless services generally will decline in the future based upon increased competition. Aerial will compete to attract and retain customers principally on the basis of services and enhancements, its customer service, the size and location of its service areas and pricing. Aerial's ability to compete successfully will also depend, in part, on its ability to anticipate and respond to various competitive factors affecting the industry, including new services that may be introduced, changes in consumer preferences, demographic trends, economic conditions and discount pricing strategies by competitors, which could adversely affect Aerial's operating margins. Aerial will compete directly with up to five other PCS providers in each of its PCS markets. The other successful bidders in the FCC's broadband Block A and Block B PCS auction in each of the six PCS markets were PCS PrimeCo (Houston and Tampa-St. Petersburg-Orlando), Sprint Spectrum (Minneapolis, Pittsburgh and Kansas City) and AT&T Wireless Services, Inc. (Columbus). Each of these PCS licensees is designing and constructing its respective networks. PCS PrimeCo's networks are commercially operational in Houston and Tampa. Sprint Spectrum has launched commercial service in Pittsburgh. The FCC has awarded the initial licenses for the Block C spectrum and has recently announced the winning bidders for the D, E and F Blocks. Aerial also expects that existing cellular providers in the PCS markets, most of which have an infrastructure in place and have been operational for a number of years, will upgrade their networks to provide comparable services in competition with Aerial. Principal cellular providers in the PCS markets are AT&T Wireless Services, Inc., BellSouth Mobility, Inc., GTE Mobile Communications Corporation, AirTouch Communications, Inc., U S WEST NewVector Group, Inc., Bell Atlantic-NYNEX Mobile and Ameritech Cellular. Aerial also expects to compete with other communications technologies that now exist, such as paging, ESMR and global satellite networks, and expects to compete with cellular and PCS resellers. In the future, cellular service and PCS will also compete more directly with traditional landline telephone service providers and with cable operators who expand into the offering of traditional communications services over their cable systems. In addition, Aerial may face competition from technologies that may be introduced in the future. All of such competition is expected to be intense. There can be no assurance that Aerial will be able to compete successfully in this environment or that new technologies and products that are more commercially effective than Aerial's technologies and products will not be developed. In addition, many of Aerial's competitors have substantially greater financial, technical, marketing, sales and distribution resources than those of Aerial and have significantly greater experience than Aerial in testing new or improved telecommunications products and services and obtaining regulatory approvals. Some competitors are expected to market other services, such as cable television access, with their wireless telecommunications service offerings. Several of Aerial's competitors are operating, or planning to operate, through joint ventures and affiliation arrangements, wireless telecommunications networks that cover most of the United States. Handsets used for GSM-based PCS networks will not be automatically compatible with cellular systems, and vice versa. Aerial expects dual-mode handsets to be available in late 1997, which will permit its customers to roam by using the existing cellular wireless network in other markets. Until then, this lack of interoperability may impede Aerial's ability to attract current cellular customers or potential new wireless communication customers that desire the ability to access different service providers in the same market. REGULATION REGULATORY ENVIRONMENT. The FCC regulates the licensing, construction, operation and acquisition of wireless telecommunications systems in the U.S. pursuant to the Communications Act, and the rules, regulations and policies promulgated by the FCC thereunder. Under the Communications Act, the FCC is authorized to allocate, grant and deny licenses for PCS frequencies, establish regulations governing the interconnection of PCS networks with wireline and other wireless carriers, grant or deny license renewals and applications for transfer of control or assignment of PCS licenses, and impose forfeitures for violations of FCC regulations. In addition, the 1996 Act, which amended the Communications Act, mandates significant changes in existing telecommunications rules and policies to promote competition, ensure the availability of 28 telecommunications services to all parts of the nation and to streamline regulation of the telecommunications industry to remove regulatory burdens, as competition develops and makes regulation unnecessary. The FCC promulgated and continues to promulgate regulations governing construction and operation of wireless providers, licensing (including renewal of licenses) and technical standards for the provision of PCS services under the Communications Act, and is implementing the legislative objectives of the 1996 Act, as discussed below. PCS LICENSING. The FCC established PCS service areas in the United States and its possessions and territories based upon Rand McNally's market definition of 51 MTAs comprised of 493 smaller BTAs. Each MTA consists of at least two BTAs. The FCC has allocated 120 MHz of radio spectrum in the 2 GHz band for licensed broadband PCS services. The FCC divided the 120 MHz of spectrum into six individual blocks, each of which is allocated to serve either MTAs or BTAs. The spectrum allocation includes two 30 MHz blocks ("A" and "B" Blocks) licensed for each of the 51 MTAs, one 30 MHz block ("C" Block) licensed for each of the 493 BTAs, and three 10 MHz blocks ("D," "E" and "F" Blocks) licensed for each of the 493 BTAs. A PCS license has been awarded for each MTA and BTA in every block, for a total of more than 2,000 licenses. This means that in any PCS service area as many as six licensees could be operating separate PCS networks. Under the FCC's rules, a broadband PCS licensee may own combinations of licenses with total aggregate spectrum coverage of up to 45 MHz in a single geographic area. The FCC adopted comprehensive rules that outlined the bidding process, described the bidding application and payment process, established penalties for certain bid withdrawals, default or disqualification and established regulatory safeguards. The FCC has awarded the initial licenses for the C Block spectrum and has recently announced the winning bidders for the D, E and F Blocks. An appeal has been taken to the FCC from the Bureau order by a party alleging that some of the authorizations were granted to parties which had engaged in collusion in the competitive bidding process. That party has also sought review of the denial of its motion for a stay of the grant of A and B Block authorizations. No allegation of collusion was made against TDS or Aerial. Aerial would defend vigorously any challenges to the authorizations it has been granted. On November 9, 1995, in Cincinnati Bell Telephone Co. v. FCC (Case No. 94-3701/4113), the United States Court of Appeals for the Sixth Circuit granted two petitions for review of an FCC order that had barred certain common ownership of cellular and PCS interests in the same market, and remanded the case to the FCC for further proceedings. Neither of the two petitioners had been barred by cross interests from applying for any of the authorizations the FCC later granted to Aerial. Aerial is watching the FCC proceedings closely. In compliance with FCC restrictions on common ownership of cellular and broadband PCS interests in overlapping market areas, United States Cellular, another subsidiary of TDS, entered into a series of arrangements for the divestiture or restructuring of certain of its cellular interests in market areas where Aerial was awarded broadband PCS licenses. A number of these proposed arrangements required FCC approval of assignment or transfer of control applications before they could be consummated. These applications have been approved by the FCC and have been consummated. The grants of licenses to Aerial are also conditioned upon timely compliance with the FCC's build-out requirements, I.E., coverage of one-third of the population of a PCS market within five years of initial license grant and coverage of two-thirds of that population within ten years. A significant factor affecting the schedule and cost of Aerial's network implementation will be the relocation of existing private microwave facilities which operate on the same frequencies to be used for Aerial's broadband PCS operations. Under the FCC's policies, if Aerial decides that any existing microwave facility must be relocated, it is required to provide substitute facilities at its own expense so that the companies using these existing facilities may continue to have access to the same or equivalent communications capabilities. The FCC concluded proceedings in 1996 clarifying and changing its requirements for permissible relocation costs, adopting incentives to encourage reliance on voluntary relocation agreements and requiring the sharing of relocation costs where the relocation of private microwave facilities benefits multiple broadband PCS licenses. 29 The FCC licenses granted to Aerial are issued for a ten-year period expiring June 23, 2005 and may be renewed. In the event challengers file competing applications in response to any of Aerial's renewal filings, the FCC has rules and policies providing that the application of the licensee seeking renewal will be granted and the application of the challenger will not be considered in the event that the broadband PCS licensee involved has (i) provided "substantial" performance, which is defined as "sound, favorable and substantially above a level of mediocre service just minimally justifying renewal" and (ii) substantially complied with FCC rules, policies and the Communications Act. Although Aerial is unaware of any circumstances which would prevent the approval of any future renewal applications, there can be no assurance that Aerial's licenses will be renewed by the FCC in the future. Moreover, although revocation and involuntary modification of licenses are extraordinary regulatory measures, the FCC has the authority to restrict the operation of licensed facilities or revoke or modify licenses. The FCC has proceedings in process which could open up other frequency bands for wireless telecommunications and PCS-like services. There can be no assurance that such proceedings will not result in additional wireless competition. In addition, there are citizenship requirements, assignment requirements and other federal regulations and requirements which may affect the business of Aerial. RECENT EVENTS. The FCC adopted certain significant decisions during 1996. In one decision, the FCC required that all licensees register and obtain FCC registration numbers for all of their antenna towers which require prior FAA clearance. The FCC also amended its environmental protection rules to adopt new guidelines and procedures for evaluating the environmental effects of RF emissions. The FCC has also imposed new "enhanced 911" regulations in broadband PCS systems to determine the precise location of the person making the emergency call. The new rules require broadband PCS providers to work with local public safety officials to process 911 calls, including those made from mobile telephones not registered with the broadband PCS provider, and to meet phased deadlines for implementing these capabilities. The FCC has adopted a limited expansion of the obligation of cellular carriers to serve the subscribers of broadband PCS providers, among others, even though the subscribers involved have no pre-existing service relationship with that carrier. Under these new policies, broadband PCS providers may offer their subscribers handsets which are capable of operating over broadband PCS and cellular networks so that when their subscribers are out of range of broadband PCS networks, they will be able to obtain non-automatic access to cellular networks. The FCC expects that implementation of these roaming capabilities will promote competition between broadband PCS and cellular service providers. The FCC has adopted requirements which will make it possible for subscribers to retain, at the same location, their existing telephone numbers when they switch from one service provider to another. This numbering portability will include switching between LEC and other wireline providers, between wireless service providers and between LEC/wireline and wireless providers. LECs have implementation deadlines by the end of 1998. Broadband PCS, cellular and certain other wireless providers have phased implementation deadlines in 1998 and 1999. The FCC is also proceeding to implement the 1996 Act. The 1996 Act provides that implementing its legislative objectives will be the task of the FCC, the state public utilities commissions and a Federal-state Joint Board. Much of this implementation is proceeding in numerous, concurrent proceedings with aggressive deadlines. Aerial cannot predict the full extent, nature and interrelationships among state and federal implementation and other responses to the 1996 Act. The primary purpose and effect of the new law is to open all telecommunications markets to competition -- including local telephone service. The 1996 Act makes most direct or indirect state and local barriers to competition unlawful. It directs the FCC to preempt all inconsistent state and local laws and regulations, after notice and comment proceedings. It also enables electric and other utilities to engage in telecommunications service through qualifying subsidiaries. Only narrow powers over competitive entry are left to state and local authorities. Each state retains the power to impose competitively neutral requirements that are consistent with the 1996 Act's universal service provision and necessary for universal services, public safety and welfare, continued service 30 quality and consumer rights. While a state may not impose requirements that effectively function as barriers to entry, it retains limited authority to regulate certain competitive practices in rural telephone company service areas. Since enactment, the FCC has adopted orders implementing the local competition provisions of the 1996 Act. The FCC found that broadband PCS and certain other wireless providers are entitled to reciprocal compensation, may not be charged for LEC-originated traffic or for code opening/per-number fees, and may obtain LEC interconnection subject to the terms of the 1996 Act. Appeals have been taken to the United States Court of Appeals for the Eighth Circuit from these FCC orders by numerous parties alleging that the FCC has exceeded its statutory mandate, among other matters. The Eighth Circuit Court granted a stay of certain rules adopted in the FCC orders pending its decision on the merits of these appeals. The 1996 Act establishes principles and a process for implementing a modified "universal service" policy. This policy seeks nationwide, affordable service and access to advanced telecommunications and information services. It calls for reasonably comparable urban and rural rates and services. The 1996 Act also requires universal service to schools, libraries and rural health facilities at discounted rates. The FCC has proceedings pending to address recommendations made by the Joint Board with respect to the implementation of the universal service provisions of the 1996 Act, including, among other issues, the size of the universal service fund and the assessment mechanism to determine how much individual wireless carriers will be required to contribute. STATE AND LOCAL REGULATION. The scope of state regulatory authority covers such matters as the terms and conditions of interconnection between LECs and wireless carriers with respect to intrastate services, customer billing information and practices, billing disputes, other consumer protection matters, facilities construction issues and transfers of control, among other matters. In these areas, particularly the terms and conditions of interconnection between LECs and wireless providers, the FCC and state regulatory authorities share regulatory responsibilities with respect to interstate and intrastate issues, respectively. The FCC has pending numerous petitions for pre-emption of state and local regulations which allege such regulations prohibit or impair the provision of interstate or intrastate telecommunications services. It has also requested public comment on a petition requesting pre-emption of moratoria imposed by state and local governments on siting of telecommunications facilities, the imposition of state taxes on the gross receipts of CMRS providers and other proposed state taxes based on the asset value of CMRS licenses awarded by the FCC. The FCC has been actively involved in educating state and local regulatory and zoning authorities as to the prohibitions in the 1996 Act against the creation of unreasonable and discriminatory zoning, taxation or other barriers to new wireless providers. The FCC is required to forbear from applying any statutory or regulatory provision that is not necessary to keep telecommunications rates and terms reasonable or to protect consumers. A state may not apply a statutory or regulatory provision that the FCC decides to forbear from applying. In addition, the FCC must review its telecommunications regulations every two years and change any that are no longer necessary. Aerial and its subsidiaries have been and intend to remain active participants in proceedings before the FCC and before state and local regulatory and zoning authorities. Proceedings with respect to the foregoing policy issues before the FCC and state regulatory authorities could have significant impacts on the competitive market structure among wireless providers and the relationships between wireless providers and other carriers. Aerial is unable to predict the scope, pace, or financial impact of policy changes which could be adopted in these proceedings. RADIO PAGING OPERATIONS The Company manages its radio paging business through American Paging, Inc. and subsidiaries. American Paging provides wireless communications messaging services in the United States with operations concentrated in Florida and in the Mid-Atlantic and Midwest regions. 31 WIRELESS MESSAGING INDUSTRY Paging is a wireless communications messaging technology which uses an assigned radio frequency, licensed by the FCC, to contact a paging customer within a geographic service area. Pagers are small, lightweight, easy-to-use, battery-operated devices which receive messages by the broadcast of a radio signal. To contact a customer, a message is initiated by placing a telephone call to the customer's pager number or through computer software which enables a computer to transmit a text message via the modem line. The message is received by a computerized paging switch which generates a signal sent to microprocessor-controlled radio transmitters within the service area. These radio transmitters are connected to the paging terminal either through land-line or satellite links. The transmitters broadcast a digital or analog signal that is received by the pager and delivered as alphanumeric text, numerical display, tone or voice message. The paging industry started in 1949 when the FCC allocated certain radio frequencies for exclusive use in providing one-way and two-way types of mobile communications services. The industry grew slowly during its first thirty years as the quality and reliability of equipment was developed and the market began to perceive the benefits of wireless communications. Until the 1980s, the industry was highly fragmented with a large number of small, local operators. During that decade, acquisitions of many firms by regional telephone companies and others greatly consolidated the industry. Several large industry acquisitions occurred in the 1990s which has resulted in the further consolidation of the paging industry. Manufacturers of pagers and transmission equipment have produced innovative technological advances which are expected to continue to broaden the potential market size for paging services and support the industry's rapid growth rate. Micro circuitry, liquid crystal display technology and digital signal processing have all expanded the capability and capacity of paging services while reducing equipment and airtime costs and equipment size. Narrowband PCS technology is expected to greatly expand the messaging capacity of the paging infrastructure and provide advanced two-way messaging and data services. Future service offerings are expected to include acknowledgment paging, which allows customers to confirm a message to the originator, as well as digitized voice paging, two-way data conveyance to highly mobile devices such as lap-top computers and Personal Digital Assistants ("PDA"), and other data transfer applications. The following table summarizes certain information about American Paging's operations.
YEAR ENDED OR AT DECEMBER 31, ------------------------------------------------------------------ 1996 1995 1994 1993 1992 ------------ ------------ ------------ ----------- ----------- (DOLLARS IN THOUSANDS) Pagers in service......................................... 777,400 784,500 652,800 460,900 322,200 Total revenues............................................ $ 104,187 $ 107,150 $ 92,065 $ 75,363 $ 54,716 Depreciation and amortization expense..................... 33,777 24,692 17,178 13,392 10,412 Operating (loss).......................................... (36,626) (8,997) (169) (721) (5,447) Additions to property and equipment....................... 32,517 26,527 28,966 21,454 14,277 Identifiable assets....................................... $ 153,374 $ 159,170 $ 146,107 $ 74,923 $ 57,080
COMPANY DEVELOPMENT American Paging's business strategy is to promote above industry average growth in customers, service revenue and operating cash flow by providing the highest quality service through one of the industry's most technologically advanced digital transmission systems with a focus on strong customer service and competitive pricing. SPECTRUM DEVELOPMENT. American Paging owns five regional narrowband PCS licenses which provide coverage equivalent to that of a nationwide license. Each of the five licenses consists of a 50 kHz outbound channel on frequency 930.625 MHz paired with a 12.5 kHz return channel on frequency 901.80625 MHz. The licenses will eventually enable American Paging to introduce two-way wireless messaging communications services including acknowledgment paging, data and telemetry services, wireless e-mail and digitized voice messaging throughout the United States. However, commerical unavailability of the ReFLEX25-Registered Trademark- protocol and related infrastructure and subscriber device equipment necessary to offer these services has resulted in American Paging suspending development of its PCS licenses. American Paging also intends to continue exploring synergies with affiliated companies, such as United States Cellular Corporation and Aerial Communications, Inc. 32 American Paging also owns an exclusive nationwide Private Carrier Paging ("PCP") channel on frequency 929.3375 MHz. American Paging believes this license will enable it to offer competitive regional and nationwide wireless messaging services. American Paging's Minnesota, Oklahoma, Texas and Washington, D.C. systems currently utilize this frequency. The narrowband PCS licenses and the PCP license will provide American Paging with significant spectrum capacity upon which to offer future wireless messaging services. Significant funds will be required when American Paging proceeds with development of its narrowband PCS licenses and PCP license. There can be no assurance that American Paging will be successful in developing these licenses due to such factors as the inability to obtain sufficient financing at a reasonable cost, availability of the supporting infrastructure and related subscriber device equipment, competition, regulatory developments or other factors. ALLIANCES AND AFFILIATES. American Paging is a joint venture partner with Nexus Telecommunication Systems Ltd. of Israel ("Nexus") in American Messaging Services, LLC ("AMS"). AMS was formed to develop multiple applications and distribution channels worldwide for a patented communications network that provides two-way paging, location and telemetry services. In June 1996, AMS constructed a beta-test system in Chicago to perform radio frequency and infrastructure tests. The system is still being tested, while also serving as a demonstration system for prospective customers of a Nexus-based technology. American Paging has notified Nexus that it will stop funding AMS as of June 30, 1997. As a result, American Paging's interest in AMS may be diluted. American Paging also has an agreement with Liazon, Inc. of Toronto for the coordinated development and use of narrowband PCS and conventional PCP paging frequencies in North America. Under the terms of the agreement, each company will pursue its own PCS build out plans, but will have the added potential to market North American coverage of advanced wireless messaging services. In a related action, both the FCC and Industry Canada have provided conditional authority for both companies to construct and operate transmitters in previously restricted areas. APP RESTRUCTURING During the third quarter of 1995, American Paging began restructuring three key operating areas: sales and marketing, administration, and customer service. The impact on operations from these restructuring efforts was more severe than originally anticipated, and results from operations were negatively impacted in 1995 and 1996. The changes implemented in 1996 caused disruptions in many aspects of the business, and also resulted in additional restructuring costs being recorded during 1996. These disruptions led to several senior management changes including the appointment of a new President and Chief Executive Officer and a new Vice President-Sales, Marketing and Field Operations in the second half of 1996. Additionally, American Paging recently added a new Vice President-Development and Engineering and a new Vice President-Finance and Chief Financial Officer. The first goal of the restructuring effort was to increase sales productivity through improved direct sales efforts and improved customer mix. Towards this end, American Paging increased the number of direct sales representatives with the goal of increasing growth in units in service, revenue and average monthly service revenue per unit ("ARPU"). During 1996, American Paging increased the number of employees involved in the sales function to approximately 60% of total employees, but improvements in units in service, service revenue and ARPU growth were not achieved due to dislocations from restructuring-related activities within the sales and customer support areas. American Paging's strategy is to organize the department on a market segment basis so that the sales and marketing employees will be better able to address current customer demands, and also be more responsive to changes within those market segments. The second and third goals of the restructuring effort were to reduce administrative expense and improve customer service. An integral part of achieving these two goals was the consolidation of 17 geographically-dispersed customer service and administrative units into a centralized Customer Telecare Center ("CTC") located in Oklahoma City, Oklahoma. The CTC, opened in April 1996, now handles all back office activities including customer service, order fulfillment, customer billing and collections, and is available 24 hours-a-day, seven days-a-week. The process of implementing the CTC, as well as changing the way American Paging sells, services and supports its customers, was very disruptive to operations during 1996. As a result, restructuring-related expenses recorded during 1996 include a 33 write-down of inventory identified as obsolete upon centralization of inventory management at the CTC, as well as costs for duplicate staffing, employee severance, and consulting and legal fees. In addition, during the consolidation of customer information databases at the CTC, it became apparent that American Paging's customer management and billing system did not provide the flexibility necessary to support its future customer growth and retention. The creation and successful operation of the CTC is critical to achieving American Paging's objective of growth in units, service revenue and ARPU. PAGING OPERATIONS American Paging provides local, statewide, regional and nationwide advanced, one-way digital wireless messaging communications services to customers in 21 states and the District of Columbia through its 51 sales and service offices. It offers local and regional paging coverage throughout Florida, the Midwest (including all or parts of Minnesota, Wisconsin, Missouri, Illinois, Indiana, and Kentucky), the Mid-Atlantic (including all or parts of Maryland, Pennsylvania, Virginia, and Washington, D.C.), and in portions of Oklahoma, Texas, Arizona and Utah. One-way paging services are also offered in portions of Ohio, Iowa and Southern California through various transmitter-sharing agreements with nonaffiliated service providers. Nationwide one-way and two-way paging services are offered through American Paging's alliances with nonaffiliated service providers. Generally, a paging system consists of a control center, transmitters and dedicated links (wire, fiber optic, radio, or satellite) between the control center and the transmitters and the pagers themselves. The control center is interconnected with the public switched telephone network ("PSTN") and receives messages from landline telephones. Messages received at the control center are matched to each pager's unique telephone number, or "cap code," translated into digital signals and forwarded over dedicated links to transmitters that broadcast the message over a specified frequency. If the pager to which the message is directed is in the transmitter coverage area, it will recognize its "cap code" and indicate to its wearer that it has received a page. American Paging currently provides four types of pagers in all of its markets: alphanumeric text display, numeric display, tone and voice. Alphanumeric text display service allows customers to receive, store, and display full text messages, consisting of both numbers and letters up to 240 characters long, which are sent from either a data entry device, message dispatch operator or via computer modem through messaging software. A numeric display pager permits a caller to transmit to the customer a numeric message that may consist of a telephone number, an account number or coded numeric information. It has the memory capability to store several numeric messages which can be recalled by the customer when desired. A tone pager notifies the customer that a message has been received by emitting an audible beep, displaying a flashing light or vibrating. In the case of voice service, the notification is followed by a brief voice message. MARKETING STRATEGY American Paging directs its marketing efforts at value-oriented customers who appreciate its high degree of technical reliability and high level of customer service. American Paging's marketing strategy is designed to increase market share and operating cash flow by achieving rapid growth at modest cost per net customer unit added. Continuing quality improvements, including new services and products, help stimulate this growth while controlling costs. American Paging generates its revenues from (i) service usage billed on a flat-rate or measured-service basis, (ii) pager rentals, (iii) pager warranties, maintenance and repair, (iv) loss protection, (v) voice mail usage on a flat-rate or measured-service basis, (vi) activation fees, (vii) the sale of pager accessories and (viii) service usage of value-added services such as information services, text dispatching, second telephone numbers or group calls. Service to end users is provided directly by American Paging in most cases. American Paging markets its services directly through its direct sales force, company-owned retail stores and indirectly through third-party resellers and agents. The direct sales staff is responsible for the development of large and medium business accounts and for the promotion of nationwide paging services. Company-owned retail stores focus on serving consumer and small business accounts as do 34 indirect agents. American Paging sells pagers to agents at a small mark-up or at cost. Agents then sell the pagers to customers who purchase the services directly from American Paging. American Paging provides sales support to its agents, including promotional material and end-user information. American Paging provides services under marketing agreements with third-party marketing organizations, or resellers. American Paging offers paging air time in bulk quantities at wholesale rates to resellers who then "re-sell" the air time to end users at a mark-up. Resellers incur the cost to acquire customers as well as to service, bill and collect revenues from the customer. They also assume the cost of the paging unit for those who rent rather than purchase. COMPETITION American Paging faces significant competition in all of its markets. Competition for subscribers in most geographic markets American Paging serves is based primarily on price, quality of services offered and the geographic area covered. A number of American Paging's competitors, which include local, regional and national paging companies and certain regional telephone companies, possess greater financial, technical and other resources than American Paging. Moreover, certain competitors in the paging business offer wider coverage in certain geographic areas than does American Paging and certain competitors follow a low-price discounting strategy to expand market share. If any of such companies were to devote additional resources to the paging business or increase competitive pressure in American Paging's markets, American Paging's results of operations could be adversely affected. A number of wireless communication technologies, including cellular telephone service, broadband PCS, enhanced SMR and others, are competitive forms of technology used in, or projected to be used for, wireless two-way communications. Cellular telephone technology provides an alternative communications system for customers who are frequently away from fixed-wire or landline communications systems (i.e., ordinary telephones). American Paging believes that paging will remain one of the lowest-cost forms of wireless messaging due to the low-cost infrastructure associated with paging systems, as well as advances in technology that will provide for reduced paging costs. Broadband PCS technology is currently available in selected markets and development continues in many other markets throughout the United States. Broadband PCS Technology is similar in design to cellular technology and will offer increased capacity for wireless two-way communication as well as short-text messaging. Accordingly, this technology is expected to result in increased competition for American Paging. American Paging believes the services offered by narrowband PCS technology will be complementary to the services and functionality of cellular and broadband PCS. Future technological developments in the wireless telecommunications industry and the enhancement of current technologies will likely create new products and services that are competitive with the paging services currently offered by American Paging. There can be no assurance that American Paging would not be adversely affected by such technology changes. REGULATION REGULATORY ENVIRONMENT. American Paging's paging operations are subject to regulation by the FCC and by state regulatory agencies. The FCC exercises broad authority to regulate market entry and rates and shares responsibilities with state regulatory authorities over a broad range of other matters. The construction, operation and transfer of American Paging's systems in the United States are regulated to varying degrees by the FCC pursuant to the Communications Act. In addition, the 1996 Act, which amended the Communications Act, mandates significant changes in existing telecommunications rules and policies to promote competition, ensure the availability of telecommunications services to all parts of the nation and to streamline regulation of the telecommunications industry to remove regulatory burdens, as competition develops and makes regulation unnecessary. The FCC has promulgated regulations governing construction and operation of wireless systems, licensing (including renewal of licenses) and technical standards for the provision of wireless services under the Communications Act, and is implementing the legislative objectives of the 1996 Act, as discussed below. LICENSING. The FCC is responsible for awarding licenses for radio frequencies used by American Paging and its subsidiaries to provide its one-way and two-way message and other service offerings. It 35 also establishes and enforces the licensing, technical and operating rules which govern operations on those frequencies, the terms and conditions under which the wireless systems of American Paging and its subsidiaries are interconnected with and obtain services and facilities from other service providers such as local exchange carriers and others with respect to interstate services and adjudicates any consumer or other complaints filed under the Communications Act with respect to service providers subject to its jurisdiction. The FCC licenses granted to American Paging are issued for up to ten years at the end of which time renewal applications must be filed with the FCC. Most of American Paging's current licenses expire between 1998 and 2001. FCC renewals are generally granted so long as American Paging is in compliance with FCC regulations. Although American Paging is unaware of any circumstances which would prevent the approval of any pending or future renewal applications, no assurance can be given that American Paging's licenses will be renewed by the FCC in the future. Moreover, although revocation and involuntary modification of licenses are extraordinary regulatory measures, the FCC has the authority to restrict the operation of licensed facilities or revoke or modify licenses. No license granted to American Paging has ever been involuntarily revoked or modified. The Communications Act requires licensees, such as American Paging, to obtain prior approval from the FCC for the assignment or transfer of control of any construction permit or station license, or any rights thereunder. The Communications Act also requires prior approval by the FCC of acquisitions of other paging companies by American Paging. The FCC has approved all transfers of control for which American Paging has sought approval. American Paging also routinely applies for FCC authority to use frequencies, modify the technical parameters of existing licenses, expand its service territory and provide new services. Although there can be no assurance that any future requests for approval or applications filed by American Paging will be approved or acted upon in a timely manner by the FCC, or that the FCC will grant the relief requested, American Paging has no reason to believe that any such requests, applications or relief will not be approved or granted. Pursuant to 1993 amendments to the Communications Act, a paging service is classified as a CMRS, to the extent that it is a service offered to the public, for a fee, which is interconnected to the public switched telephone network. These 1993 amendments prohibit state and local authorities from limiting CMRS market entry and regulating CMRS rates. RECENT EVENTS. The FCC adopted certain significant decisions during 1996. In one decision, the FCC amended its rules to allow paging and narrowband PCS carriers to offer fixed wireless service on a co-primary basis with mobile services. In another decision, the FCC required that all licensees register and obtain FCC registration numbers for all of their antenna towers which require prior FAA clearance. The FCC also amended its environmental protection rules to adopt new guidelines and procedures for evaluating the environmental effects of RF emissions. In addition, the FCC initiated proceedings proposing to adopt market area licensing to replace site-by-site licensing of paging base stations, to permit geographic partitioning and spectrum disaggregation in the event market area licensing is adopted, and to make changes affecting the licensing of local and response channels in narrowband PCS services. The FCC has also announced its intention to hold spectrum auctions for paging and narrowband PCS spectrum in 1997 if its market area licensing and narrowband PCS rule revisions are adopted. The FCC also established a phased program which requires per-call compensation to be paid to pay-phone service providers by subscribers to 800 numbers, among others. American Paging and numerous other paging providers who offer 800 number calling features as a means of accessing their networks will be required to compensate pay phone service providers under these new requirements. During 1996 the FCC implemented significant changes in existing regulation of the telecommunications industry under the 1996 Act. Some of these specific changes, potentially affecting CMRS providers, including paging and narrowband PCS providers, are summarized below. The 1996 Act provides that implementing its legislative objectives will be the task of the FCC, the state public utilities commissions and a federal-state joint board. Much of this implementation is 36 proceeding in numerous, concurrent proceedings with aggressive deadlines. The Company cannot predict the full extent, nature and interrelationships among state and federal implementation and other responses to the 1996 Act. The primary purpose and effect of the new law is to open all telecommunications markets to competition. The 1996 Act makes most direct or indirect state and local barriers to competition unlawful. It directs the FCC to preempt all inconsistent state and local laws and regulations, after notice and comment proceedings. It also enables electric and other utilities to engage in telecommunications service through qualifying subsidiaries. Only narrow powers over competitive entry are left to state and local authorities. Each state retains the power to impose competitively neutral requirements that are consistent with the 1996 Act's universal service provision and necessary for universal services, public safety and welfare, continued service quality and consumer rights. While a state may not impose requirements that effectively function as barriers to entry, it retains limited authority to regulate certain competitive practices in rural telephone company service areas. Since enactment, the FCC has adopted orders implementing the local competition provisions of the 1996 Act. The FCC found that certain wireless providers are entitled to reciprocal compensation, may not be charged for LEC-originated traffic or for code opening/per-number fees, and may obtain LEC interconnection subject to the terms of the 1996 Act. Appeals have been taken to the United States Court of Appeals for the Eighth Circuit from these FCC orders by numerous parties alleging that the FCC has exceeded its statutory mandate, among other matters. The Eighth Circuit Court of Appeals granted a stay of certain rules adopted in the FCC orders pending its decision on the merits of these appeals. The 1996 Act establishes principles and a process for implementing a modified "universal service" policy. This policy seeks nationwide, affordable service and access to advanced telecommunications and information services. It calls for reasonably comparable urban and rural rates and services. The 1996 Act also requires universal service to schools, libraries and rural health facilities at discounted rates. The FCC has proceedings pending to address recommendations made by the joint board with respect to the implementation of the universal service provisions of the 1996 Act, including, among other issues, the size of the universal service fund and the assessment mechanism to determine how much individual wireless carriers will be required to contribute. STATE AND LOCAL REGULATION. The scope of state regulatory authority, while excluding market entry and rate regulation, covers such matters as the terms and conditions of interconnection between local exchange carriers and wireless carriers with respect to intrastate services, customer billing information and practices, billing disputes, other consumer protection matters, facilities setup issues and transfers of control, among other matters. In these areas, particularly the terms and conditions of interconnection between local exchange carriers and wireless providers, the FCC and state regulatory authorities share regulatory responsibilities with respect to interstate and intrastate issues, respectively. The FCC has pending numerous petitions for pre-emption of state and local regulations which allege such regulations prohibit or impair the provision of interstate or intrastate telecommunications services. It has also requested public comment on a petition requesting pre-emption of moratoria imposed by state and local governments on siting of telecommunications facilities, the imposition of state taxes on the gross receipts of CMRS providers and other proposed state taxes based on the asset value of CMRS licenses awarded by the FCC. The FCC is required to forbear from applying any statutory or regulatory provision that is not necessary to keep telecommunications rates and terms reasonable or to protect consumers. A state may not apply a statutory or regulatory provision that the FCC decides to forbear from applying. In addition, the FCC must review its telecommunications regulations every two years and change any that are no longer necessary. American Paging and its subsidiaries have been and intend to remain active participants in proceedings before the FCC and, through its membership in state associations of wireless providers, before state regulatory authorities. Proceedings with respect to the foregoing policy issues before the FCC and state regulatory authorities could have a significant impact on the competitive market structure 37 among wireless providers and the relationships between wireless providers and other carriers. American Paging is unable to predict the scope, pace or financial impact of policy changes which could be adopted in these proceedings. OTHER SUBSIDIARIES Subsidiaries of the Company provide custom printing (Suttle Press, Inc.); and telemessaging services (Integrated Communications Services, Inc.). EMPLOYEES The Company enjoys satisfactory employee relations. As of December 31, 1996, 7,718 persons were employed by the Company, 153 of whom are represented by unions. - - -------------------------------------------------------------------------------- ITEM 2. PROPERTIES The property of TDS consists principally of switching and cell site equipment related to cellular telephone operations; telephone lines, central office equipment, telephone instruments and related equipment, and land and buildings related to telephone operations; and radio pagers and transmitting equipment related to radio paging operations. As of December 31, 1996, TDS's gross property, plant and equipment of approximately $2.7 billion consisted of the following: Cellular telephone........................... 31.8 % Telephone.................................... 48.9 PCS.......................................... 12.2 Radio paging................................. 4.3 Other........................................ 2.8 ------ 100.0 % ------ ------
The plant and equipment of TDS is maintained in good operating condition and is suitable and adequate for the Company's business operations. The properties of the operating telephone subsidiaries and most of the tangible assets of the cellular subsidiaries are subject to the lien of the mortgages securing the funded debt of such companies. The Company owns substantially all of its central office buildings, local administrative buildings, warehouses, and storage facilities used in its telephone operations and leases most of its offices and transmitter sites used in its cellular and paging businesses. All of the Company's telephone lines and cell and transmitter sites are located either on private or public property. Locations on private land are by virtue of easements or other arrangements. - - -------------------------------------------------------------------------------- ITEM 3. LEGAL PROCEEDINGS The Company is involved in a number of legal proceedings before the FCC and various state and federal courts. In some cases, the litigation involves disputes regarding rights to certain landline or cellular telephone systems and other interests. The Company does not believe that any such proceeding should have a material adverse impact on the Company. - - -------------------------------------------------------------------------------- ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of 1996. 38 - - -------------------------------------------------------------------------------- PART II - - -------------------------------------------------------------------------------- ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Except for information provided below, such information is incorporated by reference from Exhibit 13, Annual Report sections entitled "TDS Stock and Dividend Information" and "Market Price per Common Share by Quarter." On November 4, 1996, AERL issued $226.2 million in aggregate principal amount at maturity of Series A Zero Coupon Notes ("Notes") due in 2006. The issue price of the Notes was 44.2% of the principal amount at maturity or $100 million, and there is no periodic payment of interest. The $100 million in proceeds from the sale of the Notes were paid to Nokia Telecommunications, Inc., in satisfaction of all outstanding obligations and future obligations up to $100 million of AERL under a Credit Agreement dated June 19, 1996. The Notes and the obligations under the Credit Agreement are fully and unconditionally guaranteed by TDS at an annual fee rate of 3%. Such Notes and the TDS quarantee were issued without registration under the Securities Act of 1933, as amended, pursuant to an exemption therefrom in Rule 144A under such act. - - -------------------------------------------------------------------------------- ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference from Exhibit 13, Annual Report section entitled "Selected Consolidated Financial Data," except for ratios of earnings to fixed charges, which are incorporated herein by reference from Exhibit 12 to this Annual Report on Form 10-K. - - -------------------------------------------------------------------------------- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference from Exhibit 13, Annual Report section entitled "Management's Discussion and Analysis of Results of Operations and Financial Condition." - - -------------------------------------------------------------------------------- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated by reference from Exhibit 13, Annual Report sections entitled "Consolidated Statements of Income," "Consolidated Statements of Cash Flows," "Consolidated Balance Sheets," "Consolidated Statements of Common Stockholders' Equity," "Notes to Consolidated Financial Statements," "Consolidated Quarterly Income Information (Unaudited)," and "Report of Independent Public Accountants." - - -------------------------------------------------------------------------------- ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 39 - - -------------------------------------------------------------------------------- PART III - - -------------------------------------------------------------------------------- ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference from Proxy Statement sections entitled "Election of Directors" and "Executive Officers." - - -------------------------------------------------------------------------------- ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from Proxy Statement section entitled "Executive Compensation" except for the information specified in Item 402(a)(8) of Regulation S-K under the Securities Exchange Act of 1934, as amended. - - -------------------------------------------------------------------------------- ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from Proxy Statement sections entitled "Security Ownership of Management" and "Principal Shareholders." - - -------------------------------------------------------------------------------- ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from Proxy Statement section entitled "Certain Relationships and Related Transactions." 40 - - -------------------------------------------------------------------------------- PART IV - - -------------------------------------------------------------------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The following documents are filed as a part of this report: (a)(1) Financial Statements Consolidated Statements of Income.................................. Annual Report* Consolidated Statements of Cash Flows.............................. Annual Report* Consolidated Balance Sheets........................................ Annual Report* Consolidated Statements of Common Stockholders' Equity............. Annual Report* Notes to Consolidated Financial Statements......................... Annual Report* Consolidated Quarterly Income Information (Unaudited).............. Annual Report* Report of Independent Public Accountants........................... Annual Report*
- - --------- * Incorporated by reference from Exhibit 13. (2) Schedules
LOCATION -------- Report of Independent Public Accountants on Financial Statement Schedules......... page 44 I. Condensed Financial Information of Registrant-Balance Sheets as of December 31, 1996 and 1995 and Statements of Income and Statements of Cash Flows for each of the Three Years in the Period Ended December 31, 1996.............. page 45 II. Valuation and Qualifying Accounts for each of the Three Years in the Period Ended December 31, 1996.................................................... page 49 All other schedules have been omitted because they are not applicable or not required because the required information is shown in the financial statements or notes thereto.
41 (3) Exhibits The exhibits set forth in the accompanying Index to Exhibits are filed as a part of this Report. The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this Report.
EXHIBIT NUMBER DESCRIPTION - - ------------------------------------------------------------------------------------------------------------ 10.1 Salary Continuation Agreement for LeRoy T. Carlson dated May 20, 1977, as amended May 22, 1981 and May 25, 1984 is hereby incorporated by reference to the Company's Registration Statement on Form S-2, No. 2-92307. 10.2(a) Supplemental Benefit Agreement for LeRoy T. Carlson dated March 21, 1980, as amended March 20, 1981 is hereby incorporated by reference to an exhibit to the Company's Registration Statement on Form S-7, No. 2-74615. 10.2(b) Memorandum of Amendment to Supplemental Benefit Agreement dated May 28, 1991 is hereby incorporated by reference to Exhibit 10.2(b) to the Company's Annual Report Form 10-K for the year ended December 31, 1991. 10.3 Stock Option Agreement, dated February 25, 1987, between the Company and Murray L. Swanson is hereby incorporated by reference to an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1988. 10.4 Stock Appreciation Rights Award and Non-Qualified Stock Option Agreement, dated March 14, 1988, between the Company and LeRoy T. Carlson, Jr., is hereby incorporated by reference to an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1988. 10.5 Stock Option and Stock Appreciation Rights Award Agreement dated January 15, 1990 between the Company and James Barr III, is hereby incorporated by reference to Exhibit 10.13 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. 10.6(a) 1988 Stock Option and Stock Appreciation Rights Plan of the Company is hereby incorporated by reference to Exhibit A to the Company's definitive Notice of Annual Meeting and Proxy Statement dated March 31, 1988. 10.6(b) Amendment #1 to 1988 Stock Option and Stock Appreciation Rights Plan of the Company is hereby incorporated by reference to Exhibit 10.7(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1993. 10.6(c) Amendment #2 to 1988 Stock Option and Stock Appreciation Rights Plan of the Company is hereby incorporated by reference to Exhibit 10.7(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1993. 10.7 1985 Incentive Stock Option Plan of the Company is hereby incorporated by reference to Exhibit A to the Company's definitive Notice of Annual Meeting and Proxy Statement dated April 24, 1986. 10.8(a) Telephone and Data Systems, Inc. 1994 Long-Term Incentive Plan is hereby incorporated by reference to Exhibit 99.1 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.8(b) Form of 1994 Long-Term Stock Option Agreement (Transferable Form) is hereby incorporated by reference to Exhibit 99.2 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.8(c) Form of 1994 Long-Term Stock Option Agreement (Nontransferable Form) is hereby incorporated by reference to Exhibit 99.3 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.8(d) Form of 1995 Performance Stock Option Agreement (Transferable Form) is hereby incorporated by reference to Exhibit 99.4 to the Company Registration statement on Form S-8 (Registration No. 33-57257).
42
EXHIBIT NUMBER DESCRIPTION - - ------------------------------------------------------------------------------------------------------------ 10.8(e) Form of 1995 Performance Stock Option Agreement (Nontransferable Form) is hereby incorporated by reference to Exhibit 99.5 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.9 Supplemental Executive Retirement Plan of the Company is hereby incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-K for the year ended December 31, 1994. 10.10 Deferred Compensation Agreement for Rudolph E. Hornacek dated November 30, 1995, is hereby incorporated by reference to Exhibit 10.10 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. 10.14 Deferred Compensation Agreement for H. Donald Nelson dated July 15, 1996, is hereby incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report in Form 10-Q for the quarterly period ended September 30, 1996. 10.15 Description of Terms of Signing Letter with Donald W. Warkentin dated June 7, 1995.
(b) Reports on Form 8-K filed during the quarter ended December 31, 1996. TDS filed a Current Report on Form 8-K on December 19, 1996 dated December 16, 1996, which included a news release that announced the Company's Board of Directors had authorized repurchases of up to 3,000,000 TDS Common Shares. 43 - - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholders and Board of Directors of Telephone and Data Systems, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Telephone and Data Systems, Inc. and Subsidiaries Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 29, 1997 (except with respect to the matter discussed in Note 16, as to which the date is February 4, 1997). Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These financial statement schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN LLP Chicago, Illinois January 29, 1997 (except with respect to the matter discussed in Note 16, as to which the date is February 4, 1997) 44 SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) BALANCE SHEETS ASSETS - - --------------------------------------------------------------------------------
DECEMBER 31, ---------------------- (DOLLARS IN THOUSANDS) 1996 1995 - - ------------------------------------------------------------------------------------------- CURRENT ASSETS Cash and cash equivalents $ 141 $ 1,867 Temporary investments 154 99 Notes receivable from affiliates 94,421 55,156 Advances to affiliates 1,616 1,816 Accounts receivable Due from subsidiaries--Income taxes 16,211 25,890 Due from subsidiaries--Other 16,790 25,914 Other 2,903 4,895 Other current assets 2,572 2,710 ---------------------- 134,808 118,347 - - ------------------------------------------------------------------------------------------- INVESTMENT IN SUBSIDIARIES Underlying book value 2,351,057 2,121,651 Cost in excess of underlying book value at date of acquisition 112 1,987 ---------------------- 2,351,169 2,123,638 - - ------------------------------------------------------------------------------------------- OTHER INVESTMENTS Minority interests in telephone and cellular companies and other investments 44,256 28,103 - - ------------------------------------------------------------------------------------------- PROPERTY, PLANT and EQUIPMENT Property, Plant and Equipment, net of accumulated depreciation 21,394 18,586 - - ------------------------------------------------------------------------------------------- OTHER ASSETS AND DEFERRED CHARGES Debt issuance expenses 2,030 2,175 Development and acquisition expenses 2,148 1,703 Other 54 3,700 ---------------------- 4,232 7,578 - - ------------------------------------------------------------------------------------------- $2,555,859 $2,296,252 - - ------------------------------------------------------------------------------------------- - - -------------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. 45 SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) BALANCE SHEETS LIABILITIES AND STOCKHOLDERS' EQUITY - - --------------------------------------------------------------------------------
DECEMBER 31, ---------------------- (DOLLARS IN THOUSANDS) 1996 1995 - - ------------------------------------------------------------------------------------------- CURRENT LIABILITIES Current portion of long-term debt and preferred stock $ 1,810 $ 15,061 Notes payable 157,227 180,760 Notes payable to affiliates 47,990 37,086 Advances from affiliates -- 2,464 Accounts payable Due to subsidiaries--Federal income taxes 8,407 14,405 Due to subsidiaries--Other 1,867 31,495 Other 1,108 5,379 Accrued interest 10,987 10,878 Accrued taxes (19,126) (6,837) Other 7,711 4,931 ---------------------- 217,981 295,622 - - ------------------------------------------------------------------------------------------- DEFERRED LIABILITIES AND CREDITS Investment tax credits (2,697) (1,934) Income taxes 30,763 20,593 Postretirement benefits obligation other than pensions 626 11,216 Other 4,823 7,921 ---------------------- 33,515 37,796 - - ------------------------------------------------------------------------------------------- LONG-TERM DEBT, excluding current portion (Note B) 242,143 242,960 - - ------------------------------------------------------------------------------------------- REDEEMABLE PREFERRED SHARES, excluding current portion (Note A) 280 2,260 - - ------------------------------------------------------------------------------------------- NONREDEEMABLE PREFERRED SHARES 29,000 29,710 - - ------------------------------------------------------------------------------------------- COMMON STOCKHOLDERS' EQUITY Common Shares, par value $1 per share; authorized 100,000,000 shares; issued and outstanding 54,237,180 and 51,137,426 shares, respectively 54,237 51,137 Series A Common Shares, par value $1 per share; authorized 25,000,000 shares; issued and outstanding 6,916,546 and 6,893,101 shares, respectively 6,917 6,893 Common Shares issuable, 30,977 and 31,431 shares, respectively 1,461 1,496 Capital in excess of par value 1,661,093 1,417,514 Retained earnings 309,232 210,864 ---------------------- 2,032,940 1,687,904 ---------------------- $2,555,859 $2,296,252 - - ------------------------------------------------------------------------------------------- - - -------------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. 46 SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) STATEMENTS OF INCOME - - --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, ------------------------------- (DOLLARS IN THOUSANDS) 1996 1995 1994 - - ---------------------------------------------------------------------------------------- Operating service revenues $ 61,239 $ 58,071 $ 49,455 Cost of sales and operating expenses 57,538 54,682 46,921 ------------------------------- Net operations 3,701 3,389 2,534 ------------------------------- Other income Interest income received from affiliates 7,385 26,134 13,832 Other, net 4,843 (4,729) (1,707) ------------------------------- 12,228 21,405 12,125 ------------------------------- Income before interest and income taxes 15,929 24,794 14,659 Interest expense 15,790 32,233 22,954 Federal income tax expense (credit) (24,974) 7,340 2,205 ------------------------------- Corporate operations 25,113 (14,779) (10,500) Equity in net income of subsidiaries and other investments 103,026 123,395 70,321 ------------------------------- Net income $ 128,139 $ 108,616 $ 59,821 - - ---------------------------------------------------------------------------------------- - - ----------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. Note A: The annual requirements for redemption of Redeemable Preferred Shares are $1.6 million, $103,000, $100,000, and $77,000 for the years 1997 through 2000, respectively. Note B: The annual requirements for principal payments on long-term debt are $232,000, $742,000, $248,000, $258,000 and $270,000 for the years 1997 through 2001, respectively. Note C: In 1996, the data processing subsidiary of the Parent company was merged into the Parent company. Prior years' financial statements have been restated to conform to current presentation.
47 SCHEDULE I--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) STATEMENTS OF CASH FLOWS - - --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, ------------------------------------------- (DOLLARS IN THOUSANDS) 1996 1995 1994 - - ------------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 128,139 $ 108,616 $ 59,821 Add (Deduct) adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 11,047 6,541 7,294 Gain on sale of investments (3,434) (408) -- Deferred taxes 5,432 5,364 8,804 Equity income (103,026) (123,395) (70,321) Other noncash expense 677 1,317 691 Change in accounts receivable 20,795 (30,674) (2,194) Change in accounts payable (39,897) 40,866 3,129 Change in accrued taxes (12,289) (4,713) (4,587) Change in other assets and liabilities 2,849 1,401 (638) ------------------------------------------- 10,293 4,915 1,999 - - ------------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Long-term debt borrowings -- 38,909 (130) Repayment of long-term debt (2,815) (3,012) (3,137) Change in notes payable (23,533) 83,131 91,629 Change in notes payable to affiliates 104,843 28,535 1,534 Change in advances from affiliates (2,464) 2,118 (3) Common stock issued 5,114 8,078 11,185 Redemption of preferred shares (605) (9,609) (644) Dividends paid (26,232) (23,971) (20,906) ------------------------------------------- 54,308 124,179 79,528 - - ------------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Acquisitions Value of assets acquired (121,053) (129,005) (215,658) Common Shares issued 113,128 127,836 173,658 Preferred Shares issued -- -- 12,500 ------------------------------------------- Net cash paid for acquisitions (7,925) (1,169) (29,500) Additions to property, plant and equipment (13,362) (7,899) (5,655) Proceeds from sale of investments 500 4,800 -- Investments in subsidiaries (19,533) (302,722) (527) Dividends from subsidiaries 17,953 17,690 17,373 Other investments (8,941) 1,169 (2,000) Change in notes receivable from affiliates (35,165) 139,849 (65,350) Change in advances to affiliates 200 20,200 (20,400) Change in temporary investments (54) 85 (127) ------------------------------------------- (66,327) (127,997) (106,186) - - ------------------------------------------------------------------------------------------------------------------------------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (1,726) 1,097 (24,659) CASH AND CASH EQUIVALENTS Beginning of period 1,867 770 25,429 ------------------------------------------- End of period $ 141 $ 1,867 $ 770 - - ------------------------------------------------------------------------------------------------------------------------------- - - -------------------------------------------------------------------------------------------------------------------------------
The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. 48 TELEPHONE AND DATA SYSTEMS, INC. AND SUBSIDIARIES SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS - - --------------------------------------------------------------------------------
COLUMN A DESCRIPTION COLUMN B COLUMN C-1 COLUMN C-2 COLUMN E - - ---------------------------------------------------------- BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING OF COSTS AND OTHER COLUMN D END OF (DOLLARS IN THOUSANDS) PERIOD EXPENSES ACCOUNTS DEDUCTIONS PERIOD ------------ ------------ ------------ ----------- ------------ FOR THE YEAR ENDED DECEMBER 31, 1996 Deducted from deferred state tax asset: For unrealized net operating losses $ (10,061) $ 239 $ (7,069) $ -- $ (16,891) Deducted from accounts receivable: For doubtful accounts (5,104) (22,432) -- 21,446 (6,090) FOR THE YEAR ENDED DECEMBER 31, 1995 Deducted from deferred state tax asset: For unrealized net operating losses (8,962) 3,905 (5,004) -- (10,061) Deducted from accounts receivable: For doubtful accounts (2,785) (16,648) -- 14,329 (5,104) FOR THE YEAR ENDED DECEMBER 31, 1994 Deducted from deferred state tax asset: For unrealized net operating losses (8,704) 327 (585) -- (8,962) Deducted from accounts receivable: For doubtful accounts (2,093) (9,710) -- 9,018 (2,785) Deducted from marketable equity securities: For unrealized loss (626) -- 626 -- -- - - -------------------------------------------------------------------------------------------------------------------------------
49 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TELEPHONE AND DATA SYSTEMS, INC. By: /S/ LEROY T. CARLSON ------------------------------------------ LeRoy T. Carlson, CHAIRMAN By: /S/ LEROY T. CARLSON, JR. ------------------------------------------ LeRoy T. Carlson, Jr., PRESIDENT (CHIEF EXECUTIVE OFFICER) By: /S/ MURRAY L. SWANSON ------------------------------------------ Murray L. Swanson, EXECUTIVE VICE PRESIDENT-FINANCE (CHIEF FINANCIAL OFFICER) By: /S/ GREGORY J. WILKINSON ------------------------------------------ Gregory J. Wilkinson, VICE PRESIDENT AND CONTROLLER (PRINCIPAL ACCOUNTING OFFICER)
Dated March 20, 1996 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE - - -------------------------------------------------------------------- ----------- --------------------- /S/ LEROY T. CARLSON DIRECTOR March 20, 1997 ----------------------------------------------- Leroy T. Carlson /S/ LEROY T. CARLSON, JR. DIRECTOR March 20, 1997 ----------------------------------------------- LeRoy T. Carlson, Jr. /S/ MURRAY L. SWANSON DIRECTOR March 20, 1997 ----------------------------------------------- Murray L. Swanson /S/ JAMES BARR III DIRECTOR March 20, 1997 ----------------------------------------------- James Barr III /S/ RUDOLPH E. HORNACEK DIRECTOR March 20, 1997 ----------------------------------------------- Rudolph E. Hornacek /S/ DONALD C. NEBERGALL DIRECTOR March 20, 1997 ----------------------------------------------- Donald C. Nebergall /S/ HERBERT S. WANDER DIRECTOR March 20, 1997 ----------------------------------------------- Herbert S. Wander /S/ WALTER C.D. CARLSON DIRECTOR March 20, 1997 ----------------------------------------------- Walter C.D. Carlson /S/ LETITIA G.C. CARLSON DIRECTOR March 20, 1997 ----------------------------------------------- Letitia G.C. Carlson /S/ DONALD R. BROWN DIRECTOR March 20, 1997 ----------------------------------------------- Donald R. Brown /S/ GEORGE W. OFF DIRECTOR March 20, 1997 ----------------------------------------------- George W. Off
- - -------------------------------------------------------------------------------- INDEX TO EXHIBITS - - --------------------------------------------------------------------------------
EXHIBIT NO. DESCRIPTION OF DOCUMENT - - ------------ ------------------------------------------------------------------------------------------------------------------ 3.1 Articles of Incorporation, as amended, are hereby incorporated by reference to an exhibit to the Company's Report on Form 8-A/A-2 dated December 20, 1994. 3.2 By-laws, as amended, are hereby incorporated by reference to an exhibit to the Company's Report on Form 8-A/A-2 dated December 20, 1994. 4.1 Articles of Incorporation, as amended, are hereby incorporated by reference to an exhibit to the Company's Report on Form 8-A/A-2 dated December 20, 1994. 4.2 By-laws, as amended, are hereby incorporated by reference to an exhibit to the Company's Report on Form 8-A/A-2 dated December 20, 1994. 4.3 The Indenture and Supplemental Indentures for the Company's Series A, B, C, D, E and F Subordinated Debentures are not being filed as exhibits because the total authorized subordinated debentures do not exceed 10% of the total assets of the Company and its Subsidiaries. The Company agrees to furnish a copy of such Indentures and Supplemental Indentures if so requested by the Commission. 4.4 The Indenture between the Company and Harris Trust and Savings Bank, Trustee, dated February 1, 1991, under which the Company's Medium-Term Notes are issuable, is hereby incorporated by reference to the Company's Current Report on Form 8-K filed on February 19, 1991. 4.5 Revolving Credit Agreement, dated as of May 19, 1995, among TDS and the First National Bank of Boston, as agent, is hereby incorporated by reference to the registrant's Form 8-K dated May 19, 1995. 4.6 The Trust Indenture dated as of November 4, 1996 between Aerial Communications, Inc. as issuer, the Company as guarantor, and The First National Bank of Chicago, as trustee for Aerial's Series A Zero Coupon Notes, is hereby incorporated by reference to Exhibit 4.1 to Aerial's Form 8-K filed on November 29, 1996. 9.1(a) Voting Trust Agreement, dated as of June 30, 1989, is hereby incorporated by reference to an exhibit to Post-Effective Amendment No. 3 to the Company's Registration Statement on Form S-1, No. 33-12943. 9.1(b) Amendment dated as of May 9, 1991 to the Voting Trust Agreement dated as of June 30, 1989, is hereby incorporated by reference to Exhibit 9.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. 9.1(c) Amendment dated as of November 20, 1992, to the Voting Trust Agreement dated as of June 30, 1989, as amended, is hereby incorporated by reference to Exhibit 9.1(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10.1 Salary Continuation Agreement for LeRoy T. Carlson dated May 20, 1977, as amended May 22, 1981 and May 25, 1984 is hereby incorporated by reference to the Company's Registration Statement on Form S-2, No. 2-92307. 10.2(a) Supplemental Benefit Agreement for LeRoy T. Carlson dated March 21, 1980, as amended March 20, 1981, is hereby incorporated by reference to an exhibit to the Company's Registration Statement on Form S-7, No. 2-74615. 10.2(b) Memorandum of Amendment to Supplemental Benefit Agreement dated as of May 28, 1991, is hereby incorporated by reference to Exhibit 10.2(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.
EXHIBIT NO. DESCRIPTION OF DOCUMENT - - ------------ ------------------------------------------------------------------------------------------------------------------ 10.3 Stock Option Agreement, dated February 25, 1987, between the Company and Murray L. Swanson, is hereby incorporated by reference to an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1988. 10.4 Stock Appreciation Rights Award and Non-Qualified Stock Option Agreement, dated March 14, 1988, between the Company and LeRoy T. Carlson, Jr., is hereby incorporated by reference to an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1988. 10.5 Stock Option and Stock Appreciation Rights Award Agreement dated January 15, 1990 between the Company and James Barr III, is hereby incorporated by reference to Exhibit 10.13 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. 10.6(a) 1988 Stock Option and Stock Appreciation Rights Plan of the Company, is hereby incorporated by reference to Exhibit A to the Company's definitive Notice of Annual Meeting and Proxy Statement dated March 31, 1988. 10.6(b) Amendment #1 to 1988 Stock Option and Stock Appreciation Rights Plan of the Company, is hereby incorporated by reference to Exhibit 10.7(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1993. 10.6(c) Amendment #2 to 1988 Stock Option and Stock Appreciation Rights Plan of the Company, is hereby incorporated by reference to Exhibit 10.7(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1993. 10.7 1985 Incentive Stock Option Plan of the Company, is hereby incorporated by reference to Exhibit A to the Company's definitive Notice of Annual Meeting and Proxy Statement dated April 24, 1986. 10.8(a) Telephone and Data Systems, Inc. 1994 Long-Term Incentive Plan is hereby incorporated by reference to Exhibit 99.1 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.8(b) Form of 1994 Long-Term Stock Option Agreement (Transferable Form) is hereby incorporated by reference to Exhibit 99.2 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.8(c) Form of 1994 Long-Term Stock Option Agreement (Nontransferable Form) is hereby incorporated by reference to Exhibit 99.3 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.8(d) Form of 1995 Performance Stock Option Agreement (Transferable Form) is hereby incorporated by reference to Exhibit 99.4 to the Company Registration statement on Form S-8 (Registration No. 33-57257). 10.8(e) Form of 1995 Performance Stock Option Agreement (Nontransferable Form) is hereby incorporated by reference to Exhibit 99.5 to the Company's Registration Statement on Form S-8 (Registration No. 33-57257). 10.9 Supplemental Executive Retirement Plan of the Company is hereby incorporated by reference to Exhibit 10.9 to the Company's Annual Report on Form 10-K for the year ended December 31, 1994. 10.10 Deferred Compensation Agreement for Rudolph E. Hornacek dated November 30, 1995 is hereby incorporated by reference to Exhibit 10.10 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995. 10.11 Securities Loan Agreement, dated June 13, 1995, between TDS and Merrill Lynch & Co. is hereby incorporated by reference to Exhibit 99.1 to the Form 8-K dated June 16, 1995 of United States Cellular Corporation.
EXHIBIT NO. DESCRIPTION OF DOCUMENT - - ------------ ------------------------------------------------------------------------------------------------------------------ 10.12 Registration Rights Agreement among TDS, Merrill Lynch & Co. and United States Cellular Corporation is hereby incorporated by reference to Exhibit 99.2 to the Form 8-K dated June 16, 1995 of United States Cellular Corporation. 10.13 Common Share Delivery Arrangement Agreement among TDS, Merrill Lynch & Co. and United States Cellular Corporation is hereby incorporated by reference to Exhibit 99.3 to the Form 8-K dated June 16, 1995 of United States Cellular Corporation. 10.14 Deferred Compensation Agreement for H. Donald Nelson dated July 15, 1996, is hereby incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. 10.15 Description of Terms of Signing Letter with Donald W. Warkentin dated June 7, 1995. 11 Statement regarding computation of per share earnings. 12 Statements regarding computation of ratios. 13 Incorporated portions of 1996 Annual Report to Security Holders. 21 List of Subsidiaries of the Company. 23 Consent of independent public accountants. 27 Financial Data Schedules
EX-10.15 2 EXHIBIT 10.15 EXHIBIT 10.15 AERIAL COMMUNICATIONS, INC. AND SUBSIDIARIES (A DEVELOPMENT STAGE ENTERPRISE) DESCRIPTION OF TERMS OF SIGNING LETTER WITH DONALD W. WARKENTIN DATED JUNE 7, 1995 Base salary at an annual rate of $200,000 per year, with an increase effective 1/1/96 to $220,000. $150,000 signing bonus payable on first anniversary date with TDS. 1995 guaranteed bonus of $40,000 and maximum bonus of $60,000. Target bonus opportunity of 35% of base salary, starting in 1996. Participation in the TDS Long Term Incentive Plan until such time as American Portable Telecommunications, Inc. ("APT") is taken public. In the event APT is taken public, participation in the APT stock option program, with the unvested portion of the TDS Stock Option Grant offset by the APT Stock Option Grant. EX-11 3 EXHIBIT 11 EXHIBIT 11 TELEPHONE AND DATA SYSTEMS, INC. COMPUTATION OF EARNINGS PER COMMON SHARE YEAR ENDED DECEMBER 31, 1996 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) PRIMARY EARNINGS Net Income..................................................................... $ 128,139 Dividends on Preferred Shares.................................................. (1,846) --------- Net Income Available to Common................................................. $ 126,293 --------- --------- PRIMARY SHARES Weighted average number of Common and Series A Common Shares Outstanding....... 60,464 Additional shares assuming issuance of: Options and Stock Appreciation Rights........................................ 165 Convertible Preferred Shares................................................. 75 Common Shares Issuable....................................................... 28 --------- Primary Shares................................................................... 60,732 --------- --------- PRIMARY EARNINGS PER COMMON SHARE Net Income..................................................................... $ 2.08 --------- --------- FULLY DILUTED EARNINGS* Net Income..................................................................... $ 128,139 Dividends on Preferred Shares.................................................. (1,286) --------- Net Income Available to Common................................................. $ 126,853 --------- --------- FULLY DILUTED SHARES Weighted average number of Common and Series A Common Shares Outstanding....... 60,464 Additional shares assuming issuance of: Options and Stock Appreciation Rights........................................ 158 Convertible Preferred Shares................................................. 545 Common Shares Issuable....................................................... 28 --------- Fully Diluted Shares........................................................... 61,195 --------- --------- FULLY DILUTED EARNINGS PER COMMON SHARE Net Income..................................................................... $ 2.07 --------- ---------
- - --------- * This calculation is submitted in accordance with Securities Act of 1934 Release No. 9083 although not required by footnote 2 to paragraph 14 of APB Opinion No. 15 because it results in dilution of less than 3%. EX-12 4 EXHIBIT 12 EXHIBIT 12 TELEPHONE AND DATA SYSTEMS, INC. RATIOS OF EARNINGS TO FIXED CHARGES FOR THE YEAR ENDED DECEMBER 31, 1996 (DOLLARS IN THOUSANDS, EXCEPT RATIO AMOUNTS) EARNINGS: Income from Continuing Operations before Income Taxes.......................... $ 251,785 Add (Deduct): Minority Share of Losses................................................... (11,579) Earnings on Equity Method.................................................. (54,025) Distributions from Minority Subsidiaries................................... 25,453 Amortization of Non-Telephone Capitalized Interest......................... 4 Minority share of income in majority-owned subsidiaries that have fixed charges................................................................... 26,912 --------- 238,550 Add fixed charges: Consolidated interest expense.............................................. 42,294 Interest Portion (1/3) of Consolidated Rent Expense........................ 8,901 Amortization of debt expense and discount on indebtedness.................. 559 --------- $ 290,304 --------- --------- FIXED CHARGES: Consolidated interest expense.................................................. $ 42,294 Capitalized interest........................................................... 27,623 Interest Portion (1/3) of Consolidated Rent Expense............................ 8,901 Amortization of debt expense and discount on indebtedness...................... 559 --------- $ 79,377 --------- --------- RATIO OF EARNINGS TO FIXED CHARGES............................................... 3.66 --------- --------- Tax-Effected Redeemable Preferred Dividends.................................... $ 1,016 Fixed Charges.................................................................. 79,377 --------- Fixed Charges and Redeemable Preferred Dividends............................. $ 80,393 --------- --------- RATIO OF EARNINGS TO FIXED CHARGES AND REDEEMABLE PREFERRED DIVIDENDS............ 3.61 --------- --------- Tax-Effected Preferred Dividends............................................... $ 3,558 Fixed Charges.................................................................. 79,377 --------- Fixed Charges and Preferred Dividends........................................ $ 82,935 --------- --------- RATIO OF EARNINGS TO FIXED CHARGES AND PREFERRED DIVIDENDS....................... 3.50 --------- ---------
EX-13 5 EXHIBIT 13 EXHIBIT 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Telephone and Data Systems, Inc. ("TDS" or the "Company") provides high-quality telecommunications services to over 2.3 million cellular telephone, telephone and radio paging customer units in 37 states and the District of Columbia. The accompanying financial statements present the results of operations of the Company's three primary businesses: United States Cellular Corporation ("U.S. Cellular"), an 80.6%-owned subsidiary, TDS Telecommunications Corporation ("TDS Telecom"), a wholly owned subsidiary, and American Paging, Inc. ("American Paging"), an 82.3%-owned subsidiary, as well as its developing personal communications services ("PCS") business, Aerial Communications, Inc. ("Aerial", formerly American Portable Telecom, Inc.), an 82.8%-owned subsidiary. TDS's long-term business development strategy is to expand its operations through internal growth and acquisitions, and to explore and develop telecommunications businesses that management believes utilize TDS's expertise in customer-based telecommunications. 1996 MAJOR ACCOMPLISHMENTS The Company made substantial progress during 1996 with excellent growth in the cellular business and the rapid build out of the PCS business. The telephone business continues to produce steady returns and strong cash flow, while the paging business posted disappointing results. U.S. Cellular continued its rapid growth during 1996. Customer units increased 51%, exceeding the 1,000,000 mark, following a 69% increase in 1995. The increase in customer units drove a 44% increase in revenues, a 48% increase in cash flow and a 104% increase in operating income. The sale of non-strategic cellular interests generated gains of $132.7 million and cash proceeds of $213.0 million. Capital expenditures to add cell sites, expand coverage and add capacity totaled $219.4 million and expenditures for acquisitions totaled $56.1 million. Aerial made substantial progress building its business this year. The focus for 1996 was directed toward recruiting an experienced management team, developing and executing a business plan, raising capital, and designing and constructing networks in each of its markets. These activities significantly increased expenses in 1996. PCS development expenses (included in "Investment and Other Income (Expense)") increased to $43.9 million in 1996 from $7.8 million in 1995. Aerial had no revenues in 1996 as commercial service is not expected to begin until March 1997. Aerial's investment in property and equipment, including network design and equipment, site acquisition and information system development costs, totaled $312.6 million in 1996. To finance the development of its business, Aerial completed an initial public offering in 1996 raising $195.3 million. Aerial also negotiated a $200 million vendor financing arrangement for digital radio channel and switching infrastructure equipment. TDS Telecom continues to provide steady growth in revenues and cash flow. Telephone access lines increased 14% resulting in a 13% increase in operating revenues, a 10% increase in cash flow and a 5% increase in operating income. TDS Telecom's investment in outside plant facilities and upgrades of recently acquired companies for new customer growth and new digital switches totaled $144.4 million, and expenditures for acquisitions totaled $88.1 million. American Paging posted disappointing results for the year. During the third quarter of 1995, American Paging launched a comprehensive restructuring initiative relative to its sales and customer service organization. The objectives of the restructuring were to increase sales through the direct distribution channel, improve customer mix, lower administrative costs and improve customer service. The disruptions caused by the restructuring were more severe than anticipated. Customer service and sales support was affected due to the elimination of field service employees and problems with the customer management and billing system. Sales and marketing activities, hurt by a high level of employee turnover, produced no customer growth resulting in a 3% decline in revenue. The decline in revenues combined with a 21% increase in operating expenses caused operating losses to jump to $36.6 million in 1996 from $9.0 million in 1995. -36- To address these problems, American Paging appointed a new senior management team, including a new President and CEO. The senior management team is in the process of implementing a plan in 1997 centering on building a high quality, focused sales and marketing organization, creating new, goal-oriented distribution channel and pricing strategies, consolidating current systems to reduce the cost of service and continually improving customer care practices. RESULTS OF OPERATIONS Telephone and Data Systems, Inc. reported net income available to common of $126.3 million, or $2.08 per share, in 1996 compared to $102.0 million, or $1.74 per share, in 1995 and $58.0 million, or $1.06 per share, in 1994. Results of operations primarily reflects significant cellular business unit growth and steady telephone operations growth. Results of operations were negatively impacted by Aerial's development costs as it proceeds to develop and construct its PCS networks, as well as the losses incurred by American Paging. Gains on sales of non-strategic cellular interests and other investments had a significant impact on net income in 1996 and 1995. Excluding PCS development costs and gains on the sales of cellular interests and other investments, along with the related income taxes and minority interest, net income available to common would have been $77.1 million or $1.27 per share, in 1996 compared to $68.1 million or $1.16 per share, in 1995 and $53.2 million or $.98 per share in 1994. OPERATING REVENUES increased 27% ($260.3 million) during 1996 and 31% ($223.6 million) during 1995 primarily as a result of growth in the cellular telephone operations. Cellular telephone revenues increased $215.4 million in 1996 and $160.0 million in 1995 on 51% and 69% increases in customer units, respectively, and strong increases in inbound roaming revenues. Telephone revenues increased $47.8 million in 1996 and $48.5 million in 1995 as a result of acquisitions, increased network usage, recovery of increased costs of providing long-distance services and internal access line growth. Radio paging revenues decreased $3.0 million in 1996 and increased $15.1 million in 1995. Cellular made up 58% of consolidated revenue in 1996, up from 45% in 1994. Telephone and paging operations were 33% and 9% of consolidated revenue in 1996 and 42% and 13% in 1994, respectively. OPERATING EXPENSES rose 29% ($238.2 million) in 1996 and 32% ($200.4 million) in 1995. Cellular telephone operating expenses increased $170.8 million during 1996 and $134.6 million during 1995 due to the effects of additional marketing and selling expenses to add new customers as well as the costs of providing services to the larger customer base. Telephone operating expenses increased $42.7 million during 1996 and $41.9 million during 1995 due to the effects of acquisitions and growth in internal operations. Paging operating expenses increased $24.7 million in 1996 and $23.9 million in 1995 due to additional expenses to restructure certain business processes and additional costs to serve current customers and to add new customers. -37- OPERATING INCOME increased 17% ($22.1 million) in 1996 and 21% ($23.2 million) in 1995. Cellular telephone operating income increased 104% ($44.6 million) in 1996 and 146% ($25.4 million) in 1995 reflecting the increase in customers and revenues. Telephone operating income increased $5.1 million in 1996 and $6.6 million in 1995. Paging operating loss increased $27.6 million in 1996 and $8.8 million in 1995.
YEAR ENDED DECEMBER 31, ---------------------------------------------- 1996 1995 1994 -------------- -------------- -------------- (DOLLARS IN THOUSANDS) Operating Income Cellular telephone.......................................... $ 87,366 $ 42,755 $ 17,385 Telephone................................................... 103,358 98,240 91,606 Radio paging................................................ (36,626) (8,997) (169) -------------- -------------- -------------- $ 154,098 $ 131,998 $ 108,822 -------------- -------------- -------------- -------------- -------------- -------------- Operating Margins Cellular telephone.......................................... 12.3% 8.7% 5.2% Telephone................................................... 25.7% 27.7% 29.9% Radio paging................................................ (35.2)% (8.4)% (.2)% Consolidated................................................ 12.7% 13.8% 14.9% -------------- -------------- -------------- -------------- -------------- --------------
In early 1997, Aerial expects to begin commercial service which will result in Aerial's revenues and expenses being included in operating income. Operating income is expected to decrease significantly in 1997 as a result of the commencement of PCS operations. INVESTMENT AND OTHER INCOME totaled $140.5 million in 1996, $103.9 million in 1995 and $33.7 million in 1994. CELLULAR INVESTMENT INCOME, the Company's share of income of cellular markets in which the Company has a minority interest and follows the equity method of accounting, increased 33% ($13.5 million) in 1996 and 56% ($14.6 million) in 1995 as income from the cellular markets increased. Cellular investment income is net of amortization of license costs relating to these minority interests. GAIN ON SALE OF CELLULAR INTERESTS AND OTHER INVESTMENTS totaled $138.7 million in 1996, $86.6 million in 1995 and $7.5 million in 1994. TDS and U.S. Cellular continue to assess the makeup of cellular holdings in order to maximize the benefits derived from clustering markets. Certain markets, identified as non-strategic, were sold or traded in the past few years resulting in the recognition of gains. PCS DEVELOPMENT COSTS totaled $43.9 million in 1996 and $7.8 million in 1995. Aerial has been devoting substantially all of its efforts to recruiting an experienced management team, developing and executing a business plan, raising capital, and designing and constructing its PCS networks. Costs incurred in the development and administration of Aerial which do not relate to the design or construction of specific identifiable assets have been expensed. MINORITY SHARE OF INCOME, the minority shareholders' share of U.S. Cellular's, American Paging's and Aerial's net income or loss and other minority shareholders' and partners' share of subsidiaries' net income or loss, increased $800,000 in 1996 and $16.8 million in 1995. INTEREST EXPENSE decreased 16% ($8.0 million) in 1996 and increased 23% ($9.6 million) in 1995. Capitalized interest associated with expenditures for PCS licenses and capitalized construction costs increased $14.4 million in 1996 and $13.2 million in 1995. Interest expense increased $6.9 million in 1996 and $7.4 million in 1995 as a result of U.S. Cellular's convertible debt offering in June of 1995. Interest expense from U.S. Cellular's vendor financing agreement increased $5.3 million in 1995. TDS Telecom interest expense increased $1.2 million in 1996 and $1.4 million in 1995 due primarily to additional interest expense of acquired telephone companies. Corporate interest expense decreased $2.0 million in 1996 and increased $8.6 million in 1995 reflecting primarily changes in average short-term debt balances. See "Financial Resources and Liquidity" for a further discussion of short- and long-term debt. -38- TDS capitalized $27.6 million of interest expense in 1996 and $13.2 million in 1995. Interest expense will increase significantly in 1997 when TDS discontinues capitalizing interest upon commencement of Aerial's operations. INCOME TAX EXPENSE increased 53% ($42.6 million) in 1996 and 99% ($40.3 million) in 1995, reflecting primarily the 36% and 83% increases in pretax income, respectively. The effective income tax rates were 49% in 1996, 44% in 1995 and 40% in 1994. The increase in the 1996 effective tax rate reflects additional income tax expense of approximately $10.0 million due to tax gains in excess of book gains associated with the sale of certain cellular interests. The lower 1994 rate reflects deferred income taxes provided on the book/tax basis difference related to certain telephone acquisitions and certain income excluded due to the dividend exclusion rules. NET INCOME AVAILABLE TO COMMON was $126.3 million in 1996, $102.0 million in 1995 and $58.0 million in 1994. EARNINGS PER COMMON SHARE were $2.08 in 1996, $1.74 in 1995 and $1.06 in 1994. Net income available to common for 1996 and 1995 included significant gains from the sale of cellular interest and other investments as well as significant PCS development costs. The table below summarizes the effects of the gains and PCS development costs (along with the related impact on income taxes and minority interest) on net income available to common and earnings per share.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS) NET INCOME AVAILABLE TO COMMON Core Business................................................................. $ 77.1 $ 68.1 $ 53.2 Gains......................................................................... 64.5 40.6 5.8 PCS Development Costs......................................................... (15.3) (6.7) (1.0) --------- --------- --------- $ 126.3 $ 102.0 $ 58.0 --------- --------- --------- --------- --------- --------- EARNINGS PER SHARE Core Business................................................................. $ 1.27 $ 1.16 $ .98 Gains......................................................................... 1.06 .69 .10 PCS Development Costs......................................................... (.25) (.11) (.02) --------- --------- --------- $ 2.08 $ 1.74 $ 1.06 --------- --------- --------- --------- --------- ---------
TDS anticipates that start-up and development of high-quality networks and the marketing of systems in Aerial's markets will reduce the rate of growth in TDS's operating and net income from levels which would otherwise be achieved during the next few years. -39- CELLULAR TELEPHONE OPERATIONS TDS provides cellular telephone service through U.S. Cellular Corporation [AMEX: USM]. Results of operations include 1,073,000 customer units at the end of 1996 compared to 710,000 customer units at the end of 1995 and 421,000 customer units at the end of 1994.
YEAR ENDED OR AT DECEMBER 31, -------------------------------------------- 1996 1995 1994 -------------- ------------- ------------- (DOLLARS IN THOUSANDS, EXCEPT PER CUSTOMER AMOUNTS) Operating Revenues Local retail.................................................. $ 442,568 $ 289,518 $ 187,978 Inbound roaming............................................... 193,278 148,020 104,009 Long-distance and other....................................... 71,974 54,857 40,417 -------------- ------------- ------------- 707,820 492,395 332,404 -------------- ------------- ------------- Operating Expenses System operations............................................. 117,368 70,442 46,869 Marketing and selling......................................... 150,000 102,361 69,072 Cost of equipment sold........................................ 74,023 54,948 39,431 General and administrative.................................... 170,224 132,431 94,193 Depreciation.................................................. 74,631 57,302 39,520 Amortization.................................................. 34,208 32,156 25,934 -------------- ------------- ------------- 620,454 449,640 315,019 -------------- ------------- ------------- Operating Income................................................ $ 87,366 $ 42,755 $ 17,385 -------------- ------------- ------------- -------------- ------------- ------------- Consolidated Markets: Customers..................................................... 1,073,000 710,000 421,000 Markets....................................................... 131 137 130 Market penetration............................................ 4.94% 3.18% 1.98% Cell sites in service......................................... 1,328 1,116 790 Average monthly service revenue per customer.................. $ 66.36 $ 72.48 $ 79.74 Churn rate per month.......................................... 1.9% 2.1% 2.3% Marketing cost per gross customer addition.................... $ 367 $ 361 $ 408 -------------- ------------- ------------- -------------- ------------- -------------
OPERATING REVENUES increased 44% ($215.4 million) in 1996 and 48% ($160.0 million) in 1995. The revenue increases in 1996 and 1995 were driven by the 51% and 69% growth in customer units and the 31% and 42% growth in inbound roaming revenues, respectively. Acquisitions, which were not material in 1996, increased operating revenues 13% ($44.2 million) in 1995. Average monthly revenue per customer was $66.36 in 1996, $72.48 in 1995 and $79.74 in 1994. LOCAL RETAIL REVENUE (charges to U.S. Cellular's customers for local system usage) increased 53% ($153.0 million) in 1996 and 54% ($101.5 million) in 1995 due primarily to the 51% and 69% growth in customers, respectively. Local minutes of use averaged 107 per month in 1996 and 95 per month in 1995 and 1994. Average revenue per minute was $.40 in 1996, $.46 in 1995 and $.50 in 1994. U.S. Cellular's use of incentive programs in 1996 and 1995 that encourage lower-priced weekend and off-peak usage, in order to stimulate overall usage, resulted in an increase in average minutes of use and a lower average revenue per minute of use. Average monthly local retail revenue per customer was $42.54 in 1996, $44.03 in 1995 and $47.04 in 1994. -40- INBOUND ROAMING REVENUE (charges to customers of other systems who use U.S. Cellular's cellular systems when roaming) increased 31% ($45.3 million) in 1996 and 42% ($44.0 million) in 1995 due to increased minutes of use. Minutes of use increased 38% in 1996 and 60% in 1995. Average revenue per minute of use was $.94 in 1996, $.99 in 1995 and $1.11 in 1994. Average monthly inbound roaming revenue per U.S. Cellular customer was $18.58, $22.51 and $26.03 in 1996, 1995 and 1994, respectively. The decrease is the result of roaming revenue growing at a slower rate than U.S. Cellular's customer base and negotiated reductions in roaming rates. LONG-DISTANCE AND OTHER REVENUE, including equipment sales, increased 31% ($17.1 million) in 1996 and 36% ($14.4 million) in 1995 primarily due to increased long-distance revenue from the growth in the volume of long-distance calls billed by U.S. Cellular. The industry trend of declining average monthly retail revenue per customer is believed to be related to the tendency of early customers in a market to be the heaviest users during peak business hours. Newer customers have been added through continued penetration of the consumer market, which tends to include fewer peak business hour usage customers. Management anticipates that average monthly revenue per customer will continue to decrease as local retail revenue per minute of use declines due to the usage patterns of incrementally added customers and as the growth rate of the Company's customer base exceeds the growth rate of inbound roaming revenue, diluting the roaming contribution per customer. OPERATING EXPENSES increased 38% ($170.8 million) in 1996 and 43% ($134.6 million) in 1995. Acquisitions, which were not material in 1996, increased operating expenses 13% ($40.7 million) in 1995. The increase in operating expenses, excluding acquisition effects, is primarily due to the costs to expand the customer base ($66.7 million in 1996 and $33.6 million in 1995); cost of providing service to the expanding customer base ($46.9 million in 1996 and $16.0 million in 1995); increased administrative expenses ($37.8 million in 1996 and $27.1 million in 1995) additional depreciation on the increased investment in cell sites and equipment ($17.3 million in 1996 and $13.2 million in 1995) and additional fraud charges ($13.9 million in 1996). SYSTEM OPERATIONS EXPENSES increased 67% ($46.9 million) in 1996 and 50% ($23.6 million) in 1995 (34%, or $16.0 million excluding acquisitions) as a result of increases in customer usage expenses, including significant increases in fraud, and costs associated with operating the increased number of cell sites. Customer usage expenses (charges from other service providers for land line connection, toll and roaming costs incurred by customers' use of systems other than their local systems) grew 86% ($26.6 million) in 1996 and 62% ($13.4 million) in 1995. The increase was due primarily to inbound roaming usage. Fraudulent use of U.S. Cellular's customers' telephone numbers increased expenses $13.9 million to $18.0 million in 1996. U.S. Cellular continues to implement procedures in its markets to combat this fraud, which is primarily related to roaming usage. Maintenance, utility and cell site expenses grew 18% ($6.5 million) in 1996 and 40% ($10.2 million) in 1995 reflecting the 19% and 41% increase in the number of cell sites, respectively. The number of cell sites operated increased to 1,328 in 1996 from 1,116 in 1995 and 790 in 1994. MARKETING AND SELLING EXPENSES increased 47% ($47.6 million) in 1996 and 48% ($33.3 million) in 1995 (35%, or $24.3 million excluding acquisitions) due to the increase in customer activations. COST OF EQUIPMENT SOLD increased 35% ($19.1 million) in 1996 and 39% ($15.5 million) in 1995 (23%, or $9.3 million excluding acquisitions). Cost per gross customer addition (marketing and selling expenses and cost of equipment sold less equipment revenues, divided by gross customer additions) totaled $367 in 1996, $361 in 1995 and $408 in 1994. GENERAL AND ADMINISTRATIVE EXPENSES increased 29% ($37.8 million) in 1996 and 41% ($38.2 million) in 1995 (29%, or $27.1 million excluding acquisitions). The increases include the effects of an increase in expenses required to serve the growing customer base and an expansion of both local administrative office and corporate staff, resulting from growth in U.S. Cellular's business. -41- Operating cash flow increased 48% to $196.2 million in 1996 compared to a 60% increase to $132.2 million in 1995. The improvement was primarily due to the growth in customers and revenue. U.S. Cellular continues to provide increasing operating cash flow to support its operating and construction activities. DEPRECIATION EXPENSE increased 30% ($17.3 million) in 1996 and 45% ($17.8 million) in 1995 (33%, or $13.2 million excluding acquisitions), reflecting increases in average fixed asset balances of 34% and 48%, respectively. AMORTIZATION EXPENSE increased 6% ($2.1 million) in 1996 and 24% ($6.2 million) in 1995 (15%, or $4.0 million excluding acquisitions) due to increases in deferred systems development costs in both years and license costs in 1995. OPERATING INCOME was $87.4 million in 1996 compared to $42.8 million in 1995 and $17.4 million in 1994. Operating margins improved to 12.3% in 1996 from 8.7% in 1995 and 5.2% in 1994. The improvement was primarily due to the substantial growth in customers and revenue. Management believes there exists a seasonality at U.S. Cellular in both service revenues, which tend to increase more slowly in the first and fourth quarters, and operating expenses, which tend to be higher in the fourth quarter due to increased marketing activities and customer growth. This seasonality may cause operating income to vary from quarter to quarter. Competitors licensed to provide PCS services have initiated service in certain U.S. Cellular markets in recent months. U.S. Cellular anticipates that PCS operators will initiate service in several other of its markets in 1997 and 1998. U.S. Cellular's management is monitoring these and other PCS providers' strategies, but cannot at this time anticipate what effect, if any, this additional competition will have on U.S. Cellular's future strategies and results. TELEPHONE OPERATIONS TDS manages its telephone service through TDS Telecommunications Corporation ("TDS Telecom"). TDS Telecom served 484,500 access lines at the end of 1996 compared to 425,900 access lines at the end of 1995 and 392,500 access lines at the end of 1994 ("telephone operations"). TDS Telecom also manages a long-distance provider, an Internet access provider and certain other non-telephone operations ("other operations"). OPERATING REVENUE totaled $402.6 million in 1996, up 13% ($47.8 million) from 1995 and totaled $354.8 million in 1995, up 16% ($48.5 million) from 1994. The increases were due to the growth in telephone operations ($39.6 million in 1996 and $35.6 million in 1995) and additional other operations revenues ($8.0 million in 1996 and $13.3 million in 1995). OPERATING EXPENSES totaled $299.3 million in 1996, up 17% ($42.7 million) from 1995 and totaled $256.6 million in 1995, up 19% ($41.9 million) from 1994. The increases were due to the growth in telephone operations ($33.6 million in 1996 and $29.8 million in 1995) and additional other operations expenses ($8.9 million in 1996 and $12.3 million in 1995). Operating cash flow increased 10% to $192.3 million in 1996 compared to an increase of 9% to $175.6 million in 1995 due primarily to the growth in telephone operations. TDS Telecom continues to provide steadily growing operating cash flow to support its construction activities. OPERATING INCOME increased 5% ($5.1 million) in 1996 and increased 7% ($6.6 million) in 1995. The reduction in the growth rate of operating income was caused by the the reduction in the telephone operating margins and other operations margins. -42- Management expects TDS Telecom's revenues, operating income and operating cash flow to increase modestly in 1997 from steady growth in operations. TDS Telecom will continue to see pressures on revenue sources resulting from regulatory changes and competitive pressures.
YEAR ENDED OR AT DECEMBER 31, ------------------------------------- 1996 1995 1994 ----------- ----------- ----------- (DOLLARS IN THOUSANDS, EXCEPT PER CUSTOMER AMOUNTS) Telephone Operations Operating Revenue.................................................... $ 371,913 $ 332,287 $ 296,722 ----------- ----------- ----------- Operating Expenses Network operations................................................. 67,521 54,964 45,412 Depreciation and amortization...................................... 85,575 74,758 67,956 Customer operations................................................ 53,764 46,818 42,617 Corporate and other................................................ 62,276 58,998 49,706 ----------- ----------- ----------- 269,136 235,538 205,691 ----------- ----------- ----------- Telephone Operating Income......................................... 102,777 96,749 91,031 ----------- ----------- ----------- Other Operations Revenues............................................................. 31,774 23,764 10,499 Expenses............................................................. 31,193 22,273 9,924 ----------- ----------- ----------- Other Operations Operating Income..................................................... 581 1,491 575 ----------- ----------- ----------- Intercompany Eliminations Revenues............................................................. (1,058) (1,210) (880) Expenses............................................................. (1,058) (1,210) (880) ----------- ----------- ----------- Operating Income....................................................... $ 103,358 $ 98,240 $ 91,606 ----------- ----------- ----------- ----------- ----------- ----------- Companies.............................................................. 105 100 96 Access lines........................................................... 484,500 425,900 392,500 Growth in access lines from prior year-end: Acquisitions......................................................... 33,100 13,500 19,700 Internal growth...................................................... 25,500 19,900 16,600 Telephone plant in service per access line............................. $ 2,461 $ 2,356 $ 2,283 Average monthly revenue per access line................................ $ 67.12 $ 66.87 $ 66.66 ----------- ----------- ----------- ----------- ----------- -----------
OPERATING REVENUE from telephone operations increased 12% ($39.6 million) in 1996 and 12% ($35.6 million) in 1995. Acquisitions increased telephone revenues $18.8 million in 1996 and $16.8 million in 1995. Internal growth and increases in the sales of custom calling features increased revenue by $8.0 million in 1996 and $6.0 million in 1995. Increased network usage resulted in revenue increases of $4.5 million in 1996 and $5.8 million in 1995. Recovery of increased costs of providing long-distance services resulted in increases in revenue of $8.1 million in 1996 and $4.5 million in 1995. Average monthly revenue per access line was $67.12 in 1996, $66.87 in 1995 and $66.66 in 1994. OPERATING EXPENSES from telephone operations increased 14% ($33.6 million) in 1996 and 15% ($29.8 million) in 1995. The effects of acquisitions increased expenses 6% ($14.6 million) in 1996 and 7% ($13.8 million) in 1995. Depreciation and amortization expenses increased 14% ($10.8 million) in 1996 and 10% ($6.8 million) in 1995 due primarily to increased investment in plant and equipment. The development of a centralized network management center to provide more effective network monitoring and maintenance and the development of groups to explore new service offerings caused expenses to increase by $3.4 million and $3.2 million, respectively, in 1996. These expenditures are expected to begin producing cost efficiencies and new revenues in the next several quarters and beyond. Additional routine maintenance activity and equipment write-offs increased network expenses by $2.0 million in 1995. The remaining increase in each year was due primarily to growth in internal operations. -43- OPERATING INCOME from telephone operations increased 6% ($6.0 million) in 1996 and increased 6% ($5.7 million) in 1995. The effects of acquisitions increased operating income 4% ($4.2 million) in 1996 and 3% ($3.0 million) in 1995. The telephone operating margin was 27.6% in 1996, 29.1% in 1995 and 30.7% in 1994. The reduction in operating margin was caused by earnings pressures from regulatory agencies and long-distance providers and increased costs associated with the development of the centralized network management center. TDS Telecom is subject to the provisions of Statement of Financial Accounting Standards ("SFAS") No. 71, "Accounting for the Effects of Certain Types of Regulation." The Company periodically reviews the criteria for applying these provisions to determine whether continuing application of SFAS No. 71 is appropriate. The Company believes that such criteria are still being met and therefore has no current plans to change its method of accounting. In analyzing the effects of discontinuing the application of SFAS No. 71, management has determined that the useful lives of plant assets used for regulatory and financial reporting purposes are consistent with generally accepted accounting principles and therefore any adjustments to accumulated depreciation would be immaterial, as would be the write-off of regulatory assets and liabilities. RADIO PAGING OPERATIONS TDS manages its radio paging business through American Paging, Inc. [AMEX: APP]. American Paging provided wireless messaging communications through its digital radio transmission systems to 777,400 subscribers at the end of 1996 compared to 784,500 subscribers at the end of 1995 and 652,800 subscribers at the end of 1994. American Paging posted disappointing results for the year. During the third quarter of 1995, American Paging launched a comprehensive restructuring initiative relative to its sales and customer service organization. The objectives of the restructuring were to increase sales through the direct distribution channel, improve customer mix, lower administrative costs and improve customer service. The restructuring initiative continued through 1996, and had a more severe impact on American Paging's results of operations than anticipated. An integral part of the restructuring plan included the creation of a Customer Telecare Center ("CTC"). The consolidation and transfer of back office and customer service operations from 17 offices to the CTC created many disruptions throughout American Paging. The process of eliminating field administrative personnel and moving their duties to the CTC hurt customer service and sales support due to early inefficiencies encountered in the operation of the CTC. During the consolidation, it also became apparent that the customer management and information system did not provide the flexibility needed to support future customer growth and retention. American Paging is currently assessing two potential customer management and billing systems. Disruptions within the sales and marketing department led to an increase in sales employee turnover which produced no customer growth and contributed to a 3% decline in revenue. The decline in revenues combined with a 21% increase in expenses caused operating losses to jump to $36.6 million in 1996 from $9.0 million in 1995. To address these problems, American Paging appointed a new senior management team, including a new President and CEO. The senior management team began implementing a plan in 1997 centering on building a high quality, focused sales and marketing organization, creating new, goal-oriented distribution channel and pricing strategies, consolidating current systems to reduce the cost of service and continually improving customer care practices. -44-
YEAR ENDED OR AT DECEMBER 31, ------------------------------------------- 1996 1995 1994 ------------- ------------- ------------- (DOLLARS IN THOUSANDS, EXCEPT PER UNIT AMOUNTS) Operating Revenue............................................... $ 104,187 $ 107,150 $ 92,065 ------------- ------------- ------------- Costs and Expenses Cost of services.............................................. 30,092 24,062 19,347 Selling, general and administrative........................... 67,060 53,296 41,196 Cost of goods sold............................................ 9,884 14,097 14,513 Depreciation and amortization................................. 33,777 24,692 17,178 ------------- ------------- ------------- 140,813 116,147 92,234 ------------- ------------- ------------- Operating (Loss)................................................ $ (36,626) $ (8,997) $ (169) ------------- ------------- ------------- ------------- ------------- ------------- Pagers in service............................................... 777,400 784,500 652,800 Average monthly revenue per unit................................ $ 9.88 $ 10.57 $ 11.92 Transmitters in service......................................... 1,048 1,018 943 Churn rate per month............................................ 3.1% 2.5% 2.6% Marketing cost per gross customer unit addition................. $ 94 $ 50 $ 41 ------------- ------------- ------------- ------------- ------------- -------------
OPERATING REVENUES decreased 3% ($3.0 million) in 1996 primarily as a result of a 27% ($3.8 million) decline in equipment sales. Operating revenues increased 16% ($15.1 million) in 1995, primarily as a result of a 20% increase in the number of pagers in service. Average monthly revenue per unit declined 7% to $9.88 in 1996 and 11% to $10.57 in 1995. The decline in average revenue per unit reflects competitive pressures in 1996 and 1995 as well as a shift to lower revenue producing reseller channels in 1995. As a part of the restructuring efforts, American Paging is refocusing its marketing strategy to the higher revenue producing direct distribution channel. OPERATING EXPENSES increased 21% ($24.7 million) in 1996 and 26% ($23.9 million) in 1995. Restructuring costs totaled $9.3 million in 1996 and $2.9 million in 1995. Duplicate staffing, employee severance and legal and consulting fees, included in selling, general and administrative expense, totaled $4.0 million in 1996 and $2.1 million in 1995. Write-offs of $5.3 million for obsolete inventory, software and other assets, included in depreciation and amortization expense, were recorded in 1996. During 1995, an $800,000 write-off of assets retired was incurred as a result of the restructuring. Operating expenses, excluding restructuring costs, increased 16% ($18.2 million) in 1996 and 23% ($21.0 million) in 1995. Costs of serving the customer base and maintaining systems to provide system reliability and coverage increased 25% ($6.0 million) in 1996 and 24% ($4.7 million) in 1995. Selling, general and administrative expense increased 23% ($11.8 million) in 1996 and 24% ($10.0 million) in 1995. The cost per gross customer addition, excluding customers added through acquisitions, was $94 in 1996 compared to $50 in 1995 and $41 in 1994. The large increase was due to the slow unit growth caused by high employee turnover in the sales function coupled with the increase in sales and marketing costs. Depreciation and amortization charges increased 19% ($4.6 million) in 1996 and 39% ($6.7 million) in 1995, reflecting increased investment in pagers and related equipment. A change in useful lives of pagers and transmitters adopted in 1994 increased depreciation expense by approximately $1.7 million in 1995. OPERATING LOSS was $36.6 million in 1996, $9.0 million in 1995 and $200,000 in 1994. Management expects American Paging to have modest success in attracting and retaining new customers and holding down operating expenses. However, management anticipates that American Paging will incur significant operating losses again in 1997. BROADBAND PERSONAL COMMUNICATIONS SERVICES TDS manages its broadband personal communications services business through Aerial Communications, Inc. [NASDAQ: AERL], formerly American Portable Telecom, Inc. Aerial's licenses include the Major Trading Areas ("MTAs") of Minneapolis, Tampa-St. Petersburg-Orlando, Houston, Pittsburgh, Kansas City and Columbus with 27.6 million population equivalents. Aerial's focus in 1996 has been the development of its PCS business in its MTAs. This focus will continue until the expected launch of commercial service in early 1997. As of December 31, 1996, a total of 150 -45- microwave paths have been cleared, with an additional 39 paths having agreements with incumbents to be cleared. Management believes that sufficient paths have been cleared to allow service launch in all six markets. Over 600 cell sites have been secured as zoning and installation work continues. The National Operations Center in Tampa is complete. Friendly user (customer) trials are planned to conclude in the first quarter of 1997, with roll-out of commercial service after successful customer trials. Upon commencement of commercial operations, Aerial's revenues and expenses will be included in operating income. Management expects to incur significant expenditures for the continued development of PCS activities and start-up operating losses during 1997. To finance the development of its business, Aerial completed an initial public offering in 1996 raising $195.3 million. Aerial also negotiated a $200 million vendor financing arrangement for digital radio channel and switching infrastructure equipment. As part of the vendor financing arrangement, Aerial issued 10-year 8.34% Series A Zero Coupon Notes due in 2006 for $100 million of digital radio channel and switching equipment. INFLATION Management believes that inflation affects TDS's business to no greater extent than the general economy. FINANCIAL RESOURCES TDS and its subsidiaries operate relatively capital-intensive businesses. Rapid growth has caused expenditures for construction, expansion and acquisitio programs to exceed internally generated cash flow. Accordingly, TDS has obtained substantial funds from external sources to finance construction of cellular telephone systems, to acquire PCS licenses, to build-out PCS markets and to fund acquisitions. Although the steady internal cash flow from TDS Telecom and increasing internal cash flow from U.S. Cellular have reduced the need for external financing, Aerial's development and construction activities will require substantial additional funds from external sources. CASH FLOWS FROM OPERATING ACTIVITIES. TDS is generating substantial internal funds from the rapid growth in customer units and revenues. Operating cash flow (operating income plus depreciation and amortization) increased 19% ($62.2 million) to $385.7 million in 1996, and 24% ($63.2 million) to $323.5 million in 1995. The increases represent primarily cellular telephone operations increases of 48% ($64.0 million) in 1996 and 60% ($49.4 million) in 1995. Cash flows from other operating activities (investment and other income, interest and income tax expense, and changes in working capital and other assets and liabilities) required $90.7 million in 1996, $112.6 million in 1995, and $35.6 million in 1994.
YEAR ENDED DECEMBER 31, -------------------------------------- 1996 1995 1994 ----------- ------------ ----------- (DOLLARS IN THOUSANDS) Operating cash flow Cellular telephone.................................................. $ 196,205 $ 132,213 $ 82,839 Telephone........................................................... 192,325 175,594 160,484 Radio paging........................................................ (2,849) 15,695 17,009 ----------- ------------ ----------- 385,681 323,502 260,332 Other operating activities............................................ (90,687) (112,626) (35,646) ----------- ------------ ----------- Cash flows from operating activiites.................................. $ 294,994 $ 210,876 $ 224,686 ----------- ------------ ----------- ----------- ------------ -----------
CASH FLOWS FROM FINANCING ACTIVITIES. TDS' long-term strategy is to provide a strong yet flexible financial foundation for each of its principal subsidiaries. Consolidated equity capital (common equity, preferred stock and minority interest) was 68% of total capitalization at December 31, 1996, compared to 73% at December 31, 1994. The change is primarily a result of significant increases in long-term debt at U.S. Cellular and Aerial as well as increases in TDS short-term debt. TDS targets a ratio of equity to total capital in the range of 55% to 65%. -46- TDS has used short-term debt to finance its PCS, cellular telephone and radio paging operations, for acquisitions and for general corporate purposes. TDS takes advantage of attractive opportunities to retire short-term debt with the proceeds from long-term debt, equity sales and sales of non-strategic assets. In 1996, Aerial received $195.3 million in an initial public offering of Common Shares. In 1995, U.S. Cellular received approximately $221.5 million from the sale of 20-year 6% zero coupon convertible debt and TDS sold $39.2 million of Medium-Term Notes. In 1994, American Paging received $45.6 million in an initial public offering of its Common Shares and TDS sold Common Shares for cash totaling $4.9 million. Aerial, U.S. Cellular and TDS Telecom have also used long-term debt to finance their construction and development activities. In 1996, Aerial issued 10-year 8.34% zero coupon notes for $100 million of digital radio channel and switching equipment. U.S. Cellular financed cellular system equipment and construction costs totaling $59.5 million in 1995 and $18.0 million in 1994 under vendor financing arrangements. TDS Telecom telephone subsidiaries borrowed $12.2 million in 1996, $12.0 million in 1995 and $16.8 million in 1994 under the Rural Utility Service and the Rural Telephone Bank long-term federal government loan programs to finance their telephone construction programs. CASH FLOWS FROM INVESTING ACTIVITIES. TDS makes substantial investments each year to acquire, construct, operate and maintain modern high-quality communications networks and facilities with the intention of exceeding its customers expectations as a basis for creating long-term value for shareowners. In recent years, rapid changes in technology and new opportunities have required substantial investments in revenue enhancing and cost reducing upgrades of the Company's networks. Cash expenditures for property, plant and equipment additions totaled $550.2 million in 1996, $360.0 million in 1995 and $319.7 million in 1994. In addition, the acquisition and development of broadband and narrowband PCS licenses required $26.5 million in 1996, $326.0 million in 1995 and $31.6 million in 1994. Cash used for acquisitions, excluding cash acquired, totaled $31.0 million in 1996, $53.8 million in 1995 and $37.6 million in 1994. The sale of non-strategic cellular assets and other investments provided $221.5 million in net proceeds in 1996, $197.6 million in 1995 and $6.0 million in 1994. PROPERTY, PLANT AND EQUIPMENT The primary purpose of TDS's construction and expansion program is to provide for significant customer growth, to upgrade service, to expand into new communication areas, and to take advantage of service- -47- enhancing and cost-reducing technological developments. In 1996, the Company invested a significant amount of money to develop and construct Aerial's systems. The following table summarizes the Company's investments in its communications networks and related facilities during the past three years.
YEAR ENDED DECEMBER 31, -------------------------------------- 1996 1995 1994 ------------ ----------- ----------- (DOLLARS IN THOUSANDS) Cellular telephone Cell sites and equipment............................................ $ 133,832 $ 150,340 $ 128,479 Switching equipment................................................. 5,713 13,002 4,549 Systems development................................................. 28,753 10,148 9,886 Other............................................................... 79,825 37,388 24,250 ------------ ----------- ----------- 248,123 210,878 167,164 ------------ ----------- ----------- Telephone Central office...................................................... 47,208 38,697 46,618 Outside plant....................................................... 53,130 55,569 52,629 Other............................................................... 44,102 10,106 16,236 ------------ ----------- ----------- 144,440 104,372 115,483 ------------ ----------- ----------- PCS Cell sites and equipment............................................ 150,386 -- -- Switching equipment................................................. 123,470 -- -- Other............................................................... 38,713 8,521 -- ------------ ----------- ----------- 312,569 8,521 -- Less noncash items.................................................... (199,630) -- -- ------------ ----------- ----------- 112,939 8,521 -- ------------ ----------- ----------- Radio paging Pagers.............................................................. 12,081 15,582 15,641 Terminals and transmitters.......................................... 4,595 6,353 11,056 Customer Telecare Center............................................ 10,216 -- -- Other............................................................... 5,625 4,592 2,269 ------------ ----------- ----------- 32,517 26,527 28,966 ------------ ----------- ----------- Other................................................................. 12,185 9,698 8,088 ------------ ----------- ----------- $ 550,204 $ 359,996 $ 319,701 ------------ ----------- ----------- ------------ ----------- -----------
U.S. Cellular's capital additions include expenditures to add additional cell sites and radio channels to expand coverage and add capacity. U.S. Cellular constructed 242 cell sites in 1996, 292 in 1995 and 225 in 1994. TDS Telecom's capital additions include expenditures for outside plant facilities and upgrades of recently acquired companies for new customer growth and switch modernization. TDS Telecom installed 35 digital switches in 1996, 39 in 1995 and 32 in 1994. Aerial has completed the construction of the five planned switching centers and the central Network Operations Center, cleared over 150 microwave paths and is building over 600 cell sites. The Company's expected 1997 property, plant and equipment additions reflect the Company's construction and expansion programs and are anticipated to aggregate approximately $810 million. In addition, Aerial's working capital and operating expenses will require an estimated $255 million. - The cellular capital additions budget totals approximately $300 million, including about $258 million for new cell sites and about $30 million for various information systems initiatives. - The telephone capital additions budget totals approximately $130 million, including about $56 million for new digital switches and other switching facilities and $56 million for improvements to outside plant facilities. -48- - The PCS capital additions budget totals approximately $345 million, including $255 million for switching equipment and $38 million for cell sites. In addition, Aerial's working capital and operating expenses will require an estimated $255 million. - The radio paging capital additions are anticipated to total about $35 million, including $15 million for systems and transmitters and $16 million for pagers. The Company expects to finance the budgeted additions to property, plant and equipment primarily with internally generated cash, short-term and intermediate-term financing, vendor financing and the sale of minority equity interests in Aerial's MTAs to strategic investors. ACQUISITIONS TDS seeks to acquire cellular telephone and telephone interests which add value to the organization. The table below summarizes interests acquired through purchases and trades at the respective dates of acquisition during the last three years and the aggregate consideration paid, net of cash acquired.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- Cellular interests acquired Population equivalents (millions)........................................ .6 1.6 1.5 Units.................................................................... 17,000 79,000 18,000 Telephone interests acquired Companies................................................................ 5 5 3 Access lines.............................................................. 33,100 13,500 19,700 Paging units acquired...................................................... -- 28,400 37,600 Consideration (millions) Cash..................................................................... $ 31.0 $ 53.8 $ 37.6 TDS Common Shares........................................................ 113.1 127.8 173.7 TDS Preferred Shares..................................................... -- -- 12.5 USM Common Shares........................................................ -- 12.8 1.4 Other.................................................................... -- -- 1.4 --------- --------- --------- Total Consideration.................................................... $ 144.1 $ 194.4 $ 226.6 --------- --------- --------- --------- --------- ---------
The Company continually reviews attractive opportunities for the acquisition of additional cellular and telephone companies. TDS and U.S. Cellular continue to assess the makeup of cellular holdings in order to maximize the benefits derived from clustering U.S. Cellular's markets. As the number of opportunities for outright acquisitions of cellular interests has decreased and as U.S. Cellular's clusters have grown to realize greater economies of scale, U.S. Cellular's focus has shifted toward exchanges and sales of non-strategic interests. In February 1997, U.S. Cellular announced that it had entered into an exchange agreement with BellSouth Corporation, pursuant to which U.S. Cellular will receive controlling interests in twelve contiguous markets adjacent to its Iowa and Wisconsin/Illinois clusters. In exchange, U.S. Cellular will transfer its controlling interests in ten markets, investment interests in 13 markets and pay cash, the amount of which is dependent upon certain factors. U.S. Cellular will receive controlling interests representing approximately 3.9 million population equivalents ("pops") in the transaction, and will divest controlling interests representing approximately 1.9 million pops and investment interests representing 1.4 million pops. The transaction is subject to various regulatory and other approvals. U.S. Cellular expects that the completion of this transaction will have a positive effect on its consolidated operations after the transition of operators is complete. The transaction is also expected to significantly reduce investment income immediately after it is completed. Because of the uncertainty of the regulatory approval process, U.S. Cellular cannot estimate when the transaction will be completed. -49- LIQUIDITY The Company anticipates that the aggregate resources required for 1997 will include approximately $810 million for capital spending and $255 million for working capital and operating expenses for Aerial. The Company is generating substantial internal funds from the rapid growth in customer units and revenues. Operating cash flow (operating income plus depreciation and amortization), primarily from cellular and telephone operations, increased to $385.7 million in 1996 from $323.5 million in 1995 and $260.3 million in 1994. U.S. Cellular plans to finance its construction program primarily with internally generated cash supplemented by short-term and intermediate-term financing. TDS Telecom plans to finance its $130 million construction program using internally generated cash supplemented by long-term financing from federal government programs. Aerial plans to finance its construction expenditures and working capital requirements with short-term and intermediate-term financing, vendor financing and sales of minority equity interests in MTAs to strategic investors. TDS and its subsidiaries have cash and temporary investments totaling $119.3 million and longer-term investments totaling $32.4 million at December 31, 1996. These investments are primarily the result of telephone operations' internally generated cash. While certain regulated telephone subsidiaries' debt agreements place limits on intercompany dividend payments, these restrictions are not expected to affect the Company's ability to meet its cash obligations. TDS and its subsidiaries also have access to a variety of external capital sources. TDS and its subsidiaries had $653 million of bank lines of credit for general corporate purposes at December 31, 1996. Unused amounts of such lines totaled $496 million. These line of credit agreements provide for borrowings at negotiated rates up to the prime rate. TDS has a universal shelf registration statement which may be used from time to time to issue debt securities and/or Common Shares for cash. As of December 31, 1996, $238.4 million remained unused on the universal shelf. TDS and U.S. Cellular have shelf registration statements covering the issuance of equity for acquisitions. In addition, the Company has issued Common Shares for acquisitions pursuant to registration statements filed specifically for particular acquisitions. In December 1996, the Company authorized the repurchase of up to 3.0 million TDS Common Shares over a period of three years. The Company plans to finance the repurchase program using internally generated funds and borrowings under short-term lines of credit. The Company may use repurchased shares to fund acquisitions and for general corporate purposes. Subject to prevailing market conditions, purchases may be made from time to time through open market purchases or at negotiated prices in private transactions. The actual number of Common Shares which may be repurchased will be subject to the trading price of the Common Shares, the Company's financial position and other factors. The Company anticipates requiring additional funding to finance Aerial's expected capital expenditures and working capital requirements, to finance acquisitions and for general corporate purposes. The timing and amount of such funding requirements will depend on the timing of the completion of Aerial's construction and operational plans, the timing of acquisitions, and other relevant factors. There can be no assurance that sufficient funds will be available to the Company on terms or at prices acceptable to the Company. If sufficient funding is not made available to the Company on terms and prices acceptable to the Company, the Company would have to reduce its construction, development and acquisition programs. TDS and its subsidiaries anticipate accessing public and private capital markets to issue debt and equity securities only when capital requirements, financial market conditions and other factors warrant. -50- PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 SAFE HARBOR CAUTIONARY STATEMENT This Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Annual Report contain "forward-looking" statements, as defined in the Private Securities Litigation Reform Act of 1995, that are based on current expectations, estimates and projections. Statements that are not historical facts, including statements about the Company's beliefs and expectations are forward-looking statements. These statements contain potential risks and uncertainties and, therefore, actual results may differ materially. TDS undertakes no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Important factors that may affect these projections or expectations include, but are not limited to: changes in the overall economy; changes in competition in markets in which TDS operates; advances in telecommunications technology; changes in the telecommunications regulatory environment; pending and future litigation; availability of future financing; start-up of PCS operations; and unanticipated changes in growth in cellular customers, penetration rates, churn rates and the mix of products and services offered in our markets. Readers should evaluate any statements in light of these important factors. -51- CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31, --------------------------------------- 1996 1995 1994 ------------- ----------- ----------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) OPERATING REVENUES Cellular telephone........................................................... $ 707,820 $ 492,395 $ 332,404 Telephone.................................................................... 402,629 354,841 306,341 Radio paging................................................................. 104,187 107,150 92,065 ------------- ----------- ----------- 1,214,636 954,386 730,810 ------------- ----------- ----------- OPERATING EXPENSES Cellular telephone........................................................... 620,454 449,640 315,019 Telephone.................................................................... 299,271 256,601 214,735 Radio paging................................................................. 140,813 116,147 92,234 ------------- ----------- ----------- 1,060,538 822,388 621,988 ------------- ----------- ----------- OPERATING INCOME............................................................... 154,098 131,998 108,822 ------------- ----------- ----------- INVESTMENT AND OTHER INCOME (EXPENSE) Interest and dividend income................................................. 15,569 13,024 10,612 Cellular investment income, net of license cost amortization................. 54,150 40,666 26,018 PCS development costs........................................................ (43,950) (7,829) (1,709) Gain on sale of cellular interests and other investments..................... 138,735 86,625 7,457 Other income (expense), net.................................................. 2,726 (2,771) 387 Minority share of income..................................................... (26,690) (25,858) (9,079) ------------- ----------- ----------- 140,540 103,857 33,686 ------------- ----------- ----------- INCOME BEFORE INTEREST AND INCOME TAXES........................................ 294,638 235,855 142,508 Interest expense............................................................... 42,853 50,848 41,251 ------------- ----------- ----------- INCOME BEFORE INCOME TAXES..................................................... 251,785 185,007 101,257 INCOME TAX EXPENSE............................................................. 123,646 81,029 40,713 ------------- ----------- ----------- NET INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE....................... 128,139 103,978 60,544 Cumulative Effect of Accounting Change......................................... -- -- (723) ------------- ----------- ----------- NET INCOME..................................................................... 128,139 103,978 59,821 Preferred Dividend Requirement................................................. (1,846) (1,934) (1,809) ------------- ----------- ----------- NET INCOME AVAILABLE TO COMMON................................................. $ 126,293 $ 102,044 $ 58,012 ------------- ----------- ----------- ------------- ----------- ----------- WEIGHTED AVERAGE COMMON SHARES (000S).......................................... 60,732 58,356 54,197 EARNINGS PER COMMON SHARE: Before Cumulative Effect of Accounting Change................................ $ 2.08 $ 1.74 $ 1.07 Cumulative Effect of Accounting Change....................................... -- -- (.01) ------------- ----------- ----------- Net Income................................................................... $ 2.08 $ 1.74 $ 1.06 ------------- ----------- ----------- ------------- ----------- ----------- DIVIDENDS PER COMMON AND SERIES A COMMON SHARE................................. $ .40 $ .38 $ .36 ------------- ----------- ----------- ------------- ----------- -----------
The accompanying notes to consolidated financial statements are an integral part of these statements. -52- CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------------- 1996 1995 1994 ----------- ----------- ----------- (DOLLARS IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES Net income..................................................................... $ 128,139 $ 103,978 $ 59,821 Add (Deduct) adjustments to reconcile net income to net cash provided by operating activities Cumulative effect of accounting change....................................... -- -- 723 Depreciation and amortization................................................ 231,583 191,504 151,511 Deferred taxes............................................................... 75,015 19,602 14,529 Investment income............................................................ (58,455) (43,188) (30,083) Minority share of income..................................................... 26,690 25,858 9,079 Gain on sale of cellular interests and other investments..................... (138,735) (86,625) (7,457) Noncash interest expense..................................................... 17,042 12,761 26 Other noncash expense........................................................ 24,022 16,946 15,669 Change in accounts receivable................................................ (28,687) (33,346) (22,401) Change in accounts payable................................................... 23,531 (11,630) 31,714 Change in accrued taxes...................................................... (8,249) 6,252 (4,638) Change in other assets and liabilities....................................... 3,098 8,764 6,193 ----------- ----------- ----------- 294,994 210,876 224,686 ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Long-term debt borrowings...................................................... 15,846 334,323 36,916 Repayment of long-term debt.................................................... (34,200) (30,734) (33,710) Change in notes payable........................................................ (27,133) 80,351 92,318 Proceeds from the issuance of common stock..................................... 5,114 6,921 11,185 Minority partner capital (distributions) contributions......................... (4,100) 1,411 12,504 Redemption of preferred shares................................................. (605) (638) (9) Dividends paid................................................................. (26,231) (23,972) (20,906) Proceeds from the issuance of subsidiaries' stock.............................. 196,205 1,812 45,714 ----------- ----------- ----------- 124,896 369,474 144,012 ----------- ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES Additions to property, plant and equipment..................................... (550,204) (359,996) (319,701) Investments in cellular minority interests and license costs................... (23,134) (25,025) (25,494) Distributions from partnerships................................................ 25,453 9,062 17,375 Investments in PCS licenses.................................................... (26,548) (326,035) (31,604) Proceeds from investment sales................................................. 221,542 197,558 6,000 Change in other investments.................................................... (2,666) (3,632) 492 Acquisitions, excluding cash acquired.......................................... (31,019) (53,770) (37,552) Change in temporary investments and marketable securities...................... (30,797) 11,871 (9,147) ----------- ----------- ----------- (417,373) (549,967) (399,631) ----------- ----------- ----------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS............................. 2,517 30,383 (30,933) CASH AND CASH EQUIVALENTS Beginning of period............................................................ 55,116 24,733 55,666 ----------- ----------- ----------- End of period.................................................................. $ 57,633 $ 55,116 $ 24,733 ----------- ----------- ----------- ----------- ----------- -----------
The accompanying notes to consolidated financial statements are an integral part of these statements. -53- CONSOLIDATED BALANCE SHEETS--ASSETS
DECEMBER 31, ---------------------------- 1996 1995 ------------- ------------- (DOLLARS IN THOUSANDS) CURRENT ASSETS Cash and cash equivalents............................................................... $ 57,633 $ 55,116 Temporary investments................................................................... 61,664 25,735 Construction funds...................................................................... 1,405 1,588 Accounts receivable Due from customers, less allowance of $6,090 and $5,104, respectively................. 97,093 77,148 Other, principally connecting companies............................................... 84,119 68,196 Materials and supplies, at average cost............................................... 29,125 20,738 Other................................................................................. 15,031 12,689 ------------- ------------- 346,070 261,210 ------------- ------------- INVESTMENTS Cellular license acquisition costs, net of amortization................................. 1,088,409 1,075,820 Cellular minority interests............................................................. 206,390 158,559 Broadband PCS license acquisition costs................................................. 322,420 301,196 Narrowband PCS license acquisition costs................................................ 59,003 55,365 Franchise and other costs in excess of the underlying book value of subsidiaries, net of amortization........................................................................... 181,845 168,608 Other investments....................................................................... 84,537 87,726 ------------- ------------- 1,942,604 1,847,274 ------------- ------------- PROPERTY, PLANT AND EQUIPMENT Cellular Telephone In service and under construction..................................................... 846,005 674,450 Less accumulated depreciation......................................................... 195,251 144,423 ------------- ------------- 650,754 530,027 ------------- ------------- Telephone In service and under construction, substantially at original cost..................... 1,301,654 1,099,714 Less accumulated depreciation......................................................... 527,266 442,699 ------------- ------------- 774,388 657,015 ------------- ------------- PCS Primarily under construction.......................................................... 324,703 12,025 Less accumulated depreciation......................................................... 1,980 47 ------------- ------------- 322,723 11,978 ------------- ------------- Radio Paging In service and under construction..................................................... 113,000 102,385 Less accumulated depreciation......................................................... 61,528 42,933 ------------- ------------- 51,472 59,452 ------------- ------------- Other In service and under construction..................................................... 74,906 75,910 Less accumulated depreciation......................................................... 45,354 40,972 ------------- ------------- 29,552 34,938 ------------- ------------- 1,828,889 1,293,410 ------------- ------------- OTHER ASSETS AND DEFERRED CHARGES......................................................... 83,406 67,188 ------------- ------------- $ 4,200,969 $ 3,469,082 ------------- ------------- ------------- -------------
The accompanying notes to consolidated financial statements are an integral part of these statements. -54- CONSOLIDATED BALANCE SHEETS -- LIABILITIES AND STOCKHOLDERS' EQUITY
DECEMBER 31, ---------------------------- 1996 1995 ------------- ------------- (DOLLARS IN THOUSANDS) CURRENT LIABILITIES Current portion of long-term debt and preferred shares.................................. $ 38,197 $ 49,233 Notes payable........................................................................... 160,537 184,320 Accounts payable........................................................................ 205,427 113,995 Advance billings and customer deposits.................................................. 32,434 27,706 Accrued interest........................................................................ 11,777 11,573 Accrued taxes........................................................................... 3,194 11,415 Other................................................................................... 57,701 29,482 ------------- ------------- 509,267 427,724 ------------- ------------- DEFERRED LIABILITIES AND CREDITS Net deferred income tax liability....................................................... 183,792 103,206 Postretirement benefits obligation other than pensions.................................. 11,451 12,146 Other................................................................................... 19,663 22,943 ------------- ------------- 214,906 138,295 ------------- ------------- LONG-TERM DEBT, excluding current portion................................................. 982,232 858,857 ------------- ------------- REDEEMABLE PREFERRED SHARES, excluding current portion.................................... 280 1,587 ------------- ------------- MINORITY INTEREST in subsidiaries......................................................... 432,343 328,544 NONREDEEMABLE PREFERRED SHARES............................................................ 29,000 29,710 ------------- ------------- COMMON STOCKHOLDERS' EQUITY Common Shares, par value $1 per share; authorized 100,000,000 shares; issued and outstanding 54,237,180 and 51,137,426 shares, respectively............................. 54,237 51,137 Series A Common Shares, par value $1 per share; authorized 25,000,000 shares; issued and outstanding 6,916,546 and 6,893,101 shares, respectively............................... 6,917 6,893 Common Shares issuable, 30,977 and 31,431 shares, respectively.......................... 1,461 1,496 Capital in excess of par value.......................................................... 1,661,093 1,417,513 Retained earnings....................................................................... 309,233 207,326 ------------- ------------- 2,032,941 1,684,365 ------------- ------------- $ 4,200,969 $ 3,469,082 ------------- ------------- ------------- -------------
The accompanying notes to consolidated financial statements are an integral part of these statements. -55- CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31, ------------------------------------------- 1996 1995 1994 ------------- ------------- ------------- (DOLLARS IN THOUSANDS) COMMON SHARES Balance beginning of period............................................. $ 51,137 $ 47,938 $ 43,504 Add Acquisitions.......................................................... 2,649 2,960 4,041 Dividend reinvestment, incentive and benefit plans.................... 100 186 175 Sales of Common Shares................................................ -- -- 100 Conversion of Preferred Shares........................................ 348 41 116 Conversion of Series A Common Shares.................................. 3 12 2 ------------- ------------- ------------- Balance end of period................................................... $ 54,237 $ 51,137 $ 47,938 ------------- ------------- ------------- SERIES A COMMON SHARES Balance beginning of period............................................. $ 6,893 $ 6,887 $ 6,881 Add (Deduct) Dividend reinvestment plan............................................ 27 18 8 Conversion to Common Shares........................................... (3) (12) (2) ------------- ------------- ------------- Balance end of period................................................... $ 6,917 $ 6,893 $ 6,887 ------------- ------------- ------------- ------------- ------------- ------------- COMMON SHARES ISSUABLE Balance beginning of period............................................. $ 1,496 $ 1,995 $ 15,189 Add (Deduct) Acquisitions.......................................................... 464 -- 1,995 Shares issued pursuant to acquisition agreements...................... (499) (499) (15,189) ------------- ------------- ------------- Balance end of period................................................... $ 1,461 $ 1,496 $ 1,995 ------------- ------------- ------------- ------------- ------------- ------------- CAPITAL IN EXCESS OF PAR VALUE Balance beginning of period............................................. $ 1,417,513 $ 1,288,453 $ 1,069,022 Add (Deduct) Acquisitions.......................................................... 111,305 125,886 182,812 Dividend reinvestment, incentive and benefit plans.................... 4,487 6,994 6,667 Sales of Common Shares................................................ -- -- 4,924 Capital stock expense................................................. (25) (124) (53) Conversion of Preferred Shares........................................ 4,254 (3,127) 1,324 Gain on sale of subsidiary stock...................................... 123,246 714 21,184 Net unrealized gain (loss) on marketable equity securities............ 142 (2,090) 2,100 Income tax effects of capital stock transactions...................... 171 807 473 ------------- ------------- ------------- Balance end of period................................................... $ 1,661,093 $ 1,417,513 $ 1,288,453 ------------- ------------- ------------- ------------- ------------- ------------- RETAINED EARNINGS Balance beginning of period............................................. $ 207,326 $ 127,765 $ 89,689 Add net income.......................................................... 128,139 103,978 59,821 ------------- ------------- ------------- 335,465 231,743 149,510 ------------- ------------- ------------- Deduct Dividends Common and Series A Common Shares................................... 24,274 21,910 19,287 Preferred Shares.................................................... 1,958 2,507 2,458 ------------- ------------- ------------- 26,232 24,417 21,745 ------------- ------------- ------------- Balance end of period................................................... $ 309,233 $ 207,326 $ 127,765 ------------- ------------- ------------- ------------- ------------- -------------
The accompanying notes to consolidated financial statements are an integral part of these statements. -56- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting policies of Telephone and Data Systems, Inc. and its subsidiaries ("TDS" or the "Company") conform to generally accepted accounting principles. The accounting records of the telephone subsidiaries are maintained in accordance with the uniform systems of accounts prescribed by the regulatory bodies under whose jurisdiction the subsidiaries operate. NATURE OF OPERATIONS TDS is a diversified telecommunications company which, at December 31, 1996, provided high-quality telecommunications services to approximately 2.3 million cellular telephone, telephone and radio paging customers in 37 states and the District of Columbia. The Company conducts substantially all of its cellular operations through its 80.6%-owned subsidiary, United States Cellular Corporation [AMEX:USM], its telephone operations through its wholly owned subsidiary, TDS Telecommunications Corporation ("TDS Telecom"), and its radio paging operations through its 82.3%-owned subsidiary, American Paging, Inc. [AMEX:APP]. The Company is developing its personal communications services ("PCS") operations through its 82.8%-owned subsidiary Aerial Communications, Inc. [NASDAQ:AERL] (formerly American Portable Telecom, Inc.). PCS development costs for each of the three years ended December 31, 1996 are set forth in the Consolidated Statements of Income. See Note 14-Business Segment Information for summary financial information on each business segment. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of TDS, its majority-owned subsidiaries since acquisition and the cellular telephone partnerships in which TDS has a majority general partnership interest. All material intercompany items have been eliminated. Certain amounts reported in prior years have been reclassified to conform to current period presentation. TDS includes as investments in subsidiaries the value of the consideration given and all direct and incremental costs relating to acquisitions accounted for as purchases. All costs relating to unsuccessful negotiations for acquisitions are expensed. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS AND TEMPORARY INVESTMENTS Cash and cash equivalents include cash and those short-term, highly-liquid investments with original maturities of three months or less. Those investments with original maturities of more than three months to 12 months are classified as temporary investments. Temporary investments are stated at cost, which approximates market. Those investments with original maturities of more than 12 months are classified as marketable securities and are stated at amortized cost. INVESTMENTS Cellular license acquisition costs consist of costs incurred in acquiring Federal Communications Commission ("FCC") licenses or minority interests which have been awarded FCC licenses to provide cellular service. These costs include amounts paid to license applicants and owners of interests in cellular entities awarded licenses; amounts paid for legal, engineering, and consulting services; amounts incurred by TDS in acquiring these interests; and goodwill. These costs are capitalized and amortized through charges to expense over 40 years upon commencement of operations. Amortization amounted to $28.5 million, $27.8 -57- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1 (CONTINUED) million and $24.2 million in 1996, 1995 and 1994, respectively. Accumulated amortization of cellular license costs was $112.2 million and $90.6 million at December 31, 1996 and 1995, respectively. Included in cellular license costs is approximately $322 million and $363 million at December 31, 1996 and 1995, respectively, of goodwill which resulted from various acquisitions structured to be tax-free. Investments in cellular minority interests consist of amounts invested in cellular entities in which TDS holds a minority interest. The Company follows the equity method of accounting, which recognizes TDS's proportionate share of the income and losses accruing to it under the terms of its partnership or shareholder agreements, for its long-term investments ($196.0 million and $146.1 million at December 31, 1996 and 1995, respectively). Income and losses from these entities are reflected in the consolidated income statements on a pretax basis. At December 31, 1996, the cumulative share of income from minority cellular investments accounted for under the equity method was $184.3 million, of which $94.7 million was undistributed. The cost method of accounting is followed for certain minority interests managed by others ($10.4 million and $12.5 million at December 31, 1996 and 1995, respectively). Broadband and Narrowband PCS license acquisition costs consist of costs incurred in acquiring PCS licenses ($341.8 million) and capitalized interest ($39.6 million). These costs will be amortized through charges to expense upon commencement of operations. Telephone franchise and other costs include the costs in excess of the underlying book value of acquired telephone companies. Costs in excess of the underlying book value relating to acquisitions initiated before November 1, 1970, aggregating $6.5 million, are not being amortized. Costs aggregating $204.9 million and $186.9 million at December 31, 1996 and 1995, respectively, relating to acquisitions since November 1, 1970, are being amortized on a straight-line basis over a 40-year period. Amortization amounted to $4.9 million, $4.4 million and $3.3 million in 1996, 1995 and 1994, respectively. Accumulated amortization of excess cost was $29.6 million and $24.7 million at December 31, 1996 and 1995, respectively. Included in excess cost is approximately $143 million and $142 million at December 31, 1996 and 1995, respectively, of goodwill which resulted from various acquisitions structured to be tax-free. Other investments consist of the following:
DECEMBER 31, -------------------- 1996 1995 --------- --------- (DOLLARS IN THOUSANDS) Minority telephone and paging interests................................................ $ 20,989 $ 30,422 Long-term notes receivable............................................................. 14,974 16,419 Rural Telephone Bank Stock, at cost.................................................... 6,639 6,350 Marketable equity securities........................................................... 2,673 346 Marketable non-equity securities....................................................... 29,735 24,871 Other.................................................................................. 9,527 9,318 --------- --------- $ 84,537 $ 87,726 --------- --------- --------- ---------
The equity method of accounting is followed for minority telephone and paging interests in which TDS holds common stock ownership of at least 20% or can influence the policies of the affiliated company. At December 31, 1996, the cumulative share of income from minority telephone and paging investments accounted for under the equity method was $4.1 million, of which $2.2 million was undistributed. The Company's investment in debt securities with original maturities of more than 12 months are classified as marketable non-equity securities and held-to-maturity. They are stated at amortized cost. -58- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1 (CONTINUED) Information regarding the Company's marketable nonequity securities is summarized below.
DECEMBER 31, -------------------- 1996 1995 --------- --------- (DOLLARS IN THOUSANDS) Held-to-Maturity U.S. Treasury and other U.S. government corporations and agencies Aggregate Fair Value Current.......................................................................... $ 46,622 $ 12,293 Noncurrent....................................................................... 29,882 25,200 Amortized Cost Basis Current.......................................................................... 46,603 12,337 Noncurrent....................................................................... 29,735 24,871 Gross Unrealized Holding Gains.................................................................... 175 343 Gross Unrealized................................................................... Holding Losses................................................................... $ 8 $ 58 --------- --------- --------- ---------
The noncurrent investments have contractual maturities of more than one to five years at December 31, 1996. No sales or transfers of securities classified as held-to-maturity occurred during 1996. REVENUE RECOGNITION TDS's revenues are recognized when earned. Telephone network access and long-distance services are furnished jointly with other companies, primarily AT&T and the Bell Operating Companies. Compensation for interstate access services is based on tariffed access charges to interstate long-distance carriers as filed by the National Exchange Carrier Association with the FCC on behalf of TDS. Such compensation amounted to 32%, 33% and 31% of telephone revenues in 1996, 1995 and 1994, respectively. Compensation for intrastate toll and access services is based on tariffed access charges, cost separation studies, nationwide average schedules or special settlement arrangements with intrastate long-distance carriers. Network access and long-distance revenues based on cost separation studies represent estimates pending completion and acceptance of final cost studies. Management believes that recorded amounts represent reasonable estimates of the final amounts. ADVERTISING COSTS The Company expenses advertising costs as incurred. Advertising costs totaled $29.8 million, $17.2 million and $13.7 million for the years ended December 31, 1996, 1995 and 1994, respectively. EARNINGS PER COMMON SHARE Earnings per Common Share were computed by dividing Net Income Available to Common, less a minority income adjustment, by the weighted average number of Common Shares, Series A Common Shares and dilutive common equivalent shares outstanding during the year. The minority income adjustment, $271,000 and $411,000 in 1995 and 1994, respectively, reflects the additional minority share of USM's income computed as if all of USM's issuable securities were outstanding. Dilutive common stock equivalents consist of Common Shares issuable upon conversion of dilutive series of Preferred Shares and Common Share options. Preferred dividend requirements include all dividends paid on Preferred Shares which are not dilutive common stock equivalents. For the year ended December 31, 1996, the preferred dividend requirement on all outstanding Preferred Shares was $1.8 million. -59- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1 (CONTINUED) SUPPLEMENTAL CASH FLOW DISCLOSURES Following are supplemental cash flow disclosures for interest and income taxes paid, acquisitions and certain noncash transactions.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (DOLLARS IN THOUSANDS) Interest paid.............................................................. $ 76,062 $ 49,414 $ 39,904 Income taxes paid.......................................................... 67,907 60,515 27,644 Common Shares issued by TDS for conversion of TDS Preferred Shares......... 4,602 948 1,714 Increase in PCS network equipment and prepaid infrastructure costs through the issuance of long-term debt............................................ 100,000 -- -- Additions to property, plant and equipment financed through accounts payable and accrued expenses.............................................. $ 87,109 $ 3,943 $ (9,958) --------- --------- --------- --------- --------- ---------
TDS has acquired operating telephone and paging companies, certain cellular licenses and operating companies and certain other assets since January 1, 1994. In conjunction with these acquisitions, the following assets were acquired and liabilities assumed, and Common Shares and Preferred Shares issued:
YEAR ENDED DECEMBER 31, ---------------------------------------- 1996 1995 1994 ------------ ------------ ------------ (DOLLARS IN THOUSANDS) Property, plant and equipment....................................... $ 55,692 $ 56,132 $ 47,400 Cellular licenses................................................... 95,447 129,510 169,845 Franchise and other costs........................................... 17,679 25,657 41,692 Minority interest................................................... (1,109) (1,941) (259) Increase (decrease) in equity method investment in cellular interests.......................................................... (3,641) 977 (15,586) Long-term debt...................................................... (22,979) (9,254) (21,571) Deferred credits.................................................... (6,205) (538) (6,225) Other assets and liabilities, excluding cash and cash equivalents... 9,297 (6,143) 9,808 Common Shares issued and issuable................................... (113,128) (127,836) (173,658) Preferred Shares issued............................................. -- -- (12,500) USM Common Shares issued and issuable............................... (34) (12,794) (1,394) ------------ ------------ ------------ Decrease in cash due to acquisitions................................ $ 31,019 $ 53,770 $ 37,552 ------------ ------------ ------------ ------------ ------------ ------------
-60- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2 INCOME TAXES TDS files a consolidated federal income tax return. Income tax provisions charged to net income before the cumulative effect of an accounting change are summarized as follows:
YEAR ENDED DECEMBER 31, --------------------------------- 1996 1995 1994 ----------- --------- --------- (DOLLARS IN THOUSANDS) Current: Federal................................................................ $ 31,356 $ 44,690 $ 20,921 State.................................................................. 17,275 16,736 4,873 Deferred: Federal................................................................ 67,040 19,253 13,440 State.................................................................. 10,072 2,386 2,963 Amortization of deferred investment tax credits.......................... (2,097) (2,036) (1,484) ----------- --------- --------- Total income tax expense................................................. $ 123,646 $ 81,029 $ 40,713 ----------- --------- --------- ----------- --------- ---------
Investment tax credits resulting from investments in telephone plant and equipment have been deferred and are being amortized over the service lives of the related property. The statutory federal income tax rate is reconciled to TDS's effective income tax rate before the cumulative effect of an accounting change below.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- Statutory federal income tax rate................................................ 35.0% 35.0% 35.0% State income taxes, net of federal benefit....................................... 8.3 6.9 5.1 Amortization of license acquisition costs and costs in excess of book value...... 1.7 2.4 3.5 Acquisition-related tax basis adjustment......................................... -- -- (2.7) Dividend exclusion............................................................... -- (.1) (1.8) Amortization of deferred investment tax credits.................................. (.8) (1.0) (1.5) Effects of corporations not included in consolidated federal tax return.......... 1.7 2.1 1.4 Sale of cellular interests....................................................... 4.9 -- -- Other differences, net........................................................... (1.7) (1.5) 1.2 --------- --------- --------- Effective income tax rate........................................................ 49.1% 43.8% 40.2% --------- --------- --------- --------- --------- ---------
The increase in the 1996 effective tax rate reflects additional income tax expense due to tax gains in excess of book gains associated with the sale of certain cellular interests. The lower 1994 rate reflects deferred income taxes provided on the book/tax basis difference related to certain telephone acquisitions and certain income excluded due to the dividend exclusion rules. The total income tax expense for the year ended December 31, 1994, including the cumulative effect of an accounting change was $40.3 million. The effective income tax rate including the cumulative effect of an accounting change was 40.3% in 1994. Deferred income taxes are provided for the temporary differences between the amount of the Company's assets and liabilities for financial reporting purposes and their tax bases. The Company's current net deferred tax assets totaled $2.7 million and $3.2 million as of December 31, 1996 and 1995, respectively. The net current deferred tax asset primarily represents the deferred tax effects of unearned revenues. -61- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2 (CONTINUED) The temporary differences that gave rise to the noncurrent deferred tax assets and liabilities as of December 31, 1996 and 1995, are as follows:
DECEMBER 31, ------------------------ 1996 1995 ----------- ----------- (DOLLARS IN THOUSANDS) Deferred Tax Asset: Alternative minimum tax credit carryforward....................................... $ 10,433 $ 10,316 State operating loss carryforwards................................................ 17,055 10,537 Postretirement benefits........................................................... 4,819 4,502 Other............................................................................. 15,059 9,075 ----------- ----------- 47,366 34,430 Less valuation allowance............................................................ (16,891) (10,061) ----------- ----------- Net Deferred Tax Asset.............................................................. 30,475 24,369 ----------- ----------- Deferred Tax Liability: Property, plant and equipment..................................................... 86,056 83,131 Partnership investments........................................................... 26,965 20,047 Investment in equity securities................................................... 40,540 2,572 Minority share of USM income...................................................... (7,122) (1,500) Effects of corporations not included in consolidated federal tax return........... 3,945 3,642 Licenses.......................................................................... 38,656 16,001 Other............................................................................. 25,227 3,682 ----------- ----------- Total Deferred Tax Liability........................................................ 214,267 127,575 ----------- ----------- Net Deferred Income Tax Liability................................................. $ 183,792 $ 103,206 ----------- ----------- ----------- -----------
At December 31, 1996, TDS had $10.4 million of federal alternative minimum tax credit carryforward available to offset regular income tax payable in future years. In addition, TDS had $267.7 million of state net operating loss carryforward at December 31, 1996, expiring between 1996 and 2010, which generated a $17.1 million deferred tax asset. A valuation allowance was established for the state operating loss carryforwards since it is more likely than not that a portion will expire before such carryforwards can be utilized. TDS's telephone subsidiaries have recorded additional deferred income tax liabilities related primarily to temporary differences not deferred under rate-making policy. A corresponding regulatory asset or liability has been established to offset these deferred income tax adjustments. The unamortized regulated asset and liability balances are $4.3 million and $4.5 million, respectively, as of December 31, 1996, and $5.0 million and $5.8 million, respectively, as of December 31, 1995. These amounts are being amortized over the lives of the related temporary differences. NOTE 3 PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is stated at cost. Telephone plant in service and under construction is stated at the original cost of construction including the capitalized costs of certain taxes, payroll-related expenses, and an allowance for funds used during construction ("AFUDC"). The composite weighted average AFUDC rates were 7.3%, 9.3% and 10.4% in 1996, 1995 and 1994, respectively. -62- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 3 (CONTINUED) Renewals and betterments of units of property are added to telephone plant in service. The original cost of depreciable property retired is removed from plant in service and, together with removal cost less any salvage realized, is charged to accumulated depreciation. Repairs and renewals of minor items of property are included in plant operations expense. No gain or loss is recognized on ordinary retirements of depreciable telephone property. AERL capitalizes interest ($1.2 million in 1996) on certain work in process expenditures. When the assets are placed in service, they will be depreciated over their respective useful lives. Certain costs relating to the development of computer software for internal use are capitalized and are amortized over the estimated five-year life of the software. Depreciation is provided for book purposes using the straight-line method. Composite depreciation rates, as applied to the average cost of depreciable property, are as follows:
YEAR ENDED DECEMBER 31, ------------------------------------- 1996 1995 1994 ----------- ----------- ----------- Cellular Telephone............................................................... 10.4% 10.0% 10.5% Telephone........................................................................ 7.2 7.1 7.5 PCS.............................................................................. 20.2 2.2 -- Radio Paging..................................................................... 27.9 22.1 23.1 Other............................................................................ 15.9 10.0 12.8 --- --- --- --- --- ---
NOTE 4 ACQUISITIONS AND SALES During 1996, 1995 and 1994, TDS and its subsidiaries completed the following business combinations:
CONSIDERATION ----------------------------- TDS AND USM COMMON STOCK, CASH, NOTES TDS PREFERRED AND SHARES, AND LONG-TERM SUBSIDIARY DEBT PREFERRED STOCK ----------- ---------------- (DOLLARS IN THOUSANDS) Acquisitions During 1996 Cellular interests............................................................ $ 13,596 $ 42,499 Majority interests in five telephone companies................................ 17,423 70,663 Acquisitions During 1995 Cellular interests............................................................ $ 41,885 $ 94,542 Majority interests in five telephone companies................................ 250 46,087 Paging interests.............................................................. 5,656 -- Acquisitions During 1994 Cellular interests............................................................ $ 29,599 $ 110,732 Majority interests in three telephone companies............................... 7,386 71,945 Paging interest............................................................... 4,875 4,875 ----------- ---------------- ----------- ----------------
-63- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 4 (CONTINUED) Assuming that these acquisitions had taken place on January 1, 1995, unaudited pro forma results of operations from continuing operations would have been as follows:
YEAR ENDED DECEMBER 31, ---------------------------- 1996 1995 ------------- ------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Operating revenues.............................................................. $ 1,229,053 $ 1,013,326 Net income...................................................................... 129,199 105,926 Earnings per share.............................................................. $ 2.08 $ 1.69 ------------- ------------- ------------- -------------
SALES OF CELLULAR AND OTHER INVESTMENTS The $138.7 million gain in 1996 reflects the sales of non-strategic cellular and other investments. USM sold its majority interests in eight markets and minority interests in two other markets, received cash from the settlement of two separate legal matters and received cash in an exchange of markets with another cellular operator. AERL sold its majority interests in two markets. These transactions, along with the sales of certain other investments by TDS, generated net cash proceeds of $221.5 million. The $86.6 million gain in 1995 reflects the sales and exchanges of non-strategic cellular and other investments. USM sold its majority interests in six markets and its minority interests in six markets during 1995. These sales, along with the sales of marketable equity securities and certain other investments by TDS, generated net cash proceeds of $197.6 million. The $7.5 million gain in 1994 reflects the sale and exchange of minority-owned cellular and telephone interests. The cellular gain represents the excess of the fair market value of the cellular interests traded over the book value of such interests. The Company also sold its minority interest in a telephone company for preferred shares of the telephone company having a face value of $5.9 million and $6.0 million in cash. NOTE 5 NOTES PAYABLE TDS has used short-term debt to finance its investments in PCS, cellular telephone and radio paging operations, for acquisitions, and for general corporate purposes. Long-term debt and equity financing from time to time have retired such short-term debt. Proceeds from an AERL initial public offering retired $131.2 million of short-term debt in 1996. (See Note 7-Sale of Stock by Subsidiaries.) Proceeds from the sales of non-strategic cellular and other investments from time to time in 1996 and 1995 have been used to retire short-term debt. Proceeds from a USM convertible debt offering retired $131.4 million of short-term debt in 1995. Proceeds from an APP initial public offering and TDS's sales of Common Shares retired $21.2 million of short-term debt in 1994. TDS and its subsidiaries had $678.4 million of bank lines of credit for general corporate purposes at December 31, 1996, $653.4 million of which were committed. Unused amounts of such lines totaled $521.0 million, $496.0 million of which were committed. These line-of-credit agreements provide for borrowings at negotiated rates up to the prime rate. -64- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5 (CONTINUED) Information concerning notes payable is shown in the table below:
DECEMBER 31, ------------------------------------- 1996 1995 1994 ----------- ----------- ----------- (DOLLARS IN THOUSANDS) Balance at end of period............................................... $ 160,537 $ 184,320 $ 98,608 Weighted average interest rate at end of period........................ 6.0% 6.3% 6.5% Maximum amount outstanding during the period........................... $ 204,140 $ 184,320 $ 106,077 Average amount outstanding during the period (1)....................... $ 112,341 $ 139,671 $ 50,499 Weighted average interest rate during the period (1)................... 5.8% 6.4% 5.2% ----------- ----------- ----------- ----------- ----------- -----------
- - ------------ (1) The average was computed based on month-end balances. -65- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6 LONG-TERM DEBT Long-term debt as of December 31, 1996 and 1995 is as follows:
DECEMBER 31, -------------------------- 1996 1995 ------------ ------------ (DOLLARS IN THOUSANDS) Telephone and Data Systems, Inc. (Parent) Medium-term notes, 8% to 10%, due through 2025.................................. $ 239,200 $ 239,200 Purchase contracts and other long-term notes 8% to 9.6%, due through 2003....... 3,175 3,676 ------------ ------------ 242,375 242,876 Less current portion............................................................ 232 418 ------------ ------------ Total parent debt................................................................. 242,143 242,458 ------------ ------------ Subsidiaries RUS, RTB and FFB Mortgage Notes, due through 2031 0% to 2%...................................................................... 24,859 26,350 4% to 6%...................................................................... 178,499 172,231 6.04% to 9%................................................................... 103,800 84,464 9.5% to 11%................................................................... 1,213 1,233 ------------ ------------ 308,371 284,278 ------------ ------------ 6% zero coupon convertible debentures, matures June 15, 2015.................... 745,000 745,000 Unamortized discount............................................................ (494,893) (509,250) ------------ ------------ 250,107 235,750 ------------ ------------ Vendor financing, approximating 90-day Commercial Paper Rate plus 1.4% due through 2002................................................................... 103,654 119,998 ------------ ------------ 8.34% zero coupon notes, matures November 1, 2006............................... 226,245 -- Unamortized discount............................................................ (122,502) -- ------------ ------------ 103,743 -- ------------ ------------ Other long-term notes, 0% to 12.6%, due through 2009............................ 10,601 11,682 ------------ ------------ 776,476 651,708 Less current portion............................................................ 36,387 35,309 ------------ ------------ Total subsidiaries' debt.......................................................... 740,089 616,399 ------------ ------------ Total long-term debt.............................................................. $ 982,232 $ 858,857 ------------ ------------ ------------ ------------
The Company sold $39.2 million of senior unsecured debt securities in 1995 under its Medium-Term Note Program. The proceeds were used principally to retire short-term debt, as well as for working capital and general corporate purposes. The mortgage notes issued under certain loan agreements with the Rural Utilities Service ("RUS"), Rural Telephone Bank ("RTB") and Federal Financing Bank ("FFB"), agencies of the United States of America, are to be repaid in equal monthly or quarterly installments covering principal and interest beginning six months to three years after dates of issue and expiring through 2031. Substantially all telephone plant is pledged under RUS and RTB mortgage notes and various other obligations of the telephone subsidiaries. USM sold $745 million principal amount at maturity of 20-year zero coupon 6% yield to maturity convertible redeemable debt in June 1995 with proceeds to the Company of $221.5 million. No debt has been converted as of December 31, 1996. -66- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 6 (CONTINUED) USM has financing arrangements with an equipment vendor for cellular system equipment and construction costs. The borrowings are collateralized by a secured interest in some or all of the assets of USM's operating subsidiaries. Borrowings have terms of seven years at an interest rate of 1.4% over the 90-day Commercial Paper Rate (for a rate of 7.03% at December 31, 1996). AERL sold $226 million principle amount at maturity of 10-year zero coupon 8.34% yield to maturity debt in November 1996 at an issue price of $100 million. The proceeds were paid to AERL's equipment vendor in satisfaction of all outstanding and future obligations up to $100 million. The notes are fully and unconditionally guaranteed by TDS. The annual requirements for principal payments on long-term debt are approximately $36.6 million, $39.3 million, $36.8 million, $31.8 million and $27.9 million for the years 1997 through 2001, respectively. NOTE 7 MINORITY INTEREST IN SUBSIDIARIES The following table summarizes the minority shareholders' and partners' interests in the equity of consolidated subsidiaries.
DECEMBER 31, ------------------------ 1996 1995 ----------- ----------- (DOLLARS IN THOUSANDS) USM USM shareholders'................................................................. $ 285,835 $ 259,719 USM subsidiaries' partners'....................................................... 48,715 45,303 ----------- ----------- 334,550 305,022 TDS Telecom telephone subsidiaries'................................................. 21,810 17,108 AERL shareholders'.................................................................. 75,897 -- APP shareholders'................................................................... -- 6,280 Other............................................................................... 86 134 ----------- ----------- $ 432,343 $ 328,544 ----------- ----------- ----------- -----------
SALE OF STOCK BY SUBSIDIARIES USM issued Common Shares during 1996, 1995 and 1994 in connection with acquisitions and employee stock purchase plans. AERL issued 12.3 million Common Shares in an initial public offering (at a price of $17 per share) in 1996. The initial public offering reduced TDS's ownership percentage from 100% to 82.8%. APP issued Common Shares during 1996 and 1995 in connection with employee stock purchase plans, and in 1994 issued 3.5 million Common Shares in an initial public offering (at a price of $14 per share). The initial public offering reduced TDS's ownership percentage from 100% to 82.5%. The USM, AERL and APP Common Share transactions were recorded at fair market values which were either less than or in excess of TDS's book value investment in USM, AERL and APP. TDS adjusted its book value investment as a result of these issues and increased capital in excess of par value $123.2 million, $714,000 and $21.2 million in 1996, 1995 and 1994, respectively. NOTE 8 PREFERRED SHARES TDS Cumulative Voting Preferred Shares have a stated value of $100 per share. The 5,000,000 authorized Preferred Shares are issuable in series by the Board of Directors who establish the terms of the issue. Those -67- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 8 (CONTINUED) issues which contain mandatory redemption features or which are redeemable at the option of the holder are classified as Redeemable Preferred Shares. Those issues which are not redeemable or which are redeemable at the option of TDS are classified as Nonredeemable Preferred Shares. REDEEMABLE PREFERRED SHARES Redeemable Preferred Shares include outstanding series of TDS Cumulative Voting Preferred Shares with mandatory redemption features or which are redeemable at the option of the holder. At December 31, 1996, 18,581 shares of Redeemable Preferred Shares were outstanding, redeemable at $100 per share. All other dividends are payable in cash. The annual requirements for redemption of Redeemable Preferred Shares are $1.6 million, $103,000, $100,000 and $77,000 for the years 1997 through 2000, respectively. The following is a schedule of the Redeemable Preferred Shares' activity.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (DOLLARS IN THOUSANDS) Balance, beginning of period............................................... $ 15,093 $ 25,001 $ 27,367 Add: Stock dividends.......................................................... 113 546 839 Less: Redemption of preferred.................................................. (9,456) (9,608) (1,005) Conversion of preferred.................................................. (3,872) -- (1,000) Expiration of redemption feature......................................... (20) (839) (1,200) Change in redemption feature............................................. -- (7) -- --------- --------- --------- 1,858 15,093 25,001 Less current portion....................................................... 1,578 13,506 11,792 --------- --------- --------- Balance, end of period..................................................... $ 280 $ 1,587 $ 13,209 --------- --------- --------- --------- --------- ---------
NONREDEEMABLE PREFERRED SHARES Nonredeemable Preferred Shares include outstanding series of TDS Cumulative Voting Preferred Shares which have no mandatory redemption features. At December 31, 1996, 290,002 shares of Nonredeemable Preferred Shares were outstanding. Outstanding Nonredeemable Preferred Shares are generally redeemable at the option of TDS at $100 per share, plus accrued and unpaid dividends. At December 31, 1996, certain series of Preferred Shares are convertible into TDS Common Shares. (See Note 9 -- Convertible Preferred Shares) The following is a schedule of the Nonredeemable Preferred Shares activity.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (DOLLARS IN THOUSANDS) Balance, beginning of period............................................... $ 29,710 $ 29,819 $ 16,833 Add: Acquisitions............................................................. -- -- 12,500 Reclassification from Redeemable Preferred Shares........................ 20 839 1,200 Less: Conversion of preferred.................................................. (730) (948) (714) --------- --------- --------- Balance, end of period..................................................... $ 29,000 $ 29,710 $ 29,819 --------- --------- --------- --------- --------- ---------
-68- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9 COMMON STOCK ACQUISITIONS During 1996, 1995 and 1994, TDS issued 2.6 million, 3.0 million and 4.0 million Common Shares, respectively, for the acquisition of cellular and telephone interests. COMMON SHARES ISSUABLE Certain acquisition agreements require TDS to deliver 20,497 and 10,480 Common Shares in 1997 and 1998, respectively. DIVIDEND REINVESTMENT, INCENTIVE AND BENEFIT PLANS The following table summarizes Common and Series A Common Shares issued for the employee stock ownership plans and dividend reinvestment plans described below.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- Common Shares Tax-deferred savings plan................................................ 36,269 40,624 30,764 Dividend reinvestment plan............................................... 28,827 105,001 85,754 Employee stock options, awards, stock appreciation rights and employee stock purchase plan..................................................... 35,273 40,025 59,278 --------- --------- --------- 100,369 185,650 175,796 --------- --------- --------- --------- --------- --------- Series A Common Shares Dividend reinvestment plan............................................... 26,445 17,855 7,783 --------- --------- --------- --------- --------- ---------
TAX-DEFERRED SAVINGS PLAN. TDS has reserved 110,965 Common Shares for issue under the TDS Tax-Deferred Savings Plan, a qualified profit-sharing plan pursuant to Sections 401(a) and 401(k) of the Internal Revenue Code. Participating employees have the option of investing their contributions in TDS Common Shares, USM Common Shares, AERL Common Shares, APP Common Shares or five nonaffiliated funds. DIVIDEND REINVESTMENT PLANS. TDS has reserved 486,015 Common Shares for issue under the Automatic Dividend Reinvestment and Stock Purchase Plan and 192,254 Series A Common Shares for issue under the Series A Common Share Automatic Dividend Reinvestment Plan. These plans enable holders of TDS's Common Shares and Preferred Shares to reinvest cash dividends in newly issued Common Shares and holders of Series A Common Shares to reinvest cash dividends in newly issued Series A Common Shares. The purchase price of the shares is 95% of the market value, based on the average of the daily high and low sales prices for TDS's Common Shares on the American Stock Exchange for the ten trading days preceding the date on which the purchase is made. STOCK-BASED COMPENSATION PLANS TDS has reserved 1,316,196 Common Shares for options granted and to be granted to key employees. TDS has established certain plans that provide for the grant of stock options and stock appreciation rights for the officers and employees. The options are exercisable over a specified period not in excess of ten years. The options expire from 1997 to 2006 or the date of the employee's termination of employment, if earlier. TDS accounts for stock options, stock appreciation rights ("SARS") and employee stock purchase plans under Accounting Principles Board ("APB") Opinion No. 25. No compensation costs have been recognized for the stock option and employee stock purchase plans. Compensation expense for SARS, measured on the difference between the year-end market price of the Common Shares and SAR prices, was $263,000, $408,000 and $218,000 in 1996, 1995 and 1994, respectively. Had compensation cost for all plans been -69- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9 (CONTINUED) determined consistent with Financial Accounting Standards Board Statement of Accounting Standards ("SFAS") No. 123, the Company's net income and earnings per share would have been reduced to the following pro forma amounts:
YEAR ENDED DECEMBER 31, ------------------------ 1996 1995 ----------- ----------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Net Income As Reported....................................................................... $ 126,139 $ 103,978 Pro Forma......................................................................... $ 126,495 $ 103,316 Earnings per Common Share As Reported....................................................................... $ 2.08 $ 1.74 Pro Forma......................................................................... $ 2.05 $ 1.73 ----------- ----------- ----------- -----------
Because SFAS No. 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. A summary of the status of the Company's stock option plans at December 31, 1996, 1995 and 1994 and changes during the years ended is presented in the table and narrative below:
WEIGHTED WEIGHTED NUMBER OF AVERAGE AVERAGE SHARES OPTION PRICES FAIR VALUES --------- ------------- ----------- Stock Options: Outstanding January 1, 1994 (107,661 exercisable)...................... 302,685 $ 15.35 Granted.............................................................. 221,275 $ 47.59 Exercised............................................................ (25,876) $ 5.30 Cancelled............................................................ (12,487) $ 27.47 --------- Outstanding December 31, 1994 (172,689 exercisable).................... 485,597 $ 30.25 Granted.............................................................. 59,995 $ 38.67 $ 14.84 Exercised............................................................ (26,101) $ 5.52 Cancelled............................................................ (3,046) $ 43.32 --------- Outstanding December 31, 1995 (240,160 exercisable).................... 516,445 $ 32.47 Granted.............................................................. 89,228 $ 41.00 $ 13.30 Exercised............................................................ (11,025) $ 13.10 Cancelled............................................................ (3,210) $ 39.89 --------- Outstanding December 31, 1996 (405,996 exercisable).................... 591,438 $ 34.08 --------- ------------- ----------- --------- ------------- -----------
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 1996 and 1995, respectively: risk-free interest rates of 5.6% and 6.6%; expected dividend yields of 1.0% and 1.0%; expected lives of 5.1 years and 6.9 years and expected volatility of 20.5% and 25.0%. Stock appreciation rights allow the grantee to receive an amount in cash or Common Shares, or a combination thereof, equivalent to the difference between the exercise price and the fair market value of the Common Shares on the exercise date. The following table summarizes the SARs outstanding at $4.43 to $36.60 per share. These rights expire March 1997, or the date of the employee's termination of employment, if earlier. The fair value of each stock appreciation right grant is estimated on the date of grant using the Black- -70- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9 (CONTINUED) Scholes option pricing model with the following weighted-average assumptions used for grants in 1996 and 1995, respectively: risk-free interest rates of 5.2% and 5.5%; expected dividend yields of 1.0% and 1.0%; expected lives of 0.2 years and 0.7 years; and expected volatility of 18.4% and 20.2%.
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- Outstanding beginning of period............................................... 16,034 12,096 9,100 Granted..................................................................... 5,923 8,174 7,796 Exercised................................................................... (11,887) (4,236) (4,800) --------- --------- --------- Outstanding end of period..................................................... 10,070 16,034 12,096 --------- --------- --------- --------- --------- ---------
Employee Stock Purchase Plan. TDS has reserved 201,638 Common Shares for sale to the employees of TDS and its subsidiaries. The fair value of the employees' purchase rights is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants rights in 1996: risk-free interest rate of 5.6%; expected dividend yield of 1.0%; expected life of 0.5 year; and expected volatility of 15.3%. CONVERTIBLE PREFERRED SHARES TDS convertible Preferred Shares are convertible into 933,838 Common Shares (See Note 8 -- Nonredeemable Preferred Shares). TDS issued 347,707, 40,734 and 115,542 Common Shares in 1996, 1995 and 1994, respectively, for shares of TDS and subsidiary preferred stock converted. SERIES A COMMON SHARES The holders of Common Shares and the outstanding Preferred Shares are entitled to one vote per share. The holders of Series A Common Shares are entitled to ten votes per share. Series A Common Shares are convertible, on a share-for-share basis, into Common Shares. TDS has reserved 6,916,546 Common Shares for possible issuance upon such conversion. COMMON SHARE REPURCHASE PROGRAM In December 1996, the Company authorized the repurchase of up to 3.0 million TDS Common Shares over a period of three years. The Company plans to finance the repurchase program using internally generated funds and borrowings under short-term lines of credit. The Company may use repurchased shares to fund acquisitions and for general corporate purposes. Subject to prevailing market conditions, purchases may be made from time to time through open market purchases or at negotiated prices in private transactions. The actual number of Common Shares which may be repurchased will be subject to the trading price of the Common Shares, the Company's financial position and other factors. NOTE 10 COMMITMENTS AND CONTINGENCIES CONSTRUCTION AND EXPANSION The primary purpose of TDS's construction and expansion program is to provide for normal growth, to upgrade telephone service, to expand into new communication areas, and to take advantage of service-enhancing and cost-reducing technological developments. The cellular capital additions budget totals approximately $300 million for 1997, including about $258 million for new cell sites and $30 million for various information systems initiatives. The telephone capital additions budget totals approximately $130 million for 1997, including about $56 million for new digital switches and other switching facilities and $56 million for improvements to outside plant facilities. The PCS capital additions budget totals approximately $345 million -71- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 10 (CONTINUED) for 1997, including $255 million for switching equipment and $38 million for cell sites. The radio paging capital additions are anticipated to total approximately $35 million in 1997, including $15 million for systems and transmitters and $16 million for pagers. PENDING ACQUISITIONS At December 31, 1996, TDS has entered into definitive agreements to acquire a controlling interest in one cellular market and one telephone company for an aggregate consideration of approximately $39.8 million, primarily cash and TDS Common Shares. LEASE COMMITMENTS TDS and its subsidiaries have leases for certain cellular plant facilities, office space and data processing equipment, most of which are classified as operating leases. For the years 1996, 1995 and 1994, rent expense for term leases was $20.9 million, $13.6 million and $10.4 million, respectively, and rent expense under cancelable and short-term leases was $7.6 million, $7.5 million and $6.5 million, respectively. At December 31, 1996, the aggregate minimum rental commitments under noncancelable operating leases were as follows:
MINIMUM FUTURE RENTAL PAYMENTS -------------------- (DOLLARS IN THOUSANDS) 1997.................................................................................... $ 21,917 1998.................................................................................... 19,428 1999.................................................................................... 17,353 2000.................................................................................... 15,348 2001.................................................................................... 13,367 Thereafter.............................................................................. $ 56,028 -------- --------
LEGAL PROCEEDINGS The Company is involved in a number of legal proceedings before the FCC and various state and federal courts. In some cases, the litigation involves disputes regarding rights to certain cellular telephone systems and other interests. Management does not believe that any of such proceedings should have a material adverse impact on the financial position or results of operations of the Company. NOTE 11 RESTRICTION ON COMMON STOCK DIVIDENDS Under TDS's loan agreements at December 31, 1996, all of the consolidated retained earnings were available for the payment of cash dividends on shares of TDS common stock. Certain regulated telephone subsidiaries may not transfer funds to the parent in the form of cash dividends, loans or advances until certain financial requirements of their mortgages have been met. All of the $326.6 million underlying retained earnings of all TDS subsidiaries at December 31, 1996, was available for the payment of dividends on the subsidiaries common stock. Of the $2.7 billion underlying net assets of the TDS subsidiaries at December 31, 1996, $2.1 billion was available for transfer to TDS. -72- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 12 INVESTMENTS IN UNCONSOLIDATED ENTITIES The following summarizes the unaudited combined assets, liabilities and equity, and the unaudited results of operations of the cellular and telephone companies in which TDS's investments are accounted for by the equity method.
DECEMBER 31, ---------------------------- 1996 1995 ------------- ------------- (DOLLARS IN THOUSANDS) Assets Current assets................................................................ $ 324,780 $ 266,967 Due from affiliates........................................................... 6,232 24,765 Property and other............................................................ 1,121,676 937,609 ------------- ------------- $ 1,452,688 $ 1,229,341 ------------- ------------- ------------- ------------- Liabilities and Equity Current liabilities........................................................... $ 277,743 $ 240,480 Due to affiliates............................................................. 21,020 31,501 Deferred credits.............................................................. 3,380 5,766 Long-term debt................................................................ 41,591 40,220 Partners' capital and stockholders' equity.................................... 1,108,954 911,374 ------------- ------------- $ 1,452,688 $ 1,229,341 ------------- ------------- ------------- -------------
YEAR ENDED DECEMBER 31, ------------------------------------------ 1996 1995 1994 ------------- ------------- ------------ (DOLLARS IN THOUSANDS) Results of Operations Revenues........................................................ $ 1,394,781 $ 1,173,559 $ 892,530 Costs and expenses.............................................. (958,257) (808,008) (652,918) Other income.................................................... 8,558 8,249 7,952 Interest expense................................................ (6,306) (6,414) (5,650) Income taxes.................................................... (3,530) (4,670) (1,824) Extraordinary item.............................................. (2,211) -- -- ------------- ------------- ------------ Net income...................................................... $ 433,035 $ 362,716 $ 240,090 ------------- ------------- ------------ ------------- ------------- ------------
NOTE 13 EMPLOYEE BENEFIT PLANS PENSION PLAN The Company sponsors two qualified noncontributory defined contribution pension plans. One plan (the "TDS Plan") provides benefits for the employees of TDS, TDS Telecom and substantially all of the telephone company subsidiaries. (Employees of certain telephone subsidiaries are covered under other pension plans or receive direct pension payments.) The other plan provides pension benefits for USM and AERL employees. Under these plans, pension costs are calculated separately for each participant and are funded currently. TDS also sponsors an unfunded non-qualified deferred compensation plan to supplement the benefits under these plans to offset the reduction of benefits caused by the limitation on annual employee compensation under the tax laws. Total pension costs were $4.6 million, $4.6 million and $4.8 million in 1996, 1995 and 1994, respectively. -73- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13 (CONTINUED) OTHER POSTRETIREMENT BENEFITS The Company sponsors two defined benefit postretirement plans that cover most of the employees of TDS and its telephone subsidiaries. One plan provides medical benefits and the other plan provides life insurance benefits. Both plans are contributory, with retiree contributions adjusted annually. The medical plan anticipates future cost sharing changes that are consistent with the Company's intent to increase retiree contributions by the health care cost trend rate. An amount not to exceed 25% of the total contribution to the TDS Plan will be contributed to fund the cost of the medical benefits annually. An additional contribution equal to a reasonable amortization of the past service cost may be made without regard to the 25% limitation described above. The Company will limit overall contributions to the aggregate accruals recorded by its subsidiaries. The Company's postretirement medical and life insurance plans are currently underfunded. Total contributions to fund postretirement medical and life insurance plans were $2.2 million, $3.1 million and $1.1 million in 1996, 1995 and 1994, respectively. The following table sets forth the plans' funded status reconciled with the amount shown in the Company's consolidated balance sheet at December 31, 1996:
LIFE INSURANCE HEALTH PLAN CARE PLAN TOTAL ----------- --------- --------- (DOLLARS IN THOUSANDS) Accumulated postretirement benefit obligation: Retirees................................................................. $ 1,725 $ 3,144 $ 4,869 Fully eligible active plan participants.................................. 522 2,123 2,645 Other active plan participants........................................... 939 9,328 10,267 ----------- --------- --------- 3,186 14,595 17,781 Plan assets at fair value.................................................. 1,305 8,954 10,259 ----------- --------- --------- Accumulated postretirement benefit obligation in excess of plan assets..... 1,881 5,641 7,522 Unrecognized prior service cost............................................ (68) (649) (717) Unrecognized net gain from past experience different from that assumed and from changes in assumptions............................................... 46 4,600 4,646 ----------- --------- --------- Accrued postretirement benefit cost at December 31, 1996................... $ 1,859 $ 9,592 $ 11,451 ----------- --------- --------- ----------- --------- ---------
Net postretirement cost for 1996, 1995 and 1994 includes the following components:
DECEMBER 31, ------------------------------- 1996 1995 1994 --------- --------- --------- (DOLLARS IN THOUSANDS) Service cost................................................................... $ 796 $ 588 $ 810 Interest cost on accumulated postretirement benefit obligation................. 1,125 1,082 1,116 Actual return on plan assets................................................... (753) (656) -- Net amortization and deferral.................................................. 99 204 (224) --------- --------- --------- Net postretirement cost........................................................ $ 1,267 $ 1,218 $ 1,702 --------- --------- --------- --------- --------- ---------
For measurement purposes, a 10.2% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1996; the rate was assumed to decrease over seven years to 6.1% and to remain at 6.1% thereafter. The assumed rates of compensation increases and return on plan assets were 5.0% and 8.0%, respectively. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point in each year would -74- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13 (CONTINUED) increase the accumulated postretirement benefit obligation as of December 31, 1996, by $2.7 million and the aggregate of the service and interest cost components of postretirement expense for the year then ended by $419,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.0%. NOTE 14 BUSINESS SEGMENT INFORMATION TDS's businesses are classified into four principal segments: Cellular Telephone, Telephone, PCS and Radio Paging operations.
YEAR ENDED DECEMBER 31, ------------------------------------------- 1996 1995 1994 ------------- ------------- ------------- (DOLLARS IN THOUSANDS) Revenues Cellular...................................................... $ 707,820 $ 492,395 $ 332,404 Telephone..................................................... 402,629 354,841 306,341 Paging........................................................ 104,187 107,150 92,065 ------------- ------------- ------------- Total....................................................... $ 1,214,636 $ 954,386 $ 730,810 ------------- ------------- ------------- ------------- ------------- ------------- Operating Income (Loss) Cellular...................................................... $ 87,366 $ 42,755 $ 17,385 Telephone..................................................... 103,358 98,240 91,606 Paging........................................................ (36,626) (8,997) (169) ------------- ------------- ------------- Total....................................................... $ 154,098 $ 131,998 $ 108,822 ------------- ------------- ------------- ------------- ------------- ------------- Depreciation and Amortization Expense Cellular...................................................... $ 108,839 $ 89,458 $ 65,454 Telephone..................................................... 88,967 77,354 68,879 Paging........................................................ 33,777 24,692 17,178 ------------- ------------- ------------- Total....................................................... $ 231,583 $ 191,504 $ 151,511 ------------- ------------- ------------- ------------- ------------- ------------- Identifiable Assets Cellular...................................................... $ 2,116,592 $ 1,890,621 $ 1,584,142 Telephone..................................................... 1,181,084 1,058,241 984,563 PCS........................................................... 638,412 318,265 20,473 Paging........................................................ 153,374 159,170 146,107 Parent and Other.............................................. 111,507 42,785 54,842 ------------- ------------- ------------- Total....................................................... $ 4,200,969 $ 3,469,082 $ 2,790,127 ------------- ------------- ------------- ------------- ------------- ------------- Capital Expenditures Cellular...................................................... $ 248,123 $ 210,878 $ 167,164 Telephone..................................................... 144,440 104,372 115,483 PCS........................................................... 112,939 8,521 -- Paging........................................................ 32,517 26,527 28,966 Parent and Other.............................................. 12,185 9,698 8,088 ------------- ------------- ------------- Total....................................................... $ 550,204 $ 359,996 $ 319,701 ------------- ------------- ------------- ------------- ------------- -------------
-75- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 15 FAIR VALUES OF FINANCIAL INSTRUMENTS The carrying amounts of Cash and Cash Equivalents, Temporary Investments and Short-term Debt approximate fair value due to the short-term nature of these instruments. The carrying value and estimated fair value of the Company's long-term debt was $1.0 billion and $969.5 million, respectively, at December 31, 1996, and $894.6 million and $932.6 million, respectively, at December 31, 1995. The fair value was estimated using discounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The decrease in estimated fair value in 1996 was due to a change in the incremental borrowing rate related to RUS, RTB and FFB Mortgage Notes. At December 31, 1996 and 1995, the carrying value of the Company's Redeemable Preferred Shares, $1.9 million, and $15.1 million, respectively, was approximately equal to its fair value. The fair value was estimated using discounted cash flow analysis based on the Company's current dividend yield on issues of its non-convertible preferred shares and, for convertible series, the net present value of the common stock to be issued upon conversion (valued at quoted market prices). It was not practicable to estimate the fair value of the Company's cost method investments in other companies because of the lack of quoted market prices. The carrying amounts at December 31, 1996 and 1995 represent the original cost of the investments, which management believes is not impaired. NOTE 16 SUBSEQUENT EVENT Exchange of Markets with Another Cellular Operator. In February 1997, USM entered into an exchange agreement with BellSouth Corporation pursuant to which USM will receive controlling interests in twelve contiguous markets adjacent to its Iowa and Wisconsin/Illinois clusters. In exchange, USM will divest its controlling interests in ten markets and investment interests in 13 markets and cash. USM will receive controlling interests representing approximately 3.9 million pops in the transaction, and will divest controlling interests representing approximately 1.9 million pops and investment interests representing approximately 1.4 million pops. The transaction is subject to various regulatory and other approvals. STANDBY LETTER OF CREDIT The Company has entered into a standby letter of credit agreement effective July 20, 1994 with a financial institution. This standby letter of credit, which will not exceed $9.0 million, provides supplemental security in support of a bank loan to an entity minority-owned by the Company. In the event of default under the minority-owned entity's bank loan agreement, the bank may call upon the Company's standby letter of credit to satisfy any amounts still due under this loan agreement. -76- SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED OR AT DECEMBER 31, ------------------------------------------------------------------------- 1996 1995 1994 1993 1992 ------------- ------------- ------------- ------------- ------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Operating Revenues.......................... $ 1,214,636 $ 954,386 $ 730,810 $ 557,795 $ 432,740 Operating Income............................ 154,098 131,998 108,822 69,733 54,065 Net Income Before Extraordinary Item and Cumulative Effect of Accounting Changes.... 128,139 103,978 60,544 33,896 38,520 Extraordinary Item.......................... -- -- -- -- (769) Cumulative Effect of Accounting Changes..... -- -- (723) -- (6,866) Net Income.................................. 128,139 103,978 59,821 33,896 30,885 Net Income Available to Common.............. $ 126,293 $ 102,044 $ 58,012 $ 31,510 $ 28,648 Weighted Average Common Shares (000s)....... 60,732 58,356 54,197 47,266 39,074 Earnings per Common Share: Before Extraordinary Item and Cumulative Effect of Accounting Changes............. $ 2.08 $ 1.74 $ 1.07 $ .67 $ .91 Extraordinary Item........................ -- -- -- -- (.02) Cumulative Effect of Accounting Changes... -- -- (.01) -- (.17) Net Income................................ $ 2.08 $ 1.74 $ 1.06 $ .67 $ .72 Pretax Profit on Revenues................... 20.7% 19.4% 13.9% 10.8% 15.8% Effective Income Tax Rate (Before Extraordinary Item and Cumulative Effect of Accounting Changes)........................ 49.1% 43.8% 40.2% 43.9% 43.6% Dividends per Common and Series A Common Share...................................... $ .40 $ .38 $ .36 $ .34 $ .32 Cash and Cash Equivalents and Temporary Investments................................ $ 119,297 $ 80,851 $ 44,566 $ 73,385 $ 58,145 Working Capital............................. (163,197) (166,514) (160,266) 16,025 (20,864) Property, Plant and Equipment (Net)......... 1,828,889 1,293,410 1,063,656 846,089 695,623 Total Assets................................ 4,200,969 3,469,082 2,790,127 2,259,182 1,696,486 Notes Payable............................... 160,537 184,320 98,608 6,309 46,816 Long-term Debt (including current portion)................................... 1,018,851 894,584 562,164 537,566 426,885 Redeemable Preferred Shares (including current portion)........................... 1,858 15,093 25,001 27,367 27,967 Common Stockholders' Equity................. 2,032,941 1,684,365 1,473,038 1,224,285 877,419 Construction Expenditures................... $ 550,204 $ 359,996 $ 319,701 $ 200,984 $ 146,963 Current Ratio............................... .7 .6 .5 1.1 .9 Common Equity per Share..................... $ 33.23 $ 29.01 $ 26.85 $ 24.15 $ 21.27 Return on Equity............................ 6.8% 6.5% 4.4% 3.0% 4.8% ------------- ------------- ------------- ------------- ------------- ------------- ------------- ------------- ------------- -------------
-77- REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF TELEPHONE AND DATA SYSTEMS, INC.: We have audited the accompanying consolidated balance sheets of Telephone and Data Systems, Inc. (an Iowa corporation) and Subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, common stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Telephone and Data Systems, Inc. and Subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ ARTHUR ANDERSEN LLP Chicago, Illinois January 29, 1997 (except with respect to the matter discussed in Note 16, as to which the date is February 4, 1997) -78- CONSOLIDATED QUARTERLY INCOME INFORMATION (UNAUDITED)
QUARTER ENDED ------------------------------------------------------ MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31 ----------- ----------- ------------- ------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1996 Operating Revenues............................................. $ 263,387 $ 298,951 $ 315,924 $ 336,374 Operating Income............................................... 30,957 49,081 41,263 32,797 Gain on Sale of Cellular and Other Investments................. 41,758 86,494 7,797 2,686 Net Income..................................................... 33,689 59,692 22,669 12,089 Net Income Available to Common................................. 33,267 59,450 22,200 11,606 Net Income Available to Common -- Operations................. 12,959 18,969 19,271 10,852 Net Income Available to Common -- Gains...................... $ 20,308 $ 40,481 $ 2,929 $ 754 Weighted Average Common Shares (000s).......................... 59,393 61,259 61,321 61,305 Earnings per Common Share...................................... $ .56 $ .97 $ .36 $ .19 Earnings per Common Share -- Operations...................... .22 .31 .31 .18 Earnings per Common Share -- Gains........................... $ .34 $ .66 $ .05 $ .01 1995 Operating Revenues............................................. $ 209,975 $ 232,091 $ 256,508 $ 255,812 Operating Income............................................... 29,156 33,825 40,560 28,457 Gain on Sale of Cellular and Other Investments................. 19,488 16,886 43,375 6,876 Net Income..................................................... 23,193 22,580 42,596 15,609 Net Income Available to Common................................. 22,701 22,086 42,338 15,100 Net Income Available to Common -- Operations................. 13,908 12,185 21,256 14,227 Net Income Available to Common -- Gains...................... $ 8,793 $ 9,901 $ 21,082 $ 873 Weighted Average Common Shares (000s).......................... 57,292 58,508 59,038 58,741 Earnings per Common Share...................................... $ .39 $ .38 $ .72 $ .26 Earnings per Common Share -- Operations...................... .24 .21 .36 .24 Earnings per Common Share -- Gains........................... $ .15 $ .17 $ .36 $ .02
Note: Certain 1996 quarterly amounts were reclassified for current period presentation. Net Income Available to Common for 1996 and 1995 included significant gains from the sales of cellular and other investments. The table above summarizes the effect of the gains on Net Income Available to Common and Earnings per Common Share. Management believes there exists a seasonality at USM in both service revenues, which tend to increase more slowly in the first and fourth quarters, and operating expenses, which tend to be higher in the fourth quarter due to increased marketing activities and customer growth. This seasonality may cause operating income to vary from quarter to quarter. In the first part of 1997, AERL is expected to begin commercial service which will result in AERL's revenue and expenses being included in operating income. Operating income is expected to decrease significantly in 1997 as a result of the commencement of PCS operations. -79- SHAREHOLDERS' INFORMATION TDS STOCK AND DIVIDEND INFORMATION TDS's Common Shares are listed on the American Stock Exchange ("AMEX") under the symbol "TDS" and in the newspapers as "TeleData." As of February 28, 1997, TDS Common Shares were held by 4,274 record owners and the Series A Common Shares were held by 99 record owners. TDS has paid cash dividends on Common Shares since 1974, and paid dividends of $.40 and $.38 per Common and Series A Common Share during 1996 and 1995, respectively. The Common Shares of United States Cellular Corporation, an 80.6%-owned subsidiary of TDS, are listed on the AMEX under the symbol "USM" and in the newspapers as "US Cellu." The Common Shares of American Paging, Inc., an 82.3%-owned subsidiary of TDS, are also listed on the AMEX under the symbol "APP" and in the newspapers as "AmPaging." The Common Shares of Aerial Communications, Inc., an 82.8%-owned subsidiary of TDS are listed on the NASDAQ National Market under the symbol "AERL" and in the newspapers as "AerialComm." MARKET PRICE PER COMMON SHARE BY QUARTER TDS's Series A Common Shares and Preferred Shares are not actively traded and therefore, quotations are not reported for such securities. Dividends on TDS's Preferred Shares have been paid quarterly since the dates of issue. The high and low sales prices of the Common Shares on the AMEX as reported by the Dow Jones News Service are as follows:
1ST 2ND 3RD 4TH --------- --------- --------- --------- 1996 High.............................................................. $ 48.75 48.88 45.63 40.50 Low............................................................... $ 39.00 43.38 37.75 34.75 Dividends Paid.................................................... $ .10 .10 .10 .10 1ST 2ND 3RD 4TH --------- --------- --------- --------- 1995 High.............................................................. $ 46.38 39.38 42.88 43.25 Low............................................................... $ 36.13 36.00 36.38 35.63 Dividends Paid.................................................... $ .095 .095 .095 .095
-80- EX-21 6 EXHIBIT 21 EXHIBIT 21 TELEPHONE AND DATA SYSTEMS, INC. SUBSIDIARY AND AFFILIATED COMPANIES DECEMBER 31,1996
STATE OF TDS COMPANIES INCORPORATION ------------- ------------- TELEPHONE COMPANIES ------------------- TDS TELECOMMUNICATIONS CORPORATION DELAWARE NORTHEAST REGION ---------------- CHICHESTER TELEPHONE COMPANY, INC. NEW HAMPSHIRE DEPOSIT TELEPHONE COMPANY, INC. NEW YORK EDWARDS TELEPHONE COMPANY, INC. NEW YORK HAMPDEN TELEPHONE COMPANY MAINE HARTLAND & ST. ALBANS TELEPHONE COMPANY MAINE THE ISLAND TELEPHONE COMPANY MAINE KEARSARGE TELEPHONE COMPANY NEW HAMPSHIRE LUDLOW TELEPHONE COMPANY VERMONT MAHANOY & MAHANTANGO TELEPHONE COMPANY PENNSYLVANIA MERIDEN TELEPHONE COMPANY, INC. NEW HAMPSHIRE NORTHFIELD TELEPHONE COMPANY VERMONT ORISKANY FALLS TELEPHONE CORP. NEW YORK PERKINSVILLE TELEPHONE COMPANY, INC. VERMONT PORT BYRON TELEPHONE COMPANY NEW YORK SOMERSET TELEPHONE COMPANY MAINE SUGAR VALLEY TELEPHONE COMPANY PENNSYLVANIA VERNON TELEPHONE COMPANY, INC. NEW YORK WARREN TELEPHONE COMPANY MAINE WEST PENOBSCOT TELEPHONE & TELEGRAPH COMPANY MAINE SOUTHEAST REGION ---------------- AMELIA TELEPHONE CORPORATION VIRGINIA BARNARDSVILLE TELEPHONE COMPANY NORTH CAROLINA BLUE RIDGE TELEPHONE COMPANY GEORGIA BUTLER TELEPHONE COMPANY, INC. ALABAMA CALHOUN CITY TELEPHONE COMPANY. INC. MISSISSIPPI CAMDEN TELEPHONE AND TELEGRAPH COMPANY GEORGIA CONCORD TELEPHONE EXCHANGE, INC. TENNESSEE GOSHEN TELEPHONE COMPANY ALABAMA GROVE HILL TELEPHONE CORPORATION ALABAMA HUMPHREYS COUNTY TELEPHONE COMPANY TENNESSEE LESLIE COUNTY TELEPHONE COMPANY KENTUCKY LEWISPORT TELEPHONE COMPANY, INC. KENTUCKY McCLELLANVILLE TELEPHONE COMPANY, INC. SOUTH CAROLINA MYRTLE TELEPHONE COMPANY MISSISSIPPI NELSON-BALL GROUND TELEPHONE COMPANY GEORGIA NEW CASTLE TELEPHONE COMPANY VIRGINIA NORWAY TELEPHONE COMPANY SOUTH CAROLINA OAKMAN TELEPHONE COMPANY, INC. ALABAMA PEOPLES TELEPHONE COMPANY ALABAMA QUINCY TELEPHONE COMPANY FLORIDA SALEM TELEPHONE COMPANY, INC. KENTUCKY SALUDA MOUNTAIN TELEPHONE COMPANY NORTH CAROLINA SERVICE TELEPHONE COMPANY, INC. NORTH CAROLINA SOUTHEAST MISSISSIPPI TELEPHONE COMPANY, INC. MISSISSIPPI ST STEPHEN TELEPHONE COMPANY SOUTH CAROLINA TELLICO TELEPHONE COMPANY, INC. TENNESSEE TENNESSEE TELEPHONE COMPANY TENNESSEE VIRGINIA TELEPHONE COMPANY VIRGINIA WILLISTON TELEPHONE COMPANY SOUTH CAROLINA 1 STATE OF TDS COMPANIES INCORPORATION ------------- ------------- WESTERN DIVISION ---------------- ARIZONA TELEPHONE COMPANY ARIZONA ASOTIN TELEPHONE COMPANY WASHINGTON CLEVELAND COUNTY TELEPHONE CO., INC. ARKANSAS DECATUR TELEPHONE CO. ARKANSAS DELTA COUNTY TELE-COMM, INC. COLORADO HAPPY VALLEY TELEPHONE COMPANY CALIFORNIA HOME TELEPHONE COMPANY OREGON HORNITOS TELEPHONE COMPANY CALIFORNIA LEWIS RIVER TELEPHONE COMPANY, INC. WASHINGTON MCDANIEL TELEPHONE COMPANY DELAWARE MID-AMERICA TELEPHONE, INC. OKLAHOMA NEW LONDON TELEPHONE COMPANY MISSOURI OKLAHOMA COMMUNICATION SYSTEMS, INC. OKLAHOMA ORCHARD FARM TELEPHONE COMPANY MISSOURI POTLATCH TELEPHONE COMPANY IDAHO SOUTHWESTERN TELEPHONE COMPANY ARIZONA STOUTLAND TELEPHONE COMPANY MISSOURI STRASBURG TELEPHONE COMPANY COLORADO TROY TELEPHONE COMPANY, INC. IDAHO WINTERHAVEN TELEPHONE COMPANY CALIFORNIA WYANDOTTE TELEPHONE CO. OKLAHOMA MIDWEST REGION -------------- ARVIG TELEPHONE COMPANY MINNESOTA BADGER TELECOM, INC. WISCONSIN BLACK EARTH TELEPHONE COMPANY, INC. WISCONSIN BONDUEL TELEPHONE COMPANY WISCONSIN BRIDGE WATER TELEPHONE COMPANY MINNESOTA BURLINGTON, BRIGHTON & WHEATLAND TELEPHONE COMPANY WISCONSIN CENTRAL STATE TELEPHONE COMPANY WISCONSIN DANUBE TELEPHONE COMPANY MINNESOTA EASTCOAST TELECOM, INC. WISCONSIN GRANTLAND TELECOM, INC. WISCONSIN MIDWAY TELEPHONE COMPANY WISCONSIN MID-STATE TELEPHONE COMPANY MINNESOTA MT VERNON TELEPHONE COMPANY WISCONSIN RIVERSIDE TELECOM, INC. WISCONSIN SCANDINAVIA TELEPHONE COMPANY WISCONSIN STOCKBRIDGE & SHERWOOD TELEPHONE COMPANY, INC. WISCONSIN TENNEY TELEPHONE COMPANY WISCONSIN UTELCO, INC. WISCONSIN WAUNAKEE TELEPHONE COMPANY, INC. WISCONSIN WINSTED TELEPHONE COMPANY MINNESOTA MID-CENTRAL DIVISION -------------------- ARCADIA TELEPHONE COMPANY OHIO CAMDEN TELEPHONE COMPANY INDIANA CHATHAM TELEPHONE COMPANY MICHIGAN COMMUNICATION CORPORATION OF MICHIGAN MICHIGAN COMMUNICATIONS CORPORATION OF INDIANA INDIANA COMMUNICATIONS CORPORATION OF SOUTHERN INDIANA INDIANA CONTINENTAL TELEPHONE COMPANY OHIO HOME TELEPHONE COMPANY, INC. INDIANA HOME TELEPHONE COMPANY OF PITTSBORO, INC. INDIANA 2 STATE OF TDS COMPANIES INCORPORATION ------------- ------------- ISLAND TELEPHONE COMPANY MICHIGAN LITTLE MIAMI COMMUNICATIONS CORPORATION OHIO OAKWOOD TELEPHONE COMPANY OHIO SHIAWASSEE TELEPHONE COMPANY MICHIGAN TIPTON TELEPHONE COMPANY INDIANA VANLUE TELEPHONE COMPANY OHIO WOLVERINE TELEPHONE COMPANY MICHIGAN MANAGEMENT SERVICES ------------------- TDS TELECOM, INC. (f.k.a. CENTRAL REGION TSSD, INC.) IOWA ARVIG CELLULAR, INC. MINNESOTA ARVIG TELCOM, INC. MINNESOTA METROPLEX COMMUNICATIONS CORPORATION WASHINGTON METROPLEX OLYMPIA CELLULAR COMMUNICATIONS CORPORATION WASHINGTON METROPLEX PORTLAND CELLULAR COMMUNICATIONS CORPORATION WASHINGTON METROPLEX RSA-7 CELLULAR COMMUNICATIONS CORPORATION WASHINGTON METROPLEX SECURITY COMPANY WASHINGTON US LINK, INC. MINNESOTA CABLE COMPANIES --------------- ACORN CABLE COMPANY WASHINGTON 21ST CENTURY T.V., INC. ARIZONA CALHOUN ANTENNA SERVICE INC. MISSISSIPPI CAROLINA CABLE T.V. CO., INC. SOUTH CAROLINA COMVIDEO SYSTEMS, INC. CALIFORNIA CONCORD CABLE COMMUNICATIONS CO. TENNESSEE CONDON TV SYSTEMS INC. OREGON INTERLAKE CABLEVISION, INC. MINNESOTA HOME CATV SOUTH CAROLINA KEARSARGE CABLE COMMUNICATIONS INC. NEW HAMPSHIRE LEWISPORT CABLE T.V. KENTUCKY METROPLEX CABLE INC. WASHINGTON SEVIER COUNTY CABLE COMMUNICATIONS COMPANY, INC. TENNESSEE SEVIERVILLE CABLE COMMUNICATIONS COMPANY TENNESSEE TDS CABLE COMMUNICATIONS COMPANY, INC. IOWA VOLUNTEER TV CABLE CO. TENNESSEE WARREN CABLE COMPANY MAINE SERVICE COMPANIES ----------------- AFFILIATE FUND DELAWARE AMERICAN COMMUNICATIONS CONSULTANTS, INC. TENNESSEE AMERICAN RADIO COMMUNICATIONS, INC. DELAWARE COMMVEST, INC. DELAWARE INTEGRATED COMMUNICATIONS SERVICES, INC. WISCONSIN MONROE COMMUNICATIONS CORPORATION WISCONSIN NATIONAL TELEPHONE & TELEGRAPH COMPANY CALIFORNIA RUDEVCO, INC. CALIFORNIA RURAL DEVELOPMENT ACQUISITION CORP MARYLAND SUTTLE PRESS INC. WISCONSIN TCC, INC. TENNESSEE TDS DATACOM, INC. DELAWARE TDSNET ALABAMA TDS REAL ESTATE INVESTMENT CORPORATION WISCONSIN TEL RADIO COMMUNICATION PROPERTIES, INC. WISCONSIN 3 STATE OF TDS COMPANIES INCORPORATION ------------- ------------- TELECOMMUNICATION TECHNOLOGIES FUND, INC. MARYLAND RADIO PAGING COMPANIES ---------------------- AMERICAN PAGING, INC. DELAWARE ADVANCED WIRELESS MESSAGING INC. DELAWARE AMERICAN MESSAGING SERVICES, LLC MINNESOTA AMERICAN PAGING, INC. (OF ARIZONA) ARIZONA AMERICAN PAGING, INC. (OF DISTRICT OF COLUMBIA) D.C. AMERICAN PAGING, INC. (OF FLORIDA) FLORIDA AMERICAN PAGING, INC. (OF ILLINOIS) ILLINOIS AMERICAN PAGING, INC. (OF INDIANA) INDIANA AMERICAN PAGING, INC. (OF KENTUCKY) KENTUCKY AMERICAN PAGING, INC. (OF MARYLAND) MARYLAND AMERICAN PAGING, INC. (OF MINNESOTA) MINNESOTA AMERICAN PAGING OF MISSOURI, INC. MISSOURI AMERICAN PAGING, INC. (OF OKLAHOMA) OKLAHOMA A.P. OF PENNSYLVANIA, INC. PENNSYLVANIA AMERICAN PAGING, INC. (OF TEXAS) TEXAS AMERICAN PAGING, INC. (OF UTAH) UTAH AMERICAN PAGING, INC. (OF VIRGINIA) VIRGINIA AMERICAN PAGING, INC. (OF WISCONSIN) WISCONSIN APPNOC, INC. DELAWARE APIXUS INC. MINNESOTA PERSONAL COMMUNICATON SERVICE COMPANIES --------------------------------------- AERIAL COMMUNICATIONS, INC. DELAWARE APT OPERATING COMPANY, INC. DELAWARE APT ALASKA, INC. DELAWARE APT COLUMBUS, INC. DELAWARE APT GUAM, INC. DELAWARE APT HOUSTON, INC. DELAWARE APT KANSAS CITY, INC. DELAWARE APT MINNEAPOLIS, INC. DELAWARE APT TAMPA/ ORLANDO, INC. DELAWARE APT OF PITTSBURGH G.P., INC. DELAWARE APT PITTSBURGH LIMITED PARTNERSHIP DELAWARE CELLULAR COMPANIES ------------------ UNITED STATES CELLULAR CORPORATION DELAWARE UNITED STATES CELLULAR OPERATING COMPANY DELAWARE UNITED STATES CELLULAR INVESTMENT COMPANY DELAWARE USCC REAL ESTATE CORPORATION DELAWARE USCC PAYROLL CORPORATION DELAWARE CARRY PHONE, INC. DELAWARE CELLVEST, INC. DELAWARE ILP, INC. DELAWARE CALIFORNIA RURAL SERVICE AREA #1, INC. CALIFORNIA CALIFORNIA RSA #2, INC. DELAWARE CALIFORNIA RSA #9, INC. CALIFORNIA FLORIDA RSA #8, INC. DELAWARE USCOC OF FLORIDA RSA #9, INC. FLORIDA FLORIDA RSA #10, INC. FLORIDA USCOC OF GEORGIA RSA #1, INC. GEORGIA GEORGIA RSA #11, INC. GEORGIA 4 STATE OF TDS COMPANIES INCORPORATION ------------- ------------- USCOC OF HAWAII 3, INC. DELAWARE USCOC OF IDAHO RSA #5, INC. DELAWARE USCOC OF ILLINOIS RSA #1, INC. VIRGINIA ILLINOIS RSA #3, INC. ILLINOIS USCOC OF ILLINOIS RSA #4, INC. ILLINOIS USCOC OF INDIANA RSA #2, INC. INDIANA INDIANA RSA #4, INC. DELAWARE INDIANA RSA #5, INC. INDIANA USCOC OF IOWA RSA #1, INC. IOWA IOWA RSA #3, INC. DELAWARE OHIO STATE CELLULAR PHONE COMPANY, INC. DELAWARE IOWA RSA #9, INC. DELAWARE UNITED STATES CELLULAR OPERATING COMPANY - DES MOINES IOWA IOWA RSA #12, INC. DELAWARE IOWA 13, INC. DELAWARE USCOC OF IOWA RSA #16, INC. DELAWARE MAINE RSA #1, INC. MAINE MAINE RSA #4, INC. MAINE MAINE RSA NO. 4 LIMITED PARTNERSHIP USCOC OF CUMBERLAND, INC. MARYLAND MICHIGAN RSA #4, INC. MICHIGAN USCOC OF MISSOURI RSA #5, INC. ILLINOIS UNITED STATES CELLULAR OPERATING COMPANY OF COLUMBIA MISSOURI USCOC OF MISSOURI RSA #13, INC. DELAWARE MISSOURI #15 RURAL CELLULAR, INC. MISSOURI PEACE VALLEY CELLULAR TELEPHONE COMPANY DELAWARE NH #1 RURAL CELLULAR, INC. NEW HAMPSHIRE USCOC OF NEW YORK RSA #6, INC. DELAWARE HUDSON CELLULAR LIMITED PARTNERSHIP NORTH CAROLINA RSA #4, INC. DELAWARE RANDOLPH CELLULAR TELEPHONE COMPANY NORTH CAROLINA NORTH CAROLINA RSA NO. 6, INC. CALIFORNIA USCOC OF NORTH CAROLINA RSA #7, INC. NORTH CAROLINA OHIO RSA #1, INC. OHIO USCOC OF OHIO RSA #7, INC. COLORADO UNITED STATES CELLULAR OPERATING COMPANY OF TULSA, INC. OKLAHOMA OKLAHOMA OPCO. OF RSA #8, INC. OKLAHOMA USCOC OF TEXAHOMA, INC. TEXAS TEXAHOMA CELLULAR TELEPHONE CORPORATION TEXAS TEXAHOMA CELLULAR LIMITED PARTNERSHIP OKLAHOMA #9 RURAL CELLULAR, INC. OKLAHOMA USCOC OF OKLAHOMA RSA #10, INC. OKLAHOMA OREGON RSA #2, INC. OREGON OREGON RSA #3, INC. OREGON OREGON RSA NO. 3 LIMITED PARTNERSHIP USCOC OF OREGON RSA #5, INC. DELAWARE OREGON RSA #6, INC. OREGON UNITED STATES CELLULAR OPERATING COMPANY OF WILLIAMSPORT PENNSYLVANIA CANTON CELLULAR TELEPHONE COMPANY PENNSYLVANIA USCOC OF PENNSYLVANIA RSA #9, INC. DELAWARE UNIONTOWN CELLULAR TELCO, INC. DELAWARE FAYETTE - GREENE CELLULAR TELCO, INC. DELAWARE PA RURAL SERVICE AREA NO. 9 LIMITED PARTNERSHIP BLOCK B CELLULAR CORPORATION PENNSYLVANIA LAUREL HIGHLAND CELLULAR TELEPHONE COMPANY DELAWARE TRI - STATE CELLULAR PARTNERSHIP 5 STATE OF TDS COMPANIES INCORPORATION ------------- ------------- PENNSYLVANIA RSA NO. 10B (II) LIMITED PARTNERSHIP USCOC OF SOUTH CAROLINA RSA #4, INC. SOUTH CAROLINA UNITED STATES CELLULAR INVESTMENT CO. OF NASHVILLE TENNESSEE TENNESSEE RSA #3, INC. DELAWARE TENNESSEE RSA #4 SUB 2, INC. TENNESSEE TENNESSEE RSA #6 B, INC. TENNESSEE UNITED STATES CELLULAR OPERATING COMPANY OF KNOXVILLE TENNESSEE UNITED STATES CELLULAR TELEPHONE COMPANY (GREATER KNOXVILLE), L.P. TEXAS #20 RURAL CELLULAR, INC. TEXAS TDS V2B ACQUISITION CORP. DELAWARE LAKE CHAMPLAIN CELLULAR PARTNERSHIP VERMONT INDEPENDENT CELLULAR TELEPHONE GENERAL PARTNERSHIP USCOC OF VIRGINIA RSA #2, INC. VIRGINIA USCOC OF VIRGINIA RSA #4, INC. ILLINOIS VIRGINIA RSA #4, INC. VIRGINIA VIRGINIA RSA #7, INC. VIRGINIA USCOC OF WASHINGTON - 4, INC. DELAWARE WASHINGTON RSA #5, INC. WASHINGTON WESTERN SUB - RSA LIMITED PARTNERSHIP MCDANIEL CELLULAR TELEPHONE COMPANY DELAWARE USCOC OF WEST VIRGINIA RSA #2, INC. WEST VIRGINIA HARDY CELLULAR TELEPONE COMPANY DELAWARE GEORGIA RSA #13, INC. GEORGIA USCOC OF WISCONSIN RSA #6, INC. DELAWARE WISCONSIN RSA #7, INC. DELAWARE WISCONSIN RSA #8, INC. WISCONSIN WISCONSIN RSA GENERAL PARTNER, INC. DELAWARE WISCONSIN RSA NO. 8 LIMITED PARTNERSHIP USCIC OF FRESNO, INC. CALIFORNIA USCIC OF COLORADO RSA #3, INC. DELAWARE WESTERN COLORADO CELLULAR, INC. COLORADO WESTERN COLORADO CELLULAR OF COLORADO LIMITED PARTNERSHIP IDAHO INVCO OF RSA #1, INC. DELAWARE IDAHO RSA NO. 1 LIMITED PARTNERSHIP MINNESOTA INVCO OF RSA #5, INC. DELAWARE MINNESOTA INVCO OF RSA #7, INC. DELAWARE MINNESOTA INVCO OF RSA #8, INC. DELAWARE MINNESOTA INVCO OF RSA #9, INC. DELAWARE MINNESOTA INVCO OF RSA #10, INC. DELAWARE MINNESOTA INVCO OF RSA #11, INC. DELAWARE USCIC OF NORTH CAROLINA RSA #1, INC. DELAWARE NORTH CAROLINA RSA 1 PARTNERSHIP TEXAS INVCO OF RSA #6, INC. DELAWARE COMMUNITY CELLULAR TELEPHONE COMPANY TEXAS TEXAS INVCO OF RSA #17, INC. DELAWARE USCIC OF SEATTLE, INC. DELAWARE WISCONSIN INVCO OF RSA #7, INC. DELAWARE UNITED STATES CELLULAR INVESTMENT COMPANY OF ROCKFORD DELAWARE UNITED STATES CELLULAR OPERATING COMPANY OF ATLANTIC CITY, INC. NEW JERSEY UNITED STATES CELLULAR OPERATING COMPANY OF BANGOR MAINE BANGOR CELLULAR TELEPHONE, L.P. DELAWARE UNITED STATES CELLULAR OPERATING COMPANY OF BILOXI MISSISSIPPI UNITED STATES CELLULAR OPERATING COMPANY OF CEDAR RAPIDS DELAWARE CEDAR RAPIDS CELLULAR TELEPHONE, L.P. USCOC OF CHARLOTTESVILLE, INC. VIRGINIA CHARLOTTESVILLE CELLULAR PARTNERSHIP 6 STATE OF TDS COMPANIES INCORPORATION ------------- ------------- USCOC OF CORPUS CHRISTI, INC. TEXAS UNITED STATES CELLULAR OPERATING COMPANY - QUAD CITIES IOWA DAVENPORT CELLULAR TELEPHONE COMPANY, INC. DELAWARE DAVENPORT CELLULAR TELEPHONE COMPANY UNITED STATES CELLULAR OPERATING COMPANY OF DUBUQUE IOWA DUBUQUE CELLULAR TELEPHONE, L.P. DELAWARE UNITED STATES CELLULAR OPERATING COMPANY OF EVANSVILLE, INC. INDIANA EVANSVILLE CELLULAR TELEPHONE COMPANY UNITED STATES CELLULAR OPERATING COMPANY OF FT. PIERCE FLORIDA CENTRAL FLORIDA CELLULAR TELEPHONE COMPANY, INC. FLORIDA UNITED STATES CELLULAR OPERATING COMPANY OF JOPLIN MISSOURI JOPLIN CELLULAR TELEPHONE COMPANY, INC. DELAWARE TRI - STATES CELLULAR COMMUNICATIONS, INC. MISSOURI JOPLIN CELLULAR TELEPHONE COMPANY, L.P. UNITED STATES CELLULAR OPERATING COMPANY OF LACROSSE, INC. WISCONSIN LACROSSE CELLULAR TELEPHONE COMPANY, INC. DELAWARE LAR - TEX CELLULAR TELEPHONE COMPANY, INC. DELAWARE UNITED STATES CELLULAR OPERATING COMPANY OF LEWISTON - AUBURN MAINE LEWISTON CELLTELCO PARTNERSHIP UNITED STATES CELLULAR OPERATING COMPANY OF MANCHESTER - NASHUA, INC. NEW HAMPSHIRE MANCHESTER - NASHUA CELLULAR TELEPHONE, L.P. UNITED STATES CELLULAR OPERATING COMPANY OF MEDFORD OREGON MEDFORD PAGING, INC. OREGON UNITED STATES CELLULAR OPERATING COMPANY OF OWENSBORO DELAWARE OWENSBORO CELLULAR TELEPHONE, L.P. USCOC OF PORTLAND, INC. MAINE UNITED STATES CELLULAR OPERATING COMPANY OF POUGHKEEPSIE, INC. NEW YORK UNITED STATES CELLULAR OPERATING COMPANY OF RICHLAND WASHINGTON TRI - CITIES PAGING, INC. WASHINGTON UNITED STATES CELLULAR OPERATING COMPANY OF ROCHESTER MINNESOTA DRGP, INC. DELAWARE ROCHESTER CELLULAR TELEPHONE COMPANY, L.P. USCOC OF TALLAHASSEE, INC. FLORIDA TULSA GENERAL PARTNER, INC. DELAWARE UNITED STATES CELLULAR TELEPHONE COMPANY (GREATER TULSA) USCOC OF VICTORIA, INC. TEXAS VICTORIA CELLULAR PARTNERSHIP VICTORIA CELLULAR CORPORATION TEXAS UNITED STATES CELLULAR OPERATING COMPANY OF WATERLOO IOWA WATERLOO / CEDAR FALLS CELLTELCO PARTNERSHIP UNITED STATES CELLULAR OPERATING COMPANY OF WAUSAU, INC. WISCONSIN WAUSAU CELLULAR TELEPHONE COMPANY LIMITED PARTNERSHIP UNITED STATES CELLULAR OPERATING COMPANY OF YAKIMA WASHINGTON YAKIMA MSA LIMITED PARTNERSHIP YAKIMA VALLEY PAGING LIMITED PARTNERSHIP UNITED STATES CELLULAR INVESTMENT CO. OF ALLENTOWN PENNSYLVANIA USCIC OF AMARILLO. INC. DELAWARE UNITED STATES CELLULAR INVESTMENT COMPANY OF BATON ROUGE LOUISIANA CAPITOL CELLULAR, INC. LOUISIANA CSII OF BATON ROUGE, INC. DELAWARE STAR CELLULAR COMMUNICATIONS, INC. LOUISIANA STAR CELLULAR TELEPHONE COMPANY, INC. DELAWARE BATON ROUGE MSA LIMITED PARTNERSHIP UNITED STATES CELLULAR INVESTMENT COMPANY OF BINGHAMTON, INC. NEW YORK CELLULAR AMERICA TELEPHONE COMPANY PENNSYLVANIA 7 STATE OF TDS COMPANIES INCORPORATION ------------- ------------- USCIC OF BROWNSVILLE, INC. DELAWARE UNITED STATES CELLULAR INVESTMENT COMPANY OF EAU CLAIRE, INC. WISCONSIN UNIVERSAL CELLULAR FOR EAU CLAIRE MSA, INC. WISCONSIN LAVACA CELLULAR TELEPHONE COMPANY OKLAHOMA UNITED STATES CELLULAR INVESTMENT COMPANY OF GALVESTON TEXAS UNITED STATES CELLULAR INVESTMENT COMPANY OF GREEN BAY, INC. WISCONSIN UNITED STATES CELLULAR INVESTMENT COMPANY OF HUNTSVILLE, INC. ALABAMA UNITED STATES CELLULAR INVESTMENT COMPANY OF IOWA CITY IOWA USCIC OF JACKSON, INC. DELAWARE UNITED STATES CELLULAR INVESTMENT COMPANY OF LAFAYETTE LOUISIANA UNITED STATES CELLULAR INVESTMENT CORPORATION OF LOS ANGELES INDIANA USCIC OF MCALLEN, INC. DELAWARE USCIC OF OCALA, INC. FLORIDA FOUR D, LTD. MICHIGAN UNITED STATES CELLULAR INVESTMENT CO. OF OKLAHOMA CITY, INC. OKLAHOMA UNITED STATES CELLULAR INVESTMENT COMPANY OF PORTSMOUTH, INC. NEW HAMPSHIRE UNITED STATES CELLULAR INVESTMENT COMPANY OF RALEIGH - DURHAM DELAWARE CAROLINA CELLULAR, INC. NORTH CAROLINA UNITED STATES CELLULAR INVESTMENT COMPANY OF SANTA CRUZ, INC. CALIFORNIA UNITED STATES CELLULAR INVESTMENT COMPANY OF SARASOTA FLORIDA UNITED STATES CELLULAR INVESTMENT COMPANY OF ST. CLOUD, INC. MINNESOTA UNITED STATES CELLULAR INVESTMENT COMPANY OF WHEELING WEST VIRGINIA
8 EX-23 7 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS EXHIBIT 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference in this Form 10-K of Telephone and Data Systems, Inc., of our report dated January 29, 1997 (except with respect to the matter discussed in Note 16, as to which the date is February 4, 1997) on the consolidated financial statements of Telephone and Data Systems, Inc. and Subsidiaries (the "Company") included in the Company's 1996 Annual Report to Shareholders, to the inclusion in this Form 10-K of our report dated January 29, 1997 (except with respect to the matter discussed in Note 16, as to which the date is February 4, 1997) on the financial statement schedules of the Company, and to the incorporation of such reports into the Company's previously filed S-8 Registration Statements, File No. 33-1192, File No. 33-4420, File No. 33-35172, File No. 33-50747, File No. 33-57257, File No. 33-64035 and File No. 333-01041, and into the Company's previously filed S-3 Registration Statements, File No. 33-8564, File No. 33-8857, File No. 33-28348, File No. 33-68456 and File No. 33-59435, and into the Company's previously filed S-4 Registration Statements, File No. 33-45570, File No. 33-64293, File No. 33-62925 and File No. 333-00727. ARTHUR ANDERSEN LLP Chicago, Illinois March 20, 1997 EX-27 8 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED FINANCIAL STATEMENTS OF TELEPHONE AND DATA SYSTEMS, INC. AS OF DECEMBER 31, 1996, AND FOR THE YEAR THEN ENDED, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 57,633 32,408 140,532 6,076 29,125 346,070 2,660,268 831,379 4,200,969 509,267 982,232 280 29,000 61,154 1,971,787 4,200,969 0 1,214,636 0 1,060,538 (140,540) 0 42,853 251,785 123,646 128,139 0 0 0 128,139 2.08 2.07
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