UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
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, 2004
Commission File Number: 001-13891
HECTOR COMMUNICATIONS CORPORATION
Minnesota 41-1666660
- --------------------------------- -------------------
(State or other jurisdiction (Federal Employer
of incorporation or organization) Identification No.)
211 South Main Street
P.O. Box 428
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 Name of each exchange on which registered
- ---------------------------- ------------------------------------------
Common Stock, $.01 par value American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months 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. [ ]
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 and nonvoting common equity held by
non-affiliates of the Registrant (shareholders other than officers and
directors) was approximately $61,392,000 based upon the closing sale price of
the Company's common stock on the American Stock Exchange on June 30, 2004.
As of March 15, 2005 there were outstanding 3,736,723 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 24, 2005 are
incorporated by reference into Part III of this Form 10-K.
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 Quantitative and Qualitative Disclosures About Market Risk 27
8. Financial Statements and Supplementary Data 28
9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 50
9A Controls and Procedures 50
9B Other Information 50
PART III
10. Directors and Executive Officers of the Registrant 51
11. Executive Compensation 51
12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters 51
13. Certain Relationships and Related Transactions 52
14. Principal Accounting Fees and Services 52
PART IV
15. Exhibits and Financial Statement Schedules 53
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 subsidiaries, primarily provides
local telephone, cable television and internet access services. The Company also
participates in the ownership of other companies providing wireless telephone
and other telecommunications related services.
HCC, directly and through its 100% owned subsidiary, Alliance Telecommunications
Corporation ("Alliance") operates nine local exchange company subsidiaries
(generally referred to as "local exchange carriers" or "LECs") which served
29,574 access lines in 28 rural communities in Minnesota, Wisconsin and North
Dakota at December 31, 2004. HCC, through its wholly-owned subsidiaries, also
provides cable television service or video service to 7,936 subscribers in
Minnesota.
Prior to July 7, 2003 Alliance was 68% owned by HCC. Golden West
Telecommunications Cooperative, Inc. ("Golden West") of Wall, South Dakota and
Alliance Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota
owned the remaining interests in Alliance. Effective July 7, 2003 Alliance was
reorganized under Section 355 of the Internal Revenue Code ("the Split-Up
Transactions'). In the Split-Up Transactions, Golden West exchanged its minority
ownership interest in Alliance for all of the outstanding stock of Sioux Valley
Telephone Company, which included a pro rata share of Alliance's ownership
interest in Midwest Wireless Holdings, LLC and certain other Alliance assets.
ACCI exchanged its minority ownership interest in Alliance for all of the
outstanding stock of Hills Telephone Company, which included a pro rata share of
Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain
other Alliance assets. HCC became the 100% owner of all remaining Alliance
assets and operations. (See "Split-up of Alliance Telecommunications
Corporation" in Item 7.) The disclosures in this report related to periods prior
to July 7, 2003 have been restated to reflect the Company's continuing
operations.
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's website.
[b] FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS
The Company has changed its segment data presentation to match its new
organization subsequent to the Split-up Transactions. Segment information is now
presented for two segments, POTS and Unregulated Services. The majority of the
Company's operations consist of 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.
The Company also provides a number of nonregulated telecommunications services
to customers. These services include cable television or video service, internet
access services, lease of fiber optic transport facilities, billing and
collection services to long distance carriers, telephone directory services and
equipment rental. The Company also makes retail sales of consumer
telecommunications equipment and sells wireless telephone services on a
commission basis.
Information regarding segment operations is provided in Note 13 to the financial
statements found under Item 8 of this report.
3
[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.
The Company also earns revenues by providing a number of nonregulated
telecommunications services to customers. These services include cable
television or video service, 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
-----------------------------------------
2004 2003 2002
------- ------- -------
Local network 19.7% 18.9% 19.3%
Network access 48.5 49.7 50.1
Video services 10.5 11.1 12.1
Internet services 10.0 8.2 6.4
Other nonregulated services 11.3 12.1 12.1
------- ------- -------
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 directory services. The Company's most significant
minority ownership position is its 8% interest in 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 and North Dakota.
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. An "access line" is a single or
multi-party circuit between the customer's establishment and the central
switching office. The following chart presents the number of access lines served
by the Company's LEC subsidiaries at December 31, 2004, 2003 and 2002:
2004 2003 2002
------ ------ ------
Arrowhead Communications Corporation 787 804 806
Eagle Valley Telephone Company 715 719 747
Granada Telephone Company 284 287 296
Pine Island Telephone Company 3,303 3,339 3,368
Indianhead Telephone Company 2,376 2,383 2,403
Loretel Systems, Inc. 12,993 13,253 13,386
Sleepy Eye Telephone Company 6,366 6,298 6,503
Felton Telephone Company 717 732 765
Hager TeleCom, Inc. 2,033 2,067 2,061
------ ------ ------
Total Access Lines 29,574 29,882 30,235
====== ====== ======
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. 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. In 2004, 60% of the Company's access revenues were from interstate sources
and 29% were from intrastate sources and 11% came from the universal service
fund.
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. The
2000s have seen a leveling of this pattern as access minutes billed to IXCs have
declined and wireless access minutes have increased.
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 7,936 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.
The Company has 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 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, which is 18% owned by the Company. 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
maintenance and product support from Next Level Communications, Inc. If the
Company cannot obtain necessary support it could have a material adverse affect
on its broadband operations.
5
Internet
Revenues from internet services were $3,150,000, $2,647,000 and $1,945,000 in
2004, 2003 and 2002, 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 all the Company's service areas although access to the service is
restricted for some customers. The Company provided dial-up internet services to
6,679, 7,464 and 7,558 customers at December 31, 2004, 2003 and 2002
respectively. The Company provided DSL services to 3,881, 2,778 and 1,601
customers at December 31, 2004, 2003 and 2002, respectively. 57% 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 and 2003, 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 almost entirely within the LEC's local exchange
boundaries.
HCC's revenues from other nonregulated services were as follows:
2004 2003 2002
----------- ----------- -----------
Fiber leases $ 657,022 $ 682,521 $ 800,039
Engineering fees 70,378 305,423 438,534
Directory 529,796 491,902 404,136
Billing and collection 169,378 212,622 289,723
Retail sales 469,609 522,269 407,870
Cellular sales commissions 495,704 316,337 333,714
Long distance service sales commissions 382,936 381,825 250,937
Equipment rent 126,130 118,292 119,523
Customer equipment installation and repair 379,755 434,435 232,225
Other 289,963 437,381 417,803
----------- ----------- -----------
$ 3,570,671 $ 3,903,007 $ 3,694,504
=========== =========== ===========
(3) Unconsolidated Affiliates and Investments
Midwest Wireless Holdings LLC
Midwest Wireless Holdings LLC ("Midwest Wireless") provides wireless
telecommunications services to 405,000 customers in fourteen rural service areas
and one metropolitan service area in Minnesota, Wisconsin and Iowa. Population
of the service areas is approximately 1,910,000. Midwest Wireless offers a
complete package of services, including custom calling features, facsimile and
data transmission.
Midwest Wireless is owned by telecommunications companies (principally LECs)
located within Midwest Wireless' operating footprint in southern Minnesota,
northern Iowa and west central Wisconsin. HCC is presently the second largest
member of Midwest Wireless Holdings LLC, with an 8.0% 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 accounts for its
investment in Midwest Wireless using the equity method. Income recognized was
$2,766,000, $2,148,000 and $2,261,000 in 2004, 2003 and 2002, respectively.
6
Fiber-Optic Transport Investments
The Company is an investor in three 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.
Fiber routes owned by these companies serve the major telecommunications markets
in Minnesota, Wisconsin, North Dakota and South Dakota including Minneapolis-St.
Paul, Milwaukee, Madison, Duluth-Superior, Sioux Falls, Fargo-Moorhead,
Rochester, St. Cloud and Grand Forks.
Other Investments
The Company is an investor in 702 Communications, a competitive local exchange
carrier ("CLEC") providing telecommunications services in the Fargo-Moorhead
area, Wahpeton, ND and Breckinridge MN. 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. The Company is an
investor in Independent Pinnacle Services, LLC, a telephone directory publishing
company that provides directory services to over 150 telephone companies in 15
states.
(4) 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
$3,634,000 and $3,609,000 at December 31, 2004 and 2003 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 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's
investment in Onvoy debt totaled $672,000 and $626,000.at December 31, 2004 and
2003 respectively.
Other long-term investments
The Company has a long-term investments in 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.
(5) Competition
Telephone Service
LECs are subject to many forms of competition. Its competitors principally are:
- Facilities-based competition from providers, including cable television
service providers, with their own local service network;
- Resale competition from resale interconnection (providers who purchase
local services from the LEC at wholesale rates and resell the services to
their customers);
- Competition from unbundled network element interconnection (providers who
lease some of the network elements from the LEC)
- Wireless providers who may charge a competitive fee for services that
compete with wireline based local service.
- Voice over Internet Protocol (VoIP) based services that deliver
telecommunications services over high-speed internet connections.
7
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 "Telecommunications Act") 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 reduces 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 present greater competition to 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.
VoIP providers typically offer unlimited internet based calling for a flat
monthly fee. Customers wishing to use the service must have a high speed
internet connection. Due to the cost of the service and the high speed internet
connection, VoIP customers tend to be high volume users of long distance
services. Due to the poorer quality of the service, businesses have been
reluctant to use VoIP for their customer contacts. However, recent improvements
in the technology have lead more business and government customers to utilize
the service. Vonage is probably the best known VoIP provider at this time, but
the RBOCs and internet service providers like AOL and Yahoo! are considering
product offerings.
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.
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.
8
(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 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:
- Monthly charges to end users for basic local telephone services and
enhanced services;
- Access charges to interexchange carriers for originating and terminating
interstate and intrastate interexchange calls; and
- 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.
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 ("SLC"). The remaining portions of the interstate local loop costs were
recovered from interstate access charges to interexchange carriers.
9
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 increased
the maximum rate caps for SLCs in steps to the current rates of $6.50 for a
residential or single line business phone and $9.20 for a multi-line business
phone. The increased SLC revenues are 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 $1,744,000, $1,879,000 and $1,458,000 of the
Company's network access revenues in 2004, 2003 and 2002, 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. The data is 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.
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. All of HCC's LECs participate in the traffic
sensitive and 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.
Wireless Access
Access rates for wireless carriers are determined by a FCC mandated negotiation
process that takes place outside of the NECA tariff structure. Where no
agreement on access rates exist between a wireless carrier and the LEC, no
billing of access charges can be made. The Company's LECs have reciprocal
compensation agreements in place with many of the wireless carriers that use the
LECs facilities to terminate calls - but not all of them. Where agreements are
in place, they are at rates significantly below what an IXC would pay to
terminate a similar call. The Company believes the current wireless access rate
rules and rate structure give wireless carriers a significant competitive
advantage over landline carriers and have a materially negative effect on the
Company's access revenues.
10
VoIP Access
In October 2003 the U.S. District Court issued an injunction providing relief
from regulation to any service provider providing VoIP based services in
Minnesota. The ruling held that VoIP services are information services that can
be regulated only by the FCC and not telecommunications services that can be
regulated by the Minnesota Public Utilities Commission. Under current FCC rules
VoIP originated calls that cross over to the public switched telephone network
("PSTN") can use the PSTN without paying access charges. The Company cannot
predict what the impact of this ruling on future access revenues will be. (An
appeal of this ruling by the Minnesota PUC was rejected by the Federal Court of
Appeals, 8th Circuit in December, 2004.)
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:
- Offer reasonable and nondiscriminatory resale of their telecommunications
services,
- Ensure that customers can keep their telephone numbers when changing
carriers,
- 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,
- Ensure access to telephone poles, ducts, conduits and rights of way and
- Compensate competitors for the costs of terminating traffic.
The Telecommunications Act also requires incumbent local exchange carriers to:
- Negotiate in good faith the terms and conditions of interconnection with
any competitive carrier making a bona fide request for same,
- Interconnect their facilities and equipment with any requesting
telecommunications carrier at any technically feasible point,
- 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,
- Offer resale interconnection at wholesale rates,
- 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
- Provide for the physical co-location 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:
- Providing for the identification of those services eligible for universal
service support,
- Requiring the FCC to make implicit subsidies explicit,
- Expanding the types of communications carriers required to pay universal
service support and
- 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 ETC will serve the
public interest. Wireless providers have received ETC designation in each of the
Company's served areas. The addition of these ETCs could have the effect of
reducing the funding available to the Company's LECs from the federal Universal
Service Fund. Such a reduction could materially adversely affect the Company's
ability to achieve a reasonable rate of return on the capital invested in its
network.
12
State Regulation of Rural LECs
HCC's LEC subsidiaries are subject to regulation by Minnesota, North Dakota and
Wisconsin regulatory agencies with respect to:
- Intrastate toll rates,
- Intrastate access charges billed to intrastate IXCs,
- Service areas,
- Service standards,
- Accounting and related matters, and
- The use of radio frequencies in telephone operations
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. All of HCC's Minnesota-based LEC subsidiaries (except Felton
Telephone Company) elected alternative rate regulation. Local rate increases
under alternative regulation 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.
For the past several years the Minnesota Public Utilities Commission has been
considering a plan to reduce intrastate access charges and implement a state
universal service fund to compensate high cost companies. In 2004 the PUC issued
orders referring elements of the proposed plan to a contested case hearing. In
Minnesota these hearings provide an opportunity for public debate before the PUC
issues final rules. In December 2004 the PUC suspended process of the proposed
new rules due to concerns expressed by state agencies that the proposed access
rate reductions would result in higher local service rates. The Company cannot
predict the outcome of the rate investigation or if any part of the proposed
plan will be adopted.
Wisconsin based LECs are subject to rate of return review where their
residential local service rate (the "R1" rate) exceeds the statewide average R1
rate (currently $13.93 per month). In November 2004 the Wisconsin Public Service
Commission conducted a rate of return review of the Company's Hager TeleCom LEC.
As a result of the review, the Company agreed to reduce its R1 rate by $3.10 per
month and to make certain other rate reductions. The new rates went into effect
January 1, 2005.
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:
- "Must carry" rules regarding the broadcast television and translator
signals that must be included in channel offerings to subscribers,
- Exclusivity provisions which require the deletion of certain programming
carried by out-of-area stations where it would duplicate programming
carried by local stations,
- Technical standards and performance testing requirements, and
- 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.
13
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:
- Expand its existing operations through internal growth - Pursue
acquisitions of attractive properties, particularly the acquisition of
additional rural telephone exchanges and cable television properties
- Participate in opportunities afforded by new telecommunications
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, 2005, the Company had 134 full-time and part-time employees. None of
the Company's employees are represented under collective bargaining agreements.
HCC believes its employee relations to be good.
14
(9) Executive Officers of Registrant
The executive officers of the Company and their ages at March 1, 2005 were as
follows:
Name Age Position
Curtis A. Sampson 71 Chairman of the Board and Chief Executive Officer
Steven H. Sjogren 62 President and Chief Operating Officer
Paul N. Hanson 58 Vice President, Secretary and Treasurer
Charles A. Braun 47 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 devote approximately 50%,
50% and 80% respectively 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.
ITEM 2. PROPERTIES
The Company's telephone property consists of central office switching equipment,
the land and buildings in which the equipment is housed, 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 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.
Connecting lines constitute approximately 52% of the Company's telephone
property in service. Central office switching equipment represents approximately
32%. Telephones, customer premise broadband equipment and related equipment
constitute approximately 2%. Land, buildings, data processing equipment, service
vehicles and construction equipment constitute the remaining 14%. 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.
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 9 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:
2004 2003
------------------------ -------------------------
Quarter High Low High Low
First $ 19.36 $ 13.85 $ 13.60 $ 11.80
Second 21.70 18.65 13.89 11.50
Third 21.50 19.80 14.35 12.45
Fourth 22.00 20.00 14.14 13.06
[b] HOLDERS
At March 1, 2005 there were 477 holders of record of Hector Communications
Corporation common stock.
[c] DIVIDENDS
HCC paid a cash dividend of $.05 per share on its common stock and preferred
stock on December 15, 2004, the first in Company history, and has adopted a
policy to pay regular quarterly dividends. The amount of future dividends will
be determined at the discretion of the Board of Directors. HCC has no obligation
to pay dividends on its preferred stock except that preferred stock receives the
same per share dividend as common stock.
The financing agreements between HCC's subsidiaries and their lenders, and HCC
and its lenders restrict the ability of HCC to pay dividends. See Management's
Discussion and Analysis of Financial Condition and Results of Operations, and
also Note 9 to the Consolidated Financial Statements under Item 8 herein for a
description of restrictions on dividends.
[d] RECENT SALES OF UNREGISTERED SECURITIES
Not applicable.
[e] REPURCHASES OF ISSUER'S EQUITY SECURITIES
The Registrant did not repurchase any of its equity securities during the fourth
quarter of the fiscal year covered by this report. At December 31, 2004, the
Company was authorized to purchase in accordance with Rule 10b-18 215,000 shares
of its common stock pursuant to Board authorization granted on September 17,
2001.
16
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL INFORMATION
(in thousands except per share amounts)
Year Ended December 31
-------------------------------------------------------------
2004 2003 2002 2001 2000
- ---------------------------------------------------------------------------------------------------------------------------------
Selected Income Statement Information
Revenues from Continuing Operations $ 31,570 $ 32,322 $ 30,517 $ 31,073 $ 29,067
Costs and Expenses 24,588 24,365 23,875 24,404 21,913
- ---------------------------------------------------------------------------------------------------------------------------------
Operating Income from Continuing Operations 6,982 7,957 6,642 6,669 7,154
Other Income (Expenses), net 912 316 (1,053) 1,752 (1,539)
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations Before Income Taxes and
Minority Interest 7,894 8,273 5,589 8,421 5,615
Income Tax Expense 3,250 3,316 2,483 4,162 3,155
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations Before Minority Interest 4,644 4,957 3,106 4,259 2,460
Minority Interest in Earnings of Alliance
Telecommunications Corporation 660 782 1,078 411
- ---------------------------------------------------------------------------------------------------------------------------------
Income from Continuing Operations 4,644 4,297 2,324 3,181 2,049
Income from Discontinued Operations 882 1,331 1,435 1,260
- ---------------------------------------------------------------------------------------------------------------------------------
Income Before Cumulative Effect of Change in Accounting
Principle 4,644 5,179 3,655 4,616 3,309
Cumulative Effect of Change in Accounting Principle,
net of Income Taxes and Minority Interest (3,147)
- ---------------------------------------------------------------------------------------------------------------------------------
Net Income $ 4,644 $ 5,179 $ 508 $ 4,616 $ 3,309
=================================================================================================================================
Basic Income from Continuing Operations per common share $ 1.28 $ 1.23 $ .67 $ .92 $ .58
Diluted Income from Continuing Operations per common share $ 1.17 $ 1.14 $ .62 $ .85 $ .53
Cash Dividends per share $ .05 $ - $ - $ - $ -
Average Shares Outstanding:
Common shares only 3,635 3,487 3,498 3,465 3,544
Common and potential common shares 3,970 3,765 3,770 3,763 3,851
=================================================================================================================================
Selected Balance Sheet Information
Working Capital $ 17,601 $ 13,314 $ 5,718 $ 7,633 $ 8,960
Property, Plant and Equipment, net 40,040 43,088 56,666 57,362 56,227
Excess of Cost Over Net Assets Acquired, net 30,921 31,692 49,075 53,663 55,475
Total Assets 124,923 123,059 154,486 158,251 158,678
Long-Term Debt 54,084 57,529 75,148 79,642 84,378
Stockholders' Equity 54,213 48,044 42,249 42,241 39,108
- ---------------------------------------------------------------------------------------------------------------------------------
Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets".
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
HCC, directly and through its 100% owned subsidiary, Alliance Telecommunications
Corporation ("Alliance") operates nine local exchange company subsidiaries
(generally referred to as "local exchange carriers" or "LECs") which served
29,574 access lines in 28 rural communities in Minnesota, Wisconsin and North
Dakota at December 31, 2004. HCC, through its wholly-owned subsidiaries, also
provides cable television service or video service to 7,936 subscribers in
Minnesota. HCC's subsidiaries also have substantial ownership interests in other
telecommunications ventures, including, Midwest Wireless Holdings LLC.
Prior to July 7, 2003 Alliance was 68% owned by HCC. Golden West
Telecommunications Cooperative, Inc. ("Golden West") of Wall, South Dakota and
Alliance Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota
owned the remaining interests in Alliance. Effective July 7, 2003 Alliance was
reorganized under Section 355 of the Internal Revenue Code ("the Split-Up
Transactions'). In the Split-Up Transactions, Golden West exchanged its minority
ownership interest in Alliance for all of the outstanding stock of Sioux Valley
Telephone Company, which included a pro rata share of Alliance's ownership
interest in Midwest Wireless Holdings, LLC and certain other Alliance assets.
ACCI exchanged its minority ownership interest in Alliance for all of the
outstanding stock of Hills Telephone Company, which included a pro rata share of
Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain
other Alliance assets. HCC became the 100% owner of all remaining Alliance
assets and operations. (See "Split-up of Alliance Telecommunications
Corporation" below.) The disclosures in this report related to prior periods
have been restated to reflect the Company's continuing operations.
Critical Accounting Policies
The presentation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reporting of the Company's operating results and financial position.
The estimates and assumptions used in the Company's financial statements are
based upon management's evaluation of the relevant facts and circumstances as of
the time of the financial statements. These estimates are often difficult,
subjective and complex. Actual results could differ from the estimates. HCC also
gives accounting recognition to the actions of federal and state regulatory
authorities where appropriate as prescribed by SFAS No. 71.
Revenue recognition: Revenues are recognized when earned, regardless of the
period in which they are billed. Network access revenues are furnished in
conjunction with interexchange carriers and are determined by cost separation
studies and nationwide average schedules. Revenues include estimates pending
finalization of cost studies. Network access revenues are based upon interstate
tariffs filed with the Federal Communications Commission by the National
Exchange Carriers Association and state tariffs filed with state regulatory
agencies. Management believes recorded revenues are reasonable based on
estimates of final cost separation studies, which are typically settled within
two years.
Allowance for Doubtful Accounts: The allowance for doubtful accounts is an
estimate based on specifically identified problem accounts and historical
collection experience. Specific accounts are evaluated where the Company has
information that the customer may not be able to meet its financial obligations,
where payment is delinquent or where charges are in dispute. Reserves are
reevaluated and adjusted as information affecting the accounts is received. If
circumstances change, recoverability of amounts due the Company could be
materially affected.
Property, plant and equipment: The Company regularly reviews the carrying value
of its fixed assets for impairment. Carrying values are estimated based on
expected future cash flows and/or established market valuations of other similar
assets. Depreciation is calculated using the straight-line method based on the
estimated useful lives of the various asset classes. Reserves established for
asset retirement obligations have not been significant.
Goodwill and intangible assets: Effective January 1, 2002 the Company adopted
SFAS No. 142, "Goodwill and Other Intangible Assets". Under the provisions of
this accounting standard, goodwill and intangible assets with indefinite useful
lives are no longer amortized but are instead tested for impairment on at least
an annual basis. The goodwill impairment test requires the Company to determine
the fair value of its reporting units. The valuation is estimated based on
access line and customer valuations and cash flow multiple valuations the
Company considers appropriate in the current marketplace. If circumstances or
assumptions supporting these estimates change, the carrying value of the
Company's goodwill could be materially affected.
18
Income taxes: The Company estimates its income tax expense for each jurisdiction
in which it operates. The process includes apportioning the Company's income
among the jurisdictions, estimating current tax liabilities and establishing
deferred tax assets and liabilities. Deferred taxes are calculated where the
carrying amounts of assets and liabilities are different for financial and tax
reporting purposes. Valuation allowances are recorded in the tax accounts for
amounts management believes may not be recoverable in future periods.
Results of Operations
2004 Compared to 2003
Revenues from continuing operations decreased 2% to $31,570,000 in 2004 from
$32,322,000 in 2003. The revenue breakdown was as follows:
2004 2003
------------ ------------
Plain old telephone service ("POTS"):
Local network $ 6,201,326 $ 6,117,238
Network access revenues:
Long distance providers (including NECA) 13,579,375 14,196,136
Universal service fund support 1,743,721 1,879,119
------------ ------------
Total network access revenues 15,323,096 16,075,254
------------ ------------
Total POTS revenues 21,524,422 22,192,492
------------ ------------
Other services:
Video services 3,324,588 3,579,773
Internet services 3,150,089 2,647,156
Other nonregulated services:
Fiber leases 657,022 682,521
Wireless sales commissions 495,704 316,337
Directory revenues 529,796 491,902
Retail sales 469,609 522,269
Long distance service sales commissions 382,936 381,825
Customer equipment installation and repair 379,755 434,435
Billing and collection 169,378 212,622
Equipment rent 126,130 118,292
Engineering services 70,378 305,423
All other revenues 289,963 437,381
------------ ------------
Total nonregulated services revenue 3,570,671 3,903,007
------------ ------------
Total other service revenues 10,045,348 10,129,936
------------ ------------
Total revenue $ 31,569,770 $ 32,322,428
============ ============
Total POTS revenues decreased $668,000 or 3%. Local network revenues increased
$84,000 or 1%. The increase was primarily due to increased revenues from CLASS
service features (such as caller identification, call waiting, call forwarding
and other related services) and increased extended area service ("EAS") revenues
in one exchange. EAS enables customers to call neighboring telephone systems
toll free in exchange for a flat monthly fee. The Company increased the rates
charged for CLASS services during the 2003 period. The Company's access lines
count declined 1% in 2004. The number of access lines served fell due to
substitution of cellular phones for landline phones by customers and the reduced
number of second lines being used for dial-up internet service.
Network access revenues decreased $752,000 or 5%. The Company's access minutes
provided to other telecommunications carriers in 2004 and 2003 were as follows:
Access minutes of use 2004 2003
- --------------------- --------------- --------------
Wireline carriers 109,500,000 114,900,000
Wireless carriers 23,200,000 17,500,000
--------------- --------------
132,700,000 132,400,000
=============== ==============
The revenue decrease was due to lower network access revenues from wireline
carriers, which reflected the declining minutes of use by these providers.
However, access revenues from wireless communications providers were also lower,
despite the increased minutes they used, due to the impact of the lower rates
included in new interconnection agreements that have been negotiated between the
Company and selected wireless carriers. Access revenues in 2003 were higher than
normal due to greater than anticipated recovery of bankruptcy reserves the
Company established against its MCI/World Com receivables in 2002. Universal
service support funding decreased $135,000 or 7%. Increases in support funds the
Company received in areas where it has newly installed Next Level equipment were
offset by decreases in support for other areas.
19
Total revenues from other services decreased $85,000 or 1%. Revenues from video
(cable television) services declined $255,000 or 7%. Video service revenues in
2004 were reduced by the sales of seven systems serving 2,080 subscribers during
the second quarter of 2003 and by the sale of the Hudson Township WI system in
June 2004. Revenues from internet services increased $503,000 or 19%, due to a
40% increase in the number of customers subscribing to high-speed digital
subscriber line ("DSL") service. At December 31, 2004 the Company had 3,881 DSL
customers and 6,679 dial-up internet customers, compared to 2,778 DSL customers
and 7,464 dial-up customers in December 2003. The DSL customer growth was
facilitated by the deployment of broadband equipment manufactured by Next Level
Communications, Inc. in the Company's Sleepy Eye, MN exchange in 2002 and 2003.
This equipment makes it possible to deliver voice, video and high speed internet
services to the customer over the same circuit.
Revenues from other nonregulated services declined $332,000 or 9%. The revenue
decline was due to lower fees from engineering services, lower billing and
collections revenues from long distance carriers and lower revenues from leases
of fiber optic facilities, which offset higher wireless sales commissions. The
Company sold its engineering service company in July 2004.
Operating costs and expenses were $24,588,000 in 2004, an increase of $222,000
or 1% from 2003. The breakdown of costs and expenses was as follows:
2004 2003
------------ ------------
Plain old telephone service ("POTS"):
Plant operations, excluding depreciation $ 4,335,140 $ 4,511,421
Depreciation and amortization 6,147,428 6,123,086
Customer operations 1,406,020 1,359,408
General and administrative 3,475,741 3,435,078
Other costs and expenses 752,647 413,019
------------ ------------
Total POTS costs and expenses 16,116,976 15,842,012
------------ ------------
Other services:
Plant operations 3,962 5,290
Depreciation and amortization 1,842,788 1,728,425
Customer operations 211,747 192,701
General and administrative 394,070 1,096,658
Other costs and expenses:
Video services expenses 3,059,031 3,026,613
Internet expenses 959,834 910,900
Other costs and expenses 1,999,182 1,563,183
------------ ------------
Total other service costs and expenses 8,470,614 8,523,770
------------ ------------
Total costs and expenses $ 24,587,590 $ 24,365,782
============ ============
Total POTS costs and expenses increased $275,000 or 2%. Plant operations
expenses decreased $176,000 or 4% reflecting a reduced headcount in 2004 and
that 2003 included severance charges for employee headcount reductions. Customer
operations expenses increased $47,000 or 3%. General and administrative expenses
increased $41,000 or 1%. The 2004 period included $305,000 in expenses for
write-offs of accounts receivable for access services provided to wireless
telephone service providers. Operating income in 2004 from POTS was $5,407,000,
a decrease of 15% from $6,350,000 in 2003.
Total costs and expenses for other services decreased $53,000 or 1% reflecting
the following: Video service expenses increased $32,000 or 1% as expense
reductions due to sales of cable television systems in 2004 and 2003 were offset
by higher fee payments to programming providers. Internet expenses increased
$49,000 or 5%. General and administrative expenses decreased $703,000 from 2003
mainly due to the sale of the Company's engineering business in 2004. 2003
expenses also compared unfavorably due to costs incurred in the Split-Up
Transaction. Depreciation and amortization expenses increased $114,000 or 7% due
to depreciation on new plant investments. Operating income in 2004 from other
services was $1,575,000, a decrease of 2% from $1,606,000 in 2003. Consolidated
operating income from continuing operations decreased 12% to $6,982,000.
20
Interest expenses for 2004 decreased $534,000 due to lower interest rates on
borrowings from CoBank. A significant portion of the Company's CoBank debt moved
from a higher fixed interest rate to lower floating market rates during the
fourth quarter of 2003. Interest and dividend income increased $53,000 due to
higher cash balances available for investment.
Income from the Company's investment in Midwest Wireless Holdings, LLC was
$2,766,000 in 2004 compared to $2,148,000 in 2003. Midwest Wireless operations
in 2004 benefited from determinations by regulators that its operations were
eligible to receive universal service high cost support funds. The Company had
income from other unconsolidated investments of $483,000 in 2004 compared to
$96,000 in 2003. In 2004, the Company sold the assets of the cable television
system serving Hudson Township, WI for a gain of $72,000 and sold the assets of
Hastad Engineering Company for a gain of $13,000. The Company sold two groups of
cable television systems during the second quarter of 2003 for a total gain of
$1,081,000.
Income from continuing operations before income taxes and minority interest
decreased 5% to $7,894,000. Income tax expense decreased to $3,250,000 in 2004
from $3,316,000 in 2003. The Company's tax rate varies from the federal tax rate
due to state income taxes. The Company's state tax rate varies from year to year
due to variability in apportioning earnings over the various taxing
jurisdictions. Income before minority interest in the earnings of Alliance was
$4,644,000 in 2004 compared to $4,957,000 in 2003. Minority interests in
earnings of Alliance from continuing operations in 2003 were $660,000. Income
from continuing operations totaled $4,644,000 compared to $4,297,000 in 2003.
Income from discontinued operations before minority interest in 2003 was
$989,000. Minority interests in those earnings were $316,000. The Company
recorded a gain on the split-up of Alliance, net of income taxes, of $210,000 in
2003. The Company had net income of $4,644,000 in 2004 compared to $5,179,000 in
2003.
2003 Compared to 2002
Revenues from continuing operations increased 6% to $32,322,000 in 2003 from
$30,517,000 in 2002. The revenue breakdown was as follows:
2003 2002
------------ ------------
Plain old telephone service ("POTS"):
Local network $ 6,117,238 $ 5,874,728
Network access revenues:
Long distance providers (including NECA) 14,196,136 13,845,948
Universal service fund support 1,879,119 1,457,909
------------ ------------
Total network access revenues 16,075,254 15,303,857
------------ ------------
Total POTS revenues 22,192,492 21,178,585
Other services:
Video services 3,579,773 3,698,790
Internet services 2,647,156 1,944,911
Other nonregulated services:
Fiber leases 682,521 800,039
Wireless sales commissions 316,337 333,714
Directory revenues 491,902 404,136
Retail sales 522,269 407,870
Long distance service sales commissions 381,825 250,937
Customer equipment installation and repair 434,435 232,225
Billing and collection 212,622 289,723
Equipment rent 118,292 119,523
Engineering services 305,423 438,534
All other revenues 437,381 417,803
------------ ------------
Total nonregulated services revenue 3,903,007 3,694,504
------------ ------------
Total other service revenues 10,129,936 9,338,205
------------ ------------
Total revenue $ 32,322,428 $ 30,516,790
============ ============
21
Total POTS revenues increased $1,014,000 or 5%. Local network revenues increased
$243,000 or 4%. The increase was primarily due to increased revenues from CLASS
service features and custom calling. The Company increased the rates for these
services in 2003. The Company's access lines count was 29,882 at December 31,
2003, a decrease of 1% from 2002. The number of access lines served fell due to
substitution of cellular phones for landline phones by customers and the reduced
number of second lines being used for dial-up internet service.
Network access revenues increased $771,000 or 5% to $16,075,000 in 2003.
Universal service support funds received in 2003 increased $421,000 over 2002
due to investment in plant and equipment in the Sleepy Eye and Pine Island
telephone exchanges. The Company's 2002 access revenues also reflected $437,000
in write-offs associated with the bankruptcy filings of World Com and Global
Crossings.
Total revenues from other services increased $792,000 or 8% reflecting the
following: Video service revenues decreased 3% to $3,580,000 in 2003 due to the
sales of seven cable television systems serving 2,080 subscribers during the
June 30 quarter. The lost revenues were offset in part by growth in Sleepy Eye
and Pine Island, where broadband video services are available to customers.
Revenues from internet services increased 36% to $2,647,000 due to increased
availability of broadband DSL services to customers. The number of customers
purchasing DSL services from the Company increased 74% in 2003, while the number
of dial-up customers declined 1%.
Revenues from other nonregulated services increased 6% to $3,903,000 due to
higher retail sales, higher revenues from reselling long distance services and
higher directory revenues which offset lower revenues from leases of fiber optic
transport facilities, lower billing and collections revenues and lower fees from
engineering services.
Operating costs and expenses were $24,366,000 in 2003, an increase of $490,000
or 2% from 2002. The breakdown of costs and expenses was as follows:
2003 2002
------------ ------------
Plain old telephone service ("POTS"):
Plant operations, excluding depreciation $ 4,511,421 $ 4,069,318
Depreciation and amortization 6,123,086 6,259,750
Customer operations 1,359,408 1,651,034
General and administrative 3,435,078 3,434,099
Other costs and expenses 413,019 268,133
------------ ------------
Total POTS costs and expenses 15,842,012 15,682,334
------------ ------------
Other services:
Plant operations 5,290 11,098
Depreciation and amortization 1,728,425 1,727,900
Customer operations 192,701 199,051
General and administrative 1,096,658 998,143
Other costs and expenses:
Video services expenses 3,026,613 3,183,933
Internet expenses 910,900 1,019,121
Other costs and expenses 1,563,183 1,053,839
------------ ------------
Total other service costs and expenses 8,523,770 8,193,085
------------ ------------
Total costs and expenses $ 24,365,782 $ 23,875,419
============ ============
22
Total POTS costs and expenses increased $160,000 or 1% reflecting the following:
Plant operations expenses, excluding depreciation, increased 11% to $4,511,000
in 2003 due to reduced capitalization of labor expenditures for new construction
projects and severance charges for employee headcount reductions. Depreciation
and amortization expenses decreased $137,000 due to lower expense on switching
equipment at a Wisconsin subsidiary. Customer operations expenses decreased 18%
to $1,359,000 in 2003 due to employee headcount reductions. General and
administrative expenses increased $1,000. Other costs and expenses increased
$145,000 due to increased state and local taxes on telephone properties and
services. Operating income in 2003 from POTS was $6,350,000, an increase of 16%
from $5,496,000 in 2002.
Total costs and expenses for other services increased $331,000 or 4% reflecting
the following. Video service expenses declined 5% to $3,027,000 in due to sales
of cable television systems, which offset increases in the fees the Company pays
to programming providers. Internet expenses decreased 11% to $911,000 in 2003
due to lower fees from "backbone" suppliers. General and administrative expenses
increased $99,000 from 2003 due to costs incurred in breaking up Alliance.
Depreciation and amortization expenses increased $1,000 as decreases associated
with sales of cable television properties were offset by depreciation on new
plant investments. Other costs and expenses increased $509,000 or 48% due to
higher selling expenses and product costs associated with retail sales and
wireless commissions. Operating income in 2003 from other services increased 40%
to $1,606,000. Consolidated operating income from continuing operations
increased 20% to $7,957,000.
Consolidated interest expenses decreased $56,000 to $3,401,000 as lower interest
rates on variable rate loans were offset by charges on new loan funds drawn down
from the Rural Utilities Service and the Rural Telephone Bank.
Income from the Company's investment in Midwest Wireless Holdings LLC decreased
to $2,148,000 in 2003 from $2,261,000 in 2002. Midwest Wireless' 2003 income
declined due to decreases in roamer service revenues and increased costs for
converting customers from TDMA to CDMA technology. Income from investments in
other unconsolidated affiliates was $96,000 in 2003 compared to a loss of
$56,000 in 2002. Interest and dividend income increased to $392,000 in 2003 from
$334,000 in 2002 due to increases in the Company's cash balances available for
investment. The Company recorded gains on sales of cable television systems
totaling $1,081,000 in the 2003 period. An impairment loss on the Company's
marketable securities portfolio of $134,000 was recorded in 2002.
Income from continuing operations before income taxes and minority interest
increased to $8,273,000 in 2003 from $5,589,000 in 2002. The Company's effective
income tax rate was 40% in 2003 compared to 44% in 2002. The Company's tax rate
declined due to the reduced effects of state income taxes caused by changes in
apportionment. Minority interest on earnings of Alliance's continuing operations
was $660,000 for the period of 2003 prior to the Split-Up Transaction compared
to $781,000 for all of 2002. Income from continuing operations increased to
$4,297,000 in 2003 from $2,324,000 in 2002.
Income from discontinued operations before minority interest and gain on the
Split-Up Transaction in 2003 was $989,000. Minority interests in those earnings
were $316,000. Income from discontinued operations in 2002 was $1,957,000.
Minority interests in those earnings were $626,000. The Company recorded a gain,
net of income taxes, of $210,000 on the Alliance breakup transactions. 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 of $3,147,000, net
of income taxes and minority interest. The Company had net income of $5,179,000
in 2003 compared to $508,000 in 2002.
23
Liquidity and Capital Resources
Operations
Cash flows from consolidated operating activities (including the activities of
discontinued operations up to the Alliance split-up date) were $10,464,000,
$12,953,000 and $13,116,000 in 2004, 2003 and 2002, respectively. At December
31, 2004, the Company's cash and cash equivalents totaled $19,981,000 compared
to $16,581,000 at December 31, 2003. Working capital at December 31, 2004 was
$17,601,000 compared to $13,314,000 at December 31, 2003. The current ratio was
2.7 to 1 at December 31, 2004 compared to 2.1 to 1 at December 31, 2003.
The Company makes periodic improvements to its facilities to provide up-to-date
telecommunications services to its customers. Plant additions in support of POTS
operations were $3,243,000, $2,872,000 and $5,997,000 in 2004, 2003 and 2002,
respectively. Plant additions for nonregulated operations in 2004, 2003 and 2002
were $940,000, $784,000 and $1,732,000 respectively. Plant additions for
discontinued operations up to the Alliance split-up date were $257,000 and
$1,536,000 in 2003 and 2002 respectively. Plant additions for 2005 are expected
to total $7,037,000. These plant additions will upgrade the Company's telephone
equipment to allow local number portability and other advanced
telecommunications services, expand telecommunications services into new
construction developments and increase usage of Next Level broadband equipment
and high capacity fiber optics in the telephone network.
Long-Term Obligations and Commitments
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 $2,893,000, $5,998,000 and
$2,954,000 in 2004, 2003 and 2002, respectively. The average interest rate on
outstanding RUS and RTB loans is 5.0%. At December 31, 2004 unadvanced loan
commitments from the RUS and RTB to Hector's and Alliance's LEC subsidiaries
totaled $24,127,000.
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. At December 31, 2004, $12,223,000 of
subsidiaries' retained earnings was available for dividend payments to HCC. At
December 31, 2004, $37,198,000 of HCC's retained earnings was not available to
pay dividends to shareholders due to restrictions in the debt agreements. It is
the Company's plan, in so far as practical, to maintain its cash balances at the
subsidiary level to support their operations.
The Company incurred significant debt in 1996 to finance Alliance's acquisition
of Ollig Utilities Company. In concert with the Split-Up Transaction the Company
repaid the 1996 acquisition loan with proceeds from a new term loan provided to
Hector by CoBank. The loan is secured by a pledge of the stock of Hector's
subsidiary companies. Interest rates on long-term portions of the loan are fixed
through 2007, while the non-fixed portion floats at short-term market rates. The
average rate on the total loan was approximately 5.4% at December 31, 2004.
Principal payments are made quarterly and will continue until April 2013. The
outstanding balance on this loan at December 31, 2004 was $23,375,000. 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, Hector
owns stock in the bank. Its investment in CoBank stock was $2,762,000 at
December 31, 2004.
24
As part of financing its ownership interest in Alliance in 1996, Hector received
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 loan
was repaid in July 2003 as part of the CoBank refinancing.
In addition to its debt agreements, Hector and its subsidiaries have entered
into contracts with suppliers to provide switching services and fiber optic
transport facilities and other services. The Company's cash payments due for
these obligations are as follows (interest payments are estimated using December
31, 2004 interest rates):
Long-Term Interest Operating
Total Debt Payments Leases
------------ ------------ ------------ -------------
2005 $ 9,817,500 $ 6,532,000 $ 2,959,000 $ 326,500
2006 9,277,300 6,445,000 2,658,000 174,300
2007 9,124,100 6,717,000 2,347,000 60,100
2008 8,815,200 6,995,000 1,782,000 38,200
2009 8,808,200 7,327,000 1,442,000 39,200
After 2009(1) 29,625,580 26,420,480 3,177,000 28,100
------------ ------------ ------------ -------------
$ 75,467,880 $ 60,436,480 $ 14,365,000 $ 666,400
============ ============ ============ =============
(1) The Company has an obligation to pay Broadband Visions LLC ("BBV") $3,000
per month for fiber optic transport facilities until such time that the Company
is not a member of BBV. This obligation is reflected in the table for each year
from 2005 through 2009. No amount is included after 2009.
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 2004 the Company invested $321,000 in the common stock of two other Minnesota
based telecommunications companies and may make additional investments if market
conditions warrant.
The Company is an investor in partnerships and limited liability companies that
provide wireless telecommunications services, fiber optic transport services,
directory services, competing local exchange (CLEC) services and video headend
services. Cash distributions to the Company from these investments have
generally been limited to amounts necessary to pay income taxes. The Company's
participation in these ventures makes certain services available to customers
which would otherwise be beyond the Company's means to provide. The Company
expects to make additional investments of this type as opportunities arise.
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 is 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.
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. No
stock repurchases occurred in 2004. In 2003 the Company purchased and retired
1,106 shares at a cost of $17,000. In 2002 the Company purchased and retired
70,239 shares at a cost of $737,000. At December 31, 2004 215,000 shares could
be repurchased under outstanding Board authorizations.
25
Proceeds to the Company from exercises of employee stock options and employee
stock purchase plan shares totaled $1,445,000, $431,000 and $320,000 in 2004,
2003 and 2002, respectively.
Dividends
HCC paid a cash dividend of $.05 per share on its common stock and preferred
stock on December 15, 2004, the first cash dividend since inception, and has
adopted a policy of paying quarterly dividends. 0HCC has no obligation to pay
dividends on its preferred stock except that preferred stock receives the same
per share dividend as common stock.
Sales of Cable Television Systems and Other Business
The Company continuously evaluates its investments in business properties. These
evaluations have led it to sell or discontinue investments where it does not
believe it can earn an adequate return or which do not fit its strategic plan.
In 2004 the Company sold the assets of Hastad Engineering Company to Finley
Engineering Company. Proceeds from the sale totaled $48,390 and the Company
recorded a gain of $12,805. In 2004 the Company sold the assets of the cable
television system serving Hudson Township, WI to Baldwin Telecom Inc. for
$193,000 of cash and a note receivable of $395,000. The Company recorded a gain
on the sale of $72,466. In 2003 the Company sold four systems in rural North
Dakota serving 930 subscribers to MLGC, LLC for $200,000 of cash and a note
receivable of $650,000. The Company sold systems serving 1,150 subscribers in
three communities surrounding the Fargo, ND - Moorhead, MN area to Cable One,
Inc. for $1,545,000 of cash. The Company is considering sales of additional
cable television properties in areas where it does not plan to also provide
telephone and internet services.
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.
Split-Up Transactions
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 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 completed the Split-Up Transactions on July 7, 2003. As agreed among
the parties, in the split-up, Golden West exchanged its 20% ownership interest
in Alliance for all of the outstanding stock of Sioux Valley Telephone Company,
which included a pro rata share of Alliance's ownership in Midwest Wireless
Holdings, LLC and certain other Alliance assets. ACCI exchanged its 12%
ownership interest in Alliance for all of the outstanding stock of Hills
Telephone Company, which included a pro rata share of Alliance's ownership in
Midwest Wireless Holdings, LLC and certain other Alliance assets. Immediately
prior to the breakup Sioux Valley and Hills paid a dividend to Alliance of
approximately $12,849,000. The dividend proceeds were applied to repay a portion
of Alliance's acquisition loan from CoBank. Concurrent with the split-up, the
balance of Alliance's debt to CoBank and the balance of the Company's debt to
Rural Telephone Finance Cooperative were retired using proceeds from a new
$26,813,000 loan from CoBank to Hector Communications Corporation. A number of
other stock and asset transfers also occurred among Alliance and its
subsidiaries prior to the split-up in order to satisfy various regulatory and
lender requirements.
The Company believes the Split-Up Transactions are tax-free under Section 355 of
the Internal Revenue Code. The Company also believes that related internal stock
and asset transfers that occurred prior to the split-up are tax-free under
Section 355, related Code provisions and the consolidated return regulations,
although no private letter ruling was sought from the IRS in connection with the
split-up. Prior to conducting the Split-Up Transactions, the parties entered
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 Split-Up
Transactions which relate to commitments, events or circumstances in effect as
of the date of the Split-Up Transactions.
26
Acquisitions
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 ability to accommodate expense increases due to inflation are
constrained by the regulatory environment in which its POTS segment operates.
The Company's local exchange telephone companies are subject to the jurisdiction
of Minnesota, North 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 December 2004, the FASB issued SFAS No. 123 (revised 2004), "Shared-Based
Payment" (SFAS 123R), which replaces SFAS No. 123, "Accounting for Stock-Based
Compensation," (SFAS 123) and supercedes APB Opinion No. 25, "Accounting for
Stock Issued to Employees." SFAS 123R requires all share-based payments to
employees, including grants of employee stock options, to be recognized in the
financial statements based on their fair values beginning with the first interim
or annual period after June 15, 2005, with early adoption encouraged. The pro
forma disclosures previously permitted under SFAS 123 will no longer be an
alternative to financial statement recognition. The Company is required to adopt
SFAS 123R in the third quarter of fiscal 2005, beginning July 1, 2005. Under
SFAS 123R, the Company must determine the appropriate fair value model to be
used for valuing share-based payments, the amortization method for compensation
cost and the transition method to be used at the date of adoption. The
transition methods include prospective and retroactive adoption options. Under
the retroactive option, prior periods may be restated either as of the beginning
of the year of adoption or for all periods presented. The prospective method
requires that compensation expense be recorded for all unvested stock options at
the beginning of the first quarter of adoption of SFAS 123R, while the
retroactive method would record compensation expense for all unvested stock
options beginning with the first period restated. The Company is evaluating the
requirements of SFAS 123R, has not yet determined the method of adoption, and
has not determined what impact the adoption of SFAS 123R will have on its
consolidated results of operations and earnings per share. It has not determined
whether adoption will result in amounts that are similar to the current pro
forma disclosures under SFAS No. 123.
In March 2004, the FASB Emerging Issues Task Force issued EITF 03-16 "Accounting
for Investments in Limited Liability Companies". The EITF states that an
investment in a limited liability company ("LLC") that maintains a specific
ownership account for each investor should use the equity method of accounting
unless the ownership interest is so minor the investor has virtually no
influence over operating and financial policies. Practice has generally viewed
investments of more than three to five percent to be more than minor. The rule
is effective for periods beginning after June 15, 2004. Adoption of the rule did
not have a material effect on the Company's financial statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company does not use derivative financial instruments in its operations or
investment portfolio. Its operations are not subject to risks associated with
changes in the value of foreign currencies. Portions of the Company's long-term
debt have variable interest rates based on the lenders' cost of money. The
Company has investments in money market funds and mutual funds that earn
interest at prevailing market rates. In the opinion of management, the Company
does not have a material exposure to loss caused by market risk.
27
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
(a) FINANCIAL STATEMENTS
REPORT OF MANAGEMENT
The management of Hector Communications Corporation and its subsidiary companies
is responsible for the integrity and objectivity of the financial statements and
other financial information contained in the annual report. The financial
statements and related information were prepared in accordance with accounting
principles generally accepted in the United States of America and include
amounts that are based on management's informed judgments and estimates.
In fulfilling its responsibilities for the integrity of financial information,
management maintains accounting systems and related controls. These controls
provide reasonable assurance, at appropriate costs, that assets are safeguarded
against losses and that financial records are reliable for use in preparing
financial statements. Management recognizes its responsibility for conducting
the Company's affairs according to the highest standards of personal and
corporate conduct.
The Audit Committee of the Board of Directors, composed solely of outside
directors, meets with the independent auditors and management periodically to
review accounting, auditing, financial reporting and internal control matters.
The independent auditors have free access to this committee, without management
present to discuss the results of their audit work and their opinion on the
adequacy of internal financial controls and the quality of financial reporting.
Curtis A. Sampson Charles A. Braun
Chairman and Chief Executive Officer Chief Financial Officer
28
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and Board of Directors
Hector Communications Corporation
We have audited the accompanying consolidated balance sheets of Hector
Communications Corporation and subsidiaries as of December 31, 2004 and 2003,
and the related consolidated statements of income, comprehensive income,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 2004. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits. We did not audit the financial
statements of Midwest Wireless Holdings L.L.C., a limited liability company, the
investment in which, as discussed in Note 5 to the consolidated financial
statements, is accounted for by the equity method of accounting. The investment
in Midwest Wireless Holdings L.L.C. was $15,380,543 and $13,349,155 as of
December 31, 2004 and 2003 and the equity earnings in its net income was
$2,765,887, $2,148,444 and $2,261,420 for the years ended December 31, 2004,
2003 and 2002. The financial statements of Midwest Wireless Holdings L.L.C. were
audited by other auditors whose report has been furnished to us, and our
opinion, insofar as it relates to the amounts included for Midwest Wireless
Holdings L.L.C., is based solely on the report of the other auditors.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, based on our audits and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the financial position of Hector Communications Corporation
and subsidiaries as of December 31, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004 in conformity with accounting principles generally accepted in
the United States of America.
As described in Note 4 to the consolidated financial statements, effective
January 1, 2002 the Company adopted Statement of Financial Accounting Standards
No. 142, "Goodwill and Other Intangible Assets".
Olsen Thielen & Co., Ltd.
St. Paul, Minnesota
February 18, 2005
29
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31
-----------------------------
2004 2003
------------- -------------
CURRENT ASSETS:
Cash and cash equivalents $ 19,980,506 $ 16,581,315
Construction fund (Note 9) 3,944,684 3,240,073
Accounts receivable (net of allowance for
doubtful accounts of $1,026,000 and $538,000,
respectively) 3,017,569 4,140,052
Materials, supplies and inventories (Note 1) 820,081 944,099
Other current assets 250,276 285,071
------------- -------------
TOTAL CURRENT ASSETS 28,013,116 25,190,610
PROPERTY, PLANT AND EQUIPMENT,net (Notes 1 and 3) 40,040,493 43,088,106
INVESTMENTS AND OTHER ASSETS:
Excess of cost over net assets acquired (Note 4) 30,921,094 31,691,927
Investment in Midwest Wireless
Holdings LLC (Note 5) 15,380,543 13,349,155
Investments in other unconsolidated
affiliates (Note 6) 3,304,726 3,053,999
Other investments (Notes 1 and 7) 6,880,549 6,275,894
Other assets (Notes 1 and 4) 382,322 409,664
------------- -------------
TOTAL OTHER ASSETS 56,869,234 54,780,639
------------- -------------
TOTAL ASSETS $ 124,922,843 $ 123,059,355
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Notes payable and current portion of
long-term debt (Note 9) $ 6,352,000 $ 6,537,800
Accounts payable (Note 12) 2,072,722 1,557,969
Accrued expenses 1,936,188 2,238,587
Income taxes payable 51,701 1,541,830
------------- -------------
TOTAL CURRENT LIABILITES 10,412,611 11,876,186
LONG-TERM DEBT, less current portion (Note 9) 54,084,480 57,529,378
DEFERRED INVESTMENT TAX CREDITS (Note 8) 3,340 8,999
DEFERRED INCOME TAXES (Note 8) 5,460,554 4,902,870
DEFERRED COMPENSATION (Note 11) 749,128 698,254
COMMITMENTS AND CONTINGENCIES (Note 9)
STOCKHOLDERS' EQUITY: (Notes 1, 9 and 10)
Preferred stock, par value $1.00 per share;
3,000,000 shares authorized:
Convertible Series A, 157,800 and 220,100
shares issued and outstanding 157,800 220,100
Common stock, par value $.01 per share;
10,000,000 shares authorized; 3,723,390 and
3,515,482 shares issued and outstanding 37,234 35,155
Additional paid-in capital 15,621,048 13,828,414
Retained earnings 38,359,117 33,908,774
Accumulated other comprehensive income (Note 7) 37,531 51,225
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TOTAL STOCKHOLDERS' EQUITY 54,212,730 48,043