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UNITED STATES
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 [FEE REQUIRED]
For the fiscal year ended December 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
Commission File Number: 0-18587
HECTOR COMMUNICATIONS CORPORATION
(Exact name of registrant as specified in its charter)
Minnesota 41-1666660
- --------------------------------- -------------------
(State or other jurisdiction (Federal Employer
of incorporation or organization) Identification No.)
211 South Main Street
Hector, MN 55342
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (320) 848-6611
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
----------------------------
Common Stock, $.01 par value
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 a 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)
Indicate by a check mark whether the registrant is an accelerated filer (as
defined by Rule 12b-2 of the Act). Yes ( ) No (X)
The aggregate market value of the voting stock held by non-affiliates of the
Registrant was approximately $33,471,000 based upon the closing sale price of
the Company's common stock on the American Stock Exchange on March 21, 2003.
As of March 21, 2003 there were outstanding 3,473,629 shares of the Registrant's
common stock.
Documents Incorporated by Reference: Portions of the Company's definitive proxy
statement for its Annual Meeting of
Shareholders to be held on May 21, 2003 are
incorporated by reference into Part III of
this Form 10-K.
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TABLE OF CONTENTS
Item Page
PART I
1. Business 3
2. Properties 15
3. Legal Proceedings 15
4. Submission of Matters to a Vote of Security Holders 15
PART II
5. Market for Company's Common Equity and Related
Stockholder Matters 16
6. Selected Financial Data 17
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations 18
7a. Disclosures About Market Risk 27
8. Financial Statements and Supplementary Data 28
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 48
PART III
10. Directors and Executive Officers of the Registrant 49
11. Executive Compensation 49
12. Security Ownership of Certain Beneficial Owners and Management 49
13. Certain Relationships and Related Transactions 49
14. Controls and Procedures 49
PART IV
15. Exhibits, Financial Statement Schedule and Reports on Form 8-K 50
2
PART I.
ITEM 1. BUSINESS
[a] GENERAL DEVELOPMENT OF BUSINESS
Hector Communications Corporation ("HCC" or "Company") is a
telecommunications holding company which, through its wholly-owned and
majority-owned subsidiaries, primarily provides local telephone and cable
television service. The Company also invests in other companies providing
wireless telephone and other telecommunications related services.
HCC operates five wholly-owned local exchange company subsidiaries
(generally referred to as "local exchange carriers" or "LECs") which served
7,620 access lines in 9 rural communities in Minnesota and Wisconsin at December
31, 2002. HCC, through its wholly-owned subsidiaries, also provides cable
television service or video service to 4,603 subscribers in Minnesota and
Wisconsin.
HCC's 68% owned subsidiary, Alliance Telecommunications Corporation
("Alliance"), owns and operates six additional LEC subsidiaries which served
31,157 access lines in 28 rural communities in Minnesota, Wisconsin, Iowa and
South Dakota at December 31, 2002. Alliance, through its subsidiaries, also
served 9,112 cable television and video subscribers in Minnesota, North Dakota,
South Dakota and Iowa. Golden West Telecommunications Cooperative, Inc. ("Golden
West") of Wall, South Dakota and Alliance Communications Cooperative, Inc.
("ACCI", formerly Splitrock Telecom) of Garretson, South Dakota own the
remaining interests in Alliance.
The directors of Alliance have approved a reorganization of Alliance
under Section 355 of the Internal Revenue Code. Pursuant to the reorganization,
Golden West will exchange its 20% ownership interest in Alliance for all of the
outstanding stock of Sioux Valley Telephone Company and certain other Alliance
assets and ACCI will exchange its12% ownership interest in Alliance for all of
the outstanding stock of Hills Telephone Company and certain other Alliance
assets. The reorganization is expected to be completed on or about April 30,
2003. Further information concerning the reorganization is set forth under Item
7, Management's Discussion and Analysis of Financial Condition and Results of
Operations under the heading "Liquidity and Capital Resources - Break up of
Alliance Telecommunications Corporation"
Effective June 9, 2000, Alliance acquired all the outstanding common
stock of Hager TeleCom, Inc. ("Hager"); a rural telephone company located in
southwestern Wisconsin. Hager serves approximately 2,100 access lines, provides
internet service to 2,700 customers in Hager City, WI and Red Wing, MN and has
an ownership interest in Midwest Wireless Holdings LLC.
The Company maintains a website at www.hectorcom.com. Our annual
reports on Form 10-K, our quarterly reports on Form 10-Q and our periodic
reports on Form 8-K (and any amendments to these reports) are available free of
charge by linking from our website to the Securities & Exchange Commission
website.
[b] FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Company is organized in two business segments, Hector Communications
Corporation and its wholly-owned subsidiaries, and Alliance Telecommunications
Corporation and its subsidiaries. Information regarding segment operations is
provided in Note 13 to the financial statements found under Item 8 of this
report.
[c] NARRATIVE DESCRIPTION OF BUSINESS
The Company derives the majority of its revenues from providing basic
telephone services (often referred to as "plain old telephone service" or
"POTS") to residential and business customers within its service territories.
POTS revenues consist mainly of fees for local service which are billed directly
to customers and access revenues which are received for intrastate and
interstate exchange services provided to long distance carriers. POTS revenues
are subject to regulation by a number of state and federal government agencies.
3
The Company also earns revenues by providing a number of nonregulated
telecommunications services to customers. The most significant of these
nonregulated services is cable television or video service. Other services
include internet access services, lease of fiber optic transport facilities,
billing and collection services to long distance carriers, telephone directory
services, engineering services and equipment rental. The Company also makes
retail sales of consumer telecommunications equipment and sells wireless
telephone services on a commission basis.
The following table presents the percentage of revenues derived from
local service revenues, access revenues, nonregulated telecommunications
activities and cable television operations for the last three years:
Year Ended December 31
---------------------------------------------
2002 2001 2000
------- ------- -------
Local network 18.7% 17.6% 17.6%
Network access 53.5 55.0 55.1
Video services 11.1 10.2 10.5
Internet services 6.1 4.9 3.4
Other nonregulated services 10.6 12.3 13.4
------- ------- -------
100.0% 100.0% 100.0%
======= ======= =======
The Company also owns minority interests in joint ventures, partnerships
and limited liability corporations ("LLCs") that provide a wide variety of
telecommunications services, including wireless telephone services, fiber-optic
transport services and telephone switching services. The most significant of
these investments is Midwest Wireless Holdings LLC.
(1) Plain Old Telephone Service ("POTS")
Local Network
-------------
The Company's LEC subsidiaries provide basic local telephone services to
residential and business customers in Minnesota, Wisconsin, South Dakota, North
Dakota and Iowa. Local service revenues are earned by providing customers with
local service to connecting points within the local exchange boundaries and, in
certain cases, to nearby local exchanges under extended area service ("EAS")
plans that eliminate long distance charges to the neighboring exchanges. Monthly
rates for telephone service differ among the LECs depending upon the cost of
providing service, the type and grade of service, the number of customers and
calling patterns within the toll free calling area and other factors. The
following chart presents the number of access lines served by Hector's and
Alliance's LEC subsidiaries at December 31, 2002, 2001 and 2000:
Access Lines*
-----------------------------------
December 31
-----------------------------------
2002 2001 2000
------- ------- -------
Hector Communications Corporation:
Arrowhead Communications Corporation 806 808 806
Eagle Valley Telephone Company 747 727 731
Granada Telephone Company 296 289 288
Pine Island Telephone Company 3,368 3,313 3,263
Indianhead Telephone Company 2,403 2,392 2,334
------- ------- -------
Total Hector Access Lines 7,620 7,529 7,422
------- ------- -------
Alliance Telecommunications Corporation:
Loretel Systems, Inc. 13,286 13,300 13,234
Sleepy Eye Telephone Company 6,503 6,556 6,511
Sioux Valley Telephone Company 5,780 5,893 5,939
Hills Telephone Company 2,762 2,812 2,788
Felton Telephone Company 765 752 752
Hager TeleCom, Inc. 2,061 2,037 2,087
------- ------- -------
Total Alliance Access Lines 31,157 31,350 31,323
------- ------- -------
Total Access Lines 38,777 38,879 38,745
======= ======= =======
* An "access line" is a single or multi-party circuit between the customer's
establishment and the central switching office.
4
The Company's LEC subsidiaries offer their customers a number of enhanced
telecommunications services, including custom calling features like call
waiting, caller identification and voice mail. Charges for custom calling
services are generally billed monthly together with the customers' local service
bill.
The Company maintains a local presence in each of its LEC subsidiaries.
The Company provides its LEC subsidiaries with various services, including
finance, accounting and treasury services, marketing, customer service,
purchasing, engineering and construction, customer billing, rate administration,
credit and collection, and development of administrative and procedural
practices.
Access Revenues
---------------
Access revenues are received by LECs for intrastate and interstate
exchange services provided to long distance carriers (generally referred to as
interexchange carriers or "IXCs"). These services enable IXCs to provide long
distance service to end users in the local exchange network.
Access revenues are determined, in the case of interstate calls,
according to rules promulgated by the Federal Communications Commission ("FCC")
and administered by the National Exchange Carriers Association ("NECA"). In the
case of intrastate calls, access revenues are determined by state regulatory
agencies. In 2002, approximately 70% of the Company's access revenues were from
interstate sources and 30% were from intrastate sources.
A portion of the Company's interstate access revenue is derived from
subscriber line charges ("SLCs") determined by the FCC and billed directly to
end users for access to long distance carriers. Another portion consists of
universal service funds received based upon the high cost of providing service
to rural areas. The balance of the interstate access revenue is received from
NECA, which collects payments from IXCs and distributes settlement payments to
LECs.
Settlement payments are based on a number of factors, including the cost
of providing service and the amount of time the local network is utilized to
provide long distance services. Through the 1980s and 1990s a variety of
factors, including increased subscriber counts, cultural and technological
changes, and rate reductions by IXCs, resulted in a consistent pattern of
increasing use of the nation's telephone network. This growth produced higher
revenues for NECA and increased settlements for its participating LECs.
Intrastate access revenues are received from long distance carriers based
on recorded customer usage multiplied by the appropriate tariff rate. Where
applicable, HCC's LECs participate in intrastate access tariffs approved by
state regulatory authorities for intrastate intra-LATA (Local Access Transport
Area) and inter-LATA services. These intrastate arrangements are intended to
compensate LECs for the costs, including a fair rate of return, of facilities
provided in originating and terminating intrastate long distance services.
(2) Nonregulated Telecommunications Activities
Video services
--------------
The Company, through its cable television and LEC subsidiaries, provide
cable television services to 13,715 subscribers in Minnesota and the surrounding
states. Video service revenues are derived almost exclusively from monthly fees
for basic and premium programming. Fees for basic services range from $9.00 to
$44.85 per month. Basic service generally includes the major television
networks, non-network independent stations, sports programming, news services
and automated information channels, children's programming, access channels for
public, governmental, educational and leased use, senior citizens' programming
and religious programming. Premium programming services, such as the HBO or
ShowTime movie services, are provided to subscribers for an additional fee of
$1.75 to $11.00 per month per channel. Premium programming is obtained from
suppliers for a flat monthly fee per subscriber and/or a fee based on the
monthly charge to subscribers for the service.
In 2001 and 2002 the Company deployed broadband equipment manufactured by
Next Level Communications, Inc. in its exchanges serving Pine Island, MN,
Goodhue, MN and Sleepy Eye, MN. This equipment makes it possible to deliver
5
POTS, video and high speed Internet services to the customer over the same
circuit. Video programming is delivered utilizing a digital "super headend"
owned by Broadband Visions, LLC, in which the Company is an investor. The
Company is planning to install broadband equipment in additional exchanges in
future years. The Company's broadband product offerings are dependent on the
availability of equipment from Next Level Communications, Inc. If the Company
cannot obtain necessary equipment it could have a material adverse affect on its
operations.
Internet
Revenues from internet services were $2,405,000, $1,977,000 and
$1,304,000 in 2002, 2001 and 2000, respectively. Internet access is available,
through local dial-up telephone numbers, to all of the Company's local service
customers. Digital subscriber lines ("DSL") permit high-speed Internet access
and are available in many of the Company's service areas. The Company provided
dial-up internet services to 9,358, 8,859 and 7,876 customers at December 31,
2002, 2001 and 2000 respectively. The Company provided DSL services to 2,023 and
1,162 customers at December 31, 2002 and 2001, respectively. Approximately half
of the Company's DSL subscribers are in the Pine Island, Sleepy Eye and Goodhue
exchanges where service is available utilizing Next Level equipment.
Other services
HCC's LECs provide fiber optic transport facilities, sell and lease
customer premise telephone equipment, provide inside wiring services and sell
and lease other facilities for private line, teletype, data transmission and
other communications services. They also provide billing and collection services
for certain IXCs in lieu of such IXCs directly billing customers within the
LEC's service areas.
Due to changes in market conditions the Company renegotiated several of
its fiber leases in 2001, resulting in a significant decline in lease revenue.
All of the fiber-optic facilities leased are owned by HCC's LEC subsidiaries and
are located within the LEC's local exchange boundaries.
HCC's revenues from other nonregulated services were as follows:
2002 2001 2000
----------- ----------- -----------
Fiber leases $ 947,045 $ 1,300,601 $ 1,282,246
Engineering fees 438,534 464,807 536,302
Directory 408,551 429,545 378,072
Billing and collection 375,106 530,803 694,171
Retail sales 346,508 540,595 595,047
Cellular sales commissions 333,714 300,146 218,752
Resale of long distance service 250,937 214,385 273,582
Equipment rent 237,613 243,189 210,191
Other 885,347 985,594 881,237
----------- ----------- -----------
$ 4,223,355 $ 5,009,665 $ 5,069,600
=========== =========== ===========
(4) Investments in Unconsolidated Affiliates
Midwest Wireless Holdings LLC
-----------------------------
Midwest Wireless Holdings LLC ("Midwest Wireless") provides wireless
telecommunications services to 289,000 customers in eleven rural service areas
and one metropolitan service area in Minnesota, Wisconsin and Iowa. Population
of the service areas is approximately 1,590,000. Midwest Wireless offers a
complete package of services, including custom calling features, facsimile and
data transmission.
Midwest Wireless is owned by telecommunications companies (principally
ILECs) located within Midwest Wireless' operating footprint in southern
Minnesota, northern Iowa and southeastern Wisconsin. HCC is presently the
largest member of Midwest Wireless Holdings LLC, with a 10.4% ownership stake.
HCC actively participates in Midwest Wireless' operations and has had a seat on
the Board of Directors since the inception of the Company. HCC influences
Midwest Wireless policies and procedures applying to administration, planning
and budgeting, cell siting, technology selection, roaming agreements,
affiliation agreements, marketing and customer service, financing, accounting
policies and financial reporting and disclosure policies and the timing of
financial reports. HCC accounts for its investment in Midwest Wireless using the
equity method. Income recognized was $2,928,000, $1,475,000 and $1,248,000 in
2002, 2001 and 2000, respectively.
6
Fiber-Optic Transport Investments
---------------------------------
The Company has invested approximately $1,700,000 in five companies that
build and lease fiber- optic transport facilities. These facilities afford
high-quality, high-capacity communications links and generally are used to carry
long-distance traffic. Through these investments, the Company owns pieces of
fiber routes serving the Twin Cities, Duluth-Superior, Sioux Falls,
Fargo-Moorhead, Rochester, St. Cloud and Grand Forks, and extending into Iowa
and Wisconsin.
Other Investments
-----------------
The Company has an ownership interest in SDN Communications, which
provides integrated voice, data and network services in South Dakota. The
Company is an investor in Fibercom LC, a competing local exchange carrier
("CLEC") that has been established to provide local communications services to
business customers in the Sioux City, Iowa area. The Company is also an investor
in Desktop Media, Inc., a CLEC using a network employing ethernet architecture
to provide telecommunications services in southeastern Minnesota.
Wireless North, LLC
-------------------
The Company was a 10.4% owner of Wireless North, which provided personal
communications services ("PCS") to parts of Minnesota, Wisconsin, Iowa, North
Dakota and South Dakota. Wireless North was unsuccessful and has been
liquidated. Its licenses and systems were sold to other operators, or were shut
down. In 2001, the Company made payments to Wireless North's primary lender of
$1,129,000 to satisfy loan guarantees it gave with respect to Wireless North's
debt. Cash investments in Wireless North by the Company totaled $3,202,000. The
Company has written off its entire investment in Wireless North, has no
obligation to provide additional funding and does not expect to realize any
additional value from this investment.
(5) Other Investments
Bank Stocks
-----------
As part of its borrowing agreements, the Company has investments in
CoBank, Rural Telephone Finance Cooperative and the Rural Telephone Bank that
totaled $5,241,000 and $4,991,000 at December 31, 2002 and 2001 respectively.
Onvoy, Inc.
-----------
Onvoy, Inc. is a privately held company that provides integrated voice,
data, and network services through its fiber optic communications network
linking communities throughout Minnesota, including all major metropolitan
areas. Onvoy, Inc. is a leading provider of Internet, long distance,
video-conferencing and high-speed data networking services. Onvoy's customers
include Minnesota based Fortune 500 companies and many small-to-medium sized
businesses. Onvoy also serves the state's higher education institutions, the
state's K-12 schools, public libraries, state and county governments, more than
70 regional Internet service providers and the state's independent local
telephone companies.
The Company is presently the second largest common shareholder of Onvoy.
At the end of 2000 the Company determined that due to losses incurred by Onvoy's
operations, the value of the Company's investment in Onvoy's common stock was
impaired. Accordingly, the Company took a charge against earnings of $1,273,000,
representing substantially all of its investment in Onvoy common stock, during
the fourth quarter of 2000.
During 2001 and 2000 the Company purchased $190,000 and $446,000
respectively, of debt issued by Onvoy to provide additional working capital to
Onvoy's operations. At December 31, 2002, the Company's investment in Onvoy debt
totaled $591,000.
Other long-term investments
---------------------------
The Company has long-term investments in Iowa Network Services, Inc.,
Independent Information Services Corp. and NECA, Inc., which it accounts for
using the cost method. The Company also has receivables from economic
development loans made through the Rural Utilities Service and has other small
investments.
7
(6) Competition
Telephone Service
-----------------
LECs are subject to many forms of competition. Its competitors
principally are:
o Facilities-based competition from providers, including cable television
service providers, with their own local service network;
o Resale competition from resale interconnection (providers who purchase
local services from the LEC at wholesale rates and resell the services to
their customers);
o Competition from unbundled network element interconnection (providers who
lease some of the network elements from the LEC)
o Wireless providers who may charge a competitive fee for services that
could compete with wireline based local service.
Rural areas like those served by the Company are less likely to
experience competition from facilities-based competitors due to the significant
investment in plant and equipment required in relation to the lower customer
density in rural markets. Competition from resale interconnection or unbundled
network element interconnection is more likely. Under the Telecommunications Act
of 1996, the Company's LECs are not currently required to lease facilities to
competitors seeking to interconnect with its networks. However, there is no
assurance that interconnection may not be required in the future.
Wireless service has always competed directly with wireline local service
among certain classes of customers, principally customers with seasonal or lake
homes. Newer wireless service offerings that bundle local and long distance
minutes for a flat fee are competing with wireline services over a broader class
of customers. These wireless service offerings can be particularly attractive in
rural areas, where the toll free dialing areas offered by wireline carriers are
usually quite small. The Company believes that significant numbers of long
distance minutes are migrating from the wireline to the wireless network due to
these rate plans. This drives down the revenues of IXCs and negatively impacts
the Company's access revenues. Developments in technology related to cellular,
PCS, digital microwave, coaxial cable, fiber optics and other wireline or
wireless services could also lead to greater competition for traditional local
services.
LECs are increasingly subject to competition from competing access
providers ("CAPs") which construct, modify or lease facilities that enable high
volume long distance users to bypass the local telephone network. Cable
television companies may also be able to modify their networks to carry
telephone messages that bypass the local telephone network. The Company believes
its LEC subsidiaries have experienced only a small loss of traffic due to
bypass.
Video Services
--------------
In addition to competition from off-air television, other technologies
also supply services that compete with cable television. These include low power
television stations, multi-point distribution systems, over-the-air subscription
television and direct broadcast satellite ("DBS"). Cable television also
competes for customers in local markets with providers of other forms of
entertainment, news and information. These competitors include radio,
newspapers, magazines, motion picture theaters, video cassettes and Internet
service providers.
All of the Company's cable television franchises are non-exclusive. The
1992 Cable Act prohibits franchising authorities from unreasonably refusing to
grant franchises to competing cable television systems. The Company competes
with a municipally owned cable system in one community it serves. It also
competes with a much larger multi-system operator in Sleepy Eye, where the
Company is using broadband equipment to deliver video services. The degree of
competition from other cable providers will be dependent upon the state and
federal regulations concerning entry, interconnection requirements and the
degree of unbundling of the LECs' networks. The Company expects to compete based
upon product, service quality, breadth of services offered and, to a lesser
extent, on price.
8
Maintaining and expanding the Company's subscriber base depends on
numerous factors, including the quality and quantity of signals available from
"off-air" television stations, demand for satellite and premium television
channels and average household income in the service area. Promotional efforts
for video services include telephone and door-to-door selling and local media
advertising.
(6) Regulation
The Company's LECs and cable television systems are subject to federal,
state and local regulation. The Communications Act of 1934 and the
Telecommunications Act of 1996 govern Federal regulations. Under these federal
statutes, the FCC exercises jurisdiction over all interstate telecommunications
activities. Intrastate activities are governed by rules and regulations set by
the respective state public utility commissions.
Federal Regulations
-------------------
Under federal regulations, incumbent local exchange carriers ("ILECs")
are required to comply with the Communications Act of 1934 and rules issued by
the FCC. While the Telecommunications Act of 1996 amended the earlier law to
reduce regulatory burdens and promote competition, ILECs remain subject to
extensive regulatory requirements. ILECs are required to maintain accounting
records according to Uniform System of Accounts, to structure access charges
according to FCC rules and to reflect their charges for interstate services at a
rate of return prescribed by the FCC. The FCC also regulates transfer of control
and assignments of operating authorizations and construction licenses. The FCC
requires carriers providing access services to file tariffs with the FCC
reflecting rates, terms and conditions of the services. Tariffs filed are
subject to review and potential objection by third parties.
Regulation of Cost Recovery and Nonregulated Revenue Allocation
---------------------------------------------------------------
As a regulated common carrier, the Company's LEC subsidiaries can set
maximum rates at a level that allows recovery of reasonable costs incurred to
provide regulated service and earns a reasonable return on the investment
required to provide these services.
Costs are recovered through:
o Monthly charges to end users for basic local telephone services and
enhanced services;
o Access charges to interexchange carriers for originating and terminating
interstate and intrastate interexchange calls; and
o Payments from the federal Universal Service Fund and the state universal
service funds (where applicable) that offset the high cost of providing
service in certain rural markets.
Rates for regulated services and the amount of universal service fund
support are set forth by the FCC with respect to interstate services and by
state regulatory agencies with respect to intrastate services.
In conjunction with the recovery of costs and establishment of rates, a
LEC must first determine its aggregate costs and then allocate those costs
between regulated and nonregulated services. After identifying the regulated
costs of providing local telephone service, a LEC must allocate those costs
among its various local exchange and interstate and intrastate interexchange
services and between state and federal jurisdictions. Allocating costs is
complicated because the same pieces of a LEC's plant and equipment are utilized
for different services, such as local telephone and interstate and intrastate
access services. The allocation process is called "separation" and is governed
primarily by FCC regulations. The purpose of separation is to determine how a
carrier's expenses are allocated and recovered from federal and state
jurisdictions. The FCC is considering whether to change or eliminate this
process. Any change in separation rules by the FCC could reduce or increase the
LEC's revenues. However, at this time it is not possible to predict what
changes, if any, may be made.
9
Interstate End-User Rates
-------------------------
The part of the local telephone network running from the switching
facility to the customer is called the "local loop." Costs to construct, operate
and maintain the loop are among the most significant costs incurred by a local
exchange carrier. In 1984 the FCC established a rate structure that provides for
the recovery of a portion of the cost of the local loop allocated to interstate
jurisdiction directly from end-users through the assessment of a subscriber line
charge. The SLC was increased in 1989 to a $3.50 cap on residence and single
line business lines and a $6.00 cap on multi-line business lines. The remaining
portions of the interstate local loop costs were recovered from interstate
access charges to interexchange carriers.
In November 2001 the FCC adopted access charge reforms based in part on a
proposal by the Multi-Association Group (the "MAG Plan"). The MAG Plan increases
the maximum rate caps for SLCs as follows:
Residential and Single Line Business
January 1, 2002 Increase from $3.50 to $5.00
July 1, 2002 Increase from $5.00 to $6.00
July 1, 2003 Increase from $6.00 to $6.50
Multi-line Business
January 1, 2002 Increase from $6.00 to $9.20
The increased SLC revenues will be offset by reductions in recovery of
local loop costs from interexchange carriers. The plan is intended to be revenue
neutral for affected LECs.
Due to demographic and geographic conditions, costs to provide local loop
and switching services are often higher, on a per customer basis, in rural areas
compared to urban areas. Absent a regulatory framework to permit recovery of
these costs, rural LECs would be compelled to charge considerably higher rates
for local network services. Consequently, the FCC provides for additional
interstate recovery by eligible telecommunications carriers through the federal
Universal Service Fund. Funds from the federal Universal Service Fund are
available to local exchange carriers whose local loop costs are significantly
above the national average as determined by FCC rules. Interstate universal
service fund support accounted for $1,832,000, $1,744,000 and $1,490,000 of the
Company's network access revenues in 2002, 2001 and 2000, respectively.
Interstate Access Rates
-----------------------
Interstate access rates are developed on the basis of a LEC's measurement
of its interstate costs to provide access service to IXCs divided by its
projected demand for service. The resulting rates are published in the LEC's
interstate access tariff and filed with the FCC, at which time they are subject
to challenge by third parties and to review by the FCC.
The FCC recognized that the rate making and tariff filing process is
administratively burdensome for small local exchange carriers. In 1983, the FCC
established the National Exchange Carriers Association ("NECA") to develop and
administer interstate access service rates, terms and conditions. NECA develops
interstate access rates on the basis of data provided by participating local
exchange carriers and blended to yield average rates. These rates are intended
to generate revenue equal to the aggregate costs plus a return on the investment
of all of the participants.
Individual LECs are likely to have service costs that differ from the
revenues generated by applying the overall NECA tariff rates. To allow for this,
revenues generated by participating LECs are pooled and redistributed on the
basis of each individual company's costs. This process eliminates the burden of
individual tariff filing and produces a system in which small companies can
share and spread risk. For example, if a small local exchange carrier filed its
own tariff and subsequently suffered the loss of major customers that utilize
interstate access service, the local exchange carrier could suffer significant
under-recovery of its costs. In the NECA pool environment, the impact of this
loss is reduced because it is spread over all of the pool participants.
10
NECA operates separate pools for traffic sensitive costs (primarily
switching costs) and non-traffic sensitive costs (primarily loop costs). LECs
can choose to develop and administer their own interstate access charges and not
participate in the NECA pools. HCC's LECs located in Minnesota and Wisconsin
participate in the traffic sensitive NECA pools. HCC's LECs located in Iowa and
South Dakota do not participate in the traffic sensitive NECA pools. All of
HCC's LECs participate in the non-traffic sensitive NECA pools.
The FCC is reviewing its rates and policies governing interstate access
and the rate of return applicable to incumbent local exchange carriers who are
subject to rate-of-return, rather than price cap, regulation. The outcome of
this review could directly affect HCC's earnings, however, the outcome of this
proceeding cannot be predicted at this time.
The Telecommunications Act
--------------------------
The Telecommunications Act was enacted to promote competition without
jeopardizing the availability of nationwide universal service at affordable
rates. These two objectives have resulted in a complex set of rules intended to
promote competitive entry in the provision of local telephone services, except
where entry would adversely effect the provision of universal service or the
public interest.
- Promotion of Local Service Competition and the Rural Exemptions
---------------------------------------------------------------
The Telecommunications Act made competitive entry into the local
telephone business more attractive to other carriers by removing barriers to
competition. In order to promote competition the Telecommunications Act
established new interconnection rules generally requiring local exchange
carriers to allow competing carriers to interconnect with their local networks.
Congress recognized, however, that the desire to promote competition conflicted
with the ability of some existing LECs to provide universal service to high cost
customers. Congress exempted these LECs (classified as "Rural Telephone
Companies") from interconnection requirements until the continuation of the
exemption was no longer in the public interest, as defined in the
Telecommunications Act.
Under the Telecommunications Act, all local exchange carriers, including
both incumbent local exchange carriers and new competitive carriers, are
required to:
o Offer reasonable and nondiscriminatory resale of their
telecommunications services,
o Ensure that customers can keep their telephone numbers when changing
carriers,
o Ensure that competitors' customers can use the same number of digits
when dialing and receive nondiscriminatory access to telephone numbers,
operator service, directory assistance and directory listing,
o Ensure access to telephone poles, ducts, conduits and rights of way and
o Compensate competitors for the costs of terminating traffic.
The Telecommunications Act also requires incumbent local exchange
carriers to:
o Negotiate in good faith the terms and conditions of interconnection
with any competitive carrier making a bona fide request for same,
o Interconnect their facilities and equipment with any requesting
telecommunications carrier at any technically feasible point,
o Unbundle and provide nondiscriminatory access to unbundled network
elements, such as local loops, switches and transport facilities, at
nondiscriminatory rates and on nondiscriminatory terms and conditions,
o Offer resale interconnection at wholesale rates,
o Provide reasonable notice of changes in the information necessary for
transmission and routing of services over the incumbent local exchange
carrier's facilities or in the information necessary for
interoperability and
o Provide for the physical collocation of equipment necessary for
interconnection or access to unbundled network elements at the premises
of the incumbent local exchange carrier, at rates, terms and conditions
that are just, reasonable and nondiscriminatory.
11
In order to implement interconnection requirements, local exchange
carriers generally enter into negotiated interconnection arrangements with
competing carriers. Local exchange carriers may also offer interconnection
tariffs, available to all competitors.
Competitors are required to compensate a local exchange carrier for the
cost of providing interconnection services. In the case of resale
interconnection, the rules provide that the rates charged should be on a
wholesale basis and reflect the current retail rates of the incumbent local
exchange carrier, excluding the portion of costs avoided by the incumbent local
exchange carrier. In the case of unbundled network element interconnection,
rates are based on costing methodologies that employ a forward-looking economic
cost pricing methodology known as total element long run incremental cost. The
Telecommunications Act specifies that resale and unbundled network element rates
are to be negotiated among the parties, or, if the parties fail to reach an
agreement, arbitrated by the relevant state regulatory authority. Once the
parties have come to agreement, the proposed rates are subject to final approval
by the state regulatory commission.
The Company's LEC subsidiaries are defined as "rural telephone companies"
under the Telecommunications Act. As rural telephone companies, they were
granted rural exemptions from the requirements relating to both resale
interconnection and unbundled network element interconnections. The rural
exemptions are continued until regulatory authorities determine that
interconnection is technically feasible, not unduly economically burdensome and
consistent with the Telecommunications Act's universal service provisions.
- Promotion of Universal Service
While the Telecommunications Act promoted Congress' policy of ensuring
that affordable service is provided to consumers universally in rural, high-cost
areas of the country, the Telecommunications Act altered the framework for
providing universal service by:
o Providing for the identification of those services eligible for
universal service support,
o Requiring the FCC to make implicit subsidies explicit,
o Expanding the types of communications carriers required to pay
universal service support and
o Allowing competitive local exchange carriers to be eligible for
funding.
These and other provisions were intended to make provision of universal
service support compatible with a competitive market.
Pursuant to the Telecommunications Act, federal Universal Service Fund
payments are only available to carriers that are designated as eligible
telecommunications carriers ("ETC") by a state public utilities commission. In
areas served by rural LECs, the Telecommunications Act provides that a state
public utilities commission may designate more than one eligible
telecommunications carrier, in addition to the incumbent local exchange carrier,
only after determining that the designation of an additional eligible
telecommunications carrier will serve the public interest. Wireless providers
have received ETC designation in Company served areas in North Dakota and Iowa,
and have applied for ETC designation in Minnesota. The addition of a second
eligible telecommunications carrier in these service areas could have the effect
of reducing the amount of funds available to HCC's LECs from the federal
Universal Service Fund. Such a reduction could materially adversely affect HCC's
ability to achieve a reasonable rate of return on the capital invested in its
network.
State Regulation of Rural LECs
------------------------------
HCC's LEC subsidiaries are subject to regulation by Minnesota, South
Dakota, Iowa and Wisconsin regulatory agencies with respect to:
o Intrastate toll rates,
o Intrastate access charges billed to intrastate IXCs,
o Service areas,
o Service standards,
o Accounting and related matters, and
o The use of radio frequencies in telephone operations
12
In some cases state regulations also apply to local service rates, rate
of return, depreciation rates, construction plans and borrowings, and certain
other financial transactions.
Local service rates are not directly determined by regulatory
authorities, but are limited by regulation of these other areas. The Company has
sought appropriate increases in local and other service rates and approval for
changes in rate structures necessary to achieve reasonable rates and earnings.
The bulk of the Company's access lines are located in Minnesota. A bill
passed by the 1995 Minnesota legislature allows telephone companies serving
fewer than 50,000 access lines to elect to provide service under an alternate
form of regulation. Companies choosing alternative regulation agreed not to
increase rates for two years, other than in extraordinary circumstances. These
companies are not subject to rate of return review by the Public Utilities
Commission for the same two years. All of HCC's Minnesota-based LEC subsidiaries
(except Felton Telephone Company) elected alternative rate regulation election
effective January 1, 1996. Local rate increases after January 1, 1998 are not
subject to review by the Minnesota Public Utilities Commission unless the lower
of 500 or five percent of customers file a petition requesting such review. In
2001, the Company increased its local service rate for Sleepy Eye Telephone
Company. The commission did not review the rate increase.
The Minnesota Public Utilities Commission is investigating intrastate
access rates charged by local telephone companies to IXCs. The commission has
proposed a plan reducing intrastate access charges and implementing a state
universal service fund to compensate high cost companies. The Company cannot
predict the outcome of the rate investigation or if any part of the proposed
plan will be adopted.
Cable Television System Regulation
----------------------------------
The FCC regulates the providers of satellite communications services and
facilities for the transmission of programming services, the cable television
systems that carry such services, and, to some extent, the availability of the
programming services themselves through its regulation of program licensing.
Municipalities and other state and local government authorities also regulate
cable television systems. FCC regulations contain many detailed provisions
including:
o "Must carry" rules regarding the broadcast television and translator
signals that must be included in channel offerings to subscribers,
o Exclusivity provisions which require the deletion of certain
programming carried by out-of-area stations where it would duplicate
programming carried by local stations,
o Technical standards and performance testing requirements, and
o Franchise fees applicable to state and local cable television
franchises.
Thus far, HCC's cable systems have not experienced any difficulty in complying
with the FCC rules.
In Minnesota, the award of cable franchises and certain aspects of cable
operations are subject to rules of the Minnesota Cable Communications Board.
Cable television systems are operated under 15 year, non-exclusive franchises
granted by local government authorities. Franchises contain many conditions,
including time limitations on commencement or completion of construction,
approval of initial fees charged to subscribers for basic service, the number of
channels offered and the types of programming. HCC does not anticipate
difficulty in obtaining renewal of its franchises at the expiration of their
current terms.
The regulation of cable television at the federal, state and local levels
is subject to the political process and has been in constant flux over the past
decade. This process continues in the context of legislative proposals for new
laws and the adoption or deletion of administrative regulations and policies.
The Company anticipates further material developments in these areas, but cannot
anticipate their direction and impact on its cable television operations.
(7) Business Strategy
The Company is focused on business opportunities in rural
telecommunications. Its three-part strategy is to:
13
o Expand its existing operations through internal growth
o Pursue acquisitions of attractive properties, particularly the
acquisition of additional rural telephone exchanges and cable
television properties
o Participate in opportunities afforded by new telecommunication
technologies
Future growth in existing telephone and cable operations is expected to
come from providing service to new or presently unserved homes and businesses,
from sales of enhanced services to existing customers and from providing new
services made possible by improvements in technology.
The Company continually assesses possible acquisition opportunities.
Competition to acquire attractive telephone or cable television properties is
intense. Acquisitions of rural telephone exchanges are subject to the approval
of regulatory agencies in some 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. The Company will aggressively pursue acquisitions
of telephone exchanges, but there is no assurance that acquisitions can be made
on acceptable terms or that regulatory approval, where required, will be
received.
The Company has aggressively invested in new telecommunications
technologies, primarily through investments in partnerships and limited
liability companies. The Company has substantial investments in wireless
communications companies, fiber optic transport groups, CLECs and Internet
service providers. The Company intends to pursue additional investment
opportunities in the future.
(8) Employees
At March 1, 2003, the Company had 181 full-time and part-time employees,
of which 124 employees work in the Alliance operations and 57 work in Hector
operations. None of the Company's employees are represented under collective
bargaining agreements. HCC believes its employee relations to be good.
(9) Executive Officers of Registrant
The executive officers of the Company and their ages at March 1, 2003
were as follows:
Name Age Position
----------------- --- -------------------------------
Curtis A. Sampson 69 Chairman of the Board and Chief
Executive Officer
Steven H. Sjogren 60 President and Chief Operating Officer
Paul N. Hanson 56 Vice President and Treasurer
Charles A. Braun 45 Chief Financial Officer
- ----------------------------
Executive officers serve at the pleasure of the Board of Directors and
are elected annually for one-year terms. Each officer above has served the
Company in the indicated capacity since 1990.
Mr. Sjogren devotes his full time to the Company's business. Messrs.
Sampson, Hanson and Braun each devote approximately 50% of their working time to
the Company's business with the balance devoted to management responsibilities
at Communications Systems, Inc. ("CSI"), a diversified telecommunications
holding company also located in Hector, Minnesota, for which they are separately
compensated by CSI.
[d] FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND
EXPORT SALES
Not Applicable.
14
ITEM 2. PROPERTIES
The Company's telephone property consists mainly of central office
switching equipment, the land and buildings in which the equipment is housed,
and connecting lines consisting of aerial and underground cable, conduit, and
poles and wires which connect customers' premises with central offices.
Connecting lines are generally located under or above public rights of way or
land owned, for the most part, by others, pursuant to consents of various
governmental bodies or private leases, permits, easements, agreements or
licenses. The Company also owns customer-leased telephones and related terminal
equipment and a small amount of connecting lines that are located on customers'
premises.
The connecting lines constitute approximately 56% of the Company's
telephone property in service. Central office switching equipment represents
approximately 33%. Telephones and related equipment constitute approximately 1%.
Land, buildings, data processing equipment, service vehicles and construction
equipment constitute the remaining 10%. The Company owns substantially all the
land and buildings in which its central office equipment is located. HCC's
principal general offices, administrative services department and business
office are located in Hector, Minnesota and are rented by HCC from CSI. Alliance
owns the building in Ada, Minnesota where its general offices are located.
The physical assets of the Company's cable television systems consist of
signal reception equipment and distribution electronics and cables. The
receiving equipment is comprised of a tower and antennas for reception of
broadcast television signals and one or more satellite dishes for reception of
satellite signals. The Company owns or leases the land on which the towers for
its cable systems and the buildings containing other receiving equipment are
located. Pole attachment space is rented from utilities serving the community.
See Note 8 of "Notes to Consolidated Financial Statements" for additional
information regarding pledged assets.
ITEM 3. LEGAL PROCEEDINGS
No material litigation or other claims are presently pending against the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
15
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
[a] MARKET INFORMATION
The Company's common stock is traded on the American Stock Exchange
("AMEX"). The table below presents the range of high and low trading prices for
the Company's stock for each period as reported by AMEX:
2002 2001
------------------------ -------------------------
Quarter High Low High Low
First $ 16.95 $ 12.50 $ 11.50 $ 9.65
Second 14.85 11.62 13.30 9.60
Third 11.90 9.00 15.25 12.20
Fourth 12.65 8.90 16.65 13.60
[b] HOLDERS
At March 1, 2003 there were 550 holders of record of Hector
Communications Corporation common stock.
[c] DIVIDENDS
HCC has not paid cash dividends on its common stock or preferred stock
since it began operating as a public company in 1990, nor does HCC have any
obligations to pay dividends on its preferred stock. The financing agreements
between HCC's subsidiaries and their lenders, and HCC and its lenders restrict
the ability of HCC to pay dividends. At the present time, HCC intends to retain
earnings to finance the expansion of its business, and does not anticipate any
cash dividends will be paid in the foreseeable future. See Management's
Discussion and Analysis of Financial Condition and Results of Operations, and
also Note 8 to the Consolidated Financial Statements under Item 8 herein for a
description of restrictions on dividends.
[d] OTHER INFORMATION REGARDING EQUITY COMPENSATION PLANS
The following table presents information about our equity compensation
plans as of December 31, 2002:
Securities Authorized For Issuance Under Equity Compansations Plans
(a) (b) (c)
Number of shares of
Number of shares of common stock remaining
common stock to be available for future
issued upon exercise Weighted-average issuance under equity
of outstanding exercise price of compensation plans
options, warrants and outstanding options, (excluding shares in
Plan Category (1) rights warrants and rights column (a))
--------------- --------------------- -------------------- ----------------------
Equity compensation plans approved by security holders:
1990 Stock Plan 231,725 $ 10.77 -
1999 Stock Plan 214,450 11.83 83,850
1990 Employee Stock Purchase Plan 15,685 8.37 15,685
Equity compensation plans not approved by security holders:
None
-----------------------------------------------------
(1) The Company does not have individual compensation arrangements involving
the granting of options, warrants and rights.
16
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL INFORMATION
(in thousands except per share amounts)
Year Ended December 31
-------------------------------------------------------------
2002 2001 2000 1999 1998
- ---------------------------------------------------------------------------------------------------------------------------------
Selected Income Statement Information
Revenues $ 39,722 $ 40,633 $ 37,790 $ 34,117 $ 31,839
Costs and Expenses 29,680 30,112 26,799 23,063 21,192
- ---------------------------------------------------------------------------------------------------------------------------------
Operating Income 10,042 10,521 10,991 11,054 10,647
Other Income (Expenses), net (1,309) 1,170 (2,471) 7,401 (40)
- ---------------------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes and Minority Interest 8,733 11,691 8,520 18,455 10,606
Income Tax Expense 3,670 5,321 4,207 7,513 4,949
- ---------------------------------------------------------------------------------------------------------------------------------
Income Before Minority Interest 5,063 6,370 4,313 10,942 5,657
Minority Interest in Earnings of Alliance
Telecommunications Corporation 1,408 1,754 1,004 3,463 1,747
- ---------------------------------------------------------------------------------------------------------------------------------
Income Before Change in Accounting Principle 3,655 4,616 3,309 7,479 3,910
Cumulative Effect of Change in Accounting Principle,
net of Income Taxes and Minority Interest 3,147
- ---------------------------------------------------------------------------------------------------------------------------------
Net Income $ 508 $ 4,616 $ 3,309 $ 7,479 $ 3,910
=================================================================================================================================
Basic Net Income Per Common Share $ .15 $ 1.33 $ .93 $ 2.42 $ 1.63
Diluted Net Income Per Common Share $ .13 $ 1.23 $ .86 $ 1.96 $ 1.15
Average Shares Outstanding:
Common shares only 3,498 3,465 3,544 3,095 2,403
Common and potential common shares 3,770 3,763 3,851 3,945 3,937
=================================================================================================================================
Selected Balance Sheet Information
Working Capital $ 5,718 $ 7,633 $ 8,960 $ 18,736 $ 6,554
Property, Plant and Equipment, net 56,666 57,362 56,227 51,410 50,810
Excess of Cost Over Net Assets Acquired, net 49,075 53,663 55,475 51,405 53,004
Total Assets 154,486 158,251 158,678 166,797 150,680
Long-Term Debt 75,148 79,642 84,378 86,282 94,232
Stockholders' Equity 42,249 42,241 39,108 39,982 22,720
- ---------------------------------------------------------------------------------------------------------------------------------
Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accouting Standards No. 142, "Goodwill and
Other Intangible Assets".
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Hector Communications Corporation ("HCC") owns a 100% interest in five
LEC subsidiaries and one cable television subsidiary. At December 31, 2002,
these subsidiaries provided telephone service to 7,620 customers in 9 rural
communities in Minnesota and Wisconsin. They also owned cable television systems
serving 4,603 customers in Minnesota and Wisconsin. HCC's 100%-owned
subsidiaries also have substantial investments in other telecommunications
ventures, including, Midwest Wireless Holdings LLC.
HCC also owns a 68% interest in Alliance Telecommunications Corporation
("Alliance"). At December 31, 2002, Alliance, through its six LEC subsidiaries,
provided telephone service to 31,157 customers in 28 rural communities in
Minnesota, Wisconsin, South Dakota and Iowa. Alliance's subsidiaries also
provided cable television services to 9,112 subscribers in Minnesota, South
Dakota and North Dakota. Alliance's subsidiaries also own substantial
investments in Midwest Wireless Holdings LLC and have other investments. Golden
West Telecommunications Cooperative, Inc. ("Golden West") of Wall, South Dakota
and Alliance Communications Cooperative, Inc. ("ACCI", formerly Splitrock
Telecom) of Garretson, South Dakota own the remaining interests in Alliance.
Results of Operations
- ---------------------
2002 Compared to 2001
---------------------
Consolidated revenues decreased 2% to $39,722,000 in 2002 from
$40,633,000 in 2001. The following table shows revenues by operating group for
2002 compared to 2001:
Alliance Hector
Year Ended December 31 Year Ended December 31
2002 2001 2002 2001
--------------- ---------------- ---------------- -----------------
Local network $ 5,836,767 $ 5,586,670 $ 1,611,184 $ 1,562,398
Network access 16,125,314 16,689,138 5,107,970 5,652,977
Video services 2,811,913 2,690,063 1,600,459 1,465,078
Internet services 1,927,473 1,667,999 477,211 308,924
Other nonregulated services 3,554,166 4,191,933 669,189 817,732
--------------- ---------------- ---------------- -----------------
$ 30,255,633 $ 30,825,803 $ 9,466,013 $ 9,807,109
--------------- ---------------- ---------------- -----------------
Consolidated local service revenues increased 4% to $7,448,000 in 2002
from $7,149,000 in 2001. Revenue growth in Alliance was due to the full year
effect of a 2001 local service rate increase at Sleepy Eye Telephone Company.
Hector's local network revenues increased due to increases in the number of
access lines served.
Network access revenues declined $1,109,000 or 5% to $21,233,000 in 2002
compared to $22,342,000 in 2001. The Company's access revenues were reduced
$708,000 in 2002 due to write-offs associated with the bankruptcy filings of
World Com and Global Crossings. Interstate access revenues were negatively
affected by FCC mandated reductions in NECA's tariff rates. Universal service
support increased due to Alliance's increased investment in plant and equipment
in Sleepy Eye. Alliance's intrastate access revenues in South Dakota were
negatively affected by changes in settlement calculation methods.
Video service revenues increased 6% to $4,412,000 due to rate increases,
the 2001 acquisition of additional cable systems and introduction of broadband
video services in Sleepy Eye. Revenues from internet services increased 22% to
$2,405,000 due to increased customer acceptance of the technology and increased
availability of broadband DSL services to customers. Revenues from other
nonregulated services decreased $786,000 to $4,223,000 due to lower revenues
from leases of fiber optic transport facilities, lower billing and collections
revenues and lower retail sales.
18
Consolidated operating costs and expenses were $29,680,000 in 2002
compared to $30,112,000 in 2001. If the provisions of SFAS 142 had been in
effect at January 1, 2001, 2001 operating costs would have been $28,278,000.
Costs and expenses by operating group were as follows:
Alliance Hector
Year Ended December 31 Year Ended December 31
2002 2001 2002 2001
--------------- ---------------- ---------------- -----------------
Plant operations $ 3,803,872 $ 3,974,169 $ 1,581,666 $ 1,381,781
Depreciation and amortization 6,822,974 8,138,515 3,139,678 3,178,259
Customer operations 2,032,467 2,051,760 397,986 384,286
General and administrative 3,866,226 3,307,150 1,607,773 1,565,399
Other operating expenses 4,613,145 4,472,835 1,814,106 1,657,742
--------------- ---------------- ---------------- -----------------
$ 21,138,684 $ 21,944,429 $ 8,541,209 $ 8,167,467
--------------- ---------------- ---------------- -----------------
Consolidated plant operations expenses increased 1% to $5,386,000 in 2002
compared to $5,356,000 in 2001. Depreciation expense increased $480,000 due to
depreciation on new plant additions. Amortization expense decreased $1,834,000
due to the adoption of SFAS #142. Customer operations expenses decreased
$2,430,000 in 2002 from $2,436,000 in 2001. General and administrative expenses
increased 12% to $5,474,000 in 2002 from $4,873,000 in 2001 due to accounting
and legal expenses incurred in the breakup of Alliance. Other operating expenses
increased $297,000 or 5% due to increased video signal fees and increased
internet service fees.
Consolidated operating income decreased $479,000 or 5% to $10,042,000 in
2002 from $10,521,000 in 2001.
Consolidated interest expenses decreased $575,000 to $4,727,000 in 2001
from $5,302,000 in 2001. The decrease was due to lower interest rates on
variable rate debt from CoBank and lower debt levels due to principal payments.
Income from the Company's investment in Midwest Wireless Holdings LLC
increased to $2,928,000 in 2002 from $1,475,000 in 2001. Midwest Wireless' 2001
results included amortization of intangible assets totaling $721,000, which
ceased with the adoption of SFAS 142. Income from investments in other
unconsolidated affiliates decreased to $143,000 in 2002 from $665,000 in 2001
due to lower profits from fiber optic transport company investments and losses
from the Company's investment in Desktop Media.
Alliance recorded an impairment loss on its marketable securities
portfolio of $134,000 in 2002. Alliance had gains on sales of marketable
securities of Illuminet, Inc. totaling $3,659,000 in 2001. Interest and dividend
income decreased to $481,000 in 2002 from $673,000 in 2001 due to lower interest
rates on invested funds and lower dividend yields from marketable security
investments.
Consolidated income before income taxes and minority interest decreased
to $8,733,000 in 2002 from $11,691,000. The Company's effective income tax rates
was 42% compared to 45.5% in 2001. The Company's tax rate declined due to the
adoption of SFAS #142, which eliminated amortization of nondeductible goodwill.
Income before the minority interest in Alliance's earnings decreased to
$5,063,000 in 2002 from $6,370,000 in 2001. Minority interest on earnings of
Alliance was $1,408,000 compared to $1,754,000 in 2001. Income before change in
accounting principle decreased to $3,655,000 in 2002 compared to $4,616,000 in
2001.
In 2002, the Company took a charge against earnings related to the
cumulative effect of impairment of the value of its goodwill and intangible
assets, before income tax benefits and minority interest, of $4,663,000. After
income tax benefits of $121,000 and minority interest of $1,395,000, the net
charge against earnings was $3,147,000 (see Note 3 to the consolidated financial
statements). Net income for 2002 was $508,000 compared to $4,616,000 in 2001.
2001 Compared to 2000
---------------------
Consolidated revenues increased 8% to $40,633,000 in 2001 from
$37,790,000 in 2000. The following table shows revenues by operating group for
2001 compared to 2000:
19
Alliance Hector
Year Ended December 31 Year Ended December 31
2001 2000 2001 2000
--------------- ---------------- ---------------- -----------------
Local network $ 5,586,670 $ 4,934,548 $ 1,562,398 $ 1,715,694
Network access 16,689,138 15,299,095 5,652,977 5,513,268
Video services 2,690,063 2,469,407 1,465,078 1,484,004
Internet services 1,667,999 1,099,460 308,924 205,026
Other nonregulated services 4,191,933 4,308,065 817,732 761,535
--------------- ---------------- ---------------- -----------------
$ 30,825,803 $ 28,110,575 $ 9,807,109 $ 9,679,527
--------------- ---------------- ---------------- -----------------
Consolidated local service revenues grew to $7,149,000 in 2001 from
$6,650,000 in 2000, an increase of $499,000 or 8%. Revenue growth in Alliance
was due to the acquisition of Hager TeleCom, Inc. in June 2000 and a local
service rate increase at Sleepy Eye Telephone Company. Hector's local network
revenues declined due to rate reductions in Wisconsin exchanges mandated by the
public service commission.
Network access revenues increased to $22,342,000 in 2001 compared to
$20,812,000 in 2000, an increase of $1,530,000 or 7%. The increase was due to
the acquisition of Hager TeleCom, Inc., which accounted for $402,000 of the
increase, increased universal service support payments and increased settlements
payments from NECA.
Video services revenue rose to $4,155,000 in 2001 from $3,953,000 in
2000, an increase of $202,000 or 5% due to the acquisition of additional cable
systems in South Dakota. Revenues from internet services increased by $672,000
due to the acquisition of Hager and increased customer counts for both dial-up
and DSL service. Revenues from other nonregulated services declined to
$5,010,000 in 2001 from $5,070,000 in 2000 due to lower billing and collection
revenues.
Consolidated operating costs and expenses grew to $30,112,000 in 2001
from $26,799,000 in 2000, an increase of $3,313,000 or 12%. The acquisition of
Hager TeleCom, Inc. accounted for $1,113,000 of the increase. The following
table shows costs and expenses by operating group for 2001 compared to 2000:
Alliance Hector
Year Ended December 31 Year Ended December 31
2001 2000 2001 2000
--------------- ---------------- ---------------- -----------------
Plant operations $ 3,974,169 $ 3,586,255 $ 1,381,781 $ 1,224,546
Depreciation and amortization 8,138,515 7,354,503 3,178,259 2,821,781
Customer operations 2,051,760 1,805,330 384,286 310,304
General and administrative 3,307,150 2,803,504 1,565,399 1,772,180
Other operating expenses 4,472,835 3,666,506 1,657,742 1,454,337
--------------- ---------------- ---------------- -----------------
$ 21,944,429 $ 19,216,098 $ 8,167,467 $ 7,583,148
--------------- ---------------- ---------------- -----------------
Consolidated plant operations expenses increased to $5,356,000 in 2001
from $4,811,000 in 2000, an increase of $545,000 or 11% due to the acquisition
of Hager ($187,000 of the increase), and increased labor costs. Depreciation and
amortization increased to $11,317,000 in 2001 from $10,176,000 in 2000, an
increase of $1,141,000 or 11% due to increased depreciation on new telephone
equipment and the acquisition of Hager. Customer operations expenses increased
15% to $2,436,000 in 2001 from $2,116,000 in 2000 due to increased marketing and
sales costs. General and administrative expenses increased to $4,873,000 in 2001
from $4,576,000 in 2000, an increase of $297,000 or 6% due to the acquisition of
Hager. Other operating expenses increased $1,010,000 or 20% due to increased
cable television and internet service fees.
Consolidated operating income decreased $470,000 or 4% to $10,521,000 in
2001 from $10,991,000 in 2000.
Consolidated interest expenses decreased $653,000 to $5,302,000 in 2001
from $5,955,000 in 2000. The decrease was due to lower interest rates on
variable rate debt and increased patronage refunds from CoBank.
20
Income from investments in Midwest Wireless Holdings LLC increased to
$1,475,000 in 2001 from $1,248,000 in 2000. Income from other unconsolidated
affiliates was $665,000 in 2001 compared to $647,000 in 2000. The Company
recorded losses on other investments in 2000 of $1,284,000. $1,273,000 of those
losses was due to impairment of the Company's investment in Onvoy, Inc.
Alliance had gains on sales of marketable securities totaling $3,659,000
in 2001 compared to gains on sales of $1,622,000 in 2000. Most of the gains were
on sales of Illuminet, Inc. (which was acquired by VeriSign) stock sold in 2001
and Qwest stock sold in 2000. Interest and dividend income decreased to $673,000
in 2001 from $1,251,000 in 2000 due to lower interest rates on invested funds
and lower dividend yields from marketable security investments.
Consolidated income before income taxes increased to $11,691,000 in 2001
from $8,520,000 in 2000. The Company's effective income tax rate of 45.5% is
higher than the standard U.S. tax rate due to state income taxes and because the
goodwill amortization expenses from the Company's acquisitions cannot be
deducted. Income before the minority interest in Alliance's earnings increased
to $6,370,000 in 2001 from $4,313,000 in 2000. Minority interest on earnings of
Alliance was $1,754,000 in 2001 compared to $1,004,000 in 2000. Net income
increased to $4,616,000 in 2001 compared to $3,309,000 in 2000.
Liquidity and Capital Resources
- -------------------------------
Operations
----------
Cash flows from consolidated operating activities were $13,116,000,
$14,103,000 and $8,421,000 in 2002, 2001 and 2000, respectively. The decrease in
cash flows from operations in 2002 was due to smaller profits from internal
operations. At December 31, 2002, the Company's cash, cash equivalents and
marketable securities totaled $12,134,000 compared to $13,502,000 at December
31, 2001. Alliance's cash and securities were $5,653,000 of this total at
December 31, 2002. Working capital at December 31, 2002 was $5,718,000 compared
to $7,633,000 at December 31, 2001. The current ratio was 1.4 to 1 at December
31, 2002 compared to 1.6 to 1 at December 31, 2001.
The Company makes periodic improvements to its facilities to provide
up-to-date services to its telephone and cable television customers. Hector's
plant additions in 2002, 2001 and 2000 were $2,609,000, $3,985,000 and
$3,111,000 respectively. Alliance's plant additions in 2002, 2001 and 2000
(excluding the acquisition of Hager TeleCom, Inc.) were $6,657,000, $6,634,000
and $6,335,000 respectively. Plant additions for 2003 for Hector and Alliance
are expected to total $6,276,000. These plant additions will provide customers
with additional advanced telecommunications services and expand usage of Next
Level broadband equipment and high capacity fiber optics in the telephone
network.
Investments
-----------
Investment income has been derived almost exclusively from interest
earned on the Company's cash and cash equivalents. Interest income has
fluctuated in relation to changes in interest rates and availability of cash for
investment. In 2001 Alliance received $3,675,000 from sales of marketable
securities, principally Illuminet, Inc. common stock. In 2000 Alliance received
$5,421,000 from sales of marketable securities, principally Qwest common stock.
The Company does not expect proceeds from marketable securities sales in future
years to approach these levels.
The Company regularly invests cash in new telecommunications technologies
and ventures and in support of its existing affiliated interests. In 2001 the
Company invested $500,000 in Desktop Media, Inc., a start-up company providing
voice, data and internet telecommunications services in southeastern Minnesota.
The Company also invested $360,000 to support its investment in a fiber optic
transport company in northwestern Minnesota. In 2000, the Company invested
$700,000 in Broadband Visions, LLC, which constructed a digital "super headend"
in Hutchinson, MN. The Company expects to make additional investments of this
type as opportunities arise.
21
The Company was a 10.4% owner of Wireless North, which provided personal
communications services ("PCS") to parts of Minnesota, Wisconsin, Iowa, North
Dakota and South Dakota. Wireless North was unsuccessful and has been
liquidated. Its licenses and systems were sold to other operators, or were shut
down. In 2001, the Company made payments to Wireless North's primary lender of
$1,129,000 to satisfy loan guarantees it gave with respect to Wireless North's
debt. Cash investments in Wireless North by the Company totaled $3,202,000. The
Company has written off its entire investment in Wireless North, has no
obligation to provide additional funding and does not expect to realize any
additional value from this investment.
The Company's other investments consist primarily of loan related bank
stocks, long-term investments in non-marketable corporations, and notes
receivable. In 2002, the Company made investments in mutual funds and rural
development note receivables that were funded by no-interest loans from the
Rural Utilities Service.
Credit Risk
-----------
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and temporary cash
investments. The Company places its cash investments with high credit quality
financial institutions. The Company maintains its cash in bank deposit accounts.
The account balances at times exceed the federally insured limits. The Company
has not experienced losses in these accounts and does not believe they are
exposed to any significant credit risk.
A significant portion of the Company's revenues are received from long
distance carriers in the telephone industry. Consequently, the Company is
directly affected by the financial well-being of that industry. The credit risk
associated with these accounts is minimized due to the large number of long
distance carriers.
Debt and Loan Commitments
-------------------------
As part of financing its 68% ownership interest in Alliance, the Company
borrowed $6,000,000 from CoBank. In 1998, the Company replaced the loan with a
15-year term loan from Rural Telephone Finance Cooperative ("RTFC"). At December
31, 2002 the outstanding balance on this loan was $3,157,000. The interest rate
on the loan varies according to the rate RTFC charges for similar loans. The
interest rate was 5.5% at December 31, 2002.
The Company carries a significant amount of debt due to Alliance`s
borrowing to finance the acquisition of Ollig Utilities Company. Interest rates
on a portion of Alliance's acquisition loan from CoBank have been locked for
periods of one to ten years. At December 31, 2002 interest rates on the loan
averaged 6.8%. The outstanding balance on this loan at December 31, 2002 was
$38,186,000. CoBank is a cooperative, owned and controlled by its customers.
Each customer borrowing from the bank on a patronage basis shares in the bank's
net income through payment of patronage refunds. As a condition of maintaining
the loan, Alliance owns stock in the bank. Its investment in CoBank stock was
$3,772,000 at December 31, 2002.
The Company's LEC subsidiaries borrow from the Rural Utilities Service
("RUS") and the Rural Telephone Bank ("RTB") to help finance asset additions.
Proceeds from long-term borrowings from RUS and RTB were $2,954,000, $2,201,000
and $700,000 in 2002, 2001 and 2000, respectively. The average interest rate on
outstanding RUS and RTB loans is 5.4%. At December 31, 2002 unadvanced loan
commitments from the RUS and RTB to Hector's and Alliance's LEC subsidiaries
totaled $19,937,000.
Substantially all of the assets of the Company's LEC subsidiaries are
pledged or are subject to mortgages to secure obligations to the RUS and RTB.
The Company's loan agreements place significant restrictions on cash
distributions from the subsidiaries to the parent company. Alliance's loan
covenants with CoBank also restrict dividend payments at the Alliance level. A
portion of any dividend payment from Alliance to Hector would also be subject to
federal and state income taxes. At December 31, 2002, $4,294,000 of
subsidiaries' retained earnings was available for dividend payments to HCC. At
December 31, 2002, $24,449,000 of HCC's retained earnings were not available to
pay dividends to shareholders due to restrictions in the debt agreements. It is
the Company's plan, in so far as possible, to maintain its cash balances at the
subsidiary level to support their operations.
22
Common Stock
------------
The Company's Board of Directors has authorized the purchase and
retirement, from time to time, of shares of the Company's stock on the open
market, or in private transactions consistent with overall market and financial
conditions. In 2002, the Company purchased and retired 70,239 shares at a cost
of $737,000. In 2001 the Company purchased and retired 109,704 shares at a cost
of $1,268,000. In 2000, the Company purchased and retired 221,950 shares at a
cost of $3,155,000. At December 31, 2002 216,000 shares could be repurchased
under outstanding Board authorizations.
In 1995 the underwriters of the Company's convertible debenture offering
received warrants to purchase shares of the Company's common stock at a price of
$8.70 per share. Proceeds to the Company from exercises of outstanding warrants
were $757,000 in 2000. Proceeds to the Company from exercises of employee stock
options and employee stock purchase plan shares totaled $320,000, $550,000 and
$382,000 in 2002, 2001 and 2000, respectively.
By utilizing cash flow from operations, current cash and investment
balances, and other available financing sources, the Company feels it has
adequate resources to meet its anticipated operating, debt service and capital
expenditure requirements.
Breakup of Alliance Telecommunications Corporation
--------------------------------------------------
In July 2001, Golden West and ACCI, respectively the 20% and 12% minority
shareholders of Alliance, advised the Company that they were interested in
exchanging their minority investment for a pro rata share of the assets and
liabilities of Alliance. Thereafter the parties engaged in negotiations that
continued through December 2002. The negotiation process included evaluations
and appraisals of Alliance's business components, negotiations with Alliance's
lenders (CoBank, Rural Utilities Service and Rural Telephone Bank) regarding
waivers, lien releases, interest penalties where applicable and future financing
terms. The process also included seeking necessary regulatory approvals from
local, state and national regulators.
The Company expects to complete the Alliance breakup transactions by
April 30, 2003. As agreed among the parties, in the breakup, Golden West will
exchange its 20% ownership interest in Alliance for all of the outstanding stock
of Sioux Valley Telephone Company and certain other Alliance assets. ACCI will
exchange its 12% ownership interest in Alliance for all of the outstanding stock
of Hills Telephone Company and certain other Alliance assets. Sioux Valley
Telephone Company and Hills Telephone Company collectively serve 8,700 telephone
access lines and 2,400 cable television customers. In addition, under the
breakup, 32% of Alliance's ownership interest in Midwest Wireless Holdings LLC
will be transferred to Golden West and ACCI, reducing Hector's total ownership
from 10.4% to 8%. Immediately prior to the breakup Sioux Valley and Hills will
pay a dividend to Alliance of approximately $13,400,000 to equalize post breakup
values in proportion to the current 68%-20%-12% stock ownership percentages. The
dividend proceeds will used to reduce Alliance's debt to its primary lender,
CoBank. A number of other stock and asset transfers will also occur among
Alliance and its subsidiaries prior to the breakup in order to satisfy various
tax, regulatory and lender requirements.
Alliance expects the breakup transactions to be tax-free under Section
355 of the Internal Revenue Code. Alliance also expects the related internal
stock and asset transfers to be tax-free under Section 355, related Code
provisions and the consolidated return regulations, although no private letter
ruling is being sought from the IRS in connection with the breakup. Prior to
conducting the breakup transaction, the parties will enter into one or more
agreements with regard to cooperation, exchange of information, interim use of
common services, employee benefits, tax allocations and indemnification
generally in proportion to ownership percentages with respect to unexpected
adverse tax consequences, and other matters arising after the breakup
transaction which relate to commitments, events or circumstances in effect as of
the date of the breakup transaction.
The following pro forma financial statements of income and explanatory
notes show the pro forma effect on the operating results of the Company as if
the breakup occurred January 1, 2002. The pro forma balance sheet and
explanatory notes show the effect on the Company's financial position as if the
breakup occurred December 31, 2002.
23
The pro forma financial information and explanatory notes are unaudited
and include adjustments which are based on management's assumptions. Management
believes these statements provide a reasonable basis for presenting the
significant effects of the breakup and the pro forma adjustments are properly
applied in the pro forma statements.
The pro forma financial statements are not necessarily indicative of the
results of operations had the acquisition occurred at the beginning of the
periods presented, nor are they necessarily indicative of the results of future
operations.
Pro forma income statement
- -------------------------- Twelve Months Ended December 31, 2002
Eliminate Eliminate
Hector Sioux Valley Hills Other
Communications Telephone Telephone Pro forma Pro forma
Corporation Company Company Adjustments Combined
------------- ------------- ------------- ------------- -------------
REVENUES:
Local network $ 7,447,951 $ (1,276,797) $ (296,426) $ 5,874,728
Network access 21,233,284 (3,491,201) (2,438,226) 15,303,857
Video services 4,412,372 (393,184) 4,019,188
Internet services 2,404,684 (291,252) (168,521) 1,944,911
Other nonregulated services 4,223,355 (236,228) (292,623) 3,694,504
------------- ------------- ------------- ------------- -------------
TOTAL REVENUES 39,721,646 (5,688,662) (3,195,796) - 30,837,188
COSTS AND EXPENSES:
Plant operations 5,385,538 (853,145) (451,977) 4,080,416
Depreciation and amortization 9,962,652 (1,460,648) (501,642) 8,000,362
Customer operations 2,430,453 (385,820) (188,278) 1,856,355
General and administrative 5,473,999 (489,379) (227,970) $ (44,160)(e) 4,712,490
Other operating expenses 6,427,251 (776,605) (230,980) 5,419,666
------------- ------------- ------------- ------------- -------------
TOTAL COSTS AND EXPENSES 29,679,893 (3,965,597) (1,600,847) (44,160) 24,069,289
------------- ------------- ------------- ------------- -------------
OPERATING INCOME 10,041,753 (1,723,065) (1,594,949) 44,160 6,767,899
OTHER INCOME (EXPENSES):
Interest expense (4,726,799) 319,831 133,465 698,906 (a)(b)(c) (3,574,597)
Income from investments in unconsolidated
affilates:
Midwest Wireless Holdings, LLC 2,928,251 (666,831)(d) 2,261,420
Other unconsolidated affiliates 142,535 (147,300) (51,546) (56,311)
Interest and dividend income 481,258 (117,003) (30,352) 333,903
Gain (loss) on sale of marketable securities (134,498) (134,498)
------------- ------------- ------------- ------------- -------------
OTHER INCOME (EXPENSES), net (1,309,253) 55,528 51,567 32,075 (1,170,083)
------------- ------------- ------------- ------------- -------------
INCOME BEFORE INCOME TAXES AND
MINORITY INTEREST 8,732,500 (1,667,537) (1,543,382) 76,235 5,597,816
Income tax expense 3,670,000 (575,000) (643,000) 30,494 (f) 2,482,494
------------- ------------- ------------- ------------- -------------
INCOME BEFORE MINORITY INTEREST 5,062,500 (1,092,537) (900,382) 45,741 3,115,322
Minority interest in earnings of
Alliance Telecommunications Corporation 1,407,611 (1,407,611)(g) 0
------------- ------------- ------------- ------------- -------------
INCOME BEFORE CHANGE IN ACCOUNTING PRINCIPLE 3,654,889 (1,092,537) (900,382) 1,453,352 3,115,322
Cumulative effect of change in accounting
principle, net of income taxes and
minority interest 3,146,569 1,395,000 (h) 4,541,569
------------- ------------- ------------- ------------- -------------
NET INCOME (LOSS) $ 508,320 $ (1,092,537) $ (900,382) $ 58,352 $ (1,426,247)
============= ============= ============= ============= =============
BASIC NET INCOME (LOSS) PER COMMON SHARE:
Before cumulative effect of change in
accounting principle $ 1.05 $ .89
Cumulative effect of accounting change (.90) (1.30)
------------- -------------
$ .15 $ (.41)
============= =============
DILUTED NET INCOME (LOSS) PER COMMON SHARE:
Before cumulative effect of change in
accounting principle $ .97 $ .83
Cumulative effect of accounting change (.84) (1.21)
------------- -------------
$ .13 $ (.38)
============= =============
AVERAGE SHARES OUTSTANDING
Common shares only 3,498,000 3,498,000
Common and potential common shares 3,770,000 3,770,000
24
The following is a summary of the income statement adjustments required
in accordance with generally accepted accounting principles:
(a) Interest adjustment on CoBank loan at average interest rate(6.8%) $ 914,841
(b) Interest adjustment on CoBank loan for accrued patronage 95,935
(c) Estimated loan fee - CoBank refinancing 120,000
(d) Adjustment to income on Midwest Wireless Holdings LLC investment
due to ownership transfer 666,831
(e) Adjust deferred compensation expense for transfer of obligation 44,160
(f) Record income tax effect of adjustments (a),(b),(c),(d)
and (e) - 40% tax rate 30,494
(g) Eliminate minority interest in earnings of Alliance 1,407,611
(h) Eliminate minority interest from cumulative effect
of accounting change 1,395,000
Pro forma balance sheet - December 31, 2002
- -------------------------------------------
Hector Eliminate Eliminate
Communications Sioux Valley Hills Other
Corporation Telephone Telephone Pro forma Pro forma
Assets December 31, 2002 Company Company Adjustments Combined
---------------- ------------- ------------ -------------- -------------
Current assets:
Cash and cash equivalents $ 12,020,186 $ (1,467,421) $ (921,075) $ 9,631,690
Construction fund 662,232 (3) (4,184) 658,045
Accounts receivable, net 4,819,174 (839,754) (454,081) 3,525,339
Materials, supplies and inventories 1,175,587 (140,069) 1,035,518
Other current assets 231,685 (17,799) (10,369) 203,517
Accounts with affiliates (347,990) 391,027 43,037
------------- ------------- ------------ -------------
Total Current Assets 18,908,864 (2,813,036) (998,682) 15,097,146
Property, plant and equipment, net 56,665,798 (7,241,401) (2,773,900) 46,650,497
Investments and other assets:
Excess of cost over net assets acquired, net 49,074,993 $ (13,192,878)(e) 35,882,115
Marketable securities 114,234 114,234
Investment in Midwest Wireless Holdings LLC 16,232,707 (4,211,292)(a) 12,021,415
Investments in other unconsolidated
affiliates 4,373,597 (500,438) (943,058) 2,930,101
Other investments 8,704,268 (947,836) (225,907) (1,206,961)(c) 6,323,564
Other assets 411,499 (195,374) (48,832) 167,293
------------- ------------- ------------ -------------- -------------
Total investments and other assets 78,911,298 (1,643,648) (1,217,797) (18,611,131) 57,438,722
------------- ------------- ------------ -------------- -------------
Total Assets $ 154,485,960 $(11,698,085) $ (4,990,379) $ (18,611,131) $ 119,186,365
============= ============= ============ ============== =============
Liabilities and Stockholders Equity
Current liabilities:
Notes payable and current portion
of long-term debt $ 7,364,600 $ 7,364,600
Accounts payable 2,523,878 $ (193,341) $ (82,553) 2,247,984
Accrued expenses 2,422,986 (362,473) (80,080) 1,980,433
Income taxes payable 879,417 2,399 9,950 891,766
------------- ------------- ------------- -------------
Total current liabilities 13,190,881 (553,415) (152,683) 12,484,783
Long-term debt, less current portion 75,147,560 (4,251,209) (1,539,972) $ (13,453,550)(d) 55,902,829
Deferred investment tax credits 27,554 27,554
Deferred income taxes 5,866,754 (869,378) (484,411) (42,301)(a) 4,470,664
Deferred compensation 976,179 (312,377)(b) 663,802
Minority interest in Alliance
Telecommunications Corporation 17,027,697 (17,027,697)(f) 0
Stockholders' equity 42,249,335 (6,024,083) (2,813,313) 12,224,794 (a,b,c,d,e,f) 45,636,733
------------- ------------- ------------- -------------- -------------
Total Liabilities and Stockholders' Equity $ 154,485,960 $(11,698,085) $ (4,990,379) $ (18,611,131) $ 119,186,365
============= ============= ============= ============== =============
The following is a summary of the balance sheet adjustments required in
accordance with generally accepted accounting principles: (a) Record transfer of
32% of Alliance's ownership interest in Midwest Wireless
Holdings LLC, and related deferred tax liabilities of $162,523 $ 4,211,292
(b) Record transfer of 32% of deferred compensation obligations
and related deferred tax assets of $120,222 312,377
(c) Transfer 32% of investment in CoBank stock 1,206,961
(d) Record repayment of CoBank debt through dividend from Sioux Valley and Hills 13,453,550
(e) Eliminate goodwill recorded on investment in Sioux Valley and Hills 13,192,878
(f) Eliminate minority interest in Alliance Telecommunications Corporation 17,027,697
25
Acquisitions
------------
Effective June 9, 2000, Alliance acquired all the outstanding common
stock of Hager TeleCom, Inc. ("Hager"); a rural telephone company located in
southwestern Wisconsin. Hager serves approximately 2,100 access lines, provides
internet service to 2,700 customers in Hager, WI and Red Wing, MN and has an
ownership interest in Midwest Wireless Holdings LLC. The purchase price was
$9,124,500 of cash plus acquisition costs.
The Company is continually evaluating possible acquisitions that advance
its plan to be a provider of top quality telecommunications services to rural
customers. In the past, the Company has been a member of investor groups that
sought unsuccessfully to acquire rural telephone properties offered for sale by
major telephone companies. The Company cannot predict if it will be successful
in acquiring additional properties and does not currently have financing plans
in place to pay for possible acquisitions.
Effects of Inflation
--------------------
The Company's local exchange telephone companies are subject to the
jurisdiction of Minnesota, Iowa, South Dakota and Wisconsin regulatory
authorities with respect to a variety of matters, including rates for intrastate
access services, the conditions and quality of service, issuance of debt,
depreciation rates and accounting methods. Rates for local telephone service are
not established directly by regulatory authorities, but their authority over
other matters limits the Company's ability to implement rate increases. In
addition, the regulatory process inherently restricts the Company's ability to
immediately pass cost increases along to customers unless the cost increases are
anticipated and the rate increases implemented prospectively.
New Accounting Standards
------------------------
In October, 2001 the Financial Accounting Standards Board ("FASB") issued
SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets". SFAS
No. 144 was effective January 1, 2002. SFAS No. 144 sets forth requirements for
measuring and recognizing impairment losses on long-`lived assets. The statement
also establishes financial reporting requirements when impairment losses are
recognized. Adoption of SFAS No. 144 did not have a material effect on the
Company's financial statements.
In July 2001 the FASB issued Statement of Financial Accounting Standards
("SFAS") No. 141, "Business Combinations". SFAS No. 141 requires that the
purchase method of accounting be used for all business combinations initiated
after June 30, 2001. SFAS No. 141 also requires that intangible assets acquired
in a business combination be recognized and reported apart from goodwill.
Adoption of this statement had no impact on the Company's financial position or
operating results.
In July 2001 the FASB also issued SFAS No. 142, "Goodwill and Other
Intangible Assets". SFAS No. 142 was effective January 1, 2002. It requires that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead tested on a regular (at least annual) basis for
impairment. Intangible assets with determinable useful lives will remain subject
to amortization. The impact of SFAS No. 142 on the Company's financial
statements is disclosed in Note 3 to the Financial Statements included in Item 8
of this report.
In June 2001 the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations". SFAS No. 143 is effective for fiscal years beginning
after June 15, 2002. The statement establishes accounting standards for
recognition and measurement of a liability for an asset retirement obligation
and an associated asset retirement cost. The statement applies to tangible
long-lived assets, including individual assets, functional groups of related
assets and significant parts of assets. It covers a company's legal obligations
resulting from the acquisition, construction, development or normal operation of
a capital asset. The FCC has notified the Company's ILECs that SFAS No. 143 will
not be adopted for regulatory accounting purposes. Current regulatory accounting
requires ILECs to accrue for asset retirement obligations through depreciation
rates. Considering the FCC order and the provisions of SFAS No. 71, the Company
does not expect adoption of SFAS No. 143 to have a material impact on its
financial position or operating results.
26
In June 2002, the Financial Accounting Standards Board issued SFAS
No.146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS
No. 146 nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)." This statement
requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred. Under EITF Issue No.
94-3, a liability for an exit cost was recognized at the date of the entity
committed to an exit plan. The provisions of this statement are effective for
exit or disposal activities that are initiated after December 31, 2002, with
early application encouraged. The Company does not believe that the adoption of
SFAS No. 146 will have a material impact on its financial position or results of
operations.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition Disclosure - an amendment of FAS 123".
This statement amends SFAS No. 123 "Accounting for Stock-Based Compensation" to
provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. In
addition, this Statement amends the disclosure requirements of Statement 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The provisions of FAS 148 are
effective for financial statements for fiscal years ending after December 15,
2002, and disclosure requirements shall be effective for interim periods
beginning after December 15, 2002. The Company intends to continue to account
for stock-based compensation to its employees and directors using the intrinsic
value method prescribed by APB Opinion No. 25, and related interpretations. The
Company has made certain disclosures required by SFAS No. 148 in the
consolidated financial statements for the year ended December 31, 2002 and will
begin making the additional disclosures required by SFAS No. 148 in the first
quarter of 2003. Accordingly, adoption of SFAS No. 148 will not impact the
Company's financial position or results of operations.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others". This interpretation elaborates on the
disclosures required in financial statements concerning obligations under
certain guarantees. It also clarifies the requirements related to the
recognition of liabilities by a guarantor at the inception of certain
guarantees. The disclosure requirements of this interpretation were effective on
December 31, 2002, but did not require any additional disclosures on the part of
the Company. The recognition provisions of the interpretation effective for 2003
are applicable only to guarantees issued or modified after December 31, 2002.
The Company does not expect adoption of these provisions to have a material
impact on its financial position or results of operations.
Factors Affecting Future Performance
- ------------------------------------
From time to time in re